Affymetrix 10-Q 2011
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
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COMMON SHARES OUTSTANDING ON OCTOBER 28, 2011: 70,473,456
(In thousands, except per share amounts)
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2011
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, 2010, as filed with the Securities and Exchange Commission on February 28, 2011.
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 the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. On an on-going basis, management evaluates its estimates including, but not limited to, those related to revenue recognition, long-lived assets, derivative instruments and share-based compensation. The Company bases its estimates on historical experience and on various other market-specific and other relevant assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 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. 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 adopted Auditing Standards Update (“ASU”) No. 2009-13, Revenue Recognition (ASC Topic 605) — Multiple-Deliverable Revenue 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 and the change in accounting principle did not have a material impact on the Company’s financial results.
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 from equipment service contracts are recognized ratably over the life of the contract.
Revenue from scientific and DNA analysis services are recognized upon shipment of the required data to the customer.
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.
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.
License revenue is generally recognized upon the execution of an agreement or is recognized ratably over the period of expected performance.
Revenue from royalties is recognized under the terms of the related agreement.
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.
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 (Loss) Income Per Common Share
Basic net (loss) income 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 net (loss) income 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 (loss) income per common share (in thousands except per common share amounts):
Diluted earnings per share, if any, 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 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) (“OCI”) 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. Refer to Note 3. “Financial Instruments – Investments in Debt and Equity Securities” for further information.
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 owns approximately 6% interest in a limited partnership investment fund that is accounted for under the equity method.
All of the Company’s marketable and non-marketable securities are subject to quarterly reviews for impairment that is deemed to be other-than-temporary (“OTTI”). An investment is considered other-than-temporarily impaired when its fair value is below its amortized cost and (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 from the investment is not expected to recover the entire amortized cost basis. Below is a summary of the Company’s analysis:
Derivative Financial Instruments
The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. Derivatives that are not defined as hedges must be adjusted to fair value through earnings.
For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the Company measures the effectiveness of the derivative instruments by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item. The effective portion of the gain or loss on the derivative instrument is reported as a component of OCI in stockholders’ equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument is recognized in current earnings. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on hedged transactions. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the net investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. Refer to Note 3. “Financial Instruments – Foreign Currency Derivatives” for further information.
Recent Accounting Pronouncements
In June of 2011, Accounting Standards Codification Topic 220, Comprehensive Income was amended to increase the prominence of items reported in other comprehensive income. Accordingly, a company can present all non-owner changes in stockholders’ equity either in a single continuous statement of comprehensive income or in two separate but consecutive statements The Company plans to adopt this guidance as of January 1, 2012 on a retrospective basis and does not expect the adoption thereof to have a material effect on its consolidated financial statements.
NOTE 2—FAIR VALUE MEASUREMENTS
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 considers 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:
The Company considers an active market to be one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis, and views an inactive market as one in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers. Where appropriate, the Company’s or the counterparty’s non-performance risk is considered in determining the fair values of liabilities and assets, respectively.
The fair values of the Company’s Level 1 and Level 2 available-for-sale securities are based on quoted market prices and are included in cash and cash equivalents, available-for-sale securities—short-term portion and available-for-sale securities—long-term portion on the Company’s Condensed Consolidated Balance Sheets based on the maturity of the securities. During the three months ended September 30, 2011, the Company held Level 3 assets that consisted of senior guaranteed notes that were transferred from Level 2 to Level 3 as of the end of June 30, 2011 due to the lack of frequency of pricing information available. At the time of the transfer, the securities had a fair value of $4.1 million and were in an unrealized gain position. The senior guaranteed notes were issued by the National Credit Union Administration (“NCUA”), collateralized by previously-issued residential mortgage-backed securities and fully guaranteed by the full faith and credit of the United States. Since there is no public active market for these securities, the Company determined the fair value using a discounted cash flow model based on estimated interest rates, timing and amount of cash flows, credit and liquidity premiums and yield percentages. The Company sold its Level 3 assets for a price above par during the three months ended September 30, 2011. As of September 30, 2011 and December 31, 2010, the Company held no financial assets or liabilities requiring Level 3 classification.
The fair value of the Company’s foreign currency derivative assets and liabilities is determined based on the estimated consideration the Company would pay or receive to terminate these agreements on the reporting date. The foreign currency derivative assets and liabilities are located in other current assets and accrued expenses, respectively, in the Condensed Consolidated Balance Sheets.
The fair value of the Company’s convertible notes is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for the convertible notes of the same remaining maturities. As of September 30, 2011 and December 31, 2010, the estimated fair value of the convertible notes was $95.5 million.
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, 2011 and December 31, 2010 (in thousands):
* Included in the Company’s available-for-sale securities were mortgage-backed investments totaling approximately 5% and 4% of the total portfolio as at September 30, 2011 and December 31, 2010, respectively.
The following table presents a reconciliation of assets measured at fair value on a recurring basis, using significant unobservable inputs (Level 3) for the nine months ended September 30, 2011 (in thousands):
NOTE 3—FINANCIAL INSTRUMENTS
Investments in Debt and Equity Securities
The following is a summary of available-for-sale securities as of September 30, 2011 (in thousands):
The following is a summary of available-for-sale securities as of December 31, 2010 (in thousands):
* Included in the Company’s available-for-sale securities were mortgage-backed investments totaling approximately 5% and 4% of the total portfolio as at September 30, 2011 and December 31, 2010, respectively.
Realized gains for the nine months ended September 30, 2011 and 2010 were less than $0.1 million and $0.6 million, respectively. Realized losses for the nine months ended September 30, 2011 and 2010 were less than $0.1 million and $0.2 million, respectively. Realized gains and losses are included in interest income and other, net in the Condensed Consolidated Statements of Operations. The gross unrealized losses as of September 30, 2011 and 2010 included a mortgage-backed security with a carrying value of $0.6 million that was impacted by the weakening of the global economy and a lack of liquidity in the credit markets, which have not fully recovered. 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 other securities. During the three months ended September 30, 2011, the Company recognized OTTI of $0.5 million on an investment in an equity security due to a significant decline in fair value. The carrying value of this equity security, after recording the OTTI, was $0.3 million as of September 30, 2011. No further OTTI was recognized on any securities during the three and nine months ended September 30, 2010.
As of September 30, 2011 and December 31, 2010, the carrying amounts of the Company’s non-marketable securities, totaling $5.7 million and $6.8 million, respectively, equaled their estimated fair values. Their estimated fair values were based on liquidation and net realizable values.
During the three and nine months ended September 30, 2011, the Company recorded impairment charges totaling $0.2 million and $1.3 million, respectively, primarily related to its limited partnership investment fund. During the nine months ended September 30, 2010, the Company recorded impairment charges on its non-marketable securities totaling $5.3 million, primarily due to declines in the estimated fair value of two investments in private biotechnology companies that were deemed other-than-temporary as a result of the respective price per share paid by investors in the most recent round of financing for the companies, which in each case, was significantly lower than the carrying value of the Company’s investments. 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.
Foreign Currency Derivatives
The Company derives a portion of its revenues in foreign currencies, predominantly in Europe and Japan, as part of its ongoing business operations. In addition, a portion of its assets are held in the nonfunctional currencies of its subsidiaries. The Company enters into foreign currency forward contracts to manage a portion of the volatility related to transactions that are denominated in foreign currencies. The Company’s foreign currency forward contracts are entered into for periods consistent with the related underlying exposures and do not constitute positions that are independent of those exposures. The Company’s accounting policies for these instruments are based on whether the instruments are classified as designated or non-designated hedging instruments. The Company records all derivatives on the Condensed Consolidated Balance Sheets at fair value. The effective portions of designated cash flow hedges are recorded in OCI until the hedged item is recognized in earnings. As of September 30, 2011, the Company’s existing foreign currency forward exchange contracts mature within 12 months. The deferred amount currently recorded in OCI and expected to be recognized into earnings over the next 12 months is a net loss of $0.3 million. Derivatives that are not designated as hedging instruments and the ineffective portions of cash flow hedges are adjusted to fair value through earnings.
Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are reclassified immediately into earnings through other income and expense. Any subsequent changes in fair value of such derivative instruments are reflected in other income and expense unless they are re-designated as hedges of other transactions. The Company has not recognized any net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during 2011.
As of September 30, 2011, the total notional values of the Company’s foreign currency forward contracts that mature within 12 months are as follows (in thousands):
As of December 31, 2010, the Company did not have any unsettled foreign currency contracts in place.
As a result of the use of derivative instruments, the Company is exposed to the risk that the counterparties may be unable to meet the terms of the agreements. To mitigate the risk, the Company only enters into contracts with carefully selected highly-rated major financial institutions. In the event of non-performance by these counterparties, the asset position carrying values of the financial instruments represent the maximum amount of loss that can be incurred, however, no losses as a result of counterparty defaults are expected. The Company does not require and are not required to pledge collateral for these financial instruments. The Company does not enter into foreign currency forward contracts for trading or speculative purposes and is not party to any leveraged derivative instrument.
The following table shows the Company’s foreign currency derivatives measured at fair value as reflected on the Condensed Consolidated Balance Sheets as of September 30, 2011 (in thousands):
The following table shows the pre-tax effect of the Company’s derivative instruments on OCI for the three and nine months ended September 30, 2011 (in thousands):
There were no amounts classified from OCI into the Condensed Statements of Operations during the three and nine months ended September 30, 2011.
The following table shows the pre-tax effect of the Company’s derivative instruments on the Condensed Statements of Operations for the three and nine months ended September 30, 2011 (in thousands):
The following table shows the pre-tax effect of the Company’s derivative instruments on the Condensed Statements of Operations for the three and nine months ended September 30, 2010 (in thousands):
The Company did not have any derivatives designated as cash flow hedges as of September 30, 2010.
NOTE 4—SHARE-BASED COMPENSATION
The Company has a share-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. As of September 30, 2011, the Company had approximately 5.8 million shares of common stock reserved for future issuance under its share-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 share-based compensation expense as follows (in thousands):
As of September 30, 2011, $12.3 million of total unrecognized share-based compensation expense related to non-vested awards is expected to be recognized over the respective vesting terms of each award through 2015. The weighted-average term of the unrecognized share-based compensation expense is 2.6 years. As of September 30, 2011, 0.2 million of the outstanding restricted stock units were performance-based restricted stock units.
The fair value of options was estimated at the date of grant using a Black-Scholes-Merton 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, 2011 and 2010 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, 2011 and 2010 was $3.31 and $2.41, respectively, and during the nine months ended September 30, 2011 and 2010 was $3.05 and $2.66, respectively.
Employee Stock Purchase Plan
In August 2011, the Company’s Board of Directors adopted the 2011 Employee Stock Purchase Plan (“ESPP”) that is subject to approval by the stockholders at the next annual meeting. The ESPP reserved a total of 7.0 million shares of the Company’s common stock for issuance under the plan and permits eligible employees to purchase common stock at a discount through payroll deductions.
The price at which stock is purchased under the ESPP is equal to 85% of the fair market value of the common stock on the first day of the offering period or the last day of the purchase period, whichever is lower. The offering periods are twelve months and include two six month purchase periods that result in a look-back for determining the purchase price of up to 12 months. Employees can invest up to 15% of their gross compensation through payroll deductions. In no event would an employee be permitted to purchase more than 750 shares of common stock during any six-month purchase period. The initial offering period is scheduled to commence in November 2011. No shares have been issued as of September 30, 2011 under the ESPP.
At September 30, 2011 and December 31, 2010, inventories consisted of the following (in thousands):
NOTE 6—ACQUIRED TECHNOLOGY RIGHTS
Acquired technology rights, with a gross carrying value of $110.6 million at September 30, 2011, are comprised of customer relationships, 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 $81.1 million and $71.6 million at September 30, 2011 and December 31, 2010, respectively.
The expected future annual amortization expense of the Company’s acquired technology rights is as follows (in thousands):
NOTE 7—COMPREHENSIVE (LOSS) INCOME
The components of comprehensive (loss) income are as follows (in thousands):
The Company provides for anticipated warranty costs at the time the associated product revenue is recognized. Product warranty costs are estimated based upon the Company’s historical experience and the applicable warranty period. The Company periodically reviews the adequacy of its warranty reserve and adjusts, if necessary, the warranty percentage and accrual based on actual experience and estimated costs to be incurred. Information regarding the changes in the Company’s product warranty liability for the nine months ended September 30, 2011 is as follows (in thousands):
NOTE 9—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. While the results of any litigation or any other legal proceedings are uncertain, the Company does not believe the ultimate resolution of any pending legal matters is likely to have a material adverse effect on our financial position or results of operations.
On May 4, 2009 and November 3, 2009, the Company was named as a defendant in complaints filed by plaintiff Illumina, Inc., in the United States District Court for the Western District of Wisconsin (the “District Court”). In the complaints, plaintiff alleged that the Company is infringing Patent Nos. 7,510,841 and 7,612,020 (the “Patents”) by making and selling certain of the GeneChip® products. Plaintiff sought a permanent injunction enjoining the Company from further infringement and unspecified money damages. In December 2010, the District Court granted the Company’s motion for summary judgment that it did not infringe the patents held by Illumina and directed that the patent lawsuits brought by Illumina be dismissed and the cases closed. Illumina appealed the District Court’s decision and on August 18, 2011, the Court of Appeals for the Federal Circuit affirmed the District Court’s decision, and the appellate mandate issued on September 26, 2011. On March 14, 2011, the Company and Gregory L. Kirk filed a complaint against Illumina in the same District Court, seeking correction of inventorship of the Patents by naming Dr. Kirk as an inventor. On July 11, 2011, the District Court determined that the case should be stayed pending outcome of the appeal and therefore administratively closed the action with leave to reopen following resolution of the appeal. On September 26, 2011, the Company and Dr. Kirk filed a motion to reopen the case seeking correction of inventorship.
E8 Pharmaceuticals LLC
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, unspecified monetary damages, enhanced damages pursuant to 35 U.S.C. § 284, costs, attorneys’ fees and other relief as the court deems just and proper. The Company will vigorously defend against plaintiffs’ claims. There is no trial date set in this matter.
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 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 Company’s case has been related to complaints previously pending in the Southern District of New York against eight other former Enzo distributors. 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. As of the three and nine months ended September 30, 2011, the Company had not incurred significant costs in connection with administrative proceedings.
NOTE 10—INCOME TAXES
The provision for income tax for the three and nine months ended September 30, 2011 was approximately $0.7 million and $1.1 million, respectively. The provision for income tax primarily consists of foreign taxes.
Due to the Company’s history of cumulative operating losses, management concluded that, after considering all the available objective evidence, it is not more likely than not that all the Company’s net deferred tax assets will be realized. Accordingly, as of September 30, 2011, the Company has recorded a full valuation allowance against all U.S. and certain foreign deferred tax assets, net of reserves for uncertain tax positions.
In the normal course of business, the Company is subject to examination by taxing authorities in the U.S. and multiple foreign jurisdictions. The Company is currently under U.S. federal income tax examination for the 2004, 2005, 2006, 2008 and 2009 tax years.
As of September 30, 2011, 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, 2011 and for the three and nine months ended September 30, 2011 and 2010 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, 2010.
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 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 revenues.
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 and more than 24,000 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, Asia and Latin America.
We offer a comprehensive line of products for two principal applications: gene expression and genotyping. Our product sales consist primarily of sales of instruments and related consumables. We have three instrument systems, GeneTitan®, GeneChip® and GeneAtlas™, that include instruments, consumables and software. Our GeneChip® instruments run arrays packaged in cartridges and our GeneTitan® and GeneAtlasTM instruments run arrays packaged in a peg format.
We also offer a variety of assays for gene expression targeting low- to mid-plex markets that are downstream of our whole genome arrays and a range of reagent kits that are compatible with our platforms as well as the products of other vendors.
Overview of the Three and Nine Months Ended September 30, 2011
During the third quarter of 2011, our business continued to be affected by a significant drop in the volume of sales of consumables to our academic and pharmaceutical customers, particularly in North America, which led to a decrease in revenue as compared to the same period in 2010. Primarily due to lower revenues from product sales, we incurred a net loss of $9.8 million for the quarter. We also generated cash flows from operations of $11.5 million in the third quarter.
For the nine months ended September 30, 2011, we recognized a net loss of $13.4 million primarily due to lower revenues, partially offset by lower total operating expenses and improved gross margins. Revenues were lower due primarily to lower volume of product sales. Additionally, for the nine months ended September 30, 2011, we generated positive operating cash flow of $33.6 million.
Our focus remains on carrying out the following strategic initiatives:
Entering new markets and expanding our product lines. Our goal is to expand our revenue base by entering new markets, growing our customer base and successfully commercializing our established and acquired technologies. In the future, we intend to continue to expand our focus to include the validation and routine testing markets which we believe offer attractive compound annual growth rates and opportunities for more recurring revenue growth in the future. We seek to expand our product line with new products that combine automated instrumentation, powerful new biological assays, and new array designs and content.
Improving operating leverage. We remain focused on improving our operating leverage and were successful in lowering our operating expenses in the first nine months of 2011 as compared to the same period in 2010. Profitability in the future will depend on a number of factors, including but not limited to, increasing top-line revenue and sustained operating leverage.
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. During the three and nine months ended September 30, 2011, 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, 2010.
Results of Operations
The following discussion compares the historical results of operations for the three and nine months ended September 30, 2011 and 2010.
The components of product sales are as follows:
Total product sales decreased in the three and nine months ended September 30, 2011 as compared to the same period in 2010 primarily due to decreased consumable sales resulting from lower overall chip volumes.
Additionally, instruments revenue decreased in the three and nine months ended September 30, 2011 primarily due to lower volume of sales of instruments.
Services revenue increased in the three and nine months ended September 30, 2011 as compared to the same period in 2010 primarily due to increased scientific service revenue.
ROYALTIES AND OTHER REVENUE
Royalties and other revenue decreased in the three and nine months ended September 30, 2011 as compared to the same periods in 2010 primarily due to less royalties and lower research revenue in 2011.
PRODUCT AND SERVICES GROSS MARGIN
Despite lower revenues, we experienced a slight increase in product gross margin as a percentage of revenue for the three and nine months ended September 30, 2011, as compared to the same periods in 2010, primarily due to a mix shift to higher margin chip products along with lower material, warranty and excess and obsolescence costs as well as plant consolidation activities expenses incurred in 2010. These cost improvements were partially offset by lower cost absorption due to higher production levels in 2010.
Service gross margin increased in the three and nine months ended September 30, 2011 as compared to the same periods in 2010 primarily due to plant consolidation costs that were incurred in connection with the closing of the West Sacramento facility in the second quarter of 2010.
RESEARCH AND DEVELOPMENT EXPENSES
The decrease in research and development expenses for the three and nine months ended September 30, 2011 as compared to 2010 was primarily due to savings in headcount-related expenses of $0.3 million and $1.9 million, respectively, and variable compensation expenses of $0.8 million and $1.3 million, respectively, as well as reduced spending on masks, chips and supplies of $0.9 million and $2.9 million, respectively, due to the completion of developmental activities on products in 2010 . This was partially offset by an increase in facilities expenses primarily due to an expense of $1.2 million related to the plant consolidation activities of our Oakmead facility in Santa Clara recognized in the three months ended September 30, 2011.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses decreased during the nine months ended September 30, 2011 as compared to the same period in 2010 primarily due to savings of $1.8 million from headcount-related expenses, $0.8 million from variable compensation adjustments and $3.0 million in consulting and other services. These decreases were partially offset by one-time severance benefits provided to our former chief executive officer and an increase in facilities expenses of $0.6 million primarily related to the plant consolidation activities of our Oakmead facility in Santa Clara.
INTEREST INCOME AND OTHER, NET