UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

FORM 10-Q

 

(Mark One)

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

 

For the quarterly period ended September 30, 2004

 

OR

 

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

 

For the transition period from              to              

 

Commission file number 000-30755

 

CEPHEID

(Exact name of Registrant as Specified in its Charter)

 

California		77-0441625
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)
904 Caribbean Drive, Sunnyvale, California		94089-1189
(Address of Principal Executive Office)		(Zip Code)
(408) 541-4191
(Registrant’s Telephone Number, Including Area Code)

 

 

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 ý   No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  Yes ý   No o

 

As of October 29, 2004, there were 42,006,749 shares of the registrant’s common stock outstanding.

 

 

 

REPORT ON FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2004

 

INDEX

Part I.		Financial Information
	Item 1.	Financial Statements (unaudited)
		Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003
		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003
		Notes to Condensed Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures about Market Risks
	Item 4.	Controls and Procedures
Part II.		Other Information
	Item 1.	Legal Proceedings
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
	Item 3.	Defaults Upon Senior Securities
	Item 4.	Submission of Matters to a Vote of Security Holders
	Item 5.	Other Information
	Item 6.	Exhibits
Signatures

 

Cepheid®, the Cepheid logo, SmartCycler® and GeneXpert® are registered trademarks of Cepheid. SmartCycler II is a trademark of Cepheid. All other trademarks, service marks or trade names referred to in this report are the property of their respective owners.

 

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PART I - FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

CEPHEID

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

 

		September 30, 2004			December 31, 2003
		(unaudited)			(1)
ASSETS
Current assets:
Cash and cash equivalents		$	58,239		$	18,510
Accounts receivable		9,091			3,504
Collaboration receivable		—			5,000
Inventory, net		6,760			5,088
Prepaid expenses and other current assets		687			650
Total current assets		74,777			32,752
Property and equipment, net		9,561			8,071
Intangible assets, net		31,244			47
Restricted cash		688			688
Total assets		$	116,270		$	41,558
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	5,524		$	1,823
Accrued compensation		1,652			1,604
Accrued other liabilities		4,224			2,350
Current portion of deferred revenue		4,658			3,239
Current portion of license fees payable		10,898			—
Current portion of equipment financing		2,129			1,897
Total current liabilities		29,085			10,913
Long-term portion of deferred revenue		6,667			8,095
Long-term portion of license fees payable		9,477			—
Equipment financing, less current portion		1,954			1,978
Deferred rent		576			497
Commitments
Shareholders’ equity:
Preferred stock		—			—
Common stock		151,923			92,694
Additional paid-in capital		7,513			7,501
Accumulated other comprehensive loss		(45		)	(13		)
Accumulated deficit		(90,880		)	(80,107		)
Total shareholders’ equity		68,511			20,075
Total liabilities and shareholders’ equity		$	116,270		$	41,558

 

(1) The balance sheet at December 31, 2003 has been derived from the Company’s audited financial statements, which are included in the Company’s 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

 

See accompanying notes.

 

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CEPHEID

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Revenues:
Instrument sales		$	8,064		$	4,074		$	20,648		$	9,433
Reagent and disposable sales		5,385			568			9,918			1,523
Product sales		13,449			4,642			30,566			10,956
Contract revenues		624			106			2,044			426
Grant and government sponsored research revenue		4			619			13			1,868
Total revenues		14,077			5,367			32,623			13,250
Costs and operating expenses:
Cost of product sales		7,494			2,768			16,625			6,433
Research and development		4,037			3,861			11,531			11,430
Selling, general and administrative		3,984			2,646			11,485			8,364
Expense contingency for patent-related matter		—			—			1,264			—
Collaboration profit sharing		1,474			—			2,506			—
Total costs and operating expenses		16,989			9,275			43,411			26,227
Loss from operations		(2,912		)	(3,908		)	(10,788		)	(12,977		)
Other income (expenses), net		(3		)	7			15			(34		)
Net loss		$	(2,915	)	$	(3,901	)	$	(10,773	)	$	(13,011	)
Basic and diluted net loss per share		$	(0.07	)	$	(0.11	)	$	(0.26	)	$	(0.40	)
Shares used in computing basic and diluted net loss per share		41,889			33,985			40,775			32,596

 

See accompanying notes.

 

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CEPHEID

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

		Nine Months Ended September 30,
		2004			2003
OPERATING ACTIVITIES:
Net loss		$	(10,773	)	$	(13,011	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,725			1,543
Amortization of intangible assets		855			—
Amortization of imputed interest		273			—
Amortization of deferred stock-based compensation		—			82
Stock-based compensation related to consulting services rendered		12			—
Deferred rent		79			109
Changes in operating assets and liabilities:
Accounts receivable		(5,587		)	(477		)
Collaboration receivable		5,000			—
Inventory		(1,672		)	(777		)
Prepaid expenses and other assets		(37		)	(738		)
Accounts payable and other current liabilities		5,543			291
Deferred revenue		(9		)	33
Accrued compensation		48			309
Net cash used in operating activities		(4,543		)	(12,636		)
INVESTING ACTIVITIES:
Capital expenditures		(3,215		)	(3,212		)
Payments for technology licenses		(11,950		)	—
Restricted cash		—			1,130
Net cash used in investing activities		(15,165		)	(2,082		)
FINANCING ACTIVITIES:
Net proceeds from the sales of common shares		59,229			14,559
Proceeds from debt arrangements		636			1,900
Principal payments under debt arrangements		(428		)	(1,080		)
Net cash provided by financing activities		59,437			15,379
Net increase in cash and cash equivalents		39,729			661
Cash and cash equivalents at beginning of period		18,510			14,505
Cash and cash equivalents at end of period		$	58,239		$	15,166

 

See accompanying notes.

 

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CEPHEID

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

1. Organization, Business and Basis of Presentation

 

Cepheid (the Company) was incorporated in the State of California on March 4, 1996. The Company develops, manufactures, and markets fully-integrated systems that perform genetic analysis for the clinical genetic assessment, life sciences and biothreat markets. The Company’s systems enable rapid, sophisticated genetic testing of organisms by automating otherwise complex manual laboratory procedures.

 

2. Summary of Significant Accounting Policies

 

Principles of Consolidation

 

The consolidated financial statements of Cepheid include the accounts of the Company and its wholly owned subsidiaries.  All significant intercompany balances and transactions have been eliminated. Accounts denominated in foreign-currency have been translated using the U.S. dollar as the functional currency.

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes.  Actual results could differ from these estimates.

 

Inventory

 

Inventory is stated at the lower of standard cost (which approximates actual cost) or market, with cost determined on the first-in-first-out (FIFO) method.

 

The Company maintains a reserve for inventory obsolescence.  This reserve is established utilizing management’s estimate of the potential future obsolescence of inventory. The reserve for inventory obsolescence was $0.5 million and $0.3 million, respectively, at September 30, 2004 and December 31, 2003.

 

The components of inventory at September 30, 2004 and December 31, 2003 were as follows (in thousands):

 

 

Warranty Accrual

 

The Company warrants its instrument products to be free from defects for a period of 12 to 15 months from the date of sale for material and labor costs to repair the product.  Accordingly, a provision for the estimated cost of warranty repair is recorded at the time revenue is recognized. The Company’s warranty accrual is established using management’s estimate for future costs of repairing any instrument failures during the one-year warranty period.  As of September 30, 2004 and December 31, 2003, the accrued warranty liability was $350,000 and $426,000, respectively.  The activity in the warranty accrual for the three and nine months ended September 30, 2004 and 2003 consisted of the following (in thousands):

 

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Intangible Assets

 

Intangible assets are recorded at cost, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 5 to 15 years, on a straight-line basis. The balance of intangible assets as of September 30, 2004 and December 31, 2003 was as follows (in thousands):

 

 

Amortization expense of intangible assets was $0.6 million and $0.9 million, respectively, for the three and nine months ended September 30, 2004, and zero for the three and nine months ended September 30, 2003. The expected future annual amortization expense of intangible assets is as follows (in thousands):

 

 

As of September 30, 2004, intangible assets consisted primarily of rights to certain patented technologies licensed from Applera Corporation and F. Hoffmann-La Roche Ltd. (Roche), (see Note 5, “Patent License Agreements”). Amortization of intangible assets is included in cost of product sales in the accompanying condensed consolidated statements of operations. The Company reviews its intangible assets for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

 

Revenue Recognition

 

The Company recognizes revenue from the sale of products and contract arrangements.  From time to time, the Company enters into revenue arrangements with multiple deliverables. Multiple element revenue agreements entered into on or after July 1, 2003 are evaluated under Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” to determine whether the delivered item has value to the customer on a stand-alone basis and whether objective and reliable evidence of the fair value of the undelivered item exists.

 

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Deliverables in an arrangement that do not meet the separation criteria in Issue 00-21 must be treated as one unit of accounting for purposes of revenue recognition. Advance payments received in excess of amounts earned, such as funds received in advance of technologies to be delivered or services to be performed, are classified as deferred revenue until earned.

 

The Company recognizes revenue from product sales when goods are shipped and there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed and determinable and collectibility is reasonably assured. No right of return exists for the Company’s products except in the case of damaged goods. The Company has not experienced any significant returns of the Company’s products.

 

Contract revenues include fees for technology licenses, research and development services and royalties under license and collaboration agreements and fees for services rendered under research and development arrangements. Contract revenue related to technology licenses is generally fully recognized only after both the license period has commenced, the technology has been delivered and no further involvement of the Company is required. For example, the $10.0 million license execution fee from the bioMerieux collaboration in 2003 was deferred and is being amortized over the period of approximately five years, which represents the estimated period of the Company’s continuing involvement under the collaboration agreement. Royalties are typically based on licensees’ net sales of products that utilize the Company’s technology, and royalty revenues are recognized as earned in accordance with the contract terms when the royalties can be reliably measured and their collectibility is reasonably assured, such as upon the receipt of a royalty statement from the customer.

 

Grant and government sponsored research revenue and contract revenue related to research and development services are recognized as the related services are performed based on the performance requirements of the relevant contract. Under the agreements, the Company is required to perform specific research and development activities and is compensated based on the costs, or costs plus a mark-up, associated with each specific contract over the term of the agreement.

 

Stock-Based Compensation

 

The Company accounts for stock-based awards to its employees and directors using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, the Company does not recognize compensation expense for employee or director stock options granted with an exercise price not less than fair market value. For purposes of disclosures pursuant to Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123), as amended by SFAS 148, “Accounting for Stock-Based Compensation, Transition and Disclosure,” the estimated fair value of options is amortized to expense over the options’ vesting periods.  The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provision of SFAS 123 to stock-based employee compensation (in thousands, except per share data).

 

 

8

 

The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model, with the following weighted-average assumptions:

 

 

These same assumptions were applied in the determination of the option values related to stock options granted to non-employees, except the option life, for which the term of the consulting contracts, generally two years, was used.  The value has been recorded in the financial statements.

 

The weighted-average fair value of options granted was $6.73 and $6.57 per share during the three and nine months ended September 30, 2004, respectively, and $4.46 and $3.82 per share during the three and nine months ended September 30, 2003, respectively.  All options granted during these periods had exercise prices equal to the current fair market value of the underlying stock on the date of grant.

 

The fair value option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

 

On March 31, 2004, the Financial Accounting Standard Board (FASB) issued an Exposure Draft, “Share-Based Payment - An Amendment of FASB Statements No. 123 and 95” (proposed SFAS 123R). The proposed SFAS 123R addresses the accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed SFAS 123R would eliminate the ability to account for share-based compensation transactions using APB 25, and generally would require instead that such transactions be accounted for using a fair-value based method. As proposed, companies would be required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. As proposed, the new rules would be applied on a modified prospective basis as defined in the proposed SFAS 123R, and would be effective for the Company beginning July 1, 2005. The FASB expects to issue a final standard by December 31, 2004. The Company is currently evaluating option valuation methodologies and assumptions in light of the proposed SFAS 123R related to employee stock options. Current estimates of option values using the Black-Scholes method (as shown above) may not be indicative of results from valuation methodologies ultimately adopted in the final rules.

 

Net Loss Per Share

 

Basic net loss per share has been calculated based on the weighted-average number of common shares outstanding during the period, less shares subject to the Company’s right of repurchase. Common stock equivalents such as stock options have been excluded from the computation of diluted net loss per share, as their inclusion would be antidilutive for all periods presented.

 

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

 

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Comprehensive Loss

 

Comprehensive loss includes net loss as well as other comprehensive income or loss. The Company’s other comprehensive income or loss consists of foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities. Accumulated other comprehensive income or loss is displayed as a separate component of shareholders’ equity in the accompanying condensed consolidated balance sheets.  The activity in comprehensive loss during the three and nine months ended September 30, 2004 and 2003 was as follows:

 

 

Reclassifications

 

Certain prior period balances have been reclassified to conform to the current period presentation.

 

3. Segment Information and Significant Concentrations

 

The Company and its wholly owned subsidiaries operate in only one business segment.

 

The Company currently sells its products through its direct sales force and through third-party distributors. Product sales to two customers, Northrop Grumman and Smiths Detection, represented 46% and 22%, respectively, of total product sales for the three months ended September 30, 2004, and 35% and 26%, respectively, of total product sales for the nine months ended September 30, 2004. For the three and nine months ended September 30, 2003, there was no one direct customer that represented greater than 10% of total product sales. The Company has distribution agreements with Fisher Scientific Company L.L.C. to market the Cepheid SmartCycler system in the U.S. and Canada. The Company also has several regional distribution arrangements throughout Europe, Japan, South Korea, China, Mexico and other parts of the world. Information about sales through distributors for the three and nine months ended September 30, 2004 and 2003 was as follows:

 

10

 

 

No single country outside of the United States represented more than 10% of the Company’s total revenues, total net assets or total net property, plant and equipment in any period presented.

 

The Company relies on several companies as sole sources for various materials used in its manufacturing process. Any extended interruption in the supply of these materials could result in the failure to meet customer demand.

 

Financial instruments that potentially subject the Company to concentrations of credit risk primarily consist of cash equivalents and investments in debt securities.

 

4.  Collaboration Profit Sharing

 

Collaboration profit sharing represents the amount that the Company pays to Applied Biosystems Group (ABI) for ABI’s share of gross profit, as defined in the collaboration agreement, on related anthrax cartridge sales under the United States Postal Service (USPS) Biohazard Detection System (BDS) program. The profit sharing is pursuant to the Company’s collaboration agreement with ABI to develop reagents for use in the BDS developed for the USPS.  Collaboration profit sharing was $1.5 million and $2.5 million, respectively, for the three and nine months ended September 30, 2004.

 

5.  Patent License Agreements

 

In April 2004, the Company entered into a patent license agreement with Applera Corporation, through ABI and its Celera Diagnostics joint venture, for a non-exclusive worldwide license to make, use, and sell the Company’s products incorporating technology covered by Applera patents. The Company also entered into a patent license agreement with F. Hoffmann-La Roche Ltd. (Roche), effective July 1, 2004, for a non-exclusive worldwide license to make, use, and sell the Company’s products incorporating technology covered by Roche patents. Under the license agreements, the Company agreed to pay aggregate license fees of $32.2 million, of which $11.5 million has been paid as of September 30, 2004 and $1.0 million will be paid in the fourth quarter of 2004, $11.0 million will be paid in 2005, and $8.7 million will be paid in 2006. In connection with the license agreements, the Company recorded intangible assets of $31.1 million, representing the present value of license fee obligations which is net of imputed interest of $1.1 million. The intangible assets related to the Applera and Roche licenses are amortized on a straight-line basis over their useful lives of approximately 10 and 15 years, respectively, with the amortization recorded as part of the cost of product sales. The Company also paid approximately $1.3 million in back royalties related to the Applera license.  This amount was expensed during the quarter ended March 31, 2004.

 

The Company also agreed to pay Applera and Roche ongoing royalties on sales of products incorporating the licensed patents.  Resulting product royalties are recorded as part of the cost of product sales when the related product sales are recognized.

 

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

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based upon current expectations. These forward-looking statements fall within the meaning of the federal securities laws that relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including the scope and timing of actual United States Postal Service (USPS) funding and deployment of the Biohazard Detection System (BDS); the rate of environmental testing using the BDS conducted by the USPS, which will affect the amount of consumable products sold whether the BDS performs to specifications; development and manufacturing problems, including with respect to the GeneXpert system and reagents; manufacturing costs and efficiencies; the success of clinical trials for some of our products under development; the need for additional licenses for new tests and other products and the terms of such licenses; our ability to successfully commercialize our stand-alone GeneXpert system; lengthy sales cycles in certain markets; the performance and market acceptance of our new products; our ability to successfully obtain regulatory approvals and introduce new products into the clinical market; our reliance on distributors to market, sell and support our products; the occurrence of unforeseen expenditures, acquisitions or other transactions; our success in increasing direct sales; the impact of competitive products and pricing; our ability to manage geographically-dispersed operations; underlying worldwide market conditions and the other risks those set forth under “ Factors That Might Affect Future Results” and elsewhere in this report. We assume no obligation to update any of the forward-looking statements after the date of this report or to conform these forward-looking statements to actual results.

 

OVERVIEW

 

We develop, manufacture, and market fully-integrated systems that perform genetic analysis, including DNA or RNA analysis, for the clinical genetic assessment, life sciences and biothreat markets. Our systems enable rapid, sophisticated genetic testing of organisms by automating otherwise complex manual laboratory procedures. Genetic testing involves a number of complicated steps, including sample preparation, amplification and detection. Based on state-of-the-art microfluidic and microelectronic technologies, our easy-to-use systems integrate these steps and analyze complex biological samples in our proprietary test cartridges. We are focusing our efforts on those applications where rapid genetic testing is particularly important, such as the infectious disease, cancer and biothreat testing markets. In particular, we have designed our systems to be capable of use in clinical genetic assessment. We have designed our systems to perform a broad range of genetic tests that are used to identify infectious organisms, enhance cancer management and care and identify organisms that could be used as bio-terrorism agents.

 

Our two principal product platforms are our SmartCycler and GeneXpert systems. Our initial product platform, the SmartCycler, integrates DNA amplification and detection to allow rapid genetic analysis of a sample. We commenced sales of the SmartCycler in May 2000 and we have sold more than 1,700 units to date to a wide range of customers. Our second product platform, the GeneXpert, integrates automated sample preparation with our SmartCycler amplification and detection technology. We began shipping GeneXpert modules and anthrax test cartridges for use in the biothreat market in the fourth quarter of 2003. For example, the GeneXpert module is being incorporated in the BDS developed by the Northrop Grumman led consortium for use by the USPS. We launched the GeneXpert system, which contains the GeneXpert module and related software, in the biothreat market in the third quarter of 2004 and anticipate its commercial launch in the clinical genetic assessment market in the first half of 2005. We sell our products through both direct sales and various distribution channels worldwide. In addition to our own activities, we are collaborating with strategic partners to co-develop assays, or biological tests.

 

The BDS for the USPS has been developed by a Northrop Grumman-led consortium that includes Cepheid and other subcontractors. This consortium was awarded a production contract that the USPS has indicated will include a $175.0 million first phase, with the USPS having an option for a second phase. We believe that we will realize 15% to 17% of the first phase amount, the majority of which we believe we will realize in the second half of 2004 and the

 

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first quarter of 2005. At the core of the BDS, Cepheid’s GeneXpert technology rapidly analyzes samples taken from the air around USPS processing lines to detect DNA from any potential anthrax spores as mail moves through the processing equipment. The shipment and validation of the first article production GeneXpert modules for the USPS program was completed in the fourth quarter of 2003, and the BDS is currently being installed on a production basis in selected USPS mail sorting facilities throughout the United States.

 

In December 2003, we entered into an agreement for a strategic commercial relationship with bioMerieux for bioMerieux to develop DNA testing products using their proprietary Nucleic Acid Sequence-Based Amplification (NASBA) technology to be run on systems employing our GeneXpert platforms. Under the agreement, bioMerieux has paid us a $10.0 million license fee, and an additional $5.0 million payment will become due when and if bioMerieux commercializes its first product based on our technology. We may also receive potential product purchases and royalty payments on end-user GeneXpert test cartridge sales under the agreement.  The $10.0 million license fee received from bioMerieux was deferred and is being amortized over the period of approximately five years from the effective date, which represents the estimated period of our continuing involvement under the collaboration agreement.

 

During the second quarter of 2004, we entered into a patent license agreement with Applera Corporation, through Applied Biosystems Group (ABI) and Celera Diagnostics, and, effective July 1, 2004, we entered into a patent license agreement with F. Hoffmann-La Roche Ltd. (Roche), each of which provides for non-exclusive worldwide licenses to make, use, and sell our products incorporating technologies covered by Applera and Roche’s respective patents. Under the license agreements, we agreed to pay aggregate license fees of $32.2 million, of which $11.5 million has been paid as of September 30, 2004 and $1.0 million will be paid in the fourth quarter of 2004, $11.0 million will be paid in 2005, and $8.7 million will be paid in 2006. We also agreed to pay Applera and Roche ongoing royalties on sales of products incorporating their licensed patents. In connection with the license agreements, we recorded intangible assets of $31.1 million, representing the present value of license fee obligations which is net of imputed interest of $1.1 million. The intangible assets related to the Applera and Roche licenses are amortized on a straight-line basis over their useful lives of approximately 10 and 15 years, respectively, with the amortization recorded as part of the cost of product sales.

 

Sales Channels

 

We sell our products into the clinical genetic assessment, life sciences and biothreat markets through both direct and various distribution channels.  In the United States, we sell through our direct sales force in life sciences and biothreat markets, as well as through a non-exclusive distributor, Fisher Scientific Company L.L.C. (Fisher), in the life sciences market. In Europe, we sell primarily through distributors.  In Japan and other parts of the world, we sell solely through distributors.  Through Cepheid SA, our French subsidiary, we have established additional distributors in Europe, the Middle East, India and South Africa, leading to increased product sales in those regions.  We expect to continue to expand sales into other territories throughout the world by adding new distributors. For example, we added distributors in Mexico, Brazil and China in 2004.

 

Revenues

 

During the three and nine months ended September 30, 2004, we derived the majority of our revenues from sales of GeneXpert anthrax cartridges and modules to Northrop Grumman and Smiths Detection for use in the USPS program, from sales of SmartCyclers and associated disposables and reagents and, to a lesser extent, from contract revenue primarily derived from the amortization of the up-front license payments in connection with our collaboration with bioMerieux described above. In the remaining periods of 2004, we expect sales of GeneXpert anthrax cartridges to continue to contribute a substantial portion of our revenue as phase one of the USPS BDS program continues.

 

Products

 

We commenced commercial sales of the SmartCycler in May 2000. We began shipping the SmartCycler II, which

 

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features various enhancements to the SmartCycler, in November 2002.

 

Our GeneXpert module has been incorporated in the USPS BDS, and is also currently being sold for integration by partner companies into their systems. . We launched the GeneXpert system, which contains the GeneXpert module and related software, in the biothreat market in the third quarter of 2004 and anticipate its commercial launch in the clinical genetic assessment market in the first half of 2005.

 

We have begun to develop and sell tests for use with the SmartCycler and GeneXpert platforms. We currently market a group B streptococcos (GBS) test and expect to market a methicillin-resistant staphylococcus aureus (MRSA) test for use with our SmartCycler systems. We also currently market a GeneXpert anthrax test cartridge for use in the USPS BDS program and biothreat market. In addition, we are working internally and with partners to develop a variety of tests for use on our SmartCycler and GeneXpert system in the cancer and infectious disease markets.

 

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

 

We consider our accounting policies related to revenue recognition, impairment of intangible assets, inventory reserve, and warranty accrual to be critical accounting policies.  Inherent in our determination of when to recognize revenue and how to evaluate our intangible assets, and in our calculation of our inventory reserve and warranty accrual, are a number of significant estimates, assumptions and judgments.  These estimates, assumptions, and judgments include deciding whether the elements required to recognize revenue from a particular arrangement are present, estimating the fair value of an intangible asset, which represents the future undiscounted cash flows to be derived from the intangible asset, and estimating the amount of inventory obsolescence and warranty costs associated with shipped products.  We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances.  Actual results could differ materially from these estimates.  Except for the addition of the accounting policy on impairment of intangible assets discussed below, there have been no material changes to our critical accounting policies since we filed our 2003 Annual Report on Form 10-K with the Securities and Exchange Commission. For a description of our critical accounting policies, please refer to our 2003 Annual Report on Form 10-K.

 

Impairment of Intangible Assets

 

Our intangible assets consist primarily of rights to certain patented technologies that we purchased during the second quarter of 2004. Intangible assets are recorded at cost, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 5 to 15 years, on a straight-line basis. Amortization of intangible assets is included in cost of product sales in the accompanying condensed consolidated statements of operations.

 

We will review our intangible assets for impairment under Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”.  We will conduct the impairment review at least annually, or when events or circumstances indicate the carrying value of a long-lived asset may be impaired, by estimating the future undiscounted cash flows to be derived from an asset to assess whether or not a potential impairment exists. If the carrying value exceeds our estimate of future undiscounted cash flows, we will then calculate the impairment as the excess of the carrying value of the asset over our estimate of its fair market value. Events or circumstances which could trigger an impairment review include a significant adverse change in business climate, an adverse action or assessment by a regulator, unanticipated competition, significant changes in the manner of our use of acquired assets, the strategy for our overall business, or significant negative industry or economic trends.

 

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Results of Operations

 

Comparison of Three and Nine Months Ended September 30, 2004 and 2003

 

Revenues

 

 

Total revenues increased 162% and 146% in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003.  The increase was primarily due to an overall increase in product sales which was driven in large part by sales related to the USPS BDS, and, to a lesser extent, by sales of our products in the life sciences and clinical genetic assessment markets.

 

Total product sales increased 190% and 179% in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003. The increase primarily resulted from increased sales volume of GeneXpert modules and anthrax cartridges to Smiths Detection and Northrop Grumman for deployment of BDS units in selected USPS mail sorting facilities throughout the United States, which commenced in the first quarter of 2004. Product sales to Northrop Grumman and Smiths Detection represented 46% and 22%, respectively, of total product sales for the three months ended September 30, 2004, and 35% and 26%, respectively, of total product sales for the nine months ended September 30, 2004. We had no direct customers that represented more than 10% of product sales for the three and nine months ended September 30, 2003.  In the three and nine months ended September 30, 2004, product sales through distributors represented 19% and 23%, respectively, of our total product sales.  In the three and nine months ended September 30, 2003, product sales through distributors represented 47% and 58%, respectively, of our total product sales.  The following table provides a breakdown of our product sales by geographic regions:

 

 

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No single country outside of the United States represented more than 10% of our total revenues in any period presented.

 

Contract revenues increased to $0.6 million and $2.0 million in the three and nine months ended September 30, 2004, respectively, from $0.1 million and $0.4 million respectively, in the corresponding periods of 2003.  This increase was primarily a result of our collaboration with bioMerieux in which we derive revenues from the amortization of the upfront license fees paid to us by bioMerieux, as well as fees related to research and development services.

 

Grant and government sponsored research revenue decreased to $4,000 and $13,000 in the three and nine months ended September 30, 2004, respectively, from $0.6 million and $1.9 million, respectively, in the corresponding periods of 2003.  The revenue in the three and nine months ended September 30, 2003 was derived principally from our research and development contract with the U.S. Army Medical Research Institute of Infectious Diseases which was completed in November 2003.

 

 

Cost of Product Sales

 

Cost of product sales consists primarily of raw materials, direct labor, manufacturing overhead and warranty costs. Cost of product sales also includes royalties on product sales and amortization of intangible assets related to technology licenses. As a result of the increased product sales discussed above, cost of product sales increased 171% and 158% in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003. Our product gross margin percentage in the three and nine months ended September 30, 2004 was 44% and 46%, respectively, as compared to 40% and 41%, respectively, in the corresponding prior year periods. The increase of 4% and 5%, respectively, in product gross margin in the three and nine months ended September 30, 2004, as compared to the corresponding prior year periods, was primarily due to increased sales of higher gross margin products, partially offset by an increase in royalty and license costs resulting from our new license agreements, as well as manufacturing inefficiencies related to scale up of our anthrax cartridge production. We expect our gross margin for the fourth quarter of 2004 to be consistent with the gross margin for the third quarter of 2004 as well as the gross margin for the full year of 2003.

 

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Research and Development Expenses

 

Research and development expenses consist primarily of salaries and personnel-related expenses, research and development materials, facility costs and depreciation on property and equipment used in research and development. Research and development expenses increased 5% and 1% in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003. For the three months ended September 30, 2004 as compared to the corresponding period of 2003, there was an increase of $0.1 million in salaries and personnel-related expenses resulting from an increase in biotechnology, regulatory and clinical headcount and an increase of $0.2 million in facility and information technology costs, partially offset by a decrease of $0.1 million in depreciation and amortization and a decrease of $0.1 million in expenses for outside engineering services. For the nine months ended September 30, 2004 as compared to the corresponding period of 2003, there was an increase of $0.6 million in salaries and personnel-related expenses resulting from an increase in biotechnology, regulatory and clinical headcount and an increase of $0.4 million in facility and information technology costs, partially offset by a decrease of $0.5 million in expenses for research and development materials and $0.3 million in expenses for outside engineering services. We expect our quarterly research and development expenses to increase moderately in the fourth quarter of 2004 as compared to the third quarter of 2004 and corresponding period of 2003 as we incur clinical trial and regulatory costs related to the initiation of clinical trials for our GBS test for use on our GeneXpert system.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses consist primarily of salaries and personnel-related expenses, travel, allocated facility costs and legal, accounting and other professional fees. Selling, general and administrative expenses increased 51% and 37% in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003. The increases were primarily due to the increases in sales and marketing, legal, accounting and insurance expenses. Specifically, the increase in the three months ended September 30, 2004, as compared to the corresponding period of 2003, included a $0.6 million increase in salaries and personnel-related expenses primarily resulting from increases in sales and marketing and executive headcount, a $0.2 million increase in consulting and accounting expenses related to compliance with the requirements of the Sarbanes-Oxley Act of 2002, a $0.1 million increase in advertising, and a $0.1 million increase in insurance expenses. The increase in the nine months ended September 30, 2004 as compared to the corresponding period of 2003 included a $1.3 million increase in salaries and personnel-related expenses resulting from increases in sales and marketing and executive headcount, a $0.4 million increase in consulting and accounting expenses related to compliance with the requirements of the Sarbanes-Oxley Act of 2002, a $0.3 million increase in legal expenses related to licensing and other strategic activities, a $0.2 million increase in advertising, a $0.3 million increase in travel expenses, and a $0.3 million increase in insurance expenses. We expect that our quarterly selling, general and administrative expenses will increase in the fourth quarter of 2004 as compared to the corresponding period of 2003 as we continue to see the impact of additional investments in sales and marketing and executive positions as well as costs related to compliance with the requirements of the Sarbanes-Oxley Act of 2002.

 

Expense Contingency for Patent-Related Matter

 

In March 2004, before a definitive license agreement with Applera was reached, we recorded a charge and accrued a corresponding liability in the amount of $1.3 million related to estimated royalties on past product sales based on agreed-upon royalty rates.  The amount was fully paid in the second quarter of 2004 upon execution of the license agreement in that quarter.

 

Collaboration Profit Sharing

 

Collaboration profit sharing represents the amount that we pay to ABI for ABI’s share of gross profit, as defined in the collaboration agreement, on related anthrax cartridge sales under the USPS BDS program. This profit sharing is pursuant to our collaboration agreement with ABI to develop reagents for use in the BDS developed for the USPS.  The collaboration profit sharing was $1.5 million and $2.5 million for the three and nine months ended September 30, 2004, respectively.

 

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Other Income (Expenses), Net

 

 

Other income (expenses), net consists of interest income, interest expense and foreign exchange gain or loss. Interest income increased by $172,000 and $352,000 in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003. The increases were primarily due to our higher average cash and cash equivalents balance in the 2004 periods. Interest expenses increased by $191,000 and $241,000 in the three and nine months ended September 30, 2004, respectively, from the corresponding periods of 2003. The increases were primarily due to a $196,000 and $273,000, respectively, amortization of imputed interest related to the license fee payments in the three and nine months ended September 30, 2004.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash and Cash Flow

 

As of September 30, 2004, we had $58.9 million in cash and cash equivalents (including $0.7 million in restricted cash). Our net increase in cash and cash equivalents in the nine months ended September 30, 2004 was $39.7 million, including net proceeds of approximately $57.7 million from the sale of our common stock in an underwritten public offering during the first quarter of 2004, partially offset by $18.0 million of net cash used in our operating, investing and other financing activities. From our inception through September 30, 2004, we had raised approximately $151.9 million in aggregate net proceeds from sales of our equity securities. We maintain our portfolio of cash equivalents in short-term commercial paper and money market funds in order to minimize market risk and preserve principal.

 

Net cash used in operating activities was $4.5 million and $12.6 million in the nine months ended September 30, 2004 and 2003, respectively. In the nine months ended September 30, 2004, net cash used in operating activities primarily consisted of $15.4 million in cost of product sales, $10.4 million in research and development costs, $11.2 million in selling, general and administration expenses, $1.3 million in expense contingency for patent-related matter, a $1.7 million payment on collaboration profit sharing, and a $1.7 million increase in inventory, largely offset by $32.0 million in cash received from customers, including the $5.0 million collaboration receivable payment from bioMerieux, and a $4.5 million increase in accounts payable and accrued liabilities. In the nine months ended September 30, 2003, net cash used in operating activities consisted of $6.1 million in cost of product sales, $10.4 million in research and development costs, and $8.2 million in selling, general and administration expenses, partially offset by $12.8 million in cash received from customers. The above amounts for cost of product sales, research and development costs and selling, general and administrative expenses exclude non-cash expenses including depreciation and amortization on property and equipment, amortization of intangible assets and imputed interest, and stock-based compensation expenses.

 

Net cash used in investing activities was $15.2 million and $2.1 million in the nine months ended September 30, 2004 and 2003, respectively. Net cash used in investing activities in the nine months ended September 30, 2004 consisted of $12.0 million in payments on purchases of technology licenses and $3.2 million in capital expenditures. Net cash used in investing activities in the nine months ended September 30, 2003 consisted of $3.2 million in capital expenditures, partially offset by $1.1 million in decrease of restricted cash.

 

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Net cash provided by financing activities was $59.4 million and $15.4 million in the nine months ended September 30, 2004 and 2003, respectively. The $59.4 million provided in the nine months ended September 30, 2004 consisted of proceeds of $59.2 million from sales of common stock, including net proceeds of $57.7 million from our February 2004 common stock offering and $1.5 million from sales of common stock under our employee equity incentive plans, and $0.6 million in proceeds from equipment loans, partially offset by repayments of $0.4 million on our equipment loans.  The $15.4 million in the nine months ended September 30, 2003 consisted of proceeds of $14.6 million from sales of common stock, including net proceeds of $14.0 million from our March and August 2003 common stock offering and $0.6 million from sales of common stock under our employee equity incentive plans, and $1.9 million in proceeds from equipment loans, partially offset by repayments of $1.1 million on our equipment loans.

 

Contractual Obligations

 

During the nine months ended September 30, 2004, the only material change in our reported payments due under contractual obligations at December 31, 2003 was aggregated payments of $32.2 million license fees under our technology license agreements with Applera and Roche.  As of September 30, 2004, $11.5 million of the $32.2 million license fees has been paid in the second and third quarters of 2004, $1.0 million will be paid in the fourth quarter of 2004, $11.0 million will be paid in 2005, and $8.7 million will be paid in 2006.

 

Off-Balance-Sheet Arrangements

 

As of September 30, 2004, we did not have any significant “off-balance-sheet arrangements”, as defined in Item 303(a)(4)(ii) of Regulation S-K.

 

Financial Condition Outlook

 

We plan to continue to make expenditures to expand our manufacturing capacity, to support our activities in sales and marketing and research and development, to support our working capital needs, and to obtain technology licenses. For the remainder of 2004, we expect total capital expenditures of approximately $1.0 million for investments in automated manufacturing equipment, lab equipment and computer hardware and software. We expect to have negative cash flow from operations through at least the end of 2005.  Our total cash used in operating and investing activities was $19.7 million in the first nine months of 2004. We anticipate that our existing capital resources will enable us to maintain currently planned operations for the next several years. This expectation is based on our current and long-term operating plan and may change as a result of many factors, including our future capital requirements and our ability to increase revenues and reduce expenses, which, in many instances, depend on a number of factors outside our control.  For example, our future cash use will depend on, among other things, market acceptance of our products, the resources we devote to developing and supporting our products, continued progress of our research and development of potential products, the need to acquire licenses to new technology or to use our technology in new markets, and the availability of other financing.

 

In the future, we may seek additional funds to support our strategic business needs and may seek to raise such additional funds through private or public sales of securities, strategic relationships, bank debt, lease financing arrangements, or other available means. If additional funds are raised through the issuance of equity or equity-related securities, stockholders may experience additional dilution, or such equity securities may have rights, preferences, or privileges senior to those of the holders of our common stock. If adequate funds are not available or are not available on acceptable terms to meet our business needs, our business may be harmed.

 

FACTORS THAT MIGHT AFFECT FUTURE RESULTS

 

You should carefully consider the risks described below, together with all of the other information included in this report, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing Cepheid. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business,

 

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financial condition or results of operations.

 

We may not achieve profitability.

 

We have incurred operating losses in each year since our inception and expect to have negative cash flow from operations through at least the end of 2005. We experienced net losses of approximately $15.5 million in 2001, $19.7 million in 2002, $17.5 million in 2003 and $10.8 million in the nine months ended September 30, 2004. As of September 30, 2004, we had an accumulated deficit of approximately $90.9 million. Our ability to become profitable will depend on our ability to increase our revenues, which depends on a number of factors including market acceptance of our products, our ability to commercialize the GeneXpert system and develop effective GeneXpert assays, the extent of the USPS BDS program in which we are participating as it relates to whether the USPS elects to pursue the second phase of the program and what the operating parameters of all phases of the program, which affect the rate of consumable products sold, will be, the success of other collaborative programs, our ability to successfully penetrate the clinical market, and global economic and political conditions. Our ability to become profitable also depends on our expense levels and product costs, which are also influenced by a number of factors, including the resources we devote to developing and supporting our products, the continued progress of our research and development of potential products, our ability to improve manufacturing efficiency, and the need to acquire licenses to new technology or to use our technology in new markets, including potentially significant license fees and ongoing royalty payments associated with these licenses. If we fail to grow our revenue and manage our expenses and product costs, we may never achieve profitability.

 

Our participation in the USPS Biohazard Detection System program and other similar programs may not result in predictable contracts or revenues.

 

Our participation in government contracting programs, including the USPS BDS program, involves significant uncertainties related to governmental decision-making and timing of deployment, and is highly sensitive to changes in national and international priorities and budgets. The world geopolitical climate in the wake of the September 11, 2001 terrorist attacks has created substantial public interest in the BDS and our potential revenues from participating in the USPS program. However, we cannot be certain that actual funding, deployment and operating parameters, or product purchases, will occur at currently expected levels or in the currently expected timeframe. We cannot assure you that the USPS will choose to purchase additional BDS units containing our products as part of the potential second phase of the BDS program, or what the operating parameters of any phase of the program, which affect the rate of consumable products sold, will be. In addition, we cannot be sure that we will be able to sufficiently ramp up our manufacturing and implementation capacity to meet, in a timely fashion, the demands that will be placed on us by the production phase of the contract. In this and any similar future programs, there may be no obligation on the part of the eventual customer to buy a minimum number of units or tests, so, even though we are awarded a production contract, we may be subject to future spending patterns and budgetary cycles. Furthermore, if we participate in any other collaborations bidding for government contracts, the bidding and evaluation process could be lengthy and involve significant expense, and may never result in a contract or a contract with acceptable terms. Accordingly, our participation in the USPS BDS program and other similar programs is subject to a number of risks and uncertainties and may never yield significant revenues.

 

We rely on licenses of key technology from third parties and will require additional licenses for many of our new products or product features.

 

Our products typically require licenses from third parties in order to be sold. If we were to lose any of these licenses for any reason, we may not be able to enter into new agreements on terms favorable to us or at all. We will also need to introduce new products and product features in order to market our products to a broader customer base. Accordingly, our introduction of new products and product features could require us to obtain additional licenses and pay unanticipated license fees and royalties. For example, in 2004, we signed patent license agreements with Applera Corporation and F. Hoffman-La Roche Ltd. that involve aggregated license fee payments of $32.2 million and require us to record resulting royalty obligations as part of the cost of product sales when the related product sales are recognized. Furthermore, for certain markets, we intend to manufacture reagents for use with our

 

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SmartCycler and GeneXpert systems to offer a more complete solution for the detection and analysis of DNA. We believe that manufacturing reagents for use in our SmartCycler and GeneXpert systems is important to our business and growth prospects. However, we will require additional licenses for many reagents that we may wish to market. Our ability to develop, manufacture and sell products, and our strategic plans and growth, could be impaired if we are unable to obtain these licenses or if these licenses are terminated or expire and cannot be renewed. We may not be able to obtain or renew licenses for a given product or product feature, or for some reagents, on commercially reasonable terms, if at all. Furthermore, some of our competitors have rights to technologies and reagents that we do not have, which may put us at a competitive disadvantage in certain circumstances and could adversely affect our performance.

 

If we cannot successfully commercialize our products, our business could be harmed.

 

If our tests for use on the SmartCycler and GeneXpert platforms do not gain market acceptance, we will be unable to generate significant sales, which will prevent us from achieving profitability. GeneXpert modules are already being incorporated into the USPS BDS. In addition, we launched the GeneXpert system, which contains the GeneXpert module and related software, in the biothreat market in the third quarter of 2004 and anticipate its commercial launch in the clinical genetic assessment market in the first half of 2005. However, to be successful, a menu of tests needs to be available for both the SmartCycler and GeneXpert platforms. Many factors may affect the market acceptance and commercial success of our products, including:

 

•                  timely development, approval and availability of tests and reagents for use on our SmartCycler and GeneXpert systems;

 

•                  demand for the tests and reagents we are able to introduce;

 

•                  timely completion of the GeneXpert system for commercial sale in the clinical genetic assessment market;

 

•                  the timing of market entry of our GeneXpert system relative to competitive products;

 

•                  the timing and market entry of various tests for the GeneXpert and the SmartCycler systems;

 

•                  our ability to convince our potential customers of the advantages and economic value of our systems and tests over competing technologies and products;

 

•                  the breadth our test menu relative to competitors;

 

•                  our ability to obtain United States Food and Drug Administration (FDA) and any other regulatory clearances or approvals for clinical markets;

 

•                  the extent and success of our marketing and sales efforts; and

 

•                  publicity concerning our systems and tests.

 

In particular, we believe that the success of our business will depend on our ability to commercialize our products for the clinical genetic assessment market.  Our current reliance on revenues from the USPS BDS program has resulted in substantial revenue concentrations in recent periods.  However, as discussed above, revenues from the BDS program are subject to substantial risks, including potential delays in implementation or changes in governmental budgeting priorities. We cannot assure you that the USPS will choose to purchase additional BDS units containing our products as part of the potential second phase of the BDS program. In part because of the risks associated with our current reliance on the BDS business, we believe that successfully building our business in the clinical genetic assessment market is critical to our long-term goals.  In addition, we have committed substantial funds to licenses that are required for us to enter the clinical market.  If we cannot successfully penetrate the clinical

 

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market to exploit these licenses, ongoing payments that we have agreed to make under them could significantly harm our business and operating results in future periods.

 

We expect that our operating results will fluctuate significantly, and any failure to meet financial expectations may result in a decline in our stock price.

 

We expect that our quarterly operating results will fluctuate in the future as a result of many factors, such as those described elsewhere in this section, many of which are beyond our control. Because our revenue and operating results are difficult to predict, we believe that period-to-period comparisons of our results of operations are not a good indication of our future performance. Our operating results may be affected by the inability of some of our customers to consummate anticipated purchases of our products, whether due to changes in internal priorities or, in the case of governmental customers, problems with the appropriations process and variability and timing of orders. If revenue declines in a quarter, whether due to a delay in recognizing expected revenue or otherwise, our results of operations will be harmed because many of our expenses are relatively fixed. In particular, research and development and selling, general and administrative expenses are not significantly affected by variations in revenue.

 

If we are unable to manufacture our products in sufficient quantities and in a timely manner, our operating results will be harmed and our ability to generate revenue could be diminished.

 

Our revenues and other operating results will depend in large part on our ability to manufacture and assemble our products in sufficient quantities and in a timely manner. Any interruptions we experience in the manufacturing or shipping of our products could delay our ability to recognize revenues in a particular quarter. We have limited experience in manufacturing large volumes of products and manufacturing problems could arise or we may be unable to adequately scale-up manufacturing in a timely manner or on a commercially reasonable basis if we experience increased demand. In the past, we have experienced delays in our ability to ship finished products as a result of delays in production. We may not be able to react quickly enough to ship products and recognize anticipated revenues for a given quarter or other fiscal period if we again experience significant delays in the manufacturing process. If we are unable to manufacture our products consistently and on a timely basis, our revenues from product sales and our other operating results will be materially and adversely affected.

 

If our single source suppliers fail to deliver key product components in a timely manner, our manufacturing ability would be impaired and our product sales could suffer.

 

We depend on several single source suppliers that supply components used in the manufacture of the SmartCycler system, the GeneXpert modules and system, disposable reaction tubes, and cartridges. If we need alternative sources for key component parts for any reason, these component parts may not be immediately available. If alternative suppliers are not immediately available, we will have to identify and qualify alternative suppliers, and production of these components may be delayed. We may not be able to find an adequate alternative supplier in a reasonable time period, or on commercially acceptable terms, if at all. For example, we have, in the past, experienced problems with the delivery of certain parts from an existing supplier, and had to shift to an alternative supplier. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. Our inability to obtain our key source supplies for the manufacture of our products may require us to delay shipments of products, harm customer relationships or force us to curtail or cease operations.

 

If a catastrophe strikes our manufacturing facilities, we may be unable to manufacture our products for a substantial amount of time and we would experience lost revenue.

 

Our manufacturing facilities are located in Sunnyvale, California. Although we have business interruption insurance, our facilities and some pieces of manufacturing equipment are difficult to replace and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities. Earthquakes are of particular significance since the manufacturing facilities are located in an earthquake-prone area. In the event our existing manufacturing facilities or equipment is affected by man-made or natural disasters, we may be unable to manufacture products for sale, meet customer demands or sales

 

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projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business.

 

If our products fail to obtain an adequate level of reimbursement from third-party payers, our ability to sell products in the clinical genetic assessment market would be harmed.

 

Our ability to sell our products in the clinical genetic assessment market will depend in part on the extent to which reimbursement for tests using our products will be available from:

 

•                  government health administration authorities;

 

•                  private health coverage insurers;

 

•                  managed care organizations; and

 

•                  other organizations.

 

If appropriate reimbursement cannot be obtained, our business could be harmed.

 

There are efforts by governmental and third-party payers to contain or reduce the costs of health care through various means. Additionally, third-party payers are increasingly challenging the price of medical products and services. If purchasers or users of our products are not able to obtain adequate reimbursement for the cost of using our products, they may forego or reduce their use. Significant uncertainty exists as to the reimbursement status of newly approved health care products and whether adequate third-party coverage will be available.

 

The regulatory approval process is expensive, time-consuming, and uncertain and may prevent us from obtaining required approvals for the commercialization of some of our products.

 

In the clinical genetic assessment market, our products generally will be regulated as medical devices by the FDA and comparable agencies of other countries. In particular, FDA regulations govern activities such as product development, product testing, product labeling, product storage, premarket clearance or approval, manufacturing, advertising, promotion, product sales, reporting of certain product failures and distribution. Some of our products, depending on their intended use, will require either premarket approval or 510(k) clearance from the FDA prior to marketing. The 510(k) clearance process usually takes from two to twelve months from submission, but can take longer. The premarket approval process is much more costly, lengthy, uncertain and generally takes from one to two years or longer from submission. Certain of our tests for use on our SmartCycler and GeneXpert systems, when used for clinical diagnostic purposes, may require premarket approval and all such tests will most likely, at a minimum, require 510(k) clearance. Failure to comply with the applicable requirements can result in, among other things, warning letters, administrative or judicially imposed sanctions such as injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal to grant premarket clearance or premarket approval for devices, withdrawal of marketing clearances or approvals, or criminal prosecution. To date only the GBS and MRSA tests developed by Infectio Diagnostics, Inc. (IDI) for use on the SmartCycler have received FDA clearance. Approval or clearance from the FDA or any other governmental body has not been sought for other tests for the SmartCycler or GeneXpert. Any failure or material delay to obtain 510(k) clearance or premarket approval from the FDA for future products could harm our business. In addition, it is possible that the current regulatory framework could change or additional regulations could arise at any stage during our product development or marketing, which may adversely affect our ability to obtain or maintain approval of our products and could harm our business.

 

Our manufacturing facilities, where we assemble and produce the SmartCycler system and the GeneXpert system, cartridges and reagents, are subject to periodic regulatory inspections by the FDA and other federal and state regulatory agencies. These facilities are subject to Quality System Regulations (QSR) of the FDA. If we fail to maintain these facilities in accordance with the QSR requirements, international quality standards or other regulatory requirements, our manufacturing process could be suspended or terminated, which would harm our business.

 

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Our sales cycle, particularly in the life sciences market, can be lengthy, which can cause variability and unpredictability in our operating results.

 

The sales cycles for our products, particularly in the life sciences market, can be lengthy, which makes it more difficult for us to accurately forecast revenues in a given period, and may cause revenues and operating results to vary significantly from period to period. Sales of our product to the life sciences market often involves purchasing decisions by large public and private institutions, and any purchases can require many levels of pre-approval. In addition, many of these sales depend on these institutions receiving research grants from various federal agencies, which grants vary considerably from year to year in both in amount and timing due to the political process. As a result, we may expend considerable resources on unsuccessful sales efforts or we may not be able to complete transactions on the schedule anticipated.

 

If our competitors and potential competitors develop superior products and technologies our competitive position and results of operations would suffer.

 

We face intense competition from a number of companies that offer products in our target markets. These competitors include:

 

•                  companies developing and marketing sequence detection systems for life sciences research products;

 

•                  healthcare companies that manufacture laboratory-based tests and analyzers;

 

•                  diagnostic and pharmaceutical companies;

 

•                  companies developing drug discovery technologies; and

 

•                  companies developing or offering biothreat detection technologies.

 

Several companies provide instruments and reagents for DNA amplification or detection. Applied Biosystems, F. Hoffmann-La Roche, BioRad and Stratagene sell systems integrating amplification and detection (sequence detection systems) to the commercial market.  Idaho Technologies sells sequence detection systems to the military market.  F. Hoffmann-La Roche, Abbott Laboratories and GenProbe sell large batch sequence detection systems, some with separate robotic batch DNA purification systems and sell reagents to the clinical genetic assessment market. Other companies, including Becton, Dickson and Company, Bayer and bioMerieux, offer molecular tests.

 

In order to compete effectively, we will need to demonstrate the advantages of our products over alternative well-established technologies and products. We will also need to demonstrate the potential economic value of our products relative to these technologies and products.

 

We also face competition from both established and development-stage companies that continually enter these markets. Several companies are currently making or developing products that may or will compete with our products. Our competitors may succeed in developing, obtaining FDA approval for, or marketing technologies or products that are more effective or commercially attractive than our potential products, or that render our technologies and potential products obsolete. As these companies develop their technologies, they may develop proprietary positions that prevent us from successfully commercializing our products.

 

In many instances, particularly in the clinical area, our competitors have substantially greater financial, technical, research and other resources, and larger, more established marketing, sales, distribution and service organizations than we have. Moreover, these competitors may offer broader product lines and tactical discounts and have greater name recognition. If we fail to compete effectively against these and other competitors, we will lose sales and our business will be harmed.

 

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If our products do not perform as expected, or the reliability of the technology on which our products are based is questioned, we could experience lost revenue, delayed or reduced market acceptance of our products, increased costs and damage to our reputation.

 

Our success depends on the market’s confidence that we can provide reliable, high quality genetic testing systems. We believe that customers in the life sciences, biothreat and clinical markets are likely to be particularly sensitive to product defects and errors. Our reputation and the public image of our products or technologies may be impaired for any of the following reasons:

 

•                  failure of products to perform as expected;

 

•                  any perception that our products are difficult to use; or

 

•                  litigation concerning the performance of our products or our technology.

 

Furthermore, with respect to the BDS system, our products are incorporated into larger systems that are built and delivered by others. We cannot control many aspects of the final product, and any failure in the overall system, even if it is unrelated to our products, could harm our business.  Even after any underlying concerns or problems are resolved, any widespread concerns regarding our technology or any manufacturing defects or performance errors in our products could result in lost revenue, delayed market acceptance, damaged reputation, increased service and warranty costs, and claims against us.

 

If product liability lawsuits are successfully brought against us, we may face reduced demand for our products and incur significant liabilities.

 

We face an inherent risk of exposure to product liability claims if our technologies or systems are alleged to have caused harm, in part because our products are used for sensitive applications. We cannot be certain that we can successfully defend any product liability lawsuit brought against us. Regardless of merit or eventual outcome, product liability claims may result in:

 

•                  decreased demand for our products;

 

•                  injury to our reputation;

 

•                  costs of related litigation; and

 

•                  substantial monetary awards to plaintiffs.

 

If we become the subject of a successful product liability lawsuit, we could incur substantial liabilities, which could harm our business.

 

We rely on relationships with collaborative partners and other third parties for development, supply and marketing of products and potential products, and such collaborative partners or other third parties could fail to perform sufficiently.

 

We believe that our success in penetrating our target markets and in bidding for certain kinds of contracts depends in part on our ability to develop and maintain collaborative relationships with key companies. However, our collaborative partners may not be able to perform their obligations as expected or devote sufficient resources to the development, supply or marketing of potential products developed under these collaborations. Also, if a key collaborative partner fails to perform its obligations as expected, including, for example, if it becomes insolvent or is acquired by another company with which we have no relationship, we may not be able to develop an adequate alternative in a timely manner.

 

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Currently, our significant collaborative partners include:

 

•                  Northrop Grumman Corp.’s Automation and Information Systems Division, Sceptor Industries and Smiths Detection, which are purchasing the GeneXpert module for installation into the BDS for the USPS program;

 

•                  Applied Biosystems Group, in a collaboration to develop and sell reagents to detect biothreat agents for use with our GeneXpert system and cartridges;

 

•                  bioMerieux, Inc., in a collaboration to develop and sell DNA testing products using its NASBA technology on our GeneXpert platforms; and

 

•                  Infectio Diagnostics, Inc., in an agreement to distribute IDI tests for GBS and MRSA, that have been configured for use with the SmartCycler system, and to apply IDI proprietary genetic sequences for GBS and MRSA in the development and commercialization of Cepheid tests to be used in the GeneXpert system.

 

Relying on these or other collaborative relationships is risky to our future success because, among other things:

 

•                  our collaborative partners may not devote sufficient resources to the success of our collaboration;

 

•                  our collaborative partners may not obtain regulatory approvals necessary to continue the collaborations in a timely manner;

 

•                  our collaborative partners may develop technologies or components competitive with our products;

 

•                  components developed by collaborators could fail to meet specifications, possibly causing us to lose potential projects and subjecting us to liability;

 

•                  some agreements with our collaborative partners may terminate prematurely due to disagreements or may result in litigation between the partners;

 

•                  our collaborators may not have sufficient capital resources;

 

•                  our existing collaborations may preclude us from entering into additional future arrangements; or

 

•                  we may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms.

 

If our direct selling efforts for our products fail, our business expansion plans could suffer and our ability to generate revenue will be diminished.

 

We have a relatively small sales force compared to our competitors. Failure to effectively promote and sell our products in these markets could have a negative impact on their market acceptance. If we fail to establish our systems in these markets,  it could have a negative effect on our ability to sell subsequent systems and hinder the planned expansion of our business.

 

If our distributor relationships are not successful, our ability to market and sell our products would be harmed and our financial performance will be adversely affected.

 

We depend on relationships with distributors for the marketing and sales of our products in the life sciences and clinical markets in various geographic regions and we have a limited ability to influence their efforts. In the nine

 

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months ended September 30, 2004, product sales through distributors represented 23% of total product sales. Our distributors in North America, Europe, Japan and other parts of the world accounted for 11%, 7%, 3% and 2%, respectively, of total product sales in the nine months ended September 30, 2004. Fisher Scientific is our major non-exclusive distributor in the United States and Canada. Other than our reserved right to sell directly to some end user customers, Takara Bio, Inc. is the exclusive distributor of SmartCycler in the life sciences market in Japan. We also rely on various distributors for our sales of SmartCycler in Europe, China, Mexico and other parts of the world. Relying on distributors for our sales and marketing could harm our business for various reasons, including:

 

•                  agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the partners;

 

•                  our distributors may not devote sufficient resources to the sale of products;

 

•                  our distributors may be unsuccessful;

 

•                  our existing relationships with distributors may preclude us from entering into additional future arrangements; and

 

•                  we may not be able to negotiate future distributor agreements on acceptable terms.

 

We may be subject to third-party claims that we require additional licenses for our products, and such claims could interfere with our business.

 

Our industry is characterized by a large number of patents, claims of which appear to overlap in many cases. As a result, there is a significant amount of uncertainty regarding the extent of patent protection and infringement. Obtaining licenses to potentially relevant patents could be costly and could materially harm our results of operations. Failing to obtain a license could result in litigation, which may consume our resources and lead to significant damages, royalty payments or an injunction on the sale of our products. In addition, some of these licenses could result in substantial additional royalties, which could adversely impact our product costs and harm our business.

 

If our products infringe on the intellectual property rights of others, we could face costly litigation, which could cause us to pay substantial damages and limit our ability to sell some or all of our products.

 

Our ability to sell our products depends in part on us neither infringing valid, enforceable patents or proprietary rights of third parties, nor breaching any of our licenses under which we have been granted rights relating to our technologies and products. We are aware of a number of third-party patents that relate to our technology. We plan to seek licenses as we deem necessary or appropriate; however, such licenses may not be available on commercially acceptable terms, if at all. It is possible that third parties from whom we do not acquire a license may assert infringement or other intellectual property claims against us. For example, from time to time, companies have asked us to evaluate the need for a license of patents they hold, and we cannot assure you that patent infringement claims will not be filed against us in the future. Other companies may also have pending patent applications (which are typically confidential for the first eighteen months following filing) that cover technologies we incorporate in our products. As a result, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our products infringe a third party’s proprietary rights. Even if these claims are without merit, defending a lawsuit takes significant time, may be expensive and may divert management attention from other business concerns. Any public announcements related to litigation or interference proceedings initiated or threatened against us could cause our stock price to decline.

 

We may need to initiate lawsuits to protect or enforce our patents, which would be expensive and, if we lose, may cause us to lose some, if not all, of our intellectual property rights, and thereby impair our ability to compete.

 

We rely on patents to protect a large part of our intellectual property. To protect or enforce our patent rights, we may

 

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