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 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 NO. 0-28218

 

 

AFFYMETRIX, INC.

(Exact name of Registrant as specified in its charter)

 

DELAWARE		77-0319159
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)
3380 CENTRAL EXPRESSWAY SANTA CLARA, CALIFORNIA		95051
(Address of principal executive offices)		(Zip Code)

 

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

 

 

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

 

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

 

COMMON SHARES OUTSTANDING ON OCTOBER 31, 2004:  60,957,819

 

 

AFFYMETRIX, INC.

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION
	Item 1.	Financial Statements (Unaudited)
		Condensed Consolidated Balance Sheets at 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 Risk
	Item 4.	Controls and Procedures
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings
	Item 5.	Other Information
	Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES

 

2

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS)

(UNAUDITED)

 

		September 30, 2004			December 31, 2003
					(Note 1)
ASSETS
Current assets:
Cash and cash equivalents		$	26,369		$	275,928
Available-for-sale securities		155,359			183,955
Accounts receivable		65,823			71,343
Inventories		19,807			22,632
Prepaid expenses and other current assets		7,683			7,443
Total current assets		275,041			561,301
Property and equipment, net		62,630			62,611
Acquired technology rights, net		65,578			27,818
Goodwill		18,601			18,601
Notes receivable from employees		2,715			1,500
Other assets		27,443			28,333
		$	452,008		$	700,164
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities		$	52,960		$	71,044
Deferred revenue — current portion		31,932			30,019
Convertible subordinated notes — short-term		—			267,460
Total current liabilities		84,892			368,523
Deferred revenue — long-term		33,064			43,346
Other long-term liabilities		4,299			3,240
Convertible notes		120,000			120,000
Stockholders’ equity:
Common stock		608			595
Additional paid-in capital		393,270			370,304
Notes receivable from stockholders		—			(428		)
Deferred stock compensation		(4,270		)	(5,185		)
Accumulated other comprehensive loss		(1,749		)	(1,572		)
Accumulated deficit		(178,106		)	(198,659		)
Total stockholders’ equity		209,753			165,055
		$	452,008		$	700,164

 

Note 1:                             The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date included in the Company’s Form 10-K for the fiscal year ended December 31, 2003.

 

See accompanying notes.

 

3

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Revenue:
Product sales		$	62,318		$	57,467		$	185,073		$	153,441
Product related revenue		13,928			13,625			40,961			41,992
Total product and product related revenue		76,246			71,092			226,034			195,433
Royalties and other revenue		2,742			2,349			8,300			8,194
Revenue from Perlegen Sciences		879			2,744			3,920			8,005
Total revenue		79,867			76,185			238,254			211,632
Costs and expenses:
Cost of product sales		17,107			22,393			57,227			56,210
Cost of product related revenue		2,367			2,304			7,299			6,805
Cost of revenue from Perlegen Sciences		569			2,744			3,039			8,005
Research and development		17,791			16,463			52,892			48,990
Selling, general and administrative		26,989			24,092			85,212			76,250
Amortization of deferred stock compensation		267			484			915			1,852
Amortization of purchased intangibles		—			281			—			844
Charge for acquired in-process technology		—			—			—			10,096
Total costs and expenses		65,090			68,761			206,584			209,052
Income from operations		14,777			7,424			31,670			2,580
Interest and other income, net		1,638			2,403			1,773			10,765
Interest expense		(437		)	(3,559		)	(10,675		)	(13,726		)
Income (loss) before income taxes		15,978			6,268			22,768			(381		)
Income tax provision		(601		)	(466		)	(2,215		)	(1,344		)
Net income (loss)		$	15,377		$	5,802		$	20,553		$	(1,725	)
Basic net income (loss) per share		$	0.25		$	0.10		$	0.34		$	(0.03	)
Diluted net income (loss) per share		$	0.25		$	0.10		$	0.33		$	(0.03	)
Shares used in computing basic net income (loss) per share		60,617			58,881			60,300			58,717
Shares used in computing diluted net income (loss) per share		62,688			60,485			62,749			58,717

 

See accompanying notes.

 

4

 

AFFYMETRIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)
(UNAUDITED)

 

		Nine Months Ended September 30,
		2004			2003
Cash flows from operating activities:
Net income (loss)		$	20,553		$	(1,725	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		14,894			16,978
Gain from the repurchase of convertible subordinated notes		—			(739		)
Redemption premium and related write-off of debt issuance costs		8,095			—
Amortization of intangible assets		4,153			3,425
Amortization of investment (discounts) premiums, net		(1,285		)	2,056
Stock-based compensation		915			1,852
Realized loss (gain) on sales of investments		800			(5,669		)
Write down of equity investments		2,283			938
Amortization of debt offering costs		566			1,184
Accretion of interest on notes receivable		(26		)	(147		)
Loss on write-off of equipment		513			405
Changes in operating assets and liabilities:
Accounts receivable, net		5,520			10,788
Inventories		2,825			2,697
Prepaid expenses and other assets		(5,746		)	(4,897		)
Accounts payable and accrued and other current liabilities		(17,144		)	(12,687		)
Deferred revenue		(8,369		)	57,251
Other long-term liabilities		1,059			(339		)
Net cash provided by operating activities		29,606			71,371
Cash flows from investing activities:
Capital expenditures		(15,426		)	(8,046		)
Purchases of available-for-sale securities		(158,147		)	(412,822		)
Proceeds from the sales and maturities of available-for-sale securities		186,264			430,705
Purchase of non-marketable equity investment		(991		)	(1,000		)
Purchase of technology rights		(41,913		)	(5,903		)
Net cash (used in) provided by investing activities		(30,213		)	2,934
Cash flows from financing activities:
Issuance of common stock		22,979			8,947
Repurchase of convertible subordinated notes		—			(100,701		)
Redemption of convertible subordinated notes		(271,778		)	—
Net cash used in financing activities		(248,799		)	(91,754		)
Effect of exchange rate changes on cash		(153		)	(52		)
Net decrease in cash and cash equivalents		(249,559		)	(17,501		)
Cash and cash equivalents at beginning of period		275,928			67,888
Cash and cash equivalents at end of period		$	26,369		$	50,387

 

See accompanying notes.

 

5

 

AFFYMETRIX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2004

(UNAUDITED)

 

NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The condensed consolidated financial statements include the accounts of Affymetrix, Inc. (“Affymetrix” or the “Company”) and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. In the opinion of management, all adjustments (consisting only 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 fiscal year ended December 31, 2003. Certain amounts presented in the condensed consolidated financial statements for prior periods have been reclassified to conform to the current period presentation.

 

Use of Estimates

 

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

 

Revenue Recognition

 

Product Sales

 

Product sales as well as revenues from Perlegen Sciences, include sales of GeneChip® probe arrays and related instrumentation. Probe array and instrumentation revenues are recognized when earned, which is generally upon shipment and transfer of title to the customer and fulfillment of any significant post-delivery obligations. Accruals are provided for anticipated warranty expenses at the time the associated revenue is recognized.

 

Product Related Revenue

 

Product related revenue includes subscription fees earned under EasyAccess™ agreements; license fees, milestones and royalties earned from collaborative product development and supply agreements; equipment service revenue; product related scientific services revenue; revenue from custom probe array design fees; and software revenue.

 

Revenue from subscription fees earned under EasyAccess™ agreements is recorded ratably over the related supply term.

 

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. The Company accounts for multiple element arrangements under Emerging Issues Task Force Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 provides guidance on accounting for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 were adopted prospectively for revenue arrangements with multiple elements signed subsequent to June 30, 2003. The adoption of EITF 00-21 did not have a material impact on the Company’s results of operations or financial condition.

 

6

 

In accordance with EITF 00-21, the Company allocates revenue for transactions or collaborations that include multiple elements to each unit of accounting based on its relative fair value, and recognizes revenue for each unit of accounting when the revenue recognition criteria have been met. The price charged when the element is sold separately generally determines fair value. In the absence of fair value of a delivered element, the Company allocates revenue first to the fair value of the undelivered elements and the residual revenue to the delivered elements. The Company recognizes revenue for delivered elements only when undelivered elements are not essential to the functionality of delivered elements and the fair value for all undelivered elements is known. If the fair value of any undelivered element included in a multiple element arrangement cannot be objectively determined, revenue is deferred until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements.

 

Any up-front, nonrefundable payments from collaborative product development agreements are recognized over the research and product development period, and at-risk substantive based milestones are recognized when earned. Any payments received which are not yet earned are included in deferred revenue.

 

Revenue related to extended warranty arrangements is deferred and recognized over the applicable periods. Revenue from custom probe array design fees associated with the Company’s GeneChip® CustomExpress™ and CustomSeq™ products are recognized when the associated products are shipped.

 

Royalties and Other Revenue

 

Royalties and other revenue include royalties earned from third party license agreements and research revenue which mainly consists of amounts earned under government grants. Additionally, other revenue includes fees predominately earned through the license of the Company’s intellectual property not associated with current product revenue.

 

Royalty revenues are earned from the sale of products by third parties who have been licensed under the Company’s intellectual property portfolio. Revenue from minimum royalties is amortized over the term of the creditable royalty period. Any royalties received in excess of minimum royalty payments are recognized under the terms of the related agreement, generally upon notification of manufacture or shipment of a product by a licensee.

 

Research revenue is mainly comprised of amounts earned under government grants. Research revenue is recorded in the period in which the associated costs are incurred. The costs associated with these grants are reported as research and development expense.

 

License revenues are generally recognized upon execution of the agreement unless the Company has continuing performance obligations, in which case the license revenue is recognized ratably over the period of expected performance.

 

Stock-Based Compensation

 

At September 30, 2004, the Company has six stock-based employee and non-employee director compensation plans, which are more fully described in the Company’s Annual Report on Form 10-K. The Company has elected to continue to follow the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations for these plans. During the three and nine months ended September 30, 2004 and 2003, no stock-based compensation cost is reflected in net income (loss), as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant in accordance with FASB Statement No. 123, “Accounting for Stock-Based Compensation (“SFAS 123”), as amended by FASB Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“SFAS 148”).

 

The following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of SFAS 123, as amended by SFAS 148, to stock-based employee compensation (in thousands, except per share amounts):

 

7

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Net income (loss)—as reported		$	15,377		$	5,802		$	20,553		$	(1,725	)
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of tax		(3,541		)	(6,176		)	(11,364		)	(21,617		)
Pro forma net income (loss)		$	11,836		$	(374	)	$	9,189		$	(23,342	)
Net income (loss) per share:
Basic net income (loss) per share-as reported		$	0.25		$	0.10		$	0.34		$	(0.03	)
Diluted net income (loss) per share-as reported		$	0.25		$	0.10		$	0.33		$	(0.03	)
Basic net income (loss) per share-pro forma		$	0.20		$	(0.01	)	$	0.15		$	(0.40	)
Diluted net income (loss) per share-pro forma		$	0.19		$	(0.01	)	$	0.15		$	(0.40	)

 

Comprehensive Income (Loss)

 

Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss).  Other comprehensive income (loss) includes unrealized gains and losses on the Company’s available-for-sale securities, hedging contracts that are excluded from net income (loss), changes in fair value of derivatives designated as and effective as cash flow hedges, and foreign currency translation adjustments (see note 6).

 

Basic and Diluted Net Income (Loss) Per Share

 

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

 

The following table sets forth the computation of the weighted-average shares used in the basic and diluted net income (loss) per share calculations (in thousands):

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2004		2003		2004		2003
Weighted-average shares outstanding		60,691		58,983		60,379		58,829
Less: weighted-average shares of common stock subject to repurchase		(74	)	(102	)	(79	)	(112	)
Weighted-average shares used in computing basic net income (loss) per share		60,617		58,881		60,300		58,717
Weighted-average effect of dilutive securities:
Options		2,036		1,568		2,413		—
Warrants		35		36		36		—
Weighted-average shares used in computing diluted net income (loss) per share		62,688		60,485		62,749		58,717

 

8

 

Securities excluded from the computation of basic and diluted net loss per share, on an actual outstanding basis, were as follows (in thousands):

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2004		2003		2004		2003
Options and warrants		2,708		6,415		2,401		10,076
Convertible notes		3,870		2,689		3,870		2,689
Common stock subject to repurchase		9		19		9		91
Total		6,587		9,123		6,280		12,856

 

Income Taxes

 

Under the asset and liability method, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities, and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the statement of operations in the period of enactment.

 

Contingencies

 

The Company is subject to legal proceedings principally related to intellectual property matters. Based on the information available at the balance sheet dates, the Company assesses the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. If losses are probable and reasonably estimable, the Company will record a reserve in accordance with SFAS 5, “Accounting for Contingencies.” Any reserves recorded may change in the future due to new developments in each matter.

 

Derivative Instruments

 

In April 2004, the Company began hedging a percentage of its assets that are held in various nonfunctional currencies of its subsidiaries with forward contracts, with the gains or losses on these contracts largely offsetting gains and losses on the change in value of the underlying assets.  The Company’s balance sheet hedging policy is designed to reduce the fluctuations in earnings due to changes in foreign currency exchange rates.  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. In addition, the Company does not enter into foreign currency forward contracts for trading or speculative purposes, is not party to any leveraged derivative instrument, and may only enter into derivative agreements with highly rated counterparties.

 

NOTE 2—PRODUCT SALES AND PRODUCT RELATED REVENUE

 

The components of product sales are as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Probe arrays and related supplies		$	45,913		$	39,384		$	133,035		$	112,082
Instruments		16,405			18,083			52,038			41,359
Total product sales		$	62,318		$	57,467		$	185,073		$	153,441

 

The components of product related revenue are as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Subscription fees		$	5,127		$	5,984		$	15,643		$	19,537
Service and other		4,205			4,059			11,639			12,917
License fees and milestone revenue		4,596			3,582			13,679			9,538
Total product related revenue		$	13,928		$	13,625		$	40,961		$	41,992

 

9

 

NOTE 3—EQUITY INVESTMENTS

 

In August 2004, the Company paid $0.5 million for 8,235,714 shares of preferred stock in a non-public biotechnology company.  Concurrent with this investment, the Company licensed certain of its patents to the investee in exchange for an additional 15,082,956 shares of preferred stock valued at $0.9 million.  The value ascribed to the additional shares was equal to the cash price paid per share by the lead investors in the financing and was recorded as a license fee in royalties and other revenues.

 

NOTE 4—INVENTORIES

 

Inventories consist of the following (in thousands):

 

		September 30, 2004			December 31, 2003
Raw materials		$	8,074		$	9,129
Work-in-process		5,597			4,226
Finished goods		6,136			9,277
Total		$	19,807		$	22,632

 

NOTE 5—ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

 

Accounts payable and accrued liabilities consist of the following (in thousands):

 

		September 30, 2004			December 31, 2003
Accounts payable		$	12,919		$	15,130
Accrued compensation and related liabilities		21,004			18,767
Accrued interest on convertible notes		262			4,260
Accrued taxes		9,829			3,756
Accrued legal		945			3,261
Accrued royalties		466			15,465
Accrued warranties		3,323			2,950
Other		4,212			7,455
Total		$	52,960		$	71,044

 

NOTE 6—COMPREHENSIVE INCOME (LOSS)

 

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

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Net income (loss)		$	15,377		$	5,802		$	20,553		$	(1,725	)
Foreign currency translation adjustment		59			8			(153		)	(52		)
Unrealized loss on available-for-sale securities		(263		)	(1,395		)	(962		)	(350		)
Unrealized gain (loss) on hedging contracts		(82		)	(508		)	938			(913		)
Comprehensive income (loss)		$	15,091		$	3,907		$	20,376		$	(3,040	)

 

NOTE 7—INTANGIBLE ASSETS

 

Acquired technology rights are comprised of licenses to technology covered by patents to third parties and are amortized over the expected useful life of the underlying patents, which range from one to fifteen years. Accumulated amortization of these rights amounted to $12.2 million and $8.0 million at September 30, 2004 and December 31, 2003, respectively.

 

10

 

In May 2004, the Company reached an agreement with Oxford Gene Technology, Ltd. (“OGT”) to convert the Company’s non-exclusive royalty bearing license to certain of OGT’s patents to a fully paid-up license in return for a cash payment of $62.5 million.  The payment was comprised of approximately $41.9 million for the technology rights which was recorded in acquired technology rights, net and is being amortized over the remaining useful life of the patents of approximately 10 years, and approximately $20.6 million for previously accrued and expensed royalty obligations.

 

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

 

For the Year Ending December 31,		Amortization Expense
2004, remainder thereof		$	1,934
2005		7,520
2006		7,436
2007		7,436
2008		7,422
Thereafter		33,830
Total expected future annual amortization		$	65,578

 

NOTE 8—CONVERTIBLE SUBORDINATED NOTES

 

On September 22, 1999, the Company completed the sale of $150 million principal amount of 5% convertible subordinated notes due 2006 (the “5% notes”). On February 14, 2000, the Company completed the sale of $225.0 million principal amount of 4.75% convertible subordinated notes due 2007 (the “4.75% notes”).  Between August 2001 and June 2003, the Company repurchased $59.5 million and $48.0 million principal amounts of its 4.75% and 5% notes, respectively.

 

On January 9, 2004, the Company completed the redemption of its 5.0% notes ($102.0 million face value). In connection with the redemption, the Company recorded a charge of $3.2 million to interest expense in the first quarter of 2004, related to the unamortized issuance costs and redemption fee associated with the repurchased notes. On February 19, 2004, the Company also completed the redemption of its 4.75% notes ($165.5 million face value). In connection with the redemption, the Company recorded a charge of $4.9 million to interest expense related to the unamortized issuance costs and redemption fee associated with the repurchased notes.

 

NOTE 9—RELATED PARTY TRANSACTIONS

 

Perlegen Sciences, Inc.

 

As of September 30, 2004, the Company held approximately 40% ownership interest in Perlegen Sciences, Inc. (“Perlegen”), a privately-held biotechnology company in which two members of Perlegen’s board of directors are also members of the Company’s board of directors.  In addition, certain affiliates, including the Company’s chief executive officer and members of the Company’s board of directors, hold direct or indirect equity interests in Perlegen.

 

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

 

In January 2003, the Company licensed certain Perlegen technologies. Under the terms of the licensing agreement, the Company paid Perlegen a total of $15.0 million in cash and granted Perlegen a $3.0 million credit to be applied against the margin on the Company’s future sales of chips to Perlegen that were utilized by Perlegen in their revenue generating activities.  The Company engaged an independent third party to conduct a valuation analysis of the licenses acquired. Based upon that independent valuation, the Company recorded a charge of approximately $10.1 million related to acquired in-process research and development in the first quarter of 2003. The remaining $4.9 million was recorded as intangible assets which are being amortized over their useful lives of nine to ten years.  In the second quarter of 2004, Perlegen had used all of the $3.0 million credit and as such, the Company has started to record margin on specific sales to Perlegen.

 

11

 

The Company accounts for its ownership interest in Perlegen using the equity method as the Company and its affiliates do not control the strategic, operating, investing and financing activities of Perlegen. Further, the Company has no obligations to provide funding to Perlegen nor does it guarantee or otherwise have any obligations related to the liabilities or results of operations of Perlegen or its investors. Given that the Company’s investment in Perlegen has no cost basis, the Company has not recorded any proportionate share of Perlegen’s operating losses in its financial statements since the completion of Perlegen’s initial financing. In January 2004, the Company sold 400,000 shares of Perlegen common stock for a gain of $0.6 million which was included in interest and other income (expense), net during the first quarter of 2004.

 

In accordance with Financial Accounting Standards Board Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” as amended, the Company has concluded that Perlegen is a Variable Interest Entity (VIE) in which it holds a variable interest, and that the Company is not the primary beneficiary.  Accordingly, no change in accounting is appropriate and the Company will continue to account for its ownership interest in Perlegen under the equity method as described in the preceding paragraph.

 

As of September 30, 2004 and December 31, 2003, amounts due from Perlegen were $1.5 million and $2.9 million, respectively, and have been included in accounts receivable in the accompanying condensed consolidated balance sheets. Amounts due from Perlegen are payable to the Company on its normal commercial terms.

 

NOTE 10—COMMITMENTS AND CONTINGENCIES

 

Product Warranty Commitment

 

The Company provides for anticipated warranty costs at the time the associated revenue is recognized. Product warranty costs are estimated based upon the Company’s historical experience and the warranty period. Information regarding the changes in the Company’s product warranty liability for the nine months ended September 30, 2004 was as follows (in thousands):

 

Balance at December 31, 2003		$	2,950
New warranties issued		868
Repairs and replacements		(1,095		)
Balance at March 31, 2004		2,723
New warranties issued		1,201
Repairs and replacements		(933		)
Balance at June 30, 2004		2,991
New warranties issued		1,098
Repairs and replacements		(766		)
Balance at September 30, 2004		$	3,323

 

Funding Commitments

 

The Company has invested $6.8 million and is committed to invest up to an additional $3.2 million in a venture capital limited partnership. The Company accounts for this investment using the cost method of accounting, given that its ownership percentage is so minor that the Company has no influence over partnership operating and financial policies. The investment is included on the condensed consolidated balance sheet as a component of other assets.

 

Non-cancelable Supply Agreements

 

As of September 30, 2004, the Company had approximately $8.6 million of non-cancelable supply agreements through 2007.

 

Indemnifications

 

From time to time the Company has entered into indemnification provisions under certain of its agreements with other companies in the ordinary course of business, typically with business partners, customers, and suppliers. Pursuant to these agreements, the Company generally indemnifies, holds harmless, and agrees to reimburse the indemnified parties on a case by case basis for losses suffered or incurred by the indemnified parties in connection with any U.S. patent or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification provisions is generally perpetual from the time of the execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification provisions is unlimited. The Company has not

 

12

 

incurred material costs to defend lawsuits or settle claims related to these indemnification provisions. As of September 30, 2004, the Company had not accrued a liability for this guarantee, because the likelihood of incurring a payment obligation in connection with this guarantee is remote.

 

Legal Proceedings – General

 

The Company has been in the past and continues to be a party to litigation which has consumed and may in the future continue to consume substantial financial and managerial resources and which could adversely affect its business, financial condition and results of operations. If in any pending or future intellectual property litigation involving the Company or its collaborative partners, the Company is found to have infringed the valid intellectual property rights of third parties, the Company, or its collaborative partners, could be subject to significant liability for damages, could be required to obtain a license from a third party, which may not be available on reasonable terms or at all, or could be prevented from manufacturing and selling its products. In addition, if the Company is unable to enforce its patents and other intellectual property rights against others, or if its patents are found to be invalid or unenforceable, third parties may more easily be able to introduce and sell DNA array technologies that compete with the Company’s GeneChip® brand technology, and the Company’s competitive position could suffer. The Company expects to devote substantial financial and managerial resources to protect its intellectual property rights and to defend against the claims described below as well as any future claims asserted against it. Further, because of the substantial amount of discovery required in connection with any litigation, there is a risk that confidential information could be compromised by disclosure.

 

Multilyte Litigation

 

Multilyte Ltd., a British corporation, and Affymetrix commenced legal proceedings in the United States, United Kingdom and German courts to address allegations made by Multilyte that the Company infringes certain patents owned by Multilyte (the “Multilyte patents”) by making and selling the GeneChip® DNA microarray products.

 

Germany

 

In the actions pending in Germany, on July 18, 2003, Multilyte filed proceedings in the state court of Dusseldorf, alleging infringement of the Multilyte patents.  In a separate action in Germany, on October 15, 2003, the Company commenced nullity proceedings in German Federal Patent Court in Munich alleging that the German part of Multilyte’s two European patents are invalid.  On October 16, 2003, the Dusseldorf court held its first hearing in the infringement case and ruled that the case be divided into two formally separate cases (one dealing with European patent EP 0 134 215 and the other with European patent EP 0 304 202).

 

On June 29 and 30, 2004, the German Federal Patent Court in Munich held that both Multilyte’s European patents are invalid in Germany.  Following that ruling, Multilyte applied to stay both sets of infringement proceedings before the Dusseldorf court, pending Multilyte’s appeal of the decisions of the German Federal Patent Court in Munich nullifying both Multilyte patents.  On July 12, 2004, this stay was granted.

 

United Kingdom

 

In the action pending in the U.K., on August 14, 2003, the Company commenced proceedings in the English High Court seeking a declaratory judgment that three Multilyte patents are not infringed and are invalid. On September 25, 2003, Multilyte counterclaimed in the U.K. proceedings, alleging that the Company infringed two Multilyte patents (EP ‘215 and EP ‘202) in the U.K. and claiming damages, an injunction and legal costs.  Multilyte agreed that Affymetrix did not infringe the third patent and it was dropped from the lawsuit.  The English High Court directed that the issues of whether the Multilyte patents are valid and whether they have been infringed by the Company should be heard together.

 

On March 3, 2004, Multilyte notified the Company that they would be surrendering EP ‘215 and that the counterclaim of infringement would necessarily be withdrawn as a result.  On April 19, 2004, Multilyte wrote to the U.K. Patent Office to surrender EP ‘215.  On August 18, 2004, Multilyte informed the Company that Multilyte would no longer defend the invalidity proceedings in respect of EP ‘215 or EP ‘202.  At a hearing on August 31, 2004, the English High Court ruled that the EP ‘215 and EP ‘202 were invalid in the United Kingdom.  Multilyte consented to this final judgment, and it is not appealable.  As a consequence of the judgment, Multilyte was required to repay a substantial portion of Affymetrix’s costs of the U.K. actions.

 

13

 

United States

 

In the action pending in the U.S., on August 13, 2003, the Company commenced proceedings in the United States District Court for the Northern District of California seeking a declaratory judgment that eight Multilyte patents are not infringed and are invalid.  Multilyte has agreed that the Company does not infringe five of the eight named patents.  On October 24, 2003, the Company filed an amended complaint seeking a declaratory judgment as to three of the original eight named patents—U.S. Patents 5,432,099, 5,599,720 and 5,807,755.  On November 12, 2003, Multilyte filed an answer to the Company’s complaint for declaratory judgment and asserted counterclaims against the Company alleging infringement of the three patents named by the Company in its complaint.  Multilyte has submitted the three patents-in-suit to the United States Patent and Trademark Office for voluntary re-examination.  Typically, re-examination proceedings take at least 12 months.  On June 3, 2004, the Court stayed the case before it pending the outcome of the re-examination proceedings before the United States Patent and Trademark Office and set a status hearing for December 2, 2004.

 

The Company believes that Multilyte’s remaining claims in Germany and the United States are without merit and has filed the declaratory judgment and nullity actions to protect its interests.  However, the Company cannot be sure that it will prevail in these matters.  The Company’s failure to successfully defend against these allegations could result in a material adverse effect on its business, financial condition and results of operations.

 

Enzo Litigation

 

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

 

On November 10, 2003, the Company filed a complaint against Enzo in the United States District Court for the Southern District of New York for declaratory judgment, breach of contract and injunctive relief relating to the 1998 agreement.  In its complaint, the Company alleges that Enzo has engaged in a pattern of wrongful conduct against it and other Enzo labeling reagent customers by, among other things, asserting improperly broad rights in its patent portfolio, improperly using the 1998 agreement and distributorship agreements with others in order to corner the market for non-radioactive labeling reagents, and improperly using the 1998 agreement to claim ownership rights to the Company’s proprietary technology. The Company seeks declarations that it has not breached the 1998 agreement, that it is entitled to sell its remaining inventory of Enzo reagent labeling kits, and that nine Enzo patents that are identified in the 1998 agreement are invalid and/or not infringed by it.  The Company also seeks damages and injunctive relief to redress Enzo’s alleged breaches of the 1998 agreement, its alleged tortious interference with the Company’s business relationships and prospective economic advantage, and Enzo’s alleged unfair competition.  The Company filed a notice of related case stating that its complaint against Enzo is related to the complaints already pending in the Southern District of New York against eight other former Enzo distributors.  The Southern District of New York has related the Company’s case.  On April 9, 2004, the Company filed its answer to Enzo’s complaint.  Enzo filed an answer to the Company’s complaint on May 13, 2004.  On September 14, 2004, the Southern District of New York conducted a consolidated status conference for the various Enzo litigations and scheduled a claim construction hearing for the Enzo patents on June 28, 2005.  There is no trial date in the actions between Enzo and the Company.

 

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

 

Administrative Litigation and Proceedings

 

The Company’s intellectual property is expected to be subject to significant additional administrative and litigation actions. For example, in Europe and Japan, third parties are expected to oppose significant patents that the Company owns or controls. Currently, Multilyte Ltd. and ProtoGene Laboratories, Inc. are parties that have filed oppositions against the Company’s EP 0 619 321 patent in the European Patent Office, and PamGene B.V. has filed an opposition against the Company’s EP 0 728 520. Also, Abbott Laboratories, Applera, Clondiag and CombiMatrix are parties in opposition against

 

14

 

the Company’s EP 0 834 575. Abbott Laboratories, CombiMatrix, PamGene B.V., Applera and Dr. Peter Schneider have filed oppositions against the Company’s EP 0 834 576. CombiMatrix has filed an opposition against EP 0 695 941.  Agilent, CombiMatrix, Clondiag and Applera have filed an opposition against EP 0 853 679 and Applera has opposed EP 0 972 564. These procedures will result in the patents being either upheld in their entireties, allowed to issue in amended form in designated European countries, or revoked.

 

Further, in the United States, the Company expects that third parties will continue to “copy” the claims of its patents in order to provoke interferences in the United States Patent & Trademark Office, and it may copy the claims of others. These proceedings could result in the Company’s patent protection being significantly modified or reduced, and could result in significant costs and consume substantial managerial resources.

 

At this time, the Company cannot determine the outcome of any of the matters described above.

 

NOTE 11—EQUITY

 

During the nine months ended September 30, 2004, the Company issued approximately 1,300,000 shares of common stock in connection with exercises of employee stock options.

 

On June 10, 2004, at the annual shareholders’ meeting, the shareholders approved the Company’s Amended and Restated 2000 Equity Incentive Plan (the “2000 Plan”) to increase share availability by 2,500,000 shares.

 

15

 

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, 2004 and for the three and nine month periods ended September 30, 2004 and 2003 should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2003.

 

All statements in this quarterly report that do not discuss past results are forward-looking statements. Forward-looking statements are based on management’s current expectations and are therefore subject to certain risks and uncertainties, including those discussed under the section titled “Risk Factors” included in this report. Specific uncertainties which could cause our actual results to differ materially from those projected include, but are not limited to, risks of our ability to achieve and sustain higher levels of revenue, maintain gross margins, reduced operating expenses, market acceptance, personnel retention, global economic conditions, the reduction in overall capital spending in the academic, pharmaceutical and biotechnology sectors, changes in government funding policies, unpredictable fluctuations in quarterly revenues, uncertainties related to cost and pricing of Affymetrix products, dependence on collaborative partners, uncertainties relating to sole source suppliers, uncertainties relating to FDA and other regulatory approvals, competition, risks relating to intellectual property of others and the uncertainties of patent protection and litigation.

 

We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions, or circumstances on which any such statements are based.

 

Our Industry

 

Our industry is affected by a number of factors that influence its size and development. These factors include the availability of genomic sequence data for human and other organisms, technological innovation that increases throughput and lowers the cost of genomic and genetic analysis, the development of new computational techniques to handle and analyze large amounts of genomic data, the availability of government funding for basic and disease-related research, the amount of capital and ongoing expenditures allocated to research and development spending by biotechnology, pharmaceutical and diagnostic companies, the application of genomics to new areas including molecular diagnostics, agriculture, human identity and consumer goods, and the availability of genetic markers and signatures of diagnostic value.

 

Our Business and Financial Results

 

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

 

In addition to our product sales, we also generate product related revenues which is comprised of revenue from various sources including service contracts on instrumentation; product related scientific services revenue; custom array design fees; licenses, royalties and milestone payments pursuant to collaborative product and supply arrangements with our corporate partners; and subscription fees earned under EasyAccess™ agreements which provide our customers early access to our upcoming products and emerging technologies.  Finally, we derive royalty and other revenue which includes royalties earned from third party license agreements, research grants, and fees from the license of our technologies.

 

For the nine months ended September 30, 2004, we had net income of $20.6 million.  Prior to the year ended December 31, 2003, we incurred losses each year since our inception, and as a result have an accumulated deficit of approximately $178.1 million at September 30, 2004. Our losses have resulted principally from costs incurred in research and development, manufacturing and from selling, general and administrative costs associated with our operations, including the costs of patent related litigation. These costs have historically exceeded our revenues and interest income, which to date have been generated principally from product sales, product related revenue, technology access and other license fees, royalties, collaborative research and development agreements, and from interest earned on cash and investment balances.

 

16

 

Our financial results are substantially dependent on our ability to generate significant revenues and maintain profitability. Revenues are impacted principally by our ability to expand our customer base and increase sales of our current and future products to new and existing customers, and by the price of product sales, royalties, design and license fees. To maintain or gain market acceptance of our products in the face of the introduction of new products by our competitors, we may have to reduce or discount the price of our products resulting in an adverse impact on revenues and gross margins. In addition to the above, our ability to enter into additional supply, license and collaborative arrangements and our ability and that of our collaborative partners to successfully manufacture and commercialize products incorporating our technologies in new applications and in new markets will also impact our revenue and profitability.

 

Our expenses are impacted principally by the cost of goods for products; the magnitude and duration of research and development; sales and marketing costs; and general and administrative expenses. General and administrative expenses are particularly subject to variation as a result of fluctuations in the intensity of legal activities. Our operating results may also fluctuate significantly depending on other factors which include: the outcome of ongoing or future litigation; the need for additional royalty bearing licenses; adoption of new technologies; the cost, quality and availability of reagents and components; regulatory actions; and third-party reimbursement policies.

 

Company Outlook

 

As management looks ahead to the fourth quarter of 2004, we believe the outlook for our company continues to be favorable. Although it is difficult to predict product demand, we expect our existing and future product offerings to provide continued growth in our product and product related revenue as the number of experiments conducted using GeneChip® technology continues to increase.  In particular, we anticipate that our new line of DNA analysis products, which were launched in the second half of 2003, will continue to provide a meaningful contribution to our product revenue growth in the fourth quarter of 2004. Management also expects to realize additional operational efficiencies as we continue to leverage our investments in corporate infrastructure and information management systems.

 

Going forward, management is focused on growing the business and achieving sustained profitability. A key driver will be increasing the breadth of scientific and clinical applications of our technology, while also industrializing, automating and standardizing our technology to open new markets and drive revenue growth. The aim of our automation efforts is to reduce the cost per experiment, minimize operator variability and dramatically improve experimental throughput. We believe that our automation solutions will enjoy commercial success in the high-throughput markets just as our bench-top systems have in the research markets.

 

Critical Accounting Policies & Estimates

 

General

 

The following section of Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

17

 

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

 

There have been no changes to our critical accounting policies from those included in our Form 10-K for December 31, 2003.

 

Revenue Recognition

 

We enter into contracts to sell our products and, while the majority of our sales agreements contain standard terms and conditions, there are agreements that contain multiple elements or non-standard terms and conditions. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the price should be allocated among the deliverable elements, when to recognize revenue for each element, and the period over which revenue should be recognized. We recognize revenue for delivered elements only when the fair values of undelivered elements are known and there are no uncertainties regarding customer acceptance. Changes in the allocation of the sales price between deliverable elements might impact the timing of revenue recognition, but would not change the total revenue recognized on the contract.

 

Accounts Receivable

 

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

 

Inventories

 

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

 

Accounting for Acquired Technology Rights

 

Our intangible assets are comprised principally of technology rights. We apply judgment in determining the useful lives of our intangible assets and whether such assets are impaired. Factors we consider include the life of the underlying patent, the existence of competing technology and potential obsolescence, which can all adversely impact the expected period of benefit from the use of the technology. To date, we have not experienced any impairment on our intangible assets.

 

Contingencies

 

We are subject to legal proceedings principally related to intellectual property matters. Based on the information available at the balance sheet dates, we assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. If losses are probable and reasonably estimable, we will record a reserve in accordance with SFAS 5, “Accounting for Contingencies.” Any reserves recorded may change in the future due to new developments in each matter.

 

18

 

Results of Operations

 

The following discussion compares the historical results of operations for the three and nine months ended September 30, 2004 and 2003, respectively.

 

Product Sales

 

The components of product sales are as follows (in thousands):

 

		Three Months Ended September 30,							Three Months Dollar Change			Nine Months Ended September 30,						Nine Months Dollar Change
		2004				2003			From 2003			2004			2003			From 2003
Probe arrays and related supplies		$		45,913		$	39,384		$	6,529		$	133,035		$	112,082		$	20,953
Instruments		16,405				18,083			(1,678		)	52,038			41,359			10,679
Total product sales		$	62,318			$	57,467		$	4,851		$	185,073		$	153,441		$	31,632

 

Total product sales increased $4.9 million in the third quarter of 2004 as compared to the same period in 2003.  The increase was primarily due to growth in the unit sales of our GeneChip® probe arrays, which includes our new DNA analysis products and the transition of our flagship Human, Mouse and Rat products from a two chip set to one chip.  In addition, we experienced growth in unit sales of our reagents due to the increased acceptance of our new products.  These increases were partially offset by a decrease in the average selling price of our GeneChip® probe arrays, a decrease in unit sales of our Fluidics Station 450 upgrades and a decrease in unit sales of our full GeneChip® instrumentation systems.

 

Total product sales increased $31.6 million in the first nine months of 2004 as compared to the same period in 2003.  The increase was primarily due to growth in the unit sales of our GeneChip® probe arrays, which includes our new DNA analysis products and the transition of our flagship Human, Mouse and Rat products from a two chip set to one chip and growth in unit sales of our reagents due to the increased acceptance of our new products.  Instrument sales also increased primarily due to growth in unit sales and the average selling price of our GeneChip® Scanner 3000 instruments and upgrades which were partially offset by a decrease in unit sales of our full GeneChip® instrumentation systems.

 

Product Related Revenue

 

The components of product related revenue are as follows (in thousands):

 

		Three Months Ended September 30,							Three Months Dollar Change			Nine Months Ended September 30,						Nine Months Dollar Change
		2004				2003			From 2003			2004			2003			From 2003
Subscription fees		$		5,127		$	5,984		$	(857	)	$	15,643		$	19,537		$	(3,894	)
Service and other		4,205				4,059			146			11,639			12,917			(1,278		)
License fees and milestone revenue		4,596				3,582			1,014			13,679			9,538			4,141
Total product related revenue		$	13,928			$	13,625		$	303		$	40,961		$	41,992		$	(1,031	)

 

Total product related revenue increased $0.3 million in the third quarter of 2004 as compared to the same period in 2003. The increase was primarily related to the achievement of a substantive at-risk milestone which was recognized as revenue during the quarter. In addition, service and other revenue increased due to an increase in other revenue related to DNA analysis and other product related scientific services partially offset by decreases in the number of service contracts as pre-existing scanner customers upgraded to our GeneChip® Scanner 3000 which is covered by a one year warranty.  Subscription fees earned under our EasyAccess™ agreements declined as we continue to transition customers to volume-based discounting on product sales.  License fees and milestone revenue earned in connection with our Roche collaboration agreement signed in January 2003, was $4.3 million and $3.6 million for the three months ended September 30, 2004 and 2003, respectively.

 

19

 

Total product related revenue decreased $1.0 million in the first nine months of 2004 as compared to the same period in 2003. The decrease was primarily due to a decline in subscription fees earned under our EasyAccess™ agreements as we continue to transition customers to volume-based discounting on product sales. In addition, service and other revenue declined due to decreases in the number of service contracts as pre-existing scanner customers upgraded to our GeneChip® Scanner 3000 which is covered by a one year warranty.  These decreases were partially offset by increases in license fees earned in connection with the Roche agreement and the recognition of milestone revenue due to the achievement of substantive goals as defined by our collaborative agreements.  License fees and milestone revenue earned in connection with the Roche agreement was $12.2 million compared to $9.5 million for the nine months ended September 30, 2004 and 2003, respectively.

 

Royalties and Other Revenue (in thousands)

 

		Three Months Ended September 30,						Three Months Dollar Change			Nine Months Ended September 30,						Nine Months Dollar Change
		2004			2003			From 2003			2004			2003			From 2003
Royalties and other revenue		$	2,742		$	2,349		$	393		$	8,300		$	8,194		$	106

 

Royalties and other revenue increased $0.4 million in the third quarter of 2004 as compared to the same period in 2003. The increase was primarily attributable to the recognition of $0.9 million of nonmonetary revenue resulting from the receipt of preferred stock in a non-public biotechnology company in exchange for a technology access license for which we have no continuing performance obligations. These increases were partially offset by a decrease in the number and average value of our remaining non-core license agreements.

 

Royalties and other revenue increased $0.1 million in the first nine months of 2004 as compared to the same period in 2003. The increase was primarily due to the recognition of one monetary and one nonmonetary license agreement with no continuing performance obligations as well as an increase in government grant activity.  These increases were partially offset by a decrease in the number and average value of our remaining non-core license agreements.

 

Revenue From Perlegen Sciences (in thousands)

 

		Three Months Ended September 30,						Three Months Dollar Change			Nine Months Ended September 30,						Nine Months Dollar Change
		2004			2003			From 2003			2004			2003			From 2003
Revenue from Perlegen Sciences		$	879		$	2,744		$	(1,865	)	$	3,920		$	8,005		$	(4,085	)

 

Revenue from Perlegen Sciences, an affiliated party, decreased $1.9 million in the third quarter and $4.1 million in the first nine months of 2004 as compared to the same periods in 2003. The decreases were consistent with the decrease in Perlegen’s contractual obligations under their supply agreement with us.  Pursuant to this supply agreement, we sell whole wafers to Perlegen for use in Perlegen’s research and development activities at our fully burdened cost of manufacturing.  Starting in the second quarter of 2004, we began recognizing margin on the sale of probe arrays that were utilized by Perlegen for revenue generating activities.  In addition, during the first half of 2004, we also sold Perlegen GeneChip® instruments on which we earned margins consistent with our sales of instruments to other customers.

 

20

 

 

Product and Product Related Gross Margins (in thousands, except percentage amounts)

 

		Three Months Ended September 30,						Dollar / Percentage Change From			Nine Months Ended September 30,						Dollar / Percentage Change From
		2004			2003			2003			2004			2003			2003
Total gross margin on product sales		$	45,211		$	35,074		$	10,137		$	127,846		$	97,231		$	30,615
Total gross margin on product related revenue		11,561			11,321			240			33,662			35,187			(1,525		)
Total gross margin on product and product related revenue		$	56,772		$	46,395		$	10,377		$	161,508		$	132,418		$	29,090
Product gross margin as a percentage of product sales		72.5		%	61.0		%	11.5		%	69.1		%	63.4		%	5.7		%
Product related gross margin as a percentage of product related revenue		83.0		%	83.1		%	(0.1		)%	82.2		%	83.8		%	(1.6		)%

 

Gross margin on product sales increased 11.5% in the third quarter of 2004 as compared to the same period in 2003 primarily due to an increase in probe array gross margins.  These margins were favorably impacted by a decrease in our cost to produce probe arrays which resulted primarily from savings realized on the conversion of a royalty bearing technology license from Oxford Gene Technology, Ltd. (“OGT”) to a fully paid-up non-royalty bearing license in the second half of 2004.  We also realized lower costs of manufacturing related to increased utilization of our Sacramento facility as we increased probe array production.  In addition, gross margin was favorably impacted due to continued market acceptance of some of our new, higher margin reagents.

 

Gross margin on product sales increased 5.7% in the first nine months of 2004 as compared to the same period in 2003.  These improvements were primarily due to an increase in instrument gross margins related to higher average selling prices and lower costs of production due to increased utilization of our Bedford facility and an increase in probe array gross margins related to the conversion of a royalty bearing technology license from OGT to a fully paid-up non-royalty bearing license in the second half of 2004.  In addition, gross margin was favorably impacted due to continued market acceptance of some of our new, higher margin reagents.

 

Product related gross margin decreased 0.1% in the third quarter and 1.6% in the first nine months of 2004 as compared to the same period in 2003.  The decreases were primarily related to a decline in sales of our EasyAccess™ agreements as we continue to transition customers to volume-based discounting on product sales and an increase in expenses related to certain of our service agreements.  These decreases were partially offset by the recognition of milestone revenue due to the achievement of substantive goals as defined by our collaborative agreements.

 

Cost of Perlegen Revenues (in thousands)

 

		Three Months Ended September 30,						Three Months Dollar Change			Nine Months Ended September 30,						Nine Months Dollar Change
		2004			2003			From 2003			2004			2003			From 2003
Cost of revenue from Perlegen Sciences		$	569		$	2,744		$	(2,175	)	$	3,039		$	8,005		$	(4,966	)

 

Cost of Perlegen revenue decreased $2.2 million in the third quarter and $5.0 million in the first nine months of 2004 as compared to the same periods in 2003. The decreases in the cost of Perlegen revenue were related to the reduction in wafer purchases made by Perlegen, which is consistent with Perlegen’s declining contractual purchase obligations. This decrease was partially offset by costs associated with Perlegen’s purchase of GeneChip® instruments in the first half of 2004.

 

21