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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended June 30, 2014

OR

 

¨	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 No.)
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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer		x		Accelerated Filer		¨
Non-Accelerated Filer		¨  (Do not check if smaller reporting company)		Smaller Reporting Company		¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of July 25, 2014 there were 70,207,634 shares of the registrant’s common stock outstanding.

 

 

 

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REPORT ON FORM 10-Q FOR THE

QUARTER ENDED JUNE 30, 2014

INDEX

 

				Page
Part I.		Financial Information
Item 1.		Financial Statements			3
		Condensed Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013			3
		Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2014 and 2013			4
		Condensed Consolidated Statements of Comprehensive Loss for the three and six months ended June 30, 2014 and 2013			5
		Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and 2013			6
		Notes to Condensed Consolidated Financial Statements			7
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			24
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			30
Item 4.		Controls and Procedures			30
Part II.		Other Information
Item 1.		Legal Proceedings			32
Item 1A		Risk Factors			32
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			46
Item 3.		Defaults Upon Senior Securities			46
Item 4.		Mine Safety Disclosures			47
Item 5.		Other Information			47
Item 6.		Exhibits			47
Signatures					48

Cepheid^®, the Cepheid logo, GeneXpert^®, Xpert^®, and SmartCycler are trademarks of Cepheid.

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CEPHEID

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

		June 30, 2014				December 31, 2013
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	120,981			$	66,072
Short-term investments			185,279				8,837
Accounts receivable, net			55,370				52,202
Inventory			123,345				103,866
Prepaid expenses and other current assets			19,020				13,037
Total current assets			503,995				244,014
Property and equipment, net			104,354				84,886
Investments			78,773				9,820
Other non-current assets			8,124				958
Intangible assets, net			13,404				15,245
Goodwill			39,681				39,681
Total assets		$	748,331			$	394,604
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	50,892			$	52,609
Accrued compensation			24,830				22,009
Accrued royalties			4,973				5,245
Accrued and other liabilities			9,974				7,440
Current portion of deferred revenue			10,428				8,183
Total current liabilities			101,097				95,486
Long-term portion of deferred revenue			4,043				3,424
Convertible senior notes, net			273,491				—
Other liabilities			15,362				10,454
Total liabilities			393,993				109,364
Commitments and contingencies (Note 8)
Shareholders’ equity:
Preferred stock, no par value; 5,000,000 shares authorized, none issued or outstanding			—				—
Common stock, no par value; 150,000,000 and 100,000,000 shares authorized, 70,104,908 and 68,556,392 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively			407,877				383,379
Additional paid-in capital			209,431				145,900
Accumulated other comprehensive loss			(261	)			(476	)
Accumulated deficit			(262,709	)			(243,563	)
Total shareholders’ equity			354,338				285,240
Total liabilities and shareholders’ equity		$	748,331			$	394,604

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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CEPHEID

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Sales		$	116,503			$	96,012			$	223,410			$	187,950
Costs and operating expenses:
Cost of sales			59,568				52,889				112,651				95,781
Collaboration profit sharing			649				1,425				1,940				3,535
Research and development			23,998				18,572				45,738				36,299
Sales and marketing			23,502				19,105				46,960				38,231
General and administrative			14,340				9,612				28,007				19,375
Total costs and operating expenses			122,057				101,603				235,296				193,221
Loss from operations			(5,554	)			(5,591	)			(11,886	)			(5,271	)
Other income (expense):
Interest and other income, net			306				3				459				3
Interest expense			(3,500	)			(38	)			(5,363	)			(73	)
Foreign currency exchange gain (loss) and other			(176	)			(682	)			(757	)			(273	)
Other income (loss), net			(3,370	)			(717	)			(5,661	)			(343	)
Loss before income taxes			(8,924	)			(6,308	)			(17,547	)			(5,614	)
Provision for income taxes			(919	)			(272	)			(1,599	)			(653	)
Net loss		$	(9,843	)		$	(6,580	)		$	(19,146	)		$	(6,267	)
Basic net loss per share		$	(0.14	)		$	(0.10	)		$	(0.27	)		$	(0.09	)
Diluted net loss per share		$	(0.14	)		$	(0.10	)		$	(0.27	)		$	(0.09	)
Shares used in computing basic net loss per share			69,968				67,295				69,622				67,061
Shares used in computing diluted net loss per share			69,968				67,295				69,622				67,061

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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CEPHEID

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Net loss		$	(9,843	)		$	(6,580	)		$	(19,146	)		$	(6,267	)
Other comprehensive income (loss), net of taxes of $0:
Change in unrealized gains and losses related to cash flow hedges:
Gain/(Loss) recognized in other comprehensive income			(472	)			(598	)			(291	)			137
(Gain)/Loss reclassified from accumulated comprehensive income to the statement of operations			216				(63	)			503				(97	)
Change in unrealized gains and losses related to available-for-sale investments, net:
Gain recognized in other comprehensive income, net			104				—				30				—
(Gain) reclassified from accumulated comprehensive income to the statement of operations, net			(25	)			—				(27	)			—
Comprehensive loss		$	(10,020	)		$	(7,241	)		$	(18,931	)		$	(6,227	)

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

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CEPHEID

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

 

		Six Months Ended June 30,
		2014				2013
Cash flows from operating activities:
Net loss		$	(19,146	)		$	(6,267	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization of property and equipment			10,340				8,361
Amortization of intangible assets			1,841				3,146
Unrealized exchange differences			122				575
Amortization of debt discount and transaction costs			3,642				—
Stock-based compensation expense			15,930				12,806
Changes in operating assets and liabilities:
Accounts receivable			(3,167	)			(2,586	)
Inventory			(19,809	)			(14,491	)
Prepaid expenses and other current assets			(5,867	)			(6,454	)
Other non-current assets			(42	)			30
Accounts payable and other current and non-current liabilities			1,916				5,669
Accrued compensation			2,821				2,616
Deferred revenue			2,864				1,422
Net cash provided by (used in) operating activities			(8,555	)			4,827
Cash flows from investing activities:
Capital expenditures			(25,745	)			(18,974	)
Payment for a technology license			—				(1,125	)
Cost of acquisitions, net			—				(3,571	)
Proceeds from sales of marketable securities and investments			67,739				—
Proceeds from maturities of marketable securities and investments			21,326				—
Purchases of marketable securities and investments			(334,800	)			—
Net cash used in investing activities			(271,480	)			(23,670	)
Cash flows from financing activities:
Net proceeds from the issuance of common shares and exercise of stock options			24,498				9,450
Proceeds from borrowings of convertible senior notes, net of issuance costs			335,789				—
Purchase of convertible note capped call hedge			(25,082	)			—
Principal payment of notes payable			(95	)			(781	)
Net cash provided by financing activities			335,110				8,669
Effect of exchange rate change on cash			(166	)			(575	)
Net increase (decrease) in cash and cash equivalents			54,909				(10,749	)
Cash and cash equivalents at beginning of period			66,072				95,779
Cash and cash equivalents at end of period		$	120,981			$	85,030

 

 

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CEPHEID

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Organization and Summary of Significant Accounting Policies

Organization and Basis of Presentation

Cepheid (the “Company”) was incorporated in the State of California on March 4, 1996. The Company is a molecular diagnostics company that develops, manufactures, and markets fully-integrated systems for testing in the Clinical market, as well as for application in the Company’s Non-Clinical legacy market. The Company’s systems enable rapid, sophisticated molecular testing for organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures.

The Condensed Consolidated Balance Sheet at June 30, 2014, the Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2014 and 2013, the Condensed Consolidated Statements of Comprehensive Loss for the three and six months ended June 30, 2014 and 2013 and the Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and 2013 are unaudited. In the opinion of management, these condensed consolidated financial statements reflect all normal recurring adjustments that management considers necessary for a fair presentation of the Company’s financial position at such dates and the operating results and cash flows for those periods. The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States (“U.S.”). However, certain information or footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The results of operations for such periods are not necessarily indicative of the results expected for the remainder of 2014 or for any future period. The Condensed Consolidated Balance Sheet as of December 31, 2013 is derived from audited financial statements as of that date but does not include all of the information and footnotes required by accounting principles generally accepted in the U.S. for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Within the Condensed Consolidated Balance Sheet, certain amounts have been reclassified to conform to the current period presentation.

Use of Estimates

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

Cash, Cash Equivalents, Short-Term Investments and Investments

Cash and cash equivalents consist of cash on deposit with banks and money market instruments. Interest and other income, net includes interest, dividends, amortization of purchase premiums and discounts and realized gains and losses on sales of securities.

The Company’s marketable debt securities have been classified and accounted for as available-for-sale. The Company determines the appropriate classification of its investments at the time of purchase and re-evaluates the designations at each balance sheet date. The Company classifies its marketable debt securities as cash equivalents, short-term investments or long-term investments based on each instrument’s underlying contractual and effective maturity date. All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Marketable debt securities with effective maturities of 12 months or less are classified as short-term and marketable debt securities with effective maturities greater than 12 months are classified as long-term. The Company’s marketable debt securities are carried at fair value, with the unrealized gains and losses reported as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method.

The Company assesses whether an other-than-temporary impairment loss on its investments has occurred due to declines in fair value or other market conditions. With respect to the Company’s debt securities, this assessment takes into account the severity and duration of the decline in value, the Company’s intent to sell the security, whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis, and whether or not the Company expects to recover the entire amortized cost basis of the security (that is, a credit loss exists).

See Note 3, “Investments,” for information and related disclosures regarding the Company’s investments.

 

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Concentration of Credit Risks and Other Uncertainties

The carrying amounts for financial instruments consisting of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value due to their short maturities. Derivative instruments and investments are stated at their estimated fair values, based on quoted market prices for the same or similar instruments. The counterparties to the agreements relating to the Company’s derivative instruments consist of large financial institutions of high credit standing.

The Company’s main financial institution for banking operations held 72% and 55% of the Company’s cash and cash equivalents as of June 30, 2014 and December 31, 2013, respectively.

The Company’s accounts receivable are derived from net revenue to customers and distributors located in the United States and other countries. The Company performs credit evaluations of its customers’ financial condition. The Company provides reserves for potential credit losses but has not experienced significant losses to date. There was one direct customer whose accounts receivable balance represented 25% and 14% of total accounts receivable as of June 30, 2014 and December 31, 2013, respectively.

See Note 10 (Segment and Significant Concentrations) for disclosure regarding total sales to direct customers and single countries.

Inventory

Inventory is stated at the lower of standard cost (which approximates actual cost) or market value, with cost determined on the first-in-first-out method. Accordingly, allocation of fixed production overheads to conversion costs is based on normal capacity of production. Abnormal amounts of idle facility expense, freight, handling costs and spoilage are expensed as incurred and not included in overhead. In addition, unrecognized stock-based compensation cost of $1.8 million and $2.1 million was included in inventory as of June 30, 2014 and December 31, 2013, respectively.

The following table summarizes the components of inventory (in thousands):

 

		June 30, 2014				December 31, 2013
Raw Materials		$	36,867			$	35,760
Work in Process			45,240				36,580
Finished Goods			41,238				31,526
Inventory		$	123,345			$	103,866

Revenue Recognition

The Company recognizes revenue from sales when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable and collectability 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 its products. Shipping and handling costs are expensed as incurred and included in cost of sales. In those cases where the Company bills shipping and handling costs to customers, the amounts billed are classified as revenue.

The Company enters into revenue arrangements that may consist of multiple deliverables of its products and services. In situations with multiple deliverables, revenue is recognized upon the delivery of the separate elements. The Company sells service contracts for which revenue is deferred and recognized ratably over the contract period.

For multiple element arrangements, the total consideration for an arrangement is allocated among the separate elements in the arrangement based on a selling price hierarchy. The selling price hierarchy for a deliverable is based on: (1) vendor specific objective evidence (“VSOE”), if available; (2) third party evidence of selling price if VSOE is not available; or (3) an estimated selling price, if neither VSOE nor third party evidence is available. Estimated selling price is the Company’s best estimate of the selling price of an element in a transaction. The Company limits the amount of revenue recognized for delivered elements to the amount that is not contingent on the future delivery of products or services or other future performance obligations. The Company recognizes revenue for delivered elements only when the Company determines there are no uncertainties regarding customer acceptance.

Revenue includes fees for technology licenses and research and development services, including research and development under grants and government sponsored research, royalties under license and collaboration agreements. Fees for technology licenses are generally fully recognized only after the license period has commenced, the technology has been delivered and no further involvement of the Company is required. When the Company has continuing involvement related to a technology license, revenue is recognized

 

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over the license term. Revenue related to research and development services is recognized as the related service is performed based on the performance requirements of the relevant contract. Under such agreements, the Company is required to perform specific research and development activities and is compensated either based on the costs or costs plus a mark-up associated with each specific contract over the term of the agreement or based on the Company’s progress to completion and recoverability is reasonably assured. 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 collectability is reasonably assured, such as upon the receipt of a royalty statement from the customer. Advance payments received in excess of amounts earned, such as funds received in advance of products to be delivered or services to be performed, are classified as deferred revenue until earned.

Net Loss per Share

Basic net loss per share is computed by dividing net loss for the period by the weighted average number of common shares outstanding during the period. Diluted net income / (loss) per share is computed by dividing net income / (loss) for the period by the weighted average number of common and common equivalent shares outstanding during the period. Stock options, employee stock purchases, restricted stock awards, restricted stock units and shares issuable upon a potential conversion of the convertible senior notes that could potentially dilute basic earnings per share in the future were not included in the computation of diluted earnings per share because to do so would have been antidilutive for the periods presented. These anti-dilutive common stock equivalent shares totaled 9,845,000 and 5,542,000 for the three months ended June 30, 2014 and 2013, respectively, and 9,237,000 and 5,285,000 for the six months ended June 30, 2014 and 2013, respectively.

The following summarizes the computation of basic and diluted income (loss) per share (in thousands, except for per share amounts):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Basic:
Net loss		$	(9,843	)		$	(6,580	)		$	(19,146	)		$	(6,267	)
Basic weighted shares outstanding			69,968				67,295				69,622				67,061
Net loss per share		$	(0.14	)		$	(0.10	)		$	(0.27	)		$	(0.09	)
Diluted:
Net loss		$	(9,843	)		$	(6,580	)		$	(19,146	)		$	(6,267	)
Basic weighted shares outstanding			69,968				67,295				69,622				67,061
Effect of dilutive securities:
Stock options, ESPP, restricted stock units, restricted stock awards and convertible senior notes			—				—				—				—
Diluted weighted shares outstanding			69,968				67,295				69,622				67,061
Net loss per share		$	(0.14	)		$	(0.10	)		$	(0.27	)		$	(0.09	)

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in ASC 605, Revenue Recognition. The core principal of ASU 2014-09 is to recognize revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The effective date will be the first quarter of fiscal year 2017 using one of two retrospective transition methods. The Company has not yet selected a transition method nor has it determined the potential effects on the consolidated financial statements.

 

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2. Fair Value

The following tables summarize the fair value hierarchy for the Company’s financial assets (cash, cash equivalents, short-term investments, foreign currency derivatives and long-term investments) and financial liabilities (foreign currency derivatives and contingent consideration) measured at fair value on a recurring basis as of June 30, 2014 and December 31, 2013 (in thousands):

Balance as of June 30, 2014:

 

		Level 1				Level 2				Level 3				Total
Assets:
Cash and cash equivalents		$	85,136			$	35,845			$	—			$	120,981
Short-term investments:
Asset-backed securities			—				38,198				—				38,198
Commercial paper			—				73,270				—				73,270
Corporate debt securities			—				34,492				—				34,492
Government agency securities			—				32,618				—				32,618
Other securities			—				6,701				—				6,701
Total short-term investments			—				185,279				—				185,279
Foreign currency derivatives			—				641				—				641
Investments:
Asset-backed securities			—				27,946				—				27,946
Corporate debt securities			—				20,170				—				20,170
Government agency securities			—				26,106				—				26,106
United States government securities			—				1,852				—				1,852
Other securities			—				2,699				—				2,699
Total investments			—				78,773				—				78,773
Total		$	85,136			$	300,538			$	—			$	385,674
Liabilities:
Foreign currency derivatives		$	—			$	1,167			$	—			$	1,167
Contingent consideration			—				—				74				74
Total		$	—			$	1,167			$	74			$	1,241
Balance as of December 31, 2013:
		Level 1				Level 2				Level 3				Total
Assets:
Cash and cash equivalents		$	64,772			$	1,300			$	—			$	66,072
Short-term investments:
Commercial paper			—				5,448				—				5,448
Corporate debt securities			—				1,881				—				1,881
Government agency securities			—				1,508				—				1,508
Total short-term investments			—				8,837				—				8,837
Foreign currency derivatives			—				873				—				873
Investments:
Asset-backed securities			—				1,891				—				1,891
Corporate debt securities			—				1,975				—				1,975
Government agency securities			—				3,405				—				3,405
United States government securities			—				2,149				—				2,149
Other securities			—				400				—				400
Total investments			—				9,820				—				9,820
Total		$	64,772			$	20,830			$	—			$	85,602
Liabilities:
Foreign currency derivatives		$	—			$	1,555			$	—			$	1,555
Contingent consideration			—				—				310				310
Total		$	—			$	1,555			$	310			$	1,865

 

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The estimated fair values of the Company’s other financial instruments which are not measured at fair value on a recurring basis as of June 30, 2014 and December 31, 2013 were as follows (in thousands):

Balance as of June 30, 2014:

 

		Level 1				Level 2				Level 3				Total
Liabilities:
Convertible senior notes		$	—			$	357,765			$	—			$	357,765
Total		$	—			$	357,765			$	—			$	357,765
Balance as of December 31, 2013:
		Level 1				Level 2				Level 3				Total
Liabilities:
Convertible senior notes		$	—			$	—			$	—			$	—
Total		$	—			$	—			$	—			$	—

The Company utilized levels 1 and 2 to value its financial assets on a recurring basis. Level 1 instruments use quoted prices in active markets for identical assets or liabilities, which include the Company’s cash accounts, short-term deposits and money market funds as these specific assets are liquid. Level 2 instruments are valued using the market approach which uses quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 instruments include commercial paper, corporate obligations, United States government securities, government agency securities and asset-backed securities as similar or identical instruments can be found in active markets.

The Company recorded derivative assets and liabilities at fair value. The Company’s derivatives consist of foreign exchange forward contracts. The Company has elected to use the income approach to value the derivatives, using observable Level 2 market expectations at the measurement date and standard valuation techniques to convert future amounts to a single present amount assuming that participants are motivated, but not compelled to transact.

Level 2 inputs for the valuations are limited to quoted prices for similar assets or liabilities in active markets (specifically foreign currency spot rate and forward points) and inputs other than quoted prices that are observable for the asset or liability (specifically LIBOR rates, credit default spot rates, and company specific LIBOR spread). Mid-market pricing is used as a practical expedient for fair value measurements. The fair value measurement of an asset or liability must reflect the nonperformance risk of the entity and the counterparty. Therefore, the impact of the counterparty’s creditworthiness when in an asset position and the Company’s creditworthiness when in a liability position has also been factored into the fair value measurement of the derivative instruments and did not have a material impact on the fair value of these derivative instruments. Both the counterparty and the Company are expected to continue to perform under the contractual terms of the instruments. The estimated fair value of the convertible senior notes, which we have classified as Level 2 financial instruments, was determined based on the quoted price of the convertible senior notes in an over-the-counter market on June 30, 2014.

Level 3 liabilities, consisting of contingent consideration to be made in connection with the acquisition of a company in 2012 and an acquisition of certain assets in 2013, are valued by applying the income approach and are based on significant unobservable inputs that are supported by little or no market activity.

 

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3. Investments

The Company’s marketable securities as of June 30, 2014 were classified as available-for-sale securities, with changes in fair value recognized in accumulated other comprehensive loss, a component of stockholders’ equity. Classification of marketable securities as a current asset is based on the intended holding period, effective maturity and realizability of the investment. The following tables summarize available-for-sale marketable securities (in thousands):

 

Balance as of June 30, 2014:
		Cost				Gross Unrealized Gain				Gross Unrealized Loss				Estimated Fair Value
Short-term investments:
Asset-backed securities		$	38,194			$	10			$	(6	)		$	38,198
Commercial paper			102,094				22				(1	)			102,115
Corporate debt securities			34,484				12				(4	)			34,492
Government agency securities			39,628				3				(13	)			39,618
Other securities			6,715				1				(15	)			6,701
Amounts classified as cash equivalents			(35,845	)			(2	)			2				(35,845	)
Total short-term investments		$	185,270			$	46			$	(37	)		$	185,279
Investments:
Asset-backed securities		$	27,934			$	14			$	(2	)		$	27,946
Corporate debt securities			20,173				4				(7	)			20,170
Government agency securities			26,112				1				(7	)			26,106
United States government securities			1,847				5				—				1,852
Other securities			2,700				—				(1	)			2,699
Total investments		$	78,766			$	24			$	(17	)		$	78,773
Balance as of December 31, 2013:
		Cost				Gross Unrealized Gain				Gross Unrealized Loss				Estimated Fair Value
Short-term investments:
Commercial paper		$	6,747			$	1			$	—			$	6,748
Corporate debt securities			1,881				—				—				1,881
Government agency securities			1,506				2				—				1,508
Amounts classified as cash equivalents			(1,300	)			—				—				(1,300	)
Total short-term investments		$	8,834			$	3			$	—			$	8,837
Investments:
Asset-backed securities		$	1,890			$	1			$	—			$	1,891
Corporate debt securities			1,970				5				—				1,975
Government agency securities			3,405				1				(1	)			3,405
United States government securities			2,145				4				—				2,149
Other securities			400				—				—				400
Total investments		$	9,810			$	11			$	(1	)		$	9,820

For the six months ended June 30, 2014, $89.1 million of proceeds from sales and maturities of marketable securities were collected while no proceeds were received for the six months ended June 30, 2013. The Company determines gains and losses from sales of marketable securities based on specific identification of the securities sold. Gross realized gains and losses from sales of marketable securities, all of which are reported as a component of “Interest and other income, net” in the consolidated statements of operations for the three and six months ended June 30, 2014 and 2013 were as follows (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Gross realized gains		$	25			$	—			$	27			$	—
Gross realized losses			—				—				—				—
Realized gains, net		$	25			$	—			$	27			$	—

 

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The fair value of the Company’s marketable securities with unrealized losses at June 30, 2014 and December 31, 2013, and the duration of time that such losses had been unrealized (in thousands) were:

 

Balance at June 30, 2014:
		Less Than 12 months								More than 12 months								Total
		Fair Value				Unrealized Loss				Fair Value				Unrealized Loss				Fair Value				Unrealized Loss
Asset-backed securities		$	17,348			$	(8	)		$	—			$	—			$	17,348			$	(8	)
Commercial paper			15,430				(1	)			—				—				15,430				(1	)
Corporate debt securities			19,336				(11	)			—				—				19,336				(11	)
Government agency securities			43,003				(20	)			—				—				43,003				(20	)
Other securities			9,000				(16	)			—				—				9,000				(16	)
Total		$	104,117			$	(56	)		$	—			$	—			$	104,117			$	(56	)
Balance at December 31, 2013:
		Less Than 12 months								More than 12 months								Total
		Fair Value				Unrealized Loss				Fair Value				Unrealized Loss				Fair Value				Unrealized Loss
Asset-backed securities		$	600			$	—			$	—			$	—			$	600			$	—
Corporate debt securities			1,180				—				—				—				1,180				—
Government agency securities			1,104				(1	)			—				—				1,104				(1	)
Other securities			200				—				—				—				200				—
Total		$	3,084			$	(1	)		$	—			$	—			$	3,084			$	(1	)

The Company has evaluated such securities, which consist of investments in commercial paper, corporate debt securities, government agency securities and other securities as of June 30, 2014 and has determined that there was no indication of other-than-temporary impairments. This determination was based on several factors, including the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the debt issuer, and the Company’s intent and ability to hold the corporate securities for a period of time sufficient to allow for any anticipated recovery in market value.

The following table summarizes the amortized cost and estimated fair value of available-for-sale debt securities at June 30, 2014 and December 31, 2013, by contractual maturity (in thousands):

 

		June 30, 2014								December 31, 2013
		Amortized Cost				Estimated Fair Value				Amortized Cost				Estimated Fair Value
Debt securities:
Mature in one year or less		$	221,115			$	221,124			$	10,134			$	10,137
Mature after one year through three years			73,966				73,971				9,810				9,820
Mature in more than three years			4,800				4,802				—				—
Total		$	299,881			$	299,897			$	19,944			$	19,957

4. Derivative Financial Instruments

The Company uses derivatives to partially offset its business exposure to foreign currency exchange risk. The Company may enter into foreign currency forward contracts to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales and on certain existing assets and liabilities.

To help protect gross margins from fluctuations in foreign currency exchange rates, a portion of forecasted foreign currency revenue and expenses of certain of the Company’s subsidiaries are hedged. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue, cost of sales and operating expenses generally up to twelve months.

The Company may also enter into foreign currency forward contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities. However, the Company may choose not to hedge certain foreign currency exchange exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures.

 

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The Company records all derivatives in the Condensed Consolidated Balance Sheet at fair value. The Company’s accounting treatment of these instruments is based on whether the instruments are designated as hedge or non-hedge instruments. The effective portions of cash flow hedges are recorded in accumulated other comprehensive income (loss) (“AOCI”) until the hedged item is recognized in earnings. The ineffective portions of cash flow hedges are recorded in foreign currency exchange gain (loss) and other. Gains and losses related to derivatives that are designated as hedging instruments are recorded in the financial statement line item to which the derivative relates.

The Company had a net deferred loss associated with cash flow hedges of $0.5 million recorded in AOCI as of June 30, 2014. Deferred gains and losses associated with cash flow hedges of forecasted foreign currency revenue are recognized as a component of revenues in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of forecasted expenses are recognized as a component of cost of sales, research and development expense, sales and marketing expense and general and administrative expense in the same period as the related expenses are recognized. The Company’s hedged transactions as of June 30, 2014 are expected to occur within twelve months.

Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified immediately into foreign currency exchange gain (loss) and other. Any subsequent changes in fair value of such derivative instruments are reflected in foreign currency exchange gain (loss) and other unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during the three and six months ended June 30, 2014 and 2013.

Gains or losses on derivatives not designated as hedging instruments are recorded in foreign currency exchange gain (loss) and other. During the three months ended June 30, 2014 and 2013, the Company recognized a loss of $0.2 million and a loss of $0.2 million, respectively, as a component of foreign currency exchange gain (loss) and other. During the six months ended June 30, 2014 and 2013, the Company recognized a loss of $0.5 million and a gain of $0.7 million, respectively, as a component of foreign currency exchange gain (loss) and other. These amounts represent the net gain or loss on the derivative contracts and do not include changes in the related exposures or ineffective portion or amounts excluded from the effectiveness testing of cash flow hedges.

The notional principle amounts of the Company’s outstanding derivative instruments designated as cash flow hedges are $113.7 million and $96.6 million as of June 30, 2014 and December 31, 2013, respectively. The notional principle amounts of the Company’s outstanding derivative instruments not designated as cash flow hedges is $38.1 million and $24.2 million as of June 30, 2014 and December 31, 2013, respectively.

The following tables show the Company’s derivative instruments at gross fair value as reflected in the Condensed Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013, respectively (in thousands):

 

		June 30, 2014
		Fair Value of Derivates Designated as Hedge Instruments				Fair Value of Derivates Not Designated as Hedge Instruments				Total Fair Value
Derivative Assets (a):
Foreign exchange contracts		$	637			$	4			$	641
Derivative Liabilities (b):
Foreign exchange contracts			(1,099	)			(68	)			(1,167	)
		December 31, 2013
		Fair Value of Derivates Designated as Hedge Instruments				Fair Value of Derivates Not Designated as Hedge Instruments				Total Fair Value
Derivative Assets (a):
Foreign exchange contracts		$	782			$	91			$	873
Derivative Liabilities (b):
Foreign exchange contracts			(1,446	)			(109	)			(1,555	)

 

(a)	The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as prepaid expenses and other current assets in the Condensed Consolidated Balance Sheets.

 

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(b)	The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued and other liabilities in the Condensed Consolidated Balance Sheets.

The following tables show the pre-tax effect of the Company’s derivative instruments designated as cash flow hedges in the Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2014 and 2013 (in thousands):

 

		Three Months Ended
		Loss Recognized in OCI - Effective Portion								Gain (Loss) Reclassified from AOCI into Income - Effective Portion								Gain (Loss) Recognized - Ineffective Portion and Amount Excluded from Effectiveness Testing
		June 30, 2014				June 30, 2013				June 30, 2014 (a)				June 30, 2013 (b)				Location		June 30, 2014				June 30, 2013
Cash flow hedges:
Foreign exchange contracts		$	(472	)		$	(598	)		$	(216	)		$	63			Foreign currency exchange gain (loss) and other		$	20			$	8
Total		$	(472	)		$	(598	)		$	(216	)		$	63					$	20			$	8

 

(a)

Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $0.2 million gain and a $0.4 million loss were recognized within sales and costs and operating expenses, respectively, within the Condensed Consolidated Statement of Operations for the three months ended June 30, 2014.

(b)

Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $0.3 million loss and a $0.4 million gain were recognized within sales and costs and operating expenses, respectively, within the Condensed Consolidated Statement of Operations for the three months ended June 30, 2013.

 

		Six Months Ended
		Gain (Loss) Recognized in OCI - Effective Portion								Gain (Loss) Reclassified from AOCI into Income - Effective Portion								Gain (Loss) Recognized - Ineffective Portion and Amount Excluded from Effectiveness Testing
		June 30, 2014				June 30, 2013				June 30, 2014 (a)				June 30, 2013 (b)				Location		June 30, 2014				June 30, 2013
Cash flow hedges:
Foreign exchange contracts		$	(291	)		$	137			$	(503	)		$	97			Foreign currency exchange gain (loss) and other		$	33			$	2
Total		$	(291	)		$	137			$	(503	)		$	97					$	33			$	2

 

(a)

Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $0.4 million gain and a $0.9 million loss were recognized within sales and costs and operating expenses, respectively, within the Condensed Consolidated Statement of Operations for the six months ended June 30, 2014.

 

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(b)

Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $1.0 million loss and a $1.1 million gain were recognized within sales and costs and operating expenses, respectively, within the Condensed Consolidated Statement of Operations for the six months ended June 30, 2013.

5. Intangible Assets and Goodwill

Intangible assets related to licenses are recorded at cost, less accumulated amortization. Intangible assets related to technology and other intangible assets acquired in acquisitions are recorded at fair value at the date of acquisition, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 3 to 15 years, on a straight-line basis. Amortization of intangible assets is primarily included in cost of sales, research and development and sales and marketing in the accompanying condensed consolidated statements of operations.

The following table summarizes the recorded value and accumulated amortization of major classes of intangible assets (in thousands):

 

Balance, June 30, 2014:		Gross Carrying Amount				Accumulated Amortization				Net Carrying Amount
Licenses		$	28,577			$	(22,521	)		$	6,056
Technology acquired in acquisitions			8,613				(8,613	)			—
Customer relationships and other intangible assets acquired in acquisitions			15,748				(8,400	)			7,348
		$	52,938			$	(39,534	)		$	13,404

 

Balance, December 31, 2013		Gross Carrying Amount				Accumulated Amortization				Net Carrying Amount
Licenses		$	28,577			$	(21,597	)		$	6,980
Technology acquired in acquisitions			8,613				(8,613	)			—
Customer relationships and other intangible assets acquired in acquisitions			15,748				(7,483	)			8,265
		$	52,938			$	(37,693	)		$	15,245

Amortization expense of intangible assets was $0.9 million and $1.6 million for the three months ended June 30, 2014 and 2013, respectively, and $1.8 million and $3.2 million for the six months ended June 30, 2014 and 2013, respectively. The following table summarizes the expected future annual amortization expense of intangible assets recorded on the Company’s Condensed Consolidated Balance Sheet as of June 30, 2014, assuming no impairment charges (in thousands):

 

For the Years Ending December 31,		Amortization Expense
2014 (remaining six months)		$	1,830
2015			3,051
2016			2,442
2017			2,073
2018			1,994
Thereafter			2,014
Total expected future annual amortization		$	13,404

6. Income Taxes

For the six months ended June 30, 2014, the Company recorded an income tax provision of $1.6 million, primarily related to ordinary tax expense of the Company’s foreign subsidiaries. For the six months ended June 30, 2013, the Company recorded an income tax provision of $0.7 million, primarily related to ordinary tax expense of the Company’s foreign subsidiaries, partially offset by a tax benefit for research and development tax credits associated with our French subsidiary.

 

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The Company’s effective tax rate for the six months ended June 30, 2014 and June 30, 2013 differs from the statutory federal income tax rate of 34%, primarily due to the impact of operations in foreign jurisdictions, and losses in the U.S. federal and state jurisdictions for which no tax benefit is recorded. The Company’s effective tax rate increased in the six months ended June 30, 2014, as compared to the same period in 2013, due to increased U.S. losses for the six months ended June 30, 2014 for which no income tax benefit is recorded in the US federal and state tax jurisdictions, as well as to tax benefits recorded during 2013 for research and development tax credits in France for which the Company is no longer eligible during 2014.

The Company utilizes the liability method of accounting for income taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. The Company’s position is to record a valuation allowance when it is more likely than not that some of the deferred tax assets will not be realized. Based on all available objective evidence, the Company believes that it is more likely than not that the net U.S. deferred tax assets will not be fully realized. Accordingly, the Company continues to maintain a full valuation allowance on its U.S. deferred tax assets and will do so until there is sufficient evidence to support the reversal of all or some portion of this valuation allowance.

The Company or one of its subsidiaries files income tax returns in the United States federal jurisdiction and various state and foreign jurisdictions. The Company’s 2000 through 2013 tax years generally remain open to examination by U.S. federal and most state tax authorities. In addition, the Company files tax returns in multiple foreign taxing jurisdictions with open tax years ranging from 2008 to 2013.

The Company anticipates that the total unrecognized tax benefits will not significantly change within the next 12 months due to the settlement of audits and the expiration of statutes of limitations. Currently, the Company has a tax audit in progress in Sweden. To the extent the final tax liabilities are different from the amounts originally accrued, the increases or decreases are recorded as income tax expense or benefit in the consolidated statements of operations. While the Company believes that the resolution of these audits will not have a material adverse effect on the Company’s results of operations, the outcome is subject to uncertainty.

The Company recognizes interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. For the periods presented, the amount of any interest or penalties related to uncertain tax positions was not material.

7. Convertible Senior Notes

In February 2014, the Company issued $345 million aggregate principal amount of 1.25% convertible senior notes (the “Notes”) due February 1, 2021, unless earlier repurchased by the Company or converted by the holder pursuant to their terms. Interest is payable semiannually in arrears on February 1 and August 1 of each year, commencing on August 1, 2014.

The Notes are governed by an Indenture between the Company, as issuer, and Wells Fargo Bank, National Association, as trustee. The Notes are unsecured and rank: senior in right of payment to the Company’s future indebtedness that is expressly subordinated in right of payment to the Notes; equal in right of payment to the Company’s existing and future indebtedness that is not so subordinated; effectively subordinated in right of payment to any of the Company’s secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally subordinated to all existing and future indebtedness and other liabilities incurred by the Company’s subsidiaries.

Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company’s common stock or a combination of cash and shares of common stock, at the Company’s election.

The Notes have an initial conversion rate of 15.3616 shares of common stock per $1,000 principal amount of Notes. This represents an initial effective conversion price of approximately $65.10 per share of common stock and approximately 5,300,000 shares upon conversion. Throughout the term of the Notes, the conversion rate may be adjusted upon the occurrence of certain events. Holders of the Notes will not receive any cash payment representing accrued and unpaid interest, if any, upon conversion of a Note, except in limited circumstances. Accrued but unpaid interest will be deemed to be paid by the cash, shares of the Company’s common stock or a combination of cash and shares of the Company’s common stock paid or delivered, as the case may be, to the holder upon conversion of a Note.

Prior to the close of business on the business day immediately preceding August 1, 2020, the Notes will be convertible at the option of holders during certain periods, only upon satisfaction of certain conditions set forth below. On or after August 1, 2020, until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or any portion of their Notes at the conversion rate at any time regardless of whether the conditions set forth below have been met.

 

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Holders may convert all or a portion of their Notes prior to the close of business on the business day immediately preceding August 1, 2020, in multiples of $1,000 principal amount, only under the following circumstances:

 

•

during any calendar quarter commencing after the calendar quarter ending on March 31, 2014 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;

 

•

during the five business day period after any five consecutive trading day period (the “Notes Measurement Period”) in which the “trading price” (as the term is defined in the Indenture) per $1,000 principal amount of notes for each trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company’s common stock on such trading day and the conversion rate on each such trading day; or

 

•

upon the occurrence of specified corporate events.

As of June 30, 2014, the Notes are not yet convertible.

Based on market data available for publicly traded, senior, unsecured corporate bonds issued by companies in the same industry and with similar maturity, the Company estimated the implied interest rate of its Notes to be approximately 5.0%, assuming no conversion option. Assumptions used in the estimate represent what market participants would use in pricing the liability component, including market interest rates, credit standing, and yield curves, all of which are defined as Level 2 observable inputs. The estimated implied interest rate was applied to the Notes, which resulted in a fair value of the liability component of $270 million upon issuance, calculated as the present value of implied future payments based on the $345 million aggregate principal amount. The excess of the principal amount of the liability component over its carrying amount (“debt discount”) is amortized to interest expense over the term of the Notes. The $75 million difference between the aggregate principal amount of $345 million and the estimated fair value of the liability component was recorded in additional paid-in capital as the Notes were not considered redeemable.

In accounting for the transaction costs related to the issuance of the Notes, the Company allocated the total amount incurred to the liability and equity components based on their relative values. Issuance costs attributable to the liability component, totaling $7.2 million, are being amortized to expense over the term of the Notes, and issuance costs attributable to the equity component, totaling $2.0 million, and were netted with the equity component in stockholders’ equity.

The Notes consist of the following as of June 30, 2014 (in thousands):

 

Liability component:
Principal		$	345,000
Less: debt discount, net of amortization			(71,509	)
Net carrying amount		$	273,491
Equity component (a)			73,013

 

(a)	Recorded in the consolidated balance sheet within additional paid-in capital, net of $2.0 million issuance costs in equity.

The following table sets forth total interest expense recognized related to the Notes (in thousands):

 

		Three months ended June 30, 2014				Six months ended June 30, 2014
1.25% coupon		$	1,078			$	1,653
Amortization of debt issuance costs			100				150
Amortization of debt discount			2,284				3,491
		$	3,462			$	5,294

 

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As of June 30, 2014, the fair value of the Notes, which was determined based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, quoted price of the Notes in an over-the-counter market (Level 2), and carrying value of debt instruments (carrying value excludes the equity component of the Company’s convertible notes classified in equity) were as follows (in thousands):

 

		June 30, 2014								December 31, 2013
		Fair Value				Carrying Value				Fair Value				Carrying Value
Convertible Senior Notes		$	357,765			$	273,491			$	—			$	—

In connection with the issuance of the Notes, the Company entered into capped call transactions with certain counterparties affiliated with the initial purchasers and others. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the Notes. Under the capped call transactions, the Company purchased capped call options that in the aggregate relate to the total number of shares of the Company’s common stock underlying the Notes, with an initial strike price of approximately $65.10 per share, which corresponds to the initial conversion price of the Notes and is subject to anti-dilution adjustments substantially similar to those applicable to the conversion rate of the Notes, and have a cap price of approximately $78.61. The cost of the purchased capped calls of $25.1 million was recorded to stockholders’ equity and will not be re-measured.

Based on the closing price of our common stock of $47.94 on June 30, 2014, the if-converted value of the Notes was less than their respective principal amounts.

8. Commitments, Contingencies and Legal Matters

Purchase Commitments

The following table summarizes the Company’s purchase commitments at June 30, 2014 (in thousands):

 

Years Ending December 31,		Purchase Commitments
2014 (remaining six months)		$	23,859
2015			1,944
2016			1,716
2017			1,716
2018			—
Thereafter			—
Total minimum payments		$	29,235

Purchase commitments include purchase orders or contracts for the purchase of raw materials used in the manufacturing of the Company’s systems and reagents.

Legal Matters

In May 2005, the Company entered into a license agreement with Roche that provided us with rights under a broad range of Roche patents, including patents relating to the PCR process, reverse transcription-based methods, nucleic acid quantification methods, real-time PCR detection process and composition, and patents relating to methods for detection of viral and cancer targets. A number of the licensed patents expired in the United States prior to the end of August of 2010 and in Europe prior to the end of August of 2011. In August 2010, the Company terminated the Company’s license to U.S. Patent No. 5,804,375 (the “375 Patent”) and ceased paying U.S.-related royalties. The Company terminated the entire license agreement in the fourth quarter of 2011. In August 2011, Roche initiated an arbitration proceeding against the Company in the International Chamber of Commerce pursuant to the terms of the terminated agreement. The Company filed an answer challenging arbitral jurisdiction over the issues submitted by Roche and denying that the Company violated any provision of the agreement. A three-member panel has been convened to address these issues in confidential proceedings. On July 30, 2013, the panel determined that it had jurisdiction to decide the claims, a determination that the Company appealed to the Swiss Federal Supreme Court. On October 2, 2013, the arbitration panel determined that it would proceed with the arbitration while this appeal was pending. On February 27, 2014 the Swiss Federal Supreme Court upheld the jurisdiction of the arbitration panel to hear the case, and the case is continuing. The Company believes that it has not violated any provision of the agreement and that the asserted claim of the 375 Patent is expired, invalid, unenforceable, and not infringed.

 

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Management believes that it is reasonably possible that these legal proceedings could result in a material loss (i.e., the chance of the event occurring is more than remote but less than likely). However, given the nature of arbitration and the nature of the claims in this matter, the Company is unable to estimate the amount of such possible loss.

On August 21, 2012 the Company filed a lawsuit against Roche Molecular Systems, Inc., in the U.S. District Court for the Northern District of California, and F. Hoffman-La Roche LTD, for a declaratory judgment of (a) invalidity, expiration, and non-infringement of the 375 Patent; and (b) invalidity, unenforceability, expiration, and non-infringement of U.S. Patent No. 6,127,155 (the “155 Patent”). On January 17, 2013, the Court issued an order granting a motion by Roche to stay the suit with respect to the 375 Patent pending resolution of the above noted arbitration proceeding. In the same order, the Court dismissed the Company’s suit with respect to the 155 Patent for lack of subject matter jurisdiction, without considering or ruling on the merits of the Company’s case. The Court left open the possibility that the Company could re-file its case against the 155 Patent in the future. Management believes that the possibility that these legal proceedings will result in a material adverse effect on the Company’s business is remote.

On July 16, 2014 Roche Molecular Systems, Inc. filed a complaint in the U.S. District for the Northern District of California, alleging that the Company’s Xpert MTB-RIF product infringes U.S. Patent No. 5,643,723, which expired on July 1, 2014. The Company believes that the possibility that these legal proceedings will result in a material loss is remote.

The Company may be subject to additional various claims, complaints and legal actions that arise from time to time in the normal course of business. Other than as described above, the Company does not believe it is party to any currently pending legal proceedings that will result in a material adverse effect on its business. There can be no assurance that existing or future legal proceedings arising in the ordinary course of business or otherwise will not have a material adverse effect on the Company’s business, consolidated financial position, results of operations or cash flows.

The Company responds to claims arising in the ordinary course of business. Should the Company not be able to secure the terms management expects, these estimates may change and will be recognized in the period in which they are identified. Although the ultimate outcome of such claims is not presently determinable, management believes that the resolution of these matters will not have a material adverse effect on the Company’s financial position, results of operations and cash flows.

9. Employee Equity Incentive Plans and Stock-Based Compensation Expense

The following table summarizes stock-based compensation expense in the condensed consolidated statement of operations (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Cost of sales		$	1,473			$	841			$	1,854			$	1,381
Research and development			2,481				2,097				4,609				3,902
Sales and marketing			1,926				1,078				3,542				2,377
General and administrative			3,268				2,514				5,925				5,146
Total stock-based compensation expense		$	9,148			$	6,530			$	15,930			$	12,806

 

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The following table summarizes option activity under all plans (in thousands, except weighted average exercise price and weighted average remaining contractual term):

 

		Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term				Aggregate Instrinic Value
Outstanding, December 31, 2013			6,476			$	26.70
Granted			1,323			$	46.05
Exercised			(1,312	)		$	18.85
Forfeited			(85	)		$	34.42
Outstanding, June 30, 2014			6,402			$	32.20				4.36			$	101,119
Exercisable, June 30, 2014			3,350			$	24.12				2.94			$	79,787
Vested and expected to vest, June 30, 2014			6,111			$	31.71				4.28			$	99,467

The following table summarizes restricted stock plan activity, which consists of restricted stock awards and restricted stock units (in thousands, except weighted average grant date fair value):

 

		Shares				Weighted Average Grant Date Fair Value
Outstanding, December 31, 2013			742			$	34.13
Granted			288				46.06
Vested/Released			(203	)			33.94
Cancelled			(44	)			35.22
Outstanding, June 30, 2014			783			$	38.51

The following table summarizes the assumptions used in determining the fair value of the Company’s stock options granted to employees and shares purchased by employees under the Company’s 2012 Employee Stock Purchase Plan (“ESPP”):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
OPTION SHARES:
Expected Term (in years)			4.40				4.42				4.40				4.41
Volatility			0.38				0.43				0.38				0.44
Expected Dividends			—	%			—	%			—	%			—	%
Risk Free Interest Rates			1.73	%			0.71	%			1.73	%			0.72	%
Estimated Forfeitures			6.75	%			7.61	%			6.79	%			7.63	%
Weighted Average Fair Value Per Share		$	15.29			$	13.77			$	15.64			$	14.02
ESPP SHARES:
Expected Term (in years)			1.25				1.25				1.25				1.25
Volatility			0.32				0.46				0.32				0.46
Expected Dividends			—	%			—	%			—	%			—	%
Risk Free Interest Rates			0.17	%			0.19	%			0.17	%			0.19	%
Weighted Average Fair Value Per Share		$	14.54			$	12.88			$	14.54			$	12.88

 

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10. Segment and Significant Concentrations

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

The following table summarizes total sales by type (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Sales:
Systems and other sales		$	29,018			$	18,796			$	47,547			$	34,806
Reagent and disposable sales			87,485				77,216				175,863				153,144
Total sales		$	116,503			$	96,012			$	223,410			$	187,950

The following table summarizes sales in the Clinical and Non-Clinical markets (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Sales by market:
Clinical Systems		$	28,334			$	16,711			$	45,619			$	29,248
Clinical Reagents			83,006				70,772				166,166				137,821
Total Clinical			111,340				87,483				211,785				167,069
Non-Clinical			5,163				8,529				11,625				20,881
Total sales		$	116,503			$	96,012			$	223,410			$	187,950

The Company currently sells products through its direct sales force and through third-party distributors. One distributor represented greater than 10% of our total sales for the three months ended June 30, 2014. Sales from this distributor for the three months ended June 30, 2014 and 2013 were 13.1% and 0.6% of total sales, respectively. Sales from this distributor for the six months ended June 30, 2014 and 2013 were 6.8% and 0.4% of total sales, respectively. No customers accounted for more than 10% of total sales for the three months ended June 30, 2013 or for the six months ended June 30, 2014 and 2013, respectively.

The following table summarizes sales by geographic region (in thousands):

 

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Geographic sales information:
North America
Clinical		$	57,649			$	49,906			$	114,935			$	102,070
Non-Clinical			3,926				7,463				9,475				18,854
Total North America			61,575				57,369				124,410				120,924
International
Clinical		$	53,691			$	37,577			$	96,850			$	64,999
Non-Clinical			1,237				1,066				2,150				2,027
Total International			54,928				38,643				99,000				67,026
Total sales		$	116,503			$	96,012			$	223,410			$	187,950

The Company recognized sales of $60.0 million and $55.0 million to U.S. customers for the three months ended June 30, 2014 and 2013, respectively, and $121.6 million and $114.6 million for the six months ended June 30, 2014 and 2013, respectively. The Company recognized sales of $15.4 million and $0.7 million in China for the three months ended June 30, 2014 and 2013, respectively, and $15.5 million and $0.8 million for the six months ended June 30, 2014 and 2013, respectively. As of June 30, 2014 and December 31, 2013, the Company has long lived-assets (excluding intangible assets) of $83.8 million and $63.9 million, respectively, which reside in the U.S. As of June 30, 2014 and December 31, 2013, the Company has long-lived assets of $20.5 million and $21.0 million, respectively, located outside of the U.S., which reside primarily in Sweden and countries in the European Monetary Union.

 

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11. Subsequent Events

On July 16, 2014 Roche Molecular Systems, Inc. filed a complaint in the U.S. District for the Northern District of California, alleging that the Company’s Xpert MTB-RIF product infringes on U.S. Patent No. 5,643,723, which expired on July 1, 2014. The Company believes that the possibility that these legal proceedings will result in a material loss is remote.

 

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 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”, “intend”, “potential”, “project” or “continue” or the negative of these terms or other comparable terminology. Forward-looking statements are based upon current expectations that 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, but not limited to, the following: consistency of product availability and delivery; sales organization productivity; test menu expansion and utilization; improving gross margins; execution of manufacturing operations; our success in increasing product sales under the High Burden Developing Country (“HBDC”) program; commercial test and commercial system sales; the performance and market acceptance of our new products; testing volumes for our products; unforeseen supply, development and manufacturing problems; our ability to manage our inventory levels; our ability to successfully complete and improve our manufacturing scale up activities; the potential need for intellectual property licenses for tests and other products and the terms of such licenses; the environment for capital spending by hospitals and other customers for our diagnostic systems; our ability to successfully introduce and sell products in the Clinical market; lengthy sales cycles in certain markets, including the HBDC program; long sales cycles and variability in systems placements and reagent pull-through in our HBDC program; the impact of competitive products and pricing; sufficient customer demand; customer confidence in product availability and available customer budgets; the level of testing at clinical customer sites, including for healthcare associated infections; our ability to consolidate customer demand through volume pricing; our ability to develop new products and complete clinical trials successfully in a timely manner for new products; our ability to obtain regulatory approvals and introduce new products; uncertainties related to FDA regulatory and international regulatory processes; our ability to respond to changing laws and regulations affecting our industry and changing enforcement practices related thereto; the product, geography and channel mix of our sales, each of which can affect our gross margins; our reliance on distributors to market, sell and support our products in certain geographic locations; the occurrence of unforeseen expenditures, asset impairments, acquisitions or other transactions; cost of litigation, including settlement costs; our ability to integrate the businesses, technologies, operations and personnel of acquired companies; our ability to manage geographically-dispersed operations; the scope and timing of actual United States Postal Service (“USPS”) funding of the Biohazard Detection System (“BDS”) in its current configuration; the rate of environmental testing using the BDS conducted by the USPS, which will affect the amount of consumable products sold; underlying market conditions worldwide; and the other risks set forth under “Risk Factors” and elsewhere in this report. We neither undertake, nor assume any 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 are a molecular diagnostics company that develops, manufactures and markets fully-integrated systems for testing in the Clinical and Non-Clinical markets. Our systems enable rapid, sophisticated molecular testing for organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures. Our objective is to become the leading supplier of integrated systems and tests for molecular diagnostics. Key elements of our strategy to achieve this objective include:

 

•

Provide a fully-integrated molecular testing solution to the Clinical market. We are focusing our investments on selling our systems and tests to the Clinical market and we believe our GeneXpert system will continue to significantly expand our presence in the Clinical market due to its ability to deliver accurate and rapid results, ease of use, flexibility and scalability. Features of the GeneXpert system and Xpert tests include:

 

•

an approach by which the reagents are typically prepackaged in a single vessel (the test cartridge) into which the specimen is added;

 

•

no further user intervention once the Xpert cartridge is loaded into the GeneXpert system;

 

•

all three phases of PCR: 1) sample preparation, 2) amplification and 3) detection, are performed within the single sealed test cartridge automatically;

 

•

primarily moderate complexity Clinical Laboratory Improvement Amendments (“CLIA”) categorized, amplified molecular tests, which means the GeneXpert system can be operated without the need for highly-trained laboratory technologists;

 

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•

commercial availability in a variety of configurations ranging from one to 80 individual test modules, which enables testing in environments ranging from low volume testing to high volume, near-patient, core or central lab testing, and system capacity that can be expanded in support of growing test volumes by adding additional modules;

 

•

notably, to our knowledge, the only truly scalable real-time PCR system that operates entirely within a closed system architecture, reducing hands-on time, reducing the likelihood of human error and contamination, and enabling nested PCR capability, a proven process for maximizing real-time PCR sensitivity; and

 

•

full random access whereby different tests for different targets may be run simultaneously in different modules in the same GeneXpert system, which increases potential utilization and throughput of the system and also enables on-demand or “stat” testing, whereby the user can add a new test to the system at any time without regard to the stage of processing of any other test on the system.

 

•

Continue to develop and market new tests. We plan to capitalize on our strengths in nucleic acid chemistry and molecular biology to continue to develop new tests for our systems and offer our customers the broadest menu of Xpert tests designed to address many of the highest volume molecular test opportunities. Our strategy is to offer a portfolio of Xpert tests spanning healthcare associated infections, critical infectious disease, sexual health, women’s health, virology, oncology and genetics. For example, Xpert CT/NG and Xpert MTB/RIF were made commercially available in the United States in 2013, Xpert HPV and Xpert Norovirus were made commercially available in international markets in April 2014 and Xpert Carba-R was made commercially available in international markets in June 2014.

 

•

Obtain additional target rights. We expect to continue to expand our collaborations with academic institutions and commercial organizations to develop and obtain target rights to various infectious disease and oncology targets. In addition, we expect to focus key business development activities on identifying infectious disease and oncology targets held by academic institutions or commercial organizations for potential license or acquisition.

 

•

Extend geographic reach. Our international sales and marketing operations are headquartered in France. As of June 30, 2014, we had direct sales forces in Australia, the Benelux region, France, Germany, Hong Kong, Italy, South Africa and the United Kingdom (“UK”), and we have offices in Brazil, China, Dubai, India, Japan and Singapore. We expect to continue to expand our international commercial operations capability on both a direct and distributor basis in 2014 and beyond.

 

•

Extend High Burden Developing Countries sales programs. We are developing and expect to continue to expand our presence in HBDCs following the World Health Organization’s endorsement of the Xpert MTB/RIF test in late 2010 to deliver GeneXpert systems and Xpert tests to HBDCs at a discount to our standard commercial prices. We believe that participation in the HBDC program considerably broadens the geographic reach of our products and increases recognition of the Cepheid brand and product portfolio. Our ongoing collaboration with the Foundation for Innovative New Diagnostics (“FIND”) is expected to broaden the menu of tests available to HBDC customers at special pricing considerations.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

The items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operation in our 2013 Annual Report on Form 10-K filed with the Securities and Exchange Commission remain unchanged. For a description of those critical accounting policies, please refer to our 2013 Annual Report on Form 10-K.

Results of Operations

Comparison of the Three and Six months Ended June 30, 2014 and 2013

Sales

The following table summarizes total sales by type (in thousands, except percentages):

 

		Three Months Ended June 30,																Six Months Ended June 30,
		2014				2013				$ Change				% Change				2014				2013				$ Change				% Change
Sales:
System and other sales		$	29,018			$	18,796			$	10,222				54	%		$	47,547			$	34,806			$	12,741				37	%
Reagent and disposable sales			87,485				77,216				10,269				13	%			175,863				153,144				22,719				15	%
Total sales		$	116,503			$	96,012			$	20,491				21	%		$	223,410			$	187,950			$	35,460				19	%

 

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The following table summarizes sales in the Clinical and Non-Clinical and Other markets (in thousands, except percentages):

 

		Three Months Ended June 30,																Six Months Ended June 30,
		2014				2013				$ Change				% Change				2014				2013				$ Change				% Change
Sales by market:
Clinical Systems		$	28,334			$	16,711			$	11,623				70	%		$	45,619			$	29,248			$	16,371				56	%
Clinical Reagents			83,006				70,772				12,234				17	%			166,166				137,821				28,345				21	%
Total Clinical			111,340				87,483				23,857				27	%			211,785				167,069				44,716				27	%
Non-Clinical			5,163				8,529				(3,366	)			-39	%			11,625				20,881				(9,256	)			-44	%
Total sales		$	116,503			$	96,012			$	20,491				21	%		$	223,410			$	187,950			$	35,460				19	%

Total Clinical revenues increased $23.9 million, or 27%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $44.7 million, or 27%, for the six months ended June 30, 2014 as compared to the same period in the prior year. The increase in Clinical revenues for the three and six month comparative periods was driven by GeneXpert instrument placements to HBDC customers and higher Clinical Reagent sales. Clinical Reagent sales grew in all Xpert test categories led by higher Healthcare Associated Infection tests, Xpert CT/NG, Xpert MTB/RIF and Xpert Flu driven by growing install base of our GeneXpert systems.

Non-Clinical revenue decreased $3.4 million, or 39%, for the three months ended June 30, 2014 as compared to the same period in the prior year and decreased $9.3 million, or 44%, for the six months ended June 30, 2014 as compared to the same period in the prior year. The decrease in Non-Clinical revenue was primarily due to decreased sales of anthrax test cartridges under the USPS BDS program and decreased contract, grant and research revenue.

The following table summarizes sales by geographic region (in thousands, except percentages):

 

		Three Months Ended June 30,																Six Months Ended June 30,
		2014				2013				$ Change				% Change				2014				2013				$ Change				% Change
Geographic sales information:
North America
Clinical		$	57,649			$	49,906			$	7,743				16	%		$	114,935			$	102,070			$	12,865				13	%
Non-Clinical			3,926				7,463				(3,537	)			-47	%			9,475				18,854				(9,379	)			-50	%
Total North America			61,575				57,369				4,206				7	%			124,410				120,924				3,486				3	%
International
Clinical			53,691				37,577				16,114				43	%			96,850				64,999				31,851				49	%
Non-Clinical			1,237				1,066				171				16	%			2,150				2,027				123				6	%
Total International			54,928				38,643				16,285				42	%			99,000				67,026				31,974				48	%
Total sales		$	116,503			$	96,012			$	20,491				21	%		$	223,410			$	187,950			$	35,460				19	%

North American Clinical sales increased $7.7 million, or 16%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $12.9 million, or 13%, for the six months ended June 30, 2014 as compared to the same period in the prior year. The increase in North American Clinical sales was driven by growth in Clinical Reagents led by higher Healthcare Associated Infection tests, Xpert CT/NG, Xpert Flu and Xpert MTB/RIF driven by growing install base of our GeneXpert systems. North American Non-Clinical sales decreased $3.5 million, or 47%, for the three months ended June 30, 2014 as compared to the same period in the prior year and decreased $9.4 million, or 50%, for the six months ended June 30, 2014 as compared to the same period in the prior year, primarily due to decreased sales of anthrax test cartridges under the USPS BDS program and decreased contract, grant and research revenue.

International sales, which primarily represent sales in Europe, China and South Africa, increased $16.3 million, or 42%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $32.0 million, or 48%, for the six months ended June 30, 2014 as compared to the same period in the prior year. The increase for the three and six month comparative periods was primarily driven by growth in HBDC GeneXpert systems placements and growth in Commercial and HBDC reagent sales. Other than China in the three months ended June 30, 2014, no single country outside of the United States represented more than 10% of the our total sales in any other period presented.

 

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Costs and Operating Expenses

The following table summarizes costs and operating expenses (in thousands, except percentages):

 

		Three Months Ended June 30,																Six Months Ended June 30,
		2014				2013				$ Change				% Change				2014				2013				$ Change				% Change
Costs and operating expenses:
Cost of sales		$	59,568			$	52,889			$	6,679				13	%		$	112,651			$	95,781			$	16,870				18	%
Collaboration profit sharing			649				1,425				(776	)			-54	%			1,940				3,535				(1,595	)			-45	%
Research and development			23,998				18,572				5,426				29	%			45,738				36,299				9,439				26	%
Sales and marketing			23,502				19,105				4,397				23	%			46,960				38,231				8,729				23	%
General and administrative			14,340				9,612				4,728				49	%			28,007				19,375				8,632				45	%
Total costs and operating expenses		$	122,057			$	101,603			$	20,454				20	%		$	235,296			$	193,221			$	42,075				22	%

Cost of Sales

Cost of sales consists of raw materials, direct labor, stock-based compensation expense, manufacturing overhead, facility costs and warranty costs. Cost of sales also includes royalties on sales, amortization of intangible assets related to technology licenses and acquired intangibles, depreciation expense and the U.S. medical device tax under the Affordable Care Act.

Cost of sales increased $6.7 million, or 13%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $16.9 million, or 18%, for the six months ended June 30, 2014 as compared to the same period in the prior year. This increase in both the three and six month comparative periods was attributed to increased shipments of our system and reagent products, partially offset by improved manufacturing efficiencies.

Our gross margin percentage was 49% and 45% for the three months ended June 30, 2014 and 2013, respectively, and 50% and 49% for the six months ended June 30, 2014 and 2013, respectively. These increases were attributable to improved manufacturing efficiencies partially offset by an increase in our HBDC sales, which have lower gross margins, and lower average sales prices in North America due to the implementation of our strategic pricing matrix.

While we expect a trend of increasing gross margins over time, we also expect moderate fluctuations from quarter to quarter, depending on product, geography, channel and HBDC mix.

Collaboration Profit Sharing

Collaboration profit sharing represents the amount that we pay to Life Technologies Corporation (“LIFE”) under our agreement to develop reagents for use in the USPS BDS program. Under the agreement, computed gross margin on anthrax test cartridge sales is shared equally between the two parties.

Collaboration profit sharing expense decreased $0.8 million, or 54%, for the three months ended June 30, 2014 as compared to the same period in the prior year and decreased $1.6 million, or 45%, for the six months ended June 30, 2014 as compared to the same period in the prior year. These decreases for the three and six month comparative periods were due to the decrease in anthrax test cartridge sales under the USPS BDS program.

Research and Development Expenses

Research and development expenses consist of salaries and employee-related expenses, including stock-based compensation, clinical trials, research and development materials, facility costs and amortization and depreciation. Research and development expenses increased $5.4 million, or 29%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $9.4 million, or 26%, for the six months ended June 30, 2014 as compared to the same period in the prior year. These increases in both the three and six month comparative periods were primarily due to higher clinical and beta trial costs, outside consulting services, costs of research and development materials and salaries and employee-related expenses including stock based compensation expense.

 

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Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries and employee-related expenses, including commissions and stock-based compensation, travel, facility-related costs and marketing and promotion expenses. Sales and marketing expenses increased $4.4 million, or 23%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $8.7 million, or 23%, for the six months ended June 30, 2014 as compared to the same period in the prior year. These increases in both the three and six month comparative periods were primarily due to an increase in salaries and employee-related expenses in connection with the expansion of our direct sales force, including an increase in stock based compensation expense.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and employee-related expenses, which include stock-based compensation, travel, facility costs, legal, accounting and other professional fees. General and administrative expenses increased $4.7 million, or 49%, for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $8.6 million, or 45%, for the six months ended June 30, 2014 as compared to the same period in the prior year. These increases for both the three and six month comparative periods were primarily due to higher legal expenses, and salaries and employee-related expenses, including stock based compensation expense.

Other Income (Expense)

The following table summarizes other income (expense) (in thousands, except percentages):

 

		Three Months Ended June 30,																Six Months Ended June 30,
		2014				2013				$ Change				% Change				2014				2013				$ Change				% Change
Other Income (Expense)
Interest and other income		$	306			$	3			$	303				10100	%		$	459			$	3			$	456				15200	%
Interest expense			(3,500	)			(38	)			(3,462	)			9111	%			(5,363	)			(73	)			(5,290	)			7247	%
Foreign currency exchange gain (loss) and other			(176	)			(682	)			506				-74	%			(757	)			(273	)			(484	)			177	%
Other income (loss), net		$	(3,370	)		$	(717	)		$	(2,653	)			370	%		$	(5,661	)		$	(343	)		$	(5,318	)			1550	%

Interest income primarily consists of returns from our investment portfolio. Interest income increased $0.3 million for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $0.5 million for the six months ended June 30, 2014 as compared to the same period in the prior year. The increase for both the three and six month comparative periods was due to the increase in allocation into short and long-term investments following the issuance of our convertible senior notes, which were issued in February 2014.

Interest expense increased $3.5 million for the three months ended June 30, 2014 as compared to the same period in the prior year and increased $5.3 million for the six months ended June 30, 2014 as compared to the same period in the prior year. Interest expense primarily consists of accretion of debt discount and coupon interests payable on our convertible senior notes, which were issued in February 2014.

LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Flow

 

		Six Months Ended June 30,
		2014				2013				Increase/ (Decrease)
		(In thousands)
Net cash provided by (used in) operating activities		$	(8,555	)		$	4,827			$	(13,382	)
Net cash used in investing activities			(271,480	)			(23,670	)			(247,810	)
Net cash provided by financing activities			335,110				8,669				326,441

The net cash used in operating activities was $8.6 million in the first six months of 2014. It was primarily comprised of net loss and the net effect of cash provided by non-cash expenses and working capital uses of cash. Non-cash expenses were

 

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comprised of stock-based compensation, depreciation and amortization of property and equipment, amortization of debt discount and debt issuance costs and amortization of intangible assets. The primary working capital uses of cash for the six months ended June 30, 2014 were increases in inventory, prepaid expenses and other current assets and accounts receivable partially offset by increases in deferred revenue, accrued compensation and accounts payable and other current liabilities.

The net cash provided by operating activities was $4.8 million in the first six months of 2013. It was primarily comprised of the net effect of cash provided by non-cash expenses and working capital uses of cash. Non-cash expenses were comprised of stock-based compensation, depreciation and amortization expenses. The primary working capital uses of cash for the six months ended June 30, 2013 were increases in inventory, prepaid expenses, accounts receivable, accrued compensation, accounts payable, other current liabilities and deferred revenue.

The net cash used in investing activities was $271.5 million in the first six months in 2014. It was primarily comprised of purchases of marketable securities following the issuance of our convertible senior notes, which were issued in February 2014, and investments and capital expenditures, partially offset by proceeds for the sale and maturity of marketable securities.

The net cash used in investing activities was $23.7 million in the first six months of 2013. It was primarily comprised of capital expenditures, the cost of an acquisition and cash paid for a technology license.

The net cash provided by financing activities was $335.1 million in the first six months of 2014. It was primarily comprised of net proceeds from the issuance of $345 million in principal amount of convertible senior notes and, to a lesser extent, the issuance of common shares and exercises of stock options, partially offset by the purchase of the capped call transaction for approximately $25.1 million.

The net cash provided by financing activities was $8.7 million in the first six months of 2013. It was primarily comprised of net proceeds from the issuance of common shares and exercises of stock options.

Our sales, earnings, cash flows, receivables and payables are subject to fluctuations due to changes in foreign currency exchange rates. Our risk management strategy utilizes foreign currency contracts to manage our exposure to foreign currency volatility that exists as part of our ongoing business operations. We utilize cash flow hedge contracts to reduce the exchange rate impact on a portion of the net revenue or operating expense of certain anticipated transactions. In addition, we use balance sheet hedge contracts to reduce the exchange rate risk associated primarily with foreign currency denominated receivables and payables. As of June 30, 2014, we had open cash flow and balance sheet hedge contracts with future settlements within one to twelve months. Contracts were primarily denominated in euros, Swedish krona, British pounds and South African rand. We do not enter into any foreign exchange derivative instruments for trading or speculative purposes. The notional principal amounts of our outstanding derivative instruments designated as cash flow hedges are $113.7 million and $96.6 million as of June 30, 2014 and December 31, 2013, respectively. The notional principal amounts of our outstanding derivative instruments not designated as cash flow hedges was $38.1 million and $24.2 million as of June 30, 2014 and December 31, 2013, respectively.

Off-Balance-Sheet Arrangements

As of June 30, 2014, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated under the Securities Act of 1933.

Financial Condition Outlook

We plan to continue to make expenditures to expand our manufacturing capacity and to support our activities in sales and marketing and research and development. These expenditures may vary from quarter to quarter. We plan to continue to support our working capital needs and anticipate that our existing cash resources will enable us to maintain currently planned operations. Based on past performance and current expectations, we believe that our current available sources of funds will be adequate to finance our operations for at least the next year. 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 depend on a number of factors outside our control, including general global economic conditions. 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, our ability to gain FDA clearance for our new products, the need to acquire licenses to new technology or to use our technology in new markets, expansion through acquisitions 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

 

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means. If additional funds are raised through the issuance of equity or equity-related securities, shareholders 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.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

Our investment portfolio is exposed to market risk from changes in interest rates. The fair market value of fixed rate securities may be adversely impacted by fluctuations in interest rates while income earned on floating rate securities may decline as a result of decreases in interest rates. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We attempt to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We mitigate default risk by investing in investment grade securities. We have historically maintained a relatively short average maturity for our investment portfolio, and we believe a hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would change the fair value of our interest sensitive financial instruments by approximately $2.3 million. In addition, if a 100 basis point change in overall interest rates were to occur in 2014, our interest income would not change significantly in relation to amounts we would expect to earn, based on our cash, cash equivalents, and short-term investments as of June 30, 2014.

Changes in interest rates may also impact gains or losses from the conversion of our outstanding convertible senior notes. In February, 2014, we issued $345 million in aggregate principal amount of our 1.25% convertible senior notes due 2021. At our election, the notes are convertible into cash, shares of our common stock, or a combination of cash and shares of our common stock in each case under certain circumstances, including trading price conditions related to our common stock. If the trading price of our common stock reaches a price for a sustained period at 130% above the conversion price of $65.10, the notes will become convertible. Upon conversion, we are required to record a gain or loss for the difference between the fair value of the debt to be extinguished and its corresponding net carrying value. The fair value of the debt to be extinguished depends on our then-current incremental borrowing rate. If our incremental borrowing rate at the time of conversion is higher or lower than the implied interest rate of the notes, we will record a gain or loss in our consolidated statement of income during the period in which the notes are converted. The implicit interest rate for the notes is 5.0%. An incremental borrowing rate that is a hypothetical 100 basis points lower than the implicit interest rate upon conversion of $100 million aggregate principal amount of the notes would result in a loss of approximately $5.6 million.

Foreign Currency Risk

We operate primarily in the U.S. and a majority of our revenue, cost, expense and capital purchasing activities for the six months ended June 30, 2014 were transacted in U.S. dollars. As a corporation with international and domestic operations, we are exposed to changes in foreign exchange rates. In our international operations, we pay payroll and other expenses in local currencies. In the six months ended June 30, 2014 and 2013, international sales were 44% and 36%, respectively, of our total sales. Our international sales are predominantly in European countries, China and South Africa. Our exposures to foreign currency risks may change over time and could have a material adverse impact on our financial results.

We will continue to use hedging programs in the future and may use currency forward contracts, currency options, and/or other derivative financial instruments commonly utilized to reduce financial market risks if it is determined that such hedging activities are appropriate to reduce risk. A 10% change in the exchange rates upward or downward in our portfolio of foreign currency contracts would have decreased or increased, our unrealized loss by approximately $5.6 million at June 30, 2014 and our unrealized loss by approximately $3.5 million at December  31, 2013. We do not hold or purchase any currency contracts for trading purposes.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q.

 

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Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2014, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

There were no changes in our internal control over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In May 2005, we entered into a license agreement with Roche that provided us with rights under a broad range of Roche patents, including patents relating to the PCR process, reverse transcription-based methods, nucleic acid quantification methods, real-time PCR detection process and composition, and patents relating to methods for detection of viral and cancer targets. A number of the licensed patents expired in the U.S. prior to the end of August of 2010 and in Europe prior to the end of August of 2011. In August 2010, we terminated our license to U.S. Patent No. 5,804,375 (the “375 Patent”) and ceased paying U.S.-related royalties. We terminated the entire license agreement in the fourth quarter of 2011. In August 2011, Roche initiated an arbitration proceeding against us in the International Chamber of Commerce pursuant to the terms of the terminated agreement. We filed an answer challenging arbitral jurisdiction over the issues submitted by Roche and denying that we violated any provision of the agreement. A three-member panel has been convened to address these issues in confidential proceedings. On July 30, 2013, the panel determined that it had jurisdiction to decide the claims, a determination that the Company appealed to the Swiss Federal Supreme Court. On October 2, 2013, the arbitration panel determined that it would proceed with the arbitration while this appeal was pending. On February 27, 2014 the Swiss Federal Supreme Court upheld the jurisdiction of the arbitration panel to hear the case, and the case is continuing. The Company believes that it has not violated any provision of the agreement and that the asserted claim of the 375 Patent is expired, invalid, unenforceable, and not infringed.

We believe that it is reasonably possible that these legal proceedings could result in a material loss (i.e., the chance of the event occurring is more than remote but less than likely). However, given the nature of arbitration and the nature of the claims in this matter, we are unable to estimate the amount of such possible loss.

On August 21, 2012 we filed a lawsuit against Roche Molecular Systems, Inc., and F. Hoffman-La Roche LTD, in the U.S. District Court for the Northern District of California, for a declaratory judgment of (a) invalidity, expiration, and non-infringement of the 375 Patent; and (b) invalidity, unenforceability, expiration, and non-infringement of U.S. Patent No. 6,127,155 (the “155 Patent”). On January 17, 2013, the Court issued an order granting a motion by Roche to stay the suit with respect to the 375 Patent pending resolution of the above noted arbitration proceeding. In the same order, the Court dismissed our suit with respect to the 155 Patent for lack of subject matter jurisdiction, without considering or ruling on the merits of our case. The Court left open the possibility that we could re-file our case against the 155 Patent in the future. We believe that the possibility that these legal proceedings will result in a material adverse effect on our business is remote.

On July 16, 2014 Roche Molecular Systems, Inc. filed a complaint in the U.S. District Court for the Northern District of California, alleging that our Xpert MTB-RIF product infringes U.S. Patent No. 5,643,723, which expired on July 1, 2014. We believe that the possibility that these legal proceedings will result in a material loss is remote.

We may be subject to additional various claims, complaints and legal actions that arise from time to time in the normal course of business. Other than as described above, we do not believe we are party to any currently pending legal proceedings that will result in a material adverse effect on our business. There can be no assurance that existing or future legal proceedings arising in the ordinary course of business or otherwise will not have a material adverse effect on our business, consolidated financial position, results in operations or cash flows.

ITEM 1A. RISK FACTORS

You should carefully consider the risks and uncertainties 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 us. 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, financial condition or results of operations.

We have a history of operating losses and may not achieve profitability again.

We incurred operating losses in each annual fiscal year since our inception, except for 2011. For the six months ended June 30, 2014, we had a net loss of $19.1 million, and in 2013 and 2012 we experienced a net loss of $18.0 million and $20.0 million, respectively. As of June 30, 2014, we had an accumulated deficit of approximately $262.7 million. We do not expect to be profitable for fiscal 2014 and our ability to be profitable in the future will likely depend on our ability to continue to increase our revenues, which is subject to a number of factors including our ability to continue to successfully penetrate the Clinical market, our ability to successfully market the GeneXpert system and develop and market additional GeneXpert tests, our ability to secure regulatory approval of additional GeneXpert tests, our ability to continue to grow sales of our healthcare associated infection and other tests, our ability to compete effectively against current and future competitors, the increasing number of competitors in our market that could reduce the average selling price of our products, the development of our HBDC sales program, the amount of

 

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products sold through this program and the extent of global funding for such programs, our ability to penetrate new geographic markets, global economic and political conditions and our ability to increase manufacturing throughput. Our ability to be profitable also depends on our expense levels and product gross margin, which are also influenced by a number of factors, including: the mix of revenues from Clinical reagent sales and GeneXpert system sales as opposed to GeneXpert Infinity system sales and sales under our HBDC program, both of which have lower gross margins; the resources we devote to developing and supporting our products; increases in manufacturing costs associated with our operations; our ability to improve manufacturing efficiencies, including improvements in our manufacturing scale-up activities; our ability to manage our inventory levels; third-party freight costs; the continued progress of our research and development of potential products; the ability to gain FDA regulatory and international regulatory clearance for our new products; license fees or royalties we may be required to pay; the potential need to acquire licenses to new technology or to use our technology in new markets, which could require us to pay unanticipated license fees and royalties in connection with these licenses; and the prices at which we are able to sell our GeneXpert systems and tests. Our manufacturing expansion efforts may prove more expensive than we currently anticipate, and we may not succeed in increasing our revenues to offset higher expenses. These expenses or a reduction in the prices at which we are able to sell our products, among other things, may cause our net income and working capital to decrease. If we fail to grow our revenue, manage our expenses and improve our gross margin, we may never achieve profitability. If we fail to do so, the market price of our common stock will likely decline.

Our operating results may fluctuate significantly, our customers’ future purchases are difficult to predict and any failure to meet financial expectations may result in a decline in our stock price.

Our quarterly operating results may 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 indicator 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 adverse economic conditions, changes in internal priorities or, in the case of governmental customers, problems with the appropriations process, concerns over future U.S. federal government budgetary negotiations, and variability and timing of orders. Additionally, we have experienced, and expect to continue to experience, meaningful variability in connection with our commercial system placements and system placements and reagent pull-through in our HBDC program. This variability may cause our revenues and operating results to fluctuate significantly from quarter to quarter. Additionally, because of the limited visibility into the actual timing of future system placements, our operating results are difficult to forecast from quarter to quarter. Additionally, we expect moderate fluctuations from quarter to quarter in gross margin depending on product, geography and channel mix, as well as the revenue contribution from our HBDC program, which has lower margin than our other products. If revenue declines in a quarter, whether due to a delay in recognizing expected revenue, adverse economic conditions and unexpected costs or otherwise, our results of operations will be harmed because many of our expenses are relatively fixed. In particular, research and development, sales and marketing and general and administrative expenses are not significantly affected by variations in revenue. However, if we have an unexpected increase in costs and expenses in a quarter, our quarterly operating results will be affected. For example, for the year ended December 31, 2013, we incurred certain costs and inventory reserve provisions related to our manufacturing scale-up and restructuring activities. Additionally, in July 2014, we began to self-insure for a portion of employee health insurance coverage and we estimate the liabilities associated with the risks retained by the Company, in part, by considering actuarial assumptions which, by their nature, are subject to a high degree of variability. If the number or severity of claims for which we are self-insured increases, or if we are required to accrue or pay additional amounts because the claims prove to be more severe than our original assessments, our operating results may be affected. If our quarterly operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price could drop suddenly and significantly.

If we are unable to manufacture our products in sufficient quantities and in a timely manner, our operating results will be harmed, our ability to generate revenues could be diminished, and our gross margin may be negatively impacted.

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. For example, in 2012 and early 2013 we experienced lower than expected revenue due primarily to intermittent interruptions in the supply of Xpert cartridge parts, which also negatively impacted the efficiency of our manufacturing operations and our resulting gross margin. Any future interruptions we experience in the manufacturing or shipping of our products could delay our ability to recognize revenues in a particular quarter and could also adversely affect our relationships with our customers and erode customer confidence in our product availability. Manufacturing problems can and do arise, and as demand for our products increases, any such problems could have an increasingly significant impact on our operating results. In the past, we have experienced problems and delays in production that have impacted our product yield and the efficiency of our manufacturing operations and caused delays in our ability to ship finished products, and we may experience such delays in the future. We may not be able to react quickly enough to ship products and recognize anticipated revenues for a given period if we experience significant delays in the manufacturing process. In addition, we must maintain sufficient production

 

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capacity in order to minimize such delays, which carries fixed costs that we may not be able to offset if orders slow, which would adversely affect our operating margins. If we are unable to manufacture our products consistently, in sufficient quantities, and on a timely basis, our revenues from product sales, gross margins and our other operating results will be materially and adversely affected.

We have a limited number of suppliers for critical product components, and if such 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 a limited number of suppliers that supply some of the components used in the manufacture of our systems and our disposable reaction tubes and cartridges. Strategic purchases of components are necessary for our business. If we need alternative sources for key component parts for any reason, these component parts may not be immediately available to us. 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. 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. For example, during 2012 and early 2013 we experienced intermittent interruptions in the supply of Xpert cartridge parts, which negatively impacted our product sales. In addition, some companies continue to experience financial difficulties, partially resulting from continued economic uncertainty and concerns over potential future U.S. budgetary issues. We cannot be assured that our suppliers will not be adversely affected by this uncertainty or that they will be able to continue to provide us with the components we need. 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.

Our sales cycle can be lengthy, which can cause variability and unpredictability in our operating results.

The sales cycles for our systems can be lengthy, particularly during uncertain economic and political conditions, 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. For example, sales of our products often involve purchasing decisions by large public and private institutions and any purchases can require many levels of pre-approval. In addition, certain Non-Clinical sales may depend on these institutions receiving research grants from various federal agencies, which grants vary considerably from year to year in both amount and timing due to the political process, including the U.S. federal governmental budgetary pressures. Additionally, participants in our HBDC program may be dependent on funding from governmental agencies and/or non-governmental organizations and, accordingly, such customers’ purchase decisions may not be within their direct control and may be subject to lengthy administrative processes, the result of which is that the sales cycle in our HBDC program is lengthy and unpredictable. 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 we cannot successfully commercialize our products, our business could be harmed.

If our tests for use on our systems do not continue to gain market acceptance, we will be unable to generate significant sales, which will prevent us from achieving profitability. While we have received FDA clearance for a number of tests, these products may not experience increased sales. Many factors may affect the market acceptance and commercial success of our products, including:

 

•

the timely expansion of our menu of tests;

 

•

our ability to fulfill orders;

 

•

the results of clinical trials needed to support any regulatory approvals of our tests;

 

•

our ability to obtain requisite FDA or other regulatory clearances or approvals for our tests under development on a timely basis;

 

•

the demand for the tests we introduce;

 

•

the timing of market entry for 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 of our test menu relative to competitors;

 

•

changes to policies, procedures or what are considered best practices in clinical diagnostics, including practices for detecting and preventing healthcare associated infections;

 

•

the extent and success of our marketing and sales efforts;

 

•

the functionality of new products that address market requirements and customer demands;

 

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•

the pricing of our products;

 

•

the level of reimbursement for our products by third-party payers; and

 

•

the publicity concerning our systems and tests.

In particular, we believe that the success of our business will depend in large part on our ability to continue to increase sales of our Xpert tests and our ability to introduce additional tests for the Clinical market. We believe that successfully expanding our business in the Clinical market is critical to our long-term goals and success. We have limited ability to forecast future demand for our products in this market. In addition, we have committed substantial funds to licenses that are required for us to compete in the Clinical market. If we cannot successfully penetrate the Clinical market to fully exploit these licenses, these investments may not yield significant returns, which could harm our business.

The regulatory processes applicable to our products and operations are expensive, time-consuming and uncertain, and may prevent us from obtaining required approvals for the commercialization of some of our products.

In the Clinical market, our products are regulated as medical device products 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 premarket approval (“PMA”) or 510(k) clearance from the FDA prior to marketing. The 510(k) clearance process usually takes from three to four months from submission but can take longer. The PMA process is much more costly, lengthy and uncertain and generally takes from six months to one year or longer from submission. Clinical trials are generally required to support both PMA and 510(k) submissions. Certain of our products for use on our GeneXpert and SmartCycler systems, when used for clinical purposes, may require PMA, and all such tests will most likely, at a minimum, require 510(k) clearance. We are planning clinical trials for other proposed products. Clinical trials are expensive and time-consuming. In addition, the commencement or completion of any clinical trials may be delayed or halted for any number of reasons, including product performance, changes in intended use, changes in medical practice and the opinion of evaluator Institutional Review Boards. Additionally, since 2009, the FDA has significantly increased the scrutiny applied to its oversight of companies subject to its regulations, including 510(k) submissions, by hiring new investigators and increasing inspections of manufacturing facilities. In January 2011, the FDA announced that it will endeavor to streamline its 510(k) review process and the FDA’s Center for Devices and Radiological Health, (“CDRH”), issued an implementation plan containing 25 specific actions to be implemented in 2011 relating to the 510(k) review process and associated administrative matters. We continue to monitor the CDRH’s implementation of its plan of action and analyze how its decisions will impact the approval of our products. The CDRH also deferred action on several other initiatives, including the creation of a new class of devices that would be subject to heightened review processes, until the Institute of Medicine issues a related report on the 510(k) regulatory process, which was released in late July 2011. Many of the actions proposed by the CDRH could result in significant changes to the 510(k) process, which could complicate the product approval process, although we cannot predict the effect of such changes and cannot ascertain if such changes will have a substantive impact on the approval of our products. If we fail to adequately respond to the increased scrutiny and streamlined 510(k) submission process, our business may be adversely impacted.

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 PMA for devices, withdrawal of marketing clearances or approvals, or criminal prosecution. With regard to future products for which we seek 510(k) clearance or PMA from the FDA, any failure or material delay to obtain such clearance or approval could harm our business. If the FDA were to disagree with our regulatory assessment and conclude that approval or clearance is necessary to market the products, we could be forced to cease marketing the products and seek approval or clearance. With regard to those future products for which we will seek 510(k) clearance or PMA from the FDA, any failure or material delay to obtain such clearance or approval 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 located in Sunnyvale and Lodi, California, Seattle, Washington and Stockholm, Sweden, where we assemble and produce the GeneXpert and SmartCycler systems, cartridges and other molecular diagnostic kits and reagents, are subject to periodic regulatory inspections by the FDA and other federal and state and foreign regulatory agencies. For example, these facilities are subject to Quality System Regulations (“QSR”) of the FDA and are subject to annual inspection and licensing by the States of California and Washington and European regulatory agencies. 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 prevent us from being able to provide products to our customers in a timely fashion and therefore harm our business.

 

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The federal medical device tax by the U.S. government could adversely affect our business, profitability and stock price.

The comprehensive healthcare reform legislation includes an annual excise tax on the sale of medical devices equal to 2.3% of the price of the device, starting on January 1, 2013, which we believe includes all of our Clinical products sold in the United States. Since we do not intend to pass this tax onto our customers, if we are unable to identify other cost savings in our business, our future gross margins and operating results could be harmed, which in turn could cause the price of our stock to decline.

Our HBDC program exposes us to increased risks of variability and unpredictable operating results.

Our HBDC program exposes us to risks that are additional and different from the risks associated with our other commercial operations, including among other things:

 

•

the participants in our HBDC program are located in less developed countries, exposing us to customers in countries that may have less political, social or economic stability and less developed infrastructure and legal systems;

 

•

the sales cycle in our HBDC program is lengthy and unpredictable, as HBDC program participants are frequently dependent upon governmental agencies and/or non-governmental organizations with additional administrative processes, causing variability and unpredictability in our operating results;

 

•

our HBDC business has lower gross margins and, therefore, growth in our HBDC business negatively impacts our gross margins as a whole; and

 

•

our collaborative partners and other supporters, such as FIND, BMGF, USAID, UNITAID and the World Health Organization, may cease to devote financial resources to or otherwise cease to support our HBDC program.

An increase in variable and unpredictable operating results and/or an adverse development relating to one or more of these risks could negatively impact our business, results of operations and financial condition. Additionally, our HBDC program facilitates the expansion of our other commercial operations into additional geographic locations and, to the extent that our HBDC program is ineffective as a result of one or more of these risks, the international expansion of our other commercial operations could suffer.

We rely on licenses of key technology from third parties and may require additional licenses for many of our new product candidates.

We rely on third-party licenses to be able to sell many of our products, and we could lose these third-party licenses for a number of reasons, including, for example, early terminations of such agreements due to breaches or alleged breaches by either party to the agreement. If we are unable to enter into a new agreement for licensed technologies, either on terms that are acceptable to us or at all, we may be unable to sell some of our products or access some geographic or industry markets. We also need to introduce new products and product features in order to market our products to a broader customer base and grow our revenues, and many new products and product features could require us to obtain additional licenses and pay additional license fees and royalties. Furthermore, for some markets, we intend to manufacture reagents and tests for use on our systems. We believe that manufacturing reagents and developing tests for our systems is important to our business and growth prospects but may require additional licenses, which may not be available on commercially reasonable terms or at all. 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.

We may face risks associated with acquisitions of companies, products and technologies and our business could be harmed if we are unable to address these risks.

In order to remain competitive, obtain key competencies, consolidate our supply chain or sales force, acquire complementary products or technologies, or for other reasons, we may seek to acquire additional businesses, products or technologies. Even if we identify an appropriate acquisition or are presented with appropriate opportunities to acquire or make other investments, we may not be successful in negotiating the terms of the acquisition, financing the acquisition, consummating the acquisition or effectively integrating the acquired business, product or technology into our existing business and operations. For example, in 2012, we acquired one of our plastic molders and, in 2013, we acquired distributors in two of our international locations. We have limited experience in successfully acquiring and integrating businesses, products and technologies, and even if we are able to consummate an acquisition or other investment, we may not realize the anticipated benefits, including our recent acquisitions. We may face risks, uncertainties and disruptions, including difficulties in the integration of the operations and services of these acquisitions or any other acquired company, integration of acquired technology with our products, diversion of our management’s attention from other business concerns, the potential loss of key employees or customers of the acquired businesses and impairment charges if future acquisitions are not as successful as we originally anticipate. If we fail to successfully integrate companies, assets, products or technologies that we acquire, our business could be harmed. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments, the issuance of which could be

 

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dilutive to our existing shareholders. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired intangible assets. Furthermore, identifying, contemplating, negotiating or completing an acquisition and integrating an acquired business, product or technology could significantly divert management and employee time and resources.

The current uncertainty in global economic conditions makes it particularly difficult to predict product demand and other related matters and makes it more likely that our actual results could differ materially from expectations.

Our operations and performance depend on global economic conditions, which have been adversely impacted by continued global economic uncertainty, concerns over the downgrade of U.S. sovereign debt and monetary and international financial uncertainties. These conditions have and may continue to make it difficult for our customers and potential customers to accurately forecast and plan future business activities, and have caused our customers and potential customers to slow or reduce spending, particularly for systems. Furthermore, during economic uncertainty, our customers have experienced and may continue to experience issues gaining timely access to sufficient credit, which could result in their unwillingness to purchase products or an impairment of their ability to make timely payments to us. If that were to continue to occur, we may experience decreased sales, be required to increase our allowance for doubtful accounts and our days sales outstanding would be negatively impacted. Even with economic recovery, it may take time for our customers to establish new budgets and return to normal purchasing patterns. We cannot predict the reoccurrence of any economic slowdown or the strength or sustainability of the economic recovery, worldwide, in the U.S. or in our industry. These and other economic factors could have a material adverse effect on demand for our products and on our financial condition and operating results.

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

Our ability to sell our products in the Clinical 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. There are efforts by governmental and third-party payers to contain or reduce the costs of health-care through various means and the continuous growth of managed care, together with efforts to reform the health-care delivery system in the United States and Europe, has increased pressure on health-care providers and participants in the health-care industry to reduce costs. Consolidation among health-care providers and other participants in the health-care industry has resulted in fewer, more powerful health-care groups, whose purchasing power gives them cost containment leverage. Additionally, third-party payers are increasingly challenging the price of medical products and services. Furthermore, we are unable to predict what effect the current or future health-care reform will have on our business, or the effect these matters will have on our customers. 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.

In some foreign markets, pricing and profitability of medical products are subject to government control. In the United States, we expect that there will continue to be federal and state proposals for similar controls. Also, the trends toward managed healthcare in the United States and proposed legislation intended to reduce the cost of government insurance programs could significantly influence the purchase of healthcare services and products and may result in lower prices for our products or the exclusion of our products from reimbursement programs.

The life sciences industry is highly competitive and subject to rapid technological change, 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, some of which have substantially greater financial resources and larger, more established marketing, sales and service organizations than we do. These competitors include:

 

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companies developing and marketing sequence detection systems for industrial research products;

 

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diagnostic and pharmaceutical companies;

 

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companies developing drug discovery technologies; and

 

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companies developing or offering biothreat detection technologies.

Several companies provide systems and reagents for DNA amplification or detection. Life Technologies and Roche sell systems integrating DNA amplification and detection (sequence detection systems) to the commercial market. Roche, Abbott, Becton Dickinson, Qiagen, Hologic, Luminex, and Meridian sell sequence detection systems, some with separate robotic batch DNA purification systems and sell reagents to the Clinical market. Other companies, including Siemens, Hologic, bioMerieux and Quidel offer molecular tests. Additionally, we anticipate that in the future, additional competitors will emerge that offer a broad range of competing products.

 

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The life sciences industry is characterized by rapid and continuous technological innovation. We may need to develop new technologies for our products to remain competitive. One or more of our current or future competitors could render our present or future products technologically obsolete or uneconomical by reducing the prices of their competing products. In addition, the introduction or announcement of new products by us or others could result in a delay of or decrease in sales of existing products, as we await regulatory approvals and as customers evaluate these new products. We may also encounter other problems in the process of delivering new products to the marketplace such as problems related to design, development or manufacturing of such products, and as a result we may be unsuccessful in selling such products. Our future success depends on our ability to compete effectively against current technologies, as well as to respond effectively to technological advances by developing and marketing products that are competitive in the continually changing technological landscape.

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 molecular test systems. We believe that customers in our target 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 if our products fail to perform as expected or our products are perceived as difficult to use. Despite testing, defects or errors could occur in our products or technologies. Furthermore, with respect to the USPS BDS program, our products are incorporated into larger systems that are built and delivered by others; we cannot control many aspects of the final system.

In the future, if our products experience a material defect or error, this could result in loss or delay of revenues, delayed market acceptance, damaged reputation, diversion of development resources, legal claims, increased insurance costs or increased service and warranty costs, any of which could harm our business. Such defects or errors could also prompt us to amend certain warning labels or narrow the scope of the use of our products, either of which could hinder our success in the market. Furthermore, any failure in the overall USPS BDS program, 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 or do not perform in accordance with specifications, in part because our products are used for sensitive applications. We cannot be certain that we would be able to successfully defend any product liability lawsuit brought against us. Regardless of merit or eventual outcome, product liability claims may result in:

 

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decreased demand for our products;

 

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injury to our reputation;

 

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increased product liability insurance costs;

 

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costs of related litigation; and

 

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substantial monetary awards to plaintiffs.

Although we carry product liability insurance, if we become the subject of a successful product liability lawsuit, our insurance may not cover all substantial liabilities, which could harm our business.

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

We have a relatively small sales force compared to some of our competitors. In addition, we have recently undergone changes in the leadership of our sales organization, as our Executive Vice President of North American Commercial Operations joined us in December 2013, our Executive Vice President, International Commercial Operations joined us in June 2014 and our former Executive Vice President, International Commercial Operations transitioned to a new role in the Company in June 2014. If our direct sales force is not successful, or new additions to our sales team fail to gain traction among our customers, we may not be able to increase market awareness and sales of our products. If we fail to establish our systems in the marketplace, it could have a negative effect on our ability to sell subsequent systems and hinder the planned expansion of our business.

 

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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 Clinical and Non-Clinical markets in various geographic regions, and we have a limited ability to influence their efforts. We expect to continue to rely substantially on our distributor relationships for sales into other markets or geographic regions, which are key to our long-term growth strategy. Relying on distributors for our sales and marketing could harm our business for various reasons, including:

 

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

 

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we may not be able to renew existing distributor agreements on acceptable terms;

 

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

 

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our distributors may be unsuccessful in marketing our products;

 

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

 

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

If any of our distribution agreements are terminated or if we elect to distribute new products directly, we will have to invest in additional sales resources, including additional field sales personnel, which would increase future selling, general and administrative expenses. We may not be able to enter into new distribution agreements on satisfactory terms, or at all. If we fail to enter into acceptable distribution agreements or fail to successfully market our products, our product sales may decrease. We may be exposed to risks as a result of transitioning a territory from a distributor sales model to a direct sales model, such as difficulties maintaining relationships with specific customers or hiring appropriately trained personnel, any of which could result in lower revenues than we previously received from our distributor in that territory.

We may be subject to third-party claims that require additional licenses for our products and 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 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. Companies may have pending patent applications, which are typically confidential for the first eighteen months following filing that cover technologies we incorporate in our products. Accordingly, 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. Moreover, from time to time, we are subject to patent litigation and receive correspondence and other communications from companies that ask us to evaluate the need for a license of patents they hold, and indicating or suggesting that we need a license to their patents in order to offer our products and services or to conduct our business operations. For example, we are currently engaged in litigation as further described in Part II, Item 1 “Legal Proceedings.” Additionally, in September 2012, we entered into an agreement with Abaxis pursuant to which, in exchange for a one-time payment by us to Abaxis of $17.3 million, all present and future litigation relating to the alleged infringement of certain Abaxis patents by us and our counterclaims against Abaxis were resolved. Even if we are successful in defending against claims, we could incur substantial costs in doing so. Any litigation related to existing claims and others that may arise in the future would likely consume our resources and could lead to significant damages, royalty payments or an injunction on the sale of certain products. Any additional licenses to patented technology could obligate us to pay substantial additional royalties, which could adversely impact our product costs and harm our business.

 

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If we fail to maintain and protect our intellectual property rights, our competitors could use our technology to develop competing products and our business will suffer.

Our competitive success will be affected in part by our continued ability to obtain and maintain patent protection for our inventions, technologies and discoveries, including our intellectual property that includes technologies that we license. Our ability to do so will depend on, among other things, complex legal and factual questions. We have patents related to some of our technology and have licensed some of our technology under patents of others. Our patents and licenses may not successfully preclude others from using our technology. Our pending patent applications may lack priority over applications submitted by third parties or may not result in the issuance of patents. Even if issued, our patents may not be sufficiently broad to provide protection against competitors with similar technologies and may be challenged, invalidated or circumvented.

In addition, there are numerous recent changes to the patent laws and proposed changes to the rules of the U.S. Patent and Trademark Office, which may have a significant impact on our ability to protect our technology and enforce our intellectual property rights. For example, in September 2011, the United States enacted sweeping changes to the U.S. patent system under the Leahy-Smith America Invents Act, including changes that would transition the United States from a “first-to-invent” system to a “first-to-file” system and alter the processes for challenging issued patents. These changes could increase the uncertainties and costs surrounding the prosecution of our patent applications and the enforcement or defense of our issued patents. In addition to patents, we rely on a combination of trade secrets, copyright and trademark laws, nondisclosure agreements, licenses and other contractual provisions and technical measures to maintain and develop our competitive position with respect to intellectual property. Nevertheless, these measures may not be adequate to safeguard the technology underlying our products. For example, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for the breach. We also may not be able to effectively protect our intellectual property rights in some foreign countries, as many countries do not offer the same level of legal protection for intellectual property as the United States. Furthermore, for a variety of reasons, we may decide not to file for patent, copyright or trademark protection outside of the United States. Our trade secrets could become known through other unforeseen means. Notwithstanding our efforts to protect our intellectual property, our competitors may independently develop similar or alternative technologies or products that are equal or superior to our technology. Our competitors may also develop similar products without infringing on any of our intellectual property rights or design around our proprietary technologies. Furthermore, any efforts to enforce our proprietary rights could result in disputes and legal proceedings that could be costly and divert attention from our business.

The U.S. Government has certain rights to use and disclose some of the intellectual property that we license and could exclusively license it to a third party if we fail to achieve practical application of the intellectual property.

Aspects of the technology licensed by us under agreements with third party licensors may be subject to certain government rights. Government rights in inventions conceived or reduced to practice under a government-funded program may include a non-exclusive, royalty-free worldwide license to practice or have practiced such inventions for any governmental purpose. In addition, the U.S. federal government has the right to require us or our licensors (as applicable) to grant licenses which would be exclusive under any of such inventions to a third party if they determine that: (1) adequate steps have not been taken to commercialize such inventions in a particular field of use; (2) such action is necessary to meet public health or safety needs; or (3) such action is necessary to meet requirements for public use under federal regulations. Further, the government rights include the right to use and disclose, without limitation, technical data relating to licensed technology that was developed in whole or in part at government expense. At least one of our technology license agreements contains a provision recognizing these government rights.

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 initiate patent litigation against third parties, such as infringement suits or interference proceedings. For example, in August 2012, we initiated a legal proceeding in the U.S. District Court for the Northern District of California requesting such court to find that we do not infringe certain patents held by Roche. These lawsuits could be expensive, take significant time and divert management’s attention from other business concerns. They would also put our patents at risk of being invalidated or interpreted narrowly, and our patent applications at risk of not issuing. We may also provoke these third parties to assert claims against us. Patent law relating to the scope of claims in the technology fields in which we operate is still evolving and, consequently, patent positions in our industry are generally uncertain. We cannot be assured that we would prevail in any of these suits or that the damages or other remedies awarded, if any, would be commercially valuable. During the course of these suits, there may be public announcements of the results of hearings, motions and other interim proceedings or developments in the litigation. Any public announcements related to these suits could cause our stock price to decline.

 

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Our international operations subject us to additional risks and costs.

We conduct operations on a global basis. These operations are subject to a number of difficulties and special costs, including:

 

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compliance with multiple, conflicting and changing governmental laws and regulations, including U.S. laws such as the Foreign Corrupt Practices Act and local laws that prohibit bribes and certain payments to governmental officials such as the UK Bribery Act 2010, data privacy requirements, labor relations laws, tax laws, anti-competition regulations, import and trade restrictions, and export requirements;

 

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increased regulatory risk, including additional regulatory requirements different or more stringent than those in the United States;

 

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laws and business practices favoring local competitors;

 

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foreign exchange and currency risks;

 

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exposure to risks associated with sovereign debt uncertainties in Europe and other foreign countries;

 

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difficulties in collecting accounts receivable or longer payment cycles;

 

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import and export restrictions and tariffs;

 

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difficulties staffing and managing foreign operations;

 

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difficulties and expense in enforcing intellectual property rights;

 

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business risks, including fluctuations in demand for our products and the cost and effort to conduct international operations and travel abroad to promote international distribution and overall global economic conditions;

 

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multiple conflicting tax laws and regulations; and

 

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political and economic instability.

We intend to expand our international sales and marketing activities, including through our direct sales operations and through relationships with additional international distribution partners. We may not be able to attract international distribution partners that will be able to market our products effectively or may have trouble entering geographic markets that are less receptive to sales from foreign entities.

Additionally, our continued expansion into less developed countries in connection with our HBDC program, which may have less political, social or economic stability and less developed infrastructure and legal systems, heightens the exposure of the risks set forth above. An adverse development relating to one or more of these risks, or any other risks associated with our operations in less developed countries, could adversely affect our ability to conduct and expand our business, which could negatively impact on our business, results of operations and financial condition.

Our international operations could also increase our exposure to international laws and regulations. If we cannot comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potential litigation. For example, the governments of foreign countries might attempt to regulate our products and services or levy sales or other taxes relating to our activities. In addition, foreign countries may impose tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, any of which could make it more difficult for us to conduct our business.

Further, as we continue to expand our operations worldwide and potentially sell our products and services to governmental institutions, compliance with Foreign Corrupt Practices Act and local laws that also prohibit corrupt payments to governmental officials such as the UK Bribery Act 2010 will become more important, and we will need to continue to enhance our internal controls to ensure compliance with applicable laws and regulations.

 

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The nature of some of our products may also subject us to export control regulation by the U.S. Department of State and the Department of Commerce. Violations of these regulations can result in monetary penalties and denial of export privileges.

Our sales to customers outside the United States are subject to government export regulations that require us to obtain licenses to export such products. If the U.S. government was to amend its export control regulations, such amendments could create uncertainty in our industry, result in increased costs of compliance, and further restrict our ability to sell our products abroad. In particular, we are required to obtain a new license for each purchase order of our biothreat products that are exported outside the United States. Delays or denial of the grant of any required license, or changes to the regulations that make such delays or denials more likely or frequent, could make it difficult to make sales to foreign customers and could adversely affect our revenue. In addition, we could be subject to fines and penalties for violation of these export regulations if we were found in violation. Such violation could result in penalties, including prohibiting us from exporting our products to one or more countries, and could materially and adversely affect our business.

If we fail to retain key members of our staff, our ability to conduct and expand our business would be impaired.

We are highly dependent on the principal members of our management and scientific staff. The loss of services of any of these persons could seriously harm our product development and commercialization efforts. In addition, we require skilled personnel in areas such as microbiology, clinical, sales, marketing and finance. We generally do not enter into employment agreements requiring these employees to continue in our employment for any period of time. Attracting, retaining and training personnel with the requisite skills remains challenging, particularly in the Silicon Valley, where our main office is located. If at any point we are unable to hire, train and retain a sufficient number of qualified employees to match our growth, our ability to conduct and expand our business could be seriously reduced.

If we become subject to claims relating to improper handling, storage or disposal of hazardous materials, we could incur significant cost and time to comply.

Our research and development processes involve the controlled storage, use and disposal of hazardous materials, including biological hazardous materials. We are subject to foreign, federal, state and local regulations governing the use, manufacture, storage, handling and disposal of materials and waste products. We may incur significant costs complying with both existing and future environmental laws and regulations. In particular, we are subject to regulation by the Occupational Safety and Health Administration (“OSHA”) and the Environmental Protection Agency (“EPA”), and to regulation under the Toxic Substances Control Act and the Resource Conservation and Recovery Act in the United States OSHA or the EPA may adopt regulations that may affect our research and development programs. We are unable to predict whether any agency will adopt any regulations that would have a material adverse effect on our operations.

The risk of accidental contamination or injury from hazardous materials cannot be eliminated completely. In the event of an accident, we could be held liable for any damages that result, and any liability could exceed the limits or fall outside the coverage of our workers’ compensation insurance. We may not be able to maintain insurance on acceptable terms, if at all.

If a catastrophe strikes our manufacturing or warehousing facilities, we may be unable to manufacture or distribute our products for a substantial amount of time and we may experience inventory shortfalls, which would cause us to experience lost revenues.

Our manufacturing facilities are located in Sunnyvale and Lodi, California, Seattle, Washington, and Stockholm, Sweden. 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 our primary manufacturing facilities in California are located in an earthquake-prone area. In the event our existing manufacturing facilities or equipment are affected by man-made or natural disasters, we may be unable to manufacture products for sale or meet customer demands or sales projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business.

We might require additional capital to respond to business challenges or acquisitions, and such capital might not be available.

Though we recently completed a sale of $345 million of convertible senior notes in February 2014, we may in the future need to obtain additional equity or debt financing to respond to business challenges or acquire complementary businesses and technologies. Any additional equity or debt financing, however, might not be available when needed or, if available, might not be available on terms satisfactory to us. In addition, to the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in dilution to our shareholders. In addition, these securities may be sold at a discount from the market price of our common stock and may include rights, preferences or privileges senior to those of our common stock. If additional equity or debt financing is needed and we are unable to obtain adequate financing or financing on terms satisfactory to us, our ability to continue to support our business growth and to respond to business challenges could be significantly limited.

 

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Our participation in the USPS BDS program may not result in predictable revenues in the future.

Our participation in the USPS BDS program involves significant uncertainties related to governmental decision-making and timing of purchases and is highly sensitive to changes in national priorities and budgets. The USPS continued to report significant losses for the 2013 and 2012 fiscal years. Budgetary pressures may result in reduced allocations to projects such as the BDS program, sometimes without advance notice. We cannot be certain that actual funding and operating parameters, or product purchases, will occur at currently expected levels or in the currently expected timeframe.

We rely on relationships with collaborative partners and other third parties for development, supply and marketing of certain 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 depends in part on our ability to develop and maintain collaborative relationships with other companies. Relying on collaborative relationships is risky to our future success for these products because, among other things:

 

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

 

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

 

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our collaborative partners may be acquired by another company and decide to terminate our collaborative partnership or become insolvent;

 

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

 

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

 

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disagreements with collaborators could result in the termination of the relationship or litigation;

 

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collaborators may not have sufficient capital resources;

 

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collaborators may pursue tests or other products that will not generate significant volume for us, but may consume significant research and development and manufacturing resources; and

 

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

Because these and other factors may be beyond our control, the development or commercialization of these products may be delayed or otherwise adversely affected.

If we or any of our collaborative partners terminate a collaborative arrangement, we may be required to devote additional resources to product development and commercialization or we may need to cancel some development programs, which could adversely affect our product pipeline and business.

We enter into collaborations with third parties that may not result in the development of commercially viable products or the generation of significant future revenues.

In the ordinary course of our business, we enter into collaborative arrangements to develop new products or to pursue new markets. These collaborations may not result in the development of products that achieve commercial success, and these collaborations could be terminated prior to developing any products. In addition, our collaboration partners may not necessarily purchase the volume of products that we expect. Accordingly, we cannot be assured that any of our collaborations will result in the successful development of a commercially viable product or result in significant additional future revenues in the future.

The “conflicts” rule of the Securities and Exchange Commission, or SEC, has caused us to incur additional expenses, could limit the supply and increase the cost of certain metals used in manufacturing our products, and could make us less competitive in our target markets.

On August 22, 2012, the SEC adopted a rule requiring disclosure by public companies of the origin, source and chain of custody of specified minerals, known as conflict minerals, that are necessary to the functionality or production of products manufactured or contracted to be manufactured. The rule requires companies to obtain sourcing data from suppliers, engage in supply chain due diligence, and file annually with the SEC a specialized disclosure report on Form SD covering the prior calendar year, commencing with calendar year 2013. The rule could limit our ability to source at competitive prices and to secure sufficient

 

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quantities of certain minerals used in the manufacture of our products, specifically tantalum, tin, gold and tungsten, as the number of suppliers that provide conflict-free minerals may be limited. We may incur material costs associated with complying with the disclosure requirements, such as costs related to the determination of the origin, source and chain of custody of the minerals used in our products, the adoption of conflict minerals-related governance policies, processes and controls, and possible changes to products or sources of supply as a result of such activities. Within our supply chain, we may not be able to sufficiently verify the origins of the relevant minerals used in our products through the data collection and due diligence procedures that we implement, which may harm our reputation. Furthermore, we may encounter challenges in satisfying those customers that require that all of the components of our products be certified as conflict free, and if we cannot satisfy these customers, they may choose a competitor’s products. We continue to investigate the presence of conflict materials within our supply chain.

We maintain cash balances in our bank accounts that exceed the FDIC insurance limitation.

We maintain our cash assets at commercial banks in amounts in excess of the Federal Deposit Insurance Corporation insurance limit of $250,000. In the event of the commercial banks failing, we may lose the amount of our deposits over any federally-insured amount, which could have a material adverse effect on our financial conditions and our results of operations.

Compliance with laws and regulations governing public company corporate governance and reporting is complex and expensive.

We are subject to laws and regulations affecting our domestic and international operations in a number of areas. Many laws and regulations, notably those adopted in connection with the Sarbanes-Oxley Act of 2002 by the SEC, the Dodd-Frank Wall Street Reform and Consumer Protection Act and The NASDAQ Stock Market, impose obligations on public companies, such as ours, which have increased the scope, complexity, and cost of corporate governance, reporting, and disclosure practices. Compliance with these laws, regulations and similar requirements may be onerous and inconsistent from jurisdiction to jurisdiction, which has required and will continue to require substantial management time and oversight and requires us to incur significant additional accounting, legal and compliance costs. Any such costs, which may arise in the future as a result of changes in these laws and regulations or in their interpretation could individually or in the aggregate make our products and services more expensive to our customers, delay the introduction of new products in one or more regions, or cause us to change or limit our business practices. We have implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that our employees, contractors, or agents will not violate such laws and regulations or our policies and procedures.

Additionally, changes to existing accounting rules and standards and the implementation of new accounting rules or standards, such as the new lease accounting or revenue recognition rules, may adversely impact our reported financial results and business, and may further require us to incur greater accounting fees.

Our operating results could be materially affected by unanticipated changes in our tax provisions or exposure to additional income tax liabilities.

Our determination of our tax liability (like any company’s determination of its tax liability) is subject to review by applicable tax authorities. Any adverse outcome of such a review could have an adverse effect on our operating results and financial condition. In addition, the determination of our provision for income taxes and other tax liabilities requires significant judgment, including our determination of whether a valuation allowance against deferred tax assets is appropriate. We expect to maintain such valuation allowance so long as there is insufficient evidence that we will be able to realize the benefit of our deferred tax assets. We reassess the realizability of the deferred tax assets as facts and circumstances dictate. If after future assessments of the realizability of the deferred tax assets, we determine that a lesser or greater allowance is required, or that no such allowance is appropriate, we will record a corresponding change to the income tax expense and the valuation allowance in the period of such determination. The uncertainty surrounding the future realization of our net deferred tax assets could adversely impact our results of operations. Although we believe our estimates and judgments are reasonable, including those related to our valuation allowance, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made.

We have indebtedness in the form of convertible senior notes.

In February 2014, we completed an offering of $345 million of convertible senior notes due 2021 (the “Notes”).

 

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As a result of the issuance of the Notes, we incurred $345 million principal amount of indebtedness, the principal amount of which we may be required to pay at maturity in 2021, or upon the occurrence of a make-whole fundamental change (as defined in the applicable indenture). There can be no assurance that we will be able to repay this indebtedness when due, or that we will be able to refinance this indebtedness on acceptable terms or at all. In addition, this indebtedness could, among other things:

 

•

make it difficult for us to pay other obligations;

 

•

make it difficult to obtain favorable terms for any necessary future financing for working capital, capital expenditures, debt service requirements or other purposes;

 

•

require us to dedicate a substantial portion of our cash flow from operations to service the indebtedness, reducing the amount of cash flow available for other purposes; and

 

•

limit our flexibility in planning for and reacting to changes in our business.

Conversion of the Notes may affect the price of our common stock.

The conversion of some or all of our Notes may dilute the ownership interest of existing stockholders to the extent we deliver shares of common stock upon conversion. Holders of the outstanding Notes will be able to convert them only upon the satisfaction of certain conditions prior to August 1, 2020. Upon conversion, holders of the Notes will receive cash, shares of common stock or a combination of cash and shares of common stock, at our election. Any sales in the public market of shares of common stock issued upon conversion of such notes could adversely affect the trading price of our common stock.

We have broad discretion in the use of the net proceeds from the issuance of our Notes and may not use them effectively.

We have broad discretion in the application of the net proceeds that we received from the issuance of the Notes, including working capital, possible acquisitions, and other general corporate purposes, and we may spend or invest these proceeds in a way with which our investors disagree. The failure by our management to apply these funds effectively could adversely affect our business and financial condition. Pending their use, we may invest the net proceeds from our Notes in a manner that does not produce income or that loses value. These investments may not yield a favorable return to our investors, and may negatively impact the price of our securities.

Servicing our debt requires a significant amount of cash, and we may not have sufficient cash flow from our business to pay our substantial debt.

Our ability to make scheduled payments of the principal of, to pay interest on or to refinance our indebtedness, including the Notes, depends on our future performance, which is subject to economic, financial, competitive and other factors beyond our control. Our business may not generate cash flow from operations in the future sufficient to service our debt obligations and make necessary capital expenditures. If we are unable to generate the necessary cash flow, we may be required to adopt one or more alternatives, such as selling assets, restructuring debt or obtaining additional capital on terms that may be onerous or highly dilutive. Our ability to refinance our indebtedness will depend on the capital markets and our financial condition at such time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on our debt obligations.

We may not have the ability to raise the funds necessary to settle conversions of the Notes or to repurchase the Notes upon a fundamental change, and our future debt may contain limitations on our ability to pay cash upon conversion or repurchase of the Notes.

Holders of the Notes will have the right to require us to repurchase their Notes upon the occurrence of a fundamental change at a fundamental change repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any. In addition, upon conversion of the Notes, unless we elect to deliver solely shares of our common stock to settle such conversion (other than paying cash in lieu of delivering any fractional share), we will be required to make cash payments in respect of the Notes being converted. However, we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of Notes surrendered therefor or Notes being converted. In addition, our ability to repurchase the Notes or to pay cash upon conversions of the Notes may be limited by law, by regulatory authority or by agreements governing our future indebtedness. Our failure to repurchase Notes at a time when the repurchase is required by the indenture governing the Notes or to pay any cash payable on future conversions of the Notes as required by the indenture governing the Notes would constitute a default under the indenture governing the Notes. A default under the indenture governing the Notes or the fundamental change itself could also lead to a default under agreements governing our future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the Notes or make cash payments upon conversions thereof.

 

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The Notes contain a conditional conversion feature, which, if triggered, may adversely affect our financial condition and operating results.

The Notes contain a conditional conversion feature. If such feature is triggered, holders of Notes will be entitled to convert the Notes at any time during specified periods at their option. If one or more holders elect to convert their Notes, unless we elect to satisfy our conversion obligation by delivering solely shares of our common stock (other than paying cash in lieu of delivering any fractional share), we would be required to settle a portion or all of our conversion obligation through the payment of cash, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.

The accounting method for convertible debt securities that may be settled in cash, such as the Notes, is the subject of recent changes that could have a material effect on our reported financial results.

In May 2008, the Financial Accounting Standards Board, which we refer to as FASB, issued FASB Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement), which has subsequently been codified as Accounting Standards Codification 470-20, Debt with Conversion and Other Options, which we refer to as ASC 470-20. Under ASC 470-20, an entity must separately account for the liability and equity components of the convertible debt instruments (such as the Notes) that may be settled entirely or partially in cash upon conversion in a manner that reflects the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the Notes is that the equity component is required to be included in the additional paid-in capital section of shareholders’ equity on our consolidated balance sheet, and the value of the equity component would be treated as original issue discount for purposes of accounting for the debt component of the Notes. As a result, we will be required to record a greater amount of non-cash interest expense in current periods presented as a result of the amortization of the discounted carrying value of the Notes to their face amount over the term of the Notes. We will report lower net income in our financial results because ASC 470-20 will require interest to include both the current period’s amortization of the debt discount and the instrument’s coupon interest, which could adversely affect our reported or future financial results, the trading price of our common stock.

Additionally, the accounting method for convertible debt securities is subject to pronouncements, guidance and interpretations of prior pronouncements that are complex, continue to evolve and may change in future periods, as well as implementation of new accounting rules or standards, all of which may require us to record additional expenses or income or include additional shares in determining earnings per share and could have a material adverse effect on our financial conditions and our results of operations.

Our stock price is highly volatile and investing in our stock involves a high degree of risk, which could result in substantial losses for investors.

The market price of our common stock, like the securities of many other medical product companies, fluctuates over a wide range, and will continue to be highly volatile in the future. During the six months ended June 30, 2014, the sale price of our common stock on The NASDAQ Global Select Market ranged from $40.15 to $55.89 per share. Because our stock price has been volatile, investing in our common stock is risky. Furthermore, volatility in the stock price of other companies has often led to securities class action litigation against those companies. Any future securities litigation against us could result in substantial costs and divert management’s attention and resources, which could seriously harm our business, financial condition and results of operations.

Our charter documents may impede or discourage a takeover, which could reduce the market price of our common stock.

Our board of directors or a committee thereof has the power, without shareholder approval, to designate the terms of one or more series of preferred stock and issue shares of preferred stock. The ability of our board of directors or a committee thereof to create and issue a new series of preferred stock and certain provisions of our articles of incorporation and bylaws, including, without limitation, a classified board, advance notice requirements for shareholder proposals and nominations, and no cumulative voting, could impede a merger, takeover or other business combination involving us or discourage a potential acquiror from making a tender offer for our common stock, which, under certain circumstances, could reduce the market price of our common stock.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not Applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable.

 

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ITEM 4. MINE SAFETY DISCLOSURES

Not Applicable.

ITEM 5. OTHER INFORMATION

Not Applicable.

ITEM 6. EXHIBITS

(a) Exhibits

 

Exhibit Number

Exhibit Description

Incorporated by Reference

Filing Date

Filed Herewith

Form

File No.

Exhibit

3.1

Certificate of Amendment of the Fifth Amended and Restated Articles of Incorporation of Cepheid and Fifth Amended and Restated Articles of Incorporation of Cepheid.

X

10.1*

Offer Letter between Cepheid and Peter Farrell.

X

10.2*

Change of Control Retention and Severance Agreement by and between Cepheid and Peter Farrell.

X

31.1

Certification of Chief Executive Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

X

31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

X

32.1**

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

X

32.2**

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

X

101

The following materials from Cepheid’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, formatted in XBRL (Extensible Business Reporting Language): (i) the unaudited Condensed Consolidated Balance Sheets, (ii) the unaudited Condensed Consolidated Statements of Operations, (iii) the unaudited Condensed Consolidated Statements of Comprehensive Income (Loss), (iv) the unaudited Condensed Consolidated Statements of Cash Flows, and (v) Notes to Condensed Consolidated Financial Statements, tagged as blocks of text.

X

 

*	Management contract or compensatory plan or arrangement.

**

As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Annual Report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission and are not incorporated by reference in any filing of Cepheid under the Securities Act of 1933 or the Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in such filings.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, in the City of Sunnyvale, State of California on this 6^th day of August 2014.

 

 

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Exhibit Index

 

Exhibit Number		Exhibit Description
3.1		Certificate of Amendment of the Fifth Amended and Restated Articles of Incorporation of Cepheid and Fifth Amended and Restated Articles of Incorporation of Cepheid.
10.1*		Offer Letter between Cepheid and Peter Farrell.
10.2*		Change of Control Retention and Severance Agreement by and between Cepheid and Peter Farrell.
31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1**		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2**		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101		The following materials from Cepheid’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, formatted in XBRL (Extensible Business Reporting Language): (i) the unaudited Condensed Consolidated Balance Sheets, (ii) the unaudited Condensed Consolidated Statements of Operations, (iii) the unaudited Condensed Consolidated Statements of Comprehensive Income (Loss), (iv) the unaudited Condensed Consolidated Statements of Cash Flows, and (v) Notes to Condensed Consolidated Financial Statements, tagged as blocks of text.

 

*	Management contract or compensatory plan or arrangement.

**

As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Annual Report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission and are not incorporated by reference in any filing of Cepheid under the Securities Act of 1933 or the Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in such filings.