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EX-10.1 - EX-10.1 - CEPHEIDa101_offerletterxdanxmadden.htm
EX-10.3 - EX-10.3 - CEPHEIDa103_buildingxleasexthexir.htm
EX-10.2 - EX-10.2 - CEPHEIDa102_sepxagmtxilanxdaskal.htm
EX-31.1 - EX-31.1 - CEPHEIDcphd-08072015ex311.htm
EX-31.2 - EX-31.2 - CEPHEIDcphd-08072015ex312.htm
EX-32.1 - EX-32.1 - CEPHEIDcphd-08072015ex321.htm
EX-32.2 - EX-32.2 - CEPHEIDcphd-08072015ex322.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
FORM 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2015
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  ý    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  ý    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
ý
  
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    ý  No
As of October 20, 2015, there were 72,342,782 shares of the registrant’s common stock outstanding.




REPORT ON FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2015
INDEX
 
 
 
Page
Part I.
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
Part II.
 
Item 1.
Item 1A
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
Cepheid®, the Cepheid logo, GeneXpert®, Xpert®, and SmartCycler are trademarks of Cepheid.



PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CEPHEID
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
 
 
September 30,
 
December 31,
 
2015
 
2014
 
(unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
136,487

 
$
96,663

Short-term investments
189,697

 
196,729

Accounts receivable, less allowance for doubtful accounts of $409 as of September 30, 2015 and $237 as of December 31, 2014
60,383

 
68,809

Inventory, net
144,808

 
132,635

Prepaid expenses and other current assets
30,990

 
24,274

Total current assets
562,365

 
519,110

Property and equipment, net
124,366

 
115,765

Investments
60,168

 
79,731

Other non-current assets
8,215

 
7,847

Intangible assets, net
26,700

 
31,440

Goodwill
39,681

 
39,681

Total assets
$
821,495

 
$
793,574

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
65,789

 
$
50,435

Accrued compensation
33,248

 
33,760

Accrued royalties
4,862

 
5,443

Accrued and other liabilities
28,769

 
34,761

Current portion of deferred revenue
12,102

 
13,447

Total current liabilities
144,770

 
137,846

Long-term portion of deferred revenue
5,081

 
4,532

Convertible senior notes, net
285,406

 
278,213

Other liabilities
19,421

 
18,768

Total liabilities
454,678

 
439,359

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 shares authorized, 72,276,626 and 70,904,388 shares issued and outstanding at September 30, 2015 and December 31, 2014, respectively
448,525

 
422,151

Additional paid-in capital
251,772

 
225,529

Accumulated other comprehensive income (loss), net
(1,043
)
 
247

Accumulated deficit
(332,437
)
 
(293,712
)
Total shareholders’ equity
366,817

 
354,215

Total liabilities and shareholders’ equity
$
821,495

 
$
793,574

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


3


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2015
 
2014
 
2015
 
2014
Revenue
$
126,465

 
$
115,209

 
$
391,577

 
$
338,619

Costs and operating expenses:
 
 
 
 
 
 
 
Cost of sales
67,681

 
56,791

 
198,259

 
169,442

Collaboration profit sharing
1,286

 
1,291

 
3,879

 
3,231

Research and development
32,909

 
23,541

 
84,987

 
69,279

Sales and marketing
28,664

 
23,913

 
82,678

 
70,873

General and administrative
15,401

 
13,069

 
47,395

 
41,076

Total costs and operating expenses
145,941

 
118,605

 
417,198

 
353,901

Loss from operations
(19,476
)
 
(3,396
)
 
(25,621
)
 
(15,282
)
Other income (expense):
 
 
 
 
 
 
 
Interest income
494

 
325

 
1,283

 
784

Interest expense
(3,687
)
 
(3,640
)
 
(10,937
)
 
(9,003
)
Foreign currency exchange loss and other, net
(408
)
 
(258
)
 
(2,848
)
 
(1,015
)
Other expense, net
(3,601
)
 
(3,573
)
 
(12,502
)
 
(9,234
)
Loss before income taxes
(23,077
)
 
(6,969
)
 
(38,123
)
 
(24,516
)
Benefit from (provision for) income taxes
176

 
(266
)
 
(602
)
 
(1,865
)
Net loss
$
(22,901
)
 
$
(7,235
)
 
$
(38,725
)
 
$
(26,381
)
Basic net loss per share
$
(0.32
)
 
$
(0.10
)
 
$
(0.54
)
 
$
(0.38
)
Diluted net loss per share
$
(0.32
)
 
$
(0.10
)
 
$
(0.54
)
 
$
(0.38
)
Shares used in computing basic net loss per share
72,199

 
70,326

 
71,777

 
69,859

Shares used in computing diluted net loss per share
72,199

 
70,326

 
71,777

 
69,859

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


4


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
(unaudited)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(22,901
)
 
$
(7,235
)
 
$
(38,725
)
 
$
(26,381
)
Other comprehensive loss, before tax:
 
 
 
 
 
 
 
Change in unrealized gains and losses related to cash flow hedges:
 
 
 
 
 
 
 
Gain (loss) recognized in accumulated other comprehensive income (loss), net
(545
)
 
499

 
(1,596
)
 
208

Loss reclassified from accumulated other comprehensive income (loss), net to the statement of operations
369

 
284

 
414

 
787

Change in unrealized gains and losses related to available-for-sale investments:
 
 
 
 
 
 
 
Loss recognized in accumulated other comprehensive income (loss), net
(148
)
 
(60
)
 
(5
)
 
(30
)
Gain reclassified from accumulated other comprehensive income (loss), net to the statement of operations

 

 
(3
)
 
(27
)
Other comprehensive loss, before tax
(23,225
)
 
(6,512
)
 
(39,915
)
 
(25,443
)
Income tax benefit (expense) related to items of accumulated other comprehensive income (loss), net

 

 
(100
)
 

Comprehensive loss
$
(23,225
)
 
$
(6,512
)
 
$
(39,815
)
 
$
(25,443
)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.


5


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
Nine Months Ended 
 September 30,
 
2015
 
2014
Cash flows from operating activities:
 
 
 
Net loss
$
(38,725
)
 
$
(26,381
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization of property and equipment
20,170

 
15,877

Amortization of intangible assets
4,814

 
2,775

Unrealized foreign exchange differences
2,242

 
1,107

Amortization of debt discount and transaction costs
7,627

 
6,147

Impairment of acquired intangible assets, licenses, property and equipment
224

 

Stock-based compensation expense
25,752

 
24,655

Excess tax benefits from stock-based compensation expense
(53
)
 

Loss on the disposal of property, equipment and intangible assets
56

 

Other non-cash items
198

 

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
8,426

 
(3,568
)
Inventory, net
(11,733
)
 
(25,223
)
Prepaid expenses and other current assets
(9,691
)
 
(5,544
)
Other non-current assets
(801
)
 
(22
)
Accounts payable and other current and non-current liabilities
12,297

 
6,070

Accrued compensation
(511
)
 
5,940

Deferred revenue
(795
)
 
3,010

Net cash provided by operating activities
19,497

 
4,843

Cash flows from investing activities:
 
 
 
Capital expenditures
(29,087
)
 
(37,323
)
Cost of acquisitions, net
(3,000
)
 

Proceeds from sale of equipment and an intangible asset
834

 

Proceeds from sales of marketable securities and investments
49,173

 
77,038

Proceeds from maturities of marketable securities and investments
175,272

 
66,148

Purchases of marketable securities and investments
(198,701
)
 
(381,632
)
Transfer from restricted cash
1,792

 

Net cash used in investing activities
(3,717
)
 
(275,769
)
Cash flows from financing activities:
 
 
 
Net proceeds from the issuance of common shares and exercise of stock options
26,444

 
30,137

Excess tax benefits from stock-based compensation expense
53

 

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
(121
)
 
(139
)
Net cash provided by financing activities
26,376

 
340,705

Effect of foreign exchange rate change on cash and cash equivalents
(2,332
)
 
(1,175
)
Net increase in cash and cash equivalents
39,824

 
68,604

Cash and cash equivalents at beginning of period
96,663

 
66,072

Cash and cash equivalents at end of period
$
136,487

 
$
134,676

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

6


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 September 30, 2015, the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2015 and 2014, the Condensed Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2015 and 2014 and the Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2015 and 2014 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. 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 2015 or for any future period. The Condensed Consolidated Balance Sheet as of December 31, 2014 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 United States 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, 2014.
Use of Estimates
The preparation of condensed consolidated financial statements in conformity with United States GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from these estimates.
Cash, Cash Equivalents, Restricted Cash, Short-Term Investments and Non-Current Investments
Cash and cash equivalents consist of cash on deposit with banks and money market instruments. Interest income includes interest, dividends, amortization of purchase premiums and discounts and realized gains and losses on sales of securities.
Restricted cash consists of cash contractually restricted for use to develop the Xpert Ebola test in accordance with the Company’s agreements with the Bill and Melinda Gates Foundation (“BMGF”) and the National Philanthropic Trust (“NPT”). At September 30, 2015 and December 31, 2014, prepaid expense and other current assets included $0.1 million and $1.9 million of restricted cash, respectively.
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 non-current investments based on each instrument’s underlying 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 non-current. The Company’s marketable debt securities are carried at fair value, with the unrealized gains and losses reported within accumulated other comprehensive income (loss), net ("AOCI"), a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method.

7


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.
Concentration of Credit Risks and Other Uncertainties
The carrying amounts for financial instruments consisting of cash and cash equivalents, restricted cash, accounts receivable, accounts payable, and accrued and other 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 68% and 58% of the Company’s cash and cash equivalents as of September 30, 2015 and December 31, 2014, respectively.
The Company’s accounts receivable are derived from net revenue from 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 10% and 26% of total accounts receivable as of September 30, 2015 and December 31, 2014, respectively.
See Note 10, “Segment and Significant Concentrations,” for disclosure regarding total sales to direct customers and single countries.
Inventory, Net
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. 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. The Company maintains provisions for excess and obsolete inventory based on management’s estimates of forecasted demand and, where applicable, product expiration.
The components of inventories were as follows (in thousands):
 
September 30, 2015
 
December 31, 2014
Raw Materials
$
40,203

 
$
36,287

Work in Process
55,981

 
51,691

Finished Goods
48,624

 
44,657

Inventory
$
144,808

 
$
132,635

In addition, capitalized stock-based compensation expense of $2.0 million and $1.6 million were included in inventory as of September 30, 2015 and December 31, 2014, respectively.
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.

8


The Company may place an instrument at a customer site under a reagent rental. Under a reagent rental, the Company retains title to the instrument and earns revenue for the usage of the instrument and related maintenance services through the amount charged for reagents and other disposables. Under a reagent rental, a customer may commit to purchasing minimum quantities of reagents at stated prices over a defined contract term, which is typically between three to five years. Revenue is recognized over the term of a reagent rental as reagents and other disposables are shipped and all other revenue recognition criteria have been met.

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 it determines there are no uncertainties regarding customer acceptance.
Revenue includes fees for research and development services, including research and development under grants and government sponsored research and collaboration agreements. Revenue and profit under cost-plus service contracts are recognized as costs are incurred plus negotiated fees. Fixed fees on cost-plus service contracts are recognized ratably over the contract performance period as services are performed. Contract costs include labor and related employee benefits, subcontracting costs and other direct costs, as well as allocations of allowable indirect costs. For contract change orders, claims or similar items, judgment is required for estimating the amounts, assessing the potential for realization, and determining whether realization is probable. From time to time, facts develop that require revisions of revenue recognized or cost estimates. To the extent that a revised estimate affects the current or an earlier period, the cumulative effect of the revision is recognized in the period in which the facts requiring the revision become known. 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.
Earnings per Share
Basic earnings per share is computed by dividing net income or loss for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income for the period by the weighted average number of common shares outstanding and common equivalent shares from dilutive stock options, employee stock purchases, restricted stock awards, restricted stock units and shares issuable upon a potential conversion of the convertible senior notes using the treasury stock method. In loss periods, the earnings per share calculation excludes all common equivalent shares because their inclusion would be antidilutive. Antidilutive common equivalent shares totaled 9,007,000 and 10,262,000 for the three months ended September 30, 2015 and 2014, respectively, and 8,771,000 and 9,538,000 for the nine months ended September 30, 2015 and 2014, respectively.
The following summarizes the computation of basic and diluted earnings per share (in thousands, except for per share amounts): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Basic:
 
 
 
 
 
 
 
Net loss
$
(22,901
)
 
$
(7,235
)
 
$
(38,725
)
 
$
(26,381
)
Basic weighted shares outstanding
72,199

 
70,326

 
71,777

 
69,859

Net loss per share
$
(0.32
)
 
$
(0.10
)
 
$
(0.54
)
 
$
(0.38
)
Diluted:
 
 
 
 
 
 
 
Net loss
$
(22,901
)
 
$
(7,235
)
 
$
(38,725
)
 
$
(26,381
)
Basic weighted shares outstanding
72,199

 
70,326

 
71,777

 
69,859

Effect of dilutive securities:
 
 
 
 
 
 
 
Stock options, ESPP, restricted stock units, restricted stock awards and convertible senior notes

 

 

 

Diluted weighted shares outstanding
72,199

 
70,326

 
71,777

 
69,859

Net loss per share
$
(0.32
)
 
$
(0.10
)
 
$
(0.54
)
 
$
(0.38
)

9


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 2018 using one of two retrospective transition methods. The Company has not yet selected a transition method nor has it determined the potential effects on its consolidated financial statements.
In April 2015, the FASB issued ASU No. 2015-03, Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which amends limited sections within ASC Subtopic 835-30. ASU 2015-03 requires an entity to present debt issuance costs in the balance sheet as a direct deduction from the related debt liability rather than an asset. Amortization of the costs will continue to be reported as interest expense. ASU 2015-03 is effective for annual reporting periods beginning after December 15, 2015. Early adoption is permitted. The Company will adopt ASU 2015-03 on January 1, 2016, at which time the Company will reclassify approximately $6 million of debt issuance costs associated with the Company’s long-term debt from other noncurrent assets to long-term debt. A reclassification will also be applied retrospectively to each prior period presented.

2. Fair Value
The following table summarizes the fair value hierarchy for the Company’s financial assets (cash, cash equivalents, short-term investments, non-current investments and foreign currency derivatives) and financial liabilities (foreign currency derivatives) measured at fair value on a recurring basis as of September 30, 2015 and December 31, 2014 (in thousands):
Balance as of September 30, 2015:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash and cash equivalents
$
92,891

 
$
43,596

 
$

 
$
136,487

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities

 
54,544

 

 
54,544

Corporate debt securities

 
70,481

 

 
70,481

Commercial Paper

 
34,639

 

 
34,639

Government agency securities

 
16,702

 

 
16,702

Other securities

 
13,331

 

 
13,331

Total short-term investments

 
189,697

 

 
189,697

Foreign currency derivatives

 
2,043

 

 
2,043

Investments:
 
 
 
 
 
 
 
Asset-backed securities

 
11,471

 

 
11,471

Corporate debt securities

 
36,679

 

 
36,679

Government agency securities

 
8,012

 

 
8,012

Other securities

 
4,006

 

 
4,006

Total investments

 
60,168

 

 
60,168

Total
$
92,891

 
$
295,504

 
$

 
$
388,395

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives
$

 
$
2,116

 
$

 
$
2,116

Total
$

 
$
2,116

 
$

 
$
2,116

 

10


Balance as of December 31, 2014:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash and cash equivalents
$
76,065

 
$
20,598

 
$

 
$
96,663

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities

 
52,220

 

 
52,220

Corporate debt securities

 
64,202

 

 
64,202

Commercial paper

 
56,096

 

 
56,096

Government agency securities

 
15,003

 

 
15,003

Other securities

 
9,208

 

 
9,208

Total short-term investments

 
196,729

 

 
196,729

Foreign currency derivatives

 
3,887

 

 
3,887

Investments:
 
 
 
 
 
 
 
Asset-backed securities

 
12,713

 

 
12,713

Corporate debt securities

 
22,679

 

 
22,679

Government agency securities

 
39,532

 

 
39,532

Other securities

 
4,807

 

 
4,807

Total investments

 
79,731

 

 
79,731

Total
$
76,065

 
$
300,945

 
$

 
$
377,010

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives
$

 
$
3,812

 
$

 
$
3,812

Total
$

 
$
3,812

 
$

 
$
3,812

The estimated fair values of the Company’s other financial instruments which are not measured at fair value on a recurring basis as of September 30, 2015 and December 31, 2014 were as follows (in thousands):
Balance as of September 30, 2015:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Liabilities:
 
 
 
 
 
 
 
Convertible senior notes
$

 
$
347,156

 
$

 
$
347,156

Total
$

 
$
347,156

 
$

 
$
347,156

Balance as of December 31, 2014:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Liabilities:
 
 
 
 
 
 
 
Convertible senior notes
$

 
$
382,232

 
$

 
$
382,232

Total
$

 
$
382,232

 
$

 
$
382,232

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 debt securities, United States government securities, government agency securities, asset-backed securities, and other 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.

11


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 on September 30, 2015.

3. Investments
The Company’s marketable securities as of September 30, 2015, were classified as available-for-sale securities, with changes in fair value recognized in AOCI, a component of shareholders’ equity. Classification of marketable securities as a current asset is based on the intended holding period and realizability of the investment. The following tables summarize available-for-sale marketable securities (in thousands):
Balance as of September 30, 2015:
 
 
 
 
 
 
 
 
Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
$
54,544

 
$
18

 
$
(18
)
 
$
54,544

Commercial paper
78,220

 
15

 

 
78,235

Corporate debt securities
70,502

 
2

 
(23
)
 
70,481

Government agency securities
16,699

 
3

 

 
16,702

Other securities
13,315

 
18

 
(2
)
 
13,331

Amounts classified as cash equivalents
(43,591
)
 
(5
)
 

 
(43,596
)
Total short-term investments
$
189,689

 
$
51

 
$
(43
)
 
$
189,697

Investments:
 
 
 
 
 
 
 
Asset-backed securities
$
11,475

 
$
2

 
$
(6
)
 
$
11,471

Corporate debt securities
36,857

 
4

 
(181
)
 
36,680

Government agency securities
8,001

 
11

 

 
8,012

Other securities
4,001

 
6

 
(2
)
 
4,005

Total investments
$
60,334

 
$
23

 
$
(189
)
 
$
60,168

Balance as of December 31, 2014:
 
 
 
 
 
 
 
 
Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
$
52,240

 
$
3

 
$
(23
)
 
$
52,220

Commercial paper
76,683

 
12

 

 
76,695

Corporate debt securities
64,244

 
2

 
(45
)
 
64,201

Government agency securities
15,000

 
3

 

 
15,003

Other securities
9,206

 
2

 

 
9,208

Amounts classified as cash equivalents
(20,598
)
 

 

 
(20,598
)
Total short-term investments
$
196,775

 
$
22

 
$
(68
)
 
$
196,729

Investments:
 
 
 
 
 
 
 
Asset-backed securities
$
12,724

 
$

 
$
(12
)
 
$
12,712

Corporate debt securities
22,709

 

 
(29
)
 
22,680

Government agency securities
39,583

 

 
(51
)
 
39,532

Other securities
4,815

 

 
(8
)
 
4,807

Total investments
$
79,831

 
$

 
$
(100
)
 
$
79,731


12


For the nine months ended September 30, 2015 and 2014, $49.2 million and $77.0 million, respectively, of proceeds from sales of marketable securities were collected. The Company determines gains and losses from sales of marketable securities based on specific identification of the securities sold. The following table summarizes gross realized gains and losses from sales of marketable securities, all of which are reported as a component of interest income in the Condensed Consolidated Statements of Operations, for the three and nine months ended September 30, 2015 and 2014 (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Gross realized gains
$

 
$

 
$
3

 
$
27

Gross realized losses

 

 

 

Realized gains, net
$

 
$

 
$
3

 
$
27


The following table summarizes the fair value of the Company’s marketable securities with unrealized losses at September 30, 2015 and December 31, 2014, and the duration of time that such losses had been unrealized (in thousands):
Balance as of September 30, 2015:
 
 
 
 
 
 
 
 
 
 
 
 
Less Than 12 months
 
More than 12 months
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Asset-backed securities
$
31,352

 
$
(19
)
 
$
9,474

 
$
(5
)
 
$
40,826

 
$
(24
)
Corporate debt securities
81,028

 
(202
)
 
4,445

 
(2
)
 
85,473

 
(204
)
Commercial paper
6,700

 

 

 

 
6,700

 

Other securities
5,186

 
(4
)
 

 

 
5,186

 
(4
)
Total
$
124,266

 
$
(225
)
 
$
13,919

 
$
(7
)
 
$
138,185

 
$
(232
)
Balance as of December 31, 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
$
54,580

 
$
(35
)
 
$

 
$

 
$
54,580

 
$
(35
)
Corporate debt securities
79,360

 
(74
)
 

 

 
79,360

 
(74
)
Government agency securities
39,532

 
(51
)
 

 

 
39,532

 
(51
)
Other securities
4,807

 
(8
)
 

 

 
4,807

 
(8
)
Total
$
178,279

 
$
(168
)
 
$

 
$

 
$
178,279

 
$
(168
)
The Company has evaluated such securities, which consist of investments in asset-backed securities, corporate debt securities, commercial paper, government agency securities, and other securities as of September 30, 2015, 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 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 September 30, 2015 and December 31, 2014, by contractual maturity (in thousands):
 
September 30, 2015
 
December 31, 2014
 
Amortized Cost
 
Estimated Fair Value
 
Amortized Cost
 
Estimated Fair Value
Mature in one year or less
$
169,268

 
$
169,278

 
$
150,133

 
$
150,105

Mature after one year through three years
119,573

 
119,418

 
135,675

 
135,566

Mature in more than three years
4,773

 
4,765

 
11,396

 
11,387

Total
$
293,614

 
$
293,461

 
$
297,204

 
$
297,058


13


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 generally up to twelve months to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue, cost of sales, operating expenses and on certain existing assets and liabilities.
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. The Company does not hold or purchase any currency contracts for trading purposes.
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. For derivative instruments that are designated and qualify as cash flow hedges, the Company initially records the effective portion of the gain or loss on the derivative instrument in AOCI, a separate component of shareholders’ equity and subsequently reclassifies these amounts into earnings within the same financial statement line item as the hedged item in the period during which the hedged transaction is recognized in earnings. The ineffective portions of cash flow hedges are recorded in foreign currency exchange loss and other, net.
The Company had a net deferred loss of $1.0 million and a net deferred gain of $0.2 million associated with cash flow hedges recorded in AOCI as of September 30, 2015 and December 31, 2014, respectively. 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 September 30, 2015 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 loss and other, net. Any subsequent changes in fair value of such derivative instruments are reflected in foreign currency exchange loss and other, net 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 nine months ended September 30, 2015 and 2014.
Gains or losses on derivatives not designated as hedging instruments are recorded in foreign currency exchange loss and other, net. During the three months ended September 30, 2015 and 2014, the Company recognized a gain of $2.3 million and $1.7 million, respectively, as a component of foreign currency exchange loss and other, net, related to derivative instruments not designated as hedging instruments. During the nine months ended September 30, 2015 and 2014, the Company recognized a gain of $4.0 million and $1.2 million, respectively, as a component of foreign currency exchange loss and other, net, related to derivative instruments not designated as hedging instruments. 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 $154.0 million and $117.2 million as of September 30, 2015 and December 31, 2014, respectively. The notional principle amounts of the Company’s outstanding derivative instruments not designated as cash flow hedges is $27.0 million and $30.4 million as of September 30, 2015 and December 31, 2014, respectively.

14


The following tables show the Company’s derivative instruments at gross fair value as reflected in the Condensed Consolidated Balance Sheets as of September 30, 2015 and December 31, 2014, respectively (in thousands):
 
September 30, 2015
 
Fair Value of Derivatives Designated as Hedge Instruments
 
Fair Value of Derivatives Not Designated as Hedge 
Instruments
 
Total Fair Value
Derivative Assets (a):
 
 
 
 
 
Foreign exchange contracts
$
1,978

 
$
65

 
$
2,043

Derivative Liabilities (b):
 
 
 
 
 
Foreign exchange contracts
(1,967
)
 
(149
)
 
(2,116
)
 
December 31, 2014
 
Fair Value of Derivatives Designated as Hedge Instruments
 
Fair Value of Derivatives Not Designated as Hedge 
Instruments
 
Total Fair Value
Derivative Assets (a):
 
 
 
 
 
Foreign exchange contracts
$
3,887

 
$

 
$
3,887

Derivative Liabilities (b):
 
 
 
 
 
Foreign exchange contracts
(3,685
)
 
(127
)
 
(3,812
)
(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.
(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 nine month periods ended September 30, 2015 and 2014 (in thousands): 
 
Three Months Ended
 
Gain (Loss) Recognized in OCI -
Effective Portion
 
Loss Reclassified from AOCI
into Income - Effective Portion
 
Loss Recognized - Ineffective Portion and
Amount Excluded from Effectiveness Testing
 
September 30, 2015
 
September 30, 2014
 
September 30, 2015 (a)
 
September 30, 2014 (b)
 
Location
 
September 30, 2015
 
September 30, 2014
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$
(545
)
 
$
499

 
$
(369
)
 
$
(284
)
 
Foreign currency exchange loss and other, net
 
$
(45
)
 
$
(39
)
Total
$
(545
)
 
$
499

 
$
(369
)
 
$
(284
)
 
 
 
$
(45
)
 
$
(39
)
(a)
Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $1.2 million loss within costs and operating expenses and a $1.5 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the three months ended September 30, 2015.
(b)
Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $0.4 million loss within costs and operating expenses and a $0.1 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the three months ended September 30, 2014.

15


 
Nine Months Ended
 
Gain (Loss) Recognized in OCI-
Effective Portion
 
Loss Reclassified from AOCI
into Income - Effective Portion
 
Loss Recognized - Ineffective Portion and
Amount Excluded from Effectiveness Testing
 
September 30, 2015
 
September 30, 2014
 
September 30, 2015 (a)
 
September 30, 2014 (b)
 
Location
 
September 30, 2015
 
September 30, 2014
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$
(1,596
)
 
$
208

 
$
(414
)
 
$
(787
)
 
Foreign currency exchange loss and other, net
 
$
(169
)
 
$
(6
)
Total
$
(1,596
)
 
$
208

 
$
(414
)
 
$
(787
)
 
 
 
$
(169
)
 
$
(6
)
(a)
Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $6.6 million loss within costs and operating expenses and a $6.2 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the nine months ended September 30, 2015.
(b)
Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $0.1 million gain within costs and operating expenses and a $0.9 million loss within revenue, were recognized within the Condensed Consolidated Statement of Operations for the nine months ended September 30, 2014.
5. Intangible Assets
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 Condensed Consolidated Statements of Operations.
The recorded value and accumulated amortization of major classes of intangible assets were as follows (in thousands):
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
Balance, September 30, 2015
 
 
 
 
 
Licenses
$
11,454

 
$
(7,014
)
 
$
4,440

Technology acquired in acquisitions
8,613

 
(8,613
)
 

Customer relationships and other intangible assets acquired in acquisitions
35,849

 
(13,589
)
 
22,260

 
$
55,916

 
$
(29,216
)
 
$
26,700

Balance, December 31, 2014
 
 
 
 
 
Licenses
$
13,594

 
$
(8,477
)
 
$
5,117

Technology acquired in acquisitions
8,613

 
(8,613
)
 

Customer relationships and other intangible assets acquired in acquisitions
36,582

 
(10,259
)
 
26,323

 
$
58,789

 
$
(27,349
)
 
$
31,440


16


Intangible asset amortization expense was $1.5 million and $1.0 million for the three months ended September 30, 2015 and 2014, respectively, and $4.8 million and $2.8 million for the nine months ended September 30, 2015 and 2014, 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 September 30, 2015, assuming no impairment charges (in thousands):
For the Years Ending December 31,
Amortization
Expense
 
 
2015 (remaining three months)
$
1,487

2016
5,813

2017
5,448

2018
5,093

2019
4,168

Thereafter
4,691

Total expected future amortization
$
26,700

6. Income Taxes
For the three months ended September 30, 2015, the Company recorded an income tax benefit of $0.2 million due primarily to the release of tax reserves upon completion of a tax audit, partially offset by the ordinary tax expense of the Company’s foreign subsidiaries. For the nine months ended September 30, 2015, the Company recorded an income tax provision of $0.6 million, comprised primarily of ordinary tax expense of the Company’s foreign subsidiaries, and the tax effect of items in AOCI, partially offset by the benefit from the release of tax reserves upon completion of a tax audit. For the three and nine months ended September 30, 2014, the Company recorded an income tax provision of $0.3 million and $1.9 million, respectively, primarily related to ordinary tax expense of the Company’s foreign subsidiaries.
The Company’s effective tax rate for the three and nine months ended September 30, 2015 and 2014 differs from the statutory federal income tax rate of 34%, primarily due to the impact of operations in foreign jurisdictions, as well as income or loss in the United States federal and state jurisdictions for which no tax expense or benefit is recorded. The difference in the effective tax rate for the three and nine months ended September 30, 2015, compared to the three and nine months ended September 30, 2014 is primarily due to increased United States income, or decreased United States losses, for the three and nine months ended September 30, 2015, for which no income tax expense or benefit is recorded in the United States federal and state tax jurisdictions.
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 United States deferred tax assets will not be fully realized. Accordingly, the Company continues to maintain a full valuation allowance on its United States 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 United States and state income tax return years 1996 through 2014 remain open to examination. In addition, the Company files tax returns in multiple foreign taxing jurisdictions with open tax years ranging from 2009 to 2014.

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.
The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. For the three and nine months ended September 30, 2015 and 2014, the Company did not recognize any significant interest or penalties related to uncertain tax positions. As of September 30, 2015 and December 31, 2014, the Company had not accrued significant interest or penalties.

17


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.
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 September 30, 2015, the Notes were 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 estimated relative fair values. Transaction costs attributable to the liability component, totaling $7.2 million, are being amortized to expense over the term of the Notes, and transaction costs attributable to the equity component, totaling $2.0 million, and were netted with the equity component in shareholders’ equity.

18


The Notes consist of the following (in thousands):
 
September 30, 2015
 
December 31, 2014
Liability component:
 
 
 
Principal
345,000

 
345,000

Less: debt discount, net of amortization
(59,594
)
 
(66,787
)
Net carrying amount
285,406

 
278,213

Equity component (a)
73,013

 
73,013

 
(a)
Recorded in the condensed consolidated balance sheets 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 September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
1.25% coupon
$
1,078

 
$
1,113

 
$
3,234

 
$
2,766

Amortization of debt issuance costs
157

 
115

 
435

 
265

Amortization of debt discount
2,427

 
2,390

 
7,193

 
5,881

 
$
3,662

 
$
3,618

 
$
10,862

 
$
8,912

As of September 30, 2015 and December 31, 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):
 
September 30, 2015
 
December 31, 2014
 
Fair Value
 
Carrying
Value
 
Fair Value
 
Carrying
Value
Convertible Senior Notes
$
347,156

 
$
285,406

 
$
382,232

 
$
278,213

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 shareholders’ equity and will not be re-measured.
Based on the closing price of our common stock of $45.20 on September 30, 2015, 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 September 30, 2015 (in thousands):
Years Ending December 31,
Purchase Commitments
2015 (remaining three months)
$
34,216

2016

2017

2018

2019

Thereafter

Total minimum payments
$
34,216


19


Purchase commitments include non-cancellable 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 F. Hoffman-La Roche Ltd. and Roche Molecular Systems, Inc. (“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 United States Patent No. 5,804,375 (the “375 Patent”) and ceased paying United States-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.
Based on its ongoing evaluation of the facts and circumstances of the case, the Company believes that it is probable that this arbitration proceeding could result in a material loss. Accordingly, the Company recorded an estimated charge of $20 million as its best estimate of the potential loss in the fourth quarter of 2014, which was included in accrued and other liabilities in the Company’s condensed consolidated balance sheets and the Company has not changed its estimate of this potential loss. If the Company were to incur a loss in the arbitration proceeding, depending on the ruling of the arbitrators, the Company could also be responsible for certain attorneys’ fees and interest; however, at this time, the Company is unable to estimate these potential amounts. Given the inherent uncertainty of arbitration and the nature of the claims in this matter, it is possible that the Company may incur an additional material charge, but an estimate of such a charge cannot be made at this time. The Company continues to strongly dispute Roche’s claims and intends to vigorously defend against them.
On August 21, 2012 the Company filed a lawsuit against Roche in the United States District Court for the Northern District of California (“the Court”), for a declaratory judgment of (a) invalidity, expiration, and non-infringement of the 375 Patent; and (b) invalidity, unenforceability, expiration and non-infringement of United States 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. The Company 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 filed a lawsuit in the Court, alleging that the Company’s Xpert MTB-RIF product infringes United States Patent No. 5,643,723 (the “723 Patent”), which expired on July 1, 2014. On September 15, 2014, the Company filed its answer and counterclaims denying Roche’s allegations of infringement and asking the Court to find the 723 Patent invalid, unenforceable, and not infringed. On November 10, 2014, the Company filed a petition for inter partes review (“IPR”) of certain claims of the 723 Patent in the United States Patent and Trademark Office (“USPTO”) and filed a motion with the Court to stay this lawsuit pending the outcome of the IPR. On January 7, 2015, the Court issued an order staying the lawsuit pending the outcome of the IPR. On March 16, 2015, the Company filed a second petition for IPR of an additional claim of the 723 Patent. On June 11, 2015, the USPTO issued a decision declining to institute the first requested IPR. On July 13, 2015, the Company filed a request for reconsideration of the first petition for IPR with respect to certain challenged claims. On September 16, 2015, the USPTO denied the request for reconsideration. On September 17, 2015, the USPTO decided to institute the Company’s second petition for IPR. 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

20


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.

9. Employee Equity Incentive Plans and Stock-Based Compensation Expense
The following table is a summary of the major categories of stock-based compensation expense recognized in accordance with ASC 718, “Compensation—Stock Compensation” (“ASC 718”) for the three and nine months ended September 30, 2015 and 2014 (in thousands):
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2015
 
2014
 
2015
 
2014
Cost of sales
$
1,128

 
$
1,437

 
$
3,177

 
$
3,291

Research and development
3,438

 
2,274

 
7,913

 
6,883

Sales and marketing
1,825

 
1,683

 
5,018

 
5,225

General and administrative
3,584

 
3,331

 
9,694

 
9,256

Total stock-based compensation expense
$
9,975

 
$
8,725

 
$
25,802

 
$
24,655

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
(in years)
 
Intrinsic Value
Outstanding, December 31, 2014
5,581

 
$
33.20

 
 
 
 
Granted
1,293

 
$
55.98

 
 
 
 
Exercised
(996
)
 
$
23.98

 
 
 
 
Forfeited
(311
)
 
$
47.12

 
 
 
 
Outstanding, September 30, 2015
5,567

 
$
39.37

 
4.30
 
$
46,706

Exercisable, September 30, 2015
3,070

 
$
31.53

 
3.10
 
$
42,352

Vested and expected to vest, September 30, 2015
5,369

 
$
38.94

 
4.23
 
$
46,504

The following table summarizes all award 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, 2014
698

 
$
40.30

Granted
705

 
52.97

Vested
(239
)
 
39.35

Cancelled
(81
)
 
46.88

Outstanding, September 30, 2015
1,083

 
$
48.27



21


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 
 September 30,
 
Nine Months Ended 
 September 30,
 
2015
 
2014
 
2015
 
2014
OPTION SHARES:
 
 
 
 
 
 
 
Expected Term (in years)
4.49

 
4.40

 
4.46

 
4.40

Volatility
.36

 
.38

 
.36

 
0.38

Expected Dividends

 

 

 

Risk Free Interest Rates
1.54
%
 
1.75
%
 
1.46
%
 
1.72
%
Estimated Forfeitures
6.14
%
 
6.75
%
 
6.14
%
 
6.75
%
Weighted Average Fair Value Per Share
$
16.91

 
$
14.67

 
$
17.93

 
$
15.59

ESPP SHARES:
 
 
 
 
 
 
 
Expected Term (in years)
1.22

 
1.23

 
1.22

 
1.24

Volatility
.34

 
0.33

 
.34

 
0.33

Expected Dividends

 

 

 

Risk Free Interest Rates
0.41
%
 
0.23
%
 
0.39
%
 
0.22
%
Weighted Average Fair Value Per Share
$
16.50

 
$
11.37

 
$
16.49

 
$
12.12

10. Segment and Significant Concentrations
The Company and its wholly owned subsidiaries operate in one business segment.
The following table summarizes revenue in the Clinical and Non-Clinical markets (in thousands): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Revenue by market:
 
 
 
 
 
 
 
Clinical Systems
$
17,846

 
$
17,033

 
$
55,930

 
$
62,652

Clinical Reagents
102,307

 
90,123

 
314,540

 
256,289

Total Clinical
120,153

 
107,156

 
370,470

 
318,941

Non-Clinical
6,312

 
8,053

 
21,107

 
19,678

Total revenue
$
126,465

 
$
115,209

 
$
391,577

 
$
338,619

The Company currently sells product through its direct sales force and through third-party distributors. No single customer or distributor accounted for more than 10% of total revenue for the three and nine months ended September 30, 2015 and 2014.
The following table summarizes revenue by geographic region (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Geographic revenue information:
 
 
 
 
 
 
 
North America
 
 
 
 
 
 
 
Clinical
$
67,394

 
$
60,985

 
$
211,923

 
$
175,920

Non-Clinical
6,233

 
6,891

 
20,196

 
16,366

Total North America
73,627

 
67,876

 
232,119

 
192,286

International
 
 
 
 
 
 
 
Clinical
$
52,759

 
$
46,171

 
$
158,546

 
$
143,021

Non-Clinical
79

 
1,162

 
912

 
3,312

Total International
52,838

 
47,333

 
159,458

 
146,333

Total revenue
$
126,465

 
$
115,209

 
$
391,577

 
$
338,619


22


The Company recognized revenue of $70.7 million and $65.2 million for sales to United States customers for the three months ended September 30, 2015 and 2014, respectively, and $220.3 million and $186.8 million for the nine months ended September 30, 2015 and 2014, respectively.
No single country outside of the United States represented more than 10% of the Company’s total revenue for the three and nine months ended September 30, 2015 and 2014.
The following table summarizes long-lived assets, excluding intangible assets and goodwill, by geographic region (in millions):
 
September 30, 2015
 
December 31, 2014
United States
$
105.1

 
96.0

Other regions
19.3

 
19.8

Total long-lived assets
$
124.4

 
$
115.8

The Company does not hold a significant amount of long-lived assets in any single country outside of the United States as of September 30, 2015 and December 31, 2014.


23


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; speed and extent of test menu expansion and utilization; improving gross margins; execution of manufacturing operations and our reliance on a single contract manufacturer; our success in increasing product sales under the High Burden Developing Country (“HBDC”) program; the relative mix of commercial and HBDC sales and the relative mix of instrument and test sales; our success in commercial test and commercial system sales; our ability to sell directly to the smaller hospital market and the independent reference laboratory market; the performance and market acceptance of our new products; test performance in the field; testing volumes for our products; unforeseen supply, development and manufacturing problems; manufacturing costs associated with the ramp-up of new products; our ability to manage our inventory levels; our ability to scale up manufacturing; our research and development budget; 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; the effectiveness of our sales personnel and our ability to successfully expand and effectively manage increased sales and marketing operations, including expansion of our direct sales force to address the smaller hospital market and the independent reference laboratory market and expansion of our United States sales organization; lengthy sales cycles in certain markets, including the HBDC program and the smaller hospital market; variability in systems placements and reagent pull-through in our HBDC program and the smaller hospital market; 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 for 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; our reliance on distributors in some regions to market, sell and support our products in certain geographic locations; the occurrence of unforeseen expenditures, asset impairments, acquisitions or other transactions; costs of litigation, including settlement costs; our ability to manage geographically-dispersed operations; the scope and timing of actual United States Postal Service (