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CPHD > SEC Filings for CPHD > Form 10-Q on 2-Nov-2012All Recent SEC Filings

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Form 10-Q for CEPHEID


2-Nov-2012

Quarterly Report


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: continued market acceptance of our healthcare associated infection products; testing volumes for our products; the environment for capital spending by hospitals and other customers for our diagnostic instruments; our ability to secure sufficient cartridge parts and increase manufacturing throughput of our cartridge production; other unforeseen supply, development and manufacturing problems; the need for additional intellectual property licenses for new tests and other products and the terms of such licenses; our ability to successfully sell products in the Clinical market; lengthy sales cycles in certain markets, including the HBDC program; the impact of competitive products and pricing; the performance and market acceptance of our new products; sufficient customer demand; our ability to develop and complete clinical trials successfully in a timely manner for new products; our ability to obtain regulatory approvals and introduce new products and other uncertainties related to regulatory processes; our ability to respond to changing laws and regulations affecting our industry and changing enforcement practices related thereto; our ability to continue to realize manufacturing efficiencies, which is an important factor in improving gross margins; the product, geography and channel mix of our sales, each of which can affect our gross margins; our success in increasing our direct sales and the effectiveness of our sales personnel; 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; variability in systems placements and reagent pull-through in our HBDC program; 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. Molecular testing historically has involved a number of complicated and time-intensive steps, including sample preparation, DNA amplification and detection. Our easy-to-use systems integrate these steps and analyze complex biological samples in our proprietary test cartridges. We were first to the United States ("U.S.") market with a Clinical Laboratory Improvement Amendments ("CLIA") moderate complexity categorization for an amplified molecular test and the majority of our products are moderately complex, expanding our market opportunity beyond high complexity laboratories.

Our two principal systems are the GeneXpert® and the SmartCycler®. The GeneXpert system, our primary offering in the Clinical market, integrates sample preparation in addition to DNA amplification and detection. The GeneXpert system is designed for a broad range of user types ranging from reference laboratories and hospital central laboratories to satellite testing locations, such as emergency departments and intensive care units within hospitals and doctors' offices. The SmartCycler system integrates DNA amplification and detection to allow rapid analysis of a sample.

In September 2009, we launched the GeneXpert Infinity-48 system ("Infinity") for high volume testing. The Infinity uses robotic cartridge handling and a full touch screen driven menu. In July 2011, we introduced the GeneXpert Infinity-80 ("Infinity-80"), our highest throughput system, comprised of up to 80 modules, enabling more than 2,000 tests to be run during a 24-hour period, yet occupying the same footprint as the GeneXpert Infinity-48. In July 2012, we introduced the GeneXpert Infinity-48s, comprised of up to 48 modules in a footprint that is almost two feet less in width than the original Infinity-48, enabling up to 1,300 tests to be run during a 24-hour period.


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The GeneXpert system, including the Infinity, represents a paradigm shift in molecular diagnostics in terms of ease-of-use, flexibility and scalability, producing accurate results in a timely manner with minimal risk of contamination. Our Xpert tests for use on the GeneXpert system are unique in that they typically require less than two minutes of hands-on time for unprecedented ease of use, rapid results, in most cases under an hour, and the ability to do testing in any workflow environment: full random access; on-demand; or traditional batch testing.

The paradigm shift represented by the GeneXpert system includes: 1) the ability to perform multiple, highly accurate and fast time-to-result molecular diagnostic tests, at any time, even if the system is simultaneously performing other tests, either in a batch or on-demand mode; 2) the system's ease-of-use, which enables it to be operated without the need for highly-trained laboratory technologists; and 3) the scalability of the instrument, currently from one to 80 modules, enabling it to serve high volume testing requirements as well as lower volume requirements for smaller institutions or for testing at the point of patient care. Our GeneXpert system can provide rapid results with frequently superior test specificity and sensitivity over comparable systems on the market today that are integrated but have open architectures. Our GeneXpert system operates with an entirely closed cartridge, reducing the likelihood of potential human error and contamination issues. As a result, the system is particularly well suited to perform "nested" PCR, a detection method that provides an enhanced level of sensitivity, but that has historically been discouraged because of the high risk of cross-contamination during processing in an open lab environment. This method performs an additional amplification of the target sequence after the first PCR amplification.

We currently have available and under development a broad and expanding menu of tests for use on our systems, spanning infectious disease, healthcare associated infections, women's health, genetics and oncology. Our tests are marketed along with our systems on a worldwide basis.

Sales Channels

Sales for products within our specific markets are conducted through both direct sales and indirect distribution channels worldwide. Clinical market sales in the U.S., the United Kingdom, France, Germany, South Africa and the Benelux region are handled primarily through our direct sales force, while sales in all other markets are handled primarily through distributors. Clinical market sales to hospitals under 150 beds in the U.S. are handled through a distributor. As international Clinical markets continue to develop, we expect to expand our direct sales efforts. Our marketing programs are managed on a direct basis. We often sell to end customers who are part of various Group Purchasing Organizations. No single country outside of the U.S. represented more than 10% of our total revenues for any of the periods presented. No customer accounted for more than 10% of total product sales in the periods presented.

Revenues

Currently, we derive our revenues primarily from the sales of our systems and associated reagents and disposables in the Clinical and Non-Clinical markets, and to a lesser extent from contract and government sponsored research.

Research and Development

The principal objective of our research and development program is to develop high-value clinical diagnostic products for the GeneXpert system. We focus our efforts on four main areas: 1) assay development efforts to design, optimize, and produce specific tests that leverage the systems and chemistry we have developed; 2) target discovery research to identify novel micro RNA targets to be used in the development of future assays; 3) chemistry research to develop innovative and proprietary methods to design and synthesize oligonucleotide primers, probes and dyes to optimize the speed, performance and ease-of-use of our assays; and 4) engineering efforts to extend the multiplexing capabilities of our systems and to develop new low and high throughput systems.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

Litigation

We are involved in certain legal proceedings, as discussed in Note 6, "Commitments and Contingencies" of Notes to Condensed Consolidated Financial Statements of this Form 10-Q. Based upon consultation with outside counsel handling our defense in these matters and an analysis of potential results, if we believe that a loss arising from such matters is probable and can be reasonably estimated, we record the estimated liability in our Condensed Consolidated Financial Statements. If only a range of estimated losses can be estimated, we record an amount within the range that, in our judgment, reflects the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, we record the liability at the low end of the range of estimates. Any such accrual would be charged to expense in the appropriate period. We recognize litigation expenses in the period in which the litigation services were provided.


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In addition to the policy disclosed above, 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 2011 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 2011 Annual Report on Form 10-K.

Comparison of the Three and Nine Months Ended September 30, 2012 and 2011

Revenues

The following table summarizes total revenue by product sales and other revenue
(in thousands, except percentages):



                                        Three Months Ended September 30,                         Nine Months Ended September 30,
                                 2012         2011       $ Change       % Change         2012          2011        $ Change       % Change
Revenues:
System sales                   $ 13,576     $ 14,748     $  (1,172 )           -8 %    $  41,346     $  41,577     $    (231 )           -1 %
Reagent and disposable sales     64,567       52,600        11,967             23 %      190,544       147,000        43,544             30 %

Total product sales              78,143       67,348        10,795             16 %      231,890       188,577        43,313             23 %
Other revenue                     2,329        2,865          (536 )          -19 %        6,889         8,884        (1,995 )          -22 %

Total revenues                 $ 80,472     $ 70,213     $  10,259             15 %    $ 238,779     $ 197,461     $  41,318             21 %

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

                                           Three Months Ended September 30,                          Nine Months Ended September 30,
                                   2012          2011       $ Change        % Change         2012          2011        $ Change       % Change
Product sales by market:
Clinical Systems                 $  13,049     $ 13,955     $    (906 )            -6 %    $  39,440     $  38,717     $     723              2 %
Clinical Reagents                   54,527       45,692         8,835              19 %      164,727       128,461        36,266             28 %

Total Clinical                      67,576       59,647         7,929              13 %      204,167       167,178        36,989             22 %
Non-Clinical                        10,567        7,701         2,866              37 %       27,723        21,399         6,324             30 %

Total product sales              $  78,143     $ 67,348     $  10,795              16 %    $ 231,890     $ 188,577     $  43,313             23 %

Clinical revenues increased $7.9 million or 13% for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $37.0 million or 22% for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase in Clinical revenues for the three month comparative period was led by growth in the Clinical Reagent business associated with the new GX instrument placements and broader test menu adoption among existing customers partially offset by a decrease in system placements in our commercial market. The increase in Clinical revenue for the nine month comparative period was led by growth in the Clinical Reagent business associated with the new GX instrument placements and broader test menu adoption among existing Commercial and HBDC customers. Although Clinical Reagent revenue for the three and nine months ended September 30, 2012 increased over previous periods, Clinical Reagent revenue was negatively affected by intermittent interruptions in the supply of Xpert cartridge parts, resulting in a back-order situation.

In the Non-Clinical market, product sales increased $2.9 million or 37% for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $6.3 million or 30% for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase in Non-Clinical revenues for the three and nine month comparative periods was primarily due to increased sales of anthrax test cartridges under the Northrop Grumman/USPS program.


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

                                            Three Months Ended September 30,                          Nine Months Ended September 30,
                                    2012          2011       $ Change        % Change         2012          2011        $ Change       % Change
Product Sales Geographic
information:
North America
Clinical                          $  42,726     $ 43,168     $    (442 )            -1 %    $ 135,692     $ 121,571     $  14,121             12 %
Non-Clinical                          9,167        6,197         2,970              48 %       22,967        17,727         5,240             30 %

Total North America                  51,893       49,365         2,528               5 %      158,659       139,298        19,361             14 %
International
Clinical                             24,850     $ 16,479     $   8,371              51 %    $  68,475     $  45,606     $  22,869             50 %
Non-Clinical                          1,400        1,504          (104 )            -7 %        4,756         3,673         1,083             29 %

Total International                  26,250       17,983         8,267              46 %       73,231        49,279        23,952             49 %

Total product sales               $  78,143     $ 67,348     $  10,795              16 %    $ 231,890     $ 188,577     $  43,313             23 %

North American Clinical product sales decreased $0.4 million or 1% for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $14.1 million or 12% for the nine months ended September 30, 2012 as compared to the same period in the prior year. The decrease in the three month comparative period was led by a decrease in Clinical System placements partially offset by an increase in Clinical Reagent sales to new and existing customers. The increase in the nine month comparative period was led by growth in Clinical Reagent sales to new and existing customers partially offset by a decrease in North American System placements. For the three and nine month periods, Clinical Reagent revenue was negatively affected by the intermittent interruptions in the supply of Xpert cartridge parts, resulting in a back-order situation at September 30, 2012. Non-Clinical product sales increased $3.0 million or 48% for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $5.2 million or 30 % for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase was primarily due to the increase of anthrax test cartridge sales under the Northrop Grumman/USPS program.

International product sales, which primarily represent sales in Europe, increased $8.3 million or 46% for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $24.0 million or 49% for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase in both periods was primarily driven by higher Clinical Reagent sales in addition to system placements associated with our commercial customers and HBDC program. For the three and nine month periods, Clinical Reagent revenue was negatively affected by the intermittent interruptions in the supply of Xpert cartridge parts, resulting in a back-order situation at September 30, 2012.

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

Other Revenue

Other revenue decreased $0.5 million or 19% for the three months ended September 30, 2012 as compared to the same period in the prior year and decreased $2.0 million or 22% for the nine months ended September 30, 2012 as compared to the same period in the prior year. The decrease in the three month comparative period was primarily associated with incurring fewer costs under our cost plus programs of government grants and sponsored research. This decrease in the nine month comparative period was primarily associated with the one-time benefit related to a development and distribution agreement with one of our partners completed in 2011.


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Costs and Operating Expenses

The following table summarizes costs and operating expenses for the three months
ended September 30, 2012 and 2011 (in thousands, except percentages):



                                              Three Months Ended September 30,                         Nine Months Ended September 30,
                                       2012          2011       $ Change      % Change         2012          2011        $ Change      % Change
Costs and operating expenses:
Cost of product sales                $  39,789     $ 29,644     $  10,145            34 %      110,469     $  84,208     $  26,261            31 %
Collaboration profit sharing             2,438        1,096         1,342           122 %        5,767         3,281         2,486            76 %
Research and development                16,154       15,223           931             6 %       54,374        42,712        11,662            27 %
Sales and marketing                     15,993       12,875         3,118            24 %       45,613        36,201         9,412            26 %
General and administrative              11,766        9,316         2,450            26 %       33,828        25,851         7,977            31 %
Loss from legal settlement              15,110           -         15,110           100 %       15,110            -         15,110           100 %

Total costs and operating expenses   $ 101,250     $ 68,154     $  33,096            49 %    $ 265,161     $ 192,253     $  72,908            38 %

Cost of Product Sales

Cost of product sales consists of raw materials, direct labor and stock-based compensation expense, manufacturing overhead, facility costs and warranty costs. Cost of product sales also includes royalties on product sales and amortization of intangible assets related to technology licenses and intangibles.

Cost of product sales increased $10.1 million, or 34%, for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $26.3 million, or 31%, for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase in both periods was attributed to increased shipments of our system and reagent products and manufacturing inefficiencies resulting from scaling activities, including intermittent interruptions in the supply of Xpert cartridge parts.

Our product gross margin percentage was 49.1% and 56.0% for the three months ended September 30, 2012 and 2011, respectively. Our product gross margin percentage was 52.4% and 55.3% for the nine months ended September 30, 2012 and 2011, respectively. The decrease in both periods was primarily attributable to manufacturing inefficiencies resulting from scaling activities, including the intermittent interruptions in the supply of Xpert cartridge parts partially offset by the phase out of certain royalty payments associated with our Clinical business and higher volume of sales. In addition, an increase in our HBDC business, which has lower gross margins, negatively impacted gross margin.

While we expect a trend of increasing product gross margins over time, we also expect moderate fluctuations from quarter to quarter, depending on product, geography and channel mix. In addition, we are expecting an increase in our HBDC business that would negatively impact gross margin in the fourth quarter of 2012.

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 increased $1.3 million, or 122%, for the three months ended September 30, 2012 as compared to the same period in the prior year and increased $2.5 million, or 76%, for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase in both periods was due to the increase in anthrax test cartridge sales under the Northrop Grumman/USPS 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 depreciation. Research and development expenses increased $0.9 million or 6% for the three months ended September 30, 2012 as compared to the same period in the prior year. This increase was primarily due to an increase in salaries and employee-related expenses and an increase in stock-based compensation expense.

Research and development expenses increased $11.7 million, or 27%, for the nine months ended September 30, 2012 as compared to the same period in the prior year. This increase was primarily due to an increase in salaries and employee-related expenses, an increase in beta and clinical trials, as development efforts on many of our projects continued to progress and an increase in 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 $3.1 million, or 24%, for the three months ended September 30, 2012 as compared to the same period in the prior year. The increase was primarily due to an increase in salaries and employee-related expenses in connection with the expansion of our direct sales force and an increase in stock-based compensation expense.

Sales and marketing expenses increased $9.4 million, or 26%, for the nine months ended September 30, 2012 as compared to the same period in the prior year. The increase is primarily due to an increase in salaries and employee-related expenses in connection with the expansion of our direct sales force and as a result of the two acquisitions we completed during the three months ended March 31, 2012 and 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 $2.5 million, or 26%, for the three months ended September 30, 2012 as compared to the same period in the prior year. The increase was primarily due to an increase in legal expenses, an increase in salaries and employee-related expenses and an increase in stock-based compensation expense.

General and administrative expenses increased $8.0 million, or 31%, for the nine months ended September 30, 2012 as compared to the same period in the prior year. The increase was primarily due to an increase in legal expenses, an increase in salaries and employee-related expenses and an increase in stock-based compensation expense.

Litigation Settlement

Litigation settlement of $15.1 million consists of a charge related to the Abaxis settlement in September 2012. For further detail, please refer to Note 6 "Commitments and Contingencies" in the Notes to the Condensed Consolidated Financial Statements in this Form 10-Q.

LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Flow



                                                               Nine Months Ended
                                                                 September 30,
                                                                                    Increase/
                                                   2012             2011            (Decrease)
. . .
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