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CPHD > SEC Filings for CPHD > Form 10-K on 27-Feb-2014All Recent SEC Filings

Show all filings for CEPHEID

Form 10-K for CEPHEID


27-Feb-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our business, and other parts of this report, contain forward-looking statements that are based upon current expectations. These statements are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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; the breadth and speed of test menu expansion, improving gross margins, execution of manufacturing operations, product sales under the High Burden Developing Country ("HBDC") program, commercial test and commercial system sales and improvements in our manufacturing scale-up activities; our success in increasing our commercial and HBDC sales and the effectiveness of our sales personnel; the relative mix of commercial and HBDC sales; the performance and market acceptance of our new products; testing volumes for our products; unforeseen supply, development and manufacturing problems; our ability to manage our inventory levels; our ability to successfully complete and bring on-line additional manufacturing lines; the potential need for intellectual property licenses for tests and other products and the terms of such licenses; the environment for capital spending by hospitals and other customers for our diagnostic systems; our ability to successfully introduce and sell products in the Clinical market; lengthy sales cycles in certain markets, including the HBDC program; long sales cycles and variability in systems placements and reagent pull-through in our HBDC program; the impact of competitive products and pricing; sufficient customer demand; customer confidence in product availability and available customer budgets; the level of testing at clinical customer sites, including for healthcare associated infections; our ability to consolidate customer demand through volume pricing; our ability to develop new products and complete clinical trials successfully in a timely manner for new products; our ability to obtain regulatory approvals and introduce new products; uncertainties related to FDA regulatory and international regulatory processes; our ability to respond to changing laws and regulations affecting our industry and changing enforcement practices related thereto; the product, geography and channel mix of our sales, each of which can affect our gross margins; our reliance on distributors to market, sell and support our products in certain geographic locations; the occurrence of unforeseen expenditures, asset impairments, acquisitions or other transactions; cost of litigation including settlement costs; our ability to integrate the businesses, technologies, operations and personnel of acquired companies; our ability to manage geographically-dispersed operations; the scope and timing of actual United States Postal Service ("USPS") funding of the Biohazard Detection System ("BDS") in its current configuration; the rate of environmental testing using the BDS conducted by the USPS, which will affect the amount of consumable products sold; underlying market conditions worldwide; and the other risks set forth under "Risk Factors" and elsewhere in this report. We neither undertake, nor assume any obligation to update any of the forward-looking statements after the date of this report or to conform these forward-looking statements to actual results.

STRATEGY

We are a molecular diagnostics company that develops, manufactures and markets fully-integrated systems for testing in the Clinical and Non-Clinical markets. Our systems enable rapid, sophisticated molecular testing for organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures. Our objective is to become the leading supplier of integrated systems and tests for molecular diagnostics. Key elements of our strategy to achieve this objective include:

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

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

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

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


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

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

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

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

Continue to develop and market new tests. We plan to capitalize on our strengths in nucleic acid chemistry and molecular biology to continue to develop new tests for our systems and offer our customers the broadest menu of Xpert tests designed to address many of the highest volume molecular test opportunities. We currently offer a menu of 14 Xpert tests in the U.S. and international markets. Our strategy is to further extend the Xpert test menu to include healthcare associated infections, critical infectious disease, sexual health, women's health, virology, oncology and genetics. For example, Xpert CT/NG was made commercially available in the United States in the first quarter of 2013 and Xpert MTB/RIF was made commercially available in the United States in the third quarter of 2013.

Obtain additional target rights. We expect to continue to expand our collaborations with academic institutions and commercial organizations to develop and obtain target rights to various infectious disease and oncology targets. For example, in the first quarter of 2013, we entered into license agreements with Oregon Health & Sciences University to further the development of our prostate and breast oncology tests. In addition, we intend to focus key business development activities on identifying infectious disease and oncology targets held by academic institutions or commercial organizations for potential license or acquisition.

Extend geographic reach. Our international sales and marketing operations are headquartered in France. As of December 31, 2013, we had direct sales forces in the United Kingdom ("U.K."), France, Australia, the Benelux region, Germany, Italy and South Africa, and we have offices in Brazil, Singapore, India, Hong Kong Dubai, China and Japan. In 2013 we acquired our Italian distributor and we intend to continue to expand our international commercial operations capability on both a direct and distributor basis in 2014 and beyond.

Extend High Burden Developing Countries sales programs. We are developing and expect to continue to expand our presence in HBDCs following the World Health Organization's endorsement of the Xpert MTB/RIF test in late 2010. Our program to deliver GeneXpert systems and Xpert tests to HBDCs at a discount to our standard commercial prices showed continuing momentum in 2013. We believe that participation in the HBDC program considerably broadens the geographic reach of our products and increases recognition of the Cepheid brand and product portfolio globally, including in emerging commercial markets. Our ongoing collaboration with the Foundation for Innovative New Diagnostics ("FIND") is expected to broaden the menu of tests available to HBDC customers at special pricing considerations.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

We consider our accounting policies related to revenue recognition, impairment of long-lived assets, inventory valuation, warranty accrual, stock-based compensation, litigation settlement, foreign currency hedging and income taxes to be critical accounting policies. A number of significant estimates, assumptions and judgments are inherent in our determination of when to recognize revenue, how to evaluate our long-lived-assets, the calculation of our inventory valuation adjustments, warranty accrual, settlements related to litigation, valuation of our foreign currency hedges and stock-based compensation expense. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates.

Revenue Recognition

We recognize revenue from product 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 our products except in the case of damaged goods. We have not experienced any significant returns of our products. Shipping and handling costs are expensed as incurred and included in cost of product sales. In those cases where we bill shipping and handling costs to our customers, the amounts billed are classified as revenue.


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We enter into revenue arrangements that may consist of multiple deliverables of our products and services. In situations with multiple deliverables, revenue is recognized upon the delivery of each of the separate elements. We sell service contracts for which revenue is deferred and recognized ratably over the contract period.

In the first quarter of 2011, we adopted Accounting Standard Update ("ASU") No. 2009-13, Revenue Recognition (Topic 605) - Multi-Deliverables Revenue Arrangements, a Consensus of the FASB Emerging Issues Task Force, on a prospective basis for applicable transactions originating or materially modified on or subsequent to January 1, 2011. Implementation of this new authoritative guidance had an insignificant impact on reported revenue as compared to revenue under previous guidance, as the new guidance did not change the units of accounting within sales arrangements and the elimination of the residual method for the allocation of arrangement consideration had an immaterial impact on the amount and timing of revenue reported.

For multiple element arrangements entered into or materially modified on or subsequent to January 1, 2011, 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 our best estimate of the selling price of an element in a transaction. We limit 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. We recognize revenue for delivered elements only when we determine there are no uncertainties regarding customer acceptance.

Other revenue includes fees for technology licenses and research and development services, including research and development under grants and government sponsored research, royalties under license and collaboration agreements. Fees for technology licenses are generally fully recognized only after the license period has commenced, the technology has been delivered and no further involvement by us is required. When we have continuing involvement related to a technology license, revenue is recognized over the license term. Revenue related to research and development services is recognized as the related service is performed based on the performance requirements of the relevant contract. Under such agreements, we are required to perform specific research and development activities and are compensated either based on the costs or costs plus a mark-up associated with each specific contract over the term of the agreement or based on our progress to completion and recoverability is reasonably assured. Royalties are typically based on licensees' net sales of products that utilize our technology and royalty revenues are recognized as earned in accordance with the contract terms when the royalties can be reliably measured and their collectability is reasonably assured, such as upon the receipt of a royalty statement from the customer. Advance payments received in excess of amounts earned, such as funds received in advance of products to be delivered or services to be performed, are classified as deferred revenue until earned.

During 2012, we entered into agreements with The Bill and Melinda Gates Foundation ("BMGF"), The United States Agency for International Development ("USAID") and UNITAID to reduce the price of our Multi-Drug Resistant Tuberculosis test to $9.98 for customers in the HBDC program. We received one-time payments of $3.5 million each from BMGF and USAID in 2012 and $3.2 million from UNITAID during 2013. Based on the terms of the agreements, we recognized revenue related to the BMGF and USAID agreements on a per-unit basis. Under the UNITAID agreement, we are recognizing the $3.2 million of revenue on a straight line basis over a period of ten years. For the years ended December 31, 2013 and 2012, we recognized revenue of $2.7 million and $4.8 million, respectively, related to these three agreements.

Realizability of Long-Lived Assets

Our intangible assets consist primarily of rights to certain patented technologies that we purchased. Intangible assets are recorded at cost, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 5 to 15 years, on a straight-line basis except for intangible assets acquired in an acquisition, which are amortized on the basis of economic useful life. Amortization of intangible assets is primarily included in cost of sales in the consolidated statements of operations.

We review our intangible assets for impairment and conduct an impairment review when events or circumstances indicate the carrying value of a long-lived asset may be impaired, by estimating the future undiscounted cash flows to be derived from an asset to assess whether or not a potential impairment exists. If the carrying value exceeds our estimate of future undiscounted cash flows, we then calculate the impairment as the excess of the carrying value of the asset over our estimate of its fair market value. Events or circumstances which could trigger an impairment review include a significant adverse change in business climate, an adverse action or assessment by a regulator, unanticipated competition, significant changes in the manner of our use of acquired assets, the strategy for our overall business, or significant negative industry or economic trends. There is significant judgment in estimating future cash flows and fair value. In 2013, 2012 and 2011, we recorded impairment charges of $1.3 million, $1.4 million and $5.4 million, respectively, related to the impairment of acquired intangible assets.


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Goodwill

As of December 31, 2013, our carrying value of goodwill was $39.7 million. Goodwill is tested for impairment at a minimum on an annual basis and at the reporting unit level by first performing a qualitative assessment to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying value. If the reporting unit does not pass the qualitative assessment, then the reporting unit's carrying value is compared to its fair value. The fair values of the reporting units are estimated using market and discounted cash flow approaches. Goodwill is considered impaired if the carrying value of the reporting unit exceeds its fair value. The discounted cash flow approach uses expected future operating results. Failure to achieve these expected results may cause a future impairment of goodwill at the reporting unit. We conducted our annual impairment tests of goodwill in the fourth quarters of 2013 and 2012. As a result of these tests, we determined that no adjustment to the carrying value of goodwill for any reporting units was required.

Cash, Cash Equivalents, Short-Term Investments and 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.

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

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

Litigation

We are involved in certain legal proceedings, as discussed in Note 8, "Commitments, Contingencies and Legal Matters" of Notes to the Consolidated Financial Statements of this Form 10-K. 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 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.

Inventory and Warranty Provisions

We maintain provisions for inventory obsolescence and warranty costs that we believe are reasonable and that are based on our historical experience and current expectations for future performance. The inventory provision is established using our estimate of the potential future obsolescence or excess inventory. A substantial decrease in demand for our products or the introduction of new products could lead to excess inventories and could require us to increase our provision for inventory obsolescence. Our current estimates and assumptions are consistent with prior periods. In the past, there have not been significant adjustments of the actual results to our estimates.

We warrant our systems to be free from defects for a period of generally 12 to 24 months from the date of sale and our disposable products to be free from defects, when handled according to product specifications, for the stated life of such products. Accordingly, a provision for the estimated cost of warranty repair or replacement is recorded at the time revenue is recognized. Our warranty provision is established using our estimate of future failure rates and of the future costs of repairing any system failures during the warranty period or replacing any disposable products with defects. Significant increases in the failure rates of our products could lead to increased warranty costs and require us to increase our warranty provision. As of December 31, 2013 and 2012, the accrued warranty liability at each period end was $3.3 million and $2.0 million, respectively.


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Stock-Based Compensation

We account for stock-based compensation cost in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 718-25. Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is generally the vesting period. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statements of operations. We recognize the fair value of our stock option awards as compensation expense over the requisite service period of each award, which is generally four years.

In determining fair value of the stock-based compensation payments, we use the Black-Scholes model and a single option award approach, which requires the input of subjective assumptions. These assumptions include: estimating the length of time employees will retain their vested stock options before exercising them (expected term), the estimated volatility of our common stock price over the expected term (expected volatility), the risk-free interest rate (interest rate), expected dividends and the number of shares subject to options that will ultimately not complete their vesting requirements (forfeitures). Changes in the following assumptions can materially affect the estimate of fair value of stock-based compensation.

Expected term is determined based on historical experience, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its stock-based awards.

Expected volatility is based on the blend of historical volatility of the past period equal to our expected term and the current implied volatility.

Risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of a stock award.

Expected dividend is based on our expectation of issuing a dividend over the expected term. We have never issued dividends.

Estimated forfeitures are based on voluntary termination behavior as well as analysis of actual option forfeitures.

Income Taxes

We account for income taxes using an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements, but have not been reflected in our taxable income. A valuation allowance is established to reduce deferred tax assets to their estimated realizable value. Therefore, we provide a valuation allowance to the extent that we do not believe it is more likely than not that it will generate sufficient taxable income in future periods to realize the benefit of its deferred tax assets.

We recognize interest and penalties related to uncertain tax positions in income tax expense. For the year ended December 31, 2013, 2012 and 2011, we did not recognize significant interest or penalties related to uncertain tax positions in the consolidated statements of operations, and at December 31, 2013 and 2012, we had no significant accrued interest or penalties.

Foreign Currency Hedging

We use forward contracts designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in forecasted net revenue, cost of sales and operating expense denominated in currencies other than the U.S. dollar. Our foreign currency cash flow hedges mature generally within twelve months. For derivative instruments that are designated and qualify as cash flow hedges, we initially record the effective portion of the gain or loss on the derivative instrument in accumulated other comprehensive income or loss as a separate component of stockholders' equity and subsequently reclassify these amounts into earnings in the period during which the hedged transaction is recognized in earnings. The effective portion of cash flow hedges is reported in the same financial statement line item as the changes in value of the hedged item. The notional principle amounts of our outstanding derivative instruments designated as cash flow hedges are $96.6 million and $79.3 million as of December 31, 2013 and 2012, respectively. The notional principle amounts of our outstanding derivative instruments not designated as cash flow hedges is $24.2 million and $9.2 million as of December 31, 2013 and 2012, respectively. During fiscal year 2013, there was no significant impact to results of operations as a result of discontinued cash flow hedges.


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Results of Operations

Comparison of Years Ended December 31, 2013, 2012 and 2011

Revenues

The following table illustrates the components of revenues (in thousands):



                                             Years Ended December 31,                                  Years Ended December 31,
                                 2013          2012        $ Change       % Change         2012          2011        $ Change       % Change
Sales:
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