10-Q 1 q1201610q.htm FORM 10-Q 10-Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 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 March 31, 2016
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 April 26, 2016, there were 72,885,605 shares of the registrant’s common stock outstanding.




REPORT ON FORM 10-Q FOR THE
QUARTER ENDED MARCH 31, 2016
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)
 
March 31,
 
December 31,
 
2016
 
2015
 
(unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
89,820

 
$
112,568

Short-term investments
202,492

 
210,147

Accounts receivable, less allowance for doubtful accounts of $617 as of March 31, 2016 and $383 as of December 31, 2015
72,626

 
66,550

Inventory, net
150,426

 
148,690

Prepaid expenses and other current assets
26,637

 
18,515

Total current assets
542,001

 
556,470

Property and equipment, net
143,969

 
127,639

Investments
63,361

 
62,175

Other non-current assets
5,643

 
4,205

Intangible assets, net
23,812

 
25,241

Goodwill
39,681

 
39,681

Total assets
$
818,467

 
$
815,411

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
57,963

 
$
57,771

Accrued compensation
30,112

 
39,015

Accrued royalties
4,140

 
5,469

Accrued and other liabilities
27,616

 
27,451

Current portion of deferred revenue
13,586

 
12,778

Total current liabilities
133,417

 
142,484

Long-term portion of deferred revenue
6,936

 
5,538

Convertible senior notes, net
284,295

 
281,627

Other liabilities
16,639

 
15,779

Total liabilities
441,287

 
445,428

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, 72,693,942 and 72,415,317 shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively
453,943

 
449,704

Additional paid-in capital
272,480

 
263,429

Accumulated other comprehensive loss, net
(400
)
 
(908
)
Accumulated deficit
(348,843
)
 
(342,242
)
Total shareholders’ equity
377,180

 
369,983

Total liabilities and shareholders’ equity
$
818,467

 
$
815,411

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 
 March 31,
 
2016
 
2015
Revenue
$
144,780

 
$
132,637

Costs and operating expenses:
 
 
 
Cost of sales
72,595

 
61,201

Collaboration profit sharing
658

 
1,267

Research and development
29,914

 
23,986

Sales and marketing
28,795

 
25,936

General and administrative
15,055

 
15,642

Total costs and operating expenses
147,017

 
128,032

Income (loss) from operations
(2,237
)
 
4,605

Other income (expense):
 
 
 
Interest income
660

 
373

Interest expense
(3,765
)
 
(3,603
)
Foreign currency exchange loss and other, net
(528
)
 
(945
)
Other expense, net
(3,633
)
 
(4,175
)
Income (loss) before income taxes
(5,870
)
 
430

Benefit from (provision for) income taxes
(731
)
 
476

Net income (loss)
$
(6,601
)
 
$
906

Basic net income (loss) per share
$
(0.09
)
 
$
0.01

Diluted net income (loss) per share
$
(0.09
)
 
$
0.01

Shares used in computing basic net income (loss) per share
72,588

 
71,262

Shares used in computing diluted net income (loss) per share
72,588

 
73,189

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


4


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(unaudited)
 
 
Three Months Ended 
 March 31,
 
2016
 
2015
Net income (loss)
$
(6,601
)
 
$
906

Other comprehensive income, before tax:
 
 
 
Change in unrealized gains and losses related to cash flow hedges:
 
 
 
Gain (loss) recognized in accumulated other comprehensive loss, net
(74
)
 
404

Loss reclassified from accumulated other comprehensive loss, net to the statement of operations
331

 
23

Change in unrealized gains and losses related to available-for-sale investments:
 
 
 
Gain recognized in accumulated other comprehensive loss, net
547

 
142

Gain reclassified from accumulated other comprehensive loss, net to the statement of operations
(1
)
 

Other comprehensive income, before tax
803

 
569

Income tax expense related to items of accumulated other comprehensive loss, net
(295
)
 
(475
)
Comprehensive income (loss)
$
(6,093
)
 
$
1,000

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


5


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
Three Months Ended 
 March 31,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(6,601
)
 
$
906

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization of property and equipment
7,532

 
6,045

Amortization of intangible assets
1,429

 
1,673

Unrealized foreign exchange differences
(101
)
 
1,455

Amortization of debt discount and transaction costs
2,667

 
2,502

Stock-based compensation expense
9,007

 
7,557

Excess tax benefits from stock-based compensation expense

 
(53
)
Other non-cash items
357

 
142

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(6,076
)
 
(5,910
)
Inventory, net
(1,693
)
 
(8,160
)
Prepaid expenses and other current assets
(7,459
)
 
(2,299
)
Other non-current assets
(68
)
 
(197
)
Accounts payable and other current and non-current liabilities
(1,408
)
 
5,512

Accrued compensation
(8,904
)
 
(8,776
)
Deferred revenue
2,205

 
341

Net cash provided by (used in) operating activities
(9,113
)
 
738

Cash flows from investing activities:
 
 
 
Capital expenditures
(22,741
)
 
(9,989
)
Cost of acquisitions, net

 
(3,000
)
Proceeds from sale of equipment and an intangible asset
24

 
339

Proceeds from sales of marketable securities and investments
21,230

 
13,303

Proceeds from maturities of marketable securities and investments
58,627

 
61,774

Purchases of marketable securities and investments
(73,040
)
 
(62,494
)
Transfer from (to) restricted cash
(2,059
)
 
31

Net cash used in investing activities
(17,959
)
 
(36
)
Cash flows from financing activities:
 
 
 
Net proceeds from the issuance of common shares and exercise of stock options
4,251

 
13,804

Excess tax benefits from stock-based compensation expense

 
53

Principal payment of notes payable
(43
)
 
(39
)
Net cash provided by financing activities
4,208

 
13,818

Effect of foreign exchange rate change on cash and cash equivalents
116

 
(1,557
)
Net increase (decrease) in cash and cash equivalents
(22,748
)
 
12,963

Cash and cash equivalents at beginning of period
112,568

 
96,663

Cash and cash equivalents at end of period
$
89,820

 
$
109,626

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 diagnostic testing. The Company’s systems enable fast, sophisticated molecular testing for organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures.
The Condensed Consolidated Balance Sheet at March 31, 2016, the Condensed Consolidated Statements of Operations for the three months ended March 31, 2016 and 2015, the Condensed Consolidated Statements of Comprehensive Income (Loss) for the three months ended March 31, 2016 and 2015 and the Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2016 and 2015 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 2016 or for any future period. The Condensed Consolidated Balance Sheet as of December 31, 2015 is derived from audited consolidated 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, 2015.
Functional Currency
The U.S. dollar is the functional currency of all of the Company’s subsidiaries. The Company remeasures its foreign subsidiaries’ monetary assets and liabilities to the U.S. dollar and records the net gains or losses resulting from remeasurement in “Foreign currency exchange loss and other, net” in the consolidated statements of operations.
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, Short-Term Investments and Non-Current Investments
Cash and cash equivalents consist of cash on deposit with banks and money market instruments. 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 loss, a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Interest income includes interest, dividends, amortization of purchase premiums and discounts and realized gains and losses on sales of securities.

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.
Restricted Cash
Prepaid expense and other current assets included $3.4 million and $2.7 million of restricted cash as of March 31, 2016 and December 31, 2015, respectively and other non-current assets included $3.4 million and $2.1 million of restricted cash as of March 31, 2016 and December 31, 2015, respectively. These restricted cash balances are held as security for bank guarantees provided to a foreign customer contract. The Company is required to maintain such guarantees until its contractual obligations are satisfied under the contract.
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 62% and 66% of the Company’s cash and cash equivalents as of March 31, 2016 and December 31, 2015, respectively.
The Company’s accounts receivable are derived from sales to customers and distributors. 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 11% of total accounts receivable as of December 31, 2015. No direct customer represented more than 10% of total accounts receivable as of March 31, 2016.
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. The allocation of production overhead to inventory costs is based on normal production capacity. 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):
 
March 31, 2016
 
December 31, 2015
Raw Materials
$
38,887

 
$
39,267

Work in Process
67,657

 
62,153

Finished Goods
43,882

 
47,270

Inventory, net
$
150,426

 
$
148,690

In addition, capitalized stock-based compensation expense of $2.6 million and $2.5 million were included in inventory as of March 31, 2016 and December 31, 2015, respectively.

8


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 sells service contracts for which revenue is deferred and recognized ratably over the contract period.
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.
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. For sales that include customer-specified acceptance criteria, revenue is recognized after the acceptance criteria have been met.
The Company may place an instrument at a customer site under a reagent rental agreement ("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 and 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. All revenue recognized from reagent rentals is included in reagent and disposable sales in Note 10, “Segment and Significant Concentrations”.
Revenue includes fees for research and development services earned under grants and collaboration agreements, which are recognized on a contract-specific basis. Revenue and profit under cost-plus service contracts are recognized as costs are incurred plus negotiated fees. For certain contracts, the Company utilizes the proportional performance method of revenue recognition, which requires that the Company estimate the total amount of costs to be expended for a project and recognize revenue equal to the portion of costs incurred to date. The Company exercises judgment when estimating the level of effort required to complete a project. The estimated total costs to complete a project are subject to revision from time-to-time.
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 net income 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 11,256,000 and 6,477,000 for the three months ended March 31, 2016 and 2015, respectively.

9


The following summarizes the computation of basic and diluted net income (loss) per share (in thousands, except for per share amounts): 
 
Three Months Ended March 31,
 
2016
 
2015
Basic:
 
 
 
Net income (loss)
$
(6,601
)
 
$
906

Basic weighted shares outstanding
72,588

 
71,262

Net income (loss) per share
$
(0.09
)
 
$
0.01

Diluted:
 
 
 
Net income (loss)
$
(6,601
)
 
$
906

Basic weighted shares outstanding
72,588

 
71,262

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

 
1,927

Diluted weighted shares outstanding
72,588

 
73,189

Net income (loss) per share
$
(0.09
)
 
$
0.01

Recent Accounting Pronouncements
In March 2016, the Financial Accounting Standards Board (“FASB") issued Accounting Standards Update (“ASU") No. 2016-09, Improvements to Employee Share-Based Payment Accounting. This ASU affects entities that issue share-based payment awards to their employees. The ASU is designed to simplify several aspects of accounting for share-based payment award transactions which include – the income tax consequences, classification of awards as either equity or liabilities, classification on the statement of cash flows and forfeiture rate calculations. The ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2016. The Company is currently assessing the impact of this ASU on its financial statements.
In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations. The amendments are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations. The effective date for this ASU is the same as the effective date for ASU No. 2014-09, Revenue from Contracts with Customers. The Company is currently assessing the potential impact of this ASU on its financial statements.
In March 2016, the FASB issued ASU No. 2016-06, Derivatives and Hedging: Contingent Put and Call Options in Debt Instruments. The amendments clarify the steps required to assess whether a call or put option meets the criteria for bifurcation as an embedded derivative. The ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2016. The Company does not expect the adoption of this ASU to have a material impact on its financial statements.
In February 2016, the FASB issued ASU No. 2016-02, Leases. Under the new guidance, lessees will be required to recognize a lease liability and a right-of-use asset for all leases (with the exception of short-term leases) at the commencement date. The ASU is effective for fiscal years and interim periods within those years beginning after December 15, 2018. The Company is currently assessing the impact of this ASU on its financial statements.
In November 2015, the FASB issued ASU No. 2015-17, Income Taxes: Balance Sheet Classification of Deferred Taxes, which changes how deferred taxes are classified on the balance sheet. The ASU eliminates the current requirement for organizations to present deferred tax liabilities and assets as current and noncurrent in a classified balance sheet. Instead, organizations will be required to classify all deferred tax assets and liabilities as noncurrent. The Company early-adopted the provisions of this ASU as of December 31, 2015. The provisions have been applied prospectively and prior periods were not retrospectively adjusted, as permitted by the ASU.

10


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 No. 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 No. 2015-03 is effective for annual reporting periods beginning after December 15, 2015. The Company adopted ASU No. 2015-03 on January 1, 2016, and applied its provisions retrospectively for each period presented. The adoption of ASU No. 2015-03 resulted in the reclassification of approximately $6 million of unamortized debt issuance costs related to the Company's convertible senior notes from other non-current assets to convertible senior notes, net within our condensed consolidated balance sheets as of March 31, 2016 and December 31, 2015. Other than this reclassification, the adoption of ASU No. 2015-03 did not have an impact on the Company's condensed consolidated financial statements.
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 No. 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 that the adoption of ASU No. 2014-09 will have on its consolidated financial statements.

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 March 31, 2016 and December 31, 2015 (in thousands):
Balance as of March 31, 2016:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash and cash equivalents
$
53,431

 
$
36,389

 
$

 
$
89,820

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities

 
53,613

 

 
53,613

Corporate debt securities

 
77,686

 

 
77,686

Commercial paper

 
42,354

 

 
42,354

Government agency securities

 
17,206

 

 
17,206

Other securities

 
11,633

 

 
11,633

Total short-term investments

 
202,492

 

 
202,492

Foreign currency derivatives

 
1,531

 

 
1,531

Investments:
 
 
 
 
 
 
 
Asset-backed securities

 
11,917

 

 
11,917

Corporate debt securities

 
35,436

 

 
35,436

Government agency securities

 
12,000

 

 
12,000

Other securities

 
4,008

 

 
4,008

Total investments

 
63,361

 

 
63,361

Total
$
53,431

 
$
303,773

 
$

 
$
357,204

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives
$

 
$
1,316

 
$

 
$
1,316

Total
$

 
$
1,316

 
$

 
$
1,316


11


Balance as of December 31, 2015:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash and cash equivalents
$
84,625

 
$
27,943

 
$

 
$
112,568

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities

 
51,973

 

 
51,973

Corporate debt securities

 
81,600

 

 
81,600

Commercial paper

 
48,762

 

 
48,762

Government agency securities

 
12,684

 

 
12,684

Other securities

 
15,128

 

 
15,128

Total short-term investments

 
210,147

 

 
210,147

Foreign currency derivatives

 
1,431

 

 
1,431

Investments:
 
 
 
 
 
 
 
Asset-backed securities

 
11,818

 

 
11,818

Corporate debt securities

 
36,414

 

 
36,414

Government agency securities

 
11,944

 

 
11,944

Other securities

 
1,999

 

 
1,999

Total investments

 
62,175

 

 
62,175

Total
$
84,625

 
$
301,696

 
$

 
$
386,321

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives
$

 
$
1,298

 
$

 
$
1,298

Total
$

 
$
1,298

 
$

 
$
1,298

The estimated fair values of the Company’s other financial instruments which are not measured at fair value on a recurring basis as of March 31, 2016 and December 31, 2015 were as follows (in thousands):
Balance as of March 31, 2016:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Liabilities:
 
 
 
 
 
 
 
Convertible senior notes
$

 
$
312,570

 
$

 
$
312,570

Total
$

 
$
312,570

 
$

 
$
312,570

Balance as of December 31, 2015:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Liabilities:
 
 
 
 
 
 
 
Convertible senior notes
$

 
$
307,481

 
$

 
$
307,481

Total
$

 
$
307,481

 
$

 
$
307,481

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.

12


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 have been classified as Level 2 financial instruments, was determined based on the quoted price of the convertible senior notes in an over-the-counter market on March 31, 2016.

3. Investments
The Company’s marketable securities as of March 31, 2016, were classified as available-for-sale securities, with changes in fair value recognized in Accumulated Other Comprehensive Income ("AOCI"), a component of shareholders’ equity. The Company classifies its marketable securities as cash equivalents, short-term investments or non-current investments based on each instrument's underlying effective maturity date. The following tables summarize available-for-sale marketable securities (in thousands):
Balance as of March 31, 2016:
 
 
 
 
 
 
 
 
Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
$
53,663

 
$
5

 
$
(55
)
 
$
53,613

Commercial paper
78,721

 
22

 

 
78,743

Corporate debt securities
77,742

 
18

 
(74
)
 
77,686

Government agency securities
17,202

 
4

 

 
17,206

Other securities
11,626

 
9

 
(2
)
 
11,633

Amounts classified as cash equivalents
(36,387
)
 
(2
)
 

 
(36,389
)
Total short-term investments
$
202,567

 
$
56

 
$
(131
)
 
$
202,492

Investments:
 
 
 
 
 
 
 
Asset-backed securities
$
11,933

 
$
9

 
$
(25
)
 
$
11,917

Corporate debt securities
35,372

 
79

 
(15
)
 
35,436

Government agency securities
11,999

 
1

 

 
12,000

Other securities
4,000

 
8

 

 
4,008

Total investments
$
63,304

 
$
97

 
$
(40
)
 
$
63,361

Balance as of December 31, 2015:
 
 
 
 
 
 
 
 
Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
$
52,102

 
$

 
$
(129
)
 
$
51,973

Commercial paper
76,711

 
3

 
(9
)
 
76,705

Corporate debt securities
81,777

 

 
(177
)
 
81,600

Government agency securities
12,701

 

 
(17
)
 
12,684

Other securities
15,122

 
7

 
(1
)
 
15,128

Amounts classified as cash equivalents
(27,943
)
 

 

 
(27,943
)
Total short-term investments
$
210,470

 
$
10

 
$
(333
)
 
$
210,147

Investments:
 
 
 
 
 
 
 
Asset-backed securities
$
11,884

 
$

 
$
(66
)
 
$
11,818

Corporate debt securities
36,530

 
3

 
(119
)
 
36,414

Government agency securities
11,999

 

 
(55
)
 
11,944

Other securities
2,001

 

 
(2
)
 
1,999

Total investments
$
62,414

 
$
3

 
$
(242
)
 
$
62,175


13


Proceeds from the sale of marketable securities were $21.2 million and $13.3 million for the three months ended March 31, 2016 and 2015, respectively. The Company determines gains and losses from sales of marketable securities based on specific identification of the securities sold. Realized gains and losses from sales of marketable securities, all of which are reported as a component of Other income (expense) in the Condensed Consolidated Statements of Operations, were immaterial for the three months ended March 31, 2016 and 2015.

The following table summarizes the fair value of the Company’s marketable securities with unrealized losses at March 31, 2016 and December 31, 2015, and the duration of time that such losses had been unrealized (in thousands):
Balance as of March 31, 2016:
 
 
 
 
 
 
 
 
 
 
 
 
Less Than 12 months
 
More than 12 months
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Asset-backed securities
$
45,486

 
$
(80
)
 
$
250

 
$

 
$
45,736

 
$
(80
)
Corporate debt securities
55,487

 
(85
)
 
7,844

 
(4
)
 
63,331

 
(89
)
Government agency securities
2,002

 

 

 

 
2,002

 

Other securities
1,999

 
(2
)
 

 

 
1,999

 
(2
)
Total
$
104,974

 
$
(167
)
 
$
8,094

 
$
(4
)
 
$
113,068

 
$
(171
)
Balance as of December 31, 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
$
57,866

 
$
(192
)
 
$
5,923

 
$
(3
)
 
$
63,789

 
$
(195
)
Corporate debt securities
101,701

 
(289
)
 
8,911

 
(7
)
 
110,612

 
(296
)
Government agency securities
24,628

 
(72
)
 

 

 
24,628

 
(72
)
Commercial Paper
11,374

 
(9
)
 

 

 
11,374

 
(9
)
Other securities
7,496

 
(3
)
 

 

 
7,496

 
(3
)
Total
$
203,065

 
$
(565
)
 
$
14,834

 
$
(10
)
 
$
217,899

 
$
(575
)
The Company evaluated marketable securities, which consist of investments in asset-backed securities, corporate debt securities, government agency securities, commercial paper, and other securities as of March 31, 2016, 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 March 31, 2016 and December 31, 2015, by contractual maturity (in thousands):
 
March 31, 2016
 
December 31, 2015
 
Amortized Cost
 
Estimated Fair Value
 
Amortized Cost
 
Estimated Fair Value
Mature in one year or less
$
182,069

 
$
182,035

 
$
186,311

 
$
186,118

Mature after one year through three years
112,281

 
112,340

 
106,377

 
106,086

Mature in more than three years
7,908

 
7,867

 
8,139

 
8,061

Total
$
302,258

 
$
302,242

 
$
300,827

 
$
300,265

4. Derivative Financial Instruments
The Company uses derivatives to partially offset its exposure to foreign currency exchange risk. The Company may enter into foreign currency forward contracts to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue and expenses and on certain existing assets and liabilities.
To address fluctuations in foreign currency exchange rates, a portion of forecasted foreign currency revenue and expenses of certain of the Company’s subsidiaries are hedged. The Company hedges portions of its forecasted foreign currency exposure associated with revenue, cost of sales, and operating expenses for generally up to twelve months.

14


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 $0.2 million and $0.4 million associated with cash flow hedges recorded in AOCI as of March 31, 2016 and December 31, 2015, 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 March 31, 2016 are expected to occur within twelve months.
Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable that 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 months ended March 31, 2016 and 2015.
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 March 31, 2016 and 2015, the Company recognized a loss of $0.5 million and a gain of $2.0 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 principal amounts of the Company’s outstanding derivative instruments designated as cash flow hedges are $133.8 million and $117.6 million as of March 31, 2016 and December 31, 2015, respectively. The notional principal amounts of the Company’s outstanding derivative instruments not designated as cash flow hedges are $27.8 million and $25.9 million as of March 31, 2016 and December 31, 2015, respectively.

15


The following tables show the Company’s derivative instruments at gross fair value as reflected in the Condensed Consolidated Balance Sheets as of March 31, 2016 and December 31, 2015, respectively (in thousands):
 
March 31, 2016
 
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
$
1,207

 
$
324

 
$
1,531

Derivative Liabilities (b):
 
 
 
 
 
Foreign exchange contracts
(1,292
)
 
(24
)
 
(1,316
)
 
December 31, 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
$
1,390

 
$
41

 
$
1,431

Derivative Liabilities (b):
 
 
 
 
 
Foreign exchange contracts
(1,250
)
 
(48
)
 
(1,298
)
(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 month periods ended March 31, 2016 and 2015 (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
 
March 31, 2016
 
March 31, 2015
 
March 31, 2016 (a)
 
March 31, 2015 (b)
 
Location
 
March 31, 2016
 
March 31, 2015
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$
(74
)
 
$
404

 
$
(331
)
 
$
(23
)
 
Foreign currency exchange loss and other, net
 
$
(161
)
 
$
(86
)
Total
$
(74
)
 
$
404

 
$
(331
)
 
$
(23
)
 
 
 
$
(161
)
 
$
(86
)
(a)
Includes gains and losses reclassified from AOCI into net loss 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 March 31, 2016.
(b)
Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $2.3 million loss within costs and operating expenses and a $2.3 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the three months ended March 31, 2015.


16


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, March 31, 2016
 
 
 
 
 
Licenses
$
11,256

 
$
(7,342
)
 
$
3,914

Technology acquired in acquisitions
8,613

 
(8,613
)
 

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

 
(15,951
)
 
19,898

 
$
55,718

 
$
(31,906
)
 
$
23,812

Balance, December 31, 2015
 
 
 
 
 
Licenses
$
11,454

 
$
(7,280
)
 
$
4,174

Technology acquired in acquisitions
8,613

 
(8,613
)
 

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

 
(14,782
)
 
21,067

 
$
55,916

 
$
(30,675
)
 
$
25,241

Intangible asset amortization expense was $1.4 million and $1.7 million for the three months ended March 31, 2016 and 2015, 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 March 31, 2016, assuming no impairment charges (in thousands):
For the Years Ending December 31,
Amortization
Expense
 
 
2016 (remaining nine months)
$
4,361

2017
5,448

2018
5,144

2019
4,168

2020
3,891

Thereafter
800

Total expected future amortization
$
23,812

6. Income Taxes
Effective December 31, 2015, the Company early-adopted ASU No. 2015-17, Income Taxes: Balance Sheet Classification of Deferred Taxes, which changes how deferred taxes are classified on the balance sheet. The ASU eliminates the current requirement for organizations to present deferred tax liabilities and assets as current and noncurrent in a classified balance sheet. Instead, organizations will be required to classify all deferred tax assets and liabilities as noncurrent. The provisions have been applied on a prospective basis and prior periods were not retrospectively adjusted, as permitted by the ASU.
For the three months ended March 31, 2016, the Company recorded an income tax expense of $0.7 million primarily related to ordinary tax expense of the Company’s foreign subsidiaries. For the three months ended March 31, 2015, the Company recorded an income tax benefit of $0.5 million, comprised primarily of ordinary tax benefit of the Company’s foreign subsidiaries and the tax effect of items in accumulated other comprehensive loss, net.

17


The Company’s effective tax rate for the three months ended March 31, 2016 and 2015 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 months ended March 31, 2016, compared to the three months ended March 31, 2015 is primarily due to increased United States income, or decreased United States losses, for the three months ended March 31, 2016, for which no income tax expense or benefit was 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 2015 remain open to examination. In addition, the Company files tax returns in multiple foreign taxing jurisdictions with open tax years ranging from 2010 to 2015.

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 months ended March 31, 2016 and 2015, the Company did not recognize any significant interest or penalties related to uncertain tax positions, nor had any been accrued for as of March 31, 2016 and December 31, 2015.
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.

18


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 March 31, 2016, 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.
The Notes consist of the following (in thousands):
 
March 31, 2016
 
December 31, 2015
Liability component:
 
 
 
Principal
345,000

 
345,000

Less: debt discount, net of amortization and reclassification of debt issuance costs
(60,705
)
 
(63,373
)
Net carrying amount
284,295

 
281,627

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 March 31,
 
2016
 
2015
1.25% coupon
$
1,078

 
$
1,078

Amortization of debt issuance costs
179

 
134

Amortization of debt discount
2,488

 
2,368

 
$
3,745

 
$
3,580


19


As of March 31, 2016 and December 31, 2015, 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):
 
March 31, 2016
 
December 31, 2015
 
Fair Value
 
Carrying
Value
 
Fair Value
 
Carrying
Value
Convertible Senior Notes
$
312,570

 
$
284,295

 
$
307,481

 
$
281,627

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 $33.36 on March 31, 2016, 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 March 31, 2016 (in thousands):
Years Ending December 31,
Purchase Commitments
2016 (remaining nine months)
$
41,517

2017

2018

2019

2020

Thereafter

Total minimum payments
$
41,517

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

20


Legal Matters
In May 2005, the Company entered into a license agreement with F. Hoffmann-La Roche Ltd. and Roche Molecular Systems, Inc. (“Roche”) that provided the Company 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 was 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. On April 22, 2016, the arbitration panel transmitted a partial award holding that the Company was liable for damages for the manufacture and sale of certain accused products starting after the Company terminated the license until September 2015, with the final amount to be determined by audit. The partial award also denied Roche’s requests for an injunction, and allocated certain legal fees and costs between the parties.
Based on its ongoing evaluation of the facts and circumstances of the case, including the partial award, 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 as of December 31, 2014, which amount was included in accrued and other liabilities in the Company’s consolidated balance sheets. Taking into account the partial award, this continues to be the Company's best estimate for this potential loss as of March 31, 2016. Depending on the final ruling of the arbitrators, it is possible that the Company could also be responsible for certain fees, costs and/or interest, if any; however, the Company is unable at this time to determine the likelihood of whether these potential outcomes will occur or estimate their respective potential amounts.
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 the 723 Patent in the United States Patent and Trademark Office (the “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 various additional claims, complaints and legal actions that arise from time to time in the normal course of business. Other than as described above, the Company does not believe it is party to any currently pending legal proceedings that will result in a material adverse effect on its business. There can be no assurance that existing or future legal proceedings arising in the ordinary course of business or otherwise will not have a material adverse effect on the Company’s business, consolidated financial position, results of operations or cash flows.


21


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 months ended March 31, 2016 and 2015 (in thousands):
 
Three Months Ended 
 March 31,
 
2016
 
2015
Cost of sales
$
1,515

 
$
1,040

Research and development
2,278

 
2,198

Sales and marketing
1,929

 
1,450

General and administrative
3,316

 
2,869

Total stock-based compensation expense
$
9,038

 
$
7,557

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, 2015
5,442

 
$
39.46

 
 
 
 
Granted
308

 
$
32.27

 
 
 
 
Exercised
(76
)
 
$
9.33

 
 
 
 
Forfeited
(54
)
 
$
42.41

 
 
 
 
Outstanding, March 31, 2016
5,620

 
$
39.45

 
4.05
 
$
13,888

Exercisable, March 31, 2016
3,249

 
$
33.40

 
2.86
 
$
13,223

Vested and expected to vest, March 31, 2016
5,452

 
$
39.22

 
3.99
 
$
13,810

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, 2015
1,000

 
$
48.44

Granted
101

 
32.89

Vested
(55
)
 
43.46

Cancelled
(24
)
 
46.72

Outstanding, March 31, 2016
1,022

 
$
47.21



22


The following table summarizes the assumptions used in determining the fair value of the Company’s stock options granted to employees and directors and shares purchased by employees under the Company’s 2012 Employee Stock Purchase Plan (“ESPP”): 
 
Three Months Ended 
 March 31,
 
2016
 
2015
OPTION SHARES:
 
 
 
Expected Term (in years)
4.33

 
4.40

Volatility
.36

 
.38

Expected Dividends

 

Risk Free Interest Rates
1.39
%
 
1.39
%
Estimated Forfeitures
6.14
%
 
6.75
%
Weighted Average Fair Value Per Share
$
10.13

 
$
18.55

ESPP SHARES:
 
 
 
Expected Term (in years)
1.23

 
1.22

Volatility
.49

 
.32

Expected Dividends

 

Risk Free Interest Rates
0.59
%
 
0.26
%
Weighted Average Fair Value Per Share
$
9.87

 
$
16.43

10. Segment and Significant Concentrations
The Company and its wholly owned subsidiaries operate in one business segment.
The following table summarizes total revenue by type (in thousands): 
 
Three Months Ended March 31,
 
2016
 
2015
Revenue:
 
 
 
System and other revenue
$
24,284

 
$
18,714

Reagent and disposable revenue
120,496

 
113,923

Total revenue
$
144,780

 
$
132,637

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 months ended March 31, 2016 and 2015.
The following table summarizes revenue by geographic region (in thousands):
 
Three Months Ended March 31,
 
2016
 
2015
Geographic revenue information:
 
 
 
North America
$
82,390

 
$
82,305

International
62,390

 
50,332

Total revenue
$
144,780

 
$
132,637

The Company recognized revenue of $79.7 million and $77.0 million for sales to United States customers for the three months ended March 31, 2016 and 2015, respectively.
No single country outside of the United States represented more than 10% of the Company’s total revenue for the three months ended March 31, 2016 and 2015.

23


The following table summarizes long-lived assets, excluding intangible assets and goodwill, by geographic region (in millions):
 
March 31, 2016
 
December 31, 2015
United States
$
125,102

 
$
108,210

Other regions
18,867

 
19,429

Total long-lived assets
$
143,969

 
$
127,639

The Company does not hold a significant amount of long-lived assets in any single country outside of the United States as of March 31, 2016 and December 31, 2015.


24


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, as amended and Section 21E of the Securities Exchange Act of 1934, as amended 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; 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; sales organization productivity and the productivity and effectiveness of our distributors; speed and extent of test menu expansion and utilization; improving gross margins; execution of manufacturing operations; 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, including our new point-of-care system; manufacturing costs associated with the ramp-up of new products; test performance in the field; testing volumes for our products; unforeseen supply, development and manufacturing problems; 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; 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 the United States Food and Drug Administration (“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 (“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; the impact of foreign currency exchange; protection of our intellectual property and proprietary information; 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. Our systems enable fast, 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. We intend to do this, in part, by extending the reach of our platform deeper into the hospital and reference laboratory markets as well as expanding into the point-of-care market and new geographic markets, and, in part, by extending the breadth of our platform by developing new tests for our systems, such as oncology. 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 fast 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;

25


no further user intervention once the Xpert cartridge is loaded into the GeneXpert system;
all three phases of PCR: 1) sample preparation, 2) amplification and 3) detection, are performed within the single sealed test cartridge automatically;
primarily moderate complexity Clinical Laboratory Improvement Amendments ("CLIA") categorized, amplified molecular tests, which means the GeneXpert system can be operated without the need for highly-trained laboratory technologists. Additionally, we are entering the CLIA-waived market, which will enable certain of our tests to be run in point-of-care environments. For example, in December 2015, the FDA granted CLIA waiver for our Xpert Flu+RSV Xpress test for use on our GeneXpert System. The Xpert Flu+RSV Xpress is the first PCR panel test to achieve CLIA waiver, and the first in a series of reference-quality molecular tests that we intend to deliver to the point-of-care market over the next several years;
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 specificity; and
full random access whereby different tests for different targets may be run simultaneously in different modules in the same GeneXpert system, which increases potential utilization and throughput of the system and also enables on-demand or “STAT” testing, whereby the user can add a new test to the system at any time without regard to the stage of processing of any other test on the system.
Continue to develop and market new tests. We plan to capitalize on our strengths in nucleic acid chemistry and molecular biology to continue to develop new tests for our systems and offer our customers the broadest menu of Xpert tests designed to address many of the highest volume molecular test opportunities. Our strategy is to offer a portfolio of Xpert tests spanning healthcare-associated infections, critical infectious disease, sexual health, virology, oncology and genetics. For example, Xpert HPV, Xpert Carba-R, Xpert Norovirus, Xpert Flu/RSV XC, and Xpert Trichomonas were all made commercially available in all markets that recognize the CE Mark during 2014 and Xpert HIV-1 Viral Load achieved CE Mark in December 2014. In 2015, Xpert Trichomonas received FDA clearance, our Xpert Flu+RSV Xpress received a CLIA waiver from the FDA, and Xpert Ebola received Emergency Use Authorization from the FDA and was listed as eligible for procurement to Ebola-affected countries by the World Health Organization. Our Xpert Ebola test, Xpert HIV-1 Qualitative, Xpert HCV Viral Load, and Xpert BCR-ABL Ultra also achieved CE Mark during 2015. Additionally, in February 2015, we received clearance from the FDA for expanded claims on our Xpert MTB/RIF test and in March 2016, we received clearance from the FDA to market our Xpert Carba-R test for use with bacterial isolates. Our cumulative menu now stands at 23 tests that have achieved CE mark available internationally and 20 tests FDA cleared in the United States.
Market segment expansion. We plan to further extend the reach of our GeneXpert system and menu of Xpert tests to additional markets in 2016 and beyond. Following the clearance of our first CLIA-waived test for Flu+RSV at the end of 2015 and the announcement of our non-exclusive distribution agreements with Henry Schein in January 2016 and Medline and McKesson in April 2016, our GeneXpert System and menu of moderately complex Xpert tests, including the CLIA-waived test for Flu+RSV, is now increasingly available to the non-acute laboratory market, including moderately complex physician-office laboratories, women's health facilities, large multi-specialty clinics, urgent care facilities, and reference laboratories. Additionally, Henry Schein, Medline, and McKesson will distribute our CLIA-waived products for the GeneXpert Omni, which is expected to launch outside the United States in late 2017, and which we expect to further expand our presence in the point-of-care market in the years following launch.
Extend geographic reach. Our European sales and marketing operations are headquartered in France. As of March 31, 2016, we had direct sales forces in Australia, the Benelux region, France, Germany, Hong Kong, Italy, South Africa and the United Kingdom, and we have offices in Brazil, China, India, Japan and the United Arab Emirates. We expect to continue to expand our international commercial operations capability on both a direct and distributor basis in 2016 and future years.
Extend High Burden Developing Countries sales programs. We expect to continue to expand our presence in HBDCs to deliver GeneXpert systems and Xpert tests, including virology and Ebola, to HBDCs at a discount to our standard commercial prices. We believe that participation in the HBDC program considerably broadens the geographic reach of our products and increases recognition of the Cepheid brand and product portfolio.

26


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 critical infectious disease and oncology targets. In addition, we expect to focus key business development activities on identifying critical infectious disease and oncology targets held by academic institutions or commercial organizations for potential license or acquisition.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS
The items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operation in our 2015 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 2015 Annual Report on Form 10-K.
Recent Accounting Pronouncements
Refer to Note 1, “Organization and Summary of Significant Accounting Policies – Recent Accounting Pronouncements” for a discussion of new and recently adopted accounting guidance.
Results of Operations
Comparison of the Three Months Ended March 31, 2016 and 2015
Revenue
The following table summarizes total revenue by type (in thousands, except percentages): 
 
Three Months Ended March 31,
 
2016
 
2015
 
$ Change
 
% Change
Revenue:
 
 
 
 
 
 
 
System and other revenue
$
24,284

 
$
18,714

 
$
5,570

 
30
%
Reagent and disposable revenue
120,496

 
113,923

 
6,573

 
6
%
Total revenue
$
144,780

 
$
132,637

 
$
12,143

 
9
%
System and other revenue increased $5.6 million, or 30%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily driven by higher system sales to HBDC customers, including a large system order to India. Reagent and disposable revenue increased $6.6 million, or 6%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to a large reagent order to India, our growing installed base of GeneXpert instruments and our expanding menu of Xpert tests, partially offset by a decrease in sales of anthrax test cartridges under our USPS BDS program.
Our sales may be subject to seasonal fluctuations driven primarily by the timing and severity of seasonal illnesses such as influenza, respiratory syncytial virus, enteroviruses, and norovirus, which are most prevalent in the first and fourth calendar quarters of the year.
We expect our revenue to continue to increase in 2016 with the growth of our installed base of GeneXpert systems, the continued expansion of our test menu, and the adoption of additional tests within our customer base.

27


The following table provides a breakdown of our revenue by geographic regions (in thousands, expect percentages):
 
Three Months Ended March 31,
 
2016
 
2015
 
$ Change
 
% Change
Geographic revenue information:
 
 
 
 
 
 
 
North America
$
82,390

 
$
82,305

 
$
85

 
0
%
International
62,390

 
50,332

 
12,058

 
24
%
Total revenue
$
144,780

 
$
132,637

 
$
12,143

 
9
%
North American revenue increased $0.1 million for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily driven by higher sales of Xpert tests, partially offset by a decrease in sales of anthrax test cartridges under our USPS BDS program. International revenue increased $12.1 million, or 24%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily driven by higher sales of clinical systems and reagents to our HBDC customers, including a large system and reagent order to India, as well as higher sales from clinical reagents to commercial customers.
The recent strengthening of the United States dollar has impacted the relative value of sales transactions that are denominated in foreign currencies. We use foreign currency exchange forward contracts to hedge a portion of our forecasted revenue. We estimate that the foreign currency movements relative to the United States dollar negatively impacted net revenue during the three months ended March 31, 2016 by approximately $4.7 million, inclusive of net hedge benefits of approximately $2.2 million, which were recorded as revenue in the same period in the prior year.
Costs and Operating Expenses
The following table illustrates the changes in operating expenses (in thousands, except percentages):
 
Three Months Ended March 31,
 
2016
 
2015
 
$ Change
 
% Change
Costs and operating expenses:
 
 
 
 
 
 
 
Cost of sales
$
72,595

 
$
61,201

 
$
11,394

 
19
 %
Collaboration profit sharing
658

 
1,267

 
(609
)
 
(48
)%
Research and development
29,914

 
23,986

 
5,928

 
25
 %
Sales and marketing
28,795

 
25,936

 
2,859

 
11
 %
General and administrative
15,055

 
15,642

 
(587
)
 
(4
)%
Total costs and operating expenses
$
147,017

 
$
128,032

 
$
18,985

 
15
 %
Cost of Sales
Cost of sales consists of raw materials, direct labor and stock-based compensation expense, manufacturing overhead, facility costs and warranty costs. Cost of sales also includes product royalties, amortization of intangible assets related to technology licenses, and intangible assets acquired in business combinations.
Cost of sales increased $11.4 million, or 19%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily attributable to increased shipments of our clinical reagent products and increased system shipments.
Our gross margin percentage was 50% and 54% for the three months ended March 31, 2016 and 2015, respectively. The decrease for the three months ended March 31, 2016 was primarily attributable to the product mix and the increase in revenue derived from our HBDC customers, which included a large system and reagent order to India, and was also negatively impacted by changes in foreign currency rates.
We currently expect that our gross margin, as a percentage of revenue, will remain comparable to the gross margin for the three months ended March 31, 2016, during the remainder of 2016 primarily driven by manufacturing cost improvements and the suspension of the medical device excise tax, offset by a shift in customer mix. If sales to our HBDC customers are higher than anticipated, gross margin percentage may be negatively impacted.

28


Collaboration Profit Sharing
Collaboration profit sharing represents the amount that we pay to Life Technologies Corporation (acquired by Thermo Fisher Scientific) under our collaboration agreement to develop and manufacture reagents for use in the USPS BDS program. Under the agreement, computed gross margin on anthrax cartridge sales are shared equally between the two parties. Collaboration profit sharing expenses decreased $0.6 million, or 48%, for the three months ended March 31, 2016 as compared to the same period in the prior year primarily driven by lower anthrax cartridge sales under the USPS BDS program. We currently expect our 2016 collaboration profit sharing expenses to be comparable to 2015.
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, depreciation, amortization of certain intangible assets, license fees, and milestone payments related to in-licensed products if it is determined that they have no alternative future use.
Research and development expenses increased $5.9 million, or 25%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to increased headcount and an increase in engineering costs related primarily to our high-level multiplexing initiative and the development of our GeneXpert Omni for the point-of-care market.
We currently expect our research and development expenses, as a percentage of revenue, for the remainder of 2016 to be comparable to or slightly down from 2015. On a dollar basis, we expect research and development expenses to continue to increase for the remainder of 2016 compared to 2015 driven primarily by a significant increase in our clinical trial costs and engineering costs related to our high-level multiplexing initiative and the development of our GeneXpert Omni for the point-of-care market.
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 $2.9 million, or 11%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to increased headcount, increased travel, and the expansion of our sales force, and sales and marketing program costs.
We currently expect our sales and marketing expenses, as a percentage of revenue, for the remainder of 2016 to be comparable to 2015.
General and Administrative Expenses
General and administrative expenses consist primarily of salaries and employee-related expenses, which include stock-based compensation, travel, facility costs, and legal, accounting and other professional fees. General and administrative expenses decreased $0.6 million, or 4%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to lower legal and consulting fees, which were partially offset by an increase in headcount and increased stock-based compensation expense.
We currently expect our general and administrative expenses to decrease modestly as a percentage of revenue for the remainder of 2016 as compared to 2015.
Other Income (Expense)
The following table illustrates the changes in our other income (expense), net (in thousands, except percentages): 
 
Three Months Ended March 31,
 
2016
 
2015
 
$ Change
 
% Change
Other income (expense)
 
 
 
 
 
 
 
Interest income
$
660

 
$
373

 
$
287

 
77
 %
Interest expense
(3,765
)
 
(3,603
)
 
(162
)
 
4
 %
Foreign currency exchange loss and other, net
(528
)
 
(945
)
 
417

 
(44
)%
Total other expense, net
$
(3,633
)
 
$
(4,175
)
 
$
542

 
(13
)%

29


Other income (expense) primarily consists of interest income earned from our cash, cash equivalents, and investment balances, interest expense related to senior convertible notes, loans, or notes payable balances outstanding during the period and the net effect of foreign currency exchange transactions, including the net effect of non-qualifying derivative activities. Interest income increased by $0.3 million, or 77%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to an increase in yields derived from our investment portfolio. Interest expense increased $0.2 million, or 4%, for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to increased accretion of the convertible note discount into interest expense from the issuance of senior convertible notes in February 2014. Foreign currency exchange loss and other, net decreased by $0.4 million, or 44% for the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to the strengthening of the Euro, South African Rand and Australian dollar against the United States dollar, partially offset by the strengthening of the United States dollar against the British pound.
LIQUIDITY AND CAPITAL RESOURCES
Cash and Cash Flow
 
Three Months Ended March 31,
 
2016
 
2015
 
Change
 
(In thousands)
Net cash provided by (used in) operating activities
$
(9,113
)
 
$
738

 
$
(9,851
)
Net cash used in investing activities
(17,959
)
 
(36
)
 
(17,923
)
Net cash provided by financing activities
4,208

 
13,818

 
(9,610
)
Cash Flows from Operating Activities
Our largest source of operating cash flows is cash collections from customers and our primary cash outflows are purchases of inventory and personnel-related expenses. Net cash provided by operating activities during the first three months of 2016 decreased $9.9 million compared with the first three months of 2015, primarily due to the following:
a net loss of $6.6 million during the first three months of 2016 compared with net income of $0.9 million during the first three months of 2015;
a $6.9 million unfavorable impact related to our accounts payable and other current and non-current liabilities balance during the first three months of 2016 compared with the first three months of 2015, primarily driven by timing of payments; and
a $5.2 million unfavorable impact related to the rate of increase in our prepaid expenses and other current assets balance during the first three months of 2016 compared with the first three months of 2015, primarily driven by volume and timing of pre-payments and timing of payments of other receivables; partially offset by
a reduction of the rate of increase of the net inventory balance, which contributed to a net $6.5 million favorable change in our operating cash flow, primarily due to reduced volume and timing of purchases.
We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations, including our growth initiatives, for the next 12 months and beyond.
Cash Flows from Investing Activities
Our cash flows from investing activities are primarily for capital expenditures and purchases of marketable securities and investments, while cash inflows are primarily proceeds from sales and maturities of marketable securities and investments and proceeds from the sale of equipment and intangible assets. Net cash used in investing activities during the first three months of 2016 increased $17.9 million compared with the first three months of 2015, primarily due to increased capital expenditures and an increase in restricted cash.
Cash Flows from Financing Activities
Net cash provided by financing activities during the first three months of 2016 decreased $9.6 million compared with the first three months of 2015, primarily due to a decrease in net proceeds from issuance of common stock and exercise of stock options of $9.6 million during the first three months of 2016.

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Off-Balance-Sheet Arrangements
As of March 31, 2016, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated under the Securities Act of 1933, as amended.
Financial Condition Outlook
We plan to continue to make expenditures to expand our manufacturing capacity and to support our activities in sales and marketing and research and development. These expenditures may vary from quarter to quarter, as evidenced by our increased operating expenses for the three months ended March 31, 2016. We plan to continue to support our working capital needs and anticipate that our existing cash resources will enable us to maintain currently planned operations. Based on past performance and current expectations, we believe that our current available sources of funds will be adequate to finance our operations for at least the next year. This expectation is based on our current and long-term operating plan and may change as a result of many factors, including our future capital requirements and our ability to increase revenues and reduce expenses, which depend on a number of factors outside our control, including general global economic conditions. For example, our future cash use will depend on, among other things, market acceptance of our new products, manufacturing costs associated with the ramp-up of new products, the resources we devote to developing and supporting our products, the expansion of our U.S. sales organization, continued progress of our research and development of potential products, our ability to gain FDA clearance for our new products, the need to acquire licenses to new technology or to use our technology in new markets, expansion through acquisitions and the availability of other financing.
In the future, we may seek additional funds to support our strategic business needs and may seek to raise such additional funds through private or public sales of securities, strategic relationships, bank debt, lease financing arrangements, or other available means. If additional funds are raised through the issuance of equity or equity-related securities, shareholders may experience additional dilution, or such equity securities may have rights, preferences, or privileges senior to those of the holders of our common stock. If adequate funds are not available or are not available on acceptable terms to meet our business needs, our business may be harmed.
ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Interest Rate Sensitivity
Our investment portfolio is exposed to market risk from changes in interest rates. The fair market value of fixed rate securities may be adversely impacted by fluctuations in interest rates while income earned on floating rate securities may decline as a result of decreases in interest rates. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We attempt to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in investment grade securities. We have historically maintained a relatively short average maturity for our investment portfolio, and we believe a hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would change the fair value of our interest sensitive financial instruments by approximately $1.4 million as of March 31, 2016. In addition, if a 100 basis point change in overall interest rates were to occur in 2016, our interest income would not change significantly in relation to amounts we would expect to earn, based on our cash, cash equivalents, and investments as of March 31, 2016.
Changes in interest rates may also impact gains or losses from the conversion of our outstanding convertible senior notes. In February 2014, we issued $345.0 million in aggregate principal amount of our 1.25% convertible senior notes due 2021. At our election, the notes are convertible into cash, shares of our common stock, or a combination of cash and shares of our common stock in each case under certain circumstances, including trading price conditions related to our common stock. If the trading price of our common stock reaches a price for a sustained period at 130% above the conversion price of $65.10, the notes will become convertible. Upon conversion, we are required to record a gain or loss for the difference between the fair value of the debt to be extinguished and its corresponding net carrying value. The fair value of the debt to be extinguished depends on our then-current incremental borrowing rate. If our incremental borrowing rate at the time of conversion is higher or lower than the implied interest rate of the notes, we will record a gain or loss in our consolidated statement of operations during the period in which the notes are converted. The implicit interest rate for the notes is 5.0%. An incremental borrowing rate that is a hypothetical 100 basis points lower than the implicit interest rate upon conversion of $100 million aggregate principal amount of the notes would result in a loss of approximately $4.9 million.

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Foreign Currency Risk
We operate primarily in the United States and a majority of our revenue, cost, expense and capital purchasing activities for the three months ended March 31, 2016 were transacted in United States dollars. As a corporation with international and domestic operations, we are exposed to changes in foreign exchange rates. Our international revenue is predominantly in European countries and South Africa and is denominated in a number of currencies, primarily the Euro, United States dollar, British Pound, South African Rand, and Australian dollar. In our international operations, we pay payroll and other expenses in local currencies. Our exposures to foreign currency risks may change over time and could have a material adverse impact on our financial results.
We expect to continue to hedge our foreign currency exposure in the future and may use currency forward contracts, currency options, and/or other common derivative financial instruments to reduce foreign currency risk. We performed a sensitivity analysis as of March 31, 2016 based on a model that measures the impact of a hypothetical 10% adverse change in foreign exchange rates to the United States dollar (with all other variables held constant) on our underlying estimated major foreign currency exposures, net of derivative financial instruments. The foreign exchange rates used in the model were based on the spot rates in effect as of March 31, 2016. The sensitivity analysis indicated that a hypothetical 10% adverse movement in foreign exchange rates would have an unfavorable impact on the underlying cash flow exposure, net of our foreign exchange derivative financial instruments, of $2.7 million as of March 31, 2016.
ITEM 4.    CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2016, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
During the quarter ended March 31, 2016, there were no changes in internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION
 
ITEM 1.    LEGAL PROCEEDINGS
In May 2005, we entered into a license agreement with F. Hoffmann-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, we terminated our license to United States Patent No. 5,804,375 (the “375 Patent”) and ceased paying United States-related royalties. We terminated the entire license agreement in the fourth quarter of 2011. In August 2011, Roche initiated an arbitration proceeding against us in the International Chamber of Commerce pursuant to the terms of the terminated agreement. We filed an answer challenging arbitral jurisdiction over the issues submitted by Roche and denying that we violated any provision of the agreement. A three-member panel was 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 we 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. On April 22, 2016, the arbitration panel transmitted a partial award holding that we were liable for damages for the manufacture and sale of certain accused products starting after we terminated the license until September 2015, with the final amount to be determined by audit. The partial award also denied Roche’s requests for an injunction, and allocated certain legal fees and costs between the parties.
Based on our ongoing evaluation of the facts and circumstances of the case, including the partial award, we believe that it is probable that this arbitration proceeding could result in a material loss. Accordingly, we recorded an estimated charge of $20 million as our best estimate of the potential loss as of December 31, 2014, which amount was included in accrued and other liabilities in our consolidated balance sheets. Taking into account the partial award, this continues to be our best estimate for this potential loss as of March 31, 2016. Depending on the final ruling of the arbitrators, it is possible that we could also be responsible for certain fees, costs and/or interest, if any; however, we are unable at this time to determine the likelihood of whether these potential outcomes will occur or estimate their respective potential amounts.
On August 21, 2012, we 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 our suit with respect to the 155 Patent for lack of subject matter jurisdiction, without considering or ruling on the merits of our case. The Court left open the possibility that we could re-file our case against the 155 Patent in the future. We believe that the possibility that these legal proceedings will result in a material adverse effect on our business is remote.
On July 16, 2014, Roche filed a lawsuit in the Court, alleging that our 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, we filed our 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, we filed a petition for inter partes review (“IPR”) of the 723 Patent in the USPTO and we 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, we 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, we 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 our second petition for IPR. We believe that the possibility that these legal proceedings will result in a material loss is remote.
We may be subject to various additional claims, complaints and legal actions that arise from time to time in the normal course of business. Other than as described above, we do not believe we are party to any currently pending legal proceedings that will result in a material adverse effect on our business. There can be no assurance that existing or future legal proceedings arising in the ordinary course of business or otherwise will not have a material adverse effect on our business, consolidated financial position, results of operations or cash flows.

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ITEM 1A.    RISK FACTORS
You should carefully consider the risks and uncertainties described below, together with all of the other information included in this Report, in considering our business and prospects. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. The occurrence of any of the following risks could harm our business, financial condition or results of operations.

We have a history of operating losses and may not achieve profitability again.
We incurred operating losses in each annual fiscal year since our inception, except for 2011. For the three months ended March 31, 2016, we had a net loss of $6.6 million, and in 2015 and 2014 we experienced a net loss of $48.5 million and $50.1 million, respectively. As of March 31, 2016, we had an accumulated deficit of approximately $348.8 million. We do not expect to be profitable for fiscal 2016 and our ability to be profitable in the future will depend on our ability to continue to increase our revenue, which is subject to a number of factors including our ability to continue to successfully penetrate the Clinical market, our ability to successfully market the GeneXpert system and develop and market additional Xpert tests, our ability to successfully expand our United States sales organization and international commercial operations and the success of our sales organization in selling our systems and tests, the timing and success of market entry to the point-of-care market and the introduction of the GeneXpert Omni, the acceptance and success of our Xpert tests in the point-of-care market upon launch, the success of our distributor relationships, particularly in expanding our offerings into non-acute care laboratory customers, including moderately complex physician office labs, our ability to secure regulatory approval of additional Xpert tests, our ability to gain FDA regulatory and international regulatory clearance for our new products, our ability to continue to grow sales of Xpert tests, our ability to compete effectively against current and future competitors, the increasing number of competitors in our market that could reduce the average selling price of our products, the continued development of our HBDC program, the amount of products sold through the HBDC program and the extent of global funding for such program, our ability to penetrate new geographic markets, global economic and political conditions and our ability to increase manufacturing throughput. Our ability to be profitable also depends on our expense levels and product gross margin, which are also influenced by a number of factors, including: the mix of revenue from Clinical reagent sales and GeneXpert system sales as opposed to GeneXpert Infinity system sales and sales under our HBDC program, both of which have lower gross margins; the resources we devote to developing and supporting our products; increases in manufacturing costs associated with our operations, including those associated with ramp-up of new products; increases in costs related to our distributor relationships; our ability to improve manufacturing efficiencies; our ability to manage our inventory levels; third-party freight costs; the resources we devote to our research and development of, and compliance with regulatory processes for, potential products; license fees or royalties we may be required to pay; the potential need to acquire licenses to new technology or to use our technology in new markets, which could require us to pay unanticipated license fees and royalties in connection with these licenses; the impact of foreign currency exchange rates; and the prices at which we are able to sell our GeneXpert systems and Xpert tests. Our manufacturing expansion efforts may prove more expensive than we currently anticipate, and we may not succeed in increasing our revenue to offset higher expenses. These expenses or a reduction in the prices at which we are able to sell our products, among other things, may cause our net income and working capital to decrease. For example, our gross margin for the third quarter of 2015 was lower than expected due primarily to a higher proportion of lower-margin HBDC business and less commercial business as well as higher than expected manufacturing expenses associated with the ramp-up to volume of our newest virology tests. If we fail to grow our revenue, manage our expenses and improve our gross margin, we may never achieve profitability again. If we fail to do so, the market price of our common stock will likely decline.

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Our operating results may fluctuate significantly, our customers’ future purchases are difficult to predict and any failure to meet financial expectations may result in a decline in our stock price.
Our quarterly operating results may fluctuate in the future as a result of many factors, such as those described elsewhere in this section, many of which are beyond our control. Because our revenue and operating results are difficult to predict, we believe that period-to-period comparisons of our results of operations are not a good indicator of our future performance. Our operating results may be affected by the inability of some of our customers to consummate anticipated purchases of our products, whether due to adverse economic conditions, changes in internal priorities or, in the case of governmental customers, problems with the appropriations process, concerns over future United States federal government budgetary negotiations, variability and timing of orders and delays in our customer billing, and the impact of foreign currency exchange rates. Additionally, we have experienced, and expect to continue to experience, meaningful variability in connection with our commercial system placements and system placements and reagent pull-through in our HBDC program. This variability may cause our revenue and operating results to fluctuate significantly from quarter to quarter. Additionally, because of the limited visibility into the actual timing of future system placements, our operating results are difficult to forecast from quarter to quarter. Additionally, we expect moderate fluctuations from quarter to quarter in gross margin depending on product, geography and channel mix, including the relative mix of instrument and test sales, as well as the revenue contribution from our HBDC program, which has a lower gross margin than our commercial sales. If revenue declines in a quarter, whether due to a delay in recognizing expected revenue, adverse economic conditions and unexpected costs or otherwise, our results of operations will be harmed because many of our expenses are relatively fixed. In particular, research and development, sales and marketing and general and administrative expenses are not significantly affected by variations in revenue. However, if we have an unexpected increase in costs and expenses in a quarter, our quarterly operating results will be affected. For example, for the year ended December 31, 2013, we incurred certain costs and inventory reserve provisions related to our manufacturing scale up and restructuring activities. Additionally, in July 2014, we began to self-insure for a portion of employee health insurance coverage and we estimate the liabilities associated with the risks retained by us, in part, by considering actuarial assumptions which, by their nature, are subject to a high degree of variability. If the number or severity of claims for which we are self-insured increases, or if we are required to accrue or pay additional amounts because the claims prove to be more severe than our original assessments, our operating results may be affected. Additionally, we had higher than expected operating expenses and lower than expected gross margin for the third quarter of 2015, which were primarily driven by a higher proportion of lower-margin HBDC business and less commercial business and higher than expected manufacturing costs associated with the ramp-up to volume of our newest virology tests. If our quarterly operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price could drop suddenly and significantly.
If we are unable to manufacture our products in sufficient quantities and in a timely manner, our operating results will be harmed, our ability to generate revenue could be diminished, and our gross margin may be negatively impacted.
Our revenue and other operating results will depend in large part on our ability to manufacture and assemble our products in sufficient quantities and in a timely manner. In the past, we have experienced lower than expected revenue due to intermittent interruptions in our supply chain, which also negatively impacted the efficiency of our manufacturing operations and our resulting gross margin. In addition, we may incur unexpected expenses in connection with the manufacturing scale-up of new products, which could negatively impact our gross margin. For example, in the third quarter of 2015, higher than expected manufacturing costs associated with new test ramp-up contributed to lower than expected gross margin.
We recently expanded our existing relationship with a contract manufacturer, which was previously responsible for the manufacture of a significant portion of our GeneXpert systems to now include the complete manufacturing, assembly, and testing of our GeneXpert systems. This outsourced manufacturing approach was fully in place as of the end of fiscal 2015. We create estimates in order to schedule production runs with this contract manufacturer. To the extent system orders materially vary from our estimates, we may experience constraints in our systems production and delivery capacity.
Any future interruptions we or our contract manufacturer experience in the manufacturing or shipping of our products in sufficient quantities and on a timely basis could delay our ability to recognize revenue and adversely affect our operating results in a particular quarter, could adversely affect our relationships with our customers, and could erode customer confidence in our product availability. Manufacturing problems can and do arise, as evidenced by our higher than expected manufacturing costs associated with new test ramp-up in the third quarter of 2015, and as demand for our products increases, any such problems could have an increasingly significant impact on our operating results. In the past, we have experienced problems and delays in production that have impacted our product yield and the efficiency of our manufacturing operations and caused delays in our ability to ship finished products, and we, or our contract manufacturer, may experience such delays in the future. We may not be able to react quickly enough to ship products and recognize anticipated revenue for a given period if we experience significant delays in the manufacturing process. In addition, we must maintain sufficient production capacity and inventory in order to minimize such delays, which carry fixed costs that we may not be able to offset if orders slow, which would adversely affect our operating margins.

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We have a limited number of suppliers for critical product components, and a contract manufacturer for the manufacture and assembly of our systems, and our reliance on such suppliers and contract manufacturer exposes us to increased risks associated with quality control, production delays and costs.
We depend on a limited number of suppliers for some of the components used in the manufacture of our systems and our disposable reaction tubes and cartridges. We also depend on a single contract manufacturer for the manufacture and final assembly of the entire line of our GeneXpert systems. Strategic purchases of components are necessary for our business, but our reliance on a limited number of suppliers and a single contract manufacturer could expose us to reduced control over product quality and product availability, which could lead to product reliability issues and/or lower revenue and product shortages as a result of manufacturing capacity issues at our contract suppliers or manufacturer, or failure to adequately forecast demand for our components or systems. In addition, we cannot be certain that our suppliers or contract manufacturer will continue to be willing and able to meet our requirements according to existing terms or at all. If alternative suppliers or contract manufacturers are not immediately available, we will have to identify and qualify alternative suppliers or contract manufacturers and we could experience production delays and additional costs. We may not be able to find adequate alternative suppliers or contract manufacturers in a reasonable time period or on commercially acceptable terms, if at all. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. For example, in the past, we have experienced intermittent interruptions in the supply of Xpert cartridge parts, which negatively impacted our product sales. In addition, some companies continue to experience financial difficulties, partially resulting from continued economic uncertainty. We cannot be assured that our suppliers or contract manufacturer will not be adversely affected by this uncertainty or that they will be able to continue to provide us with the components we need or to manufacture and assemble our systems. If we are unable to obtain the key source supplies for the manufacture of our products or we experience interruptions in the manufacture and assembly of our systems, product shipments may be delayed, which could harm customer relationships and our distributor relationships or force us to curtail operations or temporarily cease production of our products.
If our direct selling efforts for our products fail, our business expansion plans could suffer and our ability to generate sales will be diminished.
In late 2014, we consolidated our global commercial operations under a single executive, our Executive Vice President, Worldwide Commercial Operations, to emphasize end-to-end accountability, eliminate duplication and clarify decision responsibilities, and reduce organizational complexity. In addition to the re-alignment of our organizational structure, over the past 18 months, we have substantially expanded our United States sales force and redesigned our sales territories. Further, if such expansion efforts are not successful, it could be disruptive to our sales and our ability to generate revenue will be negatively impacted.
Additionally, in 2014 and 2015, we significantly restructured our marketing organization. We appointed the head of our marketing organization in mid-2014 and hired several new leaders in specific market segments during 2015. As a result, our marketing team has only worked together for a short period of time.
If we are unable to successfully scale our sales operations, successfully manage the increase in sales force and the related territory realignment or our marketing organization is unable to support our sales, our ability to expand our business and grow sales could be harmed and our expenses could increase. If the size of our sales force, recent changes to the organization of our sales force and marketing team or other issues cause our direct selling efforts to fail, our business expansion plans could suffer and our ability to generate sales could be diminished, which would harm our business.
Our sales cycle can be lengthy, which can cause variability and unpredictability in our operating results.
The sales cycles for our systems can be lengthy, particularly during times of uncertain economic and political conditions, which makes it more difficult for us to accurately forecast revenue in a given period, and may cause revenue and operating results to vary significantly from period to period. For example, sales of our products often involve purchasing decisions by large public and private institutions where any purchases can require many levels of approval. Additionally, participants in our HBDC program may be dependent on funding from governmental agencies and/or non-governmental organizations; as a result, such customers’ purchase decisions may not be within their direct control and may be subject to lengthy administrative processes. Accordingly, the sales cycle in our HBDC program is lengthy and unpredictable. As a result, we may expend considerable resources on unsuccessful sales efforts or we may not be able to complete transactions on the schedule anticipated.

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If we cannot successfully commercialize our products, our business could be harmed.
If our tests for use on our systems do not continue to gain market acceptance or the launch of our GeneXpert Omni, our new point-of-care diagnostic platform, is not successful, we will be unable to generate significant sales growth, which may prevent us from achieving profitability. While we have received FDA clearance for a number of tests, these products may not experience increased sales. Many factors may affect the market acceptance and commercial success of our products, including:
our ability to fulfill orders;
the results of clinical trials needed to support any regulatory approvals of our tests;
our ability to obtain requisite FDA or other regulatory clearances or approvals for tests under development;
the timing of market entry for various tests for the GeneXpert systems and our new point-of-care diagnostic platform;
our ability to convince our potential customers of the advantages and economic value of our systems and tests over competing technologies and products;
the breadth of our test menu relative to competitors;
changes to policies, procedures or what are considered best practices in clinical diagnostics, including practices for detecting and preventing healthcare-associated infections;
the extent and success of our marketing and sales efforts;
the effectiveness of our distribution agreements, particularly in expanding our offerings into non-acute care laboratory customers, including moderately complex physician office labs;
the functionality of new products that address market requirements and customer demands;
the pricing of our products;
the level of reimbursement for our products by third-party payers; and
the publicity concerning our systems and tests.
In particular, we believe that the success of our business will depend in large part on our ability to continue to increase sales of our Xpert tests and our ability to successfully introduce additional tests for the Clinical market, including oncology tests, which is a key part of our strategy, and the successful launch of GeneXpert Omni, our new point-of-care diagnostic platform. For example, in April 2016, we announced a delay in the timing of the market launch of our GeneXpert Omni and any further delay could impact our ability to capitalize on this market opportunity. We believe that successfully expanding our business in the Clinical market is critical to our long-term goals and success. We have limited ability to forecast future demand for our products in this market.

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The regulatory processes applicable to our products and operations are expensive, time-consuming and uncertain, and may prevent us from obtaining required approvals for the commercialization of some of our products.
In the Clinical market, our products are regulated as medical device products by the FDA and comparable agencies of other countries, for example, the Pharmaceuticals and Medical Devices Agency ("PMDA") of Japan and the China Food and Drug Administration ("CFDA"). In particular, FDA regulations govern activities such as product development, product testing, product labeling, product storage, premarket clearance or approval, manufacturing, advertising, promotion, product sales, reporting of certain product failures and distribution. Some of our products, depending on their intended use, will require premarket approval from the FDA prior to marketing. In general, there are two types of FDA review processes applicable to our products: a premarket approval (“PMA”) and a 510(k) clearance. The PMA review process is much more costly, lengthy and uncertain, and generally takes from six months to one year or longer to complete after a submission. In some cases, the FDA may convene an expert advisory panel to independently review a submission and make a recommendation to approve or deny the submission. The 510(k) review process usually takes approximately three months after a submission, although the review process can sometimes take longer, particularly for novel or first-in-class products. Clinical studies are required to support both PMA and 510(k) submissions in the United States. Similar studies are required in other countries to support regulatory submissions, including for example, submissions to the PMDA in Japan and to the CFDA in China. Certain of our products for use on our GeneXpert and SmartCycler systems, when used for clinical purposes in the United States, may require PMA, and all such tests will most likely, at a minimum, require 510(k) clearance. Products intended for use in point-of-care settings, such as those intended to be used outside of the typical hospital laboratory environment (e.g., a physician office laboratory), require supplemental human factors clinical studies and an additional regulatory submission known as a CLIA waiver application. For example, we are seeking a CLIA waiver for GeneXpert II and IV. CLIA waiver applications may be submitted concurrently with a PMA or 510(k), or sequentially after a PMA or 510(k) review has been completed. Concurrent review of a CLIA waiver application with a PMA or 510(k) takes approximately 210 days from submission. Sequential review of a CLIA waiver application after a PMA approval or 510(k) clearance takes approximately 180 days from submission. Clinical trials are expensive and time-consuming, as are human factors studies required for a CLIA waiver. In addition, the commencement or completion of any clinical trials may be delayed or halted for any number of reasons, including product performance, changes in intended use, changes in medical practice and the opinion of evaluator Institutional Review Boards. Additionally, since 2009, the FDA has significantly increased the scrutiny applied to its oversight of companies subject to its regulations, including PMA and 510(k) submissions, by hiring new investigators and increasing inspections of manufacturing facilities. We continue to monitor the FDA Office of In Vitro Diagnostics and Radiological Health ("OIR") and analyze how its decisions will impact the approval or clearance of our products and our ability to improve our systems and tests. The OIR has proposed a new class of devices that would be subject to heightened review processes, following an Institute of Medicine report on the 510(k) regulatory process that was released in late July 2011, but has since deferred any action on this proposal. At any time, actions proposed by the OIR could result in significant changes to the PMA or 510(k) processes, which could complicate the product approval or clearance process. If we fail to adequately respond to the increased scrutiny for the PMA and 510(k) submission processes, our business may be adversely impacted.
In 2014, the FDA issued several important guidance documents on assessing risks and benefits associated with use of a 510(k) approach for PMA products, pre- and post-market balance, expedited PMA, and on oversight of laboratory developed tests. While the overall goal of these guidance documents was to streamline the regulatory process by applying a risk-based approach to the requirements for data collection in the pre- and post-market periods, it is uncertain how the guidance documents will actually be implemented. Likewise, the oversight of laboratory developed tests would require laboratories that compete with high risk (PMA) tests to go through FDA review. It is unclear if this guidance will be finalized. If it is, competition for PMA tests from laboratories would be reduced.
Further, our manufacturing facilities located in Sunnyvale and Lodi, California, Seattle, Washington and Stockholm, Sweden, where we assemble and produce cartridges and other molecular diagnostic kits and reagents, are subject to periodic regulatory inspections by the FDA and other federal and state and foreign regulatory agencies, as are the manufacturing facilities of our contract manufacturer. For example, these facilities are subject to Quality System Regulations (“QSR”) of the FDA and are subject to annual inspection and licensing by the States of California and Washington and European regulatory agencies. If we, or our contract manufacturer, fail to maintain these facilities in accordance with the QSR requirements, state or international quality standards or other regulatory requirements, the manufacture of our systems and tests could be suspended or terminated, and, in the case of a failure by our contract manufacturer, we could be required to find a suitable replacement for the manufacture and supply of our systems, which would prevent us from being able to provide products to our customers in a timely fashion, or at all, and therefore harm our business.

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Failure to comply with the applicable regulatory requirements can result in, among other things, warning letters, administrative or judicially imposed sanctions such as injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal to grant PMA for devices, withdrawal of marketing clearances or approvals, or criminal prosecution. For example, on July 27, 2015 Cepheid received a warning letter from the FDA regarding the Xpert Norovirus test describing deficiencies in the production quality system at Cepheid’s Stockholm, Sweden manufacturing facility. We continue to work with the FDA on resolution of the deficiencies. The Xpert Norovirus test manufactured in Sweden is not sold or distributed in the United States. As a result, it is our expectation that routine production and sale of the Xpert Norovirus test in the United States will not be affected. International sales of this test are not subject to FDA regulation. Until we successfully resolve the issues raised in the warning letter, the FDA will not approve any Cepheid Class III product. Cepheid has some Class III products currently in development but these are not currently expected to be available until 2017.
With regard to future products for which we seek 510(k) clearance, PMA, and/or a CLIA waiver (as appropriate) from the FDA, any failure or material delay to obtain such clearance or approval could harm our business. In addition, it is possible that the current regulatory framework could change or additional regulations could arise at any stage during our product development or marketing, which may adversely affect our ability to obtain or maintain approval of our products and could harm our business.
Recently enacted healthcare legislation reforming the United States healthcare system, as well as future reforms, may have a material adverse effect on our financial condition and results of operations.
In 2010, the United States President signed the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (collectively, the “PPACA”), which makes changes that are expected to significantly impact the pharmaceutical and medical device industries, including a requirement that medical device manufacturers pay an excise tax (or sales tax) of 2.3% of certain United States medical device revenue. Following additional legislation, the medical device excise tax will apply beginning on January 1, 2018. This excise tax will apply to all or most of our products sold within the United States and may result in decreased profits to us, lower reimbursement by payors for our products, and/or reduced medical procedure volumes, all of which may adversely affect our business, financial condition and results of operations
Legislative changes have been proposed and adopted since the PPACA was enacted. For example, on August 2, 2011, the United States President signed into law the Budget Control Act of 2011, which, among other things, creates the Joint Select Committee on Deficit Reduction to recommend proposals in spending reductions to Congress. The Joint Select Committee did not achieve a targeted deficit reduction of at least $1.2 trillion for the years 2013 through 2021, triggering the legislation’s automatic reduction to several government programs. This included aggregate reductions to Medicare payments to providers of 2% per fiscal year, which went into effect on April 1, 2013, and will remain in effect through 2024 unless additional congressional action is taken. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law, which, among other things, further reduced Medicare payments to several providers, including hospitals, imaging centers and cancer treatment centers, which could mean that such providers have less available funds to purchase our products.
The Protecting Access to Medicare Act of 2014 (“PAMA”) will require applicable laboratories to report all private payor reimbursement rates and the volumes for each test it performs. Although a final rule has yet to be published, the statute requires that Medicare establish reimbursement rates based on the weighted median of private insurance reimbursement rates effective January 1, 2017. The new Medicare rates would be subject to a maximum reduction of 10% a year for the initial three year period and a maximum of 15% a year for the subsequent three year period. There is no limit on the amount of potential rate increases. As a result, some of our customers in the United States may experience lower Medicare reimbursement rates for our products, which may adversely affect our business, financial condition and results of operations.
We expect that additional state and federal health care reform measures may be adopted in the future, any of which could have a material adverse effect on our industry generally and our ability to successfully commercialize our products. For example, the United States government has in the past considered, is currently considering and may in the future consider healthcare policies and proposals intended to curb rising healthcare costs, including those that could significantly affect both private and public reimbursement for healthcare services. Further, state and local governments, as well as a number of foreign governments, are also considering or have adopted similar types of policies. Future significant changes in the healthcare systems in the United States or elsewhere, and current uncertainty about whether and how changes may be implemented, could have a negative impact on the demand for our products. We are unable to predict whether other healthcare policies, including policies stemming from legislation or regulations affecting our business may be proposed or enacted in the future; what effect such policies would have on our business; or the effect ongoing uncertainty about these matters will have on the purchasing decisions of our customers.

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Our HBDC program exposes us to increased risks of variability and unpredictable operating results.
Our HBDC program exposes us to risks that are additional and different from the risks associated with our commercial operations, including among other things:
the participants in our HBDC program are located in less developed countries, exposing us to customers in countries that may have less political, social or economic stability and less developed infrastructure and legal systems;
the sales cycle in our HBDC program is lengthy and unpredictable, as HBDC program participants are frequently dependent upon governmental agencies and/or non-governmental organizations with additional administrative processes, causing variability and unpredictability in our operating results and timing of cash collection;
our HBDC program has lower gross margins and, therefore, growth in our HBDC program as a percentage of total revenue negatively impacts our gross margins as a whole; and
our collaborative partners and other supporters, such as FIND, BMGF, USAID, UNITAID and the World Health Organization, may cease to devote financial resources to or otherwise cease to support our HBDC program, which may result in excess capacity and higher production costs.
Continued unpredictable sales cycles and lower gross margins and/or an adverse development relating to one or more of these risks could negatively impact our business, results of operations and financial condition. Additionally, our HBDC program facilitates the expansion of our commercial operations into additional geographic locations and, to the extent that our HBDC program is ineffective as a result of one or more of these risks, the international expansion of our commercial operations could suffer.
We may face risks associated with acquisitions of companies, products and technologies and our business could be harmed if we are unable to address these risks.
In order to remain competitive, obtain key competencies, consolidate our supply chain or sales force, acquire complementary products or technologies, or for other reasons, we may seek to acquire additional businesses, products or technologies. Even if we identify an appropriate acquisition or are presented with appropriate opportunities to acquire or make other investments, we may not be successful in negotiating the terms of the acquisition, financing the acquisition, consummating the acquisition or effectively integrating the acquired business, product or technology into our existing business and operations. For example, in 2012, we acquired one of our plastic molders; in 2013, we acquired distributors in two of our international locations; and in 2014, we re-acquired certain product distribution rights and acquired customer relationship assets from a former distributor in the United States. We have limited experience in successfully acquiring and integrating businesses, products and technologies, and even if we are able to consummate an acquisition or other investment, we may not realize the anticipated benefits of such acquisitions or investments, including our recent acquisitions. We may face risks, uncertainties and disruptions, including difficulties in the integration of the operations and services of these acquisitions or any other acquired company, integration of acquired technology with our products, diversion of our management’s attention from other business concerns, the potential loss of key employees or customers of the acquired businesses and impairment charges if future acquisitions are not as successful as we originally anticipate. If we fail to successfully integrate companies, assets, products or technologies that we acquire or if we fail to successfully exploit acquired product distribution rights and maintain acquired relationships with customers, our business could be harmed. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments or issue shares of common stock as consideration in the acquisition, the issuance of which could be dilutive to our existing shareholders. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired intangible assets. Furthermore, identifying, contemplating, negotiating or completing an acquisition and integrating an acquired business, product or technology could significantly divert management and employee time and resources.

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The current uncertainty in global economic conditions makes it particularly difficult to predict product demand and other related matters and makes it more likely that our actual results could differ materially from expectations.
Our operations and performance depend on global economic conditions, which have been adversely impacted by continued global economic uncertainty, political instability and military hostilities in multiple geographies, the recent strengthening of the United States dollar compared to foreign currencies, the volatility of the capital markets in the United States and abroad, and monetary and international financial uncertainties. These conditions have and may continue to make it difficult for our customers and potential customers to accurately forecast and plan future business activities, and have caused our customers and potential customers to slow or reduce spending, particularly for systems. Furthermore, during economic uncertainty, our customers have experienced and may continue to experience issues gaining timely access to sufficient credit, which could result in their unwillingness to purchase products or an impairment of their ability to make timely payments to us. If that were to continue to occur, we might experience decreased sales, be required to increase our allowance for doubtful accounts and our days sales outstanding would be negatively impacted. Even with improved global economic conditions, it may take time for our customers to establish new budgets and return to normal purchasing patterns. We cannot predict the recurrence or worsening of any economic slowdown or the sustainability of improved economic conditions, worldwide, in the United States or in our industry. These and other economic factors could have a material adverse effect on demand for our products and on our financial condition and operating results.
If certain of our products fail to obtain an adequate level of reimbursement from third-party payers, our ability to sell products in the Clinical market would be harmed.
Our ability to sell our products in the Clinical market will depend in part on the extent to which reimbursement for tests using our products will be available from government health administration authorities, private health coverage insurers, managed care organizations and other organizations. There are efforts by governmental and third-party payers to contain or reduce the costs of healthcare through various means and the continuous growth of managed care, together with efforts to reform the healthcare delivery system in the United States and Europe, has increased pressure on healthcare providers and participants in the healthcare industry to reduce costs. Consolidation among healthcare providers and other participants in the healthcare industry has resulted in fewer, more powerful healthcare groups, whose purchasing power gives them cost containment leverage. Additionally, third-party payers are increasingly challenging the price of medical products and services. If purchasers or users of our products are not able to obtain adequate reimbursement for the cost of using our products, they may forego or reduce their use. Significant uncertainty exists as to the reimbursement status of newly approved healthcare products and whether adequate third-party coverage will be available.
The life sciences industry is highly competitive and subject to rapid technological change, if our competitors and potential competitors develop superior products and technologies, our competitive position and results of operations would suffer.
We face intense competition from a number of companies that offer products in our target markets, some of which have substantially greater financial, technical, research and other resources and larger, more established marketing, sales, distribution and service organizations than we do. Moreover, these competitors may offer broader product lines and tactical discounts and have greater name recognition. These competitors include:
companies developing and marketing sequence detection systems for production of laboratory-developed tests;