10-Q 1 q3_201610q.htm FORM 10-Q Document


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 September 30, 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 October 27, 2016, there were 73,480,343 shares of the registrant’s common stock outstanding.




cepheidlogoa24.jpg
REPORT ON FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 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)
 
September 30,
 
December 31,
 
2016
 
2015
 
(unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
115,718

 
$
112,568

Short-term investments
253,457

 
210,147

Accounts receivable, less allowance for doubtful accounts of $446 as of September 30, 2016 and $383 as of December 31, 2015
81,910

 
66,550

Inventory, net
155,720

 
148,690

Prepaid expenses and other current assets
23,056

 
18,515

Total current assets
629,861

 
556,470

Property and equipment, net
151,227

 
127,639

Investments

 
62,175

Other non-current assets
5,632

 
4,205

Intangible assets, net
20,956

 
25,241

Goodwill
39,681

 
39,681

Total assets
$
847,357

 
$
815,411

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
56,046

 
$
57,771

Accrued compensation
36,863

 
39,015

Accrued royalties
4,309

 
5,469

Accrued and other liabilities
30,919

 
27,451

Current portion of deferred revenue
18,338

 
12,778

Total current liabilities
146,475

 
142,484

Long-term portion of deferred revenue
10,614

 
5,538

Convertible senior notes, net
289,758

 
281,627

Other liabilities
19,864

 
15,779

Total liabilities
466,711

 
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, 73,281,941 and 72,415,317 shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively
458,939

 
449,704

Additional paid-in capital
292,763

 
263,429

Accumulated other comprehensive loss, net
(1,074
)
 
(908
)
Accumulated deficit
(369,982
)
 
(342,242
)
Total shareholders’ equity
380,646

 
369,983

Total liabilities and shareholders’ equity
$
847,357

 
$
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 
 September 30,
 
Nine Months Ended 
 September 30,
 
2016
 
2015
 
2016
 
2015
Revenue
$
158,488

 
$
126,465

 
$
449,269

 
$
391,577

Costs and operating expenses:
 
 
 
 
 
 
 
Cost of sales
83,390

 
67,681

 
229,220

 
198,259

Collaboration profit sharing
2,915

 
1,286

 
4,857

 
3,879

Research and development
29,912

 
32,909

 
93,418

 
84,987

Sales and marketing
29,302

 
28,664

 
87,971

 
82,678

General and administrative
18,688

 
15,401

 
49,161

 
47,395

Total costs and operating expenses
164,207

 
145,941

 
464,627

 
417,198

Loss from operations
(5,719
)
 
(19,476
)
 
(15,358
)
 
(25,621
)
Other income (expense):
 
 
 
 
 
 
 
Interest income
873

 
494

 
2,332

 
1,283

Interest expense
(3,856
)
 
(3,687
)
 
(11,433
)
 
(10,937
)
Foreign currency exchange loss and other, net
(1,012
)
 
(408
)
 
(1,242
)
 
(2,848
)
Other expense, net
(3,995
)
 
(3,601
)
 
(10,343
)
 
(12,502
)
Loss before income taxes
(9,714
)
 
(23,077
)
 
(25,701
)
 
(38,123
)
(Provision for) benefit from income taxes
(1,193
)
 
176

 
(2,039
)
 
(602
)
Net loss
$
(10,907
)
 
$
(22,901
)
 
$
(27,740
)
 
$
(38,725
)
Basic net loss per share
$
(0.15
)
 
$
(0.32
)
 
$
(0.38
)
 
$
(0.54
)
Diluted net loss per share
$
(0.15
)
 
$
(0.32
)
 
$
(0.38
)
 
$
(0.54
)
Shares used in computing basic net loss per share
73,158

 
72,199

 
72,890

 
71,777

Shares used in computing diluted net loss per share
73,158

 
72,199

 
72,890

 
71,777

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


4


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
(unaudited)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2016
 
2015
 
2016
 
2015
Net loss
$
(10,907
)
 
$
(22,901
)
 
$
(27,740
)
 
$
(38,725
)
Other comprehensive loss, before tax:
 
 
 
 
 
 
 
Change in unrealized gains and losses related to cash flow hedges:
 
 
 
 
 
 
 
Loss recognized in accumulated other comprehensive loss, net
(1,804
)
 
(545
)
 
(1,949
)
 
(1,596
)
Loss reclassified from accumulated other comprehensive loss, net to the statement of operations
320

 
369

 
1,006

 
414

Change in unrealized gains and losses related to available-for-sale investments:
 
 
 
 
 
 
 
Gain (loss) recognized in accumulated other comprehensive loss, net
(86
)
 
(148
)
 
735

 
(5
)
Gain (loss) reclassified from accumulated other comprehensive loss, net to the statement of operations
52

 

 
42

 
(3
)
Other comprehensive loss, before tax
(1,518
)
 
(324
)
 
(166
)
 
(1,190
)
Income tax benefit (expense) related to items of accumulated other comprehensive loss, net
497

 

 

 
(100
)
Comprehensive loss
$
(11,928
)
 
$
(23,225
)
 
$
(27,906
)
 
$
(39,815
)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.


5


CEPHEID
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
 
Nine Months Ended 
 September 30,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net loss
$
(27,740
)
 
$
(38,725
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization of property and equipment
24,092

 
20,170

Amortization of intangible assets
4,286

 
4,814

Unrealized foreign exchange differences
(757
)
 
2,242

Amortization of debt discount and transaction costs
8,130

 
7,627

Impairment of acquired intangible assets, licenses, property and equipment
1,286

 
224

Stock-based compensation expense
29,546

 
25,752

Excess tax benefits from stock-based compensation expense

 
(53
)
Other non-cash items
634

 
254

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(15,360
)
 
8,426

Inventory, net
(7,243
)
 
(11,733
)
Prepaid expenses and other current assets
(3,693
)
 
(9,691
)
Other non-current assets
(57
)
 
(801
)
Accounts payable and other current and non-current liabilities
3,877

 
12,297

Accrued compensation
(2,152
)
 
(511
)
Deferred revenue
10,634

 
(795
)
Net cash provided by operating activities
25,483

 
19,497

Cash flows from investing activities:
 
 
 
Capital expenditures
(49,244
)
 
(29,087
)
Cost of acquisitions, net

 
(3,000
)
Proceeds from sale of equipment and an intangible asset
44

 
834

Proceeds from sales of marketable securities and investments
86,310

 
49,173

Proceeds from maturities of marketable securities and investments
177,479

 
175,272

Purchases of marketable securities and investments
(244,495
)
 
(198,701
)
Transfer from (to) restricted cash
(2,335
)
 
1,792

Net cash used in investing activities
(32,241
)
 
(3,717
)
Cash flows from financing activities:
 
 
 
Net proceeds from the issuance of common shares and exercise of stock options
9,288

 
26,444

Excess tax benefits from stock-based compensation expense

 
53

Principal payment of notes payable
(128
)
 
(121
)
Net cash provided by financing activities
9,160

 
26,376

Effect of foreign exchange rate change on cash and cash equivalents
748

 
(2,332
)
Net increase in cash and cash equivalents
3,150

 
39,824

Cash and cash equivalents at beginning of period
112,568

 
96,663

Cash and cash equivalents at end of period
$
115,718

 
$
136,487

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.
Proposed Transaction with Danaher Corporation
On September 2, 2016, Cepheid entered into a Merger Agreement (the "Merger Agreement") with Danaher Corporation (“Danaher”) pursuant to which Danaher has agreed to acquire Cepheid for $53.00 per share in an all-cash transaction valued at approximately $4.0 billion, inclusive of the Company's net cash (the "Merger"). The transaction is expected to close in the fourth quarter of fiscal 2016, subject to certain conditions, including shareholder approval and other customary closing conditions. Cepheid incurred transaction-related costs of $2.6 million during the three months ended September 30, 2016 in connection with the Merger and expect to incur additional costs related to the Merger during the fourth quarter of fiscal 2016 if the transaction is successfully completed. For additional information related to the Merger and the Merger Agreement, please refer to Cepheid’s Current Report on Form 8-K filed with the Securities and Exchange Commission (“SEC”) on September 6, 2016 and the Definitive Proxy Statement on Schedule 14A filed with the SEC on October 7, 2016. The foregoing description of the Merger Agreement is qualified in its entirety by reference to the full text of the Merger Agreement included as Exhibit 2.1 to Cepheid’s Current Report on Form 8-K filed September 6, 2016. Upon completion of the Merger, shares of Cepheid common stock will cease trading on The Nasdaq Global Select Market.
Other than transaction expenses associated with the proposed Merger of $2.6 million, which were recorded to general and administrative expense in the Condensed Consolidated Statement of Operations, for the three and nine months ended September 30, 2016, the terms of the Merger Agreement did not impact the Company's Condensed Consolidated Financial Statements.
Basis of Presentation
The Condensed Consolidated Balance Sheet at September 30, 2016, the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015, the Condensed Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2016 and 2015 and the Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 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 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

7


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. All unrealized gains and losses associated with our investments were 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.
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 $3.7 million and $2.7 million of restricted cash as of September 30, 2016 and December 31, 2015, respectively and other non-current assets included $3.4 million and $2.1 million of restricted cash as of September 30, 2016 and December 31, 2015, respectively. The majority of this restricted cash is 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 65% and 66% of the Company’s cash and cash equivalents as of September 30, 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 September 30, 2016.
See Note 10, “Segment and Significant Concentrations,” for disclosure regarding total sales to direct customers and single countries.

8


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):
 
September 30, 2016
 
December 31, 2015
Raw Materials
$
44,108

 
$
39,267

Work in Process
66,097

 
62,153

Finished Goods
45,515

 
47,270

Inventory, net
$
155,720

 
$
148,690

In addition, capitalized stock-based compensation expense of $2.3 million and $2.5 million were included in inventory as of September 30, 2016 and December 31, 2015, respectively.
Revenue Recognition
The Company recognizes revenue from sales when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. No right of return exists for the Company’s products except in the case of damaged goods. The Company has not experienced any significant returns of its products. Shipping and handling costs are expensed as incurred and included in cost of sales. In those cases where the Company bills shipping and handling costs to customers, the amounts billed are classified as revenue. The Company 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.

9


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 10,439,000 and 9,007,000 for the three months ended September 30, 2016 and 2015, respectively, and 11,361,000 and 8,771,000 for the nine months ended September 30, 2016 and 2015, respectively.
The following summarizes the computation of basic and diluted net loss per share (in thousands, except for per share amounts): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Basic:
 
 
 
 
 
 
 
Net loss
$
(10,907
)
 
$
(22,901
)
 
$
(27,740
)
 
$
(38,725
)
Basic weighted shares outstanding
73,158

 
72,199

 
72,890

 
71,777

Net loss per share
$
(0.15
)
 
$
(0.32
)
 
$
(0.38
)
 
$
(0.54
)
Diluted:
 
 
 
 
 
 
 
Net loss
$
(10,907
)
 
$
(22,901
)
 
$
(27,740
)
 
$
(38,725
)
Basic weighted shares outstanding
73,158

 
72,199

 
72,890

 
71,777

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

 

 

 

Diluted weighted shares outstanding
73,158

 
72,199

 
72,890

 
71,777

Net loss per share
$
(0.15
)
 
$
(0.32
)
 
$
(0.38
)
 
$
(0.54
)
Recent Accounting Pronouncements
In August 2016, the Financial Accounting Standards Board (“FASB") issued Accounting Standards Update (“ASU") No. 2016-15, Classification of Certain Cash Receipts and Cash Payments. This ASU addresses how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash flow, and other Topics. The requirements of this ASU are effective for annual reporting periods, and interim periods therein, beginning after December 15, 2017. The Company is currently assessing the impact of this ASU on its financial statements.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU amends the impairment model to utilize an expected loss methodology in place of the currently used incurred loss methodology, which will result in the more timely recognition of losses. The requirements of this ASU are effective for interim and annual reporting periods beginning after December 15, 2019. The Company is currently assessing the impact of this ASU on its financial statements.
In March 2016, the FASB issued 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.

10


In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers: Principal versus Agent Considerations, which are intended to improve the operability and understandability of the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers: Identifying Performance Obligations and Licensing, which clarified the implementation guidance on identifying promised goods or services and on evaluating whether an entity's promise to grant a license of intellectual property involves a right to use the entity's intellectual property (which is satisfied at a point in time) or a right to access the entity's intellectual property (which is satisfied over time). In May 2016, the FASB issued ASU 2016-11, Revenue Recognition and Derivatives and Hedging: Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting, which rescinds certain SEC comments upon adoption of ASU 2014-09, including the SEC comments related to consideration given by a vendor to a customer. In May 2016, the FASB also issued ASU 2016-12, Revenue from Contracts with Customers: Narrow Scope Improvements and Practical Expedients, which provides narrow scope improvements and technical expedients on assessing collectability, presentation of sales taxes, evaluating contract modifications and completed contracts at transition and the disclosure requirement for the effect of the accounting change for the period of adoption. Collectively, all of these ASUs are intended to improve and clarify the implementation guidance of ASU No. 2014-09, Revenue from Contracts with Customers, and have the same effective date as the original standard. The Company is currently assessing the potential impact of this new guidance 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.
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 June 30, 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.

11


2. Fair Value
During the three months ended September 30, 2016, the Company classified all investments, which are not considered cash equivalents as short-term investments as management no longer has the intent to hold such investments until their expected maturity. As a result, the Company reclassified less than $0.1 million of unrealized investment losses to the statement of operations as a component of other income (expense) in the Condensed Consolidated Statements of Operations.
The following table summarizes the fair value hierarchy for the Company’s financial assets (cash, cash equivalents, short-term investments, non-current investments, and foreign currency derivatives) and financial liabilities (foreign currency derivatives) measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015 (in thousands):
Balance as of September 30, 2016:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash and cash equivalents
$
90,126

 
$
25,592

 
$

 
$
115,718

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities

 
58,975

 

 
58,975

Corporate debt securities

 
96,125

 

 
96,125

Commercial paper

 
90,341

 

 
90,341

Other securities

 
8,016

 

 
8,016

Total short-term investments

 
253,457

 

 
253,457

Foreign currency derivatives

 
1,109

 

 
1,109

Total
$
90,126

 
$
280,158

 
$

 
$
370,284

Liabilities:
 
 
 
 
 
 
 
Foreign currency derivatives
$

 
$
2,612

 
$

 
$
2,612

Total
$

 
$
2,612

 
$

 
$
2,612

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


12


The estimated fair values of the Company’s other financial instruments which are not measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015 were as follows (in thousands):
Balance as of September 30, 2016:
 
 
 
 
 
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Liabilities:
 
 
 
 
 
 
 
Convertible senior notes
$

 
$
355,350

 
$

 
$
355,350

Total
$

 
$
355,350

 
$

 
$
355,350

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 asset-backed securities, corporate debt securities, commercial paper, government agency 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.
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 September 30, 2016.


13


3. Investments
The Company’s marketable securities as of September 30, 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. As discussed in Note 2 of Notes to Condensed Consolidated Financial Statements, the Company classified all investments, which are not considered cash equivalents as short-term investments as management no longer has the intent to hold such investments until their expected maturity.
The following tables summarize available-for-sale marketable securities (in thousands):
Balance as of September 30, 2016:
 
 
 
 
 
 
 
 
Cost
 
Gross Unrealized
Gain
 
Gross Unrealized
Loss
 
Estimated Fair
Value
Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
$
58,914

 
$
61

 
$

 
$
58,975

Commercial paper
115,902

 
31

 

 
115,933

Corporate debt securities
96,017

 
108

 

 
96,125

Other securities
8,000

 
16

 

 
8,016

Amounts classified as cash equivalents
(25,586
)
 
(6
)
 

 
(25,592
)
Total short-term investments
$
253,247

 
$
210

 
$

 
$
253,457

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

Proceeds from the sale of marketable securities were $86.3 million and $49.2 million for the nine months ended September 30, 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 realized and unrealized 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 and nine months ended September 30, 2016 and 2015.


14


As discussed in Note 2 of Notes to Condensed Consolidated Financial Statements, the Company classified all investments, which are not considered cash equivalents as short-term investments as management no longer has the intent to hold such investments until their expected maturity. As a result, the Company recognized less than $0.1 million of unrealized investment losses to the statement of operations as a component of other income (expense) in the Condensed Consolidated Statements of Operations.
The following table summarizes the fair value of the Company’s marketable securities with unrealized losses at December 31, 2015, and the duration of time that such losses had been unrealized (in thousands):
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 December 31, 2015, and has determined that there was no indication of other-than-temporary impairments. This determination was based on several factors, including the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the debt issuer, and the Company’s intent and ability to hold the securities for a period of time sufficient to allow for any anticipated recovery in market value.
The following table summarizes the amortized cost and estimated fair value of available-for-sale debt securities at September 30, 2016 and December 31, 2015, by contractual maturity (in thousands):
 
September 30, 2016
 
December 31, 2015
 
Amortized Cost
 
Estimated Fair Value
 
Amortized Cost
 
Estimated Fair Value
Mature in one year or less
$
194,917

 
$
194,997

 
$
186,311

 
$
186,118

Mature after one year through three years
75,623

 
75,750

 
106,377

 
106,086

Mature in more than three years
8,293

 
8,302

 
8,139

 
8,061

Total
$
278,833

 
$
279,049

 
$
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.
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.

15


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 gain (loss) and other, net.
The Company had a net deferred loss of $1.4 million and net deferred loss of $0.4 million associated with cash flow hedges recorded in AOCI as of September 30, 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 September 30, 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 gain (loss) and other, net unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during the three and nine months ended September 30, 2016 and 2015.
Gains or losses on derivatives not designated as hedging instruments are recorded in foreign currency exchange gain (loss) and other, net. During the three months ended September 30, 2016 and 2015, the Company recognized a loss of $2.4 million and a gain of $2.3 million, respectively, as a component of foreign currency exchange gain (loss) and other, net, related to derivative instruments not designated as hedging instruments. During the nine months ended September 30, 2016 and 2015, the Company recognized a loss of $2.9 million and a gain of $4.0 million, respectively, as a component of foreign currency exchange gain (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 $91.0 million and $117.6 million as of September 30, 2016 and December 31, 2015, respectively. The notional principal amount of the Company’s outstanding derivative instruments not designated as cash flow hedges was $25.9 million as of December 31, 2015. There was no outstanding derivative instruments not designated as cash flow hedges as of September 30, 2016.
The following tables show the Company’s derivative instruments at gross fair value as reflected in the Condensed Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015, respectively (in thousands):
 
September 30, 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
$
1,109

 
$

 
$
1,109

Derivative Liabilities (b):
 
 
 
 
 
Foreign exchange contracts
(2,612
)
 

 
(2,612
)
 
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
)

16


(a)
The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as prepaid expenses and other current assets in the Condensed Consolidated Balance Sheets.
(b)
The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued and other liabilities in the Condensed Consolidated Balance Sheets.
The following tables show the pre-tax effect of the Company’s derivative instruments designated as cash flow hedges in the Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2016 and 2015 (in thousands): 
 
Three Months Ended September 30,
 
Loss Recognized in OCI -
Effective Portion
 
Loss Reclassified from AOCI
into Income - Effective Portion
 
Loss Recognized - Ineffective Portion and
Amount Excluded from Effectiveness Testing
 
2016
 
2015
 
2016 (a)
 
2015 (b)
 
Location
 
2016
 
2015
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$
(1,804
)
 
$
(545
)
 
$
(320
)
 
$
(369
)
 
Foreign currency exchange loss and other, net
 
$
(141
)
 
$
(45
)
Total
$
(1,804
)
 
$
(545
)
 
$
(320
)
 
$
(369
)
 
 
 
$
(141
)
 
$
(45
)
(a)
Includes gains and losses reclassified from AOCI into net loss for the effective portion of cash flow hedges, of which a $0.3 million loss within costs and operating expenses and less than a $0.1 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the three months ended September 30, 2016.
(b)
Includes gains and losses reclassified from AOCI into net loss for the effective portion of cash flow hedges, of which a $1.2 million loss within costs and operating expenses and a $1.5 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the three months ended September 30, 2015.

 
Nine Months Ended September 30,
 
Loss Recognized in OCI-
Effective Portion
 
Loss Reclassified from AOCI
into Income - Effective Portion
 
Loss Recognized - Ineffective Portion and
Amount Excluded from Effectiveness Testing
 
2016
 
2015
 
2016 (a)
 
2015 (b)
 
Location
 
2016
 
2015
Cash flow hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$
(1,949
)
 
$
(1,596
)
 
$
(1,006
)
 
$
(414
)
 
Foreign currency exchange loss and other, net
 
$
(491
)
 
$
(169
)
Total
$
(1,949
)
 
$
(1,596
)
 
$
(1,006
)
 
$
(414
)
 
 
 
$
(491
)
 
$
(169
)
(a)
Includes gains and losses reclassified from AOCI into net income for the effective portion of cash flow hedges, of which a $1.0 million loss within costs and operating expenses and a less than $0.1 million loss within revenue, were recognized within the Condensed Consolidated Statement of Operations for the nine months ended September 30, 2016.
(b)
Includes gains and losses reclassified from AOCI into net loss for the effective portion of cash flow hedges, of which a $6.6 million loss within costs and operating expenses and a $6.2 million gain within revenue, were recognized within the Condensed Consolidated Statement of Operations for the nine months ended September 30, 2015.

17


5. Intangible Assets
Intangible assets related to licenses are recorded at cost, less accumulated amortization. Intangible assets related to technology and other intangible assets acquired in acquisitions are recorded at fair value at the date of acquisition, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 3 to 15 years, on a straight-line basis. Amortization of intangible assets is primarily included in cost of sales, research and development and sales and marketing in the Condensed Consolidated Statements of Operations.
The recorded value and accumulated amortization of major classes of intangible assets were as follows (in thousands):
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
Balance, September 30, 2016
 
 
 
 
 
Licenses
$
11,256

 
$
(7,859
)
 
$
3,397

Technology acquired in acquisitions
8,613

 
(8,613
)
 

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

 
(18,290
)
 
17,559

 
$
55,718

 
$
(34,762
)
 
$
20,956

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 $1.5 million for the three months ended September 30, 2016 and 2015, respectively, and $4.3 million and $4.8 million for the nine months ended September 30, 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 September 30, 2016, assuming no impairment charges (in thousands):
For the Years Ending December 31,
Amortization
Expense
 
 
2016 (remaining three months)
$
1,426

2017
5,343

2018
5,260

2019
4,235

2020
3,891

Thereafter
801

Total expected future amortization
$
20,956

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 and nine months ended September 30, 2016, the Company recorded an income tax expense of $1.2 million and $2.0 million, respectively, primarily related to ordinary tax expense of the Company’s foreign subsidiaries. For the three and nine months ended September 30, 2015, the Company recorded an income tax benefit of $0.2 million and tax expense of $0.6 million, respectively, comprised primarily of ordinary foreign tax expense of the Company’s foreign subsidiaries, partially offset by the tax effect of items in accumulated other comprehensive loss, net.

18


The Company’s effective tax rate for the three and nine months ended September 30, 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. There is a difference in the effective tax rate for the three and nine months ended September 30, 2016, compared to the three and nine months ended September 30, 2015, which is primarily due to levels of losses in the United States for which no income tax benefit was recorded in relation to income generated in foreign 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 and nine months ended September 30, 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 September 30, 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.

19


Holders may convert all or a portion of their Notes prior to the close of business on the business day immediately preceding August 1, 2020, in multiples of $1,000 principal amount, only under the following circumstances:
during any calendar quarter commencing after the calendar quarter ending on March 31, 2014 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
during the five business day period after any five consecutive trading day period (the “Notes Measurement Period”) in which the “trading price” (as the term is defined in the Indenture) per $1,000 principal amount of notes for each trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company’s common stock on such trading day and the conversion rate on each such trading day; or
upon the occurrence of specified corporate events.
As of September 30, 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):
 
September 30, 2016
 
December 31, 2015
Liability component:
 
 
 
Principal
$
345,000

 
$
345,000

Less: debt discount, net of amortization and reclassification of debt issuance costs
(55,242
)
 
(63,373
)
Net carrying amount
$
289,758

 
$
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 September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
1.25% coupon
$
1,078

 
$
1,078

 
$
3,234

 
$
3,234

Amortization of debt issuance costs
203

 
157

 
573

 
435

Amortization of debt discount
2,551

 
2,427

 
7,558

 
7,193

 
$
3,832

 
$
3,662

 
$
11,365

 
$
10,862


20


As of September 30, 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):
 
September 30, 2016
 
December 31, 2015
 
Fair Value
 
Carrying
Value
 
Fair Value
 
Carrying
Value
Convertible Senior Notes
$
355,350

 
$
289,758

 
$
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 $52.69 on September 30, 2016, the if-converted value of the Notes was less than their respective principal amounts.
On September 2, 2016, Cepheid entered into the Merger Agreement with Danaher. At the effective time of the Merger, holders of the Company's $345 million aggregate principal amount of Notes shall have the right to convert such Notes into conversion consideration pursuant to the terms of the indenture under which the Notes were issued. In connection with the closing of the Merger, the capped call transactions will also be settled pursuant to the terms thereof.
8. Commitments, Contingencies and Legal Matters
Purchase Commitments
The following table summarizes the Company’s purchase commitments at September 30, 2016 (in thousands):
Years Ending December 31,
Purchase Commitments
2016 (remaining three months)
$
25,273

2017
3,230

2018

2019

2020

Thereafter

Total minimum payments
$
28,503

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.

21


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 polymerase chain reaction ("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 September 30, 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. On May 18, 2016, the parties submitted a joint status update to the Court in which Roche stated that it had disclaimed and would not assert the claim the Company had challenged in the second petition for IPR. On May 20, 2016, the Court issued an order lifting the 2015 stay. On July 19, 2016, the Company filed a motion for summary judgment of patent ineligibility as to all asserted claims. The Court is scheduled to conduct an oral hearing on the motion on November 16, 2016, and the Company expects a decision on the motion by the end of 2016. The Company believes that the possibility that these legal proceedings will result in a material loss is remote.

22


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.

9. Employee Equity Incentive Plans and Stock-Based Compensation Expense
The following table is a summary of the major categories of stock-based compensation expense recognized in accordance with ASC 718, “Compensation—Stock Compensation” (“ASC 718”) for the three and nine months ended September 30, 2016 and 2015 (in thousands):
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2016
 
2015
 
2016
 
2015
Cost of sales
$
1,784

 
$
1,128

 
$
4,882

 
$
3,177

Research and development
2,765

 
3,438

 
7,709

 
7,913

Sales and marketing
2,207

 
1,825

 
6,237

 
5,018

General and administrative
4,057

 
3,584

 
10,878

 
9,694

Total stock-based compensation expense
$
10,813

 
$
9,975

 
$
29,706

 
$
25,802

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
1,282

 
$
34.54

 
 
 
 
Exercised
(352
)
 
$
13.31

 
 
 
 
Forfeited
(213
)
 
$
39.47

 
 
 
 
Outstanding, September 30, 2016
6,159

 
$
39.90

 
4.21
 
$
83,020

Exercisable, September 30, 2016
3,604

 
$
38.18

 
3.10
 
$
53,971

Vested and expected to vest, September 30, 2016
5,984

 
$
39.85

 
4.15
 
$
80,667

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
669

 
34.05

Vested
(286
)
 
48.70

Cancelled
(69
)
 
45.75

Outstanding, September 30, 2016
1,314

 
$
41.20

Included in the restricted stock awards and restricted stock units granted during the nine months ended September 30, 2016 are 285,000 performance-based restricted stock units ("PRSUs"), which were granted to certain members of the Company's senior management team that vest upon the achievement of certain performance conditions, the performance period for which is the three-year period from January 1, 2016 to December 31, 2018. The number of PRSUs ultimately earned by each recipient will range from zero to 125% of the target PRSU number awarded to each recipient. Each PRSU will vest as to any earned PRSUs following determination and certification of the level of achievement of specified metrics by the Compensation Committee at the end of the performance period. To the extent earned, each PRSU will be settled by the issuance of one share of Cepheid common stock. Recipients of PRSUs generally must remain employed by Cepheid on a continuous basis through the end of the performance period in order to receive any amount of the PRSUs earned, except that recipients may be entitled to accelerated vesting of PRSUs in the case of the recipient’s death or disability or upon a change in control. In the proposed Merger with Danaher, the PRSUs will be treated as described in the Merger Agreement.

23


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 
 September 30,
 
Nine Months Ended 
 September 30,
 
2016
 
2015
 
2016
 
2015
OPTION SHARES:
 
 
 
 
 
 
 
Expected Term (in years)
4.38

 
4.49

 
4.45

 
4.46

Volatility
0.47

 
0.36

 
0.44

 
0.36

Expected Dividends

 

 

 

Risk Free Interest Rates
1.14
%
 
1.54
%
 
1.38
%
 
1.46
%
Estimated Forfeitures
6.01
%
 
6.14
%
 
6.01
%
 
6.14
%
Weighted Average Fair Value Per Share
$
14.24

 
$
16.91

 
$
13.12

 
$
17.93

ESPP SHARES:
 
 
 
 
 
 
 
Expected Term (in years)
1.24

 
1.22

 
1.23

 
1.22

Volatility
0.52

 
0.34

 
0.49

 
0.34

Expected Dividends

 

 

 

Risk Free Interest Rates
0.54
%
 
0.41
%
 
0.59
%
 
0.39
%
Weighted Average Fair Value Per Share
$
13.63

 
$
16.50

 
$
10.20

 
$
16.49

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 September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Revenue:
 
 
 
 
 
 
 
System and other revenue
$
27,496

 
$
19,749

 
$
76,618

 
$
62,823

Reagent and disposable revenue
130,992

 
106,716

 
372,651

 
328,754

Total revenue
$
158,488

 
$
126,465

 
$
449,269

 
$
391,577

The Company currently sells product through its direct sales force and through third-party distributors. No single customer or distributor accounted for more than 10% of total revenue for the three and nine months ended September 30, 2016 and 2015.
The following table summarizes revenue by geographic region (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Geographic revenue information:
 
 
 
 
 
 
 
North America
$
89,122

 
$
73,627

 
$
252,714

 
$
232,119

International
69,366

 
52,838

 
196,555

 
159,458

Total revenue
$
158,488

 
$
126,465

 
$
449,269

 
$
391,577

The Company recognized revenue of $87.2 million and $70.7 million for sales to United States customers for the three months ended September 30, 2016 and 2015, respectively, and $246.1 million and $220.3 million for the nine months ended September 30, 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 and nine months ended September 30, 2016 and 2015.

24


The following table summarizes long-lived assets, excluding intangible assets and goodwill, by geographic region (in thousands):
 
September 30, 2016
 
December 31, 2015
United States
$
129,966

 
$
108,210

Other regions
21,261

 
19,429

Total long-lived assets
$
151,227

 
$
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 September 30, 2016 and December 31, 2015.


25


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 and the September 2, 2016 Agreement and Plan of Merger (the “Merger Agreement”) with Danaher Corporation (“Danaher”), and Copper Merger Sub, Inc., a wholly-owned subsidiary of Danaher and the anticipated timing and benefits of the merger contemplated thereby (the “Merger”). 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; the success of our cost reduction and gross margin improvement efforts; 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, the GeneXpert Omni, our new Honeycomb module and new virology and oncology products; 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 and including Merger-related litigation; 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; risks relating to the Merger Agreement and Merger, including but not limited to: the timing to complete the Merger, failure to receive necessary shareholder approvals, the risk that a condition to completion of the Merger may not be satisfied, the anticipated benefits of the Merger to Danaher and Danaher’s ability to achieve the synergies and value creation projected to be realized following the completion of the Merger, Danaher’s ability to integrate Cepheid’s business with its own promptly and effectively, the diversion of management and workforce time on Merger-related issues, changes in Danaher’s or Cepheid’s businesses, future cash requirements, capital requirements, results of operations, revenues, financial condition and/or cash flow; changes in acquisition-related transaction costs, the amount of fees paid to advisors and the potential payments to Cepheid executive officers in connection with the Merger, operating costs and business disruption that may be greater than expected, the ability to retain and hire key personnel and maintain relationships with customers, providers or other business partners pending completion of the Merger and the risk that lawsuits challenging the proposed Merger may result in adverse rulings that may impair or delay completion of the Merger; 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.

26


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.
On September 2, 2016, we entered into the Merger Agreement with Danaher pursuant to which Danaher has agreed to acquire Cepheid for $53.00 per share in an all-cash transaction valued at approximately $4.0 billion, inclusive of the Company's net cash. The transaction is expected to close in the fourth quarter of fiscal 2016, subject to certain conditions, including shareholder approval and other customary closing conditions. We incurred transaction-related costs of $2.6 million during the three months ended September 30, 2016 in connection with the Merger and expect to incur additional costs related to the Merger during the fourth quarter of fiscal 2016 if the merger is successfully completed. For additional information related to the Merger Agreement, refer to the Definitive Proxy Statement on Schedule 14A filed with the SEC on October 7, 2016.
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 tests and additional virology tests. 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 and Xpert tests will continue to significantly expand our presence in the Clinical market due to their 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;
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;
a menu of moderate complexity Clinical Laboratory Improvement Amendments ("CLIA") categorized, amplified molecular tests means the GeneXpert system can be operated without the need for highly-trained laboratory technologists. Additionally, we are entering the United States 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 of systems in a variety of configurations ranging from one to 80 individual test modules, which enables testing in environments ranging from low volume 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.

27


Continue to develop and market new tests and modules and systems.
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, infectious disease, sexual health, virology, oncology and genetic disease. For example, in March 2016, we received clearance from the FDA to market our Xpert Carba-R test for use with bacterial isolates. In June 2016, we received clearance from the FDA for expanded claims for use of rectal swabs with Xpert Carba-R as an aid for infection control for monitoring the spread of carbapenem-non-susceptible organisms in healthcare settings. Also in June 2016, our Xpert HIV-1 Qualitative was awarded WHO prequalification. In September 2016, we received clearance from the FDA for expanded claims for the use of urine samples from symptomatic and asymptomatic men with our Xpert Trichomonas test. Also in September 2016, we announced the launch of Xpert C. difficile BT in countries accepting the CE mark, which expands the results reporting capability of our Xpert C. difficile test to detect the presence of binary toxin-producing C. difficile. Additionally, in October 2016, we launched our Xpert Bladder Cancer Monitor and Xpert Bladder Cancer DX tests, which are now commercially available in Germany and cleared for commercial availability in all countries accepting the CE mark. Our Xpert Xpress Flu/RSV test also achieved CE mark in October 2016 and is now available in all countries accepting the CE mark. We now have a cumulative menu of tests of 27 that have achieved CE mark available internationally and 20 unique tests that are FDA cleared in the United States.
Modules and Systems. We continue to develop the Honeycomb module (our high-level multiplexing initiative) and we are moving forward with the use of the module in the development of our Xpert Breast Cancer Signature product. The GeneXpert Omni system was originally scheduled for launch in the emerging markets in 2016 and its initial testing has been underway with a number of tests successfully running on the system and the majority of its components fully operational and functioning as expected. However, in the first quarter of 2016, we decided to delay its launch to the third quarter of 2017 so that we could invest additional time to ensure that the detection and amplification module of the system, more specifically the ICORE module, is functioning in a fully robust manner to address both our current and future test menu.
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 United States 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. Our existing GeneXpert Systems along with our Xpress Xpert tests under development will expand our presence in the United States CLIA waived market. 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. In addition, as of September 30, 2016, we had direct sales forces in Australia, the Benelux region, Brazil, France, Germany, Hong Kong, India, Italy, South Africa and the United Kingdom, and we have offices in China, Japan and the United Arab Emirates. We expect to continue to expand our international commercial operations capability on both a direct and distributor basis during the remainder of 2016 and in 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.
Obtain additional target rights. We expect to continue to expand our collaborations with academic institutions and commercial organizations to develop and obtain target rights to various infectious disease and oncology targets. In addition, we expect to focus key business development activities on identifying infectious disease and oncology targets held by academic institutions or commercial organizations for potential license or acquisition.

28


Products
Our product portfolio consists of tests, reagents and systems for the Clinical and Non-Clinical markets. Our main system is the GeneXpert system, including the Infinity systems, which incorporates sample preparation, nucleic acid extraction and purification, DNA amplification, and detection into a small, self-contained cartridge, enabling fast molecular testing 24 hours a day, 7 days a week, offering medically relevant results when and where they are needed most. We also offer our first generation system, the SmartCycler, which integrates DNA amplification and detection for fast batch or random access analysis in “real-time.”
In the Clinical market, we offer tests for the GeneXpert system in the five following disease franchises: (i) healthcare-associated infections, (ii) critical infectious disease, (iii) sexual health, (iv) virology and (v) oncology and genetics. These tests include U.S. Food and Drug Administration (“FDA”) cleared products, such as IVD medical devices, CE Marked products (“CE IVD”), Research Use Only (“RUO”) tests and Emergency Use Authorization ("EUA") tests. As of September 30, 2016, our Xpert menu includes the following FDA cleared tests, CE IVD approved tests, RUO and EUA tests:
Healthcare Associated Infections (HAI), which includes the following tests for infection control in healthcare facilities:
Xpert MRSA
Xpert MRSA/SA Nasal Complete
Xpert MRSA/SA BC for Blood Culture
Xpert MRSA/SA SSTI for Skin and Soft Tissue Infections
Xpert C. difficile
Xpert C. difficile/epi (FDA only)
Xpert C. difficile BT (CE IVD only)
Xpert Carba-R
Xpert Norovirus
Xpert Van A for vancomycin resistant enterococci (FDA only)
Xpert Van A/Van B (CE IVD only)
Critical Infectious Disease (CID), which includes the following tests for critical illness-causing, highly contagious organisms:
Xpert MTB/RIF
Xpert EV for Enterovirus
Xpert Ebola (EUA)
Xpert Flu
Xpert Flu/RSV
Xpert Flu+RSV (CLIA Waived, FDA Only)
Sexual Health, which includes the following tests for pathogens impacting sexual health:
Xpert CT/NG
Xpert CT (CE IVD only)
Xpert Trichomonas
Xpert HPV (CE IVD only)
Xpert GBS for Group B Streptococcus
Xpert GBS for Lim broth (FDA only)
Virology, which includes the following tests for detection of viruses:
Xpert HIV-1 Viral Load (CE IVD only)
Xpert HIV-1 Qualitative (CE IVD only)
Xpert HCV Viral Load (CE IVD only)
Oncology and Genetic Disease, which includes the following tests for oncology and genetic polymorphism:
Xpert Factor II and Factor V Leiden
Xpert BCR-ABL Monitor (CE IVD only)
Xpert BCR-ABL Ultra (CE IVD only)
Xpert BCR-ABL (RUO, US only)

29


The following tables present certain significant financial measurements for the period indicated (in thousands, except per share data):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Total revenue
$
158,488

 
$
126,465

 
$
32,023

 
25
 %
 
$
449,269

 
$
391,577

 
$
57,692

 
15
 %
Gross margin
47%
 
46%
 
N/A
 
1%
 
49%
 
49%
 
N/A
 
 %
Net loss
$
(10,907
)
 
$
(22,901
)
 
$
11,994

 
(52
)%
 
$
(27,740
)
 
$
(38,725
)
 
$
10,985

 
(28
)%
Diluted net loss per share
(0.15
)
 
(0.32
)
 
0.17

 
(53
)%
 
(0.38
)
 
(0.54
)
 
0.16

 
(30
)%
Non-GAAP Adjusted Results
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total revenue on a constant currency basis
$
159,214

 
$
124,943

 
$
34,271

 
27
 %
 
$
452,698

 
$
385,470

 
$
67,228

 
17
 %
Non-GAAP gross margin
49%
 
48%
 
N/A
 
1
 %
 
51%
 
51%
 
N/A
 
 %
Non-GAAP net income (loss)
$
6,448

 
$
(9,131
)
 
$
15,579

 
(171
)%
 
$
16,224

 
$
(1,270
)
 
$
17,494

 
(1,377
)%
Non-GAAP diluted net income (loss) per share
0.09

 
(0.13
)
 
0.22

 
(169
)%
 
0.22

 
(0.02
)
 
0.24

 
(1,200
)%
*Reconciliations of non-GAAP adjusted measures are presented below under "Use of Non-GAAP Measures".
Results of Operations
Comparison of the Three and Nine Months Ended September 30, 2016 and 2015
Revenue
The following table summarizes total revenue by type (in thousands, except percentages): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2016
 
2015
 
$ Change
 
% Change
 
2016
 
2015
 
$ Change
 
% Change
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
System and other revenue
$
27,496

 
$
19,749

 
$
7,747

 
39
%
 
$
76,618

 
$
62,823

 
$
13,795