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Despite Affy's Q3 Net Loss, Wall Street Rewards Better Genotyping Revenue, Ongoing Restructuring

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Hungry for good news after a year of disappointments, Affymetrix investors reacted favorably to Affy’s third quarter results this week on word that the company was making progress in building its genotyping revenues and implementing its restructuring plans.
 
Despite a limp third quarter during which revenue inched up 1 percent and last year’s profit swung to a net loss this time round, news of the improved genotyping revenue and a cost-cutting restructuring caused Affy shares to close up nearly 20 percent on the day the results were disclosed.
 
The developments also led investment bank UBS to upgrade its rating of Affy shares to “Neutral” from “Reduce” on Thursday.
 
Overall, the favorable reaction helped the array maker recover some lost value for its stock, which has been trading at around $20 since June 2006 and has lost more than half of its value since a peak of $58 in July 2005.
 
The rebound in share price was not driven by the company’s top line for the three months ended Sept. 30, which increased to $84.6 million from $83.4 million year over year. Affy also reported a $14.2-million loss this year compared to a $9.4-million profit last year.
 
Affymetrix attributed the results to reduced margins in genotyping as well as costs incurred while it restructures its business.
 
Greg Schiffman, Affymetrix’s chief financial officer, told investors during an earnings call discussing results that the $25-million change in Affy’s operating profit relative to last year was created by three primary factors: product and product-related gross margin; selling, general, and administrative expenses; and restructuring charges.
 
Of the three, “the single biggest impact on operating profit was from a decrease in product and product-related gross margin percent,” Schiffman said. He added that a reduction in gross margins accounted for around $11 million of the $25 million loss.
 
Specifically, “gross margins went from 70.6 percent in Q3, 2005, to 56.2 percent [last] quarter ... largely impacted by [Affy’s] decision to forward price the 500K two-chip set which accounts for approximately $6 million of this $11 million change,” Schiffman said.
 
Affymetrix announced its plans to halve the price of its 500K set to $250 per chip in July as it struggled to regain momentum in the genotyping space after poorer-than-expected results pushed it into a period of operating loss. The company is also planning to launch a 1 million-SNP product early next year (see BAN 7/25/2006, BAN 8/1/2006).
 
While the price cuts affected Affy’s performance this quarter, CEO Steve Fodor provided data during the call that showed a slight recovery on the genotyping front.
 
“Despite the impact of our price reduction on genotyping products in late July, we saw our overall genotyping revenues increase by greater than 30 percent over the prior quarter,” Fodor said. “In total, sequential genotyping 500K sample volumes were up 90 percent. The combination of these genotyping sales and services accounted for about 43,000 samples during the third quarter, significantly up from the approximately 22,000 samples generated during the second quarter,” he added.
 
According to Fodor, the primary interest in Affy genotyping is coming from academic and government-funded researchers, as opposed to pharmaceutical companies.
 
“I think most of the larger deals that you hear right now are really mostly academic studies,” Fodor said. “It's probably ... tilted much more toward the government and academic, probably the 70 percent to 75 percent range with maybe a quarter, between 25 percent or so and the industrial range,” he added.
 
Fodor also said that the company would recover its margins through the introduction of the 1 million-SNP chip set in 2007, which is forward priced at $500.
 
Duplicated Overhead
 
Another way Affy hopes to recover its margins will be through finishing restructuring, which cost the company about $6 million in the third quarter. Fodor said that the completion of the closure of its Bedford, Mass., manufacturing plant, which began last quarter as Affy consolidates its US manufacturing at a new space in Sacramento, should take place by July 2007 (see BAN 9/19/2006).
 
“I will say in nine months from now, when we have actually closed the Bedford facility, you will see again a fairly substantial improvement in margins,” Fodor said. Still, according to Schiffman, Affy is likely to incur $3 million in charges in each quarter over the next three quarters as it phases out the plant and transfers its operations to a facility in Sacramento, Calif.
 

“I will say in nine months from now, when we have actually closed the Bedford facility, you will see again a fairly substantial improvement in margins.”

“We will also incur a charge of up to $7 million to $9 million as we exit our Bedford facility,” Schiffman said.
 
As Affy reported in an SEC release in September, the restructuring is expected to “eliminate or transfer” around 80 jobs beginning in the fourth quarter and continuing into the first half of 2007. The company said it expects the Bedford facility closure to be “materially completed” by the third quarter next year (see BAN 9/19/2006).
 
“Through that time point, there's a lot of activities underway both in [the plants in] Sacramento and Bedford. There's duplicated overhead in place. And to some degree that's going to offset some of the benefits we're picking up from Singapore. But all of that transitioning should be complete and the restructuring charges out of the way as we look at it by third quarter next year,” Fodor explained.
 
According to Schiffman, roughly $2.5 million of the firm’s loss was incurred as part of the startup of the Singapore facility, which began shipping products in September.
 
“Over the next nine months, we will continue to increase production volumes in Singapore as well as transition our Bedford manufacturing to Sacramento. We expect to see improvements in our gross margins during this time as a result of these changes,” he added.

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