Organization and Business

 

Illumina, Inc. (the Company) is a leading developer, manufacturer, and marketer of life science tools and integrated systems for the analysis of genetic variation and biological function. Using the Company’s proprietary technologies, Illumina provides a comprehensive line of genetic analysis solutions, with products and services that serve a broad range of highly interconnected markets, including sequencing, genotyping, gene expression, and molecular diagnostics. The Company’s customers include leading genomic research centers, academic institutions, government laboratories, and clinical research organizations, as well as pharmaceutical, biotechnology, agrigenomics, and consumer genomics companies.

 

Basis of Presentation

 

The consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (GAAP) and include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.

 

Fiscal Year

 

The Company’s fiscal year is 52 or 53 weeks ending the Sunday closest to December 31, with quarters of 13 or 14 weeks ending the Sunday closest to March 31, June 30, September 30, and December 31. The year ended January 2, 2011 was 52 weeks; the year ended January 3, 2010 was 53 weeks; the year ended December 28, 2008 was 52 weeks.

 

Use of Estimates

 

The preparation of financial statements requires that management make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosure of contingent assets and liabilities. Actual results could differ from those estimates.

 

Segment Information

 

The Company is organized in two business segments, the Life Sciences Business Unit and Diagnostics Business Unit. The Life Sciences Business Unit includes all products and services that are primarily related to the research market, namely the product lines based on the Company’s sequencing, BeadArray, VeraCode, and real-time polymerase chain reaction (PCR) technologies, and the Diagnostics Business Unit focuses on the emerging opportunity in molecular diagnostics. During all periods presented, the Company had limited activity related to the Diagnostics Business Unit. Accordingly, the Company’s operating results for both units are reported on an aggregate basis as one reportable segment during these periods. The Company will begin reporting in two segments once revenues, operating profit or loss, or assets of the Diagnostics Business Unit exceed 10% of the consolidated amounts.

 

Acquisitions

 

Effective December 29, 2008, the Company adopted the FASB’s revised authoritative guidance for business combinations. This revised guidance requires an acquiring company to measure all assets acquired and liabilities assumed, including contingent considerations and all contractual contingencies, at fair value as of the acquisition date. In addition, an acquiring company is required to capitalize in-process research and development (IPR&D) and either amortize it over the life of the product upon commercialization, or write it off if the project is abandoned or impaired. Previously, post-acquisition adjustments related to business combination deferred tax asset valuation allowances and liabilities for uncertain tax positions were generally required to be recorded as an increase or decrease to Goodwill. The revised guidance does not permit this accounting and, generally, requires any such changes to be recorded in current period income tax expense. Thus, all changes to valuation allowances and liabilities for uncertain tax positions established in acquisition accounting, regardless of the guidance used to initially account for the business combination, will be recognized in current period income tax expense. Additionally, this guidance requires that contingent purchase consideration be remeasured to estimated fair value at each reporting period with the change in fair value recorded in the results of operations. The impact of the adoption of this guidance did not have an impact on the consolidated financial statements for the year ended January 3, 2010. As a result of acquisitions completed in the year ended January 2, 2011, the Company capitalized $21.4 million of IPR&D that would have been expensed under the previous guidance. In addition the Company recorded $14.1 million of contingent consideration liability at fair value at the acquisition date which was remeasured with a net consolidated statement of income impact of $10.4 million recorded in acquisition related (gain) expense, net, a component of operating expenses.

 

For an acquisition consummated prior to December 29, 2008, the Company recognizes additional contingent consideration as an additional element of the cost of the acquisition when the contingency is resolved beyond a reasonable doubt and the additional consideration is issued or becomes issuable, in accordance with the accounting guidance effective at the acquisition date. This results in additional IPR&D charges in periods subsequent to the acquisition recorded in acquisition related (gain) expense, net.

 

Cash Equivalents and Short-Term Investments

 

Cash equivalents are comprised of short-term, highly liquid investments with maturities of 90 days or less at the date of purchase.

 

Short-term investments consist of U.S. Treasury and U.S. government agency securities, corporate notes and bonds, and commercial paper. Management classifies short-term investments as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All short-term investments are recorded at estimated fair value. Unrealized gains and losses for available-for-sale securities are included in accumulated other comprehensive income, a component of stockholders’ equity. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered to be other than temporary if they are related to deterioration in credit risk or if it is likely that the Company will sell the securities before the recovery of their cost basis. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in other (expense) income, net in the consolidated statements of income.

 

Fair Value Measurements

 

The carrying amounts of financial instruments such as cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, and accrued liabilities, excluding acquisition related contingent consideration liability noted below, approximate the related fair values due to the short-term maturities of these instruments. The estimated fair value of the convertible senior notes is determined by using available market information as of the latest trading date prior to the Company’s fiscal year-end provided by a third party financial institution. The par value and approximate fair value of the Company’s convertible notes was $390.0 million and $1,142.5 million, respectively, at January 2, 2011, and $390.0 million and $553.2 million, respectively, at January 3, 2010.

 

The Company determines the fair value of its assets and liabilities based on the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs. The Company uses a fair value hierarchy with three levels of inputs, of which the first two are considered observable and the last unobservable, to measure fair value:

 

 

The following table presents the Company’s fair value hierarchy for assets and liability measured at fair value on a recurring basis as of January 2, 2011 and January 3, 2010, respectively (in thousands):

 

 

 

The Company measures the fair value of debt securities in government sponsored entities and corporate debt securities on a recurring basis primarily using quoted prices for similar assets in active markets.

 

Included in the total consideration transferred for the Company’s acquisition of Helixis, Inc. (Helixis), was contingent consideration payments that could range from $0 to $35 million based on the achievement of certain revenue-based milestones by December 31, 2010 and by December 31, 2011. On the acquisition date, a liability of $14.1 million was recorded at the estimated fair value of the contingent consideration. The December 31, 2010 milestone was not achieved and the likelihood of paying the remaining contingent consideration of up to $30 million declined. Accordingly, the Company reassessed the fair value of the contingent consideration at $3.7 million and recorded the change in fair value of $10.4 million in acquisition related (gain) expense, net, in the consolidated statements of income in the fourth quarter of 2010.

 

This fair value measurement is a Level 3 measurement as it is based on unobservable inputs that are supported by little or no market activity. Significant assumptions used in the measurement include probabilities of achieving the remaining milestone and the discount rates used in the income approach of valuation, which ranged from 27% to 52% depending on the likelihood assessed. Future changes in the fair value of the contingent consideration as a result of changes in these significant inputs could have a significant effect on the consolidated statements of income and the financial position in the period of the change.

 

The following table includes a summary of the changes in estimated fair value of the contingent consideration liability (in thousands) during the year ended January 2, 2011:

 

 

Accounts Receivable

 

Trade accounts receivable are recorded at the net invoice value and are not interest bearing. The Company considers receivables past due based on the contractual payment terms. The Company reviews its exposure to amounts receivable and reserves specific amounts if collectibility is no longer reasonably assured. The Company also reserves a percentage of its trade receivable balance based on collection history and current economic trends that might impact the level of future credit losses. The Company re-evaluates such reserves on a regular basis and adjusts its reserves as needed.

 

Concentrations of Risk

 

The Company operates in markets that are highly competitive and rapidly changing. Significant technological changes, shifting customer needs, the emergence of competitive products or services with new capabilities, and other factors could negatively impact the Company’s operating results.

 

The Company is also subject to risks related to its financial instruments including its cash and cash equivalents, investments, and accounts receivable. Most of the Company’s cash and cash equivalents as of January 2, 2011 were deposited with financial institutions in the United States. The Company’s investment policy restricts the amount of credit exposure to any one issuer to 5% of the portfolio at the time of purchase and to any one industry sector, as defined by Bloomberg classifications, to 25% of the portfolio at the time of purchase. There is no limit to the percentage of the portfolio that may be maintained in U.S. treasury obligations, U.S. government agencies, and money market funds. The Company performs a regular review of customer activity and associated credit risks and do not require collateral or enter into netting arrangements. The Company has historically not experienced significant credit losses from investments and accounts receivable.

 

The Company’s products require customized components that currently are available from a limited number of sources. The Company obtains certain key components included in its products from single vendors.

 

Shipments to customers outside the United States comprised 45%, 48%, and 51% of the Company’s revenue for the years ended January 2, 2011, January 3, 2010, and December 28, 2008, respectively. Customers outside the United States represented 59% and 46% of the Company’s gross trade accounts receivable balance as of January 2, 2011 and January 3, 2010, respectively. Sales to territories outside of the United States are generally denominated in U.S. dollars. International sales entail a variety of risks, including currency exchange fluctuations, longer payment cycles, and greater difficulty in accounts receivable collection. The Company is also subject to general geopolitical risks, such as political, social and economic instability, and changes in diplomatic and trade relations. The risks of international sales are mitigated in part by the extent to which sales are geographically distributed.

 

Inventory

 

Inventory is stated at the lower of cost (on a first in, first out basis) or market. Inventory includes raw materials and finished goods that may be used in the research and development process and such items are expensed as consumed or expired. Provisions for slow moving, excess, and obsolete inventories are estimated based on product life cycles, quality issues, historical experience, and usage forecasts.

 

Property and Equipment

 

Property and equipment are stated at cost, subject to review of impairment, and depreciated over the estimated useful lives of the assets (generally three to seven years) using the straight-line method. Amortization of leasehold improvements is computed over the shorter of the lease term or the estimated useful life of the related assets. Maintenance and repairs are charged to operations as incurred. When assets are sold, or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in operating expense.

 

Goodwill, Intangible Assets and Other Long-Lived Assets

 

Goodwill represents the excess of cost over fair value of net assets acquired. The change in the carrying value of goodwill during the year ended January 2, 2011 was due to goodwill recorded in connection with acquisitions consummated in the year. Intangible assets include acquired technology, customer relationships, other license agreements, and licensed technology (capitalized as part of the Affymetrix litigation). The cost of identified intangible assets is amortized on a straight-line basis over periods ranging from three to ten years.

 

The Company regularly performs reviews to determine if the carrying values of the long-lived assets are impaired. Goodwill and other intangible assets that have indefinite useful lives, such as IPR&D, are reviewed for impairment at least annually during the second fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. The performance of the goodwill impairment test is a two-step process. The first step of the impairment test involves comparing the estimated fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, the Company performs the second step of the goodwill impairment test to determine the amount of loss, which involves comparing the implied fair value of the goodwill with the carrying value of the goodwill. The Company performed its annual impairment test of goodwill in May of 2010, noting no impairment and has determined there have been no impairment indicators for goodwill through January 2, 2011. A review of intangible assets that have finite useful lives and other long-lived assets is performed when an event occurs indicating the potential for impairment. If indicators of impairment exist, the Company assesses the recoverability of the affected long-lived assets by determining whether the carrying amount of such assets exceeds the undiscounted expected future cash flows. If impairment is indicated, the Company compares the carrying amount to the estimated fair value of the asset and adjusts the value of the asset accordingly. Factors that would necessitate an impairment assessment include a significant decline in the Company’s stock price and market capitalization compared to its net book value, significant changes in the ability of a particular asset to generate positive cash flows, and significant changes in the Company’s strategic business objectives and utilization of the asset.

 

Reserve for Product Warranties

 

The Company generally provides a one-year warranty on instruments. Additionally, the Company provides a warranty on its consumables through the expiry date, which generally ranges from six to twelve months after the manufacture date. The Company establishes an accrual for estimated warranty expenses based on historical experience as well as anticipated product performance. The Company periodically reviews the adequacy of its warranty reserve, and adjusts, if necessary, the warranty percentage and accrual based on actual experience and estimated costs to be incurred. Warranty expense is recorded as a component of cost of product revenue. Warranty expenses associated with extended maintenance contracts for systems are recorded as cost of service and other revenue as incurred. See note “6. Warranties” for further detailed discussion.

 

Revenue Recognition

 

The Company’s revenue is generated primarily from the sale of products and services. Product revenue primarily consists of sales of instrumentation and consumables used in genetic analysis. Service and other revenue primarily consists of revenue received for performing genotyping and sequencing services, extended warranty sales, and amounts earned under research agreements with government grants, which are recognized in the period during which the related costs are incurred.

 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product or system is required, revenue is deferred until all the acceptance criteria have been met. All revenue is recorded net of any discounts.

 

Revenue for product sales is recognized generally upon transfer of title to the customer, provided that no significant obligations remain and collection of the receivable is reasonably assured. Revenue for genotyping and sequencing services is recognized when earned, which is generally at the time the genotyping or sequencing analysis data is made available to the customer or agreed upon milestones are reached.

 

In order to assess whether the price is fixed or determinable, the Company evaluates whether refund rights exist. If there are refund rights or payment terms based on future performance, the Company defers revenue recognition until the price becomes fixed or determinable. The Company assesses collectibility based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If the Company determines that collection of a payment is not reasonably assured, revenue recognition is deferred until receipt of payment.

 

The Company regularly enters into contracts where revenue is derived from multiple deliverables including any mix of products or services. These products or services are generally delivered within a short time frame, approximately three to six months, of the contract execution date. Revenue recognition for contracts with multiple deliverables is based on the individual units of accounting determined to exist in the contract. A delivered item is considered a separate unit of accounting when the delivered item has value to the customer on a stand-alone basis. Items are considered to have stand-alone value when they are sold separately by any vendor or when the customer could resell the item on a stand-alone basis.

 

For transactions entered into in 2009 and 2010, consideration is allocated at the inception of the contract to all deliverables based on their relative selling price. The relative selling price for each deliverable is determined using vendor specific objective evidence (VSOE) of selling price or third-party evidence of selling price if VSOE does not exist. If neither VSOE nor third-party evidence exists, the Company uses its best estimate of the selling price for the deliverable.

 

For transactions entered into prior to 2009, consideration was generally allocated to each unit of accounting based upon its relative fair value when objective and reliable evidence of fair value existed for all units of accounting in an arrangement. The fair value of an item was generally the price charged for the product, if the item was regularly sold on a stand-alone basis. In those instances when objective and reliable evidence of fair value existed for the undelivered items but not for the delivered items, the residual method was used to allocate the arrangement consideration. Under the residual method, the amount of arrangement consideration allocated to the delivered items equaled the total arrangement consideration less the aggregate fair value of the undelivered items. When the Company was unable to establish stand-alone value for delivered items or when fair value of undelivered items had not been established, revenue was deferred until all elements were delivered and services had been performed, or until fair value could objectively be determined for any remaining undelivered elements.

 

In order to establish VSOE of selling price, the Company must regularly sell the product or service on a standalone basis with a substantial majority priced within a relatively narrow range. VSOE of selling price is usually the midpoint of that range. If there are not a sufficient number of standalone sales and VSOE of selling price cannot be determined, then the Company considers whether third party evidence can be used to establish selling price. Due to the lack of similar products and services sold by other companies within the industry, the Company has rarely established selling price using third-party evidence. If neither VSOE nor third party evidence of selling price exists, the Company determines its best estimate of selling price using average selling prices over a rolling 12-month period coupled with an assessment of current market conditions. If the product or service has no history of sales or if the sales volume is not sufficient, the Company relies upon prices set by the Company’s pricing committee adjusted for applicable discounts. The Company recognizes revenue for delivered elements only when it determines there are no uncertainties regarding customer acceptance.

 

In the first quarter of 2010, the Company offered an incentive with the launch of the HiSeq 2000 that enabled existing Genome Analyzer customers to trade in their Genome Analyzer and receive a discount on the purchase of a HiSeq 2000. The incentive was limited to customers who had purchased a Genome Analyzer as of the date of the announcement and was the first significant trade-in program offered by the Company. The Company accounts for HiSeq 2000 discounts related to the Genome Analyzer trade-in program in the period in which the HiSeq 2000 revenue is recognized.

 

Shipping and Handling Expenses

 

Shipping and handling expenses are included in cost of product revenue.

 

Research and Development

 

Research and development expenses consist of costs incurred for internal and grant-sponsored research and development. Research and development expenses include personnel expenses, contractor fees, facilities costs, and utilities. Expenditures relating to research and development are expensed in the period incurred.

 

Advertising Costs

 

The Company expenses advertising costs as incurred. Advertising costs were $6.9 million, $4.2 million, and $3.4 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008, respectively.

 

Leases

 

Leases are reviewed and classified as capital or operating at their inception. For leases that contain rent escalations, the Company records the total rent payable on a straight-line basis over the term of the lease, which includes the construction build-out period but excludes lease extension periods. The difference between rent payments and straight-line rent expense is recorded in other long-term liabilities. Landlord allowances are also recorded in other long-term liabilities, which are amortized on a straight-line basis over the lease term as a reduction to rent expense.

 

Income Taxes

 

The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for the expected future tax benefit to be derived from tax loss and credit carryforwards. Deferred tax assets and liabilities are determined using the enacted tax rates in effect for the years in which those tax assets are expected to be realized. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the provision for income taxes in the period that includes the enactment date.

 

Deferred tax assets are regularly assessed to determine the likelihood they will be recovered from future taxable income. A valuation allowance is established when the Company believes it is more likely than not the future realization of all or some of a deferred tax asset will not be achieved. In evaluating the ability to recover deferred tax assets within the jurisdiction which they arise the Company considers all available positive and negative evidence. Factors reviewed include the cumulative pre-tax book income for the past three years, scheduled reversals of deferred tax liabilities, history of earnings and reliable forecasting, projections of pre-tax book income over the foreseeable future, and the impact of any feasible and prudent tax planning strategies.

 

The Company recognizes excess tax benefits associated with share-based compensation to stockholders’ equity only when realized. When assessing whether excess tax benefits relating to share-based compensation have been realized, the Company follows the with-and-without approach excluding any indirect effects of the excess tax deductions. Under this approach, excess tax benefits related to share-based compensation are not deemed to be realized until after the utilization of all other tax benefits available to the Company.

 

The Company recognizes the impact of a tax position in the financial statements only if that position is more likely than not of being sustained upon examination by taxing authorities, based on the technical merits of the position. Any interest and penalties related to uncertain tax positions will be reflected in income tax expense.

 

Functional Currency

 

Prior to the third quarter of 2008, the Company identified the local currency as the functional currency in each of its foreign subsidiaries, with all translation adjustments recorded as part of other comprehensive income. Beginning in the third quarter of 2008, the Company reorganized its international structure to execute a more efficient relationship among product development, product manufacturing, and sales. This reorganization increased the foreign subsidiaries’ dependence on the U.S. entity for management decisions, financial support, production assets, and inventory, thereby making the foreign subsidiaries a direct and integral component of the U.S. entity’s operations. As a result, the Company reassessed the primary economic environment of its foreign subsidiaries, resulting in a U.S. dollar functional currency determination. Beginning in the third quarter of 2008, the Company remeasures its foreign subsidiaries’ assets and liabilities and revenue and expense accounts related to monetary assets and liabilities to the U.S. dollar and records the net gains or losses resulting from remeasurement in other (expense) income, net in the consolidated statements of income. Gains or (losses) resulting from remeasurement were $0.6 million, $(2.3) million, and $3.8 million for the years ended January 2, 2011, January 3, 2010 and December 28, 2008, respectively.

 

Derivatives

 

The Company is exposed to foreign exchange rate risks in the normal course of business. To manage a portion of the accounting exposure resulting from changes in foreign currency exchange rates, the Company enters into foreign exchange contracts to hedge monetary assets and liabilities that are denominated in currencies other than the U.S. dollar. These foreign exchange contracts are carried at fair value and do not qualify for hedge accounting treatment and are not designated as hedging instruments. Changes in the value of the derivative are recognized in other (expense) income, net, in the consolidated statements of income for the current period, along with an offsetting gain or loss on the underlying assets or liabilities.

 

Share-Based Compensation

 

The Company uses the Black-Scholes-Merton option-pricing model to estimate the fair value of stock options granted and stock purchases under the Employee Stock Purchase Plan (ESPP). This model incorporates various assumptions including expected volatility, expected life of an award, expected dividends, and the risk-free interest rates. The Company determines volatility by equally weighing the historical and implied volatility of the Company’s common stock. The historical volatility of the Company’s common stock over the most recent period is generally commensurate with the estimated expected life of the Company’s stock awards, adjusted for the impact of unusual fluctuations not reasonably expected to recur and other relevant factors. The implied volatility is calculated from the implied market volatility of exchange-traded call options on the Company’s common stock. The expected life of an award is based on historical forfeiture experience, exercise activity, and on the terms and conditions of the stock awards. The fair value of restricted stock units granted is based on the market price of our common stock on the date of grant. The Company amortizes the fair value of share-based compensation on a straight-line basis over the requisite service periods of the awards.

 

The assumptions used for the specified reporting periods and the resulting estimates of weighted-average fair value per share of options granted and for stock purchases under the ESPP during those periods are as follows:

 

 

As of January 2, 2011, approximately $151.8 million of total unrecognized compensation cost related to stock options, restricted stock units, and ESPP shares issued to date is expected to be recognized over a weighted-average period of approximately 2.47 years.

 

Total share-based compensation expense for all stock awards consists of the following (in thousands):

 

 

Net Income per Share

 

On July 22, 2008, the Company announced a two-for-one stock split in the form of a 100% stock dividend with a record date of September 10, 2008 and a distribution date of September 22, 2008. Share and per share amounts have been restated to reflect the stock split for all periods presented.

 

Basic net income or loss per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding during the reporting period. Diluted net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the reporting period increased to include dilutive potential common shares using the treasury stock method. Dilutive potential common shares consist of stock options with combined exercise prices and unrecognized compensation expense that are less than the average market price of the Company’s common stock, restricted stock units with unrecognized compensation expense, convertible debt when the average market price of the Company’s common stock is above the conversion price of $21.83 and warrants with exercise prices that are less than the average market price of the Company’s common stock. Under the treasury stock method, the amount that must be paid to exercise stock options and warrants, the average amount of compensation expense for future services that the Company has not yet recognized for stock options and restricted stock units, and the amount of estimated tax benefits that will be recorded in additional paid-in capital when the awards become deductible are assumed to be used to repurchase shares. In loss periods, basic net loss per share and diluted net loss per share are identical since the effect of dilutive potential common shares is anti-dilutive and therefore excluded.

 

The following table presents the calculation of weighted average shares used to calculate basic and diluted net income per share (in thousands):

 

 

Accumulated Other Comprehensive Income

 

Comprehensive income is comprised of net income and other comprehensive income. The Company has disclosed comprehensive income as a component of stockholders’ equity. Accumulative other comprehensive income on the consolidated balance sheets at January 2, 2011 and January 3, 2010 includes accumulated foreign currency translation adjustments and unrealized gains and losses on the Company’s available-for-sale securities.

 

The components of accumulated other comprehensive income are as follows (in thousands):

 

 

 

Investments

 

The following is a summary of short-term investments (in thousands):

 

 

 

Available-For-Sale Securities

 

As of January 2, 2011 the Company had 83 available-for-sale securities in a gross unrealized loss position, all of which had been in such position for less than twelve months. There were no unrealized losses due to credit issues for the periods presented. There were no impairments considered other-than-temporary as it is more likely than not the Company will hold the securities until maturity or a recovery of the cost basis. The following table shows the fair values and the gross unrealized losses of the Company’s available-for- sale securities that were in an unrealized loss position as of January 2, 2011 and January 3, 2010 aggregated by investment category (in thousands):

 

 

Realized gains and losses are determined based on the specific identification method and are reported in interest income in the consolidated statements of income. Gross realized gains on sales of available-for sale securities for the year ended January 2, 2011 were $1.7 million and gross realized losses were immaterial. Gross realized gains and losses on sales of available-for-sale securities were immaterial for each of the years ended January 3, 2010 and December 28, 2008.

 

Contractual maturities of available-for-sale securities as of January 2, 2011 were as follows (in thousands):

 

 

Trading Securities

 

As of January 3, 2010, the Company’s short-term investments included $54.9 million (at cost) of auction rate securities issued primarily by municipalities and universities. In November 2008, the Company signed an agreement granting the Company an option to sell all of its auction rate securities at par value to UBS during the period of June 30, 2010 through July 2, 2012. To account for the option, the Company recorded a separate freestanding asset (put option). On July 1, 2010, the Company exercised its option to sell all of its remaining auction rate securities at par. From January 3, 2010 through July 1, 2010 the increase in the fair value of the auction rate securities was equal to the decrease in the fair value of the put option. As such, no gain or loss was recorded as a result of the exercise of the put option and the sale of the auction rate securities.

 

Changes in the fair value of the Company’s auction rate securities and put option from January 3, 2010 through January 2, 2011 are as follows (in thousands):

 

 

Cost-Method Investments

 

As of January 2, 2011 and January 3, 2010, the aggregate carrying amounts of the Company’s cost-method investments in non-publicly traded companies were $32.0 million and $19.9 million, respectively. The Company’s cost-method investments are assessed for impairment quarterly. The Company does not estimate the fair value of cost-method investments if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investments. See “Investments” in note “5. Impairment” for more information on the impairment of cost-method investments. The Company includes cost-method investments in other long term assets in the consolidated balance sheets.

 

Accounts Receivable

 

Accounts receivable consist of the following (in thousands):

 

 

Inventory

 

Inventory, net, consists of the following (in thousands):

 

 

Property and Equipment

 

Property and equipment consist of the following (in thousands):

 

 

Depreciation expense was $34.2 million, $24.5 million and $17.3 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008, respectively.

 

Accrued Liabilities

 

Accrued liabilities consist of the following (in thousands):

 

 

On April 30, 2010, the Company completed the acquisition of Helixis, a company developing a high-performance, low-cost, real time PCR system used for nucleic acid analysis. Total consideration for the acquisition at the closing date was approximately $86.7 million, including $70.0 million in cash (net of $2.6 million of cash acquired) and $14.1 million for the fair value of contingent consideration payments that could range from $0 to $35 million based on the achievement of certain revenue-based milestones by December 31, 2011. Using information available at the close of the acquisition, the Company allocated approximately $2.3 million of the consideration to tangible assets, net of liabilities, and approximately $28.0 million to identified intangible assets that will be amortized over a useful life of 10 years. The Company also recorded a $10.7 million deferred tax liability to reflect the tax impact of the identified intangible assets that will not generate tax deductible amortization expense and an $8.7 million deferred tax asset which primarily relates to acquired net operating loss carryforwards. The Company recorded the excess consideration of approximately $58.4 million as goodwill, which is not deductible for income tax purposes.

 

Prior to the acquisition, the Company had an equity interest in Helixis with a cost basis of $2.0 million that was accounted for under the cost method of accounting. The Company recognized a gain of $2.9 million, which was included in other (expense) income, net, in its consolidated statement of income as a result of revaluing the Company’s equity interest in Helixis on the acquisition date.

 

On July 28, 2010, the Company completed an acquisition of another privately-held, development stage entity. Total consideration for the acquisition was $22.0 million. As a result of this transaction, the company recorded an in-process research and development (IPR&D) asset of $21.4 million in other assets (long-term). In determining the fair value of the IPR&D, various factors were considered, such as future revenue contributions, additional research and development costs to be incurred, and contributory asset charges. The fair value of the IPR&D was calculated using an income approach, and the rate used to discount net future cash flows to their present values was based on a risk-adjusted rate of return of approximately 28%. Significant factors considered in the calculation of the rate of return include the weighted average cost of capital, the weighted average return on assets, the internal rate of return, as well as the risks inherent in the development process for development-stage entities of similar sizes.

 

IPR&D will not be amortized until the development efforts are complete and until then, the Company will perform an annual impairment test of the asset, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test will involve a comparison of the fair value of the asset with its carrying amount. If its carrying amount exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess. Upon completion of the related development efforts, the Company will start amortizing the IPR&D based on an estimated useful life. Through January 2, 2011, there was no indication of impairment of IPR&D and no impairment loss has been recorded.

 

In 2008, the Company completed an acquisition of another development-stage company. At the time of the acquisition, the Company paid $25.8 million in cash, including transaction costs. In accordance with the applicable accounting guidance effective at that time, the Company recorded a charge of $24.7 million for purchased in-process research and development (IPR&D). As part of the acquisition agreement, Illumina agreed to pay the former shareholders of the entity up to an additional $35.0 million in contingent cash consideration based on the achievement of certain milestones. As contingent consideration payments are made, they are recorded as IPR&D charges and compensation expenses. IPR&D and compensation expenses related to such contingent consideration recorded in the past three years are as follows (in thousands):

 

 

 

 

 

The Company’s intangible assets, excluding goodwill, are comprised primarily of licensed technology from the Affymetrix settlement entered into on January 9, 2008, acquired core technology and customer relationships from the acquisition of Solexa, and acquired core technology from the acquisition of Helixis. As a result of the Affymetrix settlement, the Company agreed, without admitting liability, to make a one-time payment to Affymetrix, of which $36.0 million was recorded as licensed technology and classified as an intangible asset. The effective life of the licensed technology extends through 2015, the final expiry date of all patents considered in valuing the intangible asset. Amortization related to the Affymetrix licensed technology is recorded on a straight-line basis.

 

In connection with the acquisition of Helixis. in April 2010, the Company recorded an additional core technology of $28.0 million with a useful life of approximately 10 years. Acquired core technologies and customer relationships are being amortized on a straight-line basis over their useful lives.

 

The following is a summary of the Company’s amortizable intangible assets as of the respective balance sheet dates (in thousands):

 

 

Amortization expense associated with the intangible assets was $7.8 million, $6.7 million, and $10.4 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008, respectively.

 

The estimated annual amortization of intangible assets for the next five years is shown in the following table (in thousands). Actual amortization expense to be reported in future periods could differ from these estimates as a result of acquisitions, divestitures, asset impairments, and other factors.

 

 

 

Investments

 

During the fourth quarter of 2010, the Company determined that a $6.0 million cost-method investment and a related $6.8 million note receivable with interest receivable of $0.4 million were below carrying value and the impairment was other-than-temporary. This determination was based upon continued shortfalls from revenue plans coupled with events in the fourth quarter of fiscal 2010 that created uncertainty regarding the entity’s ability to obtain additional funding in a required timeframe for the entity to continue operations. As a result, the Company recorded an impairment charge of $13.2 million in other (expense) income, net in the consolidated statements of income for the year ended January 2, 2011.

 

Manufacturing Equipment

 

During the year ended December 28, 2008, the Company implemented next-generation imaging and decoding systems to be used in manufacturing. These systems were developed to increase existing capacity and allow the Company to transition to the Infinium High-Density (HD) product line. As a result of this transition, the demand for products manufactured on the previous infrastructure was reduced and certain systems were no longer being utilized. A non-cash impairment charge of $4.1 million was recorded in the year ended December 28, 2008 for the excess machinery. This charge is included as a separate line item in the Company’s consolidated statement of income. There was no change to useful lives and related depreciation expenses of the remaining assets as the Company believes these estimates are currently reflective of the period the assets will be used in operations.

 

 

The Company generally provides a one-year warranty on instruments. Additionally, the Company provides a warranty on its consumables through the expiry date, which generally ranges from six to twelve months after the manufacture date. At the time revenue is recognized, the Company establishes an accrual for estimated warranty expenses based on historical experience as well as anticipated product performance. The Company periodically reviews the adequacy of our warranty reserve, and adjusts, if necessary, the warranty percentage and accrual based on actual experience and estimated costs to be incurred. Warranty expense is recorded as a component of cost of product revenue. Estimated warranty expenses associated with extended maintenance contracts for systems are recorded as a cost of service and other revenue as incurred.

 

Changes in the Company’s reserve for product warranties from January 1, 2008 through January 2, 2011 are as follows (in thousands):

 

 

 

On February 16, 2007, the Company issued $400.0 million principal amount of 0.625% convertible senior notes due 2014. The net proceeds from the offering, after deducting the initial purchasers’ discount and offering expenses, were approximately $390.3 million. The Company pays 0.625% interest per annum on the principal amount of the notes, payable semi-annually in arrears in cash on February 15 and August 15 of each year. The notes mature on February 15, 2014.

 

The notes are convertible into cash and, if applicable, shares of the Company’s common stock, $0.01 par value per share, based on a conversion rate, subject to adjustment, of 45.8058 shares per $1,000 principal amount of notes (which represents a conversion price of approximately $21.83 per share), only in the following circumstances and to the following extent: (1) during the five business-day period after any five consecutive trading-day period (the measurement period) in which the trading price per note for each day of such measurement period was less than 97% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such day; (2) during any calendar quarter, if the last reported sale price of the Company’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; (3) upon the occurrence of specified events; and (4) at any time on or after November 15, 2013 through the third scheduled trading day immediately preceding the maturity date. The requirements of the second condition above were satisfied during each of the calendar quarters of 2010 and the first, second and third quarters of 2009. Accordingly, the notes were and continue to be convertible during the period from, and including, April 1, 2009 through, and including, December 31, 2009 and again during the period April 1, 2010 through, and including, March 31, 2011. Additionally, these same requirements were satisfied during the third quarter of 2008, and, as a result, the notes were convertible during the period from, and including, October 1, 2008 through, and including, December 31, 2008. On December 29, 2008, a noteholder converted notes in an aggregate principal amount of $10.0 million. On February 4, 2009, the settlement date, we paid the noteholder the conversion value of the notes in cash, up to the principal amount of the notes. The excess of the conversion value over the principal amount, totaling $2.9 million, was paid in shares of common stock. This equity dilution upon conversion of the notes was offset by the reacquisition of the shares under the convertible note hedge transactions entered into in connection with the offering of the notes.

 

The hedge transaction entered with the initial purchasers and/or their affiliates (the hedge counterparties) entitles the Company to purchase up to 18,322,320 shares of the Company’s common stock at a strike price of approximately $21.83 per share, subject to adjustment. In addition, the Company sold to these hedge counterparties warrants exercisable, on a cashless basis, for up to 18,322,320 shares of the Company’s common stock at a strike price of $31.435 per share, subject to adjustment. The cost of the hedge transaction that was not covered by the proceeds from the sale of the warrants was approximately $46.6 million and was reflected as a reduction of additional paid-in capital. The hedge transaction is expected to reduce the potential equity dilution upon conversion of the notes to the extent the Company exercises the hedge to purchase shares from the hedge counterparties to deliver to converting noteholders. However, the warrants could have a dilutive effect on the Company’s earnings per share to the extent that the price of the Company’s common stock exceeds the strike price of the warrants.

 

As of January 2, 2011, the principal amount of the convertible senior notes was $390.0 million due to conversion of $10.0 million of the notes during the first quarter of 2009. The unamortized discount was $78.4 million resulting in a net carrying amount of the liability component of $311.6 million. As of January 3, 2010, the principal amount of the notes was $390.0 million and the unamortized discount was $99.8 million, resulting in a net carrying amount of the liability of $290.2 million. Upon the conversion, the Company recorded a gain of $0.8 million in the first quarter of 2009, calculated as the difference between the carrying amount of the converted notes and their estimated fair value as of the settlement date. To measure the fair value of the converted notes as of the settlement date, the Company calculated an interest rate of 11.3% using Level 2 Observable Inputs. This rate was applied to the converted notes and coupon interest rate using the same present value technique used in the issuance date valuation. The remaining period over which the discount on the liability component will be amortized is 3.12 years.

 

 

Operating Leases

 

The Company leases office and manufacturing facilities under various noncancellable operating lease agreements. Facility leases generally provide for periodic rent increases, and many contain escalation clauses and renewal options. Certain leases require the Company to pay property taxes and routine maintenance. The Company is headquartered in San Diego, California and leases facilities in San Diego, California; Hayward, California; Carlsbad, California; Branford, Connecticut; the United Kingdom; the Netherlands; Japan; Singapore; Australia; and China.

 

Annual future minimum payments under these operating leases as of January 2, 2011 were as follows (in thousands):

 

 

Rent expense, net of amortization of the deferred gain on sale of property, was $14.7 million, $13.6 million, and $10.7 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008, respectively.

 

On December 30, 2010, the Company entered into a lease agreement for a new corporate headquarters facility located in San Diego, California. The lease has a target commencement date of November 1, 2011 and has an initial term of 20 years with four five-year options to extend. There is a one-time option to terminate the lease after 15 years in exchange for an early termination fee. The lease includes two existing office buildings and a central plant building with approximately 346,600 square feet. The Company has also agreed to lease a third office building to be built at this facility containing approximately 123,400 rentable square feet. The Company has the right to further expand the premises and lease one or more of three additional office buildings that may be built at this facility. Included in the table above are future minimum lease payments during the initial term of the lease, which are expected to total approximately $355.9 million, excluding further expansion beyond the third building, and taking no consideration of tenant improvement allowances of approximately $21.9 million. The Company will capitalize the leasehold improvements and amortize them over the shorter of the lease term or their expected useful life. The leasehold improvement allowances will reduce rent expense over the initial lease term.

 

Lease commitments of $108.3 million related to the lease for the Company’s current headquarters are also included in the table above. The Company plans to cease the use of the facility near the end of 2011 and the Company is further obligated for certain ongoing operating costs prior to any sublease that may be obtained. Upon cease-use of the facility, the Company will record an estimated loss for the present value of the expected shortfall between the remaining lease payments obligation and estimated sublease rental during the remaining lease period, adjusted for deferred rents and leasehold improvements.

 

 

Common Stock

 

On July 22, 2008, the Company announced a two-for-one stock split in the form of a 100% stock dividend with a record date of September 10, 2008 and a distribution date of September 22, 2008. Share and per share amounts have been restated to reflect the stock split for all periods presented.

 

On August 12, 2008, a total of 8,050,000 shares were sold to the public at a public offering price of $43.75 per share, raising net proceeds to the Company of $342.7 million, after deducting underwriting discounts and commissions and offering expenses.

 

On January 2, 2011, the Company had 126,606,851 shares of common stock outstanding, excluding treasury shares.

 

Stock Options

 

On January 2, 2011, the Company had three active stock plans: the 2005 Stock and Incentive Plan (the 2005 Stock Plan), the 2005 Solexa Equity Incentive Plan (the 2005 Solexa Equity Plan), and the New Hire Stock and Incentive Plan. As of January 2, 2011, options to purchase 7,535,584 shares remained available for future grant under the 2005 Stock Plan and 2005 Solexa Equity Plan. There is no set number of shares reserved for issuance under the New Hire Stock and Incentive Plan.

 

Stock options granted at the time of hire primarily vest over a four or five-year period, with 20% or 25% of options vesting on the first anniversary of the grant date and the remaining options vesting monthly over the remaining vesting period. Stock options granted subsequent to hiring primarily vest monthly over a four or five-year period. Each grant of options has a maximum term of ten years, measured from the applicable grant date, subject to earlier termination if the optionee’s service with us ceases. Vesting in all cases is subject to the individual’s continued service to us through the vesting date. The Company satisfies option exercises through the issuance of new shares.

 

The Company’s stock option activity under all stock option plans from January 1, 2008 through January 2, 2011 is as follows:

 

 

At January 2, 2011, outstanding options to purchase 6,950,184 shares were exercisable with a weighted average per share exercise price of $17.70. The weighted average remaining life in years of options outstanding and exercisable is 6.51 years and 5.67 years, respectively, as of January 2, 2011.

 

The aggregate intrinsic value of options outstanding and options exercisable as of January 2, 2011 and January 3, 2010 was $481.4 million and $317.2 million, respectively. Aggregate intrinsic value represents the difference between the Company’s closing stock price per share on the last trading day of the fiscal period, which was $63.34 as of December 31, 2010, and the exercise price multiplied by the number of options outstanding. Total intrinsic value of options exercised was $156.9 million, $73.4 million, and $136.6 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008, respectively.

 

Employee Stock Purchase Plan

 

In February 2000, the board of directors and stockholders adopted the 2000 ESPP. A total of 15,467,426 shares of the Company’s common stock have been reserved for issuance under the ESPP. The ESPP permits eligible employees to purchase common stock at a discount, but only through payroll deductions, during defined offering periods.

 

The price at which stock is purchased under the ESPP is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. The initial offering period commenced in July 2000. In addition, beginning with fiscal 2001, the ESPP provides for annual increases of shares available for issuance by the lesser of 3% of the number of outstanding shares of the Company’s common stock on the last day of the immediately preceding fiscal year, 3,000,000 shares or such lesser amount as determined by the Company’s board of directors. Shares totaling 372,544, 359,713, and 276,198 were issued under the ESPP during fiscal 2010, 2009, and 2008, respectively. As of January 2, 2011 and January 3, 2010, there were 16,061,905 shares and 13,434,499 shares available for issuance under the ESPP, respectively.

 

Restricted Stock Units

 

In 2007 the Company began granting restricted stock units (RSUs), pursuant to its 2005 Stock and Incentive Plan as part of its periodic employee equity compensation review program. RSUs are share awards that, upon vesting, will deliver to the holder shares of the Company’s common stock. RSUs generally vest 15% on the first anniversary of the grant date, 20% on the second anniversary of the grant date, 30% on the third anniversary of the grant date, and 35% on the fourth anniversary of the grant date. The Company satisfies RSU vesting through the issuance of new shares.

 

A summary of the Company’s RSU activity and related information from January 1, 2008 through January 2, 2011 is as follows: