e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006


o		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 (State or Other Jurisdiction of Incorporation or Organization) 904 Caribbean Drive, Sunnyvale, California (Address of Principal Executive Office)		77-0441625 (I.R.S. Employer Identification No.) 94089-1189 (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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large Accelerated Filer o Accelerated Filer þ Non-Accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes þ No

As of October 31, 2006, there were 54,902,659 shares of the registrant’s common stock outstanding.

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CEPHEID

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)


	September 30,			December 31,
	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	16,213		$	16,072
Marketable securities		82,150			21,150
Accounts receivable		12,748			13,976
Inventory		9,592			7,989
Prepaid expenses and other current assets		1,469			583

Total current assets		122,172			59,770
Property and equipment, net		14,608			13,000
Restricted cash		661			661
Other non-current assets		458			—
Intangible assets, net		31,132			29,757

Total assets	$	169,031		$	103,188


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	9,533		$	9,293
Accrued compensation		2,651			3,191
Accrued royalties		3,321			3,115
Accrued collaboration proft sharing		2,358			4,371
Accrued other liabilities		2,501			2,441
Short term note payable		114			—
Current portion of deferred revenue		3,323			2,963
Current portion of license fee payable		2,415			8,538
Line of credit		—			4,000
Current portion of equipment financing		524			2,297

Total current liabilities		26,740			40,209

Long term portion of deferred revenue		2,984			4,402
Long term portion of license fees payable		—			387
Long term portion of equipment financing		46			2,052
Deferred rent		794			735
Shareholders’ equity:
Common stock		251,386			155,347
Additional paid-in capital		12,232			7,518
Accumulated other comprehensive income		34			39
Accumulated deficit		(125,185	)		(107,501	)

Total shareholders’ equity		138,467			55,403

Total liabilities and shareholders’ equity	$	169,031		$	103,188

See accompanying notes.

CEPHEID

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Revenues:
Instrument sales	$	7,287		$	8,300		$	15,855		$	21,921
Reagent and disposable sales		15,360			10,938			44,945			36,272

Total product sales		22,647			19,238			60,800			58,193
Contract revenues		987			822			2,275			2,212
Grant and government sponsored research revenues		128			352			694			957

Total revenues		23,762			20,412			63,769			61,362

Costs and operating expenses:
Cost of product sales		13,281			11,601			36,357			33,617
Collaboration profit sharing		3,813			2,904			11,467			10,112
Research and development		5,568			4,754			17,204			13,797
In-process research and development		139			—			139			—
Selling, general and administrative		6,146			4,518			19,213			14,110

Total costs and operating expenses		28,947			23,777			84,380			71,636

Loss from operations		(5,185	)		(3,365	)		(20,611	)		(10,274	)
Other income (expenses), net		1,215			103			2,927			(80	)

Net loss	$	(3,970	)	$	(3,262	)	$	(17,684	)	$	(10,354	)


Basic and diluted net loss per share	$	(0.07	)	$	(0.08	)	$	(0.34	)	$	(0.24	)


Shares used in computing basic and diluted net loss per share		54,771			42,581			51,448			42,430

See accompanying notes.

CEPHEID

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Nine Months Ended
	September 30,
	2006			2005
Cash flows from operating activities:
Net loss	$	(17,684	)	$	(10,354	)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock compensation expense		5,200			—
Stock-based compensation related to consulting services rendered		(7	)		3
Depreciation and amortization		3,507			2,813
Amortization of intangible assets		2,009			1,882
Amortization of imputed interest		691			440
In-process technology expense		139
Deferred rent		59			109
Unrealized loss on investments		6			—
Changes in operating assets and liabilities:
Accounts receivable		1,261			(2,109	)
Inventory		(1,603	)		(1,820	)
Prepaid expenses and other current assets		(761	)		(635	)
Other non-current assets		(458	)			—
Accounts payable and other current liabilities		(1,166	)		7,566
Accrued compensation		(582	)		(637	)
Deferred revenue		(1,351	)		(2,251	)

Net cash used in operating activities		(10,740	)		(4,993	)


Cash flows from investing activities:
Capital expenditures		(5,111	)		(5,630	)
Payments for technology licenses		(9,300	)		(10,585	)
Purchases of intangible assets		(928	)
Cost of acquisition, net		(422	)		—
Proceeds from maturities of marketable securities		37,950			24,206
Purchases of marketable securities		(98,950	)		(20,125	)

Net cash used in investing activities		(76,761	)		(12,134	)


Cash flows from financing activities:
Net proceeds from the sale of common shares		95,559			2,585
Principal payments of line of credit		(4,000	)		—
Proceeds from equipment financing		—			3,000
Principal payments under equipment financing		(3,906	)		(1,595	)

Net cash provided by financing activities		87,653			3,990

Effect of exchange rate change on cash		(11	)		—
Net increase (decrease) in cash and cash equivalents		152			(13,137	)
Cash and cash equivalents at beginning of period		16,072			23,189


Cash and cash equivalents at end of period	$	16,213		$	10,052

See accompanying notes.

CEPHEID

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Organization and Summary of Significant Accounting Policies

Organization and Business

Cepheid (the “Company”) was incorporated in the State of California on March 4, 1996. The Company develops, manufactures, and markets fully-integrated systems that perform genetic analysis for the clinical molecular diagnostic, industrial, and biothreat markets. The Company’s systems enable rapid, sophisticated genetic testing of organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures.

The condensed consolidated balance sheet at September 30, 2006, the condensed consolidated statements of operations for the three and nine month periods ended September 30, 2006 and 2005, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005 are unaudited. In the opinion of management, these condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) that are necessary for a fair presentation of the results for and as of the periods shown. 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 have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The results of operations for such periods are not necessarily indicative of the results expected for 2006 or for any future period. The condensed consolidated balance sheet as of December 31, 2005 is derived from audited 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 financial statements should be read in conjunction with the financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 filed with the SEC.

Principles of Consolidation

The condensed consolidated financial statements of Cepheid include the accounts of the Company and its wholly-owned subsidiary in France. In August 2006, our French subsidiary acquired a wholly owned subsidiary, Actigenics SA (Actigenics). As of the purchase date, Actigenics Financial Statements are included in the condensed consolidated financial statements. The functional currency of the French subsidiary is the U.S. dollar; accordingly, all gains and losses arising from foreign currency transactions in currencies other than the U.S. dollar are included in the consolidated statements of operations. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from these estimates.

Inventory

As of January 1, 2006, the Company has adopted Statement of Financial Accounting Standards (SFAS) No. 151, “Inventory Costs” (SFAS 151), an amendment to ARB 43, Chapter 4, “Inventory Pricing.” SFAS 151 clarifies treatment of abnormal amounts of idle facility expense, freight, handling costs and spoilage, specifying that such costs should be expensed as incurred and not included in overhead. The new statement also requires that allocation of fixed production overheads to conversion costs should be based on normal capacity of the production. The adoption of SFAS 151 has not had a material impact on the Company’s results of operations or financial position.

Inventory is stated at the lower of standard cost (which approximates actual cost) or market, with cost determined on the first-in-first-out method.

The Company maintains a reserve for inventory obsolescence. This reserve is established utilizing management’s estimate of the potential future obsolescence of inventory. The components of inventory were as follows (in thousands):


	September 30,		December 31,
	2006		2005
Raw Materials	$	5,954	$	6,042
Work in Process		1,363		565
Finished Goods		2,275		1,382

	$	9,592	$	7,989

Intangible Assets

As of September 30, 2006, intangible assets consisted primarily of rights to certain patented technologies licensed from Applera Corporation and F. Hoffmann-La Roche Ltd. (Roche) as well as other third parties. Amortization of intangible assets is included in cost of product sales in the accompanying condensed consolidated statements of operations.

Intangible assets are recorded at cost, less accumulated amortization. Intangible assets are amortized over their estimated useful lives, ranging from 5 to 20 years, on a straight-line basis. The Company reviews intangible assets for impairment under Statement of Financial Accounting Standards No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”. This impairment review is conducted at least annually, or when events or circumstances indicate the carrying value of a long-lived asset may be impaired and not recoverable. There was no impairment charge recorded during the first nine months of 2006.

Amortization expense of intangible assets was $0.7 million and $0.6 million for the three months ended September 30, 2006 and 2005, respectively, and $2.0 million and $1.9 million for the nine months ended September 30, 2006 and 2005, respectively. The expected future annual amortization expense of intangible assets recorded on our balance sheet as of September 30, 2006 is as follows (in thousands):


2006 (remaining three months)	$	762
2007		3,051
2008		3,051
2009		3,041
2010		2,993
2011 — 2024		18,234

Total expected future annual amortization	$	31,132

Warranty Accrual

The Company warrants its disposable products to be free from defects and its instrument products to be free from defects for a period of 12 to 15 months from the date of sale. A provision for the estimated cost of warranty repair or replacement is recorded at the time revenue is recognized. The Company’s warranty accrual is established using management’s estimate for the future costs of repairing any instrument failures during the warranty period or replacing any disposable products with defects. The activity in the warranty accrual for the three and nine months ended September 30, 2006 and 2005 consisted of the following (in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Balance at beginning of period	$	195		$	423		$	470		$	379
Costs incurred and charged against reserve		(26	)		(159	)		(405	)		(525	)
Provision for warranty		67			505			171			915

Balance at end of period	$	236		$	769		$	236		$	769

Revolving Line of Credit

In November 2004, the Company entered into an agreement with a financial lending institution for a revolving line of credit totaling $4.0 million of which up to $2.0 million may be used for letters of credit. The line of credit expires on November 9, 2006, at which time any outstanding balance on the line of credit will be due. The agreement was

subsequently amended in May 2005 to increase the existing line of credit to $4.3 million and to add an equipment financing line of $3.0 million. As of September 30, 2006 the Company had no borrowings under this line.

The equipment line of credit and revolving line of credit are collateralized by the Company’s accounts receivable, certain equipment, tenant improvements, or other personal property of the Company financed pursuant to the agreement, and bears an annual interest rate, at the Company’s option, equal to the lender’s prime rate or LIBOR plus 2.5% per annum. The agreement, as amended, contains a financial covenant that requires the Company to maintain at least 80% of the outstanding balance of all of the Company’s indebtedness, as such term is defined in the agreement, in cash or investments with the lender and a minimum of $25.0 million in unrestricted cash in total. As of September 30, 2006 the Company had no balance outstanding under this line.

In addition, the Company financed a portion of its equipment purchases under an equipment financing arrangement with General Electric Capital. The loans are to be repaid over periods ranging from 36 to 48 months at interest rates ranging from 7.4% to 9.9%. At September 30, 2006, there was no credit available under this arrangement, and the balance due was $0.6 million.

Revenue Recognition

The Company recognizes revenue from product sales and contract arrangements. From time to time, the Company enters into revenue arrangements with multiple deliverables. Multiple element revenue agreements entered into on or after July 1, 2003 are evaluated under Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” to determine whether the delivered item has value to the customer on a stand-alone basis and whether objective and reliable evidence of the fair value of the undelivered item exists. Deliverables in an arrangement that do not meet the separation criteria in EITF 00-21 must be treated as one unit for the purpose of revenue recognition. Advance payments received in excess of amounts earned, such as funds received in advance of products to be delivered or services to be performed, are classified as deferred revenue until earned.

The Company recognizes revenue from product sales when there is persuasive evidence that an arrangement exists, delivery has occurred, the price is fixed or determinable and collectibility 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 during 2006.

Contract revenues include fees for technology licenses and research and development services, royalties under license and collaboration agreements, and fees for services rendered under research and development arrangements. Contract revenue related to technology licenses is generally fully recognized only after the license period has commenced, the technology has been delivered, and no further involvement of the Company is required. Royalties are typically based on the licensees’ net sales of products that utilize the Company’s technology. Royalty revenues are recognized as earned in accordance with the contract terms and conditions stating when the royalties can be reliably measured and their collectibility is reasonably assured, such as upon the receipt of a royalty statement from the customer.

Grant and government sponsored research revenue and contract revenue related to research and development services are recognized as the related services are performed based on the performance requirements stated in the relevant contract. Under such agreements, the Company is required to perform specific research and development activities and is compensated either based on the costs, or costs plus a mark-up, associated with each specific contract over the term of the agreement or when certain milestones are achieved.

Stock-Based Compensation

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R) using the modified prospective transition method. Under the modified prospective transition method, prior periods are not restated for the effect of SFAS 123R. Commencing with the first quarter of 2006, compensation cost includes all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and compensation for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. The Company recognizes the fair value of its stock option awards as compensation expense over the requisite service period of each award, which is generally four years. Compensation expense related to stock options granted prior to January 1, 2006 is accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related Interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123).

Prior to the adoption of SFAS 123R, the Company applied SFAS 123, amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148), which allowed companies to apply the existing accounting rules under APB 25 and related interpretations. In general, as the exercise price of options granted under the Company’s plans was equal to the market price of the underlying common stock on the grant date, no stock-based employee compensation cost was recognized in the Company’s net income (loss) for periods prior to the adoption of SFAS 123R. As required by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro forma net income (loss) and pro forma net income (loss) per common share disclosures for stock-based awards, as if the fair-value-based method defined in SFAS 123 had been applied.

Determining Fair Value

Valuation and amortization method — The Company estimates the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term—The expected term of the award represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its stock-based awards.

Expected Volatility— Volatility is a measure of the amounts by which a financial variable such as stock price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. The Company uses the historical volatility for the past 5 years to estimate expected volatility, which matches the expected term of the option grant.

Risk-Free Interest Rate—The Company bases the risk-free interest rate used in the Black-Scholes valuation method on the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of a stock award.

Estimated Forfeitures — When estimating forfeitures, the Company considers voluntary termination behavior as well as analysis of actual option forfeitures.

Fair Value—The fair value of the Company’s stock options granted to employees and shares purchased by employees under the Company’s 2000 Employee Stock Purchase Plan (ESPP) for the three and nine months ended September 30, 2006 and 2005 was estimated using the following assumptions.

OPTION SHARES


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Expected Term (in years)		5			4			5			4
Volatility		0.96			0.84			0.97			0.93
Expected Dividends	$	—		$	—		$	—		$	—
Risk Free Interest Rates		4.84	%		4.00	%		4.89	%		3.84	%
Estimated Forfeitures		15.34	%		—			15.34	%		—
Weighted Average Fair Value	$	6.14		$	4.70		$	6.69		$	6.08

ESPP SHARES


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Expected Term (in years)		0.5 — 2.0			0.5 — 2.0			0.5 — 2.0			0.5 — 2.0
Volatility		0.48 — 0.50			0.46 — 0.54			0.48 — 0.53			0.46 — 0.68
Expected Dividends	$	—		$	—		$	—		$	—
Risk Free Interest Rates		4.97 — 5.18	%		3.78 — 4.04	%		4.50 — 5.18	%		2.85 — 4.04	%
Weighted Average Fair Value	$	3.35		$	3.19		$	3.42		$	3.61

Stock Compensation Expense— The Company recorded $1.6 million and $5.2 million of stock-based compensation for the three and nine months ended September 30, 2006, respectively. The following table is a summary of the major categories of stock compensation expense for the three and nine months ended September 30, 2006 (in thousands).


	Three Months Ended		Nine Months Ended
	September 30, 2006		September 30, 2006
Cost of product sales	$	153	$	531
Research and development		604		1,922
Selling, general and administrative		806		2,747

Total stock compensation expense	$	1,563	$	5,200

As of September 30, 2006 the total compensation cost related to unvested stock based grants awarded under the Company’s 1997 Stock Option Plan (1997 Plan) and 2006 Equity Incentive Plan (2006 Plan) but not yet recognized was approximately $20.5 million which is net of estimated forfeitures of $5.3 million. This cost will be amortized on a straight line basis over a weighted-average period of approximately 4 years and will be adjusted for subsequent changes in estimated forfeitures on a quarterly basis.

At September 30, 2006, the total compensation cost related to options to purchase the Company’s common shares under the ESPP but not yet recognized was approximately $0.9 million. The cost will be amortized on a straight-line basis over the two year “Offering Period,” as such term is defined in the ESPP.
Stock Option Activity

The following is a summary of option activity under Cepheid’s 1997 Plan, 2006 Plan, and ESPP:


	Number of			Weighted-Average		Weighted-Average		Aggregate
	Shares			Exercise Price		Contractual Life		Intrinsic Value
						(in years)		(in millions)
OPTIONS
Outstanding at December 31, 2005		6,643,899		$	6.53
Granted		2,001,625			8.78
Exercised		(593,277	)		4.66
Forfetures and Cancellations		(618,064	)		8.67


Outstanding at September 30, 2006		7,434,183		$	7.11		7.24	$	8.81


Ending Vested and Expected to Vest		6,754,006		$	6.94		0.48		8.79
Exercisable at September 30, 2006		3,752,355			5.56		6.28	$	8.45

ESPP
Purchased January and July 2006		123,118		$	7.26
Ending Vested and Expected to Vest		341,656			7.52		0.84	$	0.00

Pro-forma Disclosure

The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provision of SFAS 123 to options granted under the Company’s stock-based compensation plans prior to January 1, 2006. For purposes of this pro-forma disclosure, the value of the options was estimated using a Black-Scholes option pricing formula and amortized on a straight-line basis over the respective vesting periods of the awards.


	Three Months Ended			Nine Months Ended
(in thousands)	September 30, 2005			September 30, 2005
Net loss as reported	$	(3,262	)	$	(10,354	)
Deduct: Total stock-based employee compensation determined under the fair value method for all awards, net of tax related effects		(2,130	)		(6,125	)


Pro forma net loss	$	(5,392	)	$	(16,479	)


Basic and diluted net loss per share:
As reported	$	(0.08	)	$	(0.24	)
Pro forma	$	(0.13	)	$	(0.39	)

Net Loss per Share

Basic net loss per share has been calculated based on the weighted-average number of common shares outstanding during the period, less shares subject to the Company’s right of repurchase. Common stock equivalents consisting of stock options and warrants (calculated using the treasury stock method) have been excluded from the computation of diluted net loss per share, as their inclusion would be antidilutive for all periods presented.

The following table presents the calculation of basic and diluted net loss per share:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands)	2006			2005			2006			2005
Net Loss	$	(3,970	)	$	(3,262	)	$	(17,684	)	$	(10,354	)

Basic and Diluted:
Weighted-average shares of common stock outstanding		54,771			42,581			51,448			42,430

Shares used in computing basic and diluted net loss per share		54,771			42,581			51,448			42,430

Basic and diluted net loss per share	$	(0.07	)	$	(0.08	)	$	(0.34	)	$	(0.24	)

Comprehensive Loss

Comprehensive loss includes net loss as well as other comprehensive income or loss. The Company’s other comprehensive income or loss consists of foreign currency translation adjustments and unrealized gains and losses on available-for-sale securities. Total accumulated other comprehensive income or loss is displayed as a separate component of shareholders’ equity in the accompanying condensed consolidated balance sheets. The following table presents the calculation of comprehensive loss, including components of other comprehensive income (loss):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
(amounts in thousands)
Net Loss	$	(3,970	)	$	(3,262	)	$	(17,684	)	$	(10,354	)
Other comprehensive income (loss):
Foreign currency translation adjustments		(67	)		(1	)		(11	)		160
Unrealized gain (loss) on available-for-sale securities		—			—			6			2

Comprehensive loss	$	(4,037	)	$	(3,263	)	$	(17,689	)	$	(10,192	)

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157 “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, rather, it applies under existing accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company will adopt SFAS 157 as required. The Company is currently evaluating the impact of SFAS 157 on its consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements in Current Year Financial Statements” (SAB108). SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. SAB 108 is effective for periods ending after November 15, 2006. The Company does not expect the adoption of SAB 108 to have a material impact on its consolidated financial condition or results of operations.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 clarifies the recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as required. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

2. Segment and Significant Concentrations

The Company and its wholly owned subsidiary operate in only one business segment.

The Company currently sells its products through its direct sales force and through third-party distributors. For the three months ended September 30, 2006 there was one customer that accounted for 53% of product sales. For the nine months ended September 30, 2006 there was one customer that accounted for 59% of product sales. For the three months ended September 30, 2005, there were two direct customers that represented 51% and 18% of total product sales. For the nine months ended September 30, 2005, there were two direct customers that represented 59% and 15% of total product sales. The Company has distribution agreements with Fisher Scientific Company L.L.C. to market the Cepheid SmartCycler systems in the U.S. and Fisher Canada to market products in Canada. The Company also has several regional distribution arrangements throughout Europe, Japan, South Korea, China, Mexico and other parts of the world. Additionally, sales of SmartCycler occur through arrangements with BD-GeneOhm and Veridex. Information about sales by region as a percentage of total product sales for the three and nine months ended September 30, 2006 and 2005 was as follows:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(as % of total product sales)						(as % of total product sales)
Product Sales:
North America		87	%		95	%		89	%		95	%
Europe		10	%		3	%		9	%		3	%
Japan and other		3	%		2	%		2	%		2	%

Total Product Sales		100	%		100	%		100	%		100	%

No single country outside of the United States represented more than 10% of the Company’s total revenues, total assets or total property and equipment in any period presented.

The Company has distribution agreements with Fisher Scientific Company L.L.C. to market the Cepheid SmartCycler system in the U.S. and Fisher Canada to market products in Canada. The Company also has several regional distribution arrangements throughout Europe, Japan, South Korea, China, Mexico and other parts of the world. Additionally, sales occur through collaborations including BD-GeneOhm and Veridex. Information about sales through our distributors by geographic regions as a percentage of total product sales is listed below for the three and nine months ended September 30, 2006 and 2005:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(as % of total product sales)						(as % of total product sales)
Percentage of Total Product Sales through Distributors in:
North America		7	%		5	%		8	%		6	%
Europe		8	%		3	%		6	%		3	%
Japan and other		3	%		2	%		2	%		2	%

Total product sales		18	%		10	%		16	%		11	%

Cepheid operates in three market areas: clinical molecular diagnostics (clinical), industrial and biothreat markets. The following table illustrates product revenues in the three market areas as a percentage of total product sales for the three and nine months ended September 30, 2006 and 2005:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(as % of total product sales)						(as % of total product sales)
Product Sales by Market:
Clinical		26	%		13	%		22	%		10	%
Industrial		21	%		19	%		18	%		17	%
Biothreat		53	%		68	%		60	%		73	%

Total product sales		100	%		100	%		100	%		100	%

3. Patent License Agreements

In April 2004, the Company entered into a patent license agreement with Applera Corporation (Applera), through its Applied Biosystems group (ABI) and its Celera Group for a non-exclusive worldwide license to make, use, and sell the Company’s products incorporating technology covered by Applera patents. The Company also entered into a patent license agreement with F. Hoffmann-La Roche Ltd. (Roche), effective July 1, 2004, for a non-exclusive worldwide license to make, use, and sell the Company’s products incorporating technology covered by Roche patents. Under the license agreements, the Company agreed to pay aggregate license fees of $32.2 million, of which the final payment of $6.7 million has been paid as of September 30, 2006. In connection with the license agreements, the Company recorded intangible assets of $31.1 million, representing the present value of license fee obligations net of imputed interest of $1.1 million. The intangible assets related to the Applera and Roche licenses are being amortized on a straight-line basis over their useful lives of approximately 10 and 15 years, respectively, with the amortization recorded as part of the cost of product sales.

The Company also agreed to pay Applera and Roche ongoing royalties on sales of any products incorporating the licensed patents. Resulting product royalties will be recorded as part of the cost of product sales when the related product sales are recognized. In addition, Cepheid holds various other patent licenses acquired from other licensors, of which the aggregate cost was $4.7 million as of September 30, 2006. These other intangible assets, as of September 30, 2006, are estimated to generate an aggregate of $4.2 million in additional amortization charges over their varying lives.

4. Collaboration Profit Sharing

Collaboration profit sharing represents the amount the Company pays to ABI under its collaboration agreement to develop reagents for use in the Biohazard Detection System (BDS) developed for the United States Postal Service (USPS). Under the agreement, a computed gross margin on anthrax cartridge sales is shared equally between the two parties. Collaboration profit sharing expense was $3.8 million and $2.9 million for the three months ended September 30, 2006 and 2005, respectively. Collaboration profit sharing expense was $11.5 million and $10.1 million for the nine months ended September 30, 2006 and 2005, respectively. The total revenues and cost of sales related to these cartridge sales is included in the respective balances in the condensed consolidated statement of operations.

5. Common Stock Offering

On March 13, 2006 the Company received proceeds of approximately $80.6 million, net of expenses of $5.4 million, from the sale of 10,000,000 shares of common stock at a price of $8.60 per share in an underwritten public offering. On April 5, 2006 the underwriters of this offering exercised their over allotment option and purchased an additional 1,419,910 shares of common stock at a price of $8.60 per share and the Company received additional proceeds of $11.3 million, net of expenses of $0.9 million.

6. Legal Proceedings

In March 2006, a complaint filed on December 22, 2005, in the United States District Court for the District of Utah by Idaho Technology, Inc., and University of Utah Research Foundation, was served on Cepheid. The complaint alleges that Cepheid infringes certain patents licensed by the University of Utah Research Foundation to Idaho Technology, Inc. The complaint seeks declaratory and injunctive relief, damages, attorneys’ fees and costs. Discovery has commenced and the Court has set a trial date of February 11, 2008. We believe that we have meritorious defenses to this action and if the claims are not withdrawn, intend to defend the claims vigorously.

7. Acquisition

In August 2006, Cepheid, through its wholly owned French subsidiary, Cepheid SA, purchased 100% of the stock of Actigenics SA (Actigenics), a French microRNA research and services company. The acquisition will allow Cepheid direct access to microRNA markers used in diagnostic and therapeutic products, and the related discovery, validation and development processes. Cepheid paid $1.2 million in cash, of which 10% ($120,000) has been retained for a period of one year from the purchase date for possible breach of seller’s general representations and guarantees. In addition, Cepheid assumed approximately $0.7 million of liabilities, and acquired $0.2 million of tangible assets.

Of the $1.2 million paid $0.7 million represented deferred prepaid compensation expense to be recognized over a service period of three years from the August 2006 acquisition date. This deferred compensation expense is being amortized on a straight line basis.

The acquisition was accounted for as a purchase transaction in accordance with Statement of Financial Accounting Standard No. 141, “Business Combination,” (SFAS 141), and accordingly, the tangible and intangible assets acquired and liabilities assumed were recorded at their estimated fair value at the date of the acquisition. The results of Actigenics operations have been included in the Company’s consolidated results of operations from the acquisition date. Pro forma results of operations have not been presented because the effect of the acquisition was not material.

The purchase price was allocated as follows (in thousands):


Marker technology	$	591
Discovery and validation technology		197
In-process research and development		139
Liabilities assumed, net of assets acquired		(505	)

Total allocation of purchase price	$	422

The marker technology and discovery and validation technology will be amortized on a straight-line basis over ten and six year periods, respectively. Immediately subsequent to the acquisition date, in accordance with FASB Interpretation No. 4, $0.1 million of in-process research and development intangible assets with no alternative future uses were written off.

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 the Private Securities Litigation Reform Act of 1995. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. Forward-looking statements 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: the scope and timing of actual USPS funding of the BDS; the rate of environmental testing using the BDS conducted by the USPS, which will affect the amount of consumable products sold; unforeseen development and manufacturing problems, including with respect to the GeneXpert system and reagents; the need for additional licenses for new tests and other products and the terms of such licenses; lengthy sales cycles in certain markets; the performance and market acceptance of our new products; our ability to obtain regulatory approvals and introduce new products into the clinical market; our ability to successfully sell products in the clinical market; our reliance on distributors to market, sell and support our products; the occurrence of unforeseen expenditures, acquisitions or other transactions; our success in increasing our direct sales; the impact of competitive products and pricing; our ability to manage geographically-dispersed operations; underlying market conditions worldwide; and the other risks set forth under “Risk Factors” in our annual report on Form 10-K and elsewhere in this report, and we can not guarantee future results, levels of activity, performance or achievements. We assume no obligation to update any of the forward-looking statements after the date of this report or to conform these forward-looking statements to actual results.

OVERVIEW

We are a molecular diagnostics company that develops, manufactures, and markets fully-integrated systems for genetic analysis in the clinical molecular diagnostics, industrial, and biothreat markets. Our systems enable rapid, sophisticated molecular testing for organisms and genetic-based diseases by automating otherwise complex manual laboratory procedures. Molecular testing involves a number of complicated and time-intensive steps, including sample preparation, DNA amplification and detection. Our easy-to-use systems integrate these steps and analyze complex biological samples in our proprietary test cartridges. We are focusing our efforts on those applications where rapid molecular testing is particularly important, such as identifying infectious disease and cancer in the clinical market; food, agricultural and environmental testing in the industrial market; and identifying bio-terrorism agents in the biothreat market.

Our two principal instrument platforms are our SmartCycler and GeneXpert systems. The SmartCycler system, integrates DNA amplification and detection to allow rapid analysis of a sample. The GeneXpert system integrates automated sample preparation with our SmartCycler DNA amplification and detection technology. The GeneXpert system, a closed, self-contained, fully-integrated and automated system, represents a paradigm shift in the automation of molecular analysis, producing accurate results in a timely manner with minimal risk of contamination. Our GeneXpert system can provide rapid results with superior test specificity and sensitivity over comparable systems on the market today that are integrated but have open architectures.

During the second quarter of 2004, we entered into a patent license agreement with Applera Corporation, through its ABI and its Celera Group, and, effective July 1, 2004, we entered into a patent license agreement with Roche, each of which provides for non-exclusive worldwide licenses to make, use, and sell our products incorporating technologies covered by Applera’s and Roche’s respective patents. Under the license agreements, we agreed to pay aggregate license fees of $32.2 million, the full amount of which has been paid as of September 30, 2006. We also agreed to pay Applera and Roche ongoing royalties on sales of products incorporating their licensed patents. In connection with the license agreements, we recorded intangible assets of $31.1 million, representing the present value of license fee obligations net of imputed interest of $1.1 million. The intangible assets related to the Applera and Roche licenses are being amortized on a straight-line basis over their useful lives of approximately 10 and 15 years, respectively, with the amortization recorded as part of the cost of product sales.

On September 28, 2005, Cepheid entered into a license agreement with Abaxis, Inc., effective as of September 30, 2005, pursuant to which Abaxis granted Cepheid a non-exclusive, worldwide, royalty-bearing license to certain Abaxis patents relating to lyophilization technology. In exchange for the license rights, the Company agreed to (i) make an upfront license payment, (ii) pay royalties during the term of the agreement and (iii) pay a yearly license maintenance fee during the term of the agreement, which fee will be creditable against any royalties due during such calendar year.

In November 2005, Cepheid entered into a license agreement with DxS , a private United Kingdom based company, pursuant to which DxS granted Cepheid a non-exclusive, worldwide, royalty-bearing license to the DxS scorpions patents and other intellectual property rights relating to its Scorpions technology for the real-time PCR detection of nucleic acid amplification, including, the human in vitro diagnostics field.

In August 2006, Cepheid, through its wholly owned French subsidiary, Cepheid SA, purchased 100% of the stock of Actigenics SA (Actigenics), a French microRNA research and services company. The purchase amount paid was $1.2 million in cash, of which $120,000 has been retained for a period of one year from the purchase date as security for the seller’s indemnification obligations. In addition, Cepheid assumed approximately $0.7 million of liabilities, offset by approximately $0.2 million of assets.

The marker technology and discovery and validation technology will be amortized on a straight-line basis over ten and six year periods, respectively. Future estimated intangible asset annual amortization expense will be $0.2 million through December 2011. Immediately subsequent to the acquisition date, in accordance with FASB Interpretation No. 4, $0.1 million of in-process research and development intangible assets with no alternative future uses were written off.

Sales Channels

We sell our products through both direct and through other distribution channels. In the United States, we sell through our direct sales force in the industrial and clinical molecular diagnostics markets, as well as through a non-exclusive distributor, Fisher Scientific Company L.L.C., in the industrial market. Additional sales occur through our arrangements with BD-GeneOhm and Veridex. In Europe, our products are sold primarily through distributors. In Japan and other parts of the world, we sell solely through distributors. Through our French subsidiary, Cepheid SA, additional distributors have been established in Europe, the Middle East, India, and South Africa. We expect to continue expanding our sales efforts into other territories throughout the world by adding distributors and entering into collaboration agreements.

Revenues

Currently, our revenue is derived primarily from the sales of our two instrument platforms and associated reagents and disposables in the clinical, industrial, and biothreat markets, and to a lesser extent from contract and government sponsored research.

In December 2003, we entered into an agreement for a strategic commercial relationship with bioMerieux in which bioMerieux is to develop DNA testing products using their proprietary Nucleic Acid Sequence-Based Amplification (NASBA) technology to be run on systems employing our GeneXpert platforms. Under the agreement, bioMerieux has paid us a $10.0 million license fee, and an additional $5.0 million payment will become due when and if bioMerieux commercializes its first product based on our technology. We may also receive potential product purchases and royalty payments on end-user GeneXpert test cartridge sales if any such products are introduced under the agreement. The $10.0 million license fee received from bioMerieux was deferred and is being amortized over the period of approximately five years.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS

We consider our accounting policies related to revenue recognition, impairment of intangible assets, inventory reserve, warranty accrual, and stock based compensation to be critical accounting policies. A number of significant estimates, assumptions, and judgments are inherent in our determination of when to recognize revenue, how to evaluate our intangible assets, and the calculation of our inventory reserve, warranty accrual, and stock-based compensation expense. These estimates, assumptions, and judgments include deciding whether the elements required to recognize revenue from a particular arrangement are present, estimating the fair value of an intangible asset, which represents the future undiscounted cash flows to be derived from the intangible asset, and estimating the amount of inventory obsolescence and warranty costs associated with shipped products and estimating the useful life and volatility of stock awards granted. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be

reasonable under the circumstances. Actual results could differ materially from these estimates. Management believes that other than the adoption of SFAS No. 123 (revised 2004), “Share-Based Payment”, there have been no significant changes during the nine months ended September 30, 2006 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operation in our 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those critical accounting policies, please refer to our 2005 Annual Report on Form 10-K.

Stock-Based Compensation

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (Revised 2004), “Share-Based Payment,” using the modified-prospective-transition method. Under this transition method, stock-based compensation cost has been recognized in the statement of operations for the quarter and nine months ended September 30, 2006 for stock awards granted after December 31, 2005, and for stock awards granted prior to December 31, 2005, but unvested as of January 1, 2006. We estimate the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. We use the historical volatility for the past 5 years to estimate expected volatility, which matches the expected term of the option grant. The risk-free interest rate used in the Black-Scholes valuation method is based on the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of our stock awards. We recorded $1.6 million and $5.2 million of stock-based compensation expense for the three and nine months ended September 30, 2006, respectively.

As of September 30, 2006, the total compensation cost related to unvested stock based grants awarded under the company’s stock option plans but not yet recognized was approximately $20.5 million, which is net of estimated forfeitures of $5.3 million. This cost will be amortized on a straight line basis over a weighted-average period of approximately 4 years and will be adjusted for subsequent changes in estimated forfeitures on a quarterly basis.

At September 30, 2006, the total compensation cost related to options to purchase the Company’s common shares under the ESPP but not yet recognized was approximately $0.9 million. This cost will be amortized on a straight-line basis over the two year “Offering Period.” Stock compensation expense broken down by major categories in the statement of operations for the three and nine months ended September 30, 2006 is as follows (in thousands):


	Three Months Ended		Nine Months Ended
	September 30, 2006		September 30, 2006
Cost of product sales	$	153	$	531
Research and development		604		1,922
Selling, general and administrative		806		2,747

Total stock compensation expense	$	1,563	$	5,200

Results of Operations

Comparison of the Three and Nine Months Ended September 30, 2006 and 2005


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(amount in thousands)	2006		2005		2006		2005
Revenues:
Instrument sales	$	7,287	$	8,300	$	15,855	$	21,921
Reagent and disposable sales		15,360		10,938		44,945		36,272

Total product sales		22,647		19,238		60,800		58,193
Contract revenues		987		822		2,275		2,212
Grant and government sponsored research revenues		128		352		694		957

Total revenues	$	23,762	$	20,412	$	63,769	$	61,362

Total revenues increased 16% to $23.8 million and 4% to $63.8 million in the three and nine months ended September 30, 2006, respectively, from $20.4 million and $61.4 million for the three and nine months ended September 30, 2005, respectively. For the three months ended September 30, 2006 revenues were affected by a 28% increase in industrial

market sales, which we believe is attributable to a return of normal purchasing patterns in this market for government accounts, and a 135% increase in clinical sales offset by a 7% decrease in biothreat sales. For the nine months ended September 30, 2006 the 4% increase was primarily due to a substantial increase in our clinical product sales for the nine months ended September 30, 2006.

Product Sales

Total product sales for the three and nine months ended September 30, 2006 increased by 18% to $22.6 million and 4% to $60.8 million, respectively, from approximately $19.2 million and $58.2 million for the three and nine months ended September 30, 2005, respectively. The increase in product sales was the result of a change in product mix due to an anticipated decrease in GeneXpert module sales to the United States Postal Service (USPS) and a decrease in industrial products attributed primarily to a realignment of government funding priorities. Total sales of USPS GeneXpert modules were $3.4 million and $10.0 million for the three and nine months ended September 30, 2005, respectively. Accordingly, total sales of all other Cepheid products increased 43% and 26% for the three and nine months ended September 30, 2006, respectively, compared to the same periods of 2005.

Clinical product sales increased 135% to $5.8 million and represented 26% of our total product sales for the three months ended September 30, 2006 from $2.5 million and 13% of total product sales for the three months ended September 30, 2005. Clinical product sales increased 134% to 13.4 million and represented 22% of our total product sales for the nine months ended September 30, 2006 from $5.8 million and 10% of total product sales for the nine months ended September 30, 2005. Clinical sales increases were driven by gains in both the instrument and reagent product categories. In addition, Cepheid received FDA clearance in the United States for the GBS GeneXpert Assay and GeneXpert instrument and the GeneXpert GBS assay received a moderate complexity rating.

Industrial product sales increased 28% to $4.8 million and 12% to $11.0 million, respectively for the three and nine months ended September 30, 2006, respectively. This increase compares to industrial sales of $3.7 million and $9.8 million for the three and nine months ended September 30, 2005, respectively. We believe that the increase in the three months ended September 30, 2006 was due to a return of normal purchasing patterns for government accounts. This contrasts with the downturn in the Industrial market experienced in the second quarter of 2006. Industrial sales represented 21% and 18% of total product sales for the three and nine months ended September 30, 2006, respectively, as compared to 19% and 17% of total product sales for the three and nine months ended September 30, 2005, respectively.

Biothreat product sales decreased by 7% to $12.1 million and 15% to $36.4 million for the three and nine months ended September 30, 2006, respectively, from $13.0 million and $42.6 million for the three and nine ended months September 30, 2005, respectively. Biothreat sales represented 53% and 60% of the total product sales for the three and nine months ended September 30, 2006, respectively, as compared to 68% and 73% for the three and nine months ended September 30, 2005, respectively. For the three and nine months ended September 30, 2006, product sales to one major customer (customer A) represented 53% and 59% of total product sales, respectively. For the three and nine months ended September 30, 2005, product sales to customer A represented 51% and 59% of total product sales, respectively.

In the three months ended September 30, 2006 and 2005, product sales through distributors represented 18% and 10%, respectively, of our total product sales. In the nine months ended September 30, 2006 and 2005, product sales through distributors represented 16% and 11%, respectively, of our total product sales. The following table provides a breakdown of our product sales by geographic regions for the three and nine months ended September 30, 2006 and 2005:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(as % of total product sales)						(as % of total product sales)
Product Sales:
North America		87	%		95	%		89	%		95	%
Europe		10	%		3	%		9	%		3	%
Japan and other		3	%		2	%		2	%		2	%

Total Product Sales		100	%		100	%		100	%		100	%

No single country outside of the United States represented more than 10% of our total revenues in any period presented.

Information about sales through our distributors by geographic regions as a percentage of total product sales is listed below for the three and nine months ended September 30, 2006 and 2005:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(as % of total product sales)						(as % of total product sales)
Percentage of total product sales through distributors in:
North America		7	%		5	%		8	%		6	%
Europe		8	%		3	%		6	%		3	%
Japan and other		3	%		2	%		2	%		2	%

Total product sales		18	%		10	%		16	%		11	%


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(as % of total product sales)						(as % of total product sales)
Product sales by market:
Clinical		26	%		13	%		22	%		10	%
Industrial		21	%		19	%		18	%		17	%
Biothreat		53	%		68	%		60	%		73	%

Total product sales		100	%		100	%		100	%		100	%

Other Revenues

The decrease in other revenue for the quarter as compared to the corresponding prior year period was due primarily to the decrease in grant and government sponsored research revenue. Other revenues will fluctuate from period to period as we enter new or complete existing government sponsored and commercial arrangements.

Costs and Operating Expenses


	Three Months Ended							Nine Months Ended
	September 30,				%			September 30,				%
(amounts in thousands)	2006		2005		Change			2006		2005		Change
Costs and operating expenses:
Cost of product sales	$	13,281	$	11,601		14	%	$	36,357	$	33,617		8	%
Collaboration profit sharing		3,813		2,904		31	%		11,467		10,112		13	%
Research and development		5,568		4,754		17	%		17,204		13,797		25	%
In-process technology		139		—		—			139		—		—
Selling, general and administrative		6,146		4,518		36	%		19,213		14,110		36	%

Total costs and operating expenses	$	28,947	$	23,777		22	%	$	84,380	$	71,636		18	%

Cost of Product Sales

Cost of product sales consists of raw materials, direct labor, manufacturing overhead, facility costs and warranty costs. Cost of product sales also includes royalties on product sales and amortization of intangible assets related to technology licenses. Cost of product sales was $13.3 million and $36.4 million for the three and nine months ended September 30, 2006, respectively, compared to $11.6 million and $33.6 million during the respective periods in the prior year. The gross margin percentage on product sales for the three months ended September 30, 200 increased to 41% from 40% for the comparable prior year quarter. The increase for the quarter in product gross margin percentage was driven primarily by a favorable product mix and lower manufacturing costs as compared to the comparable prior year quarter. The gross margin percentage on product sales for the nine months ended September 30, 2006 decreased to 40% from 42% for the

comparable nine months ended September 30, 2005. The cost of product sales for the three and nine months ended September 30, 2006 included $0.2 million and $0.5 million of stock compensation expense, respectively, whereas there were no stock compensation charges in 2005. This had the effect of a 1% decrease on our product gross margin percentage for both the three and nine months ended September 30, 2006.

Collaboration Profit Sharing

Collaboration profit sharing represents the amount that we pay to ABI under our collaboration agreement to develop reagents for use in the BDS developed for the USPS. Under the agreement, computed gross margin on anthrax cartridge sales are shared equally between the two parties. The collaboration profit sharing was $3.8 million and $2.9 million in the three months ended September 30, 2006 and 2005, respectively. Collaboration profit sharing expense was $11.5 million and $10.1 million for the nine months ended September 30, 2006 and 2005, respectively. The increase in collaboration profit sharing was the result of increased anthrax cartridge sales under the USPS BDS program and this expense will remain proportional to the sales of anthrax cartridges under the USPS BDS program.

Research and Development Expenses

Research and development expenses consist of salaries and personnel-related expenses, research and development materials, facility costs and depreciation. Research and development expenses increased 17% to $5.6 million for the three months ended September 30, 2006 from $4.8 million for the same period in the prior year and increased 25% to $17.2 million for the nine months ended September 30, 2006 from $13.8 million for the same period in the prior year. For the three months ended September 30, 2006, the increase resulted primarily from a $0.7 million increase in salaries and personnel-related expenses, including stock compensation expense. Stock compensation expense included in research and development for the three months ended September 30, 2006 was $0.6 million. For the nine months ended September 30, 2006, this increase resulted primarily from a $2.5 million increase in salaries and personnel related expenses, including stock option compensation, and a $1.0 million increase in outside engineering services and supplies. Stock compensation expense included in research and development for the nine months ended September 30, 2006 was $1.9 million. We expect that our quarterly research and development expenses will increase during the remainder of 2006 as we increase our assay development costs and incur additional clinical trial costs related to the clinical trials for our MRSA test as well as costs associated with other development activities.

Selling, General and Administrative Expenses

Selling, general and administrative expenses consist primarily of salaries and personnel-related expenses, travel, facility, legal, accounting and other professional fees. Selling, general and administrative expenses increased 36% to $6.1 million for the three months ended September 30, 2006 from $4.5 million in the same period from the prior year, and increased 36% to $19.2 million for the nine months ended September 30, 2006 from $14.1 million for the same period in the prior year. For the three months ended September 30, 2006, the increase included a $1.2 million increase in salaries and personnel related expenses, including $0.8 million in stock compensation expense, a $0.1 million increase in outside legal, accounting and consulting expense, and $0.3 million increase in other expenses. For the nine months ended September 30, 2006, the increase included a $5.0 million increase in salaries and personnel related expenses, including $2.7 million in stock option compensation, and a $0.4 million increase in legal and accounting expenses, and $0.7 million increase in insurance and other administrative expenses. Stock compensation expense included in selling, general and administrative for the nine months ended September 30, 2006 was $2.7 million.

Other Income (Expenses), Net


	Three Months Ended									Nine Months Ended
	September 30,						%			September 30,						%
(amounts in thousands)	2006			2005			Change			2006			2005			Change
Other income (expenses), net:
Interest income	$	1,299		$	348			273	%	$	3,191		$	1,058			202	%
Interest expense		(28	)		(232	)		-88	%		(353	)		(824	)		-57	%
Foreign exchange gain (loss)		(59	)		(13	)		354	%		91			(314	)		-129	%
Other income / (expense)		3			—			—			(2	)		—			—

Total other income (expenses), net	$	1,215		$	103			1079	%	$	2,927		$	(80	)		-3759	%

Interest income increased $1.0 million and $2.1 million in the three and nine months ended September 30, 2006, respectively. The increase was due to additional cash balances resulting from proceeds of our public offering of common stock in March 2006. Interest expense decreased $0.2 million and $0.5 million in the three and nine months ended September 30, 2006, respectively. The decrease in interest expense was primarily due to paying off the lines of credit during the quarter ended March 31, 2006.

LIQUIDITY AND CAPITAL RESOURCES

Cash and Cash Flow

As of September 30, 2006, we had $99.0 million in cash and cash equivalents and marketable securities (including $0.7 million in restricted cash). Our net cash inflow in the first nine months of 2006 was $0.2 million, which is comprised of $10.7 million used in operating activities and $76.8 million used in investing activities and offset by $87.7 million in cash provided by financing activities. We maintain our portfolio of cash equivalents and marketable securities in short-term commercial paper, auction rate securities and money market funds in order to minimize market risk and preserve principal.

Net cash used in operating activities was $10.7 million and $5.0 million for the nine months ended September 30, 2006 and 2005, respectively. In the nine months ended September 30, 2006, net cash used in operating activities primarily consisted of $32.1 million in cost of sales, $13.9 million in research and development costs, $15.9 million in selling, general and administrative expenses, $11.5 million in collaboration profit sharing, a $1.6 million increase in inventory, a $0.6 million increase in prepaid and other current assets, a $1.2 million increase in accounts payable and accrued liabilities, largely offset by $63.7 million in cash from customers, and $2.9 million in other items. For the nine months ended September 30, 2005, net cash used in operating activities primarily consisted of $30.4 million in cost of sales, $12.8 million in research and development costs, $13.5 million in selling, general and administration expenses, a $10.1 million payment on collaboration profit sharing, a $0.6 million increase in prepaid and other current assets, a $1.8 million increase in inventory, largely offset by $58.7 million in cash received from customers , $5.3 million increase in accounts payable and accrued liabilities and $0.2 million in other items.

Net cash used in investing activities was $76.8 million and $12.1 million in the nine months ended September 30, 2006 and 2005, respectively. In 2006, net cash used in investing activities consisted of $61.0 million net purchases of marketable securities, $0.4 million net cost to acquire Actigenics, $0.9 million for purchases of intangible assets, $5.1 million in capital expenditures, and $9.3 million in payments for technology licenses, which consisted of $2.0 million for ABI licences, $6.7 million for Roche license, and $0.6 million for other technology licenses. In 2005, net cash used in investing activities consisted $10.6 million in acquiring technology licenses and $5.6 million in capital expenditures partially offset from the net maturities of marketable securities, after reinvestments of $4.1 million.

Net cash provided by financing activities was $87.7 million and $4.0 million in the nine months ended September 30, 2006 and 2005, respectively. The $87.7 million provided in the nine months ended September 30, 2006 consisted of $95.6 million in net proceeds from the sale of common stock including net proceeds of $80.6 million from our March 2006 common stock offering and $11.3 million from the underwriters’ exercise of its over-allotment option in April 2006. This was partially offset by repayments of $7.9 million on our equipment loans and line of credit. The $4.0 million provided in the nine months ended September 30, 2005 consisted of proceeds from $2.6 million from the sale of common stock under our employee equity incentive plans, and net equipment financing of $1.4 million.

Off-Balance-Sheet Arrangements

As of September 30, 2006, we did not have any significant off-balance-sheet arrangements, as defined in Item 303(a) (4) (ii) of SEC Regulation S-K.

Financial Condition Outlook

We plan to continue to make expenditures to expand our manufacturing capacity, to support our activities in sales and marketing and research and development, to support our working capital needs and to obtain technology licenses. We expect to have negative cash flow from operations through at least the end of 2006. We anticipate that our existing capital resources will enable us to maintain currently planned operations for at least the next twelve months. This expectation is based on our current and long-term operating plan and may change as a result of many factors, including our future capital requirements and our ability to increase revenues and reduce expenses, which, in many instances, depend on a number of factors outside our control. For example, our future cash use will depend on, among other things, market acceptance of our products, the resources we devote to developing and supporting our products, continued progress of our research and development of potential products, the need to acquire licenses to new technology or to use our technology in new markets and the availability of other financing.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Our investments in interest-bearing assets are subject to interest rate risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk, we maintain our interest-bearing portfolio, which consists of cash and cash equivalents and marketable securities, in short-term commercial paper, auction rate securities and money market funds. Due to the short-term nature of the investments, we believe we have no material exposure to interest rate risk arising from our investments. Further, we do not believe a 1% change in interest rates would have a material impact on our financial position. Therefore we have not included quantitative tabular disclosure in this Form 10-Q.

We do not enter into financial investments for speculation or trading purposes and are not a party to financial or commodity derivatives.

We have operated primarily in the United States and a majority of our revenue, cost, expense and capital purchasing activities are transacted in U.S. dollars. Accordingly, we do not have material exposure to foreign currency rate fluctuations.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Regulations under the Securities Exchange Act of 1934 require public companies, including our company, to maintain “disclosure controls and procedures,” which are defined to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Our Chief Executive Officer and our Chief Financial Officer, based on their evaluation of our disclosure controls and procedures as of the end of the period covered by of this report, concluded that our disclosure controls and procedures were effective for this purpose.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

Regulations under the Securities Exchange Act of 1934 require public companies, including our company, to evaluate any change in our “internal control over financial reporting,” which is defined as a process to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States. In connection with their evaluation of our disclosure controls and procedures as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer did not identify any change in our internal control over financial reporting during the nine months ended September 30, 2006 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In March 2006, we were served a complaint filed on December 22, 2005, in the United States District Court for the District of Utah by Idaho Technology, Inc. and University of Utah Research Foundation. The complaint alleges that Cepheid infringes certain patents licensed by the University of Utah Research Foundation to Idaho Technology, Inc. The complaint seeks declaratory and injunctive relief, damages, attorneys’ fees and costs. Discovery has commenced and the Court has set a trial date of February 11, 2008. We believe that we have meritorious defenses to this action and if the claims are not withdrawn, intend to defend the claims vigorously.

ITEM 1A. RISK FACTORS

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

We may not achieve profitability.

We have incurred operating losses in each year since our inception and expect to have negative cash flow from operations through at least the end of 2006. We experienced net losses of approximately, $13.0 million in 2003, $10.8 million in 2004, $10.4 million in 2005 and $17.7 million in the nine months ended September 30, 2006. As of September 30, 2006, we had an accumulated deficit of approximately $125.0 million. Our ability to become profitable will depend on our ability to increase our revenues, which is subject to a number of factors including our ability to successfully penetrate the clinical diagnostic market, our ability to successfully market the GeneXpert system and develop effective GeneXpert tests, the extent of our participation in the USPS BDS program and the operating parameters of the BDS program, which will affect the rate of our consumable products sold, the success of our other collaborative programs, our ability to compete effectively against current and future competitors, global economic and political conditions and the impact of the new accounting for share-based payments such as stock options. Our ability to become profitable also depends on our expense levels and product gross margin, which are also influenced by a number of factors, including the resources we devote to developing and supporting our products, the continued progress of our research and development of potential products, the ability to gain FDA clearance for our products, our ability to improve manufacturing efficiencies, license fees or royalties we may be required to pay, and the potential need to acquire licenses to new technology or to use our technology in new markets, which could require us to pay unanticipated license fees and royalties in connection with these licenses. Our expansion efforts may prove more expensive than we currently anticipate, and we may not succeed in increasing our revenues to offset higher expenses. These expenses, among other things, may cause our net income and working capital to decrease. If we fail to grow our revenue and manage our expenses and improve our product gross margin, we may never achieve profitability. If we fail to do so, the market price of our common stock will likely decline.

Our participation in the USPS BDS program may not result in predictable contracts or revenues.

Our participation in the USPS BDS program involves significant uncertainties related to governmental decision-making and timing of deployment, and is highly sensitive to changes in national and international priorities and budgets. The world geopolitical climate in the wake of the September 11, 2001 terrorist attacks has created substantial public interest in the BDS. However, budgetary pressures may result in reduced allocations to government agencies such as the USPS, sometimes without advanced notice. We cannot be certain that actual funding and operating parameters, or product purchases, will occur at currently expected levels or in the currently expected timeframe. There is no obligation on the part of the USPS to buy a minimum number of units or tests; we are subject to future spending patterns and budgetary cycles.

If we cannot successfully commercialize our products, our business could be harmed.

If our tests for use on the SmartCycler and GeneXpert platforms do not gain market acceptance, we will be unable to generate significant sales, which will prevent us from achieving profitability. We have recently received FDA clearance for our GBS test and we are in the process of researching and developing several tests, including a MRSA/MSSA test. Many factors may affect the market acceptance and commercial success of our products, including:

•		timely development of a menu of tests and reagents;

•		the results of clinical trials needed to support any regulatory approvals of our tests;

•		our ability to obtain requisite FDA or other regulatory clearances or approvals for our tests under development on a timely basis;

•		demand for the tests and reagents we are able to introduce;

•		the timing of market entry for various tests for the GeneXpert and the SmartCycler systems;

•		our ability to convince our potential customers of the advantages and economic value of our systems and tests over competing technologies and products;

•		the breadth of our test menu relative to competitors;

•		the extent and success of our marketing and sales efforts; and

•		publicity concerning our systems and tests.

In particular, we believe that the success of our business will depend in large part on our ability to commercialize our products for the clinical market. Our current reliance on revenues from the USPS BDS program has resulted in substantial revenue concentrations in recent periods. We believe that successfully building our business in the clinical market is critical to our long-term goals and success. We have limited experience operating in the clinical market and, as a result, we have limited ability to forecast future demand for our products in this market. In addition, we have committed substantial funds to licenses that are required for us to enter the clinical market. If we cannot successfully penetrate the clinical market to exploit these licenses, ongoing payments that we have agreed to make under them could significantly harm our business and operating results in future periods.

The regulatory approval process is expensive, time-consuming, and uncertain and may prevent us from obtaining required approvals for the commercialization of some of our products.

In the clinical market, our products may generally be regulated as medical devices by the FDA and comparable agencies of other countries. In particular, FDA regulations govern activities such as product development, product testing, product labeling, product storage, premarket clearance or approval, manufacturing, advertising, promotion, product sales, reporting of certain product failures and distribution. Some of our products, depending on their intended use, will require either premarket approval (PMA), or 510(k) clearance from the FDA prior to marketing. The 510(k) clearance process usually takes from three to six months from submission, but can take longer. The premarket approval process is much more costly, lengthy, and uncertain and generally takes from one to two years or longer from submission. Clinical trials are generally required to support both PMA and 510(k) submissions. Certain of our products for use on our SmartCycler and GeneXpert systems, when used for clinical purposes, may require premarket approval and all such tests will most likely, at a minimum, require 510(k) clearance. We are in the process of conducting clinical trials of our proposed test products and are planning clinical trials for other proposed products. Clinical trials are expensive and time-consuming. In addition, the commencement or completion of any clinical trials may be delayed or halted for any number of reasons, including product performance, changes in intended use, changes in medical practice and issues with evaluator Institutional Review Boards.

Failure to comply with the applicable requirements can result in, among other things, warning letters, administrative or judicially imposed sanctions such as injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal to grant premarket clearance or premarket approval for devices, withdrawal of marketing clearances or approvals, or criminal prosecution. To date, only our GBS test has received received FDA clearance effective July 25, 2006. In April 2006, we sought approval from the FDA for our Enterovirus GeneXpert product. With regard to future products, including Enterovirus GeneXpert, for which we seek 510(k) clearance or premarket approval for the FDA, any failure or material delay to obtain such clearance or approval could harm our business. If the FDA were to disagree with our regulatory assessment and conclude that approval or clearance is necessary to market the products, we could be forced to cease marketing the products and seek approval or clearance. With regard to those future products for which we will seek 510(k) clearance or premarket approval from the FDA, any failure or material delay to obtain such clearance or approval could harm our business. In addition, it is possible that the current regulatory framework could change or additional regulations could arise at any stage during our product development or marketing, which may adversely affect our ability to obtain or maintain approval of our products and could harm our business.

Our manufacturing facilities, where we assemble and produce the SmartCycler system and the GeneXpert system, cartridges and reagents, are subject to periodic regulatory inspections by the FDA and other federal and state regulatory agencies. For example, these facilities are subject to Quality System Regulations (QSR) of the FDA and are subject to annual inspection and licensing by the State of California. If we fail to maintain these facilities in accordance with the QSR requirements, international quality standards or other regulatory requirements, our manufacturing process could be suspended or terminated, which would harm our business.

We rely on licenses of key technology from third parties and will require additional licenses for many of our new product candidates.

We rely on third-party licenses to be able to sell many of our products, and we could lose these third-party licenses for a number of reasons, including, for example, early terminations of such agreements due to breaches or alleged breaches by either party to the agreement. If we are unable to enter into a new agreement for licensed technologies, either on terms that are acceptable to us or at all, we may be unable to sell some of our products or access some geographic or industry markets. We also need to introduce new products and product features in order to market our products to a broader customer base and grow our revenues, and many new products and product features could require us to obtain additional licenses and pay additional license fees and royalties. Furthermore, for some markets, we intend to manufacture reagents and tests for use on our instruments. We believe that manufacturing reagents and developing tests for our instruments is important to our business and growth prospects, but will require additional licenses, which may not be available on commercially reasonable terms or at all. Our ability to develop, manufacture and sell products, and our strategic plans and growth, could be impaired if we are unable to obtain these licenses or if these licenses are terminated or expire and cannot be renewed. We may not be able to obtain or renew licenses for a given product or product feature, or for some reagents, on commercially reasonable terms, if at all. Furthermore, some of our competitors have rights to technologies and reagents that we do not have which may put us at a competitive disadvantage in certain circumstances and could adversely affect our performance.

If we acquire companies, products or technologies, we may face risks associated with those acquisitions.

If we are presented with appropriate opportunities, we intend to acquire or make other investments in complementary companies, products or technologies. For example, in August 2006, we acquired Actigenics SA, a French microRNA research and services company. We may not realize the anticipated benefit of any acquisition or investment. If we acquire companies or technologies, we will likely face risks, uncertainties and disruptions associated with the integration process, including difficulties in the integration of these operations and services of an acquired company, integration of acquired technology with our products, diversion of our management’s attention from other business concerns, the potential loss of key employees or customers of the acquired businesses and impairment charges if future acquisitions are not as successful as we originally anticipate. If we fail to successfully integrate other companies, products or technologies that we may acquire, our business could be harmed. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments, the issuance of which could be dilutive to our existing shareholders. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired intangible assets.

We expect that our operating results will fluctuate significantly, and any failure to meet financial expectations may result in a decline in our stock price.

We expect that our quarterly operating results will fluctuate in the future as a result of many factors, such as those described elsewhere in this section, many of which are beyond our control. Because our revenue and operating results are difficult to predict, we believe that period-to-period comparisons of our results of operations are not a good indicator of our future performance. Our operating results may be affected by the inability of some of our customers to consummate anticipated purchases of our products, whether due to changes in internal priorities or, in the case of governmental customers, problems with the appropriations process and variability and timing of orders, or manufacturing inefficiencies. If revenue declines in a quarter, whether due to a delay in recognizing expected revenue, unexpected costs or otherwise, our results of operations will be harmed because many of our expenses are relatively fixed. In particular, research and development and selling, general and administrative expenses are not significantly affected by variations in revenue. If our quarterly operating results fail to meet or exceed the expectations of securities analysts or investors, our stock price could drop suddenly and significantly.

If we are unable to manufacture our products in sufficient quantities and in a timely manner, our operating results will be harmed and our ability to generate revenue could be diminished.

Our revenues and other operating results will depend in large part on our ability to manufacture and assemble our products in sufficient quantities and in a timely manner. Any interruptions we experience in the manufacturing or shipping of our products could delay our ability to recognize revenues in a particular quarter. We have limited experience in manufacturing large volumes of products and manufacturing problems can and do arise or we may be unable to adequately scale-up manufacturing in a timely manner or on a commercially reasonable basis if we experience increased demand. In the past, we have experienced problems and delays in production that have impacted our product yield and caused delays in our ability to ship finished products and we may experience such delays in the future. We may not be able to react quickly enough to ship products and recognize anticipated revenues for a given period if we experience significant delays in the manufacturing process. If we are unable to manufacture our products consistently and on a timely basis, our revenues from product sales, gross margins and our other operating results will be materially and adversely affected.

If certain single source suppliers fail to deliver key product components in a timely manner, our manufacturing ability would be impaired and our product sales could suffer.

We depend on certain single source suppliers that supply components used in the manufacture of the SmartCycler system, the GeneXpert modules and system, and our disposable reaction tubes and cartridges. If we need alternative sources for key component parts for any reason, these component parts may not be immediately available to us. If alternative suppliers are not immediately available, we will have to identify and qualify alternative suppliers, and production of these components may be delayed. We may not be able to find an adequate alternative supplier in a reasonable time period, or on commercially acceptable terms, if at all. Shipments of affected products have been limited or delayed as a result of such problems in the past, and similar problems could occur in the future. Our inability to obtain our key source supplies for the manufacture of our products may require us to delay shipments of products, harm customer relationships or force us to curtail or cease operations.

If certain of our products fail to obtain an adequate level of reimbursement from third-party payers, our ability to sell products in the clinical market would be harmed.

Our ability to sell our products in the clinical market will depend in part on the extent to which reimbursement for tests using our products will be available from:

•		government health administration authorities;

•		private health coverage insurers;

•		managed care organizations; and

•		other organizations.

There are efforts by governmental and third-party payers to contain or reduce the costs of health care through various means. Additionally, third-party payers are increasingly challenging the price of medical products and services. If purchasers or users of our products are not able to obtain adequate reimbursement for the cost of using our products, they may forego or reduce their use. Significant uncertainty exists as to the reimbursement status of newly approved health care products and whether adequate third-party coverage will be available.

If our competitors and potential competitors develop superior products and technologies, our competitive position and results of operations would suffer.

We face intense competition from a number of companies that offer products in our target markets. These competitors include:

•		companies developing and marketing sequence detection systems for industrial research products;

•		healthcare companies that manufacture laboratory-based tests and analyzers;

•		diagnostic companies; and

•		companies developing or offering biothreat detection technologies.

Several companies provide instruments and reagents for DNA amplification or detection. ABI, Roche, Bio-Rad Laboratories and Stratagene sell systems integrating DNA amplification and detection (sequence detection systems) to the commercial market. Idaho Technologies sells sequence detection systems to the military market. Roche, Abbott Laboratories and GenProbe sell large sequence detection systems, some with separate robotic batch DNA purification systems and sell reagents to the clinical market. Other companies, including Becton, Dickinson and Company, Bayer and bioMerieux, offer molecular tests.

If our products do not perform as expected, or the reliability of the technology on which our products are based is questioned, we could experience lost revenue, delayed or reduced market acceptance of our products, increased costs and damage to our reputation.

Our success depends on the market’s confidence that we can provide reliable, high-quality molecular test systems. We believe that customers in our target markets are likely to be particularly sensitive to product defects and errors. Our reputation and the public image of our products or technologies may be impaired if our products fail to perform as expected; or our products are perceived as difficult to use. Despite testing, defects or errors could occur in our products or technologies. Furthermore, with respect to the BDS program, our products are incorporated into larger systems that are built and delivered by others; we cannot control many aspects of the final product.

In the future, if we experience a material defect or error, this could result in loss or delay of revenues, delayed market acceptance, damaged reputation, diversion of development resources, legal claims, increased insurance costs or increased service and warranty costs, any of which could harm our business. Any failure in the overall BDS, even if it is unrelated to our products, could harm our business. Even after any underlying concerns or problems are resolved, any widespread concerns regarding our technology or any manufacturing defects or performance errors in our products could result in lost revenue, delayed market acceptance, damaged reputation, increased service and warranty costs, and claims against us.

If product liability lawsuits are successfully brought against us, we may face reduced demand for our product and incur significant liabilities.

We face an inherent risk of exposure to product liability claims if our technologies or systems are alleged to have caused harm or do not perform in accordance with specifications, in part because our products are used for sensitive applications. We cannot be certain that we would be able to successfully defend any product liability lawsuit brought against us. Regardless of merit or eventual outcome, product liability claims may result in:

•		decreased demand for our products;

•		injury to our reputation;

•		costs of related litigation; and

•		substantial monetary awards to plaintiffs.

If we become the subject of a successful product liability lawsuit, we could incur substantial liabilities, which could harm our business.

We rely on relationships with collaborative partners and other third parties for development, supply and marketing of products and potential products, and such collaborative partners or other third parties could fail to perform sufficiently.

We believe that our success in penetrating our target markets depends in part on our ability to develop and maintain collaborative relationships with other companies. Relying on collaborative relationships is risky to our future success because, among other things:

•		our collaborative partners may not devote sufficient resources to the success of our collaboration;

•		our collaborative partners may not obtain regulatory approvals necessary to continue the collaborations in a timely manner;

•		our collaborative partners may be acquired by another company and decide to terminate our collaborative partnership or become insolvent;

•		our collaborative partners may develop technologies or components competitive with our products;

•		components developed by collaborators could fail to meet specifications, possibly causing us to lose potential projects and subjecting us to liability;

•		disagreements with collaborators could result in the termination of the relationship or litigation;

•		collaborators may not have sufficient capital resources;

•		collaborators may pursue tests or other products that will not generate significant volume for us, but may consume significant research and development and manufacturing resources; or

•		we may not be able to negotiate future collaborative arrangements, or renewals of existing collaborative agreements, on acceptable terms.

Because these and other factors may be beyond our control, the development or commercialization of our products may be delayed or otherwise adversely affected.

If we or any of our collaborative partners terminate a collaborative arrangement, we may be required to devote additional resources to product development and commercialization or we may need to cancel some development programs, which could adversely affect our product pipeline and business.

If our direct selling efforts for our products fail, our business expansion plans could suffer and our ability to generate revenue will be diminished.

We have a relatively small sales force compared to our competitors. If our direct sales force is not successful, we may not be able to increase market awareness and sales of our products. If we fail to establish our systems in the marketplace, it could have a negative effect on our ability to sell subsequent systems and hinder the planned commercial expansion of our business in the marketplace.

If our distributor relationships are not successful, our ability to market and sell our products would be harmed and our financial performance will be adversely affected.

We depend on relationships with distributors for the marketing and sales of our products in the industrial and clinical markets in various geographic regions and we have a limited ability to influence their efforts. Product sales through distributors represented 14% and 20% of total product sales for 2005 and 2004, respectively, and 16% for the first nine months of 2006. While sales through distributors accounted for a smaller percentage of our total revenues in recent periods because of the increase in direct sales in connection with the BDS program, we expect to continue to rely substantially on our distributor relationships for sales into other markets or geographic regions, which is key to our long-term growth potential. Relying on distributors for our sales and marketing could harm our business for various reasons, including:

•		agreements with distributors may terminate prematurely due to disagreements or may result in litigation between the partners;

•		we may not be able to renew existing distributor agreements on acceptable terms;

•		our distributors may not devote sufficient resources to the sale of products;

•		our distributors may be unsuccessful in marketing our products;

•		our existing relationships with distributors may preclude us from entering into additional future arrangements with other distributors; and

•		we may not be able to negotiate future distributor agreements on acceptable terms.

We may be subject to third-party claims that require additional licenses for our products and we could face costly litigation, which could cause us to pay substantial damages and limit our ability to sell some or all of our products.

Our industry is characterized by a large number of patents, claims of which appear to overlap in many cases. As a result, there is a significant amount of uncertainty regarding the extent of patent protection and infringement. Companies may have pending patent applications (which are typically confidential for the first eighteen months following filing) that cover technologies we incorporate in our products. As a result, we may be subjected to substantial damages for past infringement or be required to modify our products or stop selling them if it is ultimately determined that our products infringe a third party’s proprietary rights. Moreover, from time to time, we receive correspondence and other

communications from companies that ask us to evaluate the need for a license of patents they hold, and indicating or suggesting that we need a license to their patents in order to offer our products and services or to conduct our business operations. In addition, Idaho Technology, Inc. and University of Utah Research have sued us claiming that we infringe certain patents. Litigation is inherently unpredictable and therefore we cannot assure you of the ultimate outcome of this matter. Even if we are successful in defending against claims, we could incur substantial costs in doing so. Any litigation related to claims of patent infringement could consume our resources and lead to significant damages, royalty payments or an injunction on the sale of certain products. Any additional licenses to patented technology could obligate us to pay substantial additional royalties, which could adversely impact our product costs and harm our business.

If we fail to maintain and protect our intellectual property rights, our competitors could use our technology to develop competing products and our business will suffer.

Our competitive success will be affected in part by our continued ability to obtain and maintain patent protection for our inventions, technologies and discoveries, including our intellectual property that includes technologies that we license. Our ability to do so will depend on, among other things, complex legal and factual questions. We have patents related to some technology and have licensed some of our technology under patents of others. We cannot assure you that our patents and licenses will successfully preclude others from using our technology. Our pending patent applications may lack priority over applications submitted by third parties or may not result in the issuance of patents. Even if issued, our patents may not be sufficiently broad to provide protection against competitors with similar technologies and may be challenged, invalidated or circumvented.

In addition to patents, we rely on a combination of trade secrets, copyright and trademark laws, nondisclosure agreements, licenses and other contractual provisions and technical measures to maintain and develop our competitive position with respect to intellectual property. Nevertheless, these measures may not be adequate to safeguard the technology underlying our products. For example, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property and we may not have adequate remedies for the breach. We also may not be able to effectively protect our intellectual property rights in some foreign countries, as many countries do not offer the same level of legal protection for intellectual property as the United States. Furthermore, for a variety of reasons, we may decide not to file for patent, copyright or trademark protection outside of the United States. Our trade secrets could become known through other unforeseen means. Notwithstanding our efforts to protect our intellectual property, our competitors may independently develop similar or alternative technologies or products that are equal or superior to our technology. Our competitors may also develop similar products without infringing on any of our intellectual property rights or design around our proprietary technologies. Furthermore, any efforts to enforce our proprietary rights could result in disputes and legal proceedings that could be costly and divert attention from our business.

We may need to initiate lawsuits to protect or enforce our patents, which would be expensive and, if we lose, may cause us to lose some, if not all, of our intellectual property rights, and thereby impair our ability to compete.

We rely on patents to protect a large part of our intellectual property. To protect or enforce our patent rights, we may initiate patent litigation against third parties, such as infringement suits or interference proceedings. These lawsuits could be expensive, take significant time and divert management’s attention from other business concerns. They would also put our patents at risk of being invalidated or interpreted narrowly, and our patent applications at risk of not issuing. We may also provoke these third parties to assert claims against us. Patent law relating to the scope of claims in the technology fields in which we operate is still evolving and, consequently, patent positions in our industry are generally uncertain. We cannot assure you that we would prevail in any of these suits or that the damages or other remedies awarded, if any, would be commercially valuable. During the course of these suits, there may be public announcements of the results of hearings, motions and other interim proceedings or developments in the litigation. Any public announcements related to these suits could cause our stock price to decline.

Our sales cycle can be lengthy, which can cause variability and unpredictability in our operating results.

The sales cycles for our products can be lengthy, which makes it more difficult for us to accurately forecast revenues in a given period, and may cause revenues and operating results to vary significantly from period to period. Sales of our products to the industrial market often involve purchasing decisions by large public and private institutions, and any purchases can require many levels of pre-approval. In addition, many of these sales depend on these institutions receiving research grants from various federal agencies, which grants vary considerably from year to year in both amount and timing due to the political process. As a result, we may expend considerable resources on unsuccessful sales efforts or we may not be able to complete transactions on the schedule anticipated.

Our international operations subject us to additional risks and costs.

Our international operations have expanded recently. These operations are subject to a number of difficulties and special costs, including:

•		compliance with multiple, conflicting and changing governmental laws and regulations;

•		laws and business practices favoring local competitors;

•		potential for exchange and currency risks;

•		potential difficulty in collecting accounts receivable;

•		import and export restrictions and tariffs;

•		difficulties staffing and managing foreign operations;

•		difficulties and expense in enforcing intellectual property rights;

•		business risks, including fluctuations in demand for our products and the cost and effort to conduct international operations and travel abroad to promote international distribution, and global economic conditions;

•		multiple conflicting tax laws and regulations; and

•		political and economic instability.

We intend to expand our international sales and marketing activities, including through our European subsidiary, and enter into relationships with additional international distribution partners. We may not be able to attract international distribution partners that will be able to market our products effectively.

Our international operations could also increase our exposure to international laws and regulations. If we cannot comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potential litigation. For example, the governments of foreign countries might attempt to regulate our products and services or levy sales or other taxes relating to our activities. In addition, foreign countries may impose tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, any of which could make it more difficult for us to conduct our business.

The nature of some of our products may also subject us to export control regulation by the US Department of State and the Department of Commerce. Violations of these regulations can result in monetary penalties and denial of export privileges.

Our SmartCycler and GeneXpert products are distributed in Europe under the CE IVD mark, and we intend to introduce additional products under the CE IVD mark as we pursue our expansion plans. Our use of the CE IVD mark is based on self declarations of conformity with stated directives and standards of the European Parliament and Council and is subject to review by competent authorities in Europe. To date, our products and use of self-declarations have not been reviewed by any competent authority. If our products are reviewed, a competent authority may find that our products do not comply with stated directives and standards. Any finding of non-conformity could prevent or otherwise adversely affect our ability to distribute products in Europe and result in other consequences, including both criminal sanctions, such as the imposition of fines or penalties, and civil claims for damages from persons suffering damage as a result of the non-conformity.

If we fail to retain key members of our staff, our ability to conduct and expand our business would be impaired.

We are highly dependent on the principal members of our management and scientific staff. The loss of services of any of these persons could seriously harm our product development and commercialization efforts. In addition, we will require additional skilled personnel in areas such as microbiology, clinical and sales and marketing. Attracting, retaining and training personnel with the requisite skills remains challenging, and, as general economic conditions improve, is becoming increasingly competitive, particularly in the Silicon Valley area of California where our main office is located. If at any point we are unable to hire, train and retain a sufficient number of qualified employees to match our growth, our ability to conduct and expand our business could be seriously reduced.

If we become subject to claims relating to improper handling, storage or disposal of hazardous materials, we could incur significant cost and time to comply.

Our research and development processes involve the controlled storage, use and disposal of hazardous materials, including biological hazardous materials. We are subject to federal, state and local regulations governing the use, manufacture, storage, handling and disposal of materials and waste products. We may incur significant costs complying with both existing and future environmental laws and regulations. In particular, we are subject to regulation by the Occupational Safety and Health Administration (OSHA) and the Environmental Protection Agency (EPA), and to regulation under the Toxic Substances Control Act and the Resource Conservation and Recovery Act. OSHA or the EPA may adopt regulations that may affect our research and development programs. We are unable to predict whether any agency will adopt any regulations that would have a material adverse effect on our operations.

The risk of accidental contamination or injury from hazardous materials cannot be eliminated completely. In the event of an accident, we could be held liable for any damages that result, and any liability could exceed the limits or fall outside the coverage of our insurance. We may not be able to maintain insurance on acceptable terms, if at all. We could be required to incur significant costs to comply with current or future environmental laws and regulations.

If a catastrophe strikes our manufacturing facilities, we may be unable to manufacture our products for a substantial amount of time and we would experience lost revenue.

Our manufacturing facilities are located in Sunnyvale, California. Although we have business interruption insurance, our facilities and some pieces of manufacturing equipment are difficult to replace and could require substantial replacement lead-time. Various types of disasters, including earthquakes, fires, floods and acts of terrorism, may affect our manufacturing facilities. Earthquakes are of particular significance since the manufacturing facilities are located in an earthquake-prone area. In the event our existing manufacturing facilities or equipment is affected by man-made or natural disasters, we may be unable to manufacture products for sale, meet customer demands or sales projections. If our manufacturing operations were curtailed or ceased, it would seriously harm our business.

We might require additional capital to support business growth, and such capital might not be available.

Although we recently completed a public offering, we may need to engage in additional equity or debt financing to support business growth and respond to business challenges, which include the need to develop new products or enhance existing products, conduct clinical trials, enhance our operating infrastructure and acquire complementary businesses and technologies. Equity and debt financing, however, might not be available when needed or, if available, might not be available on terms satisfactory to us. In addition, to the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in dilution to our shareholders. In addition, these securities may be sold at a discount from the market price of our common stock, and may include right preferences or privileges senior to those of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, our ability to continue to support our business growth and to respond to business challenges could be significantly limited.

Compliance with regulations governing public company corporate governance and reporting is complex and expensive.

Many laws and regulations, notably those adopted in connection with the Sarbanes-Oxley Act of 2002 by the SEC and the NASDAQ Stock Market, impose obligations on public companies, such as ours, which have increased the scope, complexity, and cost of corporate governance, reporting, and disclosure practices. Our implementation of these reforms and enhanced new disclosures necessitates substantial management time and oversight and requires us to incur significant additional accounting and legal costs.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not Applicable

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not Applicable

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

Not Applicable

ITEM 5. OTHER INFORMATION

Not Applicable

ITEM 6. EXHIBITS

(a) Exhibits

Exhibit

Incorporated by Reference

Filing

Filed

Number

Exhibit Description

Form

File No.

Exhibit

Date

Herewith

31.1

Certification of Chief Executive Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

Certification of Chief Financial Officer pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

32.2

Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*


*		These certifications accompany this report pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934 (whether made before or after the date of the Report), irrespective of any general incorporation language contained in such filing.


			Page
Part I.		Financial Information

	Item 1.	Financial Statements (unaudited)		3

		Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005		3

		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005		4

		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005		5

		Notes to Condensed Consolidated Financial Statements		6

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		21

	Item 4.	Controls and Procedures		21

Part II.		Other Information		21

	Item 1.	Legal Proceedings		21

	Item 1A	Risk Factors		22

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		30

	Item 3.	Defaults Upon Senior Securities		30

	Item 4.	Submission of Matters to a Vote of Security Holders		30

	Item 5.	Other Information		31

	Item 6.	Exhibits		31

Signatures				32
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


		CEPHEID
		(Registrant)

		/s/ John L. Bishop

		John L. Bishop
		Chief Executive Officer and Director
		(Principal Executive Officer)

		/s/ John R. Sluis

		John R. Sluis
		Senior Vice President, Finance and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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