Edgar Filing: GENENTECH INC

dna-10q_0207.htm

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 June 30, 2007

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: 1-9813

GENENTECH, INC.

(Exact name of registrant as specified in its charter)

Delaware

(State or other jurisdiction of incorporation or organization)

94-2347624

(I.R.S. Employer Identification Number)

1 DNA Way, South San Francisco, California 94080-4990

(Address of principal executive offices and Zip Code)

(650) 225-1000

(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. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ

Accelerated filer o

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). Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date.

Class	Number of Shares Outstanding
Common Stock $0.02 par value	1,053,031,880 Outstanding at July 26, 2007

GENENTECH, INC.

TABLE OF CONTENTS

		Page No.
	PART I—FINANCIAL INFORMATION

Item 1.	Financial Statements	3

	Condensed Consolidated Statements of Income— for the three months and six months ended June 30, 2007 and 2006	3

	Condensed Consolidated Statements of Cash Flows— for the six months ended June 30, 2007 and 2006	4

	Condensed Consolidated Balance Sheets— June 30, 2007 and December 31, 2006	5

	Notes to Condensed Consolidated Financial Statements	6-14

	Report of Independent Registered Public Accounting Firm	15

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16-39

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40

Item 4.	Controls and Procedures	40

	PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	41

Item 1A.	Risk Factors	41-53

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	53

Item 4.	Submission of Matters to a Vote of Security Holders	54

Item 6.	Exhibits	54

SIGNATURES		55

In this report, “Genentech,” “we,” “us,” and “our” refer to Genentech, Inc. “Common Stock” refers to Genentech’s Common Stock, par value $0.02 per share, “Special Common Stock” refers to Genentech’s callable putable common stock, par value $0.02 per share, all of which was redeemed by Roche Holdings, Inc. (RHI) on June 30, 1999.

We own or have rights to various copyrights, trademarks, and trade names used in our business, including the following: Activase® (alteplase, recombinant) tissue-plasminogen activator; Avastin® (bevacizumab) anti-VEGF antibody; Cathflo® Activase® (alteplase for catheter clearance); Herceptin® (trastuzumab) anti-HER2 antibody; Lucentis® (ranibizumab, rhuFab V2) anti-VEGF antibody fragment; Nutropin® (somatropin [rDNA origin] for injection) growth hormone; Nutropin AQ® and Nutropin AQ Pen® (somatropin [rDNA origin] for injection) liquid formulation growth hormone; Omnitarg™ (pertuzumab) HER dimerization inhibitor; Pulmozyme® (dornase alfa, recombinant) inhalation solution; Raptiva® (efalizumab) anti-CD11a antibody; and TNKase® (tenecteplase) single-bolus thrombolytic agent. Rituxan® (rituximab) anti-CD20 antibody is a registered trademark of Biogen Idec Inc.; Tarceva® (erlotinib) is a trademark of OSI Pharmaceuticals, Inc.; and Xolair® (omalizumab) anti-IgE antibody is a trademark of Novartis AG. This report also includes other trademarks, service marks, and trade names of other companies.

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

GENENTECH, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In millions, except per share amounts)

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Revenue
Product sales (including amounts from related parties: three months—2007–$256; 2006–$75; six months—2007–$522; 2006–$133)	$	2,443		$	1,810		$	4,773		$	3,454
Royalties (including amounts from related parties: three months—2007–$296; 2006–$207; six months—2007–$557; 2006–$373)		484			316			903			602
Contract revenue (including amounts from related parties: three months—2007–$34; 2006–$34; six months—2007–$104; 2006–$63)		77			73			171			129
Total operating revenue		3,004			2,199			5,847			4,185
Costs and expenses
Cost of sales (including amounts for related parties: three months—2007–$140; 2006–$65; six months—2007–$265; 2006–$115)		429			284			821			546
Research and development (including amounts for related parties: three months—2007–$79; 2006–$65; six months—2007–$147; 2006–$117) (including amounts in contract revenue: three months—2007–$60; 2006–$51; six months—2007–$106; 2006–$87)		603			390			1,213			764
Marketing, general and administrative		532			471			1,023			912
Collaboration profit sharing (including amounts for a related party: three months—2007–$49; 2006–$48; six months—2007–$96; 2006–$91)		277			259			529			485
Recurring charges related to redemption		26			26			52			52
Special items: litigation related		13			14			26			27
Total costs and expenses		1,880			1,444			3,664			2,786
Operating income		1,124			755			2,183			1,399
Other income (expense):
Interest and other income (expense), net		75			121			149			174
Interest expense		(17	)		(18	)		(35	)		(37	)
Total other income, net		58			103			114			137
Income before taxes		1,182			858			2,297			1,536
Income tax provision		435			327			844			584
Net income	$	747		$	531		$	1,453		$	952
Earnings per share
Basic	$	0.71		$	0.50		$	1.38		$	0.90
Diluted	$	0.70		$	0.49		$	1.36		$	0.89
Shares used to compute basic earnings per share		1,053			1,053			1,053			1,054
Shares used to compute diluted earnings per share		1,070			1,073			1,071			1,074

See Notes to Condensed Consolidated Financial Statements.

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GENENTECH, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions)

(Unaudited)

	Six Months Ended June 30,
	2007			2006
Cash flows from operating activities
Net income	$	1,453		$	952
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		215			199
Employee stock-based compensation		203			149
Deferred income taxes		(103	)		(85	)
Deferred revenue		(29	)		2
Litigation-related liabilities		26			26
Excess tax benefit from stock-based compensation arrangements		(127	)		(90	)
Gain on sales of securities available-for-sale and other, net		(12	)		(69	)
Write-down of securities available-for-sale and other		4			–
Loss on property and equipment dispositions		30			–
Changes in assets and liabilities:
Receivables and other current assets		(115	)		(184	)
Inventories		(180	)		(174	)
Investments in trading securities		(72	)		(15	)
Accounts payable, other accrued liabilities, and other long-term liabilities		132			205
Net cash provided by operating activities		1,425			916

Cash flows from investing activities
Purchases of securities available-for-sale		(465	)		(898	)
Proceeds from sales of securities available-for-sale		335			419
Proceeds from maturities of securities available-for-sale		261			126
Capital expenditures		(475	)		(538	)
Change in other intangible and long-term assets		(8	)		17
Net cash used in investing activities		(352	)		(874	)

Cash flows from financing activities
Stock issuances		276			187
Stock repurchases		(666	)		(540	)
Excess tax benefit from stock-based compensation arrangements		127			90
Net cash used in financing activities		(263	)		(263	)
Net increase (decrease) in cash and cash equivalents		810			(221	)
Cash and cash equivalents at beginning of period		1,250			1,225
Cash and cash equivalents at end of period	$	2,060		$	1,004

Supplemental cash flow data
Cash paid during the period for:
Interest	$	31		$	35
Income taxes		806			498
Non-cash investing and financing activities
Capitalization of construction in progress related to financing lease transactions		101			61

See Notes to Condensed Consolidated Financial Statements.

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GENENTECH, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In millions)

(Unaudited)

	June 30, 2007		December 31, 2006
Assets
Current assets
Cash and cash equivalents	$	2,060	$	1,250
Short-term investments		1,135		1,243
Accounts receivable—product sales (net of allowances: 2007–$105; 2006–$92; including amounts from related parties: 2007–$68; 2006–$57)		1,068		965
Accounts receivable—royalties (including amounts from related parties: 2007–$379; 2006–$316)		514		453
Accounts receivable—other (including amounts from related parties: 2007–$103; 2006–$150)		177		248
Inventories		1,365		1,178
Deferred tax assets		272		278
Prepaid expenses and other current assets		108		89
Total current assets		6,699		5,704
Long-term marketable debt and equity securities		1,883		1,832
Property, plant and equipment, net		4,563		4,173
Goodwill		1,315		1,315
Other intangible assets		427		476
Restricted cash and investments		788		788
Other long-term assets		684		554
Total assets	$	16,359	$	14,842

Liabilities and stockholders’ equity
Current liabilities
Accounts payable (including amounts to related parties: 2007 and 2006–$7)	$	361	$	346
Deferred revenue		52		62
Taxes payable		124		111
Other accrued liabilities (including amounts to related parties: 2007–$164; 2006–$136)		1,452		1,491
Total current liabilities		1,989		2,010
Long-term debt		2,307		2,204
Deferred revenue		180		199
Litigation-related and other long-term liabilities		1,032		951
Total liabilities		5,508		5,364
Commitments and contingencies
Stockholders’ equity
Common stock		21		21
Additional paid-in capital		10,624		10,091
Accumulated other comprehensive income		205		204
Retained earnings (accumulated deficit), since June 30, 1999		1		(838	)
Total stockholders’ equity		10,851		9,478
Total liabilities and stockholders’ equity	$	16,359	$	14,842

See Notes to Condensed Consolidated Financial Statements.

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GENENTECH, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1.

Summary of Significant Accounting Policies

Basis of Presentation

We prepared the Condensed Consolidated Financial Statements following the requirements of the United States (U.S.) Securities and Exchange Commission for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. generally accepted accounting principles (GAAP) can be condensed or omitted. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Consolidated Financial Statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of management, the financial statements include all adjustments, consisting only of normal and recurring adjustments, considered necessary for the fair presentation of our financial position and operating results.

Revenue, expenses, assets, and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be the same as those expected for the full year or any future period.

Principles of Consolidation

The consolidated financial statements include the accounts of Genentech and all wholly owned subsidiaries. Material intercompany accounts and transactions have been eliminated.

Use of Estimates and Reclassifications

The preparation of financial statements in conformity with GAAP requires management to make judgments, assumptions, and estimates that affect the amounts reported in our Condensed Consolidated Financial Statements and accompanying notes. Actual results could differ materially from those estimates.

Certain reclassifications of prior period amounts have been made to our Condensed Consolidated Financial Statements to conform to the current period presentation.

Recent Accounting Pronouncements

On January 1, 2007, we adopted Emerging Issues Task Force (EITF) Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences” (EITF 06-2). Prior to the adoption of EITF 06-2, we recorded a liability for a sabbatical leave when the employee vested in the benefit, which was only at the end of a six-year service period. Under EITF 06-2, we accrue an estimated liability for a sabbatical leave over the requisite six-year service period, as the employee’s services are rendered. Upon our adoption of EITF 06-2, we recorded an adjustment to retained earnings (accumulated deficit) of $26 million, net of tax, as a cumulative effect of a change in accounting principle.

We adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), on January 1, 2007. Implementation of FIN 48 did not result in a cumulative adjustment to retained earnings (accumulated deficit). The total amount of unrecognized tax benefits as of the date of adoption was $147 million. Of this total, $112 million represents the amount of unrecognized tax benefits that, if recognized, would favorably affect our effective income tax rate in any future period. As a result of the implementation of FIN 48, we reclassified $147 million of unrecognized tax benefits from current liabilities to long-term liabilities as of December 31, 2006 in the accompanying Condensed Consolidated Balance Sheets.

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We file income tax returns in the U.S. federal jurisdiction and various state and international jurisdictions. The Internal Revenue Service (IRS) is examining our U.S. federal income tax returns for 2002 through 2004. As of June 30, 2007, the IRS has not proposed any adjustments. We are also under examination by several state jurisdictions. As of June 30, 2007, no material adjustments related to these audits have been proposed.

We accrue tax-related interest and penalties and include such expenses with income tax expense in the Condensed Consolidated Statements of Income. We recognized approximately $2 million and $4 million in tax-related interest expense during the second quarter and first six months of 2007, respectively, and had approximately $10 million of tax-related interest accrued at January 1, 2007. Interest amounts are net of tax benefit. No penalties have been accrued.

Revenue Recognition

We recognize revenue from the sale of our products, royalties earned, and contract arrangements. Our revenue arrangements that contain multiple elements are divided into separate units of accounting if certain criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration we receive is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units. Advance payments received in excess of amounts earned are classified as deferred revenue until earned.

The Avastin Patient Assistance Program is a voluntary program that enables eligible patients who have received 10,000 milligrams of Avastin in a 12-month period to receive free Avastin in excess of the 10,000 milligrams during the remainder of the 12-month period. Based on the current wholesale acquisition cost, 10,000 milligrams is valued at $55,000 in gross revenue. We defer a portion of our gross Avastin product sales revenue to reflect our estimate of the commitment to supply free Avastin to patients who elect to enroll in the program. To calculate our deferred revenue, we estimate the number of patients who will receive free Avastin and the amount of free Avastin that we expect them to receive. Based on those estimates, we defer a portion of Avastin revenue on product vials sold through normal commercial channels. The deferred revenue is recognized as free Avastin vials are delivered.

Earnings Per Share

Basic earnings per share (EPS) are computed based on the weighted-average number of shares of our Common Stock outstanding. Diluted earnings per share are computed based on the weighted-average number of shares of our Common Stock and other dilutive securities.

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations (in millions):

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Numerator:
Net income	$	747	$	531	$	1,453	$	952
Denominator:
Weighted-average shares outstanding used to compute basic earnings per share		1,053		1,053		1,053		1,054
Effect of dilutive stock options		17		20		18		20
Weighted-average shares outstanding and dilutive securities used to compute diluted earnings per share		1,070		1,073		1,071		1,074

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Outstanding employee stock options to purchase approximately 35 million and 34 million shares of our Common Stock were excluded from the computation of diluted EPS for the second quarter and first six months of 2007, respectively, because the effect would have been anti-dilutive.

Comprehensive Income

Comprehensive income comprises net income and other comprehensive income (OCI). OCI includes certain changes in stockholders’ equity that are excluded from net income. Specifically, we include in OCI changes in the estimated fair value of derivatives designated as effective cash flow hedges, and unrealized gains and losses on our securities available-for-sale. In accordance with our adoption of Statement of Financial Accounting Standards (FAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R),” in 2006, the gains or losses and prior service costs or credits that arise during the period, but are not recognized as components of net periodic benefit cost, have been recognized in other comprehensive income.

The components of accumulated other comprehensive income, net of taxes, were as follows (in millions):

	June 30, 2007			December 31, 2006
Net unrealized gains on securities available-for-sale	$	204		$	214
Net unrealized gains (losses) on cash flow hedges		7			(4	)
Post-retirement benefit obligation		(6	)		(6	)
Accumulated other comprehensive income	$	205		$	204

The activity in comprehensive income, net of income taxes, was as follows (in millions):

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Net income	$	747		$	531		$	1,453		$	952
Decrease in unrealized gains on securities available-for-sale		(14	)		(43	)		(10	)		(40	)
Increase (decrease) in unrealized gains on cash flow hedges		8			(19	)		11			(20	)
Comprehensive income, net of income taxes	$	741		$	469		$	1,454		$	892

Derivative Instruments

Our derivative instruments, designated as cash flow hedges, consist of foreign currency exchange options and marketable equity collars. At June 30, 2007, estimated net gains expected to be reclassified from accumulated OCI to “other income, net” during the next year are $8 million.

Note 2.

Employee Stock-Based Compensation

Stock-Based Compensation Expense under FAS 123R

Employee stock-based compensation expense was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. FAS No. 123(R), “Share-Based Payment” (FAS 123R), requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

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Employee stock-based compensation expense recognized under FAS 123R was as follows (in millions):

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Cost of sales	$	16	$	–	$	33	$	–
Research and development		39		34		77		67
Marketing, general and administrative		47		41		93		82
Total employee stock-based compensation expense	$	102	$	75	$	203	$	149

As of June 30, 2007, total compensation cost related to unvested stock options not yet recognized was $667 million, which is expected to be allocated to expense and production costs over a weighted-average period of 30 months.

The carrying value of inventory on our Condensed Consolidated Balance Sheets as of June 30, 2007 and 2006 includes employee stock-based compensation costs of $75 million and $33 million, respectively. During the second quarter and first six months of 2007, $16 million and $33 million, respectively, of previously capitalized employee stock-based compensation costs were recognized in cost of sales. Substantially all of the products sold during the first six months of 2006 were manufactured in previous periods when we did not include employee stock-based compensation expense in our production costs.

Valuation Assumptions

The employee stock-based compensation expense recognized under FAS 123R was determined using the Black-Scholes option valuation model. Option valuation models require the input of subjective assumptions, and these assumptions can vary over time. The weighted-average assumptions used were as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Risk-free interest rate		4.8	%		4.9	%		4.7	%		4.8	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Expected volatility		27.0	%		29.0	%		27.0	%		29.0	%
Expected term (years)		4.6			4.2			4.6			4.2

Due to the redemption of our Special Common Stock in June 1999 by Roche Holdings, Inc. (RHI), there is limited historical information available to support our estimate of certain assumptions required to value our employee stock options and the stock issued under our employee stock purchase plan. In developing our estimate of expected term, we have determined that our historical stock option exercise experience is a relevant indicator of future exercise patterns. We also take into account other available information, including industry averages. We primarily base our determination of expected volatility on our assessment of the implied volatility of our Common Stock. Implied volatility is the volatility assumption inherent in the market prices of a company’s traded options.

Note 3.

Condensed Consolidated Financial Statement Detail

Inventories

The components of inventories were as follows (in millions):

	June 30, 2007		December 31, 2006
Raw materials and supplies	$	123	$	116
Work in process		883		818
Finished goods		359		244
Total	$	1,365	$	1,178

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Note 4.

Contingencies

We are a party to various legal proceedings, including patent infringement litigation and licensing and contract disputes, and other matters.

On October 4, 2004, we received a subpoena from the U.S. Department of Justice, requesting documents related to the promotion of Rituxan, a prescription treatment now approved for five indications. We are cooperating with the associated investigation, which is both civil and criminal in nature, and through counsel we are having discussions with government representatives about the status of their investigation and Genentech’s views on this matter. The government has called, and may continue to call, former and current Genentech employees to appear before a grand jury in connection with this investigation. The outcome of this matter cannot be determined at this time.

On July 29, 2005, a former Genentech employee, whose employment ended in April 2005, filed a qui tam complaint under seal in the United States District Court for the District of Maine against Genentech and Biogen Idec Inc., alleging violations of the False Claims Act and retaliatory discharge of employment. On December 20, 2005, the United States filed notice of its election to decline intervention in the lawsuit. The complaint was subsequently unsealed and we were served on January 5, 2006. Genentech filed a motion to dismiss the complaint and on December 14, 2006, the Magistrate Judge assigned to the case issued a Recommended Decision on that motion, which is subject to review by the District Court Judge. The Magistrate Judge recommended that the False Claims Act portion of the complaint be dismissed, leaving as the only remaining claim against Genentech the plaintiff’s retaliatory discharge claim. Plaintiff, Biogen Idec, and Genentech each subsequently filed objections with the District Court Judge concerning certain aspects of the Magistrate Judge’s Recommended Decision. On July 24, 2007, the District Court Judge affirmed the dismissal of both claims relating to the False Claims Act but denied Genentech’s motion to dismiss plaintiff’s federal retaliatory discharge claim and granted plaintiff’s motion for leave to file a Second Amended Complaint asserting an additional state law employment claim. The outcome of this matter cannot be determined at this time.

We and the City of Hope National Medical Center (COH) are parties to a 1976 agreement related to work conducted by two COH employees, Arthur Riggs and Keiichi Itakura, and patents that resulted from that work, which are referred to as the “Riggs/Itakura Patents.” Since that time, we have entered into license agreements with various companies to manufacture, use, and sell the products covered by the Riggs/Itakura Patents. On August 13, 1999, the COH filed a complaint against us in the Superior Court in Los Angeles County, California, alleging that we owe royalties to the COH in connection with these license agreements, as well as product license agreements that involve the grant of licenses under the Riggs/Itakura Patents. On June 10, 2002, a jury voted to award the COH approximately $300 million in compensatory damages. On June 24, 2002, a jury voted to award the COH an additional $200 million in punitive damages. Such amounts were accrued as an expense in the second quarter of 2002 and are included in the accompanying Condensed Consolidated Balance Sheets in “litigation-related and other long-term liabilities” at June 30, 2007 and December 31, 2006. We filed a notice of appeal of the verdict and damages awards with the California Court of Appeal. On October 21, 2004, the California Court of Appeal affirmed the verdict and damages awards in all respects. On November 22, 2004, the California Court of Appeal modified its opinion without changing the verdict and denied Genentech’s request for rehearing. On November 24, 2004, we filed a petition seeking review by the California Supreme Court. On February 2, 2005, the California Supreme Court granted that petition. The appeal to the California Supreme Court has been fully briefed, and we are waiting to be assigned an oral argument date. The amount of cash paid, if any, or the timing of such payment in connection with the COH matter will depend on the outcome of the California Supreme Court’s review of the matter. It may take longer than one year to resolve the matter.

We recorded accrued interest and bond costs related to the COH trial judgment of $13 million for the second quarter of 2007 and $14 million for the second quarter of 2006, and $26 million for the first six months of 2007 and $27 million for the first six months of 2006. In conjunction with the COH judgment, we posted a surety bond and were required to pledge cash and investments of $788 million at June 30, 2007 and December 31, 2006 to secure the bond. These amounts are reflected in “restricted cash and investments” in the accompanying Condensed Consolidated Balance Sheets. We expect that we will continue to incur interest charges on the judgment and service fees on the surety bond each quarter through the process of appealing the COH trial results.

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On April 11, 2003, MedImmune, Inc. filed a lawsuit against Genentech, COH, and Celltech R & D Ltd. in the U.S. District Court for the Central District of California (Los Angeles). The lawsuit relates to U.S. Patent No. 6,331,415 (the Cabilly patent) that we co-own with COH and under which MedImmune and other companies have been licensed and are paying royalties to us. The lawsuit includes claims for violation of antitrust, patent, and unfair competition laws. MedImmune is seeking a ruling that the Cabilly patent is invalid and/or unenforceable, a determination that MedImmune does not owe royalties under the Cabilly patent on sales of its Synagis® antibody product, an injunction to prevent us from enforcing the Cabilly patent, an award of actual and exemplary damages, and other relief. On January 14, 2004 (amending a December 23, 2003 order), the U.S. District Court granted summary judgment in our favor on all of MedImmune’s antitrust and unfair competition claims. On April 23, 2004, the District Court granted our motion to dismiss all remaining claims in the case. On October 18, 2005, the U.S. Court of Appeals for the Federal Circuit affirmed the judgment of the District Court in all respects. MedImmune filed a petition for certiorari with the United States Supreme Court on November 10, 2005, seeking review of the decision to dismiss certain of its claims. The Supreme Court granted MedImmune’s petition, and the oral argument of this case before the Supreme Court occurred on October 4, 2006. On January 9, 2007, the Supreme Court issued a decision reversing the Federal Circuit’s decision and remanding the case to the lower courts for further proceedings in connection with the patent and contract claims. The trial of this matter has been scheduled for June 23, 2008. The outcome of this matter cannot be determined at this time.

On May 13, 2005, a request was filed by a third party for reexamination of the Cabilly patent. The request sought reexamination on the basis of non-statutory double patenting over U.S. Patent No. 4,816,567. On July 7, 2005, the U.S. Patent and Trademark Office (Patent Office) ordered reexamination of the Cabilly patent. On September 13, 2005, the Patent Office mailed an initial non-final Patent Office action rejecting the claims of the Cabilly patent. We filed our response to the Patent Office action on November 25, 2005. On December 23, 2005, a second request for reexamination of the Cabilly patent was filed by another third party, and on January 23, 2006, the Patent Office granted that request. On June 6, 2006, the two reexaminations were merged into one proceeding. On August 16, 2006, the Patent Office mailed a non-final Patent Office action in the merged proceeding, rejecting the claims of the Cabilly patent based on issues raised in the two reexamination requests. We filed our response to the Patent Office action on October 30, 2006. On February 16, 2007, the Patent Office mailed a final Patent Office action rejecting all 36 claims of the Cabilly patent. We responded to the final Patent Office action on May 21, 2007 and requested continued reexamination. On May 31, 2007, the Patent Office granted the request for continued reexamination, and in doing so withdrew the finality of the February 2007 Patent Office action and agreed to treat our May 21, 2007 filing as a response to a first Patent Office action. The Cabilly patent, which expires in 2018, relates to methods that we and others use to make certain antibodies or antibody fragments, as well as cells and DNA used in these methods. We have licensed the Cabilly patent to other companies and derive significant royalties from those licenses. The claims of the Cabilly patent remain valid and enforceable throughout the reexamination and appeals processes. Because the above-described proceeding is ongoing, the outcome of this matter cannot be determined at this time.

In 2006, we made development decisions involving our humanized anti-CD20 program, and our collaborator, Biogen Idec, disagreed with certain of our development decisions related to humanized anti-CD20 products. Under our 2003 collaboration agreement with Biogen Idec, we believe that we are permitted under the agreement to proceed with further trials of certain humanized anti-CD20 antibodies, and Biogen Idec disagreed with our position. The disputed issues have been submitted to arbitration. In the arbitration, Biogen Idec filed motions for a preliminary injunction and summary judgment seeking to stop us from proceeding with certain development activities, including planned clinical trials. On April 20, 2007, the arbitration panel denied both Biogen Idec’s motion for a preliminary injunction and Biogen Idec’s motion for summary judgment. Resolution of the arbitration could require that both parties agree to certain development decisions before moving forward with humanized anti-CD20 antibody clinical trials, and possibly clinical trials of other collaboration products, including Rituxan, in which case we may have to alter or cancel planned trials in order to obtain Biogen Idec’s approval. The hearing of this matter is scheduled to begin in June 2008. We expect a final decision by the arbitrators by approximately the end of 2008 unless the parties are able to resolve the matter earlier through settlement discussions or otherwise. The outcome of this matter cannot be determined at this time.

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Note 5.

Relationship with Roche Holdings, Inc. and Related Party Transactions

Roche Holdings, Inc.’s Ability to Maintain Percentage Ownership Interest in Our Stock

We issue shares of Common Stock in connection with our stock option and stock purchase plans, and we may issue additional shares for other purposes. Our affiliation agreement with RHI provides, among other things, that with respect to any issuance of our Common Stock in the future, we will repurchase a sufficient number of shares so that immediately after such issuance, the percentage of our Common Stock owned by RHI will be no lower than 2% below the “Minimum Percentage” (subject to certain conditions). The Minimum Percentage equals the lowest number of shares of Genentech Common Stock owned by RHI since the July 1999 offering (to be adjusted in the future for dispositions of shares of Genentech Common Stock by RHI as well as for stock splits or stock combinations) divided by 1,018,388,704 (to be adjusted in the future for stock splits or stock combinations), which is the number of shares of Genentech Common Stock outstanding at the time of the July 1999 offering, adjusted for stock splits. We have repurchased shares of our Common Stock since 2001. The affiliation agreement also provides that upon RHI’s request, we will repurchase shares of our Common Stock to increase RHI’s ownership to the Minimum Percentage. In addition, RHI will have a continuing option to buy stock from us at prevailing market prices to maintain its percentage ownership interest. Under the terms of the affiliation agreement, RHI’s Minimum Percentage is 57.7%, and RHI’s ownership percentage is to be no lower than 55.7%. At June 30, 2007, RHI’s ownership percentage was 55.8%.

Related Party Transactions

We enter into transactions with our related parties, Roche Holding AG and affiliates (Roche) and Novartis AG and other Novartis affiliates (Novartis). The accounting policies that we apply to our transactions with our related parties are consistent with those applied in transactions with independent third parties.

In our royalty and supply arrangements with related parties, we are the principal, as defined under EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent” (EITF 99-19), because we bear the manufacturing risk, general inventory risk, and the risk to defend our intellectual property. For circumstances in which we are the principal in the transaction, we record the transaction on a gross basis in accordance with EITF 99-19. Otherwise, our transactions are recorded on a net basis.

Roche

Under our existing arrangements with Roche, including our licensing and marketing agreements, we recognized the following amounts (in millions):

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Product sales to Roche	$	253	$	73	$	516	$	131

Royalties earned from Roche	$	283	$	207	$	538	$	373

Contract revenue from Roche	$	30	$	21	$	60	$	40

Cost of sales on product sales to Roche	$	137	$	64	$	258	$	113

Research and development (R&D) expenses incurred on joint development projects with Roche	$	70	$	53	$	128	$	95

R&D expenses are partially reimbursable to us by Roche. In addition, these amounts include R&D expenses resulting from the net settlement of amounts we owed to Roche on R&D expenses that Roche incurred on joint development projects, less amounts reimbursable to us by Roche on these respective projects.

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Novartis

Based on information available to us at the time of filing this Form 10-Q, we believe that Novartis holds approximately 33.3 percent of the outstanding voting shares of Roche Holding AG. As a result of this ownership, Novartis is deemed to have an indirect beneficial ownership interest under FAS 57, “Related Party Disclosures,” of more than 10 percent of our voting stock.

We have an agreement with Novartis Pharma AG (a wholly owned subsidiary of Novartis AG) under which Novartis Pharma AG has the exclusive right to develop and market Lucentis outside the U.S. for indications related to diseases or disorders of the eye. As part of this agreement, the parties will share the cost of certain of our ongoing development expenses for Lucentis. Novartis Pharma AG makes royalty payments to us on sales of Lucentis outside the U.S.

We, along with Novartis Pharma AG, are co-developing Xolair in the U.S., and we and Novartis are co-promoting Xolair in the U.S. We record all sales and cost of sales in the U.S., and Novartis markets the product in and records all sales and cost of sales in Europe. We and Novartis share the resulting U.S. and European operating profits, respectively, according to prescribed profit sharing percentages, and our U.S. and European profit sharing expenses are recorded as collaboration profit sharing expense.

Under our existing arrangements with Novartis, we recognized the following amounts (in millions):

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Product sales to Novartis	$	3	$	2	$	6	$	2

Royalties earned from Novartis	$	13	$	–	$	19	$	–

Contract revenue from Novartis	$	4	$	13	$	44	$	23

Cost of sales on product sales to Novartis	$	3	$	1	$	7	$	2

R&D expenses incurred on joint development projects with Novartis	$	9	$	12	$	19	$	22

Collaboration profit sharing expense to Novartis	$	49	$	48	$	96	$	91

Contract revenue in the first six months of 2007 included a $30 million milestone payment from Novartis Pharma AG for European Union approval of Lucentis for the treatment of neovascular (wet) age-related macular degeneration.

R&D expenses are partially reimbursable to us by Novartis. In addition, these amounts include R&D expenses resulting from the net settlement of amounts we owed to Novartis on R&D expenses that Novartis incurred on joint development projects, less amounts reimbursable to us by Novartis on these respective projects.

Note 6.

Income Taxes

The effective income tax rate was 37% in the second quarter and in the first six months of 2007, compared to 38% in the second quarter and in the first six months of 2006. The decrease in the income tax rate is primarily due to the extension of the federal R&D tax credit and an increase in the domestic manufacturing deduction in 2007.

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Note 7.

Subsequent Event

On August 2, 2007, we acquired 100% of the shares of Tanox, Inc., a publicly held company based in Houston, Texas, specializing in the discovery of biotherapeutics based on monoclonal antibody technology, for $20 per share for a total cash value of approximately $919 million, including estimated transaction costs. We expect to complete the purchase price allocation for this acquisition pending the receipt of final asset appraisals and the completion of certain other analyses in the third quarter of 2007.

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Genentech, Inc.

We have reviewed the condensed consolidated balance sheet of Genentech, Inc. as of June 30, 2007, and the related condensed consolidated statements of income for the three-month and six-month periods ended June 30, 2007 and 2006, and the condensed consolidated statements of cash flows for the six-month periods ended June 30, 2007 and 2006. These financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Genentech, Inc. as of December 31, 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended, not presented herein, and in our report dated February 5, 2007, we expressed an unqualified opinion on those consolidated financial statements including an explanatory paragraph relating to the change in method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123(R), “Share-based Payment.” In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2006, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Ernst & Young LLP

Palo Alto, California

July 20, 2007,

except for Note 7, as to which the date is

August 2, 2007

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

GENENTECH, INC.

FINANCIAL REVIEW

Overview

The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the Consolidated Financial Statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2006.

The Company

Genentech is a leading biotechnology company that discovers, develops, manufactures, and commercializes biotherapeutics for significant unmet medical needs. We commercialize multiple biotechnology products, and also receive royalties from companies that are licensed to market products based on our technology.

Major Developments in the Second Quarter of 2007

We primarily earn revenue and income and generate cash from product sales and royalty revenue. In the second quarter of 2007, our total operating revenue was $3,004 million, an increase of 37% from $2,199 million in the second quarter of 2006. Our net income for the second quarter of 2007 was $747 million, an increase of 41% from $531 million in the second quarter of 2006. In the first six months of 2007, our total operating revenue was $5,847 million, an increase of 40% from $4,185 million in the first six months of 2006. Our net income for the first six months of 2007 was $1,453 million, an increase of 53% from $952 million in the first six months of 2006.

In June 2007, we submitted two supplemental Biologic License Applications (sBLAs) with the United States (U.S.) Food and Drug Administration (FDA) for the use of Herceptin in combination with a chemotherapy regimen containing doxorubicin, cyclophosphamide, and Taxotere and in combination with a non-anthracycline chemotherapy regimen consisting of Taxotere and carboplatin based on data from the BCIRG-006 trial.

On June 26, 2007, we entered into a collaboration agreement with Abbott Laboratories for the global research, development, and commercialization of two of Abbott’s investigational anti-cancer, small molecule compounds: ABT-263 and ABT-869. ABT-263 is currently in Phase I clinical trials and we, in collaboration with Abbott, are planning to initiate Phase II trials with ABT-869 in solid tumor types in the second half of 2007.

During the second quarter of 2007, we achieved four manufacturing milestones: (i) we received FDA licensure of our Oceanside, California manufacturing facility to produce bulk Avastin, (ii) we received approval for a new aseptic fill-finish line in South San Francisco, California; (iii) we broke ground on our E. coli production facility in Singapore, and (iv) we achieved mechanical completion of our second manufacturing facility in Vacaville, California, for which we continue to anticipate licensure in 2009.

On August 2, 2007, we acquired 100% of the shares of Tanox, Inc. for $20 per share for a total cash value of approximately $919 million, including estimated transaction costs. We expect to complete the purchase price allocation for this acquisition pending the receipt of final asset appraisals and the completion of certain other analyses in the third quarter of 2007.

Our Strategy and Goals

As announced in 2006, our business objectives for the years 2006 through 2010 include bringing at least 20 new molecules into clinical development, bringing at least 15 major new products or indications onto the market, becoming the number one U.S. oncology company in sales, and achieving certain financial growth measures. These

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objectives are reflected in our revised Horizon 2010 strategy and goals summarized on our website at www.gene.com/gene/about/corporate/growthstrategy.

Economic, Industry-wide, and Other Factors

Our strategy and goals are challenged by economic and industry-wide factors that affect our business. Key factors that affect our future growth are discussed below:

We face significant competition in the diseases of interest to us from pharmaceutical companies and biotechnology companies. The introduction of new competitive products or follow-on biologics, and/or new information about existing products or pricing decisions by us or our competitors, may result in lost market share for us, reduced utilization of our products, lower prices, and/or reduced product sales, even for products protected by patents.

Our long-term business growth depends upon our ability to continue to successfully develop and commercialize important novel therapeutics to treat unmet medical needs, such as cancer, as well as our ability to in-license product candidates. We recognize that the successful development of biotherapeutics is highly difficult and uncertain, and that it will be challenging for us to continue to discover and develop innovative treatments. Our business requires significant investment in research and development (R&D) over many years, often for products that fail during the R&D process. Once a product receives FDA approval, it remains subject to ongoing FDA regulation, including changes to the product label, new or revised regulatory requirements for manufacturing practices, written advisement to physicians, and/or product recalls or withdrawals.

Our near-term growth will depend on our ability to execute on recent product approvals, including Lucentis for the treatment of neovascular (wet) age-related macular degeneration (AMD) and Avastin for the treatment of non-small cell lung cancer, and to successfully obtain FDA approvals for potential new indications for our existing products such as Avastin for the treatment of metastatic breast cancer and anti-CD20 molecules for the treatment of immunological disorders.

Our business model requires appropriate pricing and reimbursement for our products, to offset the costs and risks of drug development. The pricing of our products has received negative press coverage and public scrutiny. We will continue to meet with patient groups, payers, and other stakeholders in the healthcare system to understand their issues and concerns. The reimbursement environment for our products may change in the future and become more challenging.

As the Medicare and Medicaid programs are the largest payers for our products, rules related to coverage and reimbursement continue to represent an important issue for our business. New regulations related to hospital and physician payment continue to be implemented annually. To date, we have not seen any detectable effects of the new rules on our product sales.

Intellectual property protection of our products is crucial to our business. Loss of effective intellectual property protection on one or more products could result in lost sales to competing products and may negatively affect our sales, royalty revenue, and operating results. We are often involved in disputes over contracts and intellectual property, and we work to resolve these disputes in confidential negotiations or litigation. We expect legal challenges in this area to continue. We plan to continue to build upon and defend our intellectual property position.

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Manufacturing biotherapeutics is difficult and complex, and requires facilities specifically designed and validated to run biotechnology production processes. The manufacture of a biotherapeutic requires developing and maintaining a process to reliably manufacture and formulate the product at an appropriate scale, obtaining regulatory approval to manufacture the product, and is subject to changes in regulatory requirements or standards that may require modifications to the manufacturing process. Additionally, we may have an excess of available capacity, which could lead to an idling of a portion of our manufacturing facilities and incurring unabsorbed or idle plant charges, or other excess capacity charges, resulting in an increase in our cost of sales.

Our ability to attract and retain highly qualified and talented people in all areas of the company, and our ability to maintain our unique culture, will be critical to our success over the long-term. We are working diligently across the company to make sure that we successfully hire, train, and integrate new employees into the Genentech culture and environment.

Marketed Products

We commercialize in the U.S. the biotechnology products listed below:

Avastin (bevacizumab) is an anti-VEGF humanized antibody approved for use in combination with intravenous 5-fluorouracil-based chemotherapy as a treatment for patients with first- or second-line metastatic cancer of the colon or rectum. It is also approved for use in combination with carboplatin and paclitaxel chemotherapy for the first-line treatment of unresectable, locally advanced, recurrent or metastatic non-squamous, non-small cell lung cancer.

Rituxan (rituximab) is an anti-CD20 antibody that we commercialize with Biogen Idec, Inc. It is approved for:

The treatment of patients with relapsed or refractory, low-grade or follicular, CD20-positive, B-cell non-Hodgkin’s lymphoma, including retreatment and bulky disease;

The first-line treatment of patients with diffuse large B-cell, CD20-positive, non-Hodgkin’s lymphoma in combination with CHOP (cyclophosphamide, doxorubicin, vincristine, and prednisone) or other anthracycline-based chemotherapy;

The first-line treatment of patients with follicular, CD20-positive, B-cell non-Hodgkin’s lymphoma in combination with cyclophosphamide, vincristine, and prednisone (CVP) chemotherapy regimens;

The treatment of low-grade, CD20-positive, B-cell non-Hodgkin’s lymphoma in patients with stable disease or who achieve a partial or complete response following first-line treatment with CVP chemotherapy; and

Use in combination with methotrexate for reducing signs and symptoms in adult patients with moderately to severely active rheumatoid arthritis (RA) who have had an inadequate response to one or more tumor necrosis factor antagonist therapies.

Herceptin (trastuzumab) is a humanized anti-HER2 antibody approved for use as an adjuvant treatment of node-positive breast cancer as part of a treatment regimen containing doxorubicin, cyclophosphamide, and paclitaxel for patients who have tumors that overexpress the human epidermal growth factor receptor 2 (HER2) protein. It is also approved for use as a first-line therapy in combination with paclitaxel and as a single agent in second- and third-line therapy for patients with HER2-positive metastatic breast cancer.

Lucentis (ranibizumab) is an anti-VEGF antibody fragment approved for the treatment of neovascular (wet) age-related macular degeneration.

Xolair (omalizumab) is a humanized anti-IgE antibody, which we commercialize with Novartis Pharma AG (Novartis). Xolair is approved for adults and adolescents (age 12 or older) with moderate to severe persistent asthma

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who have a positive skin test or in vitro reactivity to a perennial aeroallergen and whose symptoms are inadequately controlled with inhaled corticosteroids.

Tarceva (erlotinib), which we commercialize with OSI Pharmaceuticals, Inc., is a small-molecule tyrosine kinase inhibitor of the HER1/epidermal growth factor receptor (EGFR) signaling pathway. Tarceva is approved for the treatment of patients with locally advanced or metastatic non-small cell lung cancer after failure of at least one prior chemotherapy regimen. It is also approved, in combination with gemcitabine chemotherapy, for the first-line treatment of patients with locally advanced, unresectable, or metastatic pancreatic cancer.

Nutropin (somatropin [rDNA origin] for injection) and Nutropin AQ are growth hormone products approved for the treatment of growth hormone deficiency in children and adults, growth failure associated with chronic renal insufficiency prior to kidney transplantation, short stature associated with Turner syndrome, and long-term treatment of idiopathic short stature.

Activase (alteplase, recombinant) is a tissue plasminogen activator (t-PA) approved for the treatment of acute myocardial infarction (heart attack), acute ischemic stroke (blood clots in the brain) within three hours of the onset of symptoms, and acute massive pulmonary embolism (blood clots in the lungs).

TNKase (tenecteplase) is a modified form of t-PA approved for the treatment of acute myocardial infarction (heart attack).

Cathflo Activase (alteplase, recombinant) is a t-PA approved in adult and pediatric patients for the restoration of function to central venous access devices that have become occluded due to a blood clot.

Pulmozyme (dornase alfa, recombinant) is an inhalation solution of deoxyribonuclease (rhDNase) I, approved for the treatment of cystic fibrosis.

Raptiva (efalizumab) is a humanized anti-CD11a antibody approved for the treatment of chronic moderate-to-severe plaque psoriasis in adults age 18 or older who are candidates for systemic therapy or phototherapy.

Licensed Products

We receive royalty revenue from various licensees, including significant royalty revenue from Roche Holding AG and affiliates (Roche) on sales of:

Herceptin, Pulmozyme, and Avastin outside the U.S.;

Rituxan outside the U.S., excluding Japan; and

Nutropin products, Activase, and TNKase in Canada.

See Note 4, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for information regarding certain patent-related legal proceedings.

Available Information

The following information is found on our website at www.gene.com, or can be obtained free of charge by contacting our Investor Relations Department at (650) 225-1599 or sending an e-mail message to investor.relations@gene.com:

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission;

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Our policies related to corporate governance, including our Principles of Corporate Governance, Good Operating Principles, and our Code of Ethics, which apply to our Chief Executive Officer, Chief Financial Officer, and senior financial officials; and

The charters of the Audit Committee and the Compensation Committee of our Board of Directors.

Critical Accounting Policies and the Use of Estimates

The accompanying discussion and analysis of our financial condition and results of operations are based on our Condensed Consolidated Financial Statements and the related disclosures, which have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of these Condensed Consolidated Financial Statements requires management to make estimates, assumptions, and judgments that affect the reported amounts in our Condensed Consolidated Financial Statements and accompanying notes. These estimates form the basis for making judgments about the carrying values of assets and liabilities. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, and we have established internal controls related to the preparation of these estimates. Actual results and the timing of the results could differ materially from these estimates.

We believe the following policies to be critical to understanding our financial condition, results of operations, and expectations for 2007, because these policies require management to make significant estimates, assumptions, and judgments about matters that are inherently uncertain.

Contingencies

We are currently, and have been, involved in certain legal proceedings, including patent infringement litigation. We are also involved in licensing and contract disputes, and other matters. See Note 4, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for further information on these matters. We assess the likelihood of any adverse judgments or outcomes for these legal matters as well as potential ranges of probable losses. We record an estimated loss as a charge to income if we determine that, based on information available at the time, the loss is probable and the amount of loss can be reasonably estimated. Included in “litigation-related and other long-term liabilities” in the accompanying Condensed Consolidated Balance Sheet at June 30, 2007 is $751 million, which represents our estimate of the costs for the current resolution of the City of Hope National Medical Center (COH) matter. The nature of these matters is highly uncertain and subject to change; as a result, the amount of our liability for certain of these matters could exceed or be less than the amount of our current estimates, depending on the final outcome of these matters. An outcome of such matters that is different from previously estimated could have a material effect on our financial position or our results of operations in any one quarter.

Revenue Recognition – Avastin U.S. Product Sales

In February 2007, we launched the Avastin Patient Assistance Program, which is a voluntary program that enables eligible patients who have received 10,000 milligrams of Avastin in a 12-month period to receive free Avastin in excess of the 10,000 milligrams during the remainder of the 12-month period. Based on the current wholesale acquisition cost, the 10,000 milligrams is valued at $55,000 in gross revenue. Eligible patients include those who are being treated for an FDA-approved indication and who meet the household income criteria for this program. The program is available for eligible patients who enroll regardless of whether they are insured. We defer a portion of our gross Avastin product sales revenue to reflect our estimate of the commitment to supply free Avastin to those patients who elect to enroll in the program.

In order to make our estimate of the amount of free Avastin to be provided to patients under the program, we need to estimate several factors, most notably: the number of patients who are currently being treated for FDA-approved indications and the start date for their treatment regimen, the extent to which doctors and patients may elect to enroll in the program, the number of patients who will meet the financial eligibility requirements of the program, and the duration and extent of treatment for the FDA-approved indications, among other factors. We have based our

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enrollment assumptions on physician surveys and other information that we consider relevant. We will continue to update our estimates in each reporting period as new information becomes available. If the actual results underlying this deferred revenue accounting vary significantly from our estimates, we will need to make adjustments to these estimates, which could have a material effect on revenue and earnings in the period of adjustment. Based on these estimates, we defer a portion of Avastin revenue on product vials sold through normal commercial channels. The deferred revenue will be recognized as free Avastin vials are delivered. In the first six months of 2007, we deferred a net amount of approximately $3 million of our Avastin sales, resulting in a total deferred revenue liability in connection with the Avastin Patient Assistance Program of $12 million in our Condensed Consolidated Balance Sheet at June 30, 2007.

Product Sales Allowances

Revenue from U.S. product sales is recorded net of allowances and accruals for rebates, healthcare provider contractual chargebacks, prompt-pay sales discounts, product returns, and wholesaler inventory management allowances, all of which are established at the time of sale. Sales allowances and accruals are based on estimates of the amounts earned or to be claimed on the related sales. The amounts reflected in our Condensed Consolidated Statements of Income as product sales allowances have been relatively consistent at approximately six to eight percent of gross sales. In order to prepare our Condensed Consolidated Financial Statements, we are required to make estimates regarding the amounts earned or to be claimed on the related product sales.

Definitions for the product sales allowance types are as follows:

Rebate allowances and accruals comprise both direct and indirect rebates. Direct rebates are contractual price adjustments payable to direct customers, mainly to wholesalers and specialty pharmacies that purchase products directly from us. Indirect rebates are contractual price adjustments payable to healthcare providers and organizations such as clinics, hospitals, pharmacies, Medicaid, and group purchasing organizations that do not purchase products directly from us;

Prompt-pay sales discounts are credits granted to wholesalers for remitting payment on their purchases within established cash payment incentive periods;

Product return allowances are established in accordance with our Product Returns Policy. Our returns policy allows product returns within the period beginning two months prior to and six months following product expiration;

Wholesaler inventory management allowances are credits granted to wholesalers for compliance with various contractually defined inventory management programs. These programs were created to align purchases with underlying demand for our products and to maintain consistent inventory levels, typically at two to three weeks of sales depending on the product; and

Healthcare provider contractual chargebacks are the result of contractual commitments by us to provide products to healthcare providers at specified prices or discounts.

We believe that our estimates related to product returns allowances and wholesaler inventory management payments are not material amounts, based on the historical levels of credits and allowances as a percentage of product sales. We believe that our estimates related to healthcare provider contractual chargebacks and prompt-pay sales discounts do not have a high degree of estimation complexity or uncertainty, as the related amounts are settled within a short period of time. We consider rebate allowances and accruals to be the only estimations that involve material amounts and require a higher degree of subjectivity and judgment necessary. As a result of the uncertainties involved in estimating rebate allowances and accruals, there is a likelihood that materially different amounts could be reported under different conditions or using different assumptions.

Our rebates are based on definitive agreements or legal requirements (such as Medicaid). These rebates are primarily estimated using historical and other data, including patient usage, customer buying patterns, applicable contractual

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rebate rates, and contract performance by the benefit providers. Direct rebates are accrued at the time of sale and recorded as allowances against trade accounts receivable; indirect (including Medicaid) rebates are accrued at the time of sale and recorded as liabilities. Rebate estimates are evaluated quarterly and may require changes to better align our estimates with actual results. As part of this evaluation, we review changes to Medicaid legislation, changes to state rebate contracts, changes in the level of discounts, and significant changes in product sales trends. Although rebates are accrued at the time of sale, rebates are typically paid out, on average, up to six months after the sale. We believe that our rebate allowances and accruals estimation process provides a high degree of confidence in the amounts established and that the annual allowance amounts provided for would not vary by more than approximately 3% based on our estimate that our changes in rebate allowances and accruals estimates related to prior years have not exceeded 3%. To illustrate our sensitivity to changes in the rebate allowances and accruals process, as much as a 10% change in our annualized rebate allowances and accruals provision experienced to date in 2007 (which is in excess of three times the level of variability that we reasonably expect to observe for rebates) would have an approximate $18 million effect on our income before taxes (or approximately $0.01 per share after taxes). The total rebate allowances and accruals recorded in our Condensed Consolidated Balance Sheet were $61 million as of June 30, 2007.

All of the aforementioned categories of allowances and accruals are evaluated quarterly and adjusted when trends or significant events indicate that a change in estimate is appropriate. Such changes in estimate could materially affect our results of operations or financial position; however, to date they have not been material. It is possible that we may need to adjust our estimates in future periods. As of June 30, 2007, our Condensed Consolidated Balance Sheet reflected estimated product sales allowance reserves and accruals totaling approximately $158 million.

Royalties

For substantially all of our agreements with licensees, we estimate royalty revenue and royalty receivables in the period the royalties are earned, which is in advance of collection. Our estimates of royalty revenue and receivables in those instances are based on communication with some licensees, historical information, forecasted sales trends, and collectibility. Differences between actual royalty revenue and estimated royalty revenue are adjusted for in the period in which they become known, typically the following quarter. If the collectibility of a royalty amount is doubtful, royalty revenue is not recorded. In the case of a receivable related to previously recognized royalty revenue that is subsequently determined to be uncollectible, the receivable is reserved for in the period in which the circumstances that make collectibility doubtful are determined. Historically, adjustments to our royalty receivables have not been material to our consolidated financial condition or results of operations.

We have confidential licensing agreements with a number of companies on U.S. Patent No. 6,331,415 (the Cabilly patent), under which we receive royalty revenue on sales of products that are covered by the patent. The Cabilly patent, which expires in 2018, relates to methods that we and others use to make certain antibodies or antibody fragments, as well as cells and DNA used in these methods. The U.S. Patent and Trademark Office (Patent Office) is performing a reexamination of the patent and on February 16, 2007 issued a final Patent Office action rejecting all 36 claims of the Cabilly patent. We responded to the final Patent Office action on May 21, 2007 and requested continued reexamination. On May 31, 2007, the Patent Office granted the request for continued reexamination, and in so doing withdrew the finality of the February 2007 Patent Office action and agreed to treat our May 21, 2007 filing as a response to a first Patent Office action. The claims of the patent remain valid and enforceable throughout the reexamination and appeals processes. See also Note 4, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for further information on our Cabilly patent reexamination.

Cabilly patent royalties are generally due 60 days after the end of the quarter. Additionally, we pay COH a percentage of our Cabilly patent royalty revenue 60 days after the quarter in which we receive payments from our licensees. As of June 30, 2007, our Condensed Consolidated Balance Sheet included Cabilly patent receivables totaling approximately $48 million and the related COH payable totaling approximately $18 million.

Income Taxes

Income tax provision is based on income before taxes and is computed using the liability method. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and

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liabilities using tax rates projected to be in effect for the year in which the differences are expected to reverse. Significant estimates are required in determining our provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations. Various internal and external factors may have favorable or unfavorable effects on our future effective income tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, changing interpretations of existing tax laws or regulations, changes in estimates of prior years’ items, past and future levels of R&D spending, acquisitions, and changes in overall levels of income before taxes.

On January 1, 2007, we adopted the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). As a result of the implementation of FIN 48, we evaluated our income tax position and reclassified $147 million of unrecognized tax benefits from current liabilities to long-term liabilities as of January 1, 2007, and we also reclassified the balance as of December 31, 2006, for consistency, in the accompanying Condensed Consolidated Balance Sheets.

Inventories

Inventories may include currently marketed products manufactured under a new process or at facilities awaiting regulatory licensure. These inventories are capitalized based on management’s judgment of probable near-term regulatory licensure. The valuation of inventory requires us to estimate the value of inventory that may expire prior to use or that may fail to be released for commercial sale. The determination of obsolete inventory requires us to estimate the future demands for our products, and in the case of pre-approval inventories, to estimate the regulatory approval date for the product or for the licensure of either the manufacturing facility or the new manufacturing process. We may be required to expense previously capitalized inventory costs upon a change in our estimate, due to, among other potential factors, the denial or delay of approval of a product or the licensure of either a manufacturing facility or a new manufacturing process by the necessary regulatory bodies, or new information that suggests that the inventory will not be saleable.

Employee Stock-Based Compensation

Under the provisions of Statement of Financial Accounting Standards (FAS) No. 123(R), “Share-Based Payment” (FAS 123R), employee stock-based compensation is estimated at the date of grant based on the employee stock award’s fair value using the Black-Scholes option-pricing model and is recognized as expense ratably over the requisite service period in a manner similar to other forms of compensation paid to employees. The Black-Scholes option-pricing model requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of the expected volatility of the market price of our stock and the expected term of the award. Due to the redemption of our Special Common Stock in June 1999 (Redemption) by Roche Holdings, Inc. (RHI), there is limited historical information available to support our estimate of certain assumptions required to value our stock options. When establishing an estimate of the expected term of an award, we consider the vesting period for the award, our recent historical experience of employee stock option exercises (including forfeitures), the expected volatility, and a comparison to relevant peer group data. As required under the accounting rules, we review our valuation assumptions at each grant date, and, as a result, our valuation assumptions used to value employee stock-based awards granted in future periods may change. See also Note 2, “Employee Stock-Based Compensation,” in the Notes to Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for further information.

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Results of Operations

(In millions, except per share amounts)

	Three Months Ended June 30,									Six Months Ended June 30,
	2007			2006			% Change			2007			2006			% Change
Product sales	$	2,443		$	1,810			35	%	$	4,773		$	3,454			38	%
Royalties		484			316			53			903			602			50
Contract revenue		77			73			5			171			129			33
Total operating revenue		3,004			2,199			37			5,847			4,185			40

Cost of sales		429			284			51			821			546			50
Research and development		603			390			55			1,213			764			59
Marketing, general and administrative		532			471			13			1,023			912			12
Collaboration profit sharing		277			259			7			529			485			9
Recurring charges related to redemption		26			26			–			52			52			–
Special items: litigation-related		13			14			(7	)		26			27			(4	)
Total costs and expenses		1,880			1,444			30			3,664			2,786			32

Operating income		1,124			755			49			2,183			1,399			56

Other income (expense):
Interest and other income, net		75			121			(38	)		149			174			(14	)
Interest expense		(17	)		(18	)		(6	)		(35	)		(37	)		(5	)
Total other income, net		58			103			(44	)		114			137			(17	)

Income before taxes		1,182			858			38			2,297			1,536			50
Income tax provision		435			327			33			844			584			45
Net income	$	747		$	531			41		$	1,453		$	952			53

Earnings per share:
Basic	$	0.71		$	0.50			42		$	1.38		$	0.90			53
Diluted	$	0.70		$	0.49			43		$	1.36		$	0.89			53

Cost of sales as a % of product sales		18	%		16	%					17	%		16	%
Research and development as a % of operating revenue		20			18						21			18
Marketing, general and administrative as a % of operating revenue		18			21						17			22
Pretax operating margin		37			34						37			33
Effective income tax rate		37			38						37			38

________________________

Percentages in this table and throughout management’s discussion and analysis of financial condition and results of operations may reflect rounding adjustments.

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Total Operating Revenue

Total operating revenue increased 37% in the second quarter of 2007 and 40% in the first six months of 2007 from the comparable periods in 2006. These increases were primarily due to higher product sales and royalty revenue, and are further discussed below.

Total Product Sales

(In millions)

	Three Months Ended June 30,							Six Months Ended June 30,
	2007		2006		% Change			2007		2006		% Change
Net U.S. product sales
Avastin	$	564	$	423		33	%	$	1,097	$	821		34	%
Rituxan		582		526		11			1,117		1,003		11
Herceptin		329		320		3			640		610		5
Lucentis		209		10		*			420		10		*
Xolair		120		105		14			231		200		16
Tarceva		102		103		(1	)		203		196		4
Nutropin products		94		98		(4	)		185		185		–
Thrombolytics		67		62		8			135		121		12
Pulmozyme		55		47		17			107		96		11
Raptiva		27		22		23			51		43		19
Total U.S. product sales⁽¹⁾		2,149		1,716		25			4,186		3,285		27

Net product sales to collaborators		294		94		213			587		169		247
Total product sales	$	2,443	$	1,810		35		$	4,773	$	3,454		38

______________________

*	Calculation not meaningful.
(1)	The totals may not appear to sum due to rounding.

Total product sales increased 35% in the second quarter and 38% in the first six months of 2007 from the comparable periods in 2006. Total U.S. product sales increased 25% to $2,149 million in the second quarter and 27% to $4,186 million in the first six months of 2007 from the comparable periods in 2006. This increase in U.S. sales over the comparable periods was due to higher sales across most products, in particular higher sales of our oncology products and sales of Lucentis. Increased U.S. sales volume accounted for 86%, or $371 million, of the increase in U.S. net product sales in the second quarter of 2007, and 87%, or $786 million, of the increase in the first six months of 2007. Changes in net U.S. sales prices across the portfolio accounted for most of the remaining increase in net U.S. product sales in the second quarter and first six months of 2007.

Our references below to market adoption and penetration, as well as patient share, are derived from our analyses of market tracking studies and surveys that we undertake with physicians. We consider these tracking studies and surveys indicative of trends and information with respect to our direct customers’ buying patterns. We use statistical analyses to extrapolate the data that we obtain, and as such, the adoption, penetration, and patient share data presented herein represents estimates. Limitations in sample size and the timeliness in receiving and analyzing this data result in inherent margins of error; thus, where presented, we have rounded our percentage estimates to the nearest 5%.

Avastin

Net U.S. sales of Avastin increased 33% to $564 million in the second quarter and 34% to $1,097 million in the first six months of 2007 from the comparable periods in 2006. Net U.S. sales in the first six months of 2007 excluded $3 million of revenue that we deferred in connection with our Avastin Patient Assistance Program. There have been no price increases on Avastin.

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The increases in sales were primarily a result of increased use of Avastin in metastatic non-small cell lung cancer (NSCLC), approved on October 11, 2006, and, to a lesser extent, in metastatic breast cancer (mBC), an unapproved use of Avastin. Among first-line metastatic NSCLC patients, we estimate that Avastin penetration was approximately 30% in the second quarter of 2007, an increase from the adoption rate in the second quarter of 2006. With respect to dose, use of the 15mg/kg/every-three-weeks dose remained at approximately 75%, consistent with the first quarter of 2007. However, our tracking study for the second quarter of 2007 was fielded prior to the presentation of the results from the Roche-sponsored Phase III BO17704 study at the American Society of Clinical Oncology in June 2007. The BO17704 study evaluated two different doses of Avastin in combination with gemcitabine and cisplatin chemotherapy compared to chemotherapy alone in patients with previously untreated, advanced NSCLC. This study evaluated a 15mg/kg/every-three-weeks dose of Avastin (the dose approved in the U.S. for use in combination with carboplatin and paclitaxel) and a 7.5mg/kg/every-three-weeks dose of Avastin (a dose not approved for use in the U.S.). Both doses met the primary endpoint of prolonging progression-free survival (PFS) compared to chemotherapy alone. Although the study was not designed to compare the Avastin doses, a similar treatment effect in PFS was observed between the two arms. We expect the results of the BO17704 study to lead to some level of increased adoption of Avastin at the lower dose of 7.5mg/kg/every-three-weeks. Efficacy data from other clinical studies conducted by any party in the U.S. or internationally (such as AVADO, Roche’s study evaluating two doses of Avastin in first-line mBC), showing or perceived to be showing a similar or an improved treatment benefit at a lower dose or shorter duration of therapy, could further negatively affect future sales of Avastin.

In mBC, we estimate that Avastin use slightly increased in the second quarter of 2007 compared to the second quarter of 2006, and use was essentially flat compared to the first quarter of 2007. In first-line metastatic colorectal cancer (CRC), we estimate that penetration, duration of treatment, and dosing remained flat in the second quarter of 2007 compared to the second quarter of 2006. In combined second- and third-line CRC, we estimate that Avastin penetration decreased in the second quarter of 2007 compared to the second quarter of 2006, due to increased competition, and was flat compared to the first quarter of 2007. We believe that Avastin sales growth for the second half of 2007 will depend on increased penetration in the first-line treatment of metastatic NSCLC and the extent to which physicians prescribe Avastin at its approved dose.

Rituxan

Net U.S. sales of Rituxan increased 11% to $582 million in the second quarter and 11% to $1,117 million in the first six months of 2007 from the comparable periods in 2006. It remains difficult to precisely determine the sales split between Rituxan use in oncology and immunology settings, since many treatment centers treat both types of patients. However, based on our market research, we believe that the sales growth resulted from increased use of Rituxan in treating rheumatoid arthritis (RA), approved on February 28, 2006, and the use of Rituxan following first-line therapy in indolent non-Hodgkin’s lymphoma (NHL), including areas of unapproved uses. We estimate that Rituxan’s overall adoption rate in combined markets of NHL, including areas of unapproved use, and chronic lymphocytic leukemia (CLL), an unapproved use, remained flat in the first half of 2007 and throughout 2006. Also contributing to the increase in product sales were price increases effective on March 29, 2006, October 5, 2006, and March 26, 2007.

Herceptin

Net U.S. sales of Herceptin increased 3% to $329 million in the second quarter and 5% to $640 million in the first six months of 2007 from the comparable periods in 2006. The increases in product sales resulted primarily from price increases effective on March 26, 2006, October 3, 2006, and March 29, 2007. Also contributing to the growth in sales was increased use of Herceptin in the treatment of adjuvant (early-stage) HER2-positive breast cancer, approved on November 16, 2006. We estimate that Herceptin’s penetration in adjuvant HER2-positive breast cancer patients was over 70% in the second quarter of 2007, an increase from the adoption rate in the second quarter of 2006.

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Lucentis

Lucentis was approved by the FDA for the treatment of neovascular (wet) age-related macular degeneration (AMD) on June 30, 2006. Net U.S. sales were $209 million in the second quarter of 2007 and $211 million in the first quarter of 2007. New patient share in the second quarter of 2007 was approximately 55%, consistent with the first quarter of 2007. We believe that sales growth will depend on continued dosing of existing patients beyond the first year of therapy and to a lesser extent on increased penetration in newly diagnosed patients (including gains against the unapproved use of Avastin in this setting). Over the longer term, growth may also be affected by the duration of treatment.

Xolair

Net U.S. sales of Xolair increased 14% to $120 million in the second quarter and 16% to $231 million in the first six months of 2007 from the comparable periods in 2006. The sales growth was primarily driven by increased penetration in the asthma market and, to a lesser extent, price increases effective on April 4, 2006 and October 17, 2006. We believe that sales in the first six months of 2007 were modestly affected by the FDA’s request that we strengthen the existing warning of the potential risk for anaphylaxis in patients receiving Xolair by adding a boxed warning to the product label and implementing a Risk Minimization Action Plan (RiskMAP), including providing a medication guide for patients. We and Novartis, our co-promotion collaborator, agreed on a new U.S. label and RiskMAP with the FDA that emphasize the incidence of anaphylaxis and instruct physicians that patients should be closely observed for an appropriate period of time after Xolair administration. We believe this update to the label and RiskMAP will not have a significant effect on the way that specialists prescribe Xolair.

Tarceva

Net U.S. sales of Tarceva decreased 1% to $102 million in the second quarter and increased 4% to $203 million in the first six months of 2007 from the comparable periods in 2006. Returns and return reserve requirements were higher than normal in the second quarter of 2007. We estimate that Tarceva’s overall penetration in NSCLC remained flat in the first six months of 2007 relative to the same period in 2006. Duration of therapy in second-line NSCLC increased in the first six months of 2007 compared to the same period in 2006. We estimate that Tarceva’s penetration in first-line pancreatic cancer in the second quarter of 2007 remained flat compared to the second quarter of 2006. Sales results were primarily affected by price increases effective on November 14, 2006 and May 1, 2007, and, to a lesser extent, increases in duration of therapy. Future sales growth in NSCLC will depend on increases in duration of therapy and penetration, particularly against chemotherapy within select second-line NSCLC patient subsets.

Nutropin Products

Combined net U.S. sales of our Nutropin products decreased 4% to $94 million in the second quarter and remained flat at $185 million in the first six months of 2007 from the comparable periods in 2006. The decrease from the second quarter of 2006 was due to lower sales volume, partially resulting from the loss of managed care product placement due to pricing. The volume decrease was partially offset by price increases effective on March 1, 2007.

Thrombolytics

Combined net U.S. sales of our three thrombolytic products—Activase, Cathflo Activase, and TNKase—increased 8% to $67 million in the second quarter and 12% to $135 million in the first six months of 2007 from the comparable periods in 2006. The increases were primarily due to growth in Cathflo Activase sales in the catheter clearance market and increased Activase sales in the acute ischemic stroke market, partially offset by lower sales of TNKase. Also contributing to the increases in product sales were price increases effective on February 14, 2006, July 6, 2006, and January 18, 2007.

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Pulmozyme

Net U.S. sales of Pulmozyme increased 17% to $55 million in the second quarter and 11% to $107 million in the first six months of 2007 from the comparable periods in 2006. The increases reflected price increases effective on June 29, 2006 and May 31, 2007, and, to a lesser extent, increased penetration in certain patient segments.

Raptiva

Net U.S. sales of Raptiva increased 23% to $27 million in the second quarter and 19% to $51 million in the first six months of 2007 from the comparable periods in 2006. The growth in sales was primarily due to increased penetration in hand and foot psoriasis patients and, to a lesser extent, price increases effective on August 10, 2006 and May 31, 2007.

Sales to Collaborators

Product sales to collaborators, for use in non-U.S. markets, increased 213% to $294 million in the second quarter and 247% to $587 million in the first six months of 2007 from the comparable periods in 2006. The increases were primarily due to more favorable Herceptin pricing terms that were part of the new supply agreement with Roche signed in the third quarter of 2006 and higher sales of Herceptin, Avastin, and Rituxan to Roche. The favorable Roche Herceptin pricing terms will continue through the end of 2008.

For the full year 2007, we expect sales to collaborators to approximately double relative to 2006 levels.

Royalties

Royalty revenue increased 53% to $484 million in the second quarter and 50% to $903 million in the first six months of 2007 from the comparable periods in 2006. The increases were primarily due to higher sales by Roche of our Herceptin, Avastin, and Rituxan products. Of the overall royalties received, royalties from Roche represented approximately 58% in the second quarter and 60% in the first six months of 2007 compared to approximately 65% in the second quarter and 62% in the first six months of 2006. The increases were also due to an acceleration of royalties in the second quarter of 2007, as discussed below. Royalties from other licensees included royalty revenue on our patent licenses, including our Cabilly patent as discussed below.

In June 2007, we entered into a transaction with an existing licensee to license from them the right to co-develop and commercialize certain molecules. In exchange, we released the licensee from its obligation to make certain royalty payments to us that would have otherwise been owed over the three-and-a-half-year period ending June 2010, and that period may be extended contingent upon certain events as defined in the agreement. We estimate that the fair value of the royalty revenue owed to us over the three-and-a-half-year period, less any amount recognized in the first quarter of 2007, was approximately $65 million, and this amount was recognized as royalty revenue in the second quarter of 2007. We also recognized a similar amount as R&D expense for the purchase of the new license, and thus the second quarter net earnings per share (EPS) effect of entering into this new collaboration was not significant.

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We have confidential licensing agreements with a number of companies on U.S. Patent No. 6,331,415 (the Cabilly patent) under which we receive royalty revenue on sales of products that are covered by the patent. The Cabilly patent expires in December 2018. The net pretax contributions related to the Cabilly patent were as follows (in millions):

	Three Months Ended June 30, 2007		Six Months Ended June 30, 2007
Royalty revenue	$	46	$	108

Gross expenses⁽¹⁾	$	27	$	57

Net of tax effect of Cabilly patent on diluted EPS	$	0.01	$	0.03

______________________

(1)	Gross expenses include COH’s share of royalty revenue and royalty cost of sales on our U.S. product sales

See also Note 4, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for further information on our Cabilly patent reexamination.

Cash flows from royalty income include revenue denominated in foreign currencies. We currently purchase simple foreign currency put option contracts (options) and forwards to hedge these foreign currency cash flows. These options and forwards are due to expire between 2007 and 2009.

For the full year 2007, we expect royalty revenue to increase more than 30% over the 2006 level of $1,354 million; however, royalties are difficult to forecast because of the number of licensees and products involved, and potential licensing and intellectual property disputes.

Contract Revenue

Contract revenue increased 5% to $77 million in the second quarter and 33% to $171 million in the first six months of 2007 from the comparable periods in 2006. The increase in the first six months of 2007 was primarily due to recognition of a $30 million milestone payment from Novartis for European Union approval of Lucentis for the treatment of patients with AMD and higher reimbursements from Roche related to R&D efforts on Avastin. See “Related Party Transactions” below for more information on contract revenue from Roche and Novartis.

Contract revenue varies each quarter and is dependent on a number of factors, including the timing and level of reimbursements from ongoing development efforts, milestones, and opt-in payments received, and new contract arrangements. For the full year 2007, we expect contract revenue to be relatively flat compared to $290 million in 2006.

Cost of Sales

Cost of sales as a percentage of product sales was 18% in the second quarter and 17% in the first six months of 2007 compared to 16% in the second quarter and first six months of 2006. The increases were due to the recognition of employee stock-based compensation expense of $16 million in the second quarter and $33 million in the first half of 2007, related to products sold for which employee stock-based compensation expense was previously capitalized as part of inventory costs, and to higher volume of lower margin sales to collaborators. Cost of sales as a percentage of product sales was favorably affected by U.S. product sales mix (increased sales of our higher margin products, primarily Lucentis, Avastin, and Herceptin in the first half of 2007) and a price increase on sales of Herceptin to Roche.

Research and Development

Research and development (R&D) expenses increased 55% to $603 million in the second quarter and 59% to $1,213 million in the first six months of 2007 from the comparable periods in 2006. A significant portion of the increases in R&D expenses was due to an increase in up-front, in-licensing expense for new collaborations. The higher levels of

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expenses also reflected increased development activity across our entire product portfolio, including increased spending on clinical trials, post-marketing studies, and clinical manufacturing expenses (notably for Rituxan, Avastin, Xolair, and Herceptin), and early-stage projects, as well as higher research expenses due to increased headcount and headcount-related expenses in support of new molecular entities.

R&D as a percentage of operating revenue was 20% in the second quarter and 21% in the first six months of 2007 compared to 18% in the second quarter and first six months of 2006.

The major components of R&D expenses were as follows (in millions):

	Three Months Ended June 30,							Six Months Ended June 30,
Research and Development	2007		2006		% Change			2007		2006		% Change
Product development (including post-marketing)	$	387	$	301		29	%	$	799	$	584		37	%
Research		128		75		71			195		149		31
In-licensing (up-front and ongoing fees)		88		14		529			219		31		606
Total R&D	$	603	$	390		55		$	1,213	$	764		59

Marketing, General and Administrative

Marketing, general and administrative (MG&A) expenses increased 13% to $532 million in the second quarter and 12% to $1,023 million in the first six months of 2007 from the comparable periods in 2006. The increases were primarily due to: (i) an increase in corporate expenses, including charitable donations and losses on property and equipment disposals, (ii) an increase in royalty expense, primarily to Biogen Idec resulting from higher Roche sales of Rituxan, and (iii) an increase in marketing and sales expense primarily in support of Herceptin (adjuvant setting), Rituxan (RA setting), and post-launch activities related to Lucentis.

MG&A as a percentage of operating revenue was 18% in the second quarter and 17% in the first six months of 2007 compared to 21% in the second quarter and 22% in the first six months of 2006.

Collaboration Profit Sharing

Collaboration profit sharing expenses increased 7% to $277 million in the second quarter and 9% to $529 million in the first six months of 2007 from the comparable periods in 2006 due to higher sales of Rituxan, Xolair, and Tarceva and the related profit sharing expenses.

The following table summarizes the amounts resulting from the respective profit sharing collaborations for the periods presented (in millions):

	Three Months Ended June 30,							Six Months Ended June 30,
	2007		2006		% Change			2007		2006		% Change
U.S. Rituxan profit sharing expense	$	188	$	173		9	%	$	354	$	325		9	%
U.S. Tarceva profit sharing expense		49		48		2			96		91		5
Total Xolair profit sharing expense		40		38		5			79		69		14
Total collaboration profit sharing expense	$	277	$	259		7		$	529	$	485		9

Currently, our most significant collaboration profit sharing agreement is with Biogen Idec, with whom we co-promote Rituxan in the U.S. Under the collaboration agreement, Biogen Idec granted us a worldwide license to develop, commercialize, and market Rituxan in multiple indications. In exchange for these worldwide rights, Biogen Idec has co-promotion rights in the U.S. and a contractual arrangement under which we share a portion of the pretax U.S. co-promotion profits of Rituxan and royalty revenue on sales of Rituxan by collaborators. In June 2003, we amended and restated the collaboration agreement with Biogen Idec to include the development and commercialization of one or more anti-CD20 antibodies targeting B-cell disorders, in addition to Rituxan, for a broad range of indications.

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Under the amended and restated collaboration agreement, our share of the current pretax U.S. co-promotion profit sharing formula is approximately 60% of operating profits, and Biogen Idec’s share is approximately 40% of operating profits. For each calendar year or portion thereof following the approval date of the first new anti-CD20 product, after a period of transition, our share of the pretax U.S. co-promotion profits will change to approximately 70% of operating profits, and Biogen Idec’s share will be approximately 30% of operating profits.

Collaboration profit sharing expense, exclusive of R&D expenses, related to Biogen Idec for the periods ended June 30, 2007 and 2006 consisted of the following (in millions):

	Three Months Ended June 30,							Six Months Ended June 30,
	2007		2006		% Change			2007		2006		% Change
Product sales, net	$	582	$	525		11	%	$	1,117	$	1,002		11	%
Combined commercial and manufacturing costs and expenses		146		116		26			276		230		20
Combined co-promotion profits	$	436	$	409		7		$	841	$	772		9
Amount due to Biogen Idec for their share of co-promotion profits – included in collaboration profit sharing expense	$	188	$	173		9	%	$	354	$	325		9	%

Biogen Idec’s relative share of combined commercial costs determines the amount shown as collaboration profit sharing expense, exclusive of R&D expenses.

Revenue and expenses related to our collaboration with Biogen Idec separately included the following (in millions):

	Three Months Ended June 30,							Six Months Ended June 30,
	2007		2006		% Change			2007		2006		% Change
Contract revenue from Biogen Idec (R&D reimbursement)	$	34	$	23		48	%	$	55	$	39		41	%

Royalty expense on sales of Rituxan to Roche and Zenyaku and other patent costs – included in MG&A expense	$	51	$	45		13	%	$	107	$	80		34	%

Recurring Charges Related to Redemption

We recorded recurring charges related to the June 1999 Redemption and push-down accounting. These charges were $26 million in the second quarters of 2007 and 2006, and $52 million in the first six months of 2007 and 2006, and comprised the amortization of Redemption-related intangible assets in the periods presented.

On June 30, 1999, RHI exercised its option to cause us to redeem all of our Special Common Stock held by stockholders other than RHI. The Redemption was reflected as the purchase of a business, which under GAAP required push-down accounting to reflect in our financial statements the amounts paid for our stock in excess of our net book value.

Special Items: Litigation-Related

We recorded accrued interest and bond costs related to the COH trial judgment of $13 million for the second quarter of 2007 and $14 million for the second quarter of 2006, and $26 million for the first six months of 2007 and $27 million for the first six months of 2006. We expect that we will continue to incur interest charges on the judgment and service fees on the surety bond each quarter through the process of appealing the COH trial results. The amount of cash to be paid, if any, or the timing of such payment in connection with the COH matter will depend on the outcome of the California Supreme Court’s review. It may take longer than one year to resolve this matter. See Note

-31-

4, “Contingencies,” in the Notes to the Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for further information regarding our litigation.

Operating Income

Operating income was $1,124 million in the second quarter of 2007, a 49% increase from the second quarter of 2006, and $2,183 million in the first six months of 2007, a 56% increase from the comparable period in 2006. Our operating income as a percentage of operating revenue (pretax operating margin) was 37% in the second quarter of 2007 and 34% in the second quarter of 2006, and was 37% in the first six months of 2007 and 33% in the first six months of 2006.

Other Income (Expense)

The components of “other income (expense)” were as follows (in millions):

Three Months

Ended June 30,

Six Months

Ended June 30,

Other Income, Net

2007

2006

% Change

2007

2006

% Change