Edgar Filing: GENENTECH INC

dna-10q_0307.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 September 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	1,053,091,492 Outstanding at October 26, 2007

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GENENTECH, INC.

TABLE OF CONTENTS

		Page No.
	PART I—FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)	3

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

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

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

	Notes to Condensed Consolidated Financial Statements	6–15

	Report of Independent Registered Public Accounting Firm	16

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16–41

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	42

Item 4.	Controls and Procedures	42

	PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	43

Item 1A.	Risk Factors	43–55

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	55

Item 6.	Exhibits	56

SIGNATURES		57

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; 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 September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Revenue
Product sales (including amounts from related parties: three months—2007–$137; 2006–$87; nine months—2007–$659; 2006–$220)	$	2,321		$	1,941		$	7,094		$	5,395
Royalties (including amounts from related parties: three months—2007–$357; 2006–$230; nine months—2007–$914; 2006–$603)		524			364			1,427			966
Contract revenue (including amounts from related parties: three months—2007–$30; 2006–$52; nine months—2007–$134; 2006–$114)		63			79			234			208
Total operating revenue		2,908			2,384			8,755			6,569
Costs and expenses
Cost of sales (including amounts for related parties: three months—2007–$100; 2006–$63; nine months—2007–$365; 2006–$178)		406			297			1,227			843
Research and development (associated with related party collaborations: three months—2007–$75; 2006–$62; nine months—2007–$222; 2006–$179) (including amounts where reimbursement was recorded as contract revenue: three months—2007–$49; 2006–$48; nine months—2007–$154; 2006–$135)		615			454			1,828			1,218
Marketing, general and administrative		541			501			1,564			1,414
Collaboration profit sharing (including related party amounts: three months—2007–$47; 2006–$46; nine months—2007–$143; 2006–$137)		276			250			805			735
Write-off of in-process research and development related to acquisition		77			–			77			–
Gain on acquisition		(121	)		–			(121	)		–
Recurring charges related to redemption and acquisition		38			26			90			79
Special items: litigation related		14			13			41			40
Total costs and expenses		1,846			1,541			5,511			4,329
Operating income		1,062			843			3,244			2,240
Other income (expense):
Interest and other income, net		84			74			233			249
Interest expense		(18	)		(19	)		(53	)		(56	)
Total other income, net		66			55			180			193
Income before taxes		1,128			898			3,424			2,433
Income tax provision		443			330			1,286			914
Net income	$	685		$	568		$	2,138		$	1,519
Earnings per share
Basic	$	0.65		$	0.54		$	2.03		$	1.44
Diluted	$	0.64		$	0.53		$	2.00		$	1.41
Shares used to compute basic earnings per share		1,053			1,053			1,053			1,053
Shares used to compute diluted earnings per share		1,069			1,072			1,070			1,074

See Notes to Condensed Consolidated Financial Statements.

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GENENTECH, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions)

(Unaudited)

	Nine Months Ended September 30,
	2007			2006
Cash flows from operating activities
Net income	$	2,138		$	1,519
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		345			298
Employee stock-based compensation		300			225
In-process research and development		77			–
Gain on acquisition		(121	)		–
Deferred income taxes		(116	)		(86	)
Deferred revenue		(50	)		(13	)
Litigation-related liabilities		39			39
Excess tax benefit from stock-based compensation arrangements		(160	)		(142	)
Gain on sales of securities available-for-sale and other, net		(15	)		(76	)
Write-down of securities available-for-sale and other		4			1
Loss on property and equipment dispositions		30			–
Changes in assets and liabilities:
Receivables and other current assets		(236	)		(423	)
Inventories		(238	)		(311	)
Investments in trading securities		(140	)		(26	)
Accounts payable, other accrued liabilities, and other long-term liabilities		216			311
Net cash provided by operating activities		2,073			1,316

Cash flows from investing activities
Purchases of securities available-for-sale		(622	)		(1,078	)
Proceeds from sales of securities available-for-sale		482			366
Proceeds from maturities of securities available-for-sale		358			297
Capital expenditures		(692	)		(888	)
Change in other intangible and long-term assets		(39	)		24
Transfer to restricted cash		–			(53	)
Acquisition and related costs, net		(833	)		–
Net cash used in investing activities		(1,346	)		(1,332	)

Cash flows from financing activities
Stock issuances		381			286
Stock repurchases		(815	)		(758	)
Excess tax benefit from stock-based compensation arrangements		160			142
Net cash used in financing activities		(274	)		(330	)
Net increase (decrease) in cash and cash equivalents		453			(346	)
Cash and cash equivalents at beginning of period		1,250			1,225
Cash and cash equivalents at end of period	$	1,703		$	879

Supplemental cash flow data
Cash paid during the period for:
Interest	$	71		$	77
Income taxes		1,277			851
Non-cash investing and financing activities
Capitalization of construction in progress related to financing lease transactions		156			84
Deferral of royalty revenue associated with the acquisition of Tanox, Inc.		(185	)		–

See Notes to Condensed Consolidated Financial Statements.

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GENENTECH, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In millions)

(Unaudited)

	September 30, 2007		December 31, 2006
Assets
Current assets
Cash and cash equivalents	$	1,703	$	1,250
Short-term investments		1,217		1,243
Accounts receivable—product sales (net of allowances of: 2007–$109; 2006–$92; including amounts from related parties: 2007–$42; 2006–$57)		1,012		965
Accounts receivable—royalties (including amounts from related parties: 2007–$581; 2006–$316)		716		453
Accounts receivable—other (including amounts from related parties: 2007–$123; 2006–$150)		185		248
Inventories		1,425		1,178
Deferred tax assets		292		278
Prepaid expenses and other current assets		121		89
Total current assets		6,671		5,704
Long-term marketable debt and equity securities		1,952		1,832
Property, plant and equipment, net		4,758		4,173
Goodwill		1,574		1,315
Other intangible assets		1,208		476
Restricted cash and investments		788		788
Other long-term assets		493		554
Total assets	$	17,444	$	14,842

Liabilities and stockholders’ equity
Current liabilities
Accounts payable (including amounts to related parties: 2007–$8; 2006–$7)	$	283	$	346
Deferred revenue		44		62
Taxes payable		67		111
Other accrued liabilities (including amounts to related parties: 2007–$220; 2006–$136)		1,662		1,491
Total current liabilities		2,056		2,010
Long-term debt		2,346		2,204
Deferred revenue		353		199
Litigation-related and other long-term liabilities		1,057		951
Total liabilities		5,812		5,364
Commitments and contingencies
Stockholders’ equity
Common stock		21		21
Additional paid-in capital		10,842		10,091
Accumulated other comprehensive income		212		204
Retained earnings (accumulated deficit) since June 30, 1999		557		(838	)
Total stockholders’ equity		11,632		9,478
Total liabilities and stockholders’ equity	$	17,444	$	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 is 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. Following the completion of our acquisition of Tanox, Inc. on August 2, 2007, the financial results of Tanox’s operations have been included in the consolidated financial results of Genentech. 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 September 30, 2007, the IRS has not proposed any adjustments. We are also under examination by several state jurisdictions. As of September 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 $6 million in tax-related interest expense during the third quarter and first nine 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 when free Avastin vials are delivered or after the associated patient eligibility period has passed.

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 September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Numerator:
Net income	$	685	$	568	$	2,138	$	1,519
Denominator:
Weighted-average shares outstanding used to compute basic earnings per share		1,053		1,053		1,053		1,053
Effect of dilutive stock options		16		19		17		21
Weighted-average shares outstanding and dilutive securities used to compute diluted earnings per share		1,069		1,072		1,070		1,074

Outstanding employee stock options to purchase approximately 36 million and 35 million shares of our Common Stock were excluded from the computation of diluted EPS for the third quarter and first nine months of 2007, respectively, because the effect would have been anti-dilutive.

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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):

	September 30, 2007			December 31, 2006
Net unrealized gains on securities available-for-sale	$	224		$	214
Net unrealized losses on cash flow hedges		(6	)		(4	)
Post-retirement benefit obligation		(6	)		(6	)
Accumulated other comprehensive income	$	212		$	204

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

	Three Months Ended September 30,					Nine Months Ended September 30,
	2007			2006		2007			2006
Net income	$	685		$	568	$	2,138		$	1,519
Increase (decrease) in unrealized gains on securities available-for-sale		19			16		10			(24	)
(Decrease) increase in unrealized gains on cash flow hedges		(13	)		1		(2	)		(19	)
Comprehensive income, net of income taxes	$	691		$	585	$	2,146		$	1,476

Derivative Instruments

Our derivative instruments, designated as cash flow hedges, consist of foreign currency exchange options and marketable equity collars. At September 30, 2007, estimated net losses expected to be reclassified from accumulated OCI to “other income, net” within the next 12 months are $6 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.

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Cost of sales	$	16	$	–	$	49	$	–
Research and development		37		35		114		101
Marketing, general and administrative		44		41		137		124
Total employee stock-based compensation expense	$	97	$	76	$	300	$	225

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As of September 30, 2007, total compensation cost related to unvested stock options not yet recognized was $934 million, which is expected to be allocated to expense and production costs over a weighted-average period of 36 months.

The carrying value of inventory on our Condensed Consolidated Balance Sheets as of September 30, 2007 and 2006 includes employee stock-based compensation costs of $77 million and $49 million, respectively. During the third quarter and first nine months of 2007, $16 million and $49 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 nine 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 September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Risk-free interest rate		4.3	%		4.6	%		4.3	%		4.6	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Expected volatility		25.0	%		27.0	%		25.0	%		27.0	%
Expected term (years)		5.0			4.6			5.0			4.6

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):

	September 30, 2007		December 31, 2006
Raw materials and supplies	$	131	$	116
Work in process		933		818
Finished goods		361		244
Total	$	1,425	$	1,178

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 continuing

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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 related 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 September 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 $14 million for the third quarter of 2007 and $13 million for the third quarter of 2006, and $41 million for the first nine months of 2007 and $40 million for the first nine 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 September 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.

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,

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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 U.S. 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. On August 16, 2007, the U.S. District Court entered a Claim Construction Order defining several terms used in the ‘415 patent. Discovery and motion practice are ongoing and 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.

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

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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 September 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 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 September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Product sales to Roche	$	135	$	86	$	651	$	217

Royalties earned from Roche	$	317	$	230	$	855	$	602

Contract revenue from Roche	$	21	$	37	$	81	$	76

Cost of sales on product sales to Roche	$	98	$	60	$	356	$	173

Research and development (R&D) expenses incurred on joint development projects with Roche	$	64	$	52	$	192	$	147

Certain R&D expenses are partially reimbursable to us by Roche. In addition, R&D expenses may include 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 projects.

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.

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We have an agreement with Novartis under which Novartis 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 makes royalty payments to us on sales of Lucentis outside the U.S.

We, along with Novartis, are co-developing and 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. Effective with our acquisition of Tanox on August 2, 2007, Novartis also makes royalty payments to us on sales of Xolair worldwide and also pays us a manufacturing fee related to Xolair. See Note 6, “Acquisition of Tanox, Inc.” for more information on the acquisition.

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Product sales to Novartis	$	2	$	1	$	8	$	3

Royalties earned from Novartis	$	40	$	–	$	59	$	1

Contract revenue from Novartis	$	9	$	15	$	53	$	38

Cost of sales on product sales to Novartis	$	2	$	3	$	9	$	5

R&D expenses incurred on joint development projects with Novartis	$	11	$	10	$	30	$	32

Collaboration profit sharing expense to Novartis	$	47	$	46	$	143	$	137

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

Certain R&D expenses are partially reimbursable to us by Novartis. In addition, R&D expenses may include 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 projects.

See Note 6, “Acquisition of Tanox, Inc.” for information on Novartis proceeds resulting from our acquisition of Tanox.

Note 6.

Acquisition of Tanox, Inc.

On August 2, 2007, we completed our acquisition of 100% of the outstanding shares of Tanox, a biotechnology company specializing in the discovery and development of biotherapeutics based on monoclonal antibody technology, for $925 million in cash, plus $8 million in transaction costs. The preliminary purchase price allocation is as follows, and we may make further adjustments as we continue to evaluate the purchase price allocation within the next year.

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(In millions)
Assets
Cash	$	100
Investments		102
Working capital and other, net		56
In-process research and development (IPR&D)		77
Developed product technology		780
Core technology		34
Goodwill		259
Deferred revenue		(185	)
Deferred tax liability, net		(217	)
Total acquisition consideration and gain	$	1,006

Consideration and Gain
Consideration	$	925
Transaction costs		8
Gain on settlement of preexisting relationship, net of tax		73
	$	1,006

In accordance with FAS No. 141, “Business Combinations” (FAS 141), assets and liabilities acquired were valued at their fair values at the date of acquisition. We recorded deferred revenue associated with Tanox’s intellectual property license with Novartis related to Xolair of $185 million, which will be recognized as additional royalty revenue over the duration of the estimated remaining patent lives of approximately 12 years.

In connection with our acquisition of Tanox, we terminated certain officers and employees of Tanox. The total amount of the severance packages offered to these officers and employees was approximately $4 million. Tanox also leased a plant in San Diego, California that has been certified by the U.S. Food and Drug Administration (FDA) for clinical use. Our current estimate of the present value of the future lease payments we owe, less the expected sublease income if we are able to sublease the facility, is approximately $5 million. We expect these restructuring programs to be substantially complete within the next six months.

We recorded a $77 million charge for in-process research and development. This charge primarily represents acquired R&D for label extensions for Xolair that have not yet been approved by the FDA and require significant further development.

Under FAS 141, acquired identifiable intangible assets are measured and recognized apart from goodwill even if it would not be practical to sell or exchange the acquired intangible assets and any related license agreements apart from one another. In our accounting for our acquisition of Tanox’s developed product technology and core technology in accordance with FAS No. 142, “Goodwill and Other Intangible Assets,” the fair value assigned to those intangible assets was based on valuations using a present value technique referred to as the income approach, with estimates and assumptions determined by management, including valuing Tanox’s intellectual property and rights thereon at assumed current fair values, which, for developed product technology, were in excess of existing contractual rates. The developed product technology we valued relates to intellectual property and rights thereon primarily related to the Xolair molecule. The core technology asset we valued represents the value of Tanox’s intellectual property and rights thereon expected to be leveraged in the design and development of future products and indications. The developed product technology and core technology, which totaled $814 million, are being amortized over 12 years. The excess of purchase price over tangible assets, identifiable intangible assets, and assumed liabilities represents goodwill.

The intangible assets and goodwill acquired are not deductible for income tax purposes. As a result, we recorded a net deferred tax liability of $262 million, based on the tax effect of the amount of the acquired intangible assets other than goodwill with no tax basis. We also recorded a net deferred tax asset of approximately $45 million, primarily related to net operating loss carryforwards acquired in the transaction.

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Under EITF 04-1, “Accounting for Preexisting Relationships between the Parties to a Business Combination” (EITF 04-1), a business combination between parties with a preexisting relationship should be evaluated to determine if a settlement of a preexisting relationship exists. The acquisition of Tanox is considered to include the settlement of our 1996 license of certain intellectual property and rights thereon from Tanox. We measured the amount that the preexisting license arrangement is favorable, from our perspective, by comparing it to estimated pricing for current market transactions for intellectual property rights similar to Tanox’s intellectual property rights related to Xolair. In connection with the settlement of this license arrangement, we recorded a gain of $121 million, or $73 million net of tax, in accordance with EITF 04-1.

On August 2, 2007, we understand that Novartis owned approximately 14% of the outstanding shares of Tanox, representing approximately $127 million of the total cash paid to acquire the outstanding shares of Tanox.

Assuming that the Tanox acquisition was consummated as of January 1, 2006, pro forma consolidated financial results of the company for the three and nine months ended September 30, 2007 and 2006 would not have been materially different from the amounts reported.

Note 7.

Income Taxes

The effective income tax rate was 39% in the third quarter of 2007 compared to 37% in the third quarter of 2006. The increase was primarily due to the non-deductible IPR&D charge in the third quarter of 2007 resulting from our acquisition of Tanox. The effective income tax rate was 38% in the first nine months of 2007 and 2006.

Note 8.

Subsequent Event

On October 11, 2007, we entered into a five-year, $1 billion revolving credit facility with various financial institutions. The credit facility is expected to be used for general corporate and working capital purposes, including providing support for our new $1 billion commercial paper program. As of October 26, 2007, we had no borrowings under the credit facility and had $600 million outstanding in commercial paper.

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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 September 30, 2007, and the related condensed consolidated statements of income for the three-month and nine-month periods ended September 30, 2007 and 2006, and the condensed consolidated statements of cash flows for the nine-month periods ended September 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

October 29, 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 Third Quarter of 2007

We primarily earn revenue and income and generate cash from product sales and royalty revenue. In the third quarter of 2007, our total operating revenue was $2,908 million, an increase of 22% from $2,384 million in the third quarter of 2006. Our net income for the third quarter of 2007 was $685 million, an increase of 21% from $568 million in the third quarter of 2006. In the first nine months of 2007, our total operating revenue was $8,755 million, an increase of 33% from $6,569 million in the first nine months of 2006. Our net income for the first nine months of 2007 was $2,138 million, an increase of 41% from $1,519 million in the first nine months of 2006.

On August 2, 2007, we acquired 100% of the outstanding shares of Tanox, Inc. for $925 million, including $8 million in transaction costs. The acquired assets include $202 million of Tanox’s cash and investments, resulting in a net cash and investment outlay of $731 million. Included in our operating results for the third quarter and first nine months of 2007 are items related to our acquisition of Tanox, including a non-recurring in-process research and development (IPR&D) charge of $77 million; a non-recurring gain of $121 million on a pretax basis pursuant to the Emerging Issues Task Force (EITF) Issue 04-1, “Accounting for Preexisting Relationships between the Parties to a Business Combination” (EITF 04-1); the recognition of deferred royalty revenue; and amortization of intangible assets. Tanox’s post-acquisition operating results were not material to our consolidated results for the third quarter of 2007. See “Write-off of In-process Research and Development Related to Acquisition” and “Gain on Acquisition” in the “Results of Operations” section for more information on these items.

On August 24, 2007, we resubmitted a supplemental Biologics License Application (sBLA) to the United States (U.S.) Food and Drug Administration (FDA) for Avastin, in combination with paclitaxel chemotherapy, for patients who have not received chemotherapy for their locally recurrent or metastatic breast cancer (BC). We have been informed that an Oncologic Drugs Advisory Committee meeting will be held in December 2007, and the FDA action date is February 23, 2008.

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

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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, and/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. 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 BC 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 and distribution of our products have 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. As a result of the Deficit Reduction Act, new regulations will take effect in the fourth quarter of 2007 that will impact the discounted price for our products paid by Medicaid and government-affiliated customers. While pricing continues to be an important area of focus, we anticipate minimal impact on our revenue for the remainder of 2007.
Intellectual property protection of our products is crucial to our business. Loss of effective intellectual property protection 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 the biotechnology products listed below in the U.S.:

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 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 or following CVP chemotherapy in patients with stable disease or who achieve a partial or complete response following first-line treatment with CVP chemotherapy. Rituxan is also approved for use in the follicular setting for treatment of patients with relapsed or refractory, low-grade or follicular, CD20-positive, B-cell non-Hodgkin’s lymphoma, including retreatment and bulky diseases. Rituxan is indicated for first-line treatment of patients with diffuse large B-cell, CD20-positive, non-Hodgkin’s lymphoma in combination with cyclophosphamide, doxorubicin, vincristine, and prednisone (CHOP) or other anthracycline-based chemotherapy. Rituxan is also indicated for use in combination with methotrexate for reducing signs and symptoms in adult patients with moderately to severely active rheumatoid arthritis 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 BC.

Lucentis (ranibizumab) is an anti-VEGF antibody fragment approved for the treatment of neovascular (wet) AMD.

Xolair (omalizumab) is a humanized anti-IgE antibody, which we commercialize with Novartis Pharma AG (a wholly owned subsidiary of Novartis AG; Novartis AG and affiliates are collectively referred to herein as Novartis). Xolair is approved for adults and adolescents (age 12 or older) with moderate to severe persistent asthma 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 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.

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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 U.S. Securities and Exchange Commission;
Our policies related to corporate governance, including our Principles of Corporate Governance, Good Operating Principles, and 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.

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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 more 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 September 30, 2007 is $764 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. The outcomes of such matters that are different from our current estimates 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 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 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 when free Avastin vials are delivered. Enrollment in the program was lower than expected in the first nine months of 2007, and we recorded net decreases in deferred revenue, and

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corresponding net increases to product sales, of $5 million in the third quarter of 2007 and $2 million in the first nine months of 2007 for Avastin U.S. product sales, resulting in a remaining deferred revenue liability in connection with the Avastin Patient Assistance Program of $7 million in our Condensed Consolidated Balance Sheet at September 30, 2007. As we continue to evaluate the amount of revenue to defer related to the Avastin Patient Assistance Program, we may recognize previously deferred revenue in Avastin U.S. product sales in future periods or we may increase the amount of revenue deferred.

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 include 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 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,

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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 $63 million as of September 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 September 30, 2007, our Condensed Consolidated Balance Sheet reflected estimated product sales allowance reserves and accruals totaling approximately $166 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 those 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. In addition, MedImmune, Inc. has filed a lawsuit against us challenging the Cabilly patent. See also Note 4, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements of Part I, Item 1 of this Form 10-Q for more information on our Cabilly patent reexamination and the MedImmune lawsuit.

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 September 30, 2007, our Condensed Consolidated Balance Sheet included Cabilly patent receivables totaling approximately $57 million and the related COH payable totaling approximately $23 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 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

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on interpretations of existing tax laws or regulations, or the findings or expected results from any tax examinations. 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, the results of any tax examinations, 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. Excess or idle capacity costs, based on estimated plant capabilities, are expensed in the period in which they are incurred. 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.

Valuation of Acquired Intangible Assets

We have acquired intangible assets in connection with our acquisition of Tanox. These intangible assets consist of developed product technology and core technologies associated with intellectual property and rights thereon, primarily related to the Xolair molecule, and assets related to the fair value write-up of Tanox’s royalty contracts, as well as goodwill. When significant identifiable intangible assets are acquired, we engage an independent third-party valuation firm to assist in determining the fair values of these assets as of the acquisition date. Discounted cash flow models are typically used in these valuations, and these models require the use of significant estimates and assumptions including but not limited to determining the timing and expected costs to complete the in-process projects, projecting regulatory approvals, estimating future cash flows from product sales resulting from completed products and in-process projects, and developing appropriate discount rates and probability rates by project.

We believe that the fair values assigned to the intangible assets acquired are based on reasonable estimates and assumptions, given the available facts and circumstances as of the acquisition date. However, we may record adjustments to goodwill resulting from our acquisition of Tanox for the resolution of preacquisition contingencies, our restructuring activities, tax matters, and other estimates related to the acquisition. Further, we will have to continuously evaluate whether any or all intangible assets valued have been impaired.

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

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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 more information.

Results of Operations

(In millions, except per share amounts)

	Three Months Ended September 30,									Nine Months Ended September 30,
	2007			2006			% Change			2007			2006			% Change
Product sales	$	2,321		$	1,941			20	%	$	7,094		$	5,395			31	%
Royalties		524			364			44			1,427			966			48
Contract revenue		63			79			(20	)		234			208			13
Total operating revenue		2,908			2,384			22			8,755			6,569			33

Cost of sales		406			297			37			1,227			843			46
Research and development		615			454			35			1,828			1,218			50
Marketing, general and administrative		541			501			8			1,564			1,414			11
Collaboration profit sharing		276			250			10			805			735			10
Write-off of in-process research and development related to acquisition		77			–			–			77			–			–
Gain on acquisition		(121	)		–			–			(121	)		–			–
Recurring charges related to redemption and acquisition		38			26			46			90			79			14
Special items: litigation-related		14			13			8			41			40			3
Total costs and expenses		1,846			1,541			20			5,511			4,329			27

Operating income		1,062			843			26			3,244			2,240			45

Other income (expense):
Interest and other income, net		84			74			14			233			249			(6	)
Interest expense		(18	)		(19	)		(5	)		(53	)		(56	)		(5	)
Total other income, net		66			55			20			180			193			(7	)

Income before taxes		1,128			898			26			3,424			2,433			41
Income tax provision		443			330			34			1,286			914			41
Net income	$	685		$	568			21		$	2,138		$	1,519			41

Earnings per share:
Basic	$	0.65		$	0.54			20		$	2.03		$	1.44			41
Diluted	$	0.64		$	0.53			21	%	$	2.00		$	1.41			42	%

Cost of sales as a % of product sales		17	%		15	%					17	%		16	%
Research and development as a % of operating revenue		21			19						21			19
Marketing, general and administrative as a % of operating revenue		19			21						18			22
Pretax operating margin		37			35						37			34
Effective income tax rate		39	%		37	%					38	%		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 22% in the third quarter of 2007 and 33% in the first nine 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 September 30,							Nine Months Ended September 30,
	2007		2006		% Change			2007		2006		% Change
Net U.S. product sales
Avastin	$	597	$	435		37	%	$	1,694	$	1,256		35	%
Rituxan		572		509		12			1,689		1,511		12
Herceptin		320		302		6			960		912		5
Lucentis		198		153		29			618		163		279
Xolair		121		107		13			352		307		15
Tarceva		101		100		1			304		296		3
Nutropin products		93		92		1			278		277		0
Thrombolytics		67		60		12			202		181		12
Pulmozyme		57		50		14			164		146		12
Raptiva		29		23		26			80		66		21
Total U.S. product sales⁽¹⁾		2,155		1,830		18			6,341		5,116		24

Net product sales to collaborators		166		111		50			753		280		169
Total product sales	$	2,321	$	1,941		20	%	$	7,094	$	5,395		31	%

______________________

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

Total product sales increased 20% in the third quarter and 31% in the first nine months of 2007 from the comparable periods in 2006. Total U.S. product sales increased 18% to $2,155 million in the third quarter and 24% to $6,341 million in the first nine 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 resulting from the approval of Lucentis on June 30, 2006. Increased U.S. sales volume accounted for 82%, or $266 million, of the increase in U.S. net product sales in the third quarter of 2007, and 85%, or $1,041 million, of the increase in the first nine 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 third quarter and first nine 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 37% to $597 million in the third quarter and 35% to $1,694 million in the first nine months of 2007 from the comparable periods in 2006. Net U.S. sales in the third quarter and in the first nine months of 2007 included the net recognition of $5 million and $2 million, respectively, of previously deferred revenue due to lower than expected enrollment in 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 colorectal cancer (CRC) and in metastatic BC, an unapproved use of Avastin. Among all first-line metastatic NSCLC patients, we estimate that Avastin penetration was approximately 30% in the third quarter of 2007, an increase from the adoption rate in the third quarter of 2006, but remained flat compared to the second quarter of 2007. We estimate that approximately 55% of first-line lung cancer patients are eligible for treatment with Avastin. With respect to dose, use of the 15mg/kg/every-three-weeks dose decreased from approximately 75% in the second quarter of 2007 to approximately 60% in the third quarter of 2007. This decrease reflects physician adoption of a lower dose of Avastin following 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. The 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 greater adoption by physicians of the lower Avastin 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 metastatic BC), showing or perceived to be showing a similar or an improved treatment benefit at a lower dose, could further negatively affect future sales of Avastin.

In first-line metastatic CRC, we estimate that penetration remained flat in the third quarter of 2007 compared to the third quarter of 2006 and the second quarter of 2007. Growth in metastatic CRC during this period resulted primarily from a slight increase in treatment duration. In combined second- and third-line CRC, we estimate that Avastin penetration decreased in the third quarter of 2007 compared to the third quarter of 2006, due to increased competition, and was flat compared to the second quarter of 2007. In metastatic BC, we estimate that Avastin adoption increased in the third quarter of 2007 compared to the third quarter of 2006 and the second quarter of 2007. We believe that Avastin sales growth for the remainder 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 12% to $572 million in the third quarter and 12% to $1,689 million in the first nine 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 the increased use of Rituxan in treating rheumatoid arthritis (RA), an indication that was approved on February 28, 2006. The increase in market share was driven by both current and new prescribing physicians. Rituxan in RA continued its market share growth in the patient population with an inadequate response to anti-TNF inhibitors, with an estimated market share of more than 10% in the third quarter of 2007. We believe that sales growth also resulted from the increased use of Rituxan following first-line therapy in indolent non-Hodgkin’s lymphoma (NHL), and from increased adoption in front-line chronic lymphocytic leukemia (CLL), an unapproved use. Rituxan’s overall adoption rate in other areas of NHL and CLL remained flat in the first nine months of 2007 and throughout 2006. Also contributing to the increase in product sales were price increases in 2006 and 2007.

Herceptin

Net U.S. sales of Herceptin increased 6% to $320 million in the third quarter and 5% to $960 million in the first nine months of 2007 from the comparable periods in 2006. The increases in product sales resulted primarily from price increases in 2006 and 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 approximately 70% in the third quarter of 2007, an increase from the adoption rate in the third quarter of 2006. We believe that due to the significant adoption in the adjuvant population, further volume growth opportunities for Herceptin may be limited.

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Lucentis

Lucentis was approved by the FDA for the treatment of neovascular (wet) AMD on June 30, 2006. Net U.S. sales of Lucentis increased 29% to $198 million in the third quarter and 279% to $618 million in the first nine months of 2007 from the comparable periods in 2006, and decreased 5% from $209 million in the second quarter of 2007. New patient share in the third quarter of 2007 was approximately 50%, a decrease from 55% in the second quarter of 2007. We believe that the main factors affecting Lucentis sales are the continued off-label use of Avastin by some retinal specialists and reimbursement concerns from retinal specialists. We believe that some of the reimbursement concerns may be addressed when Lucentis receives a permanent J-code classification from the Centers for Medicare and Medicaid Services, expected in January 2008, which will allow for automated processing of claims. Sales in the third quarter of 2007 also may have been affected by some patients not returning for repeat treatments during the summer months. We expect that Lucentis sales for the remainder of 2007 will be affected by the continued off-label use of Avastin, reimbursement concerns, the extent to which patients return for treatment after the first year of therapy and the frequency with which those patients receive treatment, and reactions by physicians to our decision regarding compounding pharmacies discussed below.

Given the FDA approval of Lucentis; concerns related to the sterility and repackaging of Avastin for ocular use; and the fact that Avastin is not designed, manufactured, tested in rigorous clinical trials, or approved for ocular use, in October 2007 we announced that we would no longer allow compounding pharmacies the ability to purchase Avastin directly from wholesale distributors. We expect this change in distribution to be effective as of January 1, 2008. However, compounding pharmacies and retinal specialists may continue to obtain Avastin through other established channels.

Xolair

Net U.S. sales of Xolair increased 13% to $121 million in the third quarter and 15% to $352 million in the first nine 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 in 2006 and 2007. We believe that 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, had a modest negative effect on sales in the first nine months of 2007. We and Novartis, our co-promotion collaborator, agreed on a new U.S. label and are working with the FDA to produce a RiskMAP that emphasizes the incidence of anaphylaxis and instruct physicians that patients should be closely observed for an appropriate period of time after Xolair administration. We believe that this update to the label and RiskMAP will not have a significant effect on the way physicians prescribe Xolair.

Tarceva

Net U.S. sales of Tarceva increased 1% to $101 million in the third quarter and 3% to $304 million in the first nine months of 2007 from the comparable periods in 2006. Sales results were positively affected by price increases in 2006 and 2007, but these increases were substantially offset by product returns and return reserve requirements, which were higher than expected in the second and third quarters of 2007, and by modest decreases in volume. In second-line NSCLC, Tarceva’s overall penetration decreased in the first nine months of 2007 relative to the same period in 2006. However, duration of therapy in second-line NSCLC increased in the third quarter and first nine months of 2007 compared to the same periods in 2006. 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. In first-line pancreatic cancer, Tarceva’s penetration decreased in the first nine months of 2007 compared to the first nine months of 2006 and was flat in the third quarter of 2007 compared to third quarter of 2006.

Nutropin Products

Combined net U.S. sales of our Nutropin products increased 1% to $93 million in the third quarter and remained flat at $278 million in the first nine months of 2007 from the comparable periods in 2006. Sales in the third quarter and first nine months of 2007 were positively affected by price increases in 2007, but these increases were substantially offset by lower sales volume, partially resulting from the loss of managed care product placement due to pricing.

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Thrombolytics

Combined net U.S. sales of our three thrombolytic products—Activase, Cathflo Activase, and TNKase—increased 12% to $67 million in the third quarter and 12% to $202 million in the first nine 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 in 2006 and 2007.

Pulmozyme

Net U.S. sales of Pulmozyme increased 14% to $57 million in the third quarter and 12% to $164 million in the first nine months of 2007 from the comparable periods in 2006. The increases reflected price increases in 2006 and 2007, and, to a lesser extent, increased penetration in certain patient segments.

Raptiva

Net U.S. sales of Raptiva increased 26% to $29 million in the third quarter and 21% to $80 million in the first nine months of 2007 from the comparable periods in 2006. Contributing to the growth in sales were price increases in 2006 and 2007 and increased use of Raptiva in certain patient sub-populations.

Sales to Collaborators

Product sales to collaborators, for use in non-U.S. markets, increased 50% to $166 million in the third quarter and 169% to $753 million in the first nine months of 2007 from the comparable periods in 2006. The increases were primarily due to more favorable Herceptin pricing terms to Genentech that were part of the supply agreement with Roche signed in the third quarter of 2006 and higher sales volumes 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 be approximately 90% higher than the 2006 level; however, sales to collaborators vary depending on contractual purchase obligations, production schedules and actual demand by collaborators. Therefore, our quarterly sales to collaborators do not directly predict our collaborators’ sales to end users outside the U.S., nor are they always an indicator of the extent and timing of royalties expected to be received from the sales of our products in non-U.S. markets.

Royalties

Royalty revenue increased 44% to $524 million in the third quarter and 48% to $1,427 million in the first nine months of 2007 from the comparable periods in 2006. The increases were primarily due to higher sales by Roche of our Herceptin, Rituxan, and Avastin products and sales of our Lucentis product by Novartis. The increase from the first nine months of 2006 was also due to an acceleration of royalties in the second quarter of 2007, as discussed below. Of the overall royalties received, royalties from Roche represented approximately 60% in the third quarter and first nine months of 2007 compared to approximately 63% in the third quarter and 62% in the first nine months of 2006. 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 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 the Cabilly patent, under which we receive royalty revenue on sales of products 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 September 30, 2007		Nine Months Ended September 30, 2007
Royalty revenue	$	75	$	183

Gross expenses⁽¹⁾	$	30	$	87

Net of tax effect of Cabilly patent on diluted EPS	$	0.03	$	0.06

______________________

(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 more information on our Cabilly patent reexamination and the MedImmune lawsuit relating to the Cabilly patent.

Cash flows from royalty income include revenue denominated in foreign currencies. We currently enter into foreign currency 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 approximately 40% 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 decreased 20% to $63 million in the third quarter and increased 13% to $234 million in the first nine months of 2007 from the comparable periods in 2006. The decrease in the third quarter of 2007 was mainly due to the receipt of a Herceptin milestone payment in the third quarter of 2006 and fewer projects in 2007 on which we received reimbursements. The increase in the first nine 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, higher reimbursements from Roche related to R&D efforts on Avastin and higher reimbursements from Biogen Idec related to R&D efforts on Rituxan. 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 approximately 90% of the 2006 level; however, contract revenue is difficult to forecast because it can vary based on the mix of spending by us and our collaborators and the related reimbursements that we will receive.

Cost of Sales

Cost of sales as a percentage of product sales was 17% in the third quarter and first nine months of 2007 compared to 15% in the third quarter and 16% in the first nine months of 2006. Cost of sales in the third quarter and first nine months of 2007 included a non-recurring charge of approximately $53 million resulting from our decision to cancel and buy out a future manufacturing obligation. The increases in cost of sales as a percentage of product sales were also due to the recognition of employee stock-based compensation expense of $16 million in the third quarter and $49 million in the first nine months of 2007, related to products sold for which employee stock-based compensation expense was previously capitalized as part of inventory costs in 2006, and higher volume of lower margin sales to collaborators. However, cost of sales as a percentage of product sales was favorably affected by the U.S. product sales mix (increased sales of our higher margin products, primarily Lucentis, Avastin, and Herceptin in the first nine months of 2007) and a price increase on sales of Herceptin to Roche, which started in the third quarter of 2006.

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Research and Development

Research and development (R&D) expenses increased 35% to $615 million in the third quarter and 50% to $1,828 million in the first nine months of 2007 from the comparable periods in 2006. The higher levels of expenses in the third quarter and first nine months of 2007 reflected increased development activity across our entire product portfolio, including increased spending on clinical trials, post-marketing studies, clinical manufacturing expenses (notably for Rituxan, Avastin, Xolair, and Lucentis), early-stage projects, and higher research expenses. The increase in the first nine months of 2007 was also due to an increase in up-front, in-licensing expense for new collaborations.

R&D as a percentage of operating revenue was 21% in the third quarter and first nine months of 2007 compared to 19% in the third quarter and first nine months of 2006.

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

	Three Months Ended September 30,							Nine Months Ended September 30,
Research and Development	2007		2006		% Change			2007		2006		% Change
Product development (including post-marketing)	$	479	$	316		52	%	$	1,277	$	900		42	%
Research		109		83		31			304		232		31
In-licensing (up-front and ongoing fees)		27		55		(51	)		247		86		187
Total R&D	$	615	$	454		35	%	$	1,828	$	1,218		50	%

Marketing, General and Administrative

Marketing, general and administrative (MG&A) expenses increased 8% to $541 million in the third quarter and 11% to $1,564 million in the first nine months of 2007 from the comparable periods in 2006. The increase from the third quarter of 2006 was primarily due to (i) an increase in royalty expense, primarily to Biogen Idec, resulting from higher Roche sales of Rituxan and (ii) an increase in marketing and sales expenses primarily in support of commercial activities for Lucentis and Rituxan (RA setting). The increase from the first nine months of 2006 was primarily due to: (i) an increase in royalty expense, primarily to Biogen Idec resulting from higher Roche sales of Rituxan, (ii) an increase in general and administrative expenses, including charitable donations and losses on property and equipment disposals, and (iii) an increase in marketing and sales expense, primarily in support of Herceptin (adjuvant setting) and commercial activities related to Lucentis and Rituxan (RA setting).

MG&A as a percentage of operating revenue was 19% in the third quarter and 18% in the first nine months of 2007 compared to 21% in the third quarter and 22% in the first nine months of 2006.

Collaboration Profit Sharing

Collaboration profit sharing expenses increased 10% to $276 million in the third quarter and 10% to $805 million in the first nine months of 2007 from the comparable periods in 2006 primarily due to higher sales of Rituxan and Xolair.

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

	Three Months Ended September 30,							Nine Months Ended September 30,
	2007		2006		% Change			2007		2006		% Change
U.S. Rituxan profit sharing expense	$	187	$	165		13	%	$	541	$	490		10	%
U.S. Tarceva profit sharing expense		42		39		8			121		108		12
Total Xolair profit sharing expense		47		46		2			143		137		4
Total collaboration profit sharing expense	$	276	$	250		10	%	$	805	$	735		10	%

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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.

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 September 30, 2007 and 2006 consisted of the following (in millions):

Three Months

Ended September 30,

Nine Months

Ended September 30,