Edgar Filing: GENENTECH INC

dna-10q_q308.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, 2008

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, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ	Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)	Smaller reporting company 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	1,052,033,529 Outstanding at October 31, 2008

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, 2008 and 2007	3

	Condensed Consolidated Statements of Cash Flows— for the nine months ended September 30, 2008 and 2007	4

	Condensed Consolidated Balance Sheets— September 30, 2008 and December 31, 2007	5

	Notes to Condensed Consolidated Financial Statements	6-19

	Report of Independent Registered Public Accounting Firm	20

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21-51

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	52

Item 4.	Controls and Procedures	52

	PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	53

Item 1A.	Risk Factors	53-67

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	67

Item 6.	Exhibits	68

SIGNATURES		69

In this report, “Genentech,” “we,” “us,” and “our” refer to Genentech, Inc. and its consolidated subsidiaries. “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); Genentech®; Herceptin® (trastuzumab) anti-HER2 antibody; Lucentis® (ranibizumab) 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 registered trademark of OSI Pharmaceuticals, Inc.; and Xolair® (omalizumab) anti-IgE antibody is a registered 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,
	2008			2007			2008			2007
Revenue
Product sales (including amounts from related parties: three months—2008–$148; 2007–$137; nine months—2008–$435; 2007–$659)	$	2,634		$	2,321		$	7,549		$	7,094
Royalties (including amounts from related parties: three months—2008–$459; 2007–$357; nine months—2008–$1,333; 2007–$914)		687			524			1,932			1,427
Contract revenue (including amounts from related parties: three months—2008–$53; 2007–$30; nine months—2008–$119; 2007–$134)		91			63			230			234
Total operating revenue		3,412			2,908			9,711			8,755
Costs and expenses
Cost of sales (including amounts for related parties: three months—2008–$94; 2007–$100; nine months—2008–$251; 2007–$365)		409			406			1,240			1,227
Research and development (including amounts from programs where related parties share costs: three months—2008–$95; 2007–$75; nine months—2008–$264; 2007–$222) (including amounts for which reimbursement was recorded as contract revenue: three months—2008–$57; 2007–$49; nine months—2008–$154; 2007–$154)		777			615			2,043			1,828
Marketing, general and administrative		611			541			1,687			1,564
Collaboration profit sharing (including related party amounts: three months—2008–$49; 2007–$47; nine months—2008–$138; 2007–$143)		315			276			907			805
Write-off of in-process research and development related to acquisition		–			77			–			77
Gain on acquisition		–			(121	)		–			(121	)
Recurring amortization charges related to redemption and acquisition		43			38			129			90
Special items: litigation-related		40			14			(260	)		41
Total costs and expenses		2,195			1,846			5,746			5,511
Operating income		1,217			1,062			3,965			3,244
Other income (expense):
Interest and other income (expense), net		(33	)		84			133			233
Interest expense		(25	)		(18	)		(57	)		(53	)
Total other income (expense), net		(58	)		66			76			180
Income before taxes		1,159			1,128			4,041			3,424
Income tax provision		428			443			1,546			1,286
Net income	$	731		$	685		$	2,495		$	2,138
Earnings per share
Basic	$	0.69		$	0.65		$	2.37		$	2.03
Diluted	$	0.68		$	0.64		$	2.34		$	2.00
Shares used to compute basic earnings per share		1,055			1,053			1,053			1,053
Shares used to compute diluted earnings per share		1,071			1,069			1,067			1,070

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,
	2008			2007
Cash flows from operating activities
Net income	$	2,495		$	2,138
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		433			345
Employee stock-based compensation		311			300
Excess tax benefit from stock-based compensation arrangements		(119	)		(160	)
In-process research and development		–			77
Gain on acquisition		–			(121	)
Deferred income taxes		207			(116	)
Deferred revenue		(15	)		(50	)
Litigation-related special items		(260	)		39
Gain on sales of securities available-for-sale and other		(76	)		(15	)
Impairment of preferred securities		67			–
Write-downs of and losses on securities available-for-sale and other		48			4
Loss on property and equipment dispositions and other		24			30
Changes in assets and liabilities:
Receivables and other current assets		(31	)		(236	)
Inventories		88			(238	)
Investments in trading securities		(2	)		(140	)
Accounts payable, other accrued liabilities, and other long-term liabilities		(214	)		216
Accrued litigation		(476	)		–
Net cash provided by operating activities		2,480			2,073

Cash flows from investing activities
Purchases of securities available-for-sale		(1,314	)		(622	)
Proceeds from sales of securities available-for-sale		1,018			482
Proceeds from maturities of securities available-for-sale		192			358
Capital expenditures		(569	)		(692	)
Change in other intangible and long-term assets		22			(39	)
Acquisition and related costs, net		–			(833	)
Net cash used in investing activities		(651	)		(1,346	)

Cash flows from financing activities
Stock issuances		632			381
Stock repurchases		(756	)		(815	)
Excess tax benefit from stock-based compensation arrangements		119			160
Maturities of commercial paper		(63	)		–
Net cash used in financing activities		(68	)		(274	)
Net increase in cash and cash equivalents		1,761			453
Cash and cash equivalents at beginning of period		2,514			1,250
Cash and cash equivalents at end of period	$	4,275		$	1,703

Supplemental cash flow data
Cash paid during the period for:
Income taxes	$	1,337		$	1,277
Interest		77			71
Non-cash investing and financing activities
Capitalization of construction in progress related to financing lease transactions		104			156
Transfer of restricted cash to short-term investments		788			–

See Notes to Condensed Consolidated Financial Statements.

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GENENTECH, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In millions)

(Unaudited)

	September 30, 2008		December 31, 2007
Assets
Current assets
Cash and cash equivalents	$	4,275	$	2,514
Short-term investments		1,657		1,461
Restricted cash and investments		–		788
Accounts receivable—product sales (net of allowances of: 2008–$158; 2007–$116; including amounts from related parties: 2008–$53; 2007–$2)		862		847
Accounts receivable—royalties (including amounts from related parties: 2008–$541; 2007–$463)		734		620
Accounts receivable—other (including amounts from related parties: 2008–$115; 2007–$233)		232		299
Inventories		1,408		1,493
Deferred tax assets		395		614
Prepaid expenses		94		100
Other current assets		34		17
Total current assets		9,691		8,753
Long-term marketable debt and equity securities		2,606		2,090
Property, plant and equipment, net		5,320		4,986
Goodwill		1,590		1,577
Other intangible assets		1,046		1,168
Other long-term assets		358		366
Total assets	$	20,611	$	18,940

Liabilities and stockholders’ equity
Current liabilities
Accounts payable (including amounts to related parties: 2008–$5; 2007–$2)	$	235	$	420
Commercial paper		536		599
Deferred revenue (including amounts from related parties: 2008–$70; 2007–$63)		81		73
Taxes payable		79		173
Accrued litigation		–		776
Other accrued liabilities (including amounts to related parties: 2008–$285; 2007–$230)		1,905		1,877
Total current liabilities		2,836		3,918
Long-term debt		2,504		2,402
Deferred revenue (including amounts from related parties: 2008–$367; 2007–$384)		397		418
Other long-term liabilities		248		297
Total liabilities		5,985		7,035
Commitments and contingencies
Stockholders’ equity
Common stock		21		21
Additional paid-in capital		11,897		10,695
Accumulated other comprehensive income		137		197
Retained earnings		2,571		992
Total stockholders’ equity		14,626		11,905
Total liabilities and stockholders’ equity	$	20,611	$	18,940

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 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, 2007. 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 reported for the full year or any future period.

Principles of Consolidation

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

Use of Estimates

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 the estimates.

Recent Accounting Pronouncements

In February 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Position (FSP) No. 157-2, which delays the effective date of FASB Statement of Financial Accounting Standards (FAS) No. 157, “Fair Value Measurements” (FAS 157) for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value on a recurring basis (items that are remeasured at least annually). The FSP defers the effective date of FAS 157 for non-financial assets and non-financial liabilities until our fiscal year beginning on January 1, 2009. We do not expect the adoption of FAS 157 for non-financial assets and non-financial liabilities to have an effect on our consolidated financial statements.

In March 2008, the FASB issued FAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133” (FAS 161). FAS 161 requires us to provide greater transparency about how and why we use derivative instruments, how the instruments and related hedged items are accounted for under FAS 133, and how the instruments and related hedged items affect our financial position, results of operations, and cash flows. FAS 161 is effective for us beginning on January 1, 2009. We do not expect the adoption of FAS 161 to have an effect on our consolidated financial statements, but we will be required to expand our disclosure regarding our derivative instruments.

Revenue Recognition

We recognize revenue from the sale of our products, royalties earned, and contract arrangements. Certain of 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 standalone value to the customer and whether there is objective

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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 (mg) of Avastin in a 12-month period to receive free Avastin in excess of the 10,000 mg during the remainder of the 12-month period. Based on the current wholesale acquisition cost, 10,000 mg is valued at $55,000 in gross revenue. We defer a portion of our gross Avastin product sales revenue that is sold through normal commercial channels 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 several factors, most notably: the number of patients who are currently being treated for U.S. Food and Drug Administration (FDA)-approved indications and the start date of their treatment regimen, the extent to which patients may elect to enroll in the program, the number of patients who meet the financial eligibility requirements of the program, and the duration and extent of treatment for the FDA-approved indications, among other factors. We will continue to update our estimates for each reporting period as new information becomes available. 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 EPS are computed based on the weighted-average number of shares of our Common Stock and dilutive stock options.

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2008		2007		2008		2007
Numerator:
Net income	$	731	$	685	$	2,495	$	2,138
Denominator:
Weighted-average shares outstanding used to compute basic earnings per share		1,055		1,053		1,053		1,053
Effect of dilutive stock options		16		16		14		17
Weighted-average shares outstanding and dilutive securities used to compute diluted earnings per share		1,071		1,069		1,067		1,070

Outstanding employee stock options to purchase 17 million and 48 million shares of our Common Stock were excluded from the computation of diluted EPS for the third quarter and first nine months of 2008, respectively, because the effect would have been anti-dilutive.

Comprehensive Income

Comprehensive income comprises net income and other comprehensive income (OCI). OCI includes certain changes in stockholders’ equity that are excluded from net income. Specifically, we include in OCI changes in the estimated fair value of derivatives designated as effective cash flow hedges, net unrealized gains and losses on our securities available-for-sale, and gains or losses and prior service costs or credits related to our post-retirement benefit plan that arise during the period but are not recognized as components of net periodic benefit cost.

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The components of accumulated OCI, net of taxes, were as follows (in millions):

	September 30, 2008			December 31, 2007
Net unrealized gains on securities available-for-sale	$	136		$	219
Net unrealized gains (losses) on cash flow hedges		9			(14	)
Accumulated changes in post-retirement benefit obligation		(8	)		(8	)
Accumulated other comprehensive income	$	137		$	197

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
Net income	$	731		$	685		$	2,495		$	2,138
(Decrease) increase in unrealized gains on securities available-for-sale		(20	)		19			(83	)		10
Increase (decrease) in unrealized gains on cash flow hedges		52			(13	)		23			(2	)
Comprehensive income, net of income taxes	$	763		$	691		$	2,435		$	2,146

The increase in net unrealized gains on cash flow hedges during the third quarter and first nine months of 2008 was primarily due to the strengthening of the U.S. dollar during these periods compared to the same periods in 2007. In the periods in which the hedged transaction affects earnings, any gains or losses on cash flow hedges will be offset by revenue denominated in the underlying foreign currency.

Fair Value of Financial Instruments

The fair value of our financial instruments reflects the amounts that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The fair value estimates presented in this report reflect the information available to us as of September 30, 2008 and December 31, 2007. See Note 4, “Fair Value Measurements.”

Derivative Instruments

Our derivative instruments consist of cash flow and fair value hedges. Our cash flow hedges consist of foreign currency exchange options and forwards. As of September 30, 2008, unrealized net losses of approximately $12 million were expected to be reclassified from accumulated OCI to earnings within the next 12 months. If realized, these amounts are expected to be offset by increases in the underlying foreign-currency-denominated royalty revenue over this same 12-month period. Our fair value hedges consist of interest rate swap instruments and equity hedges which are recorded against the assets and liabilities being hedged.

Note 2.

Retention Plans and Employee Stock-Based Compensation

Retention Plan Costs

On July 21, 2008, we announced that we received an unsolicited proposal from Roche to acquire all of the outstanding shares of our Common Stock not owned by Roche at a price of $89 in cash per share (the Roche Proposal). See also Note 6, “Relationship with Roche Holdings, Inc. and Related Party Transactions,” for more information on the Roche Proposal. On August 18, 2008, we announced that a special committee of our Board of Directors composed of our independent directors (the Special Committee) approved the implementation of two retention plans that together cover substantially all employees of the company. The plans are estimated to cost approximately $375 million, payable in cash, and are being implemented in lieu of our 2008 annual stock option grant. The timing of the payments related to these plans will depend on the outcome of the Roche Proposal. If a merger of Genentech with Roche or an affiliate of Roche has not occurred on or before June 30, 2009, we will pay the retention bonus at that time in accordance with the terms of the

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plans. We are currently recognizing the retention plan costs in our financial statements ratably over the period from August 18, 2008 to June 30, 2009. If a merger of Genentech with Roche or an affiliate of Roche has occurred on or before June 30, 2009, the timing of the payments and the recognition of the expense will depend on the terms of the merger. During the third quarter and first nine months of 2008, total costs for the retention plans were $53 million, of which $44 million was expensed and $9 million was capitalized into inventory, which will be recognized as cost of sales (COS) as products that were manufactured after the initiation of the retention plans are estimated to be sold.

Stock-Based Compensation Expense under FAS 123R

The components of employee stock-based compensation expense recognized under FAS No. 123(R), “Share-Based Payment” (FAS 123R), were as follows (in millions):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2008		2007		2008		2007
Cost of sales	$	20	$	16	$	62	$	49
Research and development		39		37		119		114
Marketing, general and administrative		44		44		130		137
Total employee stock-based compensation expense	$	103	$	97	$	311	$	300

As of September 30, 2008, total compensation costs related to unvested stock options not yet recognized was $573 million, which is expected to be allocated to expense and production costs over a weighted-average period of 29 months. The portion allocated to production costs will be recognized as COS when the related products are estimated to be sold.

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,
	2008			2007			2008			2007
Risk-free interest rate		3.1	%		4.3	%		3.0	%		4.3	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Expected volatility		23.0	%		25.0	%		24.0	%		25.0	%
Expected term (years)		5.0			5.0			5.0			5.0

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. In developing our estimate of expected term, we have assumed that our recent historical stock option exercise experience is a relevant indicator of future exercise patterns. We base our determination of expected volatility predominantly on the implied volatility of our traded options with consideration of our historical volatilities and the volatilities of comparable companies.

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Note 3.

Condensed Consolidated Financial Statement Detail

Inventories

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

	September 30, 2008		December 31, 2007
Raw materials and supplies	$	116	$	119
Work-in-process		1,096		1,062
Finished goods		196		312
Total	$	1,408	$	1,493

Included in work-in-process as of September 30, 2008 were approximately $77 million of inventories using a manufacturing process that is awaiting regulatory licensure.

The carrying value of inventory on our Condensed Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007 included employee stock-based compensation costs of $67 million and $72 million, respectively. The carrying value of inventory on our Condensed Consolidated Balance Sheet as of September 30, 2008 also included retention plan costs of $9 million.

Note 4.

Fair Value Measurements

On January 1, 2008, we adopted FAS 157, which established a framework for measuring fair value under GAAP and clarified the definition of fair value within that framework. FAS 157 does not require assets and liabilities that were previously recorded at cost to be recorded at fair value. For assets and liabilities that are already required to be disclosed at fair value, FAS 157 introduced, or reiterated, a number of key concepts that form the foundation of the fair value measurement approach to be used for financial reporting purposes. The fair value of our financial instruments reflects the amounts that we estimate we would receive in connection with the sale of an asset or that we would pay in connection with the transfer of a liability in an orderly transaction between market participants at the measurement date (exit price). FAS 157 also established a fair value hierarchy that prioritizes the inputs used in valuation techniques into the following three levels:

Level 1—quoted prices in active markets for identical assets and liabilities

Level 2—observable inputs other than quoted prices in active markets for identical assets and liabilities

Level 3—unobservable inputs

The adoption of FAS 157 did not have an effect on our financial condition or results of operations, but FAS 157 introduced new disclosures about how we value certain assets and liabilities. Much of the disclosure focuses on the inputs used to measure fair value, particularly in instances in which the measurement uses significant unobservable (Level 3) inputs. A substantial majority of our financial instruments are Level 1 and Level 2 assets.

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The following table sets forth the fair value of our financial assets and liabilities measured on a recurring basis, including those that are pledged as collateral or are restricted. Assets and liabilities are measured on a recurring basis if they are remeasured at least annually.

	September 30, 2008				December 31, 2007
(In millions)	Assets		Liabilities		Assets		Liabilities
Cash and cash equivalents	$	4,275	$	–	$	2,514	$	–
Restricted cash		–		–		788		–
Short-term investments		1,657		–		1,461		–
Long-term marketable debt securities		2,266		–		1,674		–
Total fixed income investment portfolio		8,198		–		6,437		–

Long-term marketable equity securities		340		–		416		–
Total derivative financial instruments		72		12		30		19
Total	$	8,610	$	12	$	6,883	$	19

The following table sets forth the fair value of our financial assets and liabilities, allocated into Level 1, Level 2, and Level 3 that were measured on a recurring basis as of September 30, 2008 (in millions).

	Level 1		Level 2		Level 3		Total
Assets
Cash and cash equivalents	$	2,158	$	2,117	$	–	$	4,275
Trading securities		88		914		1		1,003
Securities available-for-sale		159		2,607		154		2,920
Equity securities		340		–		–		340
Derivative financial instruments		33		39		–		72
Total	$	2,778	$	5,677	$	155	$	8,610

Liabilities
Derivative financial instruments(1)	$	–	$	12	$	–	$	12

________________________

(1)	Our Level 2 liabilities consisted of derivative financial instruments including currency forward contracts and currency option contracts.

As of September 30, 2008, the fair value of our Level 1 assets was $2.8 billion, consisting primarily of cash, money market instruments, marketable equity securities in biotechnology companies with which we have collaboration agreements, and U.S. Treasury securities. Included in this amount were gross unrecognized gains and losses of approximately $320 million and $20 million, respectively, primarily related to marketable equity securities.

As of September 30, 2008, the fair value of our Level 2 assets was $5.7 billion consisting primarily of commercial paper, corporate bonds, and government and agency securities. Asset-backed securities and preferred securities represent less than 5% of the total value of Level 2 assets. Included in the total amount were gross unrecognized losses of approximately $60 million related to corporate bonds, government and agency securities and preferred securities, partially offset by approximately $10 million of gross unrecognized gains on various fixed income investments. In addition, the fair value of our Level 2 assets included approximately $40 million in gross unrecognized gains primarily related to foreign exchange derivative contracts which serve as hedge instruments against anticipated foreign-currency denominated royalty revenue. During the third quarter of 2008, the U.S. Treasury announced actions that significantly reduced the value of U.S. government agency preferred securities that we hold as investments. As a result, we recorded an impairment charge of $46 million during the third quarter of 2008. Furthermore, since we intend to hold these investments, we reclassified them from short-term Level 2 assets to long-term Level 2 assets.

Our Level 3 assets included student loan auction-rate securities, structured investment vehicle securities, and the preferred securities of an insolvent company. As of September 30, 2008, we held $155 million of investments, which were measured using unobservable (Level 3) inputs, representing approximately 2% of our total fair value investment portfolio. Student loan auction-rate securities of $154 million and structured investment vehicle

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securities of $1 million were valued based on broker-provided valuation models. In addition, our Level 3 assets included preferred securities in a financial institution that declared bankruptcy during the third quarter of 2008. We recorded the full carrying amount of $21 million as an impairment charge, because we do not expect to recover the value of these assets during the bankruptcy proceedings. We also transferred the financial institution preferred securities to Level 3 assets from Level 2 assets, since we recorded the investment at zero value rather than a value based on an observable input.

The following table sets forth a summary of the changes in the fair value of our Level 3 financial assets, which were measured at fair value on a recurring basis for the third quarter and first nine months of 2008 (in millions).

	Three Months Ended September 30, 2008									Nine Months Ended September 30, 2008
	Structured Investment Vehicle Securities			Auction-Rate Securities			Preferred Securities			Structured Investment Vehicle Securities			Auction-Rate Securities			Preferred Securities
Beginning balance	$	2		$	155		$	–		$	7		$	–		$	–
Transfer into Level 3(1)		–			–			21			–			174			21
Impairment charges		–			–			(21	)		–			–			(21	)
Unrealized losses(2)		–			–			–			(1	)		(16	)		–
Purchases, issuances, settlement		(1	)		(1	)		–			(5	)		(4	)		–
Ending balance	$	1		$	154		$	–		$	1		$	154		$	–

________________________

(1)	In the third quarter of 2008, we transferred $21 million of preferred securities into Level 3 assets. In the first nine months of 2008, we transferred $195 million of auction-rate securities and preferred securities into Level 3 assets.
(2)	The unrealized losses of $17 million in the first nine months of 2008 were included in OCI as of September 30, 2008.

Note 5.

Contingencies

We are a party to various legal proceedings, including 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. Through counsel we are having discussions with government representatives about the status of their investigation and Genentech’s views on this matter, including potential resolution. Previously, the investigation had been both criminal and civil in nature. We have been informed by the criminal prosecutor handling this matter that the government has declined to prosecute the company criminally in connection with this investigation. The civil matter is still ongoing. 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 that 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, COH filed a complaint against us in the Superior Court in Los Angeles County, California, alleging that we owe royalties to 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 COH approximately $300 million in compensatory damages. On June 24, 2002, a jury voted to award COH an additional $200 million in punitive damages. Such amounts were accrued as an expense in the second quarter of 2002. Included within current liabilities in “Accrued litigation” in the accompanying Condensed Consolidated Balance Sheet at December 31, 2007 was $776 million, which represented our estimate of the costs for the resolution of the COH matter as of that reporting date. 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 California Supreme

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Court heard our appeal on this matter on February 5, 2008, and on April 24, 2008 overturned the award of $200 million in punitive damages to COH but upheld the award of $300 million in compensatory damages. We paid $476 million to COH in the second quarter of 2008, reflecting the amount of compensatory damages awarded plus interest thereon from the date of the original decision, June 10, 2002.

As a result of the April 24, 2008 California Supreme Court decision, we reversed a $300 million net litigation accrual related to the punitive damages and accrued interest, which we recorded as “Special items: litigation-related” in our Condensed Consolidated Statements of Income for the first quarter and first nine months of 2008. In the third quarter and first nine months of 2007, we recorded accrued interest and bond costs on both compensatory and punitive damages totaling $14 million and $41 million, respectively. In conjunction with the COH judgment in 2002, we posted a surety bond and were required to pledge cash and investments of $788 million to secure the bond, and this balance was reflected in “Restricted cash and investments” in the accompanying Condensed Consolidated Balance Sheet as of December 31, 2007. During the third quarter of 2008, the court completed certain administrative procedures to dismiss the case. As a result, the restrictions were lifted from the restricted cash and investments accounts, which consisted of available-for-sale investments, and the funds became available for use in our operations. We and COH have had discussions, but have not reached agreement, regarding additional royalties and other amounts that Genentech owes COH under the 1976 agreement for third-party product sales and settlement of a third-party patent litigation that occurred after the 2002 judgment. Discussions are ongoing. We recorded additional costs of $40 million as “Special items: litigation-related” in the third quarter of 2008 based on our estimate of our range of liability in connection with the resolution of these issues.

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 related 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 included claims for violation of anti-trust, patent, and unfair competition laws. MedImmune sought a ruling that the Cabilly patent was invalid and/or unenforceable, a determination that MedImmune did not owe royalties under the Cabilly patent on sales of its Synagis® antibody product, an injunction to prevent us from enforcing the Cabilly patent, an award of actual and exemplary damages, and other relief. On June 11, 2008, we announced that we settled this litigation with MedImmune. Pursuant to the settlement agreement, the U.S. District Court dismissed all of the claims against us in the lawsuit. The litigation has been fully resolved and dismissed, and the settlement did not have a material effect on our operating results for the third quarter and first nine months of 2008.

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 all 36 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 all 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 the 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. On February 25, 2008, the Patent Office mailed a final Patent Office action rejecting all the claims of the Cabilly patent. We filed our response to that final Patent Office action on June 6, 2008. On July 19, 2008, the Patent Office mailed an advisory action replying to our response and confirming the rejection of all claims of the Cabilly patent. We filed a notice of appeal challenging the rejection on August 22, 2008. Our opening appeal brief is due to be filed by December 10, 2008. 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 deoxyribonucleic acid (DNA) used in these methods. We have licensed the Cabilly patent to other companies and derive significant royalties from those licenses. The Cabilly patent licenses contributed royalty revenue of $106 million and $265 million in the third quarter and first nine months of 2008, respectively. The claims

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of the Cabilly patent remain valid and enforceable throughout the reexamination and appeals processes. 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 Inc., 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 to proceed with further trials of certain humanized anti-CD20 antibodies, but 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 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 clinical trials in order to obtain Biogen Idec’s approval. Each party is also seeking monetary damages from the other. The arbitrators held hearings on this matter over several days in September 2008, and an additional day of hearing is scheduled for December 9, 2008. We expect a final decision from the arbitrators by approximately June 2009, 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.

On June 28, 2003, Mr. Ubaldo Bao Martinez filed a lawsuit against the Porriño Town Council and Genentech España S.L. in the Contentious Administrative Court Number One of Pontevedra, Spain. The lawsuit challenges the Town Council’s decision to grant licenses to Genentech España S.L. for the construction and operation of a warehouse and biopharmaceutical manufacturing facility in Porriño, Spain. On January 16, 2008, the Administrative Court ruled in favor of Mr. Bao on one of the claims in the lawsuit and ordered the closing and demolition of the facility, subject to certain further legal proceedings. On February 12, 2008, we and the Town Council filed appeals of the Administrative Court decision at the High Court in Galicia, Spain. In addition, through legal counsel in Spain we are pursing other administrative remedies to try to overcome the Administrative Court’s ruling. We sold the assets of Genentech España S.L., including the Porriño facility, to Lonza Group Ltd. in December 2006, and Lonza has operated the facility since that time. Under the terms of that sale, we retained control of the defense of this lawsuit and agreed to indemnify Lonza against certain contractually defined liabilities up to a specified limit, which is currently estimated to be approximately $100 million. The outcome of this matter and our indemnification obligation to Lonza, if any, cannot be determined at this time.

On May 30, 2008, Centocor, Inc. filed a patent lawsuit against Genentech and COH in the U.S. District Court for the Central District of California. The lawsuit relates to the Cabilly patent that we co-own with COH and under which Centocor and other companies have been licensed and are paying royalties to us. The lawsuit seeks a declaratory judgment of patent invalidity and unenforceability with regard to the Cabilly patent and of patent non-infringement with regard to Centocor’s marketed product ReoPro® (Abciximab) and its unapproved product CNTO 1275 (Ustekinumab). Centocor originally sought to recover the royalties that it has paid to Genentech for ReoPro® and the monies it alleges that Celltech has paid to Genentech for Remicade® (infliximab), a product marketed by Centocor (a wholly owned subsidiary of Johnson & Johnson) under an agreement between Centocor and Celltech, but Centocor withdrew those claims in connection with its first amended complaint filed on September 3, 2008. Genentech answered the complaint on September 19, 2008 and also filed counterclaims against Centocor alleging that four Centocor products infringe certain Genentech patents. Genentech filed an amendment to those counterclaims on October 10, 2008. The outcome of this matter cannot be determined at this time.

On May 8, June 11, August 8, and September 29 of 2008, Genentech was named as a defendant, along with InterMune, Inc. and its former chief executive officer, W. Scott Harkonen, in four separate class-action complaints filed in the U.S. District Court for the Northern District of California on behalf of plaintiffs who allegedly paid part or all of the purchase price for Actimmune® for the treatment of idiopathic pulmonary fibrosis. Actimmune® is an interferon-gamma product that was licensed by Genentech to Connectics Corporation and was subsequently assigned to InterMune. InterMune currently sells Actimmune® in the U.S. The complaints are related in part to royalties that we received in connection with the Actimmune® product. The May 8, June 11, and August 8 complaints have been consolidated into a single amended complaint that claims and seeks damages for violations of federal racketeering laws, unfair competition laws, and consumer protection laws, and for unjust enrichment. The

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September 29 complaint includes six claims, but only names Genentech as a defendant in one claim for damages for unjust enrichment. The outcome of these matters cannot be determined at this time.

Subsequent to the Roche Proposal, more than thirty shareholder lawsuits have been filed against Genentech and/or the members of its Board of Directors, and various Roche entities, including RHI, Roche Holding AG, and Roche Holding Ltd. The lawsuits are currently pending in various state courts, including the Delaware Court of Chancery, San Francisco County Superior Court, and San Mateo County Superior Court, as well as in the United States District Court for the Northern District of California. The lawsuits generally assert class-action claims for breach of fiduciary duty and aiding and abetting breaches of fiduciary duty based in part on allegations that, in connection with Roche’s offer to purchase the remaining shares, some or all of the defendants failed to properly value Genentech, failed to solicit other potential acquirers, and are engaged in improper self-dealing. Several of the suits also seek the invalidation, in whole or in part, of the July 1999 Affiliation Agreement between Genentech and RHI (Affiliation Agreement), and an order deeming Articles 8 and 9 of the company’s Amended and Restated Certificate of Incorporation invalid or inapplicable to a potential transaction with Roche. The outcome of these matters cannot be determined at this time.

On October 27, 2008, Genentech and Biogen Idec Inc. filed a complaint against Sanofi-Aventis Deutschland GmbH (Sanofi), Sanofi-Aventis U.S. LLC, and Sanofi-Aventis U.S. Inc. in the Northern District of California, seeking a declaratory judgment that certain Genentech products, including Rituxan (which is co-marketed with Biogen Idec) do not infringe U.S. Patents 5,849,522 (‘522 patent) and 6,218,140 (‘140 patent) and a declaratory judgment that the ‘522 and ‘140 patents are invalid. Also on October 27, 2008, Sanofi filed suit against Genentech and Biogen Idec in the Eastern District of Texas, Lufkin Division, claiming that Rituxan and at least eight other Genentech products infringe the ‘522 and ‘140 patents. Sanofi is seeking preliminary and permanent injunctions, compensatory and exemplary damages, and other relief. In addition, on October 24, 2008, Hoechst GmbH filed with the ICC International Court of Arbitration (Paris) a request for arbitration against Genentech, relating to a terminated agreement between Hoechst’s predecessor and Genentech that pertained to the above-referenced patents and related patents outside the U.S. Hoechst is seeking payment of royalties on sales of Genentech products, damages for breach of contract, and other relief. Genentech intends to vigorously defend itself. The outcome of these matters can not be determined at this time.

Note 6.

Relationship with Roche Holdings, Inc. and Related Party Transactions

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

We issue shares of Common Stock in connection with our stock option and stock purchase plans, and we may issue additional shares for other purposes. Our Affiliation Agreement with RHI provides, among other things, that with respect to any issuance of our Common Stock in the future, we will repurchase a sufficient number of shares so that immediately after such issuance, the percentage of our Common Stock owned by RHI will be no lower than 2% below the “Minimum Percentage” (subject to certain conditions). The Minimum Percentage equals the lowest number of shares of Genentech Common Stock owned by RHI since its July 1999 offering of our Common Stock (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, as 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%. RHI’s ownership percentage of our outstanding shares was 55.8% as of September 30, 2008. Future share repurchases under our share repurchase program may increase Roche’s ownership percentage. However, significant option exercises and stock purchases by employees could result in further dilution, and limitations in our ability to enter into new share repurchase arrangements could negatively affect our ability to offset dilution.

The Roche Proposal

We announced on July 21, 2008 that we received the Roche Proposal, and on July 24, 2008 we announced that the Special Committee was formed to review, evaluate, and, in the Special Committee’s discretion, negotiate and recommend or not recommend the Roche Proposal. On August 13, 2008, we announced that the Special Committee

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unanimously concluded that the Roche Proposal substantially undervalues the company, but that the Special Committee would consider a proposal that recognizes the value of the company and reflects the significant benefits that would accrue to Roche as a result of full ownership. On August 18, 2008, we also announced that the Special Committee adopted two retention plans being implemented in lieu of our 2008 annual stock option grant. See also Note 2, “Retention Plans and Employee Stock-Based Compensation,” for more information on the retention plans. In addition, the Special Committee and the company have incurred and will continue to incur third-party legal and advisory costs in connection with the Roche Proposal that are included in the “Marketing, general and administrative” expenses line of our Condensed Consolidated Statements of Income.

The retention plan and third-party legal and advisory costs were as follows (in millions):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2008		2007		2008		2007
Retention plan costs(1)
Research and development	$	22	$	–	$	22	$	–
Marketing, general and administrative		22		–		22		–
Total retention plan costs		44		–		44		–
Third-party legal and advisory costs incurred by us on behalf of the Special Committee		6		–		6		–
Other third-party legal and advisory costs		3		–		3		–
Total retention plan costs and legal and advisory costs	$	53	$	–	$	53	$	–

_______________________

(1)	During the third quarter of 2008, $9 million of retention plan costs were capitalized into inventory, which will be recognized as COS as products that were manufactured after the initiation of the retention plans are estimated to be sold.

Related Party Transactions

We enter into transactions with 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, and all related party agreements are negotiated on an arm’s-length basis.

In our royalty and supply arrangements with related parties, we are the principal, as defined under Emerging Issues Task Force (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

We signed two product supply agreements with Roche in July 2006, each of which was amended in November 2007. The Umbrella Manufacturing Supply Agreement (Umbrella Agreement) supersedes our previous product supply agreements with Roche. The Short-Term Supply Agreement (Short-Term Agreement) supplements the terms of the Umbrella Agreement. Under the Short-Term Agreement, Roche agreed to purchase specified amounts of Herceptin, Avastin, and Rituxan through 2008. Under the Umbrella Agreement, Roche agreed to purchase specified amounts of Herceptin and Avastin through 2012, and on a perpetual basis, either party may order other collaboration products from the other party, including Herceptin and Avastin after 2012, pursuant to certain forecasted terms. The Umbrella Agreement also provides that either party can terminate its obligation to purchase and/or supply Avastin and/or Herceptin with six years’ notice on or after December 31, 2007. To date, we have not received a notice of termination from Roche.

Under the July 1999 amended and restated licensing and commercialization agreement, Roche has the right to opt in to development programs that we undertake on our products at certain pre-defined stages of development. Previously, Roche also had the right to develop certain products under the July 1998 licensing and commercialization agreement related to anti-HER2 antibodies (including Herceptin, pertuzumab, and trastuzumab-DM1). When Roche opts in to a program, we record the opt-in payments that we receive as deferred revenue, which

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we recognize over the expected development periods or product life, as appropriate. As of September 30, 2008, the amounts in short-term and long-term deferred revenue related to opt-in payments received from Roche were $51 million and $191 million, respectively. For the third quarter and first nine months of 2008, we recognized $19 million and $43 million, respectively, as contract revenue related to opt-in payments previously received from Roche. For the third quarter and first nine months of 2007, we recognized $10 million and $33 million, respectively, as contract revenue related to opt-in payments previously received from Roche.

In February 2008, Roche acquired Ventana Medical Systems, Inc., and as a result of the acquisition, Ventana is considered a related party. We have engaged in transactions with Ventana prior to and since the acquisition, but these transactions have not been material to our results of operations.

In May 2008, Roche acquired Piramed Limited, a privately held entity based in the United Kingdom, and as a result of the transaction, Piramed is considered a related party. Previous to the Roche acquisition of Piramed, we had entered into a licensing agreement with Piramed related to a molecule in our development pipeline.

In June 2008, we entered into a licensing agreement with Roche under which we obtained rights to a preclinical small-molecule drug development program. We recorded $35 million in research and development (R&D) expense in the second quarter of 2008 related to this agreement. The future R&D costs incurred under the agreement and any profit and loss from global commercialization will be shared equally with Roche.

In July 2008, we signed an agreement with Chugai-Pharmaceutical Co., Ltd., a Japan-based entity and part of Roche, under which we agreed to manufacture Actemra, a product of Chugai, at our Vacaville, California facility. After an initial term of five years, the agreement may be terminated subject to certain terms and conditions under the contract.

In September 2008, we entered into a collaboration agreement with Roche and GlycArt Biotechnology AG (wholly owned by Roche) for the joint development and commercialization of GA101, a humanized anti-CD20 monoclonal antibody for the potential treatment of hematological malignancies and other oncology-related B-cell disorders such as non-Hodgkin’s lymphoma (NHL). We recorded $105 million in R&D expense in the third quarter and first nine months of 2008 related to this collaboration. The future global R&D costs incurred under the agreement will be shared equally with Roche. We received commercialization rights in the U.S. and have the right to manufacture our own commercial requirements for the U.S. On October 28, 2008, Biogen Idec exercised the right under our collaboration agreement with them to opt in to this agreement and paid us an upfront fee of $32 million as part of the opt-in, which we will recognize ratably as contract revenue over future periods.

We currently have no commercialized products subject to profit sharing arrangements with 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,
	2008		2007		2008		2007
Product sales to Roche	$	144	$	135	$	425	$	651

Royalties earned from Roche	$	381	$	317	$	1,142	$	855

Contract revenue from Roche	$	35	$	21	$	75	$	81

Cost of sales on product sales to Roche	$	90	$	98	$	242	$	356

Research and development expenses incurred on joint development projects with Roche	$	84	$	64	$	232	$	192

In-licensing expenses to Roche	$	105	$	–	$	140	$	–

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Certain R&D expenses are partially reimbursable to us by Roche. Amounts that Roche owes us, net of amounts reimbursable to Roche by us on those projects, are recorded as contract revenue. Conversely, R&D expenses may include the net settlement of amounts we owe 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 Quarterly Report on Form 10-Q, we believe that Novartis holds approximately 33.3% of the outstanding voting shares of Roche. As a result of this ownership, Novartis is deemed to have an indirect beneficial ownership interest under FAS No. 57, “Related Party Disclosures” (FAS 57), of more than 10% of our voting stock.

We have an agreement with Novartis Pharma AG (a wholly owned subsidiary of Novartis AG; Novartis Pharma AG and affiliates are collectively referred to hereafter as Novartis) under which it 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.

We and Novartis are co-promoting Xolair in the U.S and co-developing Xolair in both the U.S. and Europe. We record sales, COS, and marketing and sales expenses in the U.S.; Novartis markets the product in and records sales, COS, and marketing and sales expenses in Europe and also records marketing and sales expenses in the U.S. We and Novartis share the resulting U.S. and European operating profits according to prescribed profit sharing percentages. Generally, we evaluate whether we are a net recipient or payer of funds on an annual basis in our cost and profit sharing arrangements. Net amounts received on an annual basis under such arrangements are classified as contract revenue, and net amounts paid on an annual basis are classified as collaboration profit sharing expense. With respect to the U.S. operating results, for the full year in 2007 we were a net payer to Novartis, and we anticipate that for the full year in 2008 we will be a net payer to Novartis. As a result, for the third quarters and first nine months of 2008 and 2007, the portion of the U.S. operating results that we owed to Novartis was recorded as collaboration profit sharing expense. With respect to the European operating results, for the full year in 2007 we were a net payer to Novartis, and we anticipate that for the full year in 2008 we will be a net recipient from Novartis. As a result, for the third quarter and first nine months of 2008, the portion of the European operating results that Novartis owed us was recorded as contract revenue. For the same periods in 2007, however, our portion of the European operating results was recorded as collaboration profit sharing expense. Effective with our acquisition of Tanox, Inc. on August 2, 2007, Novartis also makes: (1) additional profit sharing payments to us on U.S. sales of Xolair, which reduces our profit sharing expense; (2) royalty payments to us on sales of Xolair worldwide, which we record as royalty revenue; and (3) manufacturing service payments related to Xolair, which we record as contract revenue.

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2008		2007		2008		2007
Product sales to Novartis	$	4	$	2	$	10	$	8

Royalties earned from Novartis	$	78	$	40	$	191	$	59

Contract revenue from Novartis	$	18	$	9	$	44	$	53

Cost of sales on product sales to Novartis	$	4	$	2	$	9	$	9

Research and development expenses incurred on joint development projects with Novartis	$	11	$	11	$	32	$	30

Collaboration profit sharing expense to Novartis	$	49	$	47	$	138	$	143

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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 (AMD).

Certain R&D expenses are partially reimbursable to us by Novartis. The amounts that Novartis owes us, net of amounts reimbursable to Novartis by us on those projects, are recorded as contract revenue. Conversely, R&D expenses may include the net settlement of amounts we owe Novartis for R&D expenses that Novartis incurred on joint development projects, less amounts reimbursable to us by Novartis on those projects.

Note 7.

Income Taxes

Our effective income tax rate was 37% in the third quarter of 2008 compared to 39% in the third quarter of 2007. The decrease was mainly due to the non-deductible in-process research and development charge in the third quarter of 2007 resulting from our acquisition of Tanox. Our effective income tax rate was 38% in the first nine months of 2008, which included a settlement with the Internal Revenue Service (IRS) in the second quarter of 2008 for an item related to prior years. Our effective income tax rate was 38% in the first nine months of 2007, which included the non-deductible in-process research and development charge resulting from our acquisition of Tanox.

The IRS continues to examine our U.S. income tax returns for 2002 through 2004, and has proposed adjustments related to research credits and other items, including the settlement reached in the second quarter of 2008. We believe it is reasonably possible, that the unrecognized tax benefits, as of September 30, 2008, related to these items could decrease (by payment, release, or combination of both) in the next twelve months by approximately $100 million.

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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, 2008, and the related condensed consolidated statements of income for the three-month and nine-month periods ended September 30, 2008 and 2007 and cash flows for the nine-month periods ended September 30, 2008 and 2007. 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, 2007, 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, 2008, we expressed an unqualified opinion on those consolidated financial statements and included 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, 2007, 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 27, 2008

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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, 2007.

The Company

Genentech is a leading biotechnology company that discovers, develops, manufactures, and commercializes medicines for patients with 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.

Recent Major Developments

We primarily earn revenue and income and generate cash from product sales and royalty revenue. In the third quarter of 2008, our total operating revenue was $3,412 million, an increase of 17% from $2,908 million in the third quarter of 2007. Our net income for the third quarter of 2008 was $731 million, an increase of 7% from $685 million in the third quarter of 2007. In the first nine months of 2008, our total operating revenue was $9,711 million, an increase of 11% from $8,755 million in the first nine months of 2007. Our net income for the first nine months of 2008 was $2,495 million, an increase of 17% from $2,138 million in the first nine months of 2007.

We announced on July 21, 2008 that we received an unsolicited proposal from Roche to acquire all of the outstanding shares of our Common Stock not owned by Roche at a price of $89 in cash per share (the Roche Proposal) and on July 24, 2008 we announced that a special committee of our Board of Directors composed of our independent directors (the Special Committee) was formed to review, evaluate, and, in the Special Committee’s discretion, negotiate and recommend or not recommend the Roche Proposal. On August 13, 2008, we announced that the Special Committee unanimously concluded that the Roche Proposal substantially undervalues the company, but that the Special Committee would consider a proposal that recognizes the value of the company and reflects the significant benefits that would accrue to Roche as a result of full ownership.

On August 18, 2008, the Special Committee adopted two retention plans and two severance plans that together cover substantially all employees of the company, including our executive officers. The two retention plans are being implemented in lieu of our 2008 annual stock option grant, and the aggregate cost is currently estimated to be approximately $375 million payable in cash.

On October 2, 2008, we announced that we entered into a collaboration agreement with Roche and GlycArt in September for the joint development and commercialization of GA101, a humanized anti-CD20 monoclonal antibody for the potential treatment of hematological malignancies and other oncology-related B-cell disorders such as NHL. GA101 is currently in Phase I/II clinical trials for CD20-positive B-cell malignancies, such as NHL and chronic lymphocytic leukemia (CLL). On October 28, 2008, Biogen Idec exercised the right under our collaboration agreement with them to opt in to this agreement and paid us an upfront fee as part of the opt-in.

On October 2, 2008, we announced that we issued a Dear Healthcare Provider letter to inform potential prescribers of a case of progressive multifocal leukoencephalopathy (PML) in a 70-year-old patient who had received Raptiva for more than four years for treatment of chronic plaque psoriasis. The patient subsequently died. On October 16, 2008, revised prescribing information for Raptiva was approved by the FDA. A boxed warning was added that includes the recently reported case of PML and updated information on the risk of serious infections leading to hospitalizations and death in patients receiving Raptiva. The updated label also includes a warning about certain

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neurologic events as well as precautions regarding immunizations and pediatric use. A Dear Healthcare Provider letter was issued to communicate this updated prescribing information to healthcare professionals.

On October 5, 2008, we and OSI Pharmaceuticals, Inc. announced that a randomized Phase III study (BeTa Lung) evaluating Avastin in combination with Tarceva in patients with advanced non-small cell lung cancer (NSCLC) whose disease had progressed following platinum-based chemotherapy did not meet its primary endpoint of improving overall survival compared to Tarceva in combination with a placebo. However, there was clear evidence of clinical activity with improvements in the secondary endpoints of progression-free survival (PFS) and response rate when Avastin was added to Tarceva compared to Tarceva alone. No new or unexpected safety signals for either Avastin or Tarceva were observed in the study, and adverse events were consistent with those observed in previous NSCLC clinical trials evaluating the agents.

On October 6, 2008, we and Biogen Idec announced that a global Phase III study of Rituxan in combination with fludarabine and cyclophosphamide chemotherapy met its primary endpoint of improving PFS, as assessed by investigators, in patients with previously treated CD20-positive CLL compared to chemotherapy alone. There were no new or unexpected safety signals reported in the study. An independent review of the primary endpoint is being conducted for U.S. regulatory purposes. Earlier this year, Roche announced that another Phase III study of Rituxan, CLL-8, showed that a similar treatment combination improved PFS in patients with CLL who had not previously received treatment.

On October 19, 2008, we announced that the National Surgical Adjuvant Breast and Bowel Project (NSABP) informed us that an ongoing Phase III study (NSABP C-08) of Avastin plus chemotherapy in patients with early-stage colon cancer will continue as planned. The NSABP’s decision to continue the trial was based on a recommendation from an independent data monitoring committee after a planned interim analysis. We anticipate final results from NSABP C-08 in mid-2009.

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. In 2007, we announced an internal stretch goal to add a total of 30 molecules into development during the five-year period from the beginning of 2006 through the end of 2010.

Economic and Industry-wide 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 and biotechnology companies. The introduction of new competitive products or follow-on biologics, new information about existing products, and pricing and distribution 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. We monitor the competitive landscape and develop strategies in response to new information.

Our long-term business growth depends upon our ability to continue to successfully develop and commercialize important novel therapeutics to treat unmet medical needs. We recognize that the successful development of pharmaceutical products 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 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 product recalls or withdrawals.

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Our business model requires appropriate pricing and reimbursement for our products to offset the costs and risks of drug development. Some of the pricing and distribution of our products have received negative press coverage and public and governmental scrutiny. We will continue to meet with patient groups, payers, and other stakeholders in the healthcare system to understand their issues and concerns. The pricing and reimbursement environment for our products may change in the future and become more challenging due to, among other reasons, new policies of the next presidential administration or new healthcare legislation passed by Congress.

As the Medicare and Medicaid programs are the largest payers for our products, rules related to the programs’ 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. As a result of the Deficit Reduction Act of 2005, regulations became effective in the fourth quarter of 2007 that have affected and will continue to affect the reimbursement for our products paid by Medicare, Medicaid, and other public payers. We consider these rules as we plan our business and as we work to present our point of view to the legislators and payers.

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 loss of royalty payments (for example, royalty income associated with the Cabilly patent) from licensees, 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.

Manufacturing pharmaceutical products is difficult and complex, and requires facilities specifically designed and validated to run biotechnology production processes. Difficulties or delays in product manufacturing or in obtaining materials from our suppliers, or difficulties in accurately forecasting manufacturing capacity needs or complying with regulatory requirements, could negatively affect our business. Additionally, we have had, and may continue to have, an excess of available capacity, which could lead to idling of a portion of our manufacturing facilities, during which time we would incur unabsorbed or idle plant charges or other excess capacity charges, resulting in an increase in our COS. We use integrated demand management and manufacturing processes to optimize our production processes.

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, particularly in light of the Roche Proposal, 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.

During the months of September and October 2008, the financial markets experienced high volatility and significant price declines and the availability of credit decreased significantly, making it more difficult for businesses to access capital. Various macroeconomic factors impacted by the financial markets could affect our business and the results of our operations. Interest rates and the ability to access credit markets could affect the ability of our customers/distributors to purchase, pay for, and effectively distribute our products. Similarly, these macroeconomic factors could also affect the ability of our sole-source or single-source suppliers to remain in business or otherwise supply product; failure by any of them to remain a going concern could affect our ability to manufacture products. In addition, if inflation or other factors were to significantly increase our business costs, it may not be feasible to pass significant price increases on to our customers due to the process by which physicians are reimbursed for our products by the government.

Marketed Products

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

Avastin (bevacizumab) is an anti-VEGF (vascular endothelial growth factor) humanized antibody approved for use in combination with intravenous 5-fluorouracil-based chemotherapy as a treatment for patients with first- or second-

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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 NSCLC. On February 22, 2008, we received accelerated approval from the FDA to market Avastin in combination with paclitaxel chemotherapy for the treatment of patients who have not received prior chemotherapy for metastatic HER2-negative breast cancer (BC).

Rituxan (rituximab) is an anti-CD20 antibody that we commercialize with Biogen Idec. It is approved for first-line treatment of patients with follicular, CD20-positive, B-cell NHL 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 treatment of patients with relapsed or refractory, low-grade or follicular, CD20-positive, B-cell NHL, including retreatment and bulky diseases. Rituxan is indicated for first-line treatment of patients with diffuse large B-cell, CD20-positive NHL in combination with cyclophosphamide, doxorubicin, vincristine, and prednisone (CHOP) or other anthracycline-based chemotherapy. Rituxan is also indicated for use in combination with methotrexate to reduce signs and symptoms and slow the progression of structural damage in adult patients with moderate-to-severe rheumatoid arthritis (RA) who have had an inadequate response to one or more tumor necrosis factor (TNF) antagonist therapies.

Herceptin (trastuzumab) is a humanized anti-HER2 antibody approved for treatment of patients with node-positive or node-negative early-stage BC, whose tumors overexpress the HER2 protein, as part of an adjuvant treatment regimen containing 1) doxorubicin, cyclophosphamide, and either paclitaxel or docetaxel; 2) docetaxel and carboplatin and as a single agent following multi-modality anthracycline-based therapy. It is also approved for use as a first-line metastatic therapy in combination with paclitaxel and as a single agent in patients who have received one or more chemotherapy regimens for metastatic disease.

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

Xolair (omalizumab) is a humanized anti-IgE (immunoglobulin E) antibody that we commercialize with Novartis Pharma AG. 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, 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 NSCLC after failure of at least one prior chemotherapy regimen. It is also approved, in combination with gemcitabine chemotherapy, for the first-line treatment of patients with locally advanced, unresectable, or metastatic pancreatic cancer.

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

Activase (alteplase) 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.

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 I, approved for the treatment of cystic fibrosis.

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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 on sales of:

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

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

Ÿ	Nutropin products, Activase, and TNKase in Canada.

See Note 5, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for information regarding certain patent-related legal proceedings.

Available Information

The following information can be found on our website at www.gene.com, or can be obtained free of charge by contacting our Investor Relations Department at (650) 225-4150 or by sending an e-mail message to investor.relations@gene.com:

Ÿ	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 is reasonably practicable after such material is electronically filed with the U.S. Securities and Exchange Commission;

Ÿ	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

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

Critical Accounting Policies and the Use of Estimates

The accompanying discussion and analysis of our financial condition and results of operations are based on our Condensed Consolidated Financial Statements and the related disclosures, which have been prepared in accordance with U.S. 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 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 2008, because these policies require management to make significant estimates, assumptions, and judgments about matters that are inherently uncertain.

Loss Contingencies

We are currently, and have been, involved in certain legal proceedings, including licensing and contract disputes, stockholder lawsuits, and other matters. See Note 5, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on 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. If only a range of the

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probable loss can be reasonably estimated, we accrue a liability at the low end of that range. The nature of these matters is highly uncertain and subject to change; as a result, the amount of our liability for certain of these matters could exceed or be less than the amount of our current estimates, depending on the final outcome of these matters. An outcome of such matters that differs from our current estimates could have a material effect on our financial position or our results of operations in any one quarter.

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 seven 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 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.

Ÿ	Product returns 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.

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

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.

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

We believe that our estimates related to 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 and product returns allowances to be the only estimations that involve material amounts and require a higher degree of subjectivity and judgment to account for the obligations. As a result of the uncertainties involved in estimating rebate allowances and accruals and product returns allowances, there is a possibility 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). Direct rebates are accrued at the time of sale and recorded as allowances against trade accounts receivable; indirect rebates (including Medicaid) 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. These rebates are primarily estimated and evaluated using historical and other data, including patient usage, customer buying patterns, applicable contractual rebate rates, contract performance by the benefit providers, changes to Medicaid legislation and state rebate contracts, changes in the level of discounts, and significant changes in product sales trends. Although rebates are

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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 annual allowance amounts established. Based on our estimation, the changes in rebate allowances and accruals estimates related to prior years have not exceeded 3%. To further illustrate our sensitivity to changes in the rebate allowances and accruals process, a 10% change in our annualized rebate allowances and accruals provision experienced to date in 2008 (which is in excess of three times the level of variability that we reasonably expect to observe for rebates) would have an approximate $20 million unfavorable effect on our results (or approximately $0.01 per share). The total rebate allowances and accruals recorded in our Condensed Consolidated Balance Sheets were $82 million as of September 30, 2008 and $70 million as of December 31, 2007.

At the time of sale, we record product returns allowances based on our best estimate of the portion of sales that will be returned by our customers in the future. Product returns allowances are established in accordance with our returns policy, which allows buyers to return our products with two months or less remaining prior to product expiration and up to six months following product expiration. As part of the estimation process, we compare historical returns data to the related sales on a production lot basis. Historical rates of return are then determined by product and may be adjusted for known or expected changes in the marketplace. Actual annual product returns processed were less than 0.5% of gross product sales in all periods between 2005 and 2007, while annual provisions for expected future product returns were less than 1% of gross product sales in all such periods. Although product returns allowances are recorded at the time of sale, the majority of the returns are expected to occur within two years of sale. Therefore, our provisions for product returns allowances may include changes in the estimate for a prior period due to the lag time. However, to date such changes have not been material. For example, in 2007, changes in estimates related to prior years were approximately 0.3% of 2007 gross product sales. To illustrate our sensitivity to changes in the product returns allowances, if we were to experience an adjustment rate of 0.5% of 2007 gross product sales, which is nearly twice the level of annual variability that we have historically observed for product returns, that change in estimate would likely have an unfavorable effect of approximately $50 million (or approximately $0.03 per share) on our results of operations. We estimate that for the first nine months of 2008, our changes in estimates for product returns allowances related to prior years were approximately $25 million, or 0.4% of gross product sales, during this period. Product returns allowances recorded in our Condensed Consolidated Balance Sheets were $97 million as of September 30, 2008 and $60 million as of December 31, 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. Our Condensed Consolidated Balance Sheets reflect estimated product sales allowance reserves and accruals totaling $234 million as of September 30, 2008 and $176 million as of December 31, 2007.

Royalties

For substantially all of our agreements with licensees, we estimate royalty revenue and royalty receivables in the period that the royalties are earned, which is in advance of collection. Royalties from Roche, which are approximately 60% of our total royalty revenue, are reported using actual sales reports from Roche. Our royalty revenue and receivables from non-Roche licensees are determined primarily based on communication with some licensees, historical information, forecasted sales trends, and our assessment of collectibility. As all of these factors represent an estimation process, there is inherent uncertainty and variability in our recorded royalty revenue. Differences between actual royalty revenue and estimated royalty revenue are adjusted for in the period in which they become known, typically the following quarter. Since 2005, the changes in estimates for our royalty revenue related to prior periods arising from this estimation process has not exceeded 1% of total annual royalty revenue. However, on a quarterly basis, changes in estimates related to prior quarters have been higher than 1% of total royalty revenue for the respective quarter. For example, in the third quarter of 2008, royalty revenue benefited from approximately $25 million of changes in estimates related to the second quarter, which represents approximately 4% of royalty revenue for the third quarter of 2008. To further illustrate our sensitivity to the royalty estimation process, a 1% adjustment to total annual royalty revenue, which is at the upper end of the range of our historic experience, would result in an adjustment to total 2007 annual royalty revenue of approximately $25 million (or approximately $0.01 to $0.02 per share, net of any related royalty expenses).

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For cases in which the collectibility of a royalty amount is doubtful, royalty revenue is not recorded in advance of payment but is recognized as cash is received. In the case of a receivable related to previously recognized royalty revenue that is subsequently determined to be uncollectible, the receivable is reserved for by reversing the previously recorded royalty revenue in the period in which the circumstances that make collectibility doubtful are determined, and future royalties from the licensee are recognized on a cash basis until it is determined that collectibility is reasonably assured.

We have confidential licensing agreements with a number of companies under which we receive royalty revenue on sales of products that are covered by the Cabilly patent. The Cabilly patent, which expires in December 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 Patent Office has been performing a reexamination of the patent, and we are in the process of appealing the Patent Office’s decision. See also Note 5, “Contingencies,” in the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for more information on our Cabilly patent litigation and reexamination.

Cabilly patent royalties are generally due 60 days after the end of the quarter in which they are earned and recorded by us as royalty revenue. 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, 2008, our Condensed Consolidated Balance Sheet included Cabilly patent receivables totaling approximately $81 million and related COH payables totaling approximately $39 million.

Revenue Recognition—Avastin U.S. Product Sales and Patient Assistance Program

In February 2007, we launched the Avastin Patient Assistance Program, which is a voluntary program that enables eligible patients who have received 10,000 mg of Avastin in a 12-month period to receive free Avastin in excess of the 10,000 mg during the remainder of the 12-month period. Based on the current wholesale acquisition cost, the 10,000 mg 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 financial eligibility requirements 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 that is sold through normal commercial channels to reflect our estimate of the commitment to supply free Avastin to eligible patients who elect to enroll in the program.

In order to estimate the amount of free Avastin to be provided to patients under the Avastin Patient Assistance 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 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 adjust these estimates. The deferred revenue will be recognized when free Avastin vials are delivered. In the third quarter and first nine months of 2008, we deferred $1 million and $3 million, respectively, of Avastin product sales, resulting in a total deferred revenue liability in connection with the Avastin Patient Assistance Program of $5 million in our Condensed Consolidated Balance Sheet as of September 30, 2008. In the third quarter and first nine months of 2007, we recorded net decreases in deferred revenue, and corresponding net increases to product sales of $5 million and $2 million, respectively, of Avastin product sales in connection with the Avastin Patient Assistance Program. 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 increase the amount of revenue deferred.

Income Taxes

Our income tax provision is based on income before taxes and is computed using the liability method in accordance with FAS No. 109, “Accounting for Income Taxes.” 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

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effect for the year in which the differences are expected to reverse. Significant estimates are required in determining our provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations, 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; changes in our corporate structure; and changes in overall levels of income before taxes—all of which may result in periodic revisions to our effective income tax rate. For example, the effective income tax rate in the first nine months of 2008 was unfavorably affected by a $33 million settlement with the IRS for an item related to prior years. Uncertain tax positions are accounted for in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” We accrue tax-related interest and penalties related to uncertain tax positions, and include these items with income tax expense in the Condensed Consolidated Statements of Income.

Inventories

Inventories may include currently marketed products manufactured under a new process or at facilities awaiting regulatory licensure. These inventories are capitalized if in our judgment at the time of manufacture, there is a high probability of near-term regulatory licensure. Excess or idle capacity costs, resulting from utilization below a plant’s normal capacity, 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. For example, in the first nine months of 2008, we recognized charges of $83 million related to unexpected failed lots and delays in manufacturing start-up campaigns and excess capacity. The determination of obsolete inventory requires us to estimate the future demands for our products. In the case of inventories of products not yet approved, we determine whether to capitalize inventory based on the probability and expected date of regulatory approval of 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 salable.

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 determine the fair value of the assets as of the acquisition date, using valuation techniques such as discounted cash flow models. 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.

In the third quarter of 2008, we adjusted the purchase price allocation related to our 2007 acquisition of Tanox by recording a net increase to goodwill of $13 million, due to revised estimates of certain restructuring liabilities and deferred tax assets. We will continue to evaluate whether the fair value of any or all of our intangible assets have been impaired. If we determine that the fair value of an intangible asset has been impaired, we will record an impairment charge in that period. As of September 30, 2008, we did not believe that there was any impairment of the intangible assets related to the Tanox acquisition.

Employee Stock-Based Compensation

Under the provisions of 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

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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 RHI, there is limited historical information available to support our estimate of certain assumptions required to value our stock options. When establishing an estimate of the expected term of an award, we consider the vesting period for the award, our recent historical experience of employee stock option exercises (including forfeitures), the expected volatility, and a comparison to relevant peer group data. As required under GAAP, 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 Note 2, “Retention Plans and Employee Stock-Based Compensation,” in the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for more information.

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Results of Operations

(In millions, except per share amounts)

	Three Months Ended September 30,									Nine Months Ended September 30,
	2008			2007			% Change			2008			2007			% Change
Product sales	$	2,634		$	2,321			13	%	$	7,549		$	7,094			6	%
Royalties		687			524			31			1,932			1,427			35
Contract revenue		91			63			44			230			234			(2	)
Total operating revenue		3,412			2,908			17			9,711			8,755			11

Cost of sales		409			406			1			1,240			1,227			1
Research and development		777			615			26			2,043			1,828			12
Marketing, general and administrative		611			541			13			1,687			1,564			8
Collaboration profit sharing		315			276			14			907			805			13
Write-off of in-process research and development related to acquisition		–			77			–			–			77			–
Gain on acquisition		–			(121	)		–			–			(121	)		–
Recurring amortization charges related to redemption and acquisition		43			38			13			129			90			43
Special items: litigation-related		40			14			186			(260	)		41			(734	)
Total costs and expenses		2,195			1,846			19			5,746			5,511			4

Operating income		1,217			1,062			15			3,965			3,244			22

Other income (expense):
Interest and other income (expense), net		(33	)		84			(139	)		133			233			(43	)
Interest expense		(25	)		(18	)		39			(57	)		(53	)		8
Total other income (expense), net		(58	)		66			(188	)		76			180			(58	)

Income before taxes		1,159			1,128			3			4,041			3,424			18
Income tax provision		428			443			(3	)		1,546			1,286			20
Net income	$	731		$	685			7		$	2,495		$	2,138			17

Earnings per share:
Basic	$	0.69		$	0.65			6	%	$	2.37		$	2.03			17	%
Diluted	$	0.68		$	0.64			6		$	2.34		$	2.00			17

Cost of sales as a % of product sales		16	%		17	%					16	%		17	%
Research and development as a % of operating revenue		23			21						21			21
Marketing, general and administrative as a % of operating revenue		18			19						17			18

Pretax operating margin		36	%		37	%					41	%		37	%

Effective income tax rate		37	%		39	%					38	%		38	%

________________________

Percentages in this table and throughout the discussion and analysis of our financial condition and results of operations may reflect rounding adjustments.

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Total Operating Revenue

Total operating revenue increased 17% in the third quarter and 11% in the first nine months of 2008 from the comparable periods in 2007. These increases were primarily due to higher product sales and royalty revenue, and are discussed below.

Total Product Sales

(In millions)

	Three Months Ended September 30,							Nine Months Ended September 30,
	2008		2007		% Change			2008		2007		% Change
Net U.S. product sales
Avastin	$	704	$	597		18	%	$	1,954	$	1,694		15	%
Rituxan		655		572		15			1,911		1,689		13
Herceptin		368		320		15			1,046		960		9
Lucentis		225		198		14			639		618		3
Xolair		136		121		12			382		352		9
Tarceva		110		101		9			340		304		12
Nutropin products		95		93		2			269		278		(3	)
Thrombolytics		66		67		(1	)		200		202		(1	)
Pulmozyme