Fulgent Genetics, Inc. - Quarter Report: 2016 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2016

OR

For the transition period from                              to                             

Commission File Number: 001-37894

FULGENT GENETICS, INC.

(Exact Name of Registrant as Specified in its Charter)

(626) 350-0537

(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  ☐    No  ☒  

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of November 14, 2016, the registrant had 17,676,256 shares of common stock, $0.0001 par value per share, outstanding.

Table of Contents

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

FULGENT GENETICS, INC.

Condensed Consolidated Balance Sheets

(in thousands, except par value per share data)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FULGENT GENETICS, INC.

Condensed Consolidated Statements of Operations

(in thousands, except  per share data and as noted)

(unaudited)

*Basic and diluted income (loss) per common share was calculated prospectively from the date the Class D common units were issued in the October 2015 Recapitalization.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FULGENT GENETICS, INC.

Consolidated Statements of Stockholders’/ Members’ equity

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FULGENT GENETICS, INC.

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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FULGENT GENETICS, INC.

Notes to the Condensed Consolidated Financial Statements

(unaudited)

(in thousands, except per share and Reorganization ratio data)

Note 1. Overview and Basis of Presentation

Nature of the Business

Fulgent Genetics, Inc., together with its subsidiary (collectively referred to as the “Company,” unless otherwise noted or the context otherwise requires), is a rapidly growing technology company with an initial focus on offering comprehensive genetic testing to provide physicians with clinically actionable diagnostic information they can use to improve the overall quality of patient care. The Company has developed a proprietary technology platform that allows it to offer a broad and flexible test menu while maintaining accessible pricing, high accuracy and competitive turnaround times. The Company’s current test menu offers single-gene tests and pre-established, multi-gene, disease-specific panels that collectively test for many genetic conditions, including various cancers, cardiovascular diseases and neurological disorders. The Company’s existing customer base consists primarily of hospitals and medical institutions, which are frequent and high-volume users of genetic tests.

Background and Reorganization

The Company was incorporated in the State of Delaware on May 13, 2016. On August 2, 2016, pursuant to the approval of the board of directors of the Company, the Company changed its name from Fulgent Diagnostics, Inc. to Fulgent Genetics, Inc. Prior to the Reorganization, as defined and described below, the Company had no material assets and had not conducted any activities other than those incidental to its incorporation and preparation for the initial public offering of its common stock. Following the Reorganization, the Company is a holding company with no material assets other than 100% of the equity interests in Fulgent LLC, and Fulgent LLC is considered the Company’s predecessor for accounting purposes and its financial statements for all periods prior to completion of the Reorganization constitute the Company’s historical financial statements.  

On September 30, 2016, the Company completed a reorganization pursuant to which Fulgent Therapeutics LLC, a California limited liability company (referred to, together with its former subsidiary unless otherwise noted or the context otherwise requires, as “Fulgent LLC”), became a wholly owned subsidiary of the Company (the “Reorganization”). For purposes of these notes and the accompanying condensed consolidated financial statements: (i) Fulgent LLC’s operating agreement, as amended from time to time, is referred to as the “Operating Agreement;” (ii) Fulgent LLC’s equity holders are referred to as “members;” (iii) Fulgent LLC’s authorized, issued and outstanding equity interests prior to the Reorganization are referred to as “units” and consisted of Class D common units and Class D-1 and Class D-2 preferred units; (iv) certain of Fulgent LLC’s Class D common units outstanding prior to the Reorganization constituted profits interests, which are a type of equity award containing a participation threshold (which is sometimes referred to as a “profits interest threshold”) that entitled the recipient of the award to participate in the value of Fulgent LLC only to the extent it appreciated from and after the grant date of the award; and (v) prior to the Reorganization, Fulgent LLC was managed by its Manager, Ming Hsieh, who was also Fulgent LLC’s controlling equity holder. In the Reorganization, each outstanding 7.6 units of Fulgent LLC were cancelled in exchange for one share of the Company’s common stock, such that (i) all outstanding Class D common units of Fulgent LLC (including Class D common units that constitute profits interests) were cancelled in exchange for an aggregate of 4,060 shares of the Company’s common stock; (ii) all outstanding Class D-1 preferred units of Fulgent LLC were cancelled in exchange for an aggregate of 6,761 shares of the Company’s common stock; (iii) all outstanding Class D-2 preferred units were cancelled in exchange for an aggregate of 2,026 shares of the Company’s common stock; (iv) all outstanding options to acquire common units of Fulgent LLC were cancelled in exchange for equivalent options to acquire up to an aggregate of 591,112 shares of the Company’s common stock, and all such options became immediately exercisable to the extent vested; and (v) all outstanding restricted share units relating to common units of Fulgent LLC were cancelled in exchange for equivalent restricted stock units (“RSUs”) relating to 65,789 shares of the Company’s common stock. The Reorganization was accounted for as a common control transaction and no gain or loss was recorded.

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Initial Public Offering

On October 4, 2016, the Company completed the initial public offering of its common stock (the “IPO”), in which it issued and sold an aggregate of 4,830 shares of common stock (including 630 shares issued and sold on October 7, 2016 pursuant to the underwriters’ exercise in full of their option to purchase additional shares) at a public offering price of $9.00 per share. The Company received net proceeds of approximately $36,258, after deducting underwriting discounts and commissions of $3,043 and other offering expenses paid or payable by the Company of approximately $4,169. The shares issued and sold in the IPO were registered under the Securities Act of 1933, as amended, on a registration statement on Form S-1 (File No. 333- 213469), as amended (the “Registration Statement,” and the final prospectus dated September 28, 2016 included in the Registration Statement, the “Prospectus”).  The issuance of shares in the IPO occurred subsequent to September 30, 2016 and therefore is not reflected in the results of operations or financial position of the Company as set forth in these notes and the accompanying condensed consolidated financial statements.

Unaudited Interim Financial Information

The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its subsidiary. All intercompany accounts and transactions have been eliminated in consolidation. These interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These financial statements have been prepared on the same basis as the audited consolidated financial statements for the fiscal year ended December 31, 2015 and, in the opinion of management, include all adjustments, which are normal and recurring in nature, necessary for a fair presentation of the Company's financial position and results of operations. Operating results for interim periods are not necessarily indicative of the results that may be expected for a full fiscal year. The accompanying condensed consolidated balance sheet as of December 31, 2015 has been derived from the audited financial statements at that date but does not include all of the disclosures required by GAAP.  As such, the information included in this quarterly report on Form 10-Q should be read in conjunction with the Company’s audited consolidated financial statements included in the Company’s prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”), with the Securities and Exchange Commission on September 28, 2016 (the “Prospectus”).

Discontinued Operations

In April 2016, Fulgent LLC’s Operating Agreement was amended and restated to provide for the distribution of its wholly owned subsidiary, Fulgent Pharma LLC (“Fulgent Pharma”), in full redemption and cancellation of its former Class P preferred and common units (collectively, the “Class P units”). On April 4, 2016, the Company completed the split-off of Fulgent Pharma and the pharmaceutical business operated by Fulgent Pharma (the “Pharma business”) by redeeming all of the then-outstanding Class P units and distributing to each holder of Class P units substantially identical shares of Fulgent Pharma and causing Fulgent Pharma to assume all then-outstanding options to purchase Class P units. All Class P units were immediately cancelled upon redemption. The split-off of the Pharma business was a pro-rata distribution to all of the holders of Class P units, but did not involve the holders of Fulgent LLC’s Class D units. The Manager and controlling unitholder of Fulgent LLC prior to the Reorganization, Mr. Hsieh, is the Manager and controlling unitholder of Fulgent Pharma.  Therefore, Fulgent LLC concluded that the split-off transaction should be accounted for as a common control transaction and the recorded amount of Fulgent Pharma’s net assets was transferred to the holders of Class P units and no gain or loss was recorded.

The split-off of the Pharma business is presented as discontinued operations in the accompanying condensed consolidated financial statements for all periods presented. Significant asset and liability categories of the Pharma business are disclosed on the accompanying condensed consolidated balance sheet. Significant assets and liabilities of the discontinued operations consist of fixed assets and accounts payable.

The major components of statements of operations data comprising the income (loss) on discontinued operations are as follows:

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Note 2. Summary of Significant Accounting Policies

See the summary of the Company’s significant accounting policies set forth in the notes to its consolidated financial statements for the year ended December 31, 2015, which are included in the Prospectus. Except as described below, no such policies materially changed during the nine months ended September 30, 2016.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reported periods. These estimates, judgments and assumptions are based on historical data and experience available at the date of the accompanying condensed consolidated financial statements, as well as various other factors that management believes to be reasonable under the circumstances. Actual results could differ from these estimates.

Significant items subject to such estimates and assumptions include revenue recognition criteria, the fair value of equity-based awards, accounts receivable and allowances for doubtful accounts, the useful lives of fixed assets and estimates of tax liabilities.

Reporting Segment and Geographic Information

Reporting segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker in making decisions regarding resource allocation and assessing performance. The Company’s chief operating decision maker is its CEO. The Company views its operations and manages its business in one reporting segment.

Income Taxes

Income taxes are accounted for under the asset and liability method. The Company provides for federal, state and foreign income taxes currently payable, as well as for those deferred due to timing differences between reporting income and expenses for financial statement purposes versus tax purposes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in income tax rates is recognized as income or expense in the period that includes the enactment date.

The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, the Company does not recognize a tax benefit in the financial statements. The Company records interest and penalties related to uncertain tax positions, if applicable, as a component of income tax expense.

Prior to the Reorganization, Fulgent LLC was organized as a limited liability company and its members elected to have Fulgent LLC treated as a partnership for income tax purposes. All taxable income or loss and tax credits generally were reflected in the personal income tax returns of the Fulgent LLC’s members. Accordingly, no provision for federal and state income taxes was provided in the accompanying consolidated financial statements prior to the Reorganization. Pursuant to the Reorganization, the Company is a taxable entity. The change in tax status resulted in the recognition of a deferred tax asset in the amount of $86 and a deferred tax liability in the amount of $503 representing the initial temporary differences at the time of the change in status.  The most significant components of the deferred tax asset and liability were the result of differences in book and tax depreciation  and equity-based compensation.

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Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, which provides a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and will supersede most current revenue recognition guidance The FASB continues to address certain implementation issues and clarify certain core revenue recognition principles of ASU 2014-09. In July 2015, the FASB voted to delay the effective date of this standard such that ASU 2014-09, as amended, will be effective for the Company for annual and interim periods beginning after December 15, 2017. Early adoption of the standard is permitted for annual periods beginning after December 15, 2016. The guidance permits two implementation approaches, one requiring retrospective application of the new standard with restatement of prior years and one requiring prospective application of the new standard with disclosure of results under old standards. The Company is evaluating the effects of this standard on its financial position, results of operations and cash flows.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments, including a provision that requires equity investments (except for investments accounted for under the equity method of accounting) to be measured at fair value, with changes in fair value recognized in current earnings. ASU 2016-01 is effective for the Company in the first quarter of 2018, with early adoption permitted. The Company is currently evaluating the effect that ASU 2016-01 will have on its consolidated financial statements and related disclosures.

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The update is aimed at making leasing activities more transparent and comparable, and requires substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases currently accounted for as operating leases. This guidance will become effective for interim and annual reporting periods beginning with the year ending December 31, 2019. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements and related disclosures.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows. The standard clarifies the way certain cash receipts and cash payments are classified with the objective of reducing the existing diversity in practice. The standard is effective for fiscal years and interim periods beginning after December 15, 2017. Early adoption is permitted for all periods beginning after December 15, 2016. The Company is currently evaluating the impact of adopting this standard.

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Note 3. Income (Loss) per Share

The income (loss) per share for the periods ended September 30, 2016 were computed as if the Reorganization, including the exchange of 1 share of common stock for every 7.6 Fulgent LLC unit had occurred on January 1, 2016. Income (loss) per share prior to the October 2015 Recapitalization is not presented. The following table presents the calculation of basic and diluted income (loss) per share for the three and nine months ended September 30, 2016:

On April 4, 2016, Fulgent LLC completed the split-off of the Pharma business. The financial condition and results of the Pharma business are included in the accompanying condensed consolidated financial statements as discontinued operations for all periods presented, and the weighted -average Class P units related to the Pharma business were computed through the separation date of April 4, 2016.

The following securities have been excluded from the calculation of diluted income (loss) per share for all periods presented because their effect would have been anti-dilutive:

The anti-dilutive shares disclosed above were calculated using the treasury stock method. During the three and nine month periods ended September 30, 2016, the Company had common share options and restricted units that were excluded from the weighted average share calculation for continuing operations due to the Company’s net loss positions. During the nine month period ended September 30, 2016, the Company had Class P common unit options that were excluded from the weighted average share calculation for discontinued operations as the shares were determined to be anti-dilutive using the treasury method.

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Note 4. Fixed Assets

Major classes of fixed assets were as follows:

Depreciation expense on fixed assets totaled $304 and $171 in the three months ended September 30, 2016 and 2015, respectively. Depreciation expense on fixed assets totaled $750 and $385 in the nine months ended September 30, 2016 and 2015, respectively.

Note 5. Other Current Assets

Other current assets consisted of the following:

Reagents are used for DNA sequencing applications in the Company’s DNA sequencing equipment.

Note 6. Other Current Liabilities

The Company has accrued tax distributions of $1.3 million to the former LLC members as of September 30, 2016 based on the income tax liabilities of such former members attributable to Fulgent LLC’s 2016 net taxable income through the date of the Reorganization, as determined by the Manager in accordance with the Third Amended and Restated Operating Agreement for Fulgent LLC, and presented such in Other Current Liabilities on the accompanying condensed consolidated balance sheet.

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Note 7. Reporting Segment and Geographic Information

The Company views its operations and manages its business in one reporting segment. All long-lived assets are located in the United States.

Revenue by region was as follows:

Note 8. Major Customers and Accounts Receivable

The Company had a customer whose revenue individually represented 10% or more of the Company’s total revenue, or whose accounts receivable balance individually represented 10% or more of the Company’s total accounts receivable, as follows:

For the three months ended September 30, 2016 and 2015, one customer accounted for 23% and zero of revenue, respectively. For the nine months ended September 30, 2016 and 2015, the Company did not have a customer whose revenue individually represented 10% or more of the Company’s total revenue.

At September 30, 2016, one customer accounted for 26% of the Company’s total accounts receivable. At December 31, 2015, there were no customers that accounted for 10% or more of the Company’s total accounts receivable.

Note 9. Commitments and Contingencies

Operating Leases

The Company has commitments under non-cancelable operating leases of varying terms and duration for its headquarters located in Temple City, California, which is comprised of various corporate offices and a laboratory certified under the Clinical Laboratory Improvement Amendments of 1988 (“CLIA”), accredited by the College of American Pathologists (“CAP”) and licensed by the State of California Department of Public Health (“CA DPH”). Rent expense for the three months ended September 30, 2016 and 2015 was $55 and $47, respectively. Rent expense for the nine months ended September 30, 2016 and 2015 was $179 and $115, respectively.

Contingencies

From time to time, the Company may be subject to legal proceedings and claims arising in the ordinary course of business. Management does not believe that the outcome of any of these matters will have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

Note 10. Members’ / Stockholders' Equity

Reorganization

Upon completion of the Reorganization on September 30, 2016, all of Fulgent LLC’s outstanding units were cancelled in exchange for shares of the Company’s common stock, at a ratio of 7.6 units of Fulgent LLC cancelled for each one share of the Company’s common stock.

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The following is a summary of the units of Fulgent LLC that were cancelled in exchange for shares of the Company’s common stock:

The units set forth in the table above were cancelled in exchange for an aggregate of 12,846 shares of the Company’s common stock. The members’ equity balance of $72 million was reclassified into common stock and additional paid-in capital in the accompanying condensed consolidated balance sheet as of September 30, 2016.

Certificate of Incorporation

In accordance with the Company’s certificate of incorporation, the Company is authorized to issue 200,000 shares of common stock, with a par value of $0.0001 per share, and 1,000 shares of preferred stock, with a par value of $0.0001 per share. Holders of the Company’s common stock are entitled to one vote for each share held on all matters submitted to a vote of its stockholders. Holders of the Company’s common stock have no cumulative voting rights. Further, as of September 30, 2016, holders of the Company’s common stock have no preemptive, conversion, redemption or subscription rights and there are no sinking fund provisions applicable to the Company’s common stock. Upon liquidation, dissolution or winding-up of the Company, holders of the Company’s common stock are entitled to share ratably in all assets remaining after payment of all liabilities and the liquidation preferences of any outstanding shares of preferred stock. Subject to preferences that may be applicable to any outstanding shares of preferred stock, holders of the Company’s common stock are entitled to receive dividends, if any, as may be declared from time to time by the Company’s board of directors. As of September 30, 2016, there were no outstanding shares of preferred stock.

Distributions

The Company has accrued a tax distribution to Class D common and preferred unitholders as of September 30, 2016 in the amount of $1.3 million. The amount was based on income allocable to the LLC up to the Reorganization date.  In addition, in September 2016, the Company distributed $4.6 million to Mr. Hsieh in his capacity as a member of Fulgent LLC as a return of capital contribution.

Note 11. Equity-Based Compensation

Equity-based compensation expense to employees is measured based on the fair value of the awards on the grant date and recognized in the Company’s consolidated statements of operations over the period during which the employee is required to perform services in exchange for the award (generally the vesting period of the award). Compensation expense for awards with both a service and performance condition is recognized over the period required to achieve both conditions using the accelerated attribution method. The Company estimates the fair value of stock options using the Black-Scholes option valuation model. The Company measures the fair value of RSUs based on the fair value of the underlying shares on the date of grant. For awards of Fulgent LLC units subject to a profits interest threshold, the fair value is measured using the Black-Scholes option valuation model.

Prior to the Reorganization, the Company’s employees and other service providers were granted awards under the Fulgent Therapeutics LLC Amended and Restated 2015 Equity Incentive Plan (the “2015 Plan”), which provided for the issuance of equity-based awards to eligible employees, directors and consultants. These awards generally consisted of options, restricted share units and units subject to a profits interest threshold. Options granted under the 2015 Plan typically vested over four years and expired 10 years from the date of grant, and were not exercisable, whether or not vested, until the earlier of a liquidity event or incorporation, each as defined in the 2015 Plan. Because the options were subject to both a service condition (as set forth in their vesting schedules) and a performance condition (the occurrence of a qualifying liquidity event or incorporation), no equity-based compensation expense was recognized for these options until the performance condition was deemed to have been satisfied. Restricted share units granted under the 2015 Plan typically vested over four years. Awards of units subject to profits interest thresholds were typically fully vested at the date of grant.

In connection with the Reorganization, the Company approved its 2016 Omnibus Incentive Plan (the “2016 Plan”), which provides for the issuance of up to an aggregate of 2,038 shares of the Company’s common stock pursuant to awards granted to eligible

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employees, directors and consultants. Terms regarding vesting period and contractual life of the 2016 Plan have not significantly changed from the terms of the 2015 Plan. Additionally, at the effective time of the Reorganization:

The following table summarizes the Company’s equity-based compensation expense for the three and nine months ended September 30, 2016 in the accompanying condensed consolidated statements of operations:

Award Activity

Option Awards

The following table summarizes activity for options to acquire common shares in the nine months ended September 30, 2016:

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The number of shares subject to options and weighted average exercise price in the table above have been adjusted to show the effects of the Reorganization. The weighted-average grant date fair value of options to acquire common shares granted in the nine months ended September 30, 2016 was $6.98. As of September 30, 2016, the remaining unrecognized compensation expense of $2.0 million related to these options is expected to be recognized over a weighted-average period of 3.1 years.

Share and Restricted Stock Unit Awards

The following table shows grants of share awards and grants of restricted stock units during the nine months ended September 30, 2016:

The common shares issued in the nine months ended September 30, 2016 were related to one award granted to an employee in January 2016, and recorded based on the estimated fair value of common shares on the grant date which resulted in equity-based compensation expense of $1.6 million. These shares were granted outside of the Plan, were immediately vested and are not subject to a profits interest threshold. The restricted stock units issued in the nine months ended September 30, 2016 are recorded based on the fair value of common shares on the grant date which resulted in equity-based compensation expense of $770 to be recognized over four years. As of September 30, 2016, $27 has been recognized and the remaining unrecognized compensation expense of $743 related to these restricted stock units is expected to be recognized over a weighted-average period of 3.9 years.

Fair Value Assumptions

Option Awards to Employees

The following table sets forth weighted-average assumptions used to estimate the fair value of options to acquire common shares granted to employees during the nine months ended September 30, 2016:

These assumptions and estimates are as follows:

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Option Awards to Non-Employees

Equity-based compensation expense related to options granted to non-employees is recognized as the options are earned. The fair value of the options is more reliably measurable than the fair value of the services received.

The fair value of non-employee options is calculated at each reporting date, using the Black-Scholes option-pricing model, until the award vests or there is a substantial incentive for the non-employee not to perform the required services.

The following table sets forth the weighted-average assumptions used to estimate the fair value of options to acquire common shares granted to non-employees during the nine months ended September 30, 2016:

Note 12. Income Taxes

Income tax expense consists of federal and state income taxes. A deferred tax liability is recognized for all taxable temporary differences, and a deferred tax asset is recognized for all deductible temporary differences, operating losses and tax credit carryforwards.  A valuation allowance is provided when it is more likely than not that some portion or all of a deferred tax asset will not be realized. Upon completion of the Reorganization, the Company converted from a pass-through entity for tax purposes to a taxable entity. The change in tax status resulted in the recognition of a deferred tax asset of $86 and a deferred tax liability of $503 for the initial temporary differences between book and tax, primarily from depreciation and equity-based compensation at the time of the change in status.  No tax expense resulted as of the date of the Reorganization as it took place on the last day of quarter. Operational results attributed to that one day were deemed insignificant.

Note 13. Subsequent Events

Initial Public Offering

On October 4, 2016, the Company completed the IPO, in which it issued and sold an aggregate of 4,830 shares of common stock (including 630 shares issued and sold on October 7, 2016 pursuant to the underwriters’ exercise in full of their option to purchase additional shares) at a public offering price of $9.00 per share. The Company received net proceeds of approximately $36,258, after deducting underwriting discounts and commissions of $3,043 and other offering expenses paid or payable by the Company of approximately $4,169.

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

On September 30, 2016, Fulgent Therapeutics LLC became a wholly owned subsidiary of Fulgent Genetics, Inc. in a transaction we refer to as the “Reorganization”. As used in the following discussion and analysis and elsewhere in this report, unless the context otherwise requires, (i) the term “Fulgent LLC” refers to Fulgent Therapeutics LLC, (ii) the term “Fulgent Inc.” refers to Fulgent Genetics, Inc. and (iii) the terms “Fulgent,” the “company,” “we,” “us” and “our” refer, for periods prior to completion of the Reorganization, to Fulgent LLC and, for periods after completion of the Reorganization, to Fulgent Inc. and its consolidated subsidiary after giving effect to the Reorganization. Following the Reorganization, Fulgent Inc. is a holding company with no material assets other than 100% of the equity interests in its subsidiary, including Fulgent LLC, and Fulgent LLC is considered Fulgent Inc.’s predecessor for accounting purposes and its financial statements for all periods prior to completion of the Reorganization constitute Fulgent Inc.’s historical financial statements.

The following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and related notes included in this report. Additionally, pursuant to Instruction 2 to paragraph (b) of Item 303 of Regulation S-K promulgated by the Securities and Exchange Commission, or the SEC, in preparing this discussion and analysis, we presume that readers have access to and have read the discussion and analysis of our financial condition and results of operations included in our registration statement on Form S-1 (File No. 333-213469), as amended, and the final prospectus dated September 28, 2016 included therein, or the Prospectus.

Forward Looking Statements

The statements in this discussion and analysis regarding expectations of our future performance, liquidity and capital resources and all other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, among others, the risks and uncertainties described in “Risk Factors” in this report. Our actual results could differ materially from the results described in or implied by the forward-looking statements contained in this discussion and analysis.

The following discussion and analysis and other sections of this report contain forward-looking statements covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements other than historical facts and often address matters such as, for instance, our future financial and operating performance, future cash flows and liquidity, our strategies for growth and anticipated trends in our business and industry. These forward-looking statements are based on the beliefs and assumptions of our management, based on information currently available and expectations that we believe are reasonable. However, these statements are only predictions and are subject to known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those expressed or implied by the forward-looking statements. These risks, uncertainties, and other factors include, among others, those discussed under “Risk Factors” in this report and in the Prospectus. Given these risks, uncertainties and other important factors, undue reliance should not be placed on these forward-looking statements. These forward-looking statements represent our estimates and assumptions only as of the date made, and we undertake no duty to update any of these forward-looking statements to conform to actual results or revised expectations except as otherwise required by law.

Overview

We are a rapidly growing technology company with an initial focus on offering comprehensive genetic testing to provide physicians with clinically actionable diagnostic information they can use to improve the overall quality of patient care. We have developed a proprietary technology platform that integrates sophisticated data comparison and suppression algorithms, adaptive learning software, advanced genetic diagnostics tools and integrated laboratory processes. This platform allows us to offer a broad and flexible test menu and continually expand and improve our proprietary genetic reference library, while maintaining accessible pricing, high accuracy and competitive turnaround times. We believe our test menu offers more genes for testing than our competitors in today’s market, which enables us to provide expansive options for test customization and clinically actionable results. Our current test menu includes more than 18,000 single-gene tests and approximately 250 pre-established, multi-gene, disease-specific panels that collectively test for more than 7,500 genetic conditions, including various cancers, cardiovascular diseases, neurological disorders and pediatric tests.

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We have generated growing demand for our tests with relatively little marketing efforts to date, which we believe demonstrates the advantages of our offering compared to other available testing alternatives. We offer tests at competitive prices, averaging approximately $1,440 per billable test delivered in the nine months ended September 30, 2016, and at a lower cost to us than many of our competitors, totaling approximately $560 per billable test delivered in the nine months ended September 30, 2016. Our volume has grown rapidly since our commercial launch, with over 15,000 billable tests delivered to over 600 total customers as of September 30, 2016. We delivered 3,419 and 8,628 billable tests in the three and nine months ended September 30, 2016, respectively, compared to 2,052 and 4,814 billable tests delivered in the three and nine months ended September 30, 2015, respectively. We recorded revenue of $5 million and $12.4 million and a net loss of $1 million and $6.2 million in the three and nine months ended September 30, 2016, respectively.

Factors Affecting Our Performance

Market and Industry Trends

Genetic testing has experienced significant growth in recent years. As this trend continues, we believe genetic testing will become a more accepted part of standard medical care and the knowledge of a person’s unique genetic makeup will begin to play a more important role in the practice of medicine. The advent of next generation sequencing, or NGS, technology, a relatively new genetic testing technique that enables millions of DNA fragments to be sequenced in parallel, has dramatically lowered the cost and improved the quality of genetic testing, contributing to increased adoption generally and increased volumes for our tests. According to GrandView Research, the size of the global NGS genetic testing market, which includes pre-sequencing, sequencing and data analysis, is estimated to be approximately $4.0 billion in 2016, including approximately $1.4 billion in the United States, and is expected to reach approximately $10.5 billion by 2022, including approximately $3.6 billion in the United States.

While adoption of genetic testing has increased in recent years, we believe widespread utilization has been limited in large part because of certain barriers to adoption that exist in today’s market. Among these barriers are that genetic testing can be prohibitively expensive, only a limited number of genetic tests are currently reimbursable, certain genetic conditions cannot be diagnosed due to the limited scope of genetic analysis, genetic testing can be an inefficient process and the interpretation of genetic results can be cumbersome and time-consuming. We believe a significant market exists for a genetic testing option that provides broad genetic coverage and the flexibility to customize tests for individual patient needs, while maintaining accuracy and affordability, and we believe that the proprietary technology platform that we have developed will enable us to overcome many of these challenges facing our industry today.

Number of Billable Tests Delivered

Our performance is closely correlated with the number of tests for which we bill our customers, which we refer to as billable tests. The number of billable tests we deliver in a period depends on a number of factors, including the other factors affecting our performance discussed in this discussion and analysis. We believe the number of billable tests delivered in any period is an important indicator of the performance of our business. We have experienced compound quarterly growth of 20% in the number of billable tests delivered from the first quarter of 2015 through the third quarter of 2016.

Mix of Customers

Our existing customer base consists primarily of hospitals and medical institutions, which are frequent and high-volume users of genetic tests. We are focused on more deeply penetrating our relationships with existing customers to increase the volume of tests they order. In addition, we are seeking to grow our customer base by continuing to acquire new hospital and medical institution customers and expand into additional customer groups, such as individual physicians and other practitioners, as well as research institutions.

To this end, in 2016 to date, we have made efforts to diversify our customer base beyond hospitals by establishing a vendor code with a national clinical laboratory that orders our tests to fulfill some of the genetic testing orders it receives from certain U.S. government agencies, contracting with a regional hospital network within the U.S. Army to provide genetic tests for members and their families, and contracting with a healthcare services provider in the prenatal sector to provide proprietary carrier screening tests that we developed for this service provider. We have also pursued relationships with payors, including Medicare, some state Medicaid programs and third-party payors, in order to obtain coverage and reimbursement for our tests to make them accessible to more individual physicians. Other than our relationship with the hospital network within the U.S. Army, which involves a minimum commitment of approximately $400,000 of our tests annually over a three-year period, none of these relationships obligate any party to order our tests at any agreed volume or frequency, or at all. However, we believe our ability to establish these types of relationships and relationships with other new customers and achieve increased sales to existing customers are significant indicators of the potential for growth of our business.

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We believe the key to further penetrating our existing customer base and expanding into new customer markets is to continue to focus on delivering a superior test menu while maintaining affordable prices. In order to offer our customers affordable price points, we continue to enhance our technology platform to develop tests that we can perform at a low internal cost. In addition, we believe an increased focus on sales and marketing will facilitate customer growth. To that end, we plan to invest in our sales and marketing function in the near-term, with the goal of more than doubling the size of our sales and marketing team in the next 12 months.

Ability to Maintain Our Broad and Flexible Test Menu

We believe the number of genes that we incorporate into our test menu provides a meaningful competitive advantage. We believe the breadth of genes in our portfolio allows us to provide more comprehensive genetic information and improves our variant detection rate, which can increase the clinical actionability of the data we produce. The breadth of genes in our portfolio also allows us to provide a flexible and customizable test menu for our customers. We believe that our ability to continue to offer more genes than our competitors could be a key contributor to the rate of growth of our business.

Ability to Maintain Low Costs

We have developed various proprietary technologies that improve our laboratory efficiency and reduce the costs we incur to perform our tests, including our proprietary gene probes, data algorithms, adaptive learning software and genetic reference library. This technology platform enables us to perform each test and deliver its results at a lower cost to us than many of our competitors, totaling approximately $560 per billable test delivered in the nine months ended September 30, 2016. This low cost per billable test allows us to maintain affordable pricing for our customers, averaging approximately $1,440 per billable test delivered in the nine months ended September 30, 2016, which we believe encourages repeat ordering from existing customers and attracts new customers. We believe this low internal cost is a key contributor to our ability to grow our business and drive profitability.

Expansion into New Markets

We intend to continue to expand our test menu to include more options and to cover more genes. For example, we intend to expand our offering of oncology, cardiology, pediatrics and prenatal test panels, which represent large genetic testing markets in which we believe our comprehensive and flexible tests will be competitive. For instance, we recently launched a new chromosomal test called CNV+ that is designed to use NGS technology to detect copy number variants with similar or improved results as compared to microarray-based genomic tests. In addition, we expect to offer somatic testing for certain cancers in the near future. We also believe there is a large potential for growth of genetic testing in many international markets due to the presence of high unmet diagnostic and predictive testing needs, rapidly rising healthcare expenditures and patient awareness of next generation sequencing technologies. We plan to engage distributors or establish other types of arrangements, such as joint ventures, in an effort to expand our presence and test volume in new geographic markets. To this end, we are working with Xi Long USA, Inc., or Xi Long, a stockholder of our company, to form a joint venture in China in which we expect to be a minority partner. Although the terms of this relationship have not yet been finalized and the joint venture has not yet been formed, we anticipate that this joint venture, if it proceeds, could afford us long-term opportunities to further address the genetic testing market in Asia. We believe expanding our test menu and our geographic presence will appeal to a broader base of potential customers and increase our revenue potential.

Success Obtaining Reimbursement

In today’s market, third-party payors generally restrict the reimbursement of genetic testing to a limited subset of genetic tests and only for those patients that meet specific criteria. This lack of widespread favorable reimbursement policies has presented a challenge for genetic testing companies in building sustainable business models. As part of our strategy for growth, we intend to pursue coverage and reimbursement from third-party payors at a level adequate for us to achieve profitability with this payor group. To this end, in 2016 to date, we have contracted with a regional physician services organization and a national health insurance company to become an in-network provider and enrolled as a supplier with Medicare and approximately ten  state Medicaid programs which means that we have agreed with these payors to provide certain of our tests at negotiated rates. Although this does not guarantee that we will receive reimbursement for our tests from these or any other payors at adequate levels, we believe our low cost per billable test will enhance our ability to compete effectively in the third-party payor market and our flexibility in establishing additional relationships with third-party payors. Our level of success in obtaining and maintaining adequate coverage and reimbursement from third-party payors for our testing services will, we believe, be a key factor in the rate of growth of our business over the long term.

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Equity-Based Compensation

Our predecessor, Fulgent LLC granted an award of fully vested equity to our Chief Financial Officer, Paul Kim, upon his appointment in January 2016. The equity-based compensation expense associated with this award was $1.6 million recorded in full in the period in which the award was granted. As a result, there was a substantial increase in operating expenses in the quarter ended March 31, 2016. We do not intend to make additional awards of fully vested equity and, as a result, we do not expect that we will experience similar levels of stock-based compensation expense in future periods. Equity-based compensation is expected to be recorded over the requisite service period from the grant of restricted stock units as described in the 2016 Omnibus Incentive Plan.

During 2016, Fulgent LLC issued options that were not exercisable, whether or not vested, until the earlier of a liquidity event or an incorporation of Fulgent LLC, each as defined in Fulgent LLC’s equity incentive plan under which the awards were granted. An incorporation was deemed to have occurred upon completion of the Reorganization on September 30, 2016, at which time the options became immediately exercisable, to the extent vested. As a result, no expense was recorded for these options prior to their exercisability, and an expense of $1.1 million was recorded for the completion of service related to these options as of the completion of the Reorganization on September 30, 2016. Generally, we record stock-based compensation expense for option awards over the requisite service period. The Company currently does not have any awards subject to performance conditions as of September 30, 2016.

During 2016, Fulgent LLC granted awards of units that constituted profits interests, which are a type of equity award containing a participation threshold (which we sometimes refer to as a “profits interest threshold”) that entitled the recipient of the award to participate in the value of Fulgent LLC only to the extent it appreciated from and after the grant date of the award. Pursuant to the determination of the Manager of Fulgent LLC, the participation thresholds applicable to units that constituted profits interests (i) were ignored and not applied in calculating the number of shares of our common stock that were issued in exchange for such units in the Reorganization, and (ii) did not carry over to such shares of our common stock. As a result, the holders of Fulgent LLC’s units that constituted profits interests received shares of our common stock in the Reorganization at the same ratio as the holders of Fulgent LLC’s units that were not subject to such profits interest thresholds. Ignoring all profits interest thresholds upon the modification of the units that constituted profits interests into shares of our common stock resulted in a stock-based compensation expense of $1.4 million that we recorded in the period of the Reorganization.

Xi Long Financing

In May 2016, Fulgent LLC completed a transaction with Xi Long and certain members of Fulgent LLC. In this transaction, (i) Xi Long acquired 4,618,421 Class D-1 preferred units and 5,644,737 Class D common units from certain existing members of Fulgent LLC for an aggregate purchase price of approximately $12.0 million, which units were required to be redeemed by Fulgent LLC in exchange for its issuance to Xi Long of an equivalent number of Class D-2 preferred units, and (ii) Fulgent LLC sold an additional 5,131,579 Class D-2 preferred units to Xi Long for gross proceeds of approximately $15.2 million. Fulgent LLC incurred issuance costs of $185,000 for the transaction, resulting in net proceeds to Fulgent LLC of approximately $15.0 million. As a result of the transaction, Xi Long acquired an aggregate of 15,394,737 Class D-2 preferred units for an aggregate purchase price of approximately $27.2 million, even though, at issuance, the fair value of 15,394,737 Class D-2 preferred units as evidenced by Fulgent LLC’s then most recent third-party valuation was approximately $32.6 million. The $5.5 million difference between the fair value of, and the aggregate consideration paid by Xi Long for, the Class D-2 preferred units issued in the transaction was not attributable to any stated rights or privileges. Rather Fulgent LLC, Xi Long and the members of Fulgent LLC that were party to the transaction determined to complete the transaction in line with their discussions, notwithstanding that the fair value of the Class D-2 preferred units as evidenced by Fulgent LLC’s third-party valuation had increased from the time these discussions were initiated to the time the transaction was completed. The $5.5 million difference was determined to be a cost of completing the transaction with Xi Long and was recorded as an expense in the nine months ended September 30, 2016 in the accompanying condensed consolidated statement of operations which contributed to our net loss for the period.

Business Risks and Uncertainties

Our business and prospects are exposed to numerous risks and uncertainties. For more information, see “Risk Factors” in Part II, Item 1A of this report.

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Discontinued Operations

Prior to April 4, 2016, Fulgent LLC conducted the following two lines of business: our existing business as described in this report, which Fulgent LLC conducted directly; and our former pharmaceutical business, or the Pharma Business, which was conducted through Fulgent LLC’s former subsidiary, Fulgent Pharma LLC, or Fulgent Pharma. Prior to April 4, 2016, all of Fulgent LLC’s authorized, issued and outstanding equity interests were separated into two series based on these two lines of business, such that holders of Fulgent LLC’s Class D-1 preferred units and Class D voting and non-voting common units had economic rights based on the assets, income, earnings and profits and any liabilities, expenses, costs and charges of our existing business, and holders of Fulgent LLC’s Class P preferred units and Class P voting and non-voting common units had economic rights based on the assets, income, earnings and profits and any liabilities, expenses, costs and charges of the Pharma Business. On April 4, 2016, Fulgent LLC separated the Pharma Business from our existing business in a transaction we refer to as the “Pharma Split-Off.” To effect the Pharma Split-Off, Fulgent LLC redeemed each member’s Class P preferred and common units, distributed to each such member substantially identical units of Fulgent Pharma and caused Fulgent Pharma to assume all then-outstanding options to acquire Class P common units.

The operating results of the Pharma Business have been reported as discontinued operations for all periods presented in the consolidated financial data included in this report. In the three months ended September 30, 2016 and 2015, we recorded an income (loss) from discontinued operations of zero and $(821,000), respectively. In the nine months ended September 30, 2016 and 2015, we recorded an income (loss) from discontinued operations of $41,000 and $(2.1) million, respectively.

Reorganization

On September 30, 2016, our predecessor Fulgent LLC became our wholly owned subsidiary upon completion of the Reorganization.

Prior to the Reorganization, among other things:

Upon completion of the Reorganization, among other things:

After completion of the Reorganization, we continue to exist as a holding company, with no material assets other than 100% of the equity interests of Fulgent LLC. In addition, we consolidate the financial results of Fulgent LLC, and the historical financial statements of Fulgent LLC are our historical financial statements.

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Financial Overview

Revenue

We generate revenue from sales of our genetic tests. We recognize revenue upon delivery of a report to the ordering physician based on the established billing rate less contractual and other adjustments to arrive at the amount that we expect to collect. We generally bill directly to a hospital, medical institution or research institution customer or to a patient, a third-party payor or a combination of the patient and third-party payor.

Cost of Revenue

Cost of revenue reflects the aggregate costs incurred in delivering test results and consists of: personnel costs, including salaries, employee benefit costs, bonuses and equity-based compensation expenses; costs of laboratory supplies; depreciation of laboratory equipment; amortization of leasehold improvements and allocated overhead, including rent and utilities. Costs associated with performing tests are recorded as tests are processed. We expect cost of revenue to generally increase as we increase the number of tests we deliver.

Operating Expenses

Our operating expenses are classified into the following three categories: research and development; selling and marketing; and general and administrative. For each category, the largest component is personnel costs, which include salaries, employee benefit costs, bonuses and equity-based compensation expenses.

Research and Development Expenses

Research and development expenses represent costs incurred to develop our technology and future tests. These costs consist of personnel costs, laboratory supplies, consulting costs and allocated overhead, including rent and utilities. We expense all research and development costs in the periods in which they are incurred. We expect our research and development expenses will increase in absolute dollars in future periods as we continue to invest in research and development.

Selling and Marketing Expenses

Selling and marketing expenses consist of personnel costs, customer service expenses, direct marketing expenses, educational and promotional expenses, market research and analysis and allocated overhead, including rent and utilities. We expense all selling and marketing costs as incurred. We expect our selling and marketing costs will continue to increase in absolute dollars, primarily driven by our efforts to expand our sales and marketing team, increase our presence within and outside the United States and expand our brand awareness and customer base through targeted marketing initiatives.

General and Administrative Expenses

General and administrative expenses include executive, finance and accounting, legal and human resources functions. These expenses consist of personnel costs, audit and legal expenses, consulting costs and allocated overhead, including rent and utilities. We expense all general and administrative expenses as incurred. We expect our general and administrative expenses will increase as we scale our operations. We also expect to incur additional general and administrative expenses as a result of our initial public offering and operating as a public company, including expenses related to compliance with the rules and regulations of the Securities and Exchange Commission and the NASDAQ Stock Market, additional insurance expenses, investor relations activities and other administration and professional services.

Provision for (Benefit from) Income Taxes

Provision for income taxes consists of U.S. federal and state income taxes. To date, we have no significant U.S. federal and state income taxes because of the status of our predecessor, Fulgent LLC, as a pass through entity for tax purposes prior to September 30, 2016.

We record a valuation allowance when it is more likely than not that some portion or all of a deferred tax asset will not be realized. In making such a determination, we consider all the available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, and ongoing prudent and feasible tax planning strategies, to assess the amount of the valuation allowance. When we establish or reduce the valuation allowance against the deferred tax assets, our provision for income taxes will increase or decrease, respectively, in the period in which such a determination is made.

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Results of Operations

Comparison of Three Months Ended September 30, 2015 and 2016

The following table summarizes the results of our continuing operations for each of the periods indicated:

* Percentage not meaningful.

Revenue

Revenue increased $2.1 million, or 72%, from the three months ended September 30, 2015 to the three months ended September 30, 2016, primarily due to the increased number of billable tests delivered. The number of billable tests delivered increased from 2,052 in the three months ended September 30, 2015 to 3,419 in the same period in 2016. The increase in the number of billable tests delivered that positively impacted our revenue between periods was primarily attributable to the expansion of our test menu, including single-gene tests and multi-gene panels, and an increase in sales to our existing customers, combined with growth in the genetic testing market and increased physician awareness and acceptance of genetic tests. The average price of the billable tests we delivered remained relatively consistent between periods, but increased slightly from $1,420 in the three months ended September 30, 2015 to $1,470 in the three months ended September 30, 2016, largely due to our ability to offer more complex and customized tests. Revenue from non-U.S. and Canadian customers accounted for 38% and 19% of total revenue in the three months ended September 30, 2016 and 2015, respectively.

Cost of Revenue

Cost of revenue increased $1.2 million, or 133%, from the three months ended September 30, 2015 to the three months ended September 30, 2016. The increase was primarily due to increases of $586,000 in equity-based compensation,  $251,000 in personnel costs related to increased headcount, $237,000 in reagents and supplies expenses, and $99,000 in depreciation. Our gross profit increased $881,000 between periods, primarily due to increased revenue, and our cost of revenue as a percent of revenue, or gross margin, decreased from 68% to 57% between periods, primarily due to the effects of equity-based compensation expense.

Research and Development

Research and development expenses increased $1.2 million, or 390%, from the three months ended September 30, 2015 to the three months ended September 30, 2016, primarily due to increases of $959,000 in equity-based compensation expense, $97,000 in reagents and supplies expenses, $77,000 in personnel costs related to increased headcount.

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Selling and Marketing

Selling and marketing expenses increased $613,000, or 219%, from the three months ended September 30, 2015 to the three months ended September 30, 2016, primarily due to increases of $396,000 in equity-based compensation expense, $95,000 in consulting fees and $45,000 in travel expenses.

General and Administrative

General and administrative expenses increased $931,000, or 431%, from the three months ended September 30, 2015 to the three months ended September 30, 2016, primarily due to increases of $552,000  in equity-based compensation expense, $209,000  in accounting fees and $178,000 in personnel costs related to increased headcount.

Provision for Income Taxes

Provision for income taxes increased $417,000 from the three months ended September 30, 2015 to the three months ended September 30, 2016, primarily due to the conversion of the Company from a pass- through entity to a taxable entity. Prior to the Reorganization, Fulgent LLC was organized as a limited liability company and its members elected to have Fulgent LLC treated as a partnership for income tax purposes. All taxable income or loss and tax credits generally were reflected in the personal income tax returns of the Fulgent LLC’s members. Accordingly, no provision for federal and state income taxes was provided in the accompanying consolidated financial statements prior to the Reorganization. Pursuant to the Reorganization, the Company is a taxable entity. The change in tax status resulted in the recognition of a deferred tax asset in the amount of $86,000 and a deferred tax liability in the amount of $503,000 representing the initial temporary differences at the time of the change in status.  The most significant components of the deferred tax asset and liability were the result of differences in book and tax depreciation and equity-based compensation.

Comparison of Nine Months Ended September 30, 2015 and 2016

The following table summarizes the results of our continuing operations for each of the periods indicated:

* Percentage not meaningful.

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Revenue

Revenue increased $5.7 million, or 86%, from the nine months ended September 30, 2015 to the nine months ended September 30, 2016, primarily due to the increased number of billable tests delivered. The number of billable tests delivered increased from 4,814 in the nine months ended September 30, 2015 to 8,628 in the same period in 2016. The increase in the number of billable tests delivered that positively impacted our revenue was primarily attributable to the expansion of our test menu, including single-gene tests and multi-gene panels, and an increase in sales to our existing customers, combined with growth in the genetic testing market and increased physician awareness and acceptance of genetic tests. The average price of the billable tests we delivered remained relatively consistent between periods, but increased slightly from $1,400 in the nine months ended September 30, 2015  to $1,440 in the nine months ended September 30, 2016. Revenue from non-U.S. and Canadian customers accounted for 28% and 15% of total revenue in the nine months ended September 30, 2016 and 2015, respectively.

Cost of Revenue

Cost of revenue increased $2.5 million, or 107%, from the nine months ended September 30, 2015 to the nine months ended September 30, 2016. The increase was primarily due to increases of $777,000 in reagents and supplies expenses, $709,000 in personnel costs related to increased headcount, $586,000 in equity-based compensation, and $430,000 of facility and depreciation costs. Our gross profit increased $3.2 million between periods, primarily due to increased revenue, and our gross margin decreased from 65% to 61% between periods, primarily due to the effects of equity-based compensation expense.

Research and Development

Research and development expenses increased $2.0 million, or 250%, from the nine months ended September 30, 2015 to the nine months ended September 30, 2016, primarily due to increases of $959,000 increase equity-based compensation expense, $525,000 in personnel costs related to increased headcount, and $267,000 in reagents and supplies expenses.

Selling and Marketing

Selling and marketing expenses increased $914,000, or 121%, from the nine months ended September 30, 2015 to the nine months ended September 30, 2016, primarily due to increases of $396,000 in equity-compensation expense, $143,000 in travel expenses, $125,000 in personnel costs related to increased headcount, and $97,000 in consulting fees.

General and Administrative

General and administrative expenses increased $3 million, or 658%, from the nine months ended September 30, 2015 to the nine months ended September 30, 2016, primarily due to increases of $2.2 million in equity-based compensation expense, a $399,000 in personnel costs related to increased headcount and $384,000  in accounting fees.

Interest and Other Income (Expense)

Interest and other income (expense) was $(5.4) million for the nine months ended September 30, 2016, compared to income of $20,000 for the nine months ended September 30, 2015. The expense in the 2016 period related to the difference between the fair value and the effective issuance price of the Class D-2 preferred units we issued in the Xi Long financing in May 2016, which was determined to be a cost of completing the transaction with Xi Long and was recorded as an expense in the accompanying condensed consolidated statement of operations. Interest income was not significant in either the nine months ended September 30, 2016 or 2015.

Provision for Income Taxes

Provision for income taxes increased $417,000 from the nine months ended September 30, 2015 to the nine months ended September 30, 2016, primarily due to the conversion of the Company from a pass through entity to a taxable entity. Prior to the Reorganization, Fulgent LLC was organized as a limited liability company and its members elected to have Fulgent LLC treated as a partnership for income tax purposes. All taxable income or loss and tax credits generally were reflected in the personal income tax returns of the Fulgent LLC’s members. Accordingly, no provision for federal and state income taxes was provided in the accompanying consolidated financial statements prior to the Reorganization. Pursuant to the Reorganization, the Company is a taxable entity. The change in tax status resulted in the recognition of a deferred tax asset in the amount of $86,000 and a deferred tax liability in the amount of $503,000 representing the initial temporary differences at the time of the change in status.  The most significant components of the deferred tax asset and deferred tax liability were the result of differences in book and tax depreciation and equity-based compensation.

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Liquidity and Capital Resources

Liquidity and Sources of Cash

As of September 30, 2016 and December 31, 2015, we had $8.2 million and $0.5 million of cash, respectively.

Since inception, our operations have been financed primarily by our founder, Ming Hsieh, and, in recent periods, by cash from our operations and equity financings. In May 2016, we closed the Xi Long financing for net proceeds to us of approximately $15.0 million, and in October 2016, we closed the initial public offering of our common stock, in which we issued an aggregate of 4,830,000 shares of our common stock and received net proceeds of approximately $36.3 million, after deducting underwriting discounts and commissions and offering expenses paid or payable by us.

Our primary uses of cash are to fund our operations as we continue to grow and invest in our business. Cash used to fund operating expenses is impacted by the timing of our payment of expenses, as reflected in the changes in our outstanding accounts payable and accrued expenses. In addition, in September 2016, we distributed $4.6 million to Mr. Hsieh in his capacity as a member of Fulgent LLC as a return of capital contribution, and in the fourth quarter of 2016, we expect to pay approximately $1.3 million in tax distributions to the former members of Fulgent LLC based on the income tax liabilities of such former members attributable to Fulgent LLC’s 2016 net taxable income through the date of the Reorganization.

We believe that our existing cash, along with cash from our operations and proceeds from offering, will be sufficient to meet our anticipated cash requirements for at least the next 12 months. Much of the losses we incurred during the nine months ended September 30, 2016 are attributable to non-cash charges for equity-based compensation expense, as well as for other expense associated with the difference between the fair value and the effective issuance price of the units we issued to Xi Long in May 2016. Thus, in spite of the losses we recorded, cash provided by continuing operations has been positive since 2015 and has significantly contributed to our ability to meet our liquidity needs, including our ability to pay capital expenditures. Additionally, if our business continues to grow as we anticipate and we are able to achieve increased efficiencies and economies of scale in line with this growth, we expect that increased revenue will increase our ability to rely on cash from our operations to support our business in future periods, even if our expenses also increase as a result of the growth of our business. As a result, we anticipate that cash from our operations will play a meaningful role in our ability to meet our liquidity requirements and pursue our business plan and strategies in the next 12 months and in the longer term.

However, our expectations regarding the cash to be provided by our operations and our cash needs in future periods could be wrong, in which case we may require additional financing to support our operations, as we do not presently have any commitments for future capital. Further, even if our liquidity expectations are correct, we may seek to raise additional capital through securities offerings, credit facilities or other debt financings, asset sales or collaborations or licensing arrangements. Additional funding may not be available to us when needed, on acceptable terms or at all. If we raise funds by issuing equity securities, our existing stockholders could experience substantial dilution. Additionally, any preferred equity securities we issue could provide for rights, preferences or privileges senior to those of our common stock and our issuance of any additional equity securities, or the possibility of such an issuance, could cause the market price of our common stock to decline. The terms of debt securities issued or borrowings, if available, could impose significant restrictions on our operations, such as limitations on our ability to incur additional debt or issue additional equity, limitations on our ability to acquire or license intellectual property rights and other operating restrictions that could adversely affect our ability to conduct our business, and would result in increased fixed payment obligations. In the event that we seek to sell assets or enter into collaborations or licensing arrangements to raise capital, we may be required to accept unfavorable terms or relinquish or license to a third party our rights to important or valuable technologies or tests we may otherwise seek to develop ourselves. Moreover, we may incur substantial costs in pursuing future capital, including investment banking, legal and accounting fees, printing and distribution expenses and other costs. If we are not able to secure additional funding when needed and on reasonable terms, we may be forced to delay, reduce the scope of or eliminate one or more sales and marketing initiatives, research and development programs or other growth plans or strategies. In addition, we may be forced to work with a partner on one or more aspects of our tests or market development programs or initiatives, which could lower the economic value of these tests, programs or initiatives to our company. Any such outcome could significantly harm our business, performance and prospects.

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Cash Flows

Continuing Operations

The following table summarizes cash flows from continuing operations for each of the periods indicated:

Operating Activities

Cash provided by operating activities in the nine months ended September 30, 2016 was $3.2 million. The difference between net loss and cash provided by operating activities for the period was primarily due to the effect of a $5.5 million of non-cash charge associated with the difference between the fair value and the effective issuance price of the units we issued to Xi Long, which was recorded as other expense, and the effect of $4 million of non-cash equity-based compensation charges. Cash provided by operating activities increased between periods primarily due to a $1.3 million increase in accounts payable and accrued liabilities, which resulted from increased revenue and purchases, offset by the negative effect of $2.3 million increase in accounts receivable from increased revenue. Cash provided by operating activities in the nine months ended September 30, 2015 was $1.6 million. The difference between net loss and cash provided by operating activities for the period was primarily due to $2.4 million of income from continuing operations, a $0.4 million increase in accounts payable, which resulted from increased revenue and purchases, offset by the negative effect of $1.3 million increase in accounts receivable from increased revenue.

Investing Activities

Cash used in investing activities in the nine months ended September 30, 2016 was $3.4 million, which was primarily related to purchases of fixed assets consisting mainly of medical laboratory equipment, computer hardware, software and leasehold improvements. Cash used in investing activities in the nine months ended September 30, 2015 was $1.8 million, which was primarily related to purchases of fixed assets consisting mainly of computer hardware and medical laboratory equipment.

Discontinued Operations

The following table summarizes cash flows from discontinued operations for each of the periods indicated:

Financing Activities

Cash provided by financing activities in the nine months ended September 30, 2016 was $7.9 million, compared to cash provided by financing activities in the nine months ended September 30, 2015 of $3.5 million. All cash provided by financing activities in the nine months ended September 30, 2015 represents capital contributions received from Mr. Hsieh, and all cash provided by financing activities in the nine months ended September 30, 2016 represents net proceeds of approximately $15.0 million received from the issuance of Class D-2 preferred units to Xi Long, partially offset by $4.6 million return of capital contribution to Mr. Hsieh and $2.3 million of costs related to our initial public offering completed in October 2016.

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Critical Accounting Policies and Use of Estimates

The preparation of financial statements in accordance with generally accepted accounting principles in the United States of America, or U.S. GAAP, requires us to make a variety of decisions which affect reported amounts and related disclosures, including the selection of appropriate accounting principles and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgment based on our understanding and analysis of the relevant circumstances, including our historical experience and other assumptions. Actual results could differ from our estimates. We are committed to incorporating accounting principles, assumptions and estimates that promote the representational faithfulness, verifiability, neutrality and transparency of the accounting information included in the financial statements.

There have been no significant changes in the critical accounting policies and estimates as previously described in our Prospectus.

Recent Accounting Pronouncements

The Jumpstart Our Business Startups Act of 2012, or the JOBS Act, permits an “emerging growth company” such as us to take advantage of an extended transition period for complying with new or revised accounting standards applicable to public companies. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period and, as a result, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. See Note 2 to the condensed consolidated financial statements included in this report for a description of recent accounting pronouncements of new or revised accounting standards.

Off-Balance Sheet Arrangements

We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the Securities and Exchange Commission, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Contractual Obligations and Other Commitments

There were no material changes in our commitments under contractual obligations, as disclosed in the Company’s audited consolidated financial statements for the year ended December 31, 2015.

Our principal commitments consist of obligations under our operating leases for office space.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

We are exposed to various market risks in the ordinary course of our business. We had cash of $8.2 million as of September 30, 2016, which consists of bank deposits. Such interest-bearing instruments carry a degree of risk; however, we have not been exposed to, nor do we anticipate being exposed to, material risks due to changes in interest rates. A hypothetical 10% change in interest rates during any of the periods presented in this report would not have had a material impact on our financial results.

Revenue from sales outside of the United States represented 49% of our revenue in the nine months ended September 30, 2016. Currently, our revenue-producing transactions are primarily denominated in U.S. dollars; however, as we continue to expand internationally, our results of operations and cash flows may increasingly become subject to fluctuations due to changes in foreign currency exchange rates. In periods when the U.S. dollar declines in value as compared to foreign currencies in which we incur expenses, our foreign-currency based expenses will increase when translated into U.S. dollars. In addition, future fluctuations in the value of the U.S. dollar may affect the price at which we sell our tests outside the United States. To date, our foreign currency risk has been minimal and we have not historically hedged our foreign currency risk, although we may consider doing so in the future.

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Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended, or Exchange Act, our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2016. Disclosure controls and procedures are controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, or the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of September 30, 2016, our Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2016, our disclosure controls and procedures were effective.

Management recognizes that any controls and procedures, no matter how well-designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Changes in Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting during the quarter ended September 30, 2016, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II—OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may be involved in legal proceedings arising in the ordinary course of our business. We are not presently a party, and our properties are not currently subject, to any legal proceedings that, in the opinion of management, would have a material adverse effect on our business. Regardless of outcome, litigation can have an adverse impact on us due to defense and settlement costs, diversion of management resources, negative publicity and reputational harm, among other factors.

Item 1A. Risk Factors.

Investing in our common stock involves a high degree of risk. Before making any investment decision with respect to our common stock, you should carefully consider the risks described below and all of the other information included in this report and the other filings we make with the SEC. We believe the risks and uncertainties described below are the most significant we face. The occurrence of any of these risks could harm our business, financial condition, results of operations, prospects and reputation and could cause the trading price of our common stock to decline. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business.

Business and Strategy Risks

Our industry is subject to rapidly changing technology and new and increasing amounts of scientific data, and if we fail to keep pace with these technological advances, we may be unable to compete effectively and our business and prospects could suffer.

In recent years, there have been numerous advances in the analysis of large amounts of genomic information and the role of genetics and gene variants in disease diagnosis and treatment. Our industry has been, and we believe will continue to be, characterized by rapid technological change, increasing amounts of data, frequent introductions of new genetic tests and evolving industry standards, all of which could make our tests obsolete if we are not able to enhance our technologies and tests faster and better than our competitors to maintain our competitive advantage. Our future success will depend on our ability to keep pace with the evolving needs of our customers in a timely and cost-effective manner and to pursue new market opportunities that develop as a result of technological and scientific advances. If we are not able to keep pace with technological advances and increased customer expectations that develop as a result of these advances, we may be unable to sustain or grow our business and our future operations and prospects could suffer.

We are an early-stage company with a limited operating history, which may expose us to enhanced risks and increase the difficulty of evaluating our business and prospects.

We began operations in May 2012 and commercially launched our first genetic tests in 2013. As a result, we have only a limited operating history upon which you can evaluate our business and prospects. Our revenue growth may not continue or increase, we may not achieve profitability and, if we achieve profitability, we may not be able to sustain it. Our limited operating history makes it difficult to evaluate our current business and inhibits our ability to forecast our future operating results, including revenue, cash flows and movement toward profitability. For example, our gross profit during the last three months of 2015 was less than our gross profit in the preceding and subsequent four months. Our limited operating history makes it difficult to determine if these fluctuations reflect seasonality in our performance or are the result of other events. We have encountered and will continue to encounter risks and uncertainties frequently experienced by growing companies in the life sciences and technology industries, such as risks related to an evolving and unpredictable industry and business model, management of growth and other uncertainties described in this report. If our assumptions regarding these risks and uncertainties are incorrect or these risks and uncertainties change due to changes in our markets, or if we do not address these risks successfully, our operating and financial results could differ materially from our expectations and our business could suffer.

We have a history of losses, and we may never be able to achieve or sustain profitability.

We have a history of losses. For the year ended December 31, 2015 and the nine months ended September 30, 2016, we recorded a loss from continuing operations of $5.0 million and $6.2 million, respectively. To date, we have generated limited revenue, and we may never achieve revenue sufficient to offset our expenses and achieve or sustain profitability. In addition, we may continue to incur losses in the future, particularly as we focus on growing our business and operations and experience expected increases in expenses related to this growth. Our prior losses and any future losses have had and will continue to have an adverse effect on our stockholders’ equity and working capital. Our failure to achieve and sustain profitability in the future would negatively affect our business, financial condition, results of operations and cash flows, and could cause the market price of our common stock to decline.

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If we are not able to grow our customer base and increase demand for our tests from existing and new customers, our commercial success would be limited.

To achieve our anticipated revenue growth, we must increase test volume by further penetrating our existing hospital and medical institution customers. In addition, we must grow our customer base beyond hospitals and medical institutions and into additional customer groups, such as individual physicians, other practitioners and research institutions. For example, in 2016 to date, we have made efforts to diversify our customer base by establishing a vendor code with a national clinical laboratory that orders our tests to fulfill some of the genetic testing orders it receives from certain U.S. government agencies, contracting with a regional hospital network within the U.S. Army to provide genetic tests for members and their families, and contracting with a healthcare services provider in the prenatal sector to provide proprietary carrier screening tests that we developed for this service provider. We have also pursued relationships with payors, including Medicare, some state Medicaid programs and third-party payors, in order to obtain coverage and reimbursement for our tests to make them accessible to more individual physicians. Establishing these relationships means that we have agreed with the applicable payor, laboratory or other customer to provide certain of our tests at negotiated rates, but, except for our relationship with the hospital network within the U.S. Army, which involves a minimum commitment of approximately $400,000 of our tests annually over a three-year period, none of these relationships obligate any party to order our tests at any agreed volume or frequency, or at all. As a result, these relationships, or any similar relationships we may establish in the future, may not amount to meaningful increases in our customer base, the number of billable tests we deliver or our total revenue, or improve our ability to achieve profitability. We may not succeed in facilitating the clinical acceptance and adoption of our tests needed to achieve the increased volumes and customer growth we expect. Because detailed genetic data from tests such as ours have only recently become available at relatively affordable prices, the pace and degree of market acceptance and adoption of these tests is uncertain.

We may fail to expand our customer base and grow our volume of tests delivered for a variety of reasons, including, among others: