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Affymetrix Raking in the Chips

Investors in Affymetrix (Nasdaq: AFFX  ) had a great week. The life sciences research chip maker announced fourth-quarter revenues and profits that handily beat consensus expectations, and then gave an upbeat view of 2005.

Affymetrix's upside revenue surprise (its $107.7 million in revenue was 2.5% above guidance) or even its earnings outperformance ($0.41 per share -- almost 11% above the analyst consensus) led to a gleeful investor dogpile as the stock rose more than 14% the day after the announcement. It now trades at $41.50.

This isn't the first surge Affymetrix shareholders have enjoyed in the last few weeks. Shares jumped about 6% on January 5, the day management said revenues for the quarter would come in over $100 million. Because previous guidance was for $103 million to $105 million, all management was really saying then was that it promised not to fail expectations by too wide a margin. So Affymetrix has been rewarded twice: once for hinting at a good quarter, and again for actually having it. Why, exactly, are investors so jubilant?

Chock part of it up to relief. Affymetrix has proven tricky for analysts to predict. The day before management announced that revenue would come in over $100 million, Piper Jaffray said it expected the company to miss its top-line number. But it is hardly alone; Affymetrix has surprised the Street over and over again. About the one number you can count on Affymetrix not hitting is its consensus earnings estimate.

Yet this week's lovefest was driven by more than just relief. Gross margins came in at a robust 74%, and management expects to keep them around there through 2005. Sales grew healthily in every segment, and new product offerings this year should keep them climbing.

Indeed, if there is a worry on the horizon, it is instrument sales. Affymetrix makes the bulk of its money through lines of disposable GeneChip products and related reagents, but it also makes the machines used to read them. If GeneChips are razor blades, these instruments are the handles, but they still account for about a quarter of the company's revenue.

Right now, the company is in the thick of an upgrade cycle, having introduced its fourth-generation scanner in early 2003. It's looking to upgrade 60% to 75% of about 800 older-generation installed systems. Having shipped around 350 new GeneChip Scanner 3000 systems over the past two years (albeit not all to users of older systems), Affymetrix could see its upgrade cycle decelerate this year. Nevertheless, growth in sales of chips and their equipment, as well as instrument sales to new users, should easily pick up the slack.

This year, Affymetrix is looking to earn $1.12 per share on revenues of $405 million. For the first quarter -- traditionally a bit slow -- the company expects to see a brisk $90 million in revenues and 20 cents per share in earnings. After this week's surge, the company is valued at about 37 times forward earnings -- a pretty hefty multiple. But it's worth a look anyway when you consider that patents and its first-mover advantage in the field drove deep-pocketed players like Corning (NYSE: GLW  ) and Motorola (NYSE: MOT  ) out of the business several years ago. Now Affymetrix is building a moat so wide, the crocodiles won't be able to swim across it.

Affymetrix already owns the gene-expression analysis market, or RNA analysis, which is examining what genes are on or off at any given time in a cell, and is becoming increasingly dominant in genotyping, or DNA analysis, which is examining minute genetic differences among different populations. And this quarter, it sold its first GSP 3000DX instruments, used for diagnostic arrays. Right now, that product line is pretty much limited to a cytochrome p450 array from Roche Diagnostics, something used to pinpoint genetic variations that may cause some people to react poorly to various medicines. But this will be a huge potential market down the road, when increasingly targeted, or "personalized," drugs go hand in hand with diagnostics.

With a dominant market position and those kinds of growth prospects, Affymetrix may just be all that and a bag of chips.

If you are interested in other first movers and highfliers, check out ourRule Breakersnewsletter service.

Fool contributor Karl Thiel does not own shares of any company mentioned.

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