# ** **

# **UNITED STATES**

# **SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

# **FORM 10-Q**

# ** **

| **ý**                                                                                                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                  |                                                                                          |
| **For The  Quarterly Period Ended June 30, 2003**                                                                                |
|                                                                                                                                  |                                                                                          |
| **o**                                                                                                                                 | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                  |                                                                                          |
| **For The Transition Period  From        To        ** |

 

**Commission File No. 000-30981**

 

**GENAISSANCEPHARMACEUTICALS, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

 

| **Delaware**                                                     |   | **06-1338846**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **Five  Science Park, New Haven, Connecticut   06511**      |
| (Address of  principal executive office and zip code)            |
|                                                             |
| **(203)  773-1450**                                              |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by check markwhether the registrant:  (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days:

 

| Yes ý |   | No o |
|------------|--------|------|

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in rule 12b-2 of theExchange Act):

 

| Yes o |   | No ý |
|-------|--------|-----------|

 

The number of shares ofthe registrant’s outstanding common stock as of August 1, 2003 was  23,041,167 shares.

 

 

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**GENAISSANCEPHARMACEUTICALS, INC.**

 

For the quarter ended June 30, 2003

 

**Index**

 
| **PART I – FINANCIAL  INFORMATION**                                                                   |
|------------------------------------------------------------------------------------------------------------|
|                                                                                                       |
| Item 1 – Financial  statements (unaudited)                                                            |
|                                                                                                       |
| Balance Sheets as of June 30, 2003  and December 31, 2002                                        |
|                                                                                                       |
| Statements  of Operations for the three and six months ended June 30, 2003 and 2002                   |
|                                                                                                       |
| Statements  of Cash Flows for the six months ended June 30, 2003 and 2002                             |
|                                                                                                       |
| Notes to the  Unaudited Financial Statements                                                               |
|                                                                                                       |
| Item  2 – Management’s Discussion and Analysis of Financial Condition and Results  of Operations |
|                                                                                                       |
| Item  3 – Quantitative and Qualitative Disclosures about Market Risk                                  |
|                                                                                                       |
| Item 4 – Controls and  Procedures                                                                     |
|                                                                                                       |
| **PART II – OTHER INFORMATION**                                                                       |
|                                                                                                       |
| Item  2 – Changes in Securities and Use of Proceeds                                                   |
|                                                                                                       |
| Item  4 – Submission of Matters to a Vote of Security Holders                                         |
|                                                                                                       |
| Item 6 –  Exhibits and Reports on Form 8-K                                                            |
|                                                                                                       |
| Signature                                                                                                  |

 

----

 

**PART I – Financial Information**

** **

**Item 1 – Financial Statements****.**

**GENAISSANCEPHARMACEUTICALS, INC.**

Balance Sheets

(Unaudited)

(In thousands,except per share data)

 
|                                                                                                                                                                        |   | **June 30,  2003** |       | **December 31,  2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                        |   |                    | ** ** |                        | ** ** |
| **ASSETS**                                                                                                                                                                  |   |                    | ** ** |                        | ** ** |
| Current Assets:                                                                                                                                                             |   |                    |       |                        |       |
| Cash  and cash equivalents                                                                                                                                                  |   | $                       | 7,811      |                        | $          | 16,578 |   |
| Restricted  cash                                                                                                                                                            |   | 2,100                   |       | 2,100                       |       |
| Marketable  securities                                                                                                                                                      |   | 13,412                  |       | 15,472                      |       |
| Accounts  receivable                                                                                                                                                        |   | 1,271                   |       | 448                         |       |
| Taxes  receivable                                                                                                                                                           |   | 608                     |       | —                      |       |
| Other  current assets                                                                                                                                                       |   | 489                     |       | 407                         |       |
| Total  current assets                                                                                                                                                       |   | 25,691                  |       | 35,005                      |       |
|                                                                                                                                                                        |   |                    |       |                        |       |
| Property  and equipment, net                                                                                                                                                |   | 11,892                  |       | 14,554                      |       |
| Intangible  assets, net                                                                                                                                                     |   | 899                     |       | —                      |       |
| Other  assets                                                                                                                                                               |   | 1,086                   |       | 1,163                       |       |
|                                                                                                                                                                        |   |                    |       |                        |       |
| Total  assets                                                                                                                                                               |   | $                       | 39,568     |                        | $          | 50,722 |   |
|                                                                                                                                                                        |   |                    | ** ** |                        | ** ** |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                              |   |                    | ** ** |                        | ** ** |
| Current  Liabilities:                                                                                                                                                       |   |                    |       |                        |       |
| Current  portion of long-term debt due to a shareholder                                                                                                                     |   | $                       | 411        |                        | $          | 397 |   |
| Current  portion of capital lease obligations                                                                                                                               |   | 7,748                   |       | 11,187                      |       |
| Accounts  payable                                                                                                                                                           |   | 1,482                   |       | 838                         |       |
| Accrued  expenses                                                                                                                                                           |   | 2,396                   |       | 2,037                       |       |
| Accrued  dividends                                                                                                                                                          |   | 1,159                   |       | 1,159                       |       |
| Current  portion of deferred revenue                                                                                                                                        |   | 2,491                   |       | 3,026                       |       |
| Total  current liabilities                                                                                                                                                  |   | 15,687                  |       | 18,644                      |       |
|                                                                                                                                                                        |   |                    |       |                        |       |
| Long-Term  Liabilities:                                                                                                                                                     |   |                    |       |                        |       |
| Long-term  debt due to a shareholder, less current portion                                                                                                                  |   | 4,325                   |       | 4,501                       |       |
| Deferred  revenue, less current portion                                                                                                                                     |   | 1,619                   |       | 1,722                       |       |
| Total  long-term liabilities                                                                                                                                                |   | 5,944                   |       | 6,223                       |       |
|                                                                                                                                                                        |   |                    |       |                        |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                 |   |                    |       |                        |       |
| Common  stock, 58,000 authorized shares, $.001 par value, 23,041 and 22,847 shares  issued and outstanding at June 30, 2003, and December 31, 2002,  respectively |   | 23                      |       | 23                          |       |
| Additional  paid-in capital                                                                                                                                                 |   | 220,030                 |       | 219,413                     |       |
| Accumulated  deficit                                                                                                                                                        |   | (202,114                | )          | (193,602                    | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                              |   | (2                      | )          | 21                          |       |
| Total  stockholders’ equity                                                                                                                                            |   | 17,937                  |       | 25,855                      |       |
|                                                                                                                                                                        |   |                    |       |                        |       |
| Total  liabilities and stockholders’ equity                                                                                                                            |   | $                       | 39,568     |                        | $          | 50,722 |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

 

1

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Statements of Operations

(Unaudited)

(In thousands,except per share data)

 
|                                                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|---------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                                |   | **2003**                               |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| License and service revenue                                         |   | $                                      | 3,113  |                                 | $      | 1,933 |   | $ | 5,252 |   | $ | 3,784 |   |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Operating expenses:                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Research and development                                            |   | 5,056                                  |   | 6,630                                |   | 9,795 |   | 14,912 |   |
| General and administrative                                          |   | 2,062                                  |   | 2,556                                |   | 4,121 |   | 5,013 |   |
| Impairment of fixed assets                                          |   | —                                 |   | 6,000                                |   | — |   | 6,000 |   |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Total operating expenses                                            |   | 7,118                                  |   | 15,186                               |   | 13,916 |   | 25,925 |   |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Loss from operations                                                |   | (4,005                                 | )      | (13,253                              | )      | (8,664 | ) | (22,141 | ) |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Interest income                                                     |   | 90                                     |   | 285                                  |   | 224 |   | 639 |   |
| Interest expense                                                    |   | (191                                   | )      | (495                                 | )      | (392 | ) | (1,022 | ) |
| Income tax benefit                                                  |   | 320                                    |   | —                               |   | 320 |   | — |   |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Net loss attributable to common  stockholders                       |   | $                                      | (3,786 | )                                    | $      | (13,463 | ) | $ | (8,512 | ) | $ | (22,524 | ) |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Net loss per common share, basic  and diluted                       |   | $                                      | (.17   | )                                    | $      | (.59 | ) | $ | (.37 | ) | $ | (.99 | ) |
|                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Weighted average shares used in computing net loss per common share |   | 22,900                                 |   | 22,793                               |   | 22,883 |   | 22,790 |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

 

2

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**GENAISSANCE PHARMACEUTICALS, INC.**

 

Statements of Cash Flows

(Unaudited)

(In thousands)

 
|                                                                                                            |   | **Six Months Ended  June 30,** |       |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|------------|
|                                                                                                            |   | **2003**                            |       | **2002** | ** ** |
|                                                                                                            |   |                                | ** ** |   | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                                       |   |                                | ** ** |   | ** ** |
| Net loss                                                                                                        |   | $                                   | (8,512     | ) | $ | (22,524 | ) |
| Adjustment to reconcile net loss to net cash used in  operating activities, net of acquisition of DNA Sciences: |   |                                |       |   |   |
| Depreciation and amortization                                                                                   |   | 3,562                               |       | 4,590 |   |
| Impairment of fixed assets                                                                                      |   | —                              |       | 6,000 |   |
| Stock based compensation                                                                                        |   | 117                                 |       | 207 |   |
| Changes in assets and liabilities -                                                                             |   |                                |       |   |   |
| Accounts receivable                                                                                             |   | (35                                 | )          | 188 |   |
| Taxes receivable                                                                                                |   | (608                                | )          | — |   |
| Other current assets                                                                                            |   | (47                                 | )          | 770 |   |
| Other assets                                                                                                    |   | 16                                  |       | 19 |   |
| Accounts payable                                                                                                |   | 644                                 |       | (1,427 | ) |
| Accrued expenses                                                                                                |   | 402                                 |       | (1,518 | ) |
| Deferred revenue                                                                                                |   | (638                                | )          | (8 | ) |
| Net cash used in operating activities                                                                           |   | (5,099                              | )          | (13,703 | ) |
|                                                                                                            |   |                                |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                       |   |                                |       |   |   |
| Acquisition of DNA Sciences                                                                                     |   | (1,668                              | )          | — |   |
| Purchases of property and equipment                                                                             |   | (530                                | )          | (70 | ) |
| Investments in marketable securities                                                                            |   | (13,299                             | )          | — |   |
| Proceeds from sale of marketable  securities                                                                    |   | 15,336                              |       | 17,876 |   |
| Net cash (used in) provided by investing  activities                                                            |   | (161                                | )          | 17,806 |   |
|                                                                                                            |   |                                |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                       |   |                                | ** ** |   | ** ** |
| Net proceeds from issuance of  common stock                                                                     |   | 94                                  |       | 38 |   |
| Repayment of long-term debt due to  related parties, net                                                        |   | (162                                | )          | (414 | ) |
| Repayment of long-term debt, net                                                                                |   | —                              |       | (45 | ) |
| Repayment of capital lease  obligations                                                                         |   | (3,439                              | )          | (3,232 | ) |
| Net cash used in financing activities                                                                           |   | (3,507                              | )          | (3,653 | ) |
|                                                                                                            |   |                                |       |   |   |
| NET (DECREASE) INCREASE IN CASH AND  CASH EQUIVALENTS                                                           |   | (8,767                              | )          | 450 |   |
|                                                                                                            |   |                                |       |   |   |
| CASH AND CASH EQUIVALENTS,  beginning of period                                                                 |   | 16,578                              |       | 25,204 |   |
|                                                                                                            |   |                                |       |   |   |
| CASH AND CASH EQUIVALENTS, end of  period                                                                       |   | $                                   | 7,811      |   | $ | 25,654 |   |
|                                                                                                            |   |                                |       |   |   |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:**                                                             |   |                                | ** ** |   | ** ** |
| Interest paid                                                                                                   |   | 191                                 |       | 526 |   |
| Issuance of restricted shares                                                                                   |   | 296                                 |       | — |   |
| Issuance of stock and warrants in  connection with the acquisition of DNA Sciences                              |   | 110                                 |       | — |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

 

3

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**GENAISSANCE PHARMACEUTICALS, INC**.

 

# **Notes to Unaudited FinancialStatements**

For the QuarterEnded June 30, 2003

 

**(1)****                     BASISOF PRESENTATION**

 

Genaissance Pharmaceuticals, Inc. is seeking to createpersonalized medicines through the integration of pharmacogenomics into drugdevelopment and marketing. The Company discovers inherited differences, orgenomic markers, that exist in human genes. The Company uses its technologicalcapabilities and methods as well as its clinical genetic development skills toidentify the genomic markers that appear to define a patient population thatresponds best to a medication and has a superior safety profile.  The Company markets its technology and itspredictive genomic markers to the pharmaceutical and biotechnology industriesas a means to improve the development, marketing and prescribing of drugs.  Additionally, the Company provides GLPcompliant DNA banking and research and GLP compliant genotyping and relatedservices to a variety of companies.

 

The Company has prepared the accompanying financialstatements without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to such rules and regulations. Thesefinancial statements should be read in conjunction with the Company’s auditedfinancial statements and related footnotes for the year ended December 31,2002, included in our Annual Report on Form 10-K (File No. 000-30981).  The unaudited financial statements include,in the opinion of management, all adjustments (consisting only of normalrecurring adjustments) necessary to present fairly our financial position as ofJune 30, 2003, and the results of our operations for the three and sixmonth periods ended June 30, 2003 and 2002. The results of operations forsuch interim periods are not necessarily indicative of the results to beachieved for the full year.

 

**(2)****                    ****ACQUISITION OF DNA SCIENCES**

 

On May 15, 2003, under order of the United StatesBankruptcy Court, the Company acquired certain assets and liabilities of DNA Sciences, Inc. for $1,778,000 inclusive ofrelated fees and expenses.  Included inthe fees and expenses is $74,700 which represents the fair value of warrantsexercisable for up to an aggregate of 75,000 shares of the Company’s commonstock at an exercise price of $2 per share issued in connection with investmentbanking services performed, as well as $35,000 which represents the fair valueof 25,000 shares issued by the Company to a licensor in connection with alicense modification of a license acquired in connection with theacquisition.  The primary assetsacquired consisted of a good laboratory practices (GLP) compliant and ClinicalLaboratory Improvement Amendments (CLIA) licensed genotyping services businessand licenses and patent estates surrounding Long QT Syndrome and a thiopurineS-methyltransferase (TPMT) diagnostic test, as well as certain trade accountsreceivable and fixed assets.

 

The acquisition has been accounted for using thepurchase method of accounting and, accordingly, the purchase price has beenallocated to the assets purchased and liabilities assumed based upon theestimated fair values on the date of acquisition.  The fair value of the assets received was greater than thepurchase price and,****therefore, thefair value of the long-lived assets was reduced, on a pro-rata basis, by theexcess.  After consideration of suchreduction, we have included in the accompanying June 30, 2003 balancesheet $899,000 of acquired intellectual property and other intangible assets,net of accumulated amortization of approximately $15,000.  The intellectual property is being amortizedover its estimated useful life of 5 to 10 years and is estimated to beapproximately $120,000 per year for each of the next five years.

 

4

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The accompanying statement of operations includes theoperating results of DNA Sciences since the date of the acquisition.  Pro forma results of operations have notbeen presented, as the acquisition is not deemed to be a material businesscombination.

 

In May, subsequent to the closing, the Company****and Prometheus Laboratories Inc.(Prometheus) amended a license agreement primarily to provide certainadditional rights to the TPMT test to Prometheus in exchange for a $675,000cash payment to the Company, which is included in License and Service Revenuein the accompanying statement of operations.

 

**(3)****                     EARNINGSPER SHARE**

 

TheCompany computes and presents net loss per share in accordance with Statementof Financial Accounting Standards No. 128, *Earnings Per Share*(SFAS No. 128).  For thethree and six months ended June 30, 2003 and 2002, there is no differencein basic and diluted net loss per common share as the effect of stock optionsand warrants would be anti-dilutive for all periods presented.  The outstanding stock options and warrants(prior to application of the treasury stock method) would entitle holders toacquire 4,581,000 and 3,735,000 shares of common stock at June 30, 2003and 2002, respectively.

 

**(4)****                     REVENUERECOGNITION**

 

The Company earns its revenues primarily throughthe licensing of its *HAP*TMTechnology, by providing *HAP*TMTyping services and by providing GLP compliant DNA banking and genotypingservices. The Company has also entered into agreements which provide for futuremilestones and royalty payments.  TheCompany recognizes revenue in accordance with Staff Accounting Bulletin No.101, *Revenue Recognition in FinancialStatements* (SAB 101), and in accordance with Statement of Position97-2, *Software Revenue Recognition*(SOP 97-2), as amended by Statement of Position 98-9 (SOP 98-9).  In accordance therewith, the Companyrecognizes annual license and subscription fees over the term of the agreementand service fees as the services are performed.  Future milestones and royalty payments, if any, will berecognized when received provided that the milestone is substantive and aculmination of the earnings process has occurred.  Amounts received in advance of revenue recognition are recordedas deferred revenue.

 

**(5)****                     ACCOUNTING FOR STOCK BASED COMPENSATION**

 

In December 2002, the FASB issued Statement of Financial StandardsNo. 148, *Accounting for Stock-BasedCompensation - Transition and Disclosure - an amendment of FAS 123*(FAS148).  FAS 148 provides additionaltransition guidance for those entities that elect to voluntarily adopt theaccounting provisions of FAS 123, *Accountingfor Stock-Based Compensation*. FAS 148 also mandates certain new disclosures that are incremental tothose required by FAS 123.  Theprovisions of FAS 148 are effective for fiscal years ending afterDecember 15, 2002, and for interim periods beginning afterDecember 15, 2002.  The Companyadopted the disclosure provisions of FAS 148 during the fourth quarter of 2002.

 

At June 30,2003, the Company had one stock-based compensation plan accounted for under therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for Stock Issuedto Employees,* and related Interpretations.  The Company has not issued stock options or made modifications toexisting stock options where the exercise price is less than the market valueof our common stock on the date of grant or modification.

 

The followingtable illustrates the effect on net income and earnings per share if theCompany had applied the fair value recognition provisions of FASB Statement No.123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation for the quarters ended June 30, 2003and 2002:

 

5

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(Inthousands, except per share data)

 
|                                                                                                              |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|-------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                                                                              |   | **2003**                              |   | **2002**                            |   | **2003** |   | **2002** |   |
|                                                                                                              |   |                                  |   |                                |   |   |   |   |   |
| Net  loss, as reported                                                                                            |   | $                                     | (3,786 | )                                   | $      | (13,463 | ) | $ | (8,512 | ) | $ | (22,524 | ) |
| Add:  Stock-based employee compensation expense included in reported net loss                                     |   | 59                                    |   | 23                                  |   | 117 |   | 89 |   |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards |   | (368                                  | )      | (664                                | )      | (777 | ) | (1,310 | ) |
| Pro  forma net loss                                                                                               |   | $                                     | (4,095 | )                                   | $      | (14,104 | ) | $ | (9,172 | ) | $ | (23,745 | ) |
|                                                                                                              |   |                                  |   |                                |   |   |   |   |   |
| Net  loss per share:                                                                                              |   |                                  |   |                                |   |   |   |   |   |
| Basic  and diluted -as reported                                                                                   |   | $                                     | (0.17  | )                                   | $      | (0.59 | ) | $ | (0.37 | ) | $ | (0.99 | ) |
|                                                                                                              |   |                                  |   |                                |   |   |   |   |   |
| Basic  and diluted - pro forma                                                                                    |   | $                                     | (0.18  | )                                   | $      | (0.62 | ) | $ | (0.40 | ) | $ | (1.04 | ) |

 

**(6)**                     **SIGNIFICANT CUSTOMERS**

 

Forthe six months ended June 30, 2003 and June 30, 2002, customer Aaccounted for 29% and 43% of the Company’s revenue, respectively.  Customers B and C accounted for 14% and 11%of revenue for the six months ended June 30, 2003, respectively.  Customer D accounted for 26% of revenue forthe six months ended June 30, 2002. The collaboration agreement with customer A expires in the fourthquarter of 2003 and the collaboration agreement with customer D expired in thefourth quarter of 2002.  In addition,the Prometheus license fee accounted for 22% and 14% of revenue for the threeand six months ended June 30, 2003, respectively.  See Note 2 for further discussion of thislicense fee.

 

**(7)**                     **CAPITAL LEASES**

 

In December 2002, the Company announced it hadreceived a notice from General Electric Capital Corporation (GE) claiming thatan event of default had occurred under the lease agreement as a result of analleged material adverse change in the Company’s business.  Because of the alleged default, GE declaredthat all principal and future interest obligations were due and payableimmediately.  GE also filed a complaintin the Superior Court of the State of Connecticut, demanding payment of allamounts due under the lease agreements. The Company also received a notice from Finova Capital Credit Corp.(Finova) stating that, as a result of the alleged default claim by GE, therehad been a cross-default under the Company’s agreement with Finova.  To remedy the cross-default, Finova declaredthat all principal and future interest obligations were due and payableimmediately.  In March 2003, theCompany settled the claim with GE and simultaneously amended its leaseagreement with GE (GE Amendment).  In connectionwith the GE Amendment, and as additional security for its payment obligation toGE, the Company delivered to GE a $2 million irrevocable letter of credit andagreed to additional covenants in the GE Amendment.  The Company may cause the letter of credit to be adjusted on aquarterly basis commencing on October 1, 2003 based on a decrease inoutstanding amounts due to GE, as defined. The letter of credit is collateralized by cash at 105% of theoutstanding letter of credit balance. In connection with the GE Amendment, GE retroactively rescinded itsdefault claim and both parties have withdrawn from any legal action.  The GE Amendment and letter of credit havebeen retroactively reflected in the accompanying financial statements as ofDecember 31, 2002.  In connectionwith the cross-default claim, the Company has not entered into a settlementagreement with Finova.  The Companyrecorded an additional charge to interest expense during the fourth quarter of2002 for future interest due under the capital lease agreement with Finova toreflect the fact that all future interest and principal could be currently dueand payable under the Finova capital lease agreement as a result of the defaultclaim.  As a result of the continuingmaterial adverse change provisions within the GE agreement and as a result ofthe Finova default claim, we have classified as current the GE and Finova leaseobligations as of December 31, 2002 and June 30, 2003.

 

**(8)**                     **COMPREHENSIVE LOSS**

 

The Company reports and presents comprehensiveincome (loss) in accordance with SFAS No. 130, *ReportingComprehensive Income,* which establishes standards for reporting andthe display of comprehensive income (loss) and its components in a full set ofgeneral purpose financial statements. The

 

6

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objective of the statement is to report a measureof all changes in equity of an enterprise that result from transactions andother economic events of the period other than transactions with owners.  The Company’s other comprehensive income(loss) arises from net unrealized gains (losses) on marketable securities. TheCompany has elected to display comprehensive income (loss) as a component ofthe statements of stockholders’ equity and comprehensive loss. 

A summary of total comprehensive loss is as follows(dollars in thousands):

 
|                               |   | **Three months ended  June 30,** |   | **Six months ended****June 30,** |   |
|------------------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|
|                               |   | **2003**                              |   | **2002**                              |   | **2003** |   | **2002** |   |
|                               |   |                                  |   |                                  |   |   |   |   |   |
| Net  loss                          |   | $                                     | (3,786 | )                                     | $      | (13,463 | ) | $ | (8,512 | ) | $ | (22,524 | ) |
| Other  comprehensive income (loss) |   | (7                                    | )      | 20                                    |   | (23 | ) | (62 | ) |
| Total  comprehensive loss          |   | $                                     | (3,793 | )                                     | $      | (13,443 | ) | $ | (8,535 | ) | $ | (22,586 | ) |

 

**(9)**                     **INCOME TAX BENEFIT**

 

Recent legislationenacted by the State of Connecticut reinstated its research and development taxcredit exchange program.  The programallows companies to receive a cash payment from the State in exchange forforegoing certain research and development tax credit carryforwards.  The State exchanges the research anddevelopment tax credit carryforwards, at the rate of 65% of the annual researchand development tax credit, as defined. The legislation to reinstate the exchange program only for the 2002 taxyear was passed during the second quarter of 2003 and, as a result, the Companyrecorded a benefit of approximately $320,000 in the accompanying statement ofoperations.

 

**(10)****              COMMITMENTS ANDCONTINGENCIES**

 

The Company, fromtime to time, has been subject to legal claims arising in connection with itsbusiness.  While the ultimate results ofthe legal claims cannot be predicted with certainty, at June 30, 2003, therewere no asserted claims against the Company which, in the opinion ofmanagement, if adversely decided would have a material adverse effect on theCompany’s financial position and cash flows.

 

InNovember 2002, the FASB issued FASB Interpretation No. (FIN 45), *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, including Indirect Guarantees of Indebtedness of Others*,an interpretation of SFAS Nos. 5, 57 and 107 and Rescission of FIN 34.  FIN 45 clarifies the requirements of SFASNo. 5, *Accounting for Contingencies*,relating to the guarantor’s accounting for, and disclosure of, the issuance ofcertain types of guarantees.  Adoptionof FIN 45 did not have an impact on either the operating results or financialposition of the Company.

 

The Company hasentered into indemnification provisions under certain of its agreements withother companies in the ordinary course of business, typically with businesspartners.  Pursuant to these agreements,the Company may indemnify, hold harmless and/or reimburse the indemnifiedparties for certain stipulated losses suffered or incurred by the indemnifiedparties in connection with the Company’s products or services.  The term of these indemnification agreementsis generally perpetual.  The maximumpotential amount of future payments the Company could be required to make underthese indemnification agreements is unlimited. The Company has not incurred any costs to defend lawsuits or settleclaims related to any of these indemnification agreements.  As a result, the estimated fair value ofthese agreements is minimal. Accordingly, the Company has no liabilitiesrecorded for these agreements as of June 30, 2003.

 

**(11)**              **RECENTLY ISSUED ACCOUNTINGPRONOUNCEMENTS**

 

In May 2003,the FASB issued SFAS No. 150, *Accounting forCertain Financial Instruments with Characteristics of Both Liabilities andEquity*.  SFAS No. 150establishes standards for how an issuer classifies

 

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and measurescertain financial instruments with characteristics of both liabilities andequity.  The standard is effective fornew or modified contracts after May 31, 2003, and otherwise is effectiveat the beginning of the first interim period beginning after June 15,2003.  The Company does not believe thatthe adoption of SFAS No. 150 will be material to the Company’s operatingresults or financial position.

 

**(12)**              **IMPAIRMENT OF FIXED ASSETS**

 

During the secondquarter of 2002, the Company recorded a $6.0 million charge for the impairmentof fixed assets.  This charge wasrelated to sequencing equipment, computer hardware and software and leaseholdimprovements in the Company’s DNA sequencing facility that the Companydetermined needed to be reviewed for potential impairment.  As a result of the review, the Companydetermined that the carrying value of the assets was in excess of expecteddiscounted future cash flows to be generated by the asset group and a writedown of $6.0 million was recorded.

 

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**Item 2 –Management’s Discussion and Analysis of Financial Condition and Results ofOperations****.**

 

*Thefollowing discussion and analysis of our financial condition and the results ofoperations should be read in conjunction with the financial statements andrelated notes appearing elsewhere in this Quarterly Report on Form 10-Q.  This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 21E of the SecuritiesExchange Act of 1934, as amended, that involve risks and uncertainties, including,but not limited to, statements about management’s expectations as to costs andour liquidity position.  Theseexpectations are based on certain assumptions regarding our research anddevelopment activities, projected expenditures, the ability of our technologiesto improve the drug development process, success of our commercializationefforts and growth in our revenues and other factors relating to ourbusiness.  These expectations may notmaterialize if development efforts are delayed or suspended or if otherassumptions prove incorrect.  Thesefactors are more fully discussed below under the heading “Factors AffectingFuture Operating Results” and in our other filings with the Securities andExchange Commission.  Readers arecautioned not to place undue reliance on these or other forward-lookingstatements, which reflect management’s analysis, judgment, belief orexpectation only as of the date on which they are made.  While we may elect to update forward-lookingstatements at some time in the future, we specifically disclaim any obligationto do so, even if our estimates change.*

 

**Common Terms**

 

*HAP*TM Technology – the key components of our *HAP*TM Technology are:  a database of highly-informative, proprietary measures of genomicvariation, or haplotypes, which we call *HAP*TM Markers, for pharmaceutically relevantgenes; a proprietary informatics system, which we call *DecoGen*®, including unique algorithms, for defining patient populations withdifferent drug responses; a cost-effective, efficient process for measuringgenomic variation in clinical DNA samples, which we call *HAP*TM Typing; and clinical genetics developmentskills.

 

STRENGTHprogram (Statin Response Examined by Genetic *HAP*TM Markers) — we applied our *HAP*TM Technology and our clinical geneticsdevelopment skills to the statin class of drugs, which doctors use to treatpatients with high cholesterol and lipid levels and who are, therefore, at riskfor cardiovascular disease.

 

CARINGprogram (Clozapine *HAP*TM Marker Discovery Study) – this program is designed to identify which ofour *HAP*TM Markers define the patients who are mostlikely to develop agranulocytosis, a potentially life-threatening depletion ofwhite blood cells, if treated with clozapine.

 

**Overview**

 

Since our inception, wehave incurred significant operating losses, and, as of June 30, 2003, wehad an accumulated deficit of $202.1 million. The majority of our operating losses have resulted from costs weincurred in developing our *HAP*TM Technology, including ourclinical trials and administrative costs associated with operations.  We expect to dedicate a significant portionof our resources for the foreseeable future to service our *HAP*TMPartnership program partners, our pharmacogenetic support service customers,our CARING program and to maintain our *HAP*TMTechnology.  To date, our revenue hasbeen primarily from licensing and service fees from our agreements withAstraZeneca UK Limited (AstraZeneca), Biogen, Inc. (Biogen), Gene Logic, Inc.(GLI), Johnson & Johnson Pharmaceutical Research & Development, a partof Johnson & Johnson (J&J PRD), Millennium Pharmaceuticals, Inc.(Millennium) and Pfizer, Inc., as well as a sublicensing agreement with VisibleGenetics, Inc., a part of Bayer AG, and government grants.

 

On May 15, 2003,under order of the United States Bankruptcy Court, we acquired certain assetsand liabilities of DNA Sciences, Inc. for $1,778,000, inclusive of related feesand expenses.  Included in the fees andexpenses is $74,700 which represents the fair value of warrants exercisable forup to an aggregate of 75,000 shares of our common stock at an exercise price of$2 per share issued in connection with investment banking services performed aswell as $35,000 which represents the fair value of 25,000 shares we issued to alicensor in connection with a license modification.  The primary assets acquired consisted of a GLP compliant DNAbanking and a GLP compliant and CLIA licensed genotyping services business andlicenses and patent estates surrounding Long QT Syndrome and a TPMT diagnostictest as well as certain trade accounts receivable and fixed assets.  Subsequent to the closing,

 

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we entered into anamendment (the TPMT Amendment) to an existing license agreement with Prometheusunder which we provide Prometheus with certain additional rights to the TPMTtest for a $675,000 cash payment, which is included in License and servicerevenue in the accompanying statement of operations for the three months endedJune 30, 2003.  By combining DNA Sciences’ offerings of GLPcompliant DNA Banking and GLP compliant and CLIA licensed genotyping serviceswith our *HAP*TM Technology andhigh-throughput research genotyping capabilities, we seek to provide a completerange of offerings for the application of DNA tests to the clinical developmentand marketing of drugs. Additionally, we will seek to broaden our relationshipswith the pharmaceutical and biotechnology clients that had agreements with DNASciences by offering them access to our *HAP*TMTechnology platform as well as offering our existing customers access to ournewly acquired facility for their GLP compliant DNA banking and genotypingneeds.

 

InDecember 2002, we announced that we received a notice from GeneralElectric Capital Corporation (GE) claiming that an event of default hadoccurred under the lease agreement as a result of an alleged material adversechange in our business.  Because of thealleged default, GE declared that all principal and future interest obligationswere due and payable immediately.  GEalso filed a complaint in the Superior Court of the State of Connecticut,demanding payment of all amounts due under the lease agreements.  In March 2003, we entered into anamendment (GE lease amendment) to our existing lease agreement with GE.  In connection with this amendment, GErescinded and withdrew its default claim and both parties withdrew from anylegal action.  The GE lease amendmentrequires compliance with certain additional covenants as well as a $2 millionletter of credit, which is collateralized by cash.  We also received a notice from Finova Capital Corporation(Finova), stating that as a result of the alleged default claim by GE, therewas a cross-default under our agreement with Finova.  Because of the outstanding claim of default by Finova, we recordedan additional charge to interest expense during the fourth quarter of2002.  This charge represents all futureinterest payments due under the terms of the agreement with Finova.  As a result of the continuing materialadverse change provisions within the GE agreement and as a result of the Finovadefault claim, we have classified as current the GE and Finova leaseobligations as of December 31, 2002 and June 30, 2003.

 

In August 2002, weannounced a restructuring and cost reduction program to revise our businessfocus and to better align our operating cost structure with our current andprojected partner needs and projected revenues from our current and projectedpartners. The cost reduction program included a realignment of managementresponsibilities, a reduction in our workforce and a decision at that time toseek partners for all internal product development programs. The workforce wasreduced by 20 percent to 110 employees in the third fiscal quarter of 2002,with the majority of the workforce reductions occurring in our DNA sequencingfacility and related informatics support. We incurred a charge for severance and related costs of approximately$200,000, which was recorded in operating results in the third fiscal quarterof 2002.  All severance obligationsassociated with this workforce reduction had been paid by December 31,2002.

 

During the second quarterof 2002, we recorded a $6.0 million charge for the impairment of fixedassets.  This charge was related tosequencing equipment, computer hardware and software and leasehold improvementsin our DNA sequencing facility that we determined needed to be reviewed forpotential impairment.  As a result ofour review, we determined that the carrying value of the assets was in excessof expected discounted future cash flows to be generated by the asset group andwe recorded a write down of $6.0 million.

 

**CriticalAccounting Policies**

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make certain estimates and assumptions thataffect the reported amounts of assets and liabilities, the disclosure ofcontingent liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.

 

We believe the followingcritical accounting policies affect the more significant judgments andestimates used in the preparation of our financial statements:

•                  revenue recognition;

•                  valuation of long-lived assets; and

•                  research and development expenses.

 

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Revenuerecognition.  We earn our revenues primarily through thelicensing of our *HAP*TMTechnology and by providing *HAP*TMTyping services, and GLP compliant DNA banking and genotyping services.  We have also entered into agreements whichprovide for future milestones and royalty payments.  We recognize revenue in accordance with Staff Accounting BulletinNo. 101, *Revenue Recognition in FinancialStatements* (SAB 101), and in accordance with Statement of Position97-2, *Software Revenue Recognition*(SOP 97-2), as amended by Statement of Position 98-9 (SOP 98-9).  In accordance therewith, we recognize annuallicense and subscription fees over the term of the agreement and service feesas the services are performed.  Futuremilestones and royalty payments, if any, will be recognized when receivedprovided that the milestone is substantive and a culmination of the earningsprocess has occurred.  Revenues derivedfrom the achievement of milestones or recognition of related work performedunder the terms of a contract, as well as the access period of the licenseagreement, may cause our operating results to vary considerably from period toperiod.  Deferred revenue results fromcash received or amounts receivable in advance of revenue recognition.

 

Valuation oflong-lived assets. We assess the impairment of long-livedassets whenever events or changes in circumstances indicate that the carryingvalue may not be recoverable.  Factorswe consider important, which could trigger an impairment review, include, amongothers, the following:

 

•                  a significant adverse change in theextent or manner in which a long-lived asset is being used;

 

•                  a significant adverse change in thebusiness climate that could affect the value of a long-lived asset; and

 

•                  a significant decrease in the marketvalue of assets.

 

If we determinethat the carrying value of long-lived assets may not be recoverable, based uponthe existence of one or more of the above indicators of impairment, we comparethe carrying value of the asset group to the undiscounted cash flows expectedto be generated by the group.  If thecarrying value exceeds the undiscounted cash flows, an impairment charge may beneeded.  To determine the amount of theimpairment charge, we compare the carrying value of the applicable fixed assetgroup to its fair value.  We determinethe fair value of the fixed asset group by discounting expected future cashflow using a discount rate determined by us to be commensurate with the riskinherent in our current business.  Ifthe fair value is less than the carrying value, such amount is recognized as animpairment charge.

 

Research and development expenses. We record research and development expenseswhen they are incurred or, in the case of clinical trial expenses, based uponinformation we receive from third party clinical research organizations.  Research and development expenses includethe following major types of costs: salaries and benefits, material and reagentcosts, research license fees, clinical trial expenses, depreciation andamortization of laboratory equipment and leasehold improvements and buildingand utility costs related to research space. We expense clinical trial costs as incurred based on information wereceive from third parties and estimates that we make.  Our estimates may change as additionalinformation becomes available, which could cause results to vary from period toperiod.

 

**Results of Operations**

 

**Three Months Ended June 30, 2003 and 2002**

 

License and servicerevenue consists primarily of revenue recognized in connection with thelicensing of our *HAP*TM Technology and from *HAP*TMTyping and GLP compliant DNA banking and genotyping services. Revenue increasedto approximately $3.1 million in the three months ended June 30, 2003 from$1.9 million in the three months ended June 30, 2002.  The increase in revenue is primarilyattributable to the $675,000 license fee received from Prometheus for theirexpanded rights to the TPMT test under the TPMT Amendment and the revenuerecognized for services provided under contracts we assumed through thepurchase of certain of the assets of DNA Sciences.  The increase is also due to the increased commercialization ofour *HAP*TM TechnologyPartnership program and our *HAP*TMDrug-Specific Partnership program, including agreements entered into withMillennium in 2003 and Pfizer

 

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(formerly Pharmacia &Upjohn) in 2002, which was partially offset by the expiration of a contractwith a customer in the fourth quarter of 2002.

 

Research and developmentexpenses consist primarily of payroll and benefits for research and developmentpersonnel, material and reagent costs, costs incurred in connection withclinical trials, depreciation and maintenance costs for equipment used for *HAP*TMMarker discovery and *HAP*TM Typing and facility-relatedcosts.  We expense our research anddevelopment costs as incurred.  Researchand development expenses decreased to approximately $5.1 million in the threemonths ended June 30, 2003 from approximately $6.6 million in the threemonths ended June 30, 2002.  Thedecrease in expenses is primarily attributable to a decrease of approximately$750,000 in technology license fees and a decrease of approximately $500,000 indepreciation expense.  The decrease intechnology license fees is primarily due to a license agreement that expired inthe fourth quarter of 2002.  Thedecrease in depreciation expense is primarily due to the asset impairment charge recorded in thequarter ended June 30, 2002.

 

General and administrative expenses consist primarilyof payroll and benefits for executive, business development, finance and otheradministrative personnel as well as facility-related costs and outsideprofessional fees incurred in connection with corporate development and generallegal and financial matters.  General andadministrative expenses decreased to approximately $2.1 million in the threemonths ended June 30, 2003 from approximately $2.6 million in the threemonths ended June 30, 2002.  Thedecrease is primarily attributable to a $288,000 sales and use tax refund,which was recognized during the quarter ended June 30, 2003 as well as ageneral reduction in expenses as part of our cost reduction program initiatedduring the quarter ended September 30, 2002.

 

The impairment of fixedassets charge relates to sequencing equipment, computer hardware and softwareand leasehold improvements used in our DNA sequencing facility.  During the quarter ended June 30, 2002,our management determined that certain conditions had arisen during the quarterthat triggered the need for a review of our long-lived assets for potentialimpairment.  These conditions include,but were not limited to, the overall business climate in which we operate and asignificant change in the manner in which we were utilizing our DNA sequencingfacility and related assets.  Inparticular, during the quarter ended June 30, 2002, we determined that ourproduction capacity significantly exceeded our forecasted demand for theforeseeable future, which resulted in our decision to remove from productionthe majority of our ABI Prism® 3700 DNA Analyzers, the primary assetof the group.  Accordingly, we performedan impairment review on our sequencing long-lived assets.  As a result of our review, we determinedthat the carrying value of the assets was in excess of the projectedundiscounted cash flows to be generated by the asset group.  To determine the impairment charge wecompared the carrying value of the applicable fixed assets to their fair value.  We determined the fair value of the fixedassets by discounting expected future cash flows using a discount ratedetermined by our management to be commensurate with the risk inherent in ourcurrent business.  As a result of our analysis, we determinedthat the carrying value of the assets was in excess of discounted future cashflow to be generated by the asset group and we recorded a write-down of $6.0million.  The impairment charge wasallocated to the individual assets on a pro-rata basis.  The revised carrying value of theassets is being depreciated over the average remaining life of the primaryasset of the group.

 

Interest income decreasedto approximately $90,000 in the three months ended June 30, 2003 fromapproximately $285,000 for the same period in 2002.  The decrease is the result of higher cash, cash equivalent andshort-term investment balances in 2002 and lower interest rates on investmentsduring 2003.

 

Interest expensedecreased to approximately $191,000 in the three months ended June 30,2003 from approximately $495,000 in the three months ended June 30,2002.  The decrease is primarily theresult of the recording of all future interest associated with the Finovacapital leases in the quarter ended December 31, 2002.  If, in the future, we enter into asettlement or amend our agreement with Finova, it may result in the reversal,in the period of amendment or settlement, of some of the interest expenserecognized in the fourth quarter of 2002.

 

Income tax benefit was$320,000 for the three months ended June 30, 2003.  This increase is the result of recentlegislation passed by the State of Connecticut that reinstated the research anddevelopment tax credit exchange program. The legislation allows companies to exchange research and developmenttax credits earned in 2002.  The

 

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program allows companiesto receive cash refunds from the State at a rate of 65% of the research taxcredit, as defined, in exchange for foregoing the carryforward of the researchand development tax credit.

 

**Six Months Ended June 30, 2003 and 2002**

 

Revenue increased toapproximately $5.3 million in the six months ended June 30, 2003 from $3.8million in the six months ended June 30, 2002.  The increase in revenue is primarily attributable to the $675,000license fee received from Prometheus for their expanded rights to the TPMT testunder the TPMT Amendment and the revenue recognized for services, which wereprovided under contracts we assumed through the purchase of certain of theassets of DNA Sciences.  The increase isalso due to the increased commercialization of our *HAP*TM TechnologyPartnership program and our *HAP*TM Drug-Specific Partnershipprogram, including agreements entered into with Millennium in 2003 and Pfizerin 2002, which was partially offset by the expiration of a contract with acustomer in the fourth quarter of 2002.

 

Research and developmentexpenses decreased to approximately $9.8 million in the six months endedJune 30, 2003 from approximately $14.9 million in the six months endedJune 30, 2002.  The decrease inexpenses is primarily attributable to a decrease of approximately $1.5 millionin technology license fees, a decrease of approximately $1.6 million indepreciation and repair and maintenance expenses and a decrease ofapproximately $600,000 in payroll and related costs. The decrease in technology license fees isprimarily due to a license agreement that expired in the fourth quarter of2002.  The decreases in depreciation and repair and maintenance expensesare primarily due to a reduction in DNA sequencing, consistent with the removalof the majority of our ABI Prism® 3700 DNA analyzers from productionand the asset impairment charge recorded in the quarter ended June 30,2002. The decrease in payroll and related costs is primarily due to our work forcereduction in connection with our restructuring program that was initiated inthe third quarter of 2002.

 

General andadministrative expenses decreased to approximately $4.1 million in the sixmonths ended June 30, 2003 from approximately $5.0 million in the sixmonths ended June 30, 2002.  Thedecrease is primarily attributable to a $288,000 sales and use tax refundrecorded in the second quarter of 2003 and a general reduction in expenses aspart of our cost reduction program initiated during the quarter endedSeptember 30, 2002.

 

Theimpairment of fixed assets charge relates to sequencing equipment, computerhardware and software and leasehold improvements used in our DNA sequencingfacility.  During the quarter endedJune 30, 2002, our management determined that certain conditions hadarisen during the quarter that triggered the need for a review of ourlong-lived assets for potential impairment. Our review determined that a $6.0 million write-down in the carryingvalue of the long-lived assets was needed. Please see “Results of Operations - Three Months ended June 30,2003 and 2002” for further explanation of this charge.

 

Interest income decreasedto approximately $224,000 in the six months ended June 30, 2003 from$639,000 in the six months ended June 30, 2002.  The decrease is the result of higher cash, cash equivalent andshort-term investment balances in 2002 and lower interest rates on investmentsduring 2003.

 

Interest expensedecreased to approximately $392,000 in the six months ended June 30, 2003from approximately $1.0 million in the six months ended June 30,2002.  The decrease is primarily theresult of the recording of all future interest associated with the Finovacapital leases in the quarter ended December 31, 2002.  If, in the future, we enter into asettlement or amend our agreement with Finova, it may result in the reversal,in the period of amendment or settlement, of some of the remaining interestexpense recognized in the fourth quarter of 2002.

 

**Liquidity and Capital Resources**

 

We have financed ouroperations primarily through the sale of common and preferred stock, paymentsreceived under licensing agreements, loans and capital leases.  From inception through June 30, 2003,we have received aggregate gross proceeds of approximately $163.2 million fromissuance of common and preferred stock. In addition, through June 30, 2003, we have received $22.7 millionfrom license and service fees, royalties and research

 

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contracts.  We have also received $26.2 million****fromcapital lease financing arrangements and $8.2 million from other loans.  We have acquired, through June 30,2003, $42.6 million of property and equipment. The majority of these assets were financed through capital leasefinancing arrangements and other loans.

 

We expect to continue tofinance our operations in the short-term from cash we received in 2000 from thesale of our common stock and revenue from our *HAP*TM Technology Partnershipprogram and our pharmacogenetic support service customers.  In addition, we may seek to raise additionalfunds through the issuance of debt and/or equity securities.  Our business strategy depends on, among otherthings, entering into partnership agreements with pharmaceutical and biotechnologycompanies and growing the revenue from our pharmacogenetic support servicesbusiness.  If we are unsuccessful inentering into new partnership programs, growing the revenue from ourpharmacogenetic support services business, or obtaining additional financingfunds, we may not generate sufficient funds to sustain our operations atplanned levels.

 

Cash used in operationsfor the six months ended June 30, 2003 was $5.1 million compared with$13.7 million for the same period in 2002. The cash used in operations for the six months ended June 30, 2003resulted primarily from a net loss of $8.5 million, partially offset by $3.7million of non-cash charges for depreciation and amortization expense andstock-based compensation.  Cash used inoperations for the six months ended June 30, 2002 resulted primarily froma net loss of $22.5 million and a $2.9 million decrease in accounts payable andaccrued liabilities, partially offset by $4.8 million of non-cash charges fordepreciation and amortization expense and stock-based compensation and a $6.0million non-cash asset impairment charge.

 

Cash used in investingactivities for the six months ended June 30, 2003 was $161,000 comparedwith net cash provided by investing activities of $17.8 million for the same periodin 2002.  Net proceeds from the sale ofmarketable securities totaled $2.0 million for the six months endedJune 30, 2003 compared to $17.9 million for the same period in 2002.  During the six months ended June 30,2003 we used $1.7 million of cash for the purchase of certain assets andliabilities of DNA Sciences.  Inaddition, during the six months ended June 30, 2003, we used $530,000 ofcash for the purchase of property and equipment compared to $70,000 for thesame period in 2002.

 

Cash used for financingactivities for the six months ended June 30, 2003 was $3.5 millioncompared with $3.7 million for the same period in 2002.  The primary use of cash from financingactivities for the six months ended June 30, 2003 and 2002 was therepayment of long-term debt and capital lease obligations.

 

Ourcontractual cash obligations as of June 30, 2003, are as follows:

 
|                                                |   | **Payments Due by Period**          |   |
|-----------------------------------------------------|--------|-------------------------------------|--------|
|                                                |   | **(in thousands)**                  |   |
| **Contractual********Obligations**                  |   | **Total  Amounts********Committed** |   | **Total for  remainder of********Fiscal 2003** |   | **Total for  Fiscal Years  2004 and 2005** |   | **Total for  Fiscal Years  2006 and 2007** |   | **Total for  Fiscal Year  2008 and later** |   |
| Long-Term Debt, including interest                  |   | $                                   | 6,120  |   | $ | 352 |   | $ | 1,408 |   | $ | 1,408 |   | $ | 2,952 |   |
| Capital Lease  Obligations, including  interest (1) |   | 7,910                               |   | 7,910 |   | — |   | — |   | — |   |
| Operating Leases                                    |   | 8,615                               |   | 563 |   | 2,235 |   | 2,025 |   | 3,792 |   |
| Minimum License Obligations                         |   | 500                                 |   | 88 |   | 206 |   | 206 |   | — |   |
| Total Contractual Cash Obligations                  |   | $                                   | 23,145 |   | $ | 8,913 |   | $ | 3,849 |   | $ | 3,639 |   | $ | 6,744 |   |

 

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(1)                      Reflects all lease obligations as beingcurrent.  We are permitted however, as aresult of the GE Amendment that we entered into in March 2003 to pay theoutstanding GE lease obligations under the original maturity schedule throughFebruary 2005.  Obligations dueunder the original maturity schedules total $3,739,000 for fiscal 2003 and$4,171,000 in aggregate for fiscal 2004 and 2005.  See Management’s Discussion and Analysis – Overview and Note 7 ofNotes to Financial Statements for additional information regarding theclassification of certain amounts as current obligations.

 

Long-termdebt consists of three financing agreements with Connecticut Innovations Inc.(CII), a stockholder, used to finance certain leasehold improvements and othercosts associated with our facility expansion. Each agreement provided for interest only with principal payments, basedon a 120-month amortization beginning April 2001 throughOctober 2002, with final balloon payments due in March 2009 throughJune 2011.  Borrowings under theagreements

 

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bearinterest at 6.5% and are collateralized by the related leaseholdimprovements.  We are in compliance withall debt covenants as of June 30, 2003 and no cross default provisionsexist under these agreements.

 

Capitallease obligations related to equipment consist principally of arrangements withfour equipment leasing companies.  Theleases have terms ranging from two to four years with installments originallyscheduled to end between August 2003 and February 2005 and which bearinterest at rates ranging from 8.15% to 12.46%.  Borrowings under these agreements are secured by the underlyingleased equipment.  The majority of thecapital lease arrangements allow for the purchase of the related equipment atthe completion of the lease term, as defined in the agreements, and certain ofthe agreements require the purchase of the equipment at the completion of thelease term.

 

We lease our operatingfacilities located in New Haven, Connecticut and Morrisville, NorthCarolina.  We are currently atenant-at-will in the North Carolina facility and are in the process ofnegotiating a new lease agreement.  TheConnecticut lease agreements currently require annual lease payments ofapproximately $1.1 million per year over the original term, which expires in2006.  We have two five-year renewaloptions to extend the lease agreements beyond the initial term.  We are recording the expense associated withthe leases on a straight-line basis over the expected term of the leasesthrough September 2011.  Inaddition to the operating lease agreements for our current facility, we alsohave operating leases for certain of our office equipment.

 

Weperiodically enter into agreements with third parties to obtain exclusive ornon-exclusive licenses for certain technologies.  The terms of certain of these agreements require us to makefuture royalty payments and certain milestone payments based on product salesor sublicense income generated from the applicable technologies, if any, andinclude provisions requiring future minimum lease payments, whether or not thetechnology is commercialized.  Theamount of such payments will depend upon successful commercialization ofapplicable technologies, if any.  Thefuture minimum payments (assuming non-termination of these agreements) areincluded in the minimum license obligations above.

 

Basedon our current business plans, capital expenditures are not expected to exceed$1.5 million for each of fiscal 2003 and 2004.

 

Our cash requirementswill vary depending upon a number of factors, many of which are beyond ourcontrol, including:

 

•                  the demand for our *HAP*TM Technology;

 

•                  the efforts and success of our *HAP*TM partnership program;

 

•                  the commercialization of intellectualproperty derived from our associations;

 

•                  the growth of our pharmacogeneticssupport services business;

 

•                  the level of competition we face;

 

•                  our ability to maintain our *HAP* TM Technology; and

 

•                  our ability to effectively manage ouroperating expenses.

 

On June 30, 2003,cash, cash equivalents and short-term investments totaled $23.3 millioncompared to approximately $34.2 million at December 31, 2002.  Our cash reserves are held ininterest-bearing high-grade corporate bonds and money market accounts.  We believe that our existing cash reserveswill be sufficient to support our expected net losses, debt obligations andcapital expenditures for at least 15 months. To execute our long-term business plan, we will need to grow ourrevenues significantly each year and we may need to seek additional fundingthrough public or private equity offerings or debt financings or throughcommercial partners.  We cannot assureyou that we will obtain additional partners or capital funding on acceptableterms, if at all.

 

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**Factors Affecting Future Operating Results**

 

*This Quarterly Report on Form 10-Q contains “forward-lookingstatements” within the meaning of Section 21E of the Securities Exchange Act of1934, as amended.  These statements aresubject to risks and uncertainties and are based on the beliefs and assumptionsof our management based on information currently available to ourmanagement.  Use of words, such as “believes,”“expects,” “anticipates,” “intends,” “plans,” “estimates,” “should,” “likely”or similar expressions, indicate a forward-looking statement.  Forward-looking statements involve risks,uncertainties and assumptions.  Certainof the information contained in this Quarterly Report on Form 10-Q consists offorward-looking statements.  Importantfactors that could cause actual results to differ materially from theforward-looking statements include the following:*

 

**Weare an early stage company with a history of losses and we expect to incur netlosses for the foreseeable future such that we may never be profitable**.

 

We have incurredsubstantial operating losses since our inception.  As of June 30, 2003, we have generated only minimal revenuefrom our *HAP*TMPartnership program and our pharmacogenetic support services, and we do notexpect to generate significant revenues for several years, if ever.  From inception through June 30, 2003,we had an accumulated deficit of approximately $202.1 million.  Our losses to date have resulted principallyfrom costs we incurred in the development of our *HAP*TM Technology, in our clinical trials and fromgeneral and administrative costs associated with operations.  We expect to devote substantially all of ourresources to service our *HAP*TMPartnership program and STRENGTH program partners, our pharmacogenetic supportservices customers and our CARING program and to maintain our *HAP*TM Technology.

 

We expect to incuradditional losses this year and in future years, and we may never achieveprofitability.  In addition,pharmaceutical and biotechnology companies are only now beginning to useproducts such as ours in their drug and diagnostic development or marketingefforts and, accordingly, they may not choose to use our *HAP*TM Technology.  We do not expect our losses to besubstantially mitigated by revenues from our *HAP*TMPartnership and STRENGTH programs and our CARING program, if any, and our LongQT program, if any, or from our pharmacogenomics support services for a numberof years.

 

**Wecurrently rely on a limited number of customers for substantially all of our revenues.  As a result, the loss of one major customeror our inability to secure additional significant customers during a givenperiod would have an adverse affect on our business and operating results.**

 

We are dependent upon alimited number of customers that represent substantially all of ourrevenues.  In the quarter endedJune 30, 2003, two of our customers accounted for 47% of our totalrevenues.  The agreement with the one ofthe two customers expires in the fourth quarter of 2003.  If we are unable to replace, uponsubstantially similar terms, the agreement that expires in the fourth quarterof 2003, or the agreement which expired in 2002, which accounted for 26% of ourrevenue for the six months ended June 30, 2002 or if we lose any of ourother remaining significant customers, it would have a material adverse affecton our revenues and on our business in general and could cause volatility or adecline in our stock price.

 

**Togenerate significant revenues, we must obtain additional customers for our *HAP*TM Partnership program andour STRENGTH, CARING and Long QT programs and for our pharmacogenetic supportservices.**

 

Our strategy depends onentering into agreements with pharmaceutical and biotechnology companies forour *HAP*TM Partnershipprogram and our STRENGTH, CARING and Long QT programs and obtaining additionalcustomers for our pharmacogenetic support services.  We currently have a *HAP*TM Partnership program with fivepharmaceutical and biotechnology companies as well as an agreement witha major diagnostic company to commercialize exclusively the diagnostic rightsand non-exclusively the product development rights from our STRENGTHprogram.  Our contracts for ourpharmacogenetic support services are specific limited term projects.  Wemay not be successful in obtaining additional partners for our *HAP*TM Partnership program andour STRENGTH program or obtaining any partners for our CARING or Long QTprograms or obtain sufficient new customers for our pharmacogenetic supportservices to replace our current projects. If we are unsuccessful in finding additional partners for our *HAP*TM Partnership program andour STRENGTH program or in finding any partners for our CARING or Long QTprograms or new customers for our pharmacogenetic support services, we may nevergenerate sufficient revenues to sustain our operations.  In addition, we expect that some of ourfuture *HAP*TMPartnership

 

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program collaborations, like some of our current *HAP*TM Partnership program collaborations,will be limited to specific, limited-term projects or that some of thesecollaborations may not be renewed. Accordingly, we must continually obtain new customers to be successful.  To date, the integration of pharmacogenomicsinto drug development and marketing has not achieved widespread marketacceptance.

 

**Ifthe estimates we make, and the assumptions on which we rely, in preparing ourfinancial statements prove inaccurate, our actual results may vary from thosereflected in our projections.**

 

Our financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America.  Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of our assets, liabilities, revenuesand expenses, the amounts of charges accrued by us and related disclosure ofcontingent assets and liabilities.  Webase our estimates on historical experience and on various other assumptionsthat we believe to be reasonable at that time under the circumstances.  There can be no assurance, however, that ourestimates or the assumptions underlying our estimates will be correct.

 

**Wemay require additional funding to fund operations and repay debt and we may notbe able to obtain any.**

 

We have used substantialamounts of cash to fund our research and development activities.  We will continue to spend funds to serviceour *HAP*TM Partnershipprogram and STRENGTH program partners, our pharmacogenetic support services customersand our CARING and Long QT programs and to maintain our *HAP*TM Technology.  We plan to pay for these activities withfunds from:

 

•                  ourexisting cash and investment securities, and

 

•                  income that we may receive from our *HAP*TM Partnership program andSTRENGTH program partners and pharmacogenetic support services customers.

 

We intend to rely on ourcurrent *HAP*TMPartnership program and STRENGTH program partners and future partners, if any,and our current pharmacogenetic support services customers and futurecustomers, if any, for significant funding in the future to support ourdevelopment efforts.  To execute ourbusiness plans, we will need to grow our revenues significantly each year.  We cannot be certain when we will begin toreceive additional income, if at all, from our *HAP*TMPartnership and STRENGTH programs and our pharmacogenetic support services andincome, if any, from our CARING and Long QT programs.  If we do not receive this income or do not receive it as rapidlyas we expect, we would spend our existing cash and investment securities morerapidly than we currently plan.

 

We believe that ourexisting cash reserves will be sufficient to support our expected net losses,debt obligations and capital expenditures for at least 15 months.  We cannot assure you that we will be able toobtain new partners or to generate the increased revenues required to meet ourbusiness plan objectives.  In addition,to execute our business plans, we may need to seek additional funding throughpublic or private equity offerings, debt financings or through commercialpartners.  We cannot assure you that wewill obtain additional partners or capital funding on acceptable terms, if atall.  If we are unable to generatesufficient revenues or access capital on acceptable terms, we may be requiredto (a) obtain funds on unfavorable terms that may require us to relinquishrights to certain of our technologies or that would significantly dilute ourstockholders and/or (b) significantly scale back current operations.  Either of these two possibilities would havea material adverse effect on our business.

 

**Our*HAP*TM Technology maynot allow our partners to develop commercial products or to increase sales oftheir marketed products.**

 

We developed our *HAP*TM Technology on theassumption that information about gene variation and gene variation associatedwith drug response may help drug development professionals better understandthe drug response of particular populations and complex disease processes.  Although the pharmaceutical andbiotechnology industries are increasing their use of genomics in analyzing drugresponse and diseases, we are unaware of any successful drug developmentprogram applying population genomics.

 

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We discover *HAP*TM Markers forpharmaceutically relevant genes.  If weare unable to find *HAP*TMMarkers for pharmaceutically relevant genes in a timely manner, our potentialpartners may lose confidence in our *HAP*TMTechnology and our company, which could decrease our ability to generaterevenues.  Even if we are able todiscover *HAP*TM Markersfor pharmaceutically relevant genes, this information may not prove to besuperior to genomic variation information discovered by our competitors.  Furthermore, pharmaceutical andbiotechnology companies may not choose our *HAP*TMTechnology over competing technologies.

 

Our *DecoGen*® Informatics System mayalso be less effective than we expect or may not allow our partners or us todetermine a correlation between drug response and genomic variation.  Furthermore, even if our partners or we aresuccessful in identifying such a correlation, our partners may not be able todevelop or sell commercially viable products nor may our partners be able toincrease the sales of their marketed products using this correlation.  Accordingly, our *HAP*TM Markers and *HAP*TM Technology may not improve the development,marketing and prescribing of drugs or the development and marketing ofdiagnostics developed by our *HAP*TMPartnership program and STRENGTH program partners.

 

**Ifwe are unable to obtain intellectual property protection for our *HAP*TM Technology, trade secretsor know how, we may not be able to operate our business profitably.**

 

Our success depends, inpart, on our ability to protect our *HAP*TMTechnology, any associations that we find between clinical outcomes and geneticvariation and any other proprietary software, methods and technologies that wedevelop, either as a trade secret or under the patent and other intellectualproperty laws of the United States and other countries, so that we can preventunauthorized entities from using our inventions and proprietaryinformation.  Because patentapplications that were filed prior to November 29, 2000 in the UnitedStates are confidential until patents issue, third parties may have filedpatent applications for technology covered by our pending patent applicationswithout our being aware of those applications, and our patent applications maynot have priority over any patent applications of others.  We are aware that there are other firms orindividuals who have discovered, or are currently discovering, informationsimilar to the information we are discovering, who may have filed, and in thefuture are likely to file, patent applications that are similar or identical toour *HAP*TM Technologypatent applications.

 

Our pending patentapplications may not result in issued patents. The patent positions of pharmaceutical and biotechnology companies,including ours, are generally uncertain as a result of the uncertain state ofthe patent law in the biotechnology field. There is no uniform, worldwide policy regarding the subject matter andscope of claims granted or allowable in biotechnology patents, particularlythose involving genomics.  In addition,some interest groups are lobbying for restrictions on patenting of genetictests.

 

**Wemay be unable to develop or commercialize our *HAP*TMTechnology if we cannot establish additional collaborative relationships and wewill depend on our partners to develop or to co-develop products.**

 

Wecurrently have a *HAP*TM Partnership program with five pharmaceutical and biotechnologycompanies as well as an agreement with a major diagnostic company tocommercialize exclusively the diagnostic rights and non-exclusively the productdevelopment rights from our STRENGTH program. We do not currently have any partners for our CARING or Long QTprograms.  Under our current strategy,and for the foreseeable future, we do not expect to develop or marketpharmaceutical or diagnostic products on our own.  As a result, part of our current and future revenues will dependon payments from our current *HAP*TMPartnership program and STRENGTH program partners and our future *HAP*TM Partnership, STRENGTH,CARING and Long QT program partners, if any, for either the new products theymay develop, or for increased sales of their existing products, made possiblethrough the use of our *HAP*TMTechnology.  If we are unable to attractnew *HAP*TM Partnershipprogram and STRENGTH program partners or any partners for our CARING and LongQT programs, we may never generate sufficient revenues to sustain ouroperations.

 

Our partners for our *HAP*TM Partnership program andSTRENGTH program and our partners, if any, for our CARING and Long QT programs,will be responsible for pre-clinical study and clinical development oftherapeutic and diagnostic products and for regulatory approval, manufacturingand marketing of any products or enhanced marketing claims that result from theapplication of our *HAP*TMTechnology.  Our current agreements withthese partners, and we anticipate that any future agreements with partners,will allow them significant discretion in

 

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pursuing these activities.  Wecannot control the amount and timing of resources that any such current orpotential partners will devote to our programs or potential products.  Our *HAP*TMPartnership program and STRENGTH program arrangements and our CARING and LongQT program arrangements, if any, may also have the effect of limiting the areasof research that we may pursue either alone or with others.  Because part of our revenues will bedependent on the successful commercialization or development of our partners’products, if, for any reason, a *HAP*TMPartnership program partner or our STRENGTH program partner delays or abandonsits development or commercialization of a product developed using our *HAP*TM Technology, we mayreceive reduced royalty or other payments or no royalty or other payments atall.  In addition, because part of ourfuture revenues will be dependent on the successful commercialization ofadditional aspects of our *HAP*TMPartnership and STRENGTH programs with partners and the successfulcommercialization of our CARING and Long QT programs with partners, if, for anyreason, a partner delays or abandons its development or commercialization ofthese additional aspects of our *HAP*TMPartnership program or STRENGTH program or its development or commercializationof our CARING and Long QT programs, we may receive reduced royalty or otherpayments or no royalty or other payments at all.

 

Although we intend toretain the rights to all *HAP*TMMarkers, which we discover as well as to *HAP*TMMarkers discovered jointly with our *HAP*TMPartnership and STRENGTH program partners and with our CARING and Long QTprogram partners, if any, we may not always be able to negotiate the retentionof these rights.  Furthermore, disputesmay arise in the future over the ownership of rights to *HAP*TM Markers as well as anyother technology we develop with our *HAP*TMPartnership and STRENGTH program partners or with our CARING and Long QTprogram partners, if any.  These andother possible disagreements between our *HAP*TMPartnership and STRENGTH program partners and us or between our CARING and LongQT program partners, if any, and us could lead to delays in the research,development or commercialization of their products.  These disagreements could also result in litigation or requirearbitration to resolve.  Any of these eventscould prevent us from effectively marketing our *HAP*TM Technology.

 

**Weinvest considerable amounts of time, effort, and money to license our *HAP***TM**Technology; and if we are unable to license ourtechnology, we may not generate sufficient revenue to sustain our operations**.

 

Our ability to obtainpartners for our *HAP*TMPartnership program and our STRENGTH, CARING and Long QT programs will dependin significant part upon the pharmaceutical and biotechnology industries’acceptance that our *HAP*TMTechnology can help accelerate or improve their drug and diagnostic developmentand marketing efforts.  To achievemarket acceptance, we must continue to educate the pharmaceutical andbiotechnology industries and the public in general as to the potential benefitsof our *HAP*TMPartnership, STRENGTH, CARING and Long QT programs.  Most importantly, we must convince the research and development,clinical and marketing departments of pharmaceutical and biotechnologycompanies that our *HAP*TMTechnology can accelerate and improve the processes for developing, marketingand prescribing drugs and for developing and marketing diagnostics and that our*HAP*TM Partnership,STRENGTH, CARING and Long QT programs will be commercially viable.  If we fail to gain this acceptance, we maynever generate sufficient revenues to sustain our operations.  We may expend substantial funds andmanagement effort to market our *HAP*TMPartnership, STRENGTH, CARING Long QT programs, without any resulting revenues.

 

**Ourability to make any acquisitions is dependent on the availability of adequatecash and the attractiveness of our stock price.**

 

We anticipate that any future acquisitions ofbusinesses or technologies will be financed through available cash, theissuance of shares of our common stock and/or seller financing.  We cannot assure you that we will havesufficient existing capital resources or that we will be able to raisesufficient additional capital resources on terms satisfactory to us, if at all,in order to meet the capital requirements for such acquisitions.

 

We also believe that a significant factor in ourability to close acquisitions using stock as consideration will be theattractiveness of our common stock for potential acquisition candidates.  This attractiveness may, in large part, bedependent upon the relative market price and capital appreciation prospects ofour common stock compared to the equity securities of our competitors.  The trading price of our common stock on theNasdaq National Market could in the future materially adversely affect ouracquisition program.

 

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**Integrationof acquisitions or strategic investments could interrupt our business and ourfinancial condition could be harmed.**

 

From time to time, we mayacquire or make strategic investments in other businesses or technologies.  For example, on May 15, 2003, theUnited States Bankruptcy Court approved our bid to purchase substantially allof the assets and to assume certain liabilities of DNA Sciences, Inc.  In addition, we signed a modification to alicense agreement for certain intellectual property that we acquired from DNASciences.  The DNA Sciences acquisition,as well as any other acquisitions or strategic investments we may make in thefuture, entail numerous risks that include the following:

 

•                  difficultiesintegrating any acquired operations, personnel, technologies or products;

•                  diversionof management’s focus from our core business concerns;

•                  enteringmarkets in which we have no or limited prior experience or knowledge;

•                  exposureto litigation from stockholders or creditors of, or other parties affiliatedwith, the target company or companies;

•                  dilutionto existing stockholders and earnings per share; and

•                  incurrenceof substantial debt.

 

Any such difficulties encountered as a result of amerger, acquisition or strategic investment could adversely affect ourbusiness, operating results and financial condition.

 

**Ifwe are unable to prevent others from unauthorized use of, or are unable todefend our use of, our *HAP*TMTechnology, trade secrets or know how, we may not be able to operate ourbusiness profitably.**

 

Despite ourefforts to protect our proprietary rights, unauthorized parties may be able toobtain and use information that we regard as proprietary.  The issuance of a patent does not guaranteethat it is valid or enforceable; thus, even if we obtain patents, they may notbe valid or enforceable against third parties.

 

We also rely uponunpatented trade secrets and improvements, unpatented know-how and continuingtechnological innovation to develop and maintain our competitive position.  We generally protect this information withreasonable security measures, including confidentiality agreements signed byour employees, academic collaborators and consultants that provide that allconfidential information developed or made known to others during the course ofthe employment, consulting or business relationship will be kept confidentialexcept in specified circumstances. Agreements with employees, consultants and collaborators generallyprovide that all inventions conceived by the individual while employed by usare our exclusive property.  Ifemployees, consultants or collaborators do not honor these agreements, we maynot have adequate remedies for breach. Furthermore, our trade secrets may otherwise become known or beindependently discovered by competitors.

 

Further, a patent doesnot provide the patent holder with freedom to operate in a way that infringesthe patent rights of others.  A thirdparty may sue us for infringing on its patent rights.  Likewise, we may need to resort to litigation to enforce a patentissued to us or to determine the scope and validity of third party proprietaryrights.  The cost to us of anylitigation or other proceeding relating to intellectual property rights, evenif resolved in our favor, could be substantial, and the litigation would divertour management’s focus from our core business concerns.  Some of our competitors may be able tosustain the costs of complex patent litigation more effectively than we canbecause they have substantially greater resources.  Uncertainties resulting from the initiation and continuation ofany litigation could limit our ability to continue our operations.

 

If any party shouldsuccessfully claim that the creation or use of our *HAP*TM Technology or *HAP*TM Marker association data infringe upon theirintellectual property rights, in addition to any damages we might have to pay,a court could require us to stop the infringing activity or obtain a license onunfavorable terms.  Moreover, any legalaction against us or any of our program partners claiming damages or seeking toenjoin commercial activities relating to the affected products and processes could,in addition to subjecting us to potential liability for damages, require us orour *HAP*TM Partnershipand STRENGTH program partners or any CARING program partners to obtain alicense in order to continue to manufacture or market the affected products andprocesses.  Any license required underany patent may not be made available on commercially acceptable terms, if atall.  In addition, some licenses may benon-exclusive and, therefore, our competitors may have access to the sametechnology licensed to us.  If we

 

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fail to obtain a required license or are unable to design around apatent, we may be unable to market effectively some of our *HAP*TM Technology, which couldlimit our profitability and possibly prevent us from generating revenue sufficientto sustain our operations.

 

**Regulatoryoversight of our *HAP*TMTechnology and public opinion regarding ethical issues surrounding the use ofgenetic information may adversely affect our ability to market our *HAP*TM Technology.**

 

Currently, there is limitedFood and Drug Administration (FDA) regulation of genetic tests.  The Secretary’s Advisory Committee onGenetic Testing, an advisory panel to the Secretary of the U.S. Department ofHealth and Human Services, has recommended that the FDA expand its regulationof genetic testing to require FDA approval for all new genetic tests andlabeling of genetic tests.  If the FDAadopts this recommendation, it may require that we, or our partners, apply forFDA approval as a prerequisite to marketing genetic tests that incorporate our *HAP*TM Technology.  If the FDA were to deny any application ofthis kind, it could adversely affect our business and we may be unable togenerate sufficient revenues to sustain our operations.

 

The FDA has only oncerequired that a physician must have genomic variation information determinedabout a patient before the doctor prescribes a drug.  In this one instance, the FDA has stipulated that thisrequirement can be fulfilled with either gene expression information or genomicvariation information.  OnJanuary 31, 2003, the FDA announced an initiative to help make innovativemedical technology available sooner, including the use of pharmacogenomicsduring drug development.  The FDAindicated that the agency would issue guidance on when and how to submitpharmacogenomic information to the FDA during the drug developmentprocess.  The FDA said that thisguidance would facilitate the exploratory use of pharmacogenomic screeningduring drug development and would clarify when such information would beconsidered part of the evaluation of drug safety.  In addition, the FDA stated that the agency would hold a workshopin 2003 on issues that are involved in the co-development of a pharmacogenomictest and a drug and that within 18 months the agency would issue guidance onthe regulatory pathway for such combinations through the agency’s Center forDrug Evaluation and Research and the Center for Devices and RadiologicalHealth.  Our success will depend in parton what guidance the FDA issues with regard to the use of genomic variationanalysis as part of the drug approval process and, accordingly, the validity ofour *HAP*TM Technologyas a basis for identifying genomic variation and for correlating drug responsewith genomic variation.  Without this acceptanceby the FDA and the pharmaceutical and biotechnology industry, we may be unableto market effectively our *HAP*TMTechnology and we may not generate sufficient revenues to sustain ouroperations.

 

Within the field ofpersonalized health and medicine, governmental and other entities may enactpatient privacy and healthcare laws and regulations that may limit the use ofgenomic variation data.  To the extentthat these laws and regulations limit the use of our *HAP*TM Technology or impose additional costs onour partners, we may be unable to market effectively our *HAP*TM Partnership, STRENGTH,CARING and Long QT programs and we may not generate sufficient revenues tosustain our operations.

 

Additionally, publicopinion on ethical issues related to the confidentiality and appropriate use ofgenetic testing results may influence governmental authorities to call forlimits on, or regulation of the use of, genetic testing.  In addition, governmental authorities orother entities may call for limits on, or regulation of the use of, genetictesting or prohibit testing for genetic predisposition to certain conditions,particularly for those that have no known cure.  The occurrence of any of these events could reduce the potentialmarkets for our *HAP*TMTechnology, which could prevent us from generating sufficient revenues tosustain our operations.

 

Furthermore, we may bedirectly subject to regulations as a provider of diagnostic information.  To the extent that these regulationsrestrict the sale of our *HAP*TMTechnology or impose other costs, we may be unable to provide our *HAP*TM Technology to ourcustomers on terms sufficient to recover our expenses.

 

**Ifour partners do not seek, or do not receive, marketing approval for productsdeveloped, if any, using our *HAP*TMTechnology, we may receive delayed royalty or other payments or no royalty orother payments at all.**

 

Any new drug, biologic ornew drug or biologic indication our partners develop using our *HAP*TM Technology must undergoan extensive regulatory review process in the United States and other countriesbefore a new product or indication of this kind could be marketed.  This regulatory process can take many yearsand require

 

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substantial expense.  Changes inFDA policies and the policies of similar foreign regulatory bodies can prolongthe regulatory review of each new drug or biologic license application orprevent approval of the application.  Weexpect similar delays and risks in the regulatory review process for anydiagnostic product developed by our partners, whenever this regulatory reviewis required.  Even if a product obtainsmarketing clearance, a marketed product and its manufacturer are subject tocontinuing review.  A manufacturer maybe forced to withdraw a product from the market if a previously unknown problemwith a product becomes apparent. Because our future revenues will be dependent on the successfulcommercialization or development of products using our *HAP*TM Technology, any delay ofour partners in obtaining, failing to obtain, or failing to maintain regulatoryapproval for a product developed using our *HAP*TMTechnology may delay our receipt of royalty or other payments or prevent usfrom receiving royalty or other payments sufficient to recover our expenses.

 

**Ifour partners are unable to obtain FDA approval for therapeutic or diagnosticproducts developed using our *HAP*TMTechnology, the lack of regulatory approval will diminish the value of our *HAP*TM Technology.**

 

To date, no one has developedor commercialized any therapeutic product or commercialized any diagnosticproduct using our *HAP*TMTechnology.  We expect to rely on ourprogram partners to file applications for regulatory approval and generallydirect the regulatory review process and obtain FDA acceptance of our *HAP*TM Partnership and STRENGTHprograms and our CARING and Long QT programs, if any.  Our program partners may not submit an application for regulatoryreview.  Even if they do submitapplications, they may not be able to obtain marketing clearance for anyproducts on a timely basis, if at all. If our partners fail to obtain required governmental clearances fortherapeutic or diagnostic products, they will not be able to market theseproducts unless and until they obtain these clearances.  As a result, we may not receive royalty orother payments from our customers.  Theoccurrence of any of these events may prevent us from generating revenues sufficientto sustain our operations.

 

**Ifwe do not successfully distinguish and commercialize our *HAP*TM Technology, we may beunable to compete successfully with our competitors or to generate revenuesignificant to sustain our operations**.

 

Numerous entities areattempting to identify genomic variation predictive of specific diseases anddrug response and to develop products and services based on thesediscoveries.  We face competition inthese areas from pharmaceutical, biotechnology and diagnostic companies,academic and research institutions and government and other publicly-fundedagencies, both in the United States and abroad, most of which havesubstantially greater capital resources, research and development staffs,facilities, manufacturing and marketing experience, distribution channels andhuman resources than we do.

 

These competitors maydiscover, characterize or develop important technologies applying populationgenomics before us or our partners for our *HAP*TMPartnership and STRENGTH programs that are more effective than thosetechnologies which, we develop or which our partners for our *HAP*TM Partnership and STRENGTHprograms develop, or these competitors may obtain regulatory approvals of theirdrugs and diagnostics more rapidly than our partners for our *HAP*TM Partnership and STRENGTHprograms do, any of which could limit our ability to market effectively our *HAP*TM Technology.

 

**Somecompanies and governments are marketing or developing a number of databases andinformatics tools to assist participants in the healthcare industry andacademic researchers in the management and analysis of genomic data.  Entities such as Perlegen Sciences, CeleraGenomics Group and the International HapMap Project have developed or plan todevelop databases containing gene sequence, genomic variation or other genomicinformation and are marketing or plan to market their data to pharmaceuticaland biotechnology companies or plan to make freely available theirdatabases.  In addition, numerouspharmaceutical and biotechnology companies, such as GlaxoSmithKline plc, eitheralone or in partnership with our competitors, are developing genomic researchprograms that involve the use of information that can be found in thesedatabases.  Furthermore, companies, suchas deCODE genetics, Inc., have technologies for using genetic variation indiagnostics and in the drug development process and have partnerships withcompanies employing these technologies.**

** **

Genomic technologies haveundergone, and are expected to continue to undergo, rapid and significantchange.  Our future success will dependin large part on maintaining a competitive position in the genomics field.  Others may rapidly develop new technologiesthat may result in our products or technologies becoming obsolete

 

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before we recover the expenses that we incur in connection with thedevelopment of these products.  Our *HAP*TM Technology could becomeobsolete if our competitors offer less expensive or more effective drugdiscovery and development technologies, including technologies that may beunrelated to genomics.

 

**We depend on third-party products andservices and limited sources of supply for our sequencing and genotypinglaboratories.**

 

We rely onoutside vendors to supply certain software, products and materials used in ourlaboratories. Some of these products and materials are obtained from a singlesupplier or a limited group of suppliers. Our reliance on outside vendors generally, and a sole or a limited groupof suppliers in particular, involves several risks, including:

 

•                  the inability to obtain anadequate supply of required software, products and materials due to capacityconstraints, product defects, a discontinuance of a product by a supplier orother supply constraints;

•                  reduced control over qualityand pricing of software, products and materials; and

•                  delays and long lead timesin receiving software, products, or materials from vendors.

 

**Ifwe fail to maintain our computer hardware, software and related infrastructure,we could experience loss of, or delay in, revenues and market acceptance.**

 

Because our businessrequires manipulating and analyzing large amounts of data, we depend on thecontinuous, effective, reliable and secure operation of our computer hardware,software and related infrastructure.  Tothe extent that our hardware or software malfunctions, we will experiencereduced productivity.  We protect ourcomputer hardware through physical and software safeguards.  However, our computer hardware is stillvulnerable to fire, weather, earthquake, or other natural disaster and powerloss, telecommunications failures, physical or software break-ins and similarevents.  In addition, the software andalgorithmic components of our *DecoGen*®Informatics System are complex and sophisticated, and as such, could containdata, design or software errors that could be difficult to detect andcorrect.  Users of our system may findsoftware defects in current or future products.  If we fail to maintain the necessary computer capacity and datato support our computational needs and our customers’ drug and diagnosticdiscovery and development efforts, we could experience a loss in revenues, or adelay in receiving revenues and a delay in obtaining market acceptance for ourtechnology.

 

**Ouroperating results may fluctuate significantly and any failure to meet financialexpectations may disappoint securities analysts or investors and result in adecline in our common stock price.**

 

Our operating resultshave fluctuated in the past and we expect they will fluctuate in the future.These fluctuations could cause our common stock price to decline.  Some of the factors that could cause ouroperating results to fluctuate include:

 

•                  recognitionof non-recurring revenues due to receipt of license fees, achievement ofmilestones, completion of contracts or other revenues;

 

•                  demand for and market acceptance ofour *HAP*TM Partnership,STRENGTH, CARING and Long QT programs;

 

•                  timing of the execution of agreementson our *HAP*TMPartnership, STRENGTH, CARING and Long QT programs and other materialcontracts;

 

•                  our competitors’ announcements orintroduction of new products, services or technological innovations;

 

•                  disputes regarding patents or otherintellectual property rights;

 

•                  securities class actions or otherlitigation;

 

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•                  adverse changes in the level ofeconomic activity in the United States and other major regions in which we dobusiness; and

 

•                  general and industry-specificeconomic conditions, which may affect our partners’ use of our *HAP*TM Technology.

 

Due to volatile andunpredictable revenues and operating expenses, we believe that period-to-periodcomparisons of our results of operations may not be a good indication of ourfuture performance.  It is possible thatour operating results may be below the expectations of securities analysts orinvestors.  In this event, the marketprice of our common stock could fluctuate significantly or decline.

 

**Item3 – Quantitative and Qualitative Disclosures about Market Risk.**

 

Our exposure to market risk is principally confined to our cashequivalents and short-term investments, all of which have maturities of lessthan one year.  We maintain anon-trading investment portfolio of investment grade, liquid debt securitiesthat limit the amount of credit exposure to any one issue, issuer or type ofinstrument.  In view of the nature andmix of our total portfolio, a 10% movement in market interest rates would nothave a significant impact on the total value of our investment portfolio as ofJune 30, 2003.

 

**Item 4 – Controls andProcedures.**

** **

**TheCompany’s management, with the participation of the Company’s chief executiveofficer and chief financial officer, evaluated the effectiveness of theCompany’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act) as of June 30, 2003.  Based on this evaluation, the Company’schief executive officer and chief financial officer concluded that, as ofJune 30, 2003, the Company’s disclosure controls and procedures were (1)designed to ensure that material information relating to the Company is madeknown to the Company’s chief executive officer and chief financial officer byothers within the Company, particularly during the period in which this reportwas being prepared and (2) effective, in that they provide reasonable assurancethat information required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the periods specified in the SEC’s rules and forms.**

** **

**Nochange in the Company’s internal control over financial reporting (as definedin Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during thefiscal quarter ended June 30, 2003 that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.**

 

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**PARTII - Other Information**

 

**Item2 – Changes in Securities and Use of Proceeds.**

 

**Changes in Securities**

 

Not applicable.

 

**Use of Proceeds**

 

The proceeds from ourinitial public offering have been invested in interest-bearing high-gradecorporate bonds and money market accounts.

 

From the closing of ourinitial public offering through June 30, 2003, we have used the proceedsfor research and development activities, capital expenditures, working capital,debt service and other general corporate purposes.  We will continue to spend funds to service our *HAP*TM Technology Partnershipprogram and our STRENGTH program partners, our pharmacogenetic support servicescustomers, our CARING and Long QT programs and to maintain our *HAP*TM Technology.  As of June 30, 2003, $23.3 million ofthe net proceeds remain available and are primarily invested in short-termmarketable securities.

 

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

 

At our 2003 annualmeeting of stockholders (the “Annual Meeting”) held on May 21, 2003, thefollowing matters were acted upon by the stockholders of the Company:

 

1.               Theelection of Gualberto Ruaño, M.D., Ph.D., and Seth Rudnick, M.D., as Class IIIdirectors of the Company, to serve for the ensuing three years; and

 

2.               Approvalof an amendment to our 2000 Amended and Restated Equity Incentive Planincreasing the aggregate number of shares of common stock issuable thereunderfrom 4,287,375 to 4,787,375.

 

The number of shares of common stock outstanding and entitled to voteat the Annual Meeting was 23,049,397. The other directors of the Company, whose terms of office as directorscontinued after the Annual Meeting, are Harry H. Penner, Jr., Jürgen Drews,M.D., Kevin Rakin and Christopher Wright. The results of the voting on each of the matters presented tostockholders at the Annual Meeting are set forth below:

 

 
| **Matter**                                                                                                              |   | **Votes For** |   | **Votes  Withheld/Against** |   | **Abstentions** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|---------------|--------|-----------------------------|--------|-----------------|--------|
| 1.    Election of Directors:                                                                             |   |          |   |                        |   |            |   |
|              Gualberto  Ruaño, M.D., Ph.D.             |   | 15,745,205    |   | 2,919,383                   |   | N/A             |   |
|              Seth  Rudnick, M.D.                            |   | 17,592,434    |   | 1,072,154                   |   | N/A             |   |
| 2.    Approval of Amendment to the  Company’s 2000 Amended and  Restated Equity Incentive Plan |   | 16,035,243    |   | 2,106,381                   |   | 522,963         |   |

 

InJuly 2003, Dr. Ruaño notified the Company that he intended to resign asChief Scientific Officer and as a Director of the Company, effectiveAugust 31, 2003.

 

**Item6 – Exhibits and Reports on Form 8-K.**

 

(a) Exhibits

 

See Index toExhibits attached hereto.

 

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(b) Reports onForm 8-K

 

We filed thefollowing reports on Form 8-K during the fiscal quarter ended June 30,2003:

 

Current Report onForm 8-K dated May 13, 2003, furnishing under Item 12 our financialresults for our first quarter ended March 31, 2003.

 

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** **

**GENAISSANCE PHARMACEUTICALS, INC.**

 

**SIGNATURE**

 

Pursuant to the requirements of the Securities Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                        | GENAISSANCE  PHARMACEUTICALS, INC.                 |
|-----------------------------|----------------------------------------------------|
|                        |                                               |   |
|                        |                                               |   |
| Date: August 14,  2003 | By:                                                |    /s/  Ben Kaplan |   |
|                        | Ben Kaplan                                         |
|                        | Senior Vice President  and Chief Financial Officer |
|                        | (Principal Financial  and Accounting Officer)      |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** |   | **Description of Document**                                                                                              |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------|
| 10.1*           |   | Employment  Agreement with Ben Kaplan dated May 6, 2003.                                                                 |
|            |   |                                                                                                                     |
| 31.1            |   | Certification  pursuant to Rules 13a-14(a)/15d-14(a) promulgated under the Securities  Exchange Act of 1934, as amended. |
|            |   |                                                                                                                     |
| 31.2            |   | Certification  pursuant to Rules 13a-14(a)/15d-14(a) promulgated under the Securities  Exchange Act of 1934, as amended. |
|            |   |                                                                                                                     |
| 32.1            |   | Certification  pursuant to 18 U.S.C. Section 1350.                                                                       |
|            |   |                                                                                                                     |
| 32.2            |   | Certification  pursuant to 18 U.S.C. Section 1350.                                                                       |

 

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*                 Indicates amanagement contract or compensatory plan.

 

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