** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

**(Mark One)**
| **ý**                                                                                                                                                                   | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                         |       |                                                                                                 |
| **For  the quarterly period ended December 31, 2004**                                                                                                                        |
| ** **                                                                                                                                                                   |
| **or**                                                                                                                                                                       |
| ** **                                                                                                                                                                   |
| **o**                                                                                                                                                                        | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                         |       |                                                                                                 |
| **For the transition period from                          to** |

 

**Commission File Number: 0-27118**

 

**ACCELRYS, INC.**

(Exactname of registrant as specified in its charter)

 
| **Delaware**                                                   | ** ** | **33-0557266**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                           |       |                                 |
| **10188 Telesis Court, Suite 100, San Diego,  California**     | ** ** | **92121-1761**                       |
| (Address of principal executive offices)                       |       | (Zip code)                           |

 

**(858)799-5000**

(Registrant’s telephone number, including area code)

 

**Former address: 9685 Scranton Road, San Diego, California**

(Former name, former address and former fiscal year, if changed sincelast report)

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or such shorter period that the registrant was required tofile such reports) and (2) has been subject to such filing requirementsfor the past 90 days.  Yes ý                No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes ý         No o

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

 
| **Class**                       | ** ** | **Outstanding  at January 31, 2005** |
|---------------------------------|------------|--------------------------------------|
| Common Stock, $.0001 par  value |       | 26,582,344  shares                   |

 

 

----

 

#### **ACCELRYS, INC.**

 

**Form 10-Q**

 

#### **Table of Contents**

 
| **Item**                      | ** **                                                                                  | **Page**   | ** ** |
|-------------------------------|---------------------------------------------------------------------------------------------|------------|------------|
| ** **                    | ** **                                                                                  | ** ** | ** ** |
| PART I. FINANCIAL INFORMATION | 3                                                                                           |       |
|                          |                                                                                        |       |       |
| Item 1.                  | Unaudited Consolidated  Financial Statements:                                               | 3          |       |
|                          |                                                                                        |       |       |
|                          | Balance Sheets — December  31, 2004 and December 31, 2003                              | 3          |       |
|                          |                                                                                        |       |       |
|                          | Statements of Operations —  Three and Nine Months Ended December 31, 2004 and 2003     | 4          |       |
|                          |                                                                                        |       |       |
|                          | Statements of Cash Flows —  Nine Months Ended December 31, 2004 and 2003               | 5          |       |
|                          |                                                                                        |       |       |
|                          | Notes to Unaudited  Consolidated Financial Statements                                       | 6          |       |
|                          |                                                                                        |       |       |
| Item 2.                  | Management’s Discussion  and Analysis of Financial Condition and Results of Operations | 12         |       |
|                          |                                                                                        |       |       |
| Item 3.                       | Quantitative and Qualitative  Disclosures about Market Risk                                 | 28         |       |
|                          |                                                                                        |       |       |
| Item 4.                       | Controls and Procedures                                                                     | 28         |       |
|                          |                                                                                        |       |       |
| PART II. OTHER INFORMATION    |                                                                                        |       |
|                          |                                                                                        |       |       |
| Item 1.                       | Legal Proceedings                                                                           | 29         |       |
|                          |                                                                                        |       |       |
| Item 2.                       | Unregistered Sales of  Equity Securities and Use of Proceeds                                | 29         |       |
|                          |                                                                                        |       |       |
| Item 3.                       | Defaults Upon Senior  Securities                                                            | 29         |       |
|                          |                                                                                        |       |       |
| Item 4.                       | Submission of Matters to a  Vote of Security Holders                                        | 29         |       |
|                          |                                                                                        |       |       |
| Item 5.                       | Other Information                                                                           | 29         |       |
|                          |                                                                                        |       |       |
| Item 6.                       | Exhibits                                                                                    | 29         |       |
|                          |                                                                                        |       |       |
| Signature                     |                                                                                        | 30         |       |
|                          |                                                                                        |       |       |
| Exhibit Index                 | 31                                                                                          |       |

 

 

2

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** **

**PART I- FINANCIAL INFORMATION**

 

**Item 1.****  Unaudited Consolidated Financial Statements**

 

**Accelrys, Inc.**

**Consolidated Balance Sheets**

**(Dollars and share amounts in thousands, except per share data)**

 
| ** **                                                                                               | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                               | ** ** | **2004**         | ** ** | **2003**         | ** ** |
| **ASSETS**                                                                                               | ** ** | **(unaudited)**  | ** ** | **(note 1)**     | ** ** |
| Current assets:                                                                                          |       |             |       |             |       |
| Cash and cash equivalents                                                                                |       | $                | 18,786     |             | $          | 26,985 |   |
| Restricted cash                                                                                          |       | 7,133            |       | —           |       |
| Marketable securities                                                                                    |       | 33,162           |       | 106,546          |       |
| Trade receivables, net of allowance for doubtful accounts of $93 and  $505, respectively                 |       | 32,830           |       | 39,780           |       |
| Prepaid expenses and other current assets                                                                |       | 8,590            |       | 4,197            |       |
| Current assets of discontinued operations                                                                |       | —           |       | 3,994            |       |
| Total current assets                                                                                     |       | 100,501          |       | 181,502          |       |
| Property and equipment, net                                                                              |       | 8,910            |       | 8,441            |       |
| Goodwill                                                                                                 |       | 43,298           |       | 34,072           |       |
| Intangible assets, net of accumulated amortization of $621 and $0,  respectively                         |       | 10,879           |       | —           |       |
| Software development costs, net of accumulated amortization of  $30,087 and $26,555, respectively        |       | 8,565            |       | 7,634            |       |
| Other assets                                                                                             |       | 886              |       | 960              |       |
| Long-term assets of discontinued operations                                                              |       | —           |       | 7,058            |       |
| Total assets                                                                                             |       | $                | 173,039    |             | $          | 239,667 |   |
|                                                                                                     |       |             |       |             |       |
| **LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                 | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current liabilities:                                                                                     |       |             |       |             |       |
| Accounts payable                                                                                         |       | $                | 1,153      |             | $          | 1,850 |   |
| Accrued liabilities                                                                                      |       | 23,056           |       | 18,819           |       |
| Deferred revenue, current portion                                                                        |       | 36,648           |       | 24,595           |       |
| Current liabilities of discontinued operations                                                           |       | —           |       | 6,420            |       |
| Total current liabilities                                                                                |       | 60,857           |       | 51,684           |       |
| Deferred revenue, long-term                                                                              |       | 6,719            |       | 4,924            |       |
| Lease obligations, long-term                                                                             |       | 2,209            |       | —           |       |
| Long-term liabilities of discontinued operations                                                         |       | —           |       | 325              |       |
| Stockholders' equity:                                                                                    |       |             |       |             |       |
| Preferred stock, $.0001 par value, 2,000 shares authorized, none  issued and outstanding                 |       | —           |       | —           |       |
| Common stock, $.0001 par value, 40,000 shares authorized, 26,582 and  24,949 shares issued, respectively |       | 2                |       | 2                |       |
| Additional paid-in capital                                                                               |       | 253,078          |       | 287,592          |       |
| Unearned compensation                                                                                    |       | (1,694           | )          | (536             | )          |
| Lease guarantee                                                                                          |       | (714             | )          | —           |       |
| Treasury stock, 644 shares                                                                               |       | (8,340           | )          | (8,340           | )          |
| Accumulated deficit                                                                                      |       | (139,998         | )          | (97,318          | )          |
| Accumulated comprehensive income                                                                         |       | 920              |       | 1,334            |       |
| Total stockholders' equity                                                                               |       | 103,254          |       | 182,734          |       |
| Total liabilities and stockholders' equity                                                               |       | $                | 173,039    |             | $          | 239,667 |   |

 

See accompanying notes to these unaudited consolidated financialstatements.

 

 

3

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**Accelrys, Inc.**

#### **Consolidated Statements of Operations**

**(Dollars and shares in thousands, except per share data, unaudited)**

 
| ** **                                                                   | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **Ended December 31,**   | ** ** | **Ended December 31,**  | ** ** |
| ** **                                                                   | ** ** | **2004**                 | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                                                      |       | $                        | 22,229     |                    | $          | 31,577 |   | $ | 50,687 |   | $ | 68,342 |   |
| Cost of revenue                                                              |       | 5,161                    |       | 4,507                   |       | 12,084 |   | 14,676 |   |
| Gross margin                                                                 |       | 17,068                   |       | 27,070                  |       | 38,603 |   | 53,666 |   |
| Research and development                                                     |       | 4,659                    |       | 4,578                   |       | 13,164 |   | 13,386 |   |
| Sales and marketing                                                          |       | 10,109                   |       | 9,502                   |       | 25,348 |   | 25,629 |   |
| General and administrative                                                   |       | 4,139                    |       | 4,890                   |       | 11,827 |   | 13,579 |   |
| Lease abandonment                                                            |       | 3,612                    |       | —                  |       | 3,612 |   | — |   |
| Write-off (reversal) of in-process research and development                  |       | (250                     | )          | —                  |       | 450 |   | — |   |
| Total operating costs and expenses                                           |       | 22,269                   |       | 18,970                  |       | 54,401 |   | 52,594 |   |
| Operating income (loss) from continuing operations                           |       | (5,201                   | )          | 8,100                   |       | (15,798 | ) | 1,072 |   |
| Spin-off transaction costs                                                   |       | —                   |       | (700                    | )          | — |   | (700 | ) |
| Interest and other income, net                                               |       | 184                      |       | 939                     |       | 1,257 |   | 3,032 |   |
| Loss from continuing operations before provision (benefit) for income  taxes |       | (5,017                   | )          | 8,339                   |       | (14,541 | ) | 3,404 |   |
| Provision (benefit) for income taxes                                         |       | (362                     | )          | 140                     |       | 252 |   | 731 |   |
| Income (loss) from continuing operations                                     |       | (4,655                   | )          | 8,199                   |       | (14,793 | ) | 2,673 |   |
| Discontinued operations:                                                     |       |                     |       |                    |       |   |   |   |   |
| Loss from discontinued operations                                            |       | —                   |       | (347                    | )          | (1,117 | ) | (717 | ) |
| Net income (loss)                                                            |       | $                        | (4,655     | )                       | $          | 7,852 |   | $ | (15,910 | ) | $ | 1,956 |   |
| Income (loss) from continuing operations per share:                          |       |                     |       |                    |       |   |   |   |   |
| - Basic                                                                      |       | $                        | (0.18      | )                       | $          | 0.34 |   | $ | (0.60 | ) | $ | 0.11 |   |
| - Diluted                                                                    |       | $                        | (0.18      | )                       | $          | 0.33 |   | $ | (0.60 | ) | $ | 0.11 |   |
| Loss from discontinued operations per share:                                 |       |                     |       |                    |       |   |   |   |   |
| - Basic                                                                      |       | $                        | —     |                    | $          | (0.01 | ) | $ | (0.04 | ) | $ | (0.03 | ) |
| - Diluted                                                                    |       | $                        | —     |                    | $          | (0.01 | ) | $ | (0.04 | ) | $ | (0.03 | ) |
| Net income (loss) per share:                                                 |       |                     |       |                    |       |   |   |   |   |
| - Basic                                                                      |       | $                        | (0.18      | )                       | $          | 0.33 |   | $ | (0.64 | ) | $ | 0.08 |   |
| - Diluted                                                                    |       | $                        | (0.18      | )                       | $          | 0.32 |   | $ | (0.64 | ) | $ | 0.08 |   |
| Weighted average shares of common stock outstanding:                         |       |                     |       |                    |       |   |   |   |   |
| - Basic                                                                      |       | 25,841                   |       | 23,870                  |       | 24,876 |   | 23,796 |   |
| - Diluted                                                                    |       | 25,841                   |       | 24,926                  |       | 24,876 |   | 24,499 |   |
|                                                                              |            |                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to these unaudited consolidated financialstatements.

 

 

4

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**Accelrys, Inc.**

**Consolidated Statements of CashFlows**

**(Dollars in thousands)**

 
| ** **                                                                           | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                           | ** ** | **Ended December 31,**  | ** ** |
| ** **                                                                           | ** ** | **2004**                | ** ** | **2003** | ** ** |
| OPERATING ACTIVITIES:                                                                |       |                    |       |   |   |
| Net income (loss)                                                                    |       | $                       | (15,910    | ) | $ | 1,956 |   |
| Adjustments to reconcile net income (loss) to net cash used by  operating activities |       |                    |       |   |   |
| Depreciation                                                                         |       | 3,283                   |       | 3,363 |   |
| Amortization                                                                         |       | 3,227                   |       | 3,660 |   |
| Write-off of in-process research and development                                     |       | 450                     |       | — |   |
| Contribution of stock to 401(k) members                                              |       | 431                     |       | 762 |   |
| Amortization of unearned compensation                                                |       | 405                     |       | — |   |
| Non-cash compensation                                                                |       | —                  |       | 83 |   |
| Changes in assets and liabilities:                                                   |       |                    |       |   |   |
| Trade receivables                                                                    |       | (20,354                 | )          | (22,775 | ) |
| Prepaid expenses and other current assets                                            |       | (4,021                  | )          | 176 |   |
| Other assets                                                                         |       | 177                     |       | (470 | ) |
| Accounts payable                                                                     |       | (4,586                  | )          | (2 | ) |
| Accrued liabilities                                                                  |       | 6,176                   |       | 3,289 |   |
| Deferred revenue                                                                     |       | 12,538                  |       | 4,049 |   |
| Net cash used by operating activities                                                |       | (18,184                 | )          | (5,909 | ) |
| INVESTING ACTIVITIES:                                                                |       |                    |       |   |   |
| Capital expenditures                                                                 |       | (3,654                  | )          | (2,117 | ) |
| Increase in capitalized software development costs                                   |       | (3,338                  | )          | (3,095 | ) |
| Acquisition of business, net of cash acquired                                        |       | (10,910                 | )          | — |   |
| Purchases of marketable securities                                                   |       | (44,352                 | )          | (74,255 | ) |
| Proceeds from sales of marketable securities                                         |       | 105,170                 |       | 81,882 |   |
| Net cash provided by investing activities                                            |       | 42,916                  |       | 2,415 |   |
| FINANCING ACTIVITIES:                                                                |       |                    |       |   |   |
| Proceeds from issuance of common stock                                               |       | 1,625                   |       | 1,667 |   |
| Net cash provided by financing activities                                            |       | 1,625                   |       | 1,667 |   |
| Exchange rate effect on cash and cash equivalents                                    |       | 458                     |       | 703 |   |
| Cash distribution to PDD (see Note 6)                                                |       | (46,500                 | )          | — |   |
| Net cash used in discontinued operations                                             |       | (1,233                  | )          | (3,470 | ) |
| Net decrease in cash and cash equivalents                                            |       | (20,918                 | )          | (4,594 | ) |
| Cash and cash equivalents, beginning of period                                       |       | 39,704                  |       | 31,579 |   |
| Cash and cash equivalents, end of period                                             |       | $                       | 18,786     |   | $ | 26,985 |   |
| SUPPLEMENTAL INFORMATION:                                                            |       |                    |       |   |   |
| Cash paid during the period for:                                                     |       |                    |       |   |   |
| Interest expense                                                                     |       | $                       | 5          |   | $ | — |   |
| Income tax expense                                                                   |       | 436                     |       | $ | 155 |   |
|                                                                                      |            |                         |            |  |  |  |  |  |  |

 

See accompanying notes to these unaudited consolidated financialstatements.

 

 

5

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#### ** **

#### **Accelrys, Inc.**

**Notes to Unaudited ConsolidatedFinancial Statements**

 

**1.  Basis of Presentation**

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, these unaudited financial statements do not include all ofthe information and disclosures required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation of thefinancial statements have been included. Interim results are not necessarily indicative of the results that maybe expected for the year.  Thesefinancial statements should be read in conjunction with the audited financialstatements and disclosures thereto included in the Company’s Annual Report(under our former name Pharmacopeia, Inc.) on Form 10-K for the yearended December 31, 2003.

 

OnApril 1, 2004 the Company changed its fiscal year end from December 31 to March31.

 

OnApril 30, 2004 the Company completed the spin-off of the Company’s DrugDiscovery segment, Pharmacopeia Drug Discovery, Inc. (“PDD”), see Note 6.  The operations, financial position and cashflows of PDD have been represented as discontinued operations in theaccompanying financial statements.

 

OnMay 11, 2004, the Company’s shareholders approved the change of the Company’sname to Accelrys, Inc. from Pharmacopeia, Inc.

 

**2.  Business Combination**

 

OnSeptember 27, 2004, the Company acquired all of the outstanding common sharesof SciTegic, Inc. (“SciTegic”).  Theresults of SciTegic’s operations have been included in the consolidatedfinancial statements since that date. SciTegic is a leading provider of workflow software solutions for thescientific research market.  The primaryreason for the acquisition was to complement the Company’s existing productofferings.

 

Theaggregate purchase price was $20.8 million including $13.4 million of cash and1,166,218 common shares of stock valued at $7.4 million.  The per share value of the stock issued was$6.37 determined on the average market price of Accelrys’ common shares overthe five-day period including two days before, the day of and two days afterthe terms of the acquisition were agreed to and announced.  On the date of acquisition, 1,040,119 commonshares of stock were issued to SciTegic stockholders and 126,099 common sharesof stock (earnout shares) were deposited into an escrow account.  Further, the Company deposited $3.2 millionof the cash consideration into an escrow account.

 

OnJanuary 31, 2005, a portion of the cash escrow was released to the formerSciTegic stockholders pursuant to the terms of the merger agreement.  Subject to indemnification claims by theCompany, the remaining cash escrow may be released to the former SciTegicstockholders on September 27, 2005.  Thestock held in escrow, earnout shares, will be released in four semi-annualinstallments to former SciTegic stockholders subject to, among other things,the continued employment by the Company of two founders of SciTegic through theperiod starting September 27, 2004 and ending September 27, 2006.

 

Inaddition to the earnout shares above, 208,225 common shares of stock weredeposited in the escrow account for the two founders of SciTegic.  The Company recorded deferred compensation of$1.3 million related to these shares. Additionally, the Company convertedSciTegic employees’ unvested stock options into unvested options in the Companyresulting in deferred compensation. As of December 31, 2004, the remainingdeferred compensation balance was $1.4 million.

 

 

6

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Thefollowing table summarizes the estimated fair values of the assets acquired andliabilities assumed at the date of acquisition. During the quarter ended December 31, 2004, the Company finalized thevaluation of certain intangible assets with the assistance of a third-partyvaluation company.  The following allocationwas made based upon management’s review of the tangible and intangible assetsand liabilities of SciTegic.

 
| **At September 27, 2004**                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------|------------|
| **(in thousands)**                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets                                                  |       |       |       | $          | 3,471      |   |
| Property and equipment                                          |       |       |       | 163        |       |
| In-process research and development assets                      |       |       |       | 450        |       |
| Other long-term assets                                          |       |       |       | 21         |       |
| Intangible assets not subject to amortization-                  |       |       |       |       |       |
| Trademark/Tradename                                             |       |       |       | 2,500      |       |
| Intangible assets subject to amortization-                      |       |       |       |       |       |
| Developed Technology (five year weighted-average useful life)   |       | 6,750      |       |       |       |
| Customer Relationships (ten year weighted-average useful life)  |       | 1,650      |       |       |       |
| Backlog (two and one-quarter year weighted-average useful life) |       | 550        |       |       |       |
| Contract based (five year weighted-average useful life)         |       | 50         |       |       |       |
|                                                            |       |       |       | 9,000      |       |
| Goodwill                                                        |       |       |       | 9,726      |       |
| Total assets acquired                                           |       |       |       | 25,331     |       |
|                                                            |       |       |       |       |       |
| Current liabilities                                             |       |       |       | (2,297     | )          |
| Deferred revenue                                                |       |       |       | (2,172     | )          |
| Long-term liabilities                                           |       |       |       | (15        | )          |
| Total liabilities acquired                                      |       |       |       | (4,484     | )          |
|                                                            |       |       |       |       |       |
| Net assets acquired                                             |       |       |       | 20,847     |       |
|                                                                 |            |            |            |            |            |  |

 

 

The$0.5 million assigned to in-process research and development assets werewritten off at the date of acquisition in accordance with FASB InterpretationNo.4, *Applicability of FASB Statement No. 2 to BusinessCombinations Accounted for by the Purchase Method*.  Those write-offs are included in theStatement of Operations as a separate line item.

 

Ofthe $9.7 million assigned to goodwill, there will be no deduction for taxpurposes as this was a stock acquisition.

 

Assumingthe acquisition had occurred on April 1 of the following respective periods,the pro forma consolidated results of operations would be as follows (inthousands, except per share data):

 
| ** **                   | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                   | ** ** | **Ended December 31,**   | ** ** | **Ended December 31,**  | ** ** |
| ** **                   | ** ** | **2004**                 | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Total revenue                |       | $                        | 22,229     |                    | $          | 34,494 |   | $ | 54,501 |   | $ | 74,169 |   |
| Net income (loss)            |       | (4,655                   | )          | 8,437                   |       | (16,154 | ) | 2,358 |   |
|                         |       |                     |       |                    |       |   |   |   |   |
| Net income (loss) per share: |       |                     |       |                    |       |   |   |   |   |
| Basic                        |       | $                        | (0.18      | )                       | $          | 0.35 |   | $ | (0.65 | ) | $ | 0.10 |   |
| Diluted                      |       | $                        | (0.18      | )                       | $          | 0.34 |   | $ | (0.65 | ) | $ | 0.10 |   |

 

7

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**3.  Net Income (Loss) Per Share**

 

TheCompany computes net income (loss) per share in accordance with Statement ofFinancial Accounting Standard No. 128, “Earnings PerShare” (“SFAS 128”).  Under theprovisions of SFAS 128, basic net income (loss) per share is computed bydividing the net income (loss) for the period by the weighted-average number ofcommon shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted-average number of common sharesand dilutive common equivalent shares outstanding during the period.  Diluted earnings per share include thepotentially dilutive effect of outstanding stock options, or other dilutivesecurities.  In periods presented wherethe Company had a net loss the inclusion of common stock equivalents foroutstanding stock options would be anti-dilutive and therefore theweighted-average shares used to calculate both basic and diluted loss per shareare the same.

 

**4.  Stock-Based Compensation**

 

Statementof Financial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation” (“SFAS 123”) encourages, but does not require, companies torecord compensation cost for stock-based compensation plans at fair value.  As permitted by SFAS 123, the Company haselected to continue following Accounting Principles Board Opinion No. 25 “Accountingfor Stock Issued to Employees,” (“APB 25”) and related interpretations, toaccount for stock-based compensation. Under APB 25, no compensation expense is recognized at the time ofoption grant because the exercise price of the Company’s employee stock optionequals the fair market value of the underlying common stock on the date ofgrant.

 

Hadthe Company followed the fair value measurement provisions of SFAS 123, thefollowing table summarizes the pro forma net income (loss) and pro forma netincome (loss) per share that would have been recorded (in thousands, except pershare data):

 
| ** **                                                                                                                                   | ** ** | **Three Months Ended December 31,** | ** ** | **Nine Months Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss):                                                                                                                           |       |                                |       |                               |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                                   | (4,655     | )                                  | $          | 7,852 |   | $ | (15,910 | ) | $ | 1,956 |   |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards, net of related tax effects |       | (1,665                              | )          | (2,397                             | )          | (5,697 | ) | (8,618 | ) |
| Pro forma                                                                                                                                    |       | $                                   | (6,320     | )                                  | $          | 5,455 |   | $ | (21,607 | ) | $ | (6,662 | ) |
|                                                                                                                                         |       |                                |       |                               |       |   |   |   |   |
| Basic net income (loss) per share:                                                                                                           |       |                                |       |                               |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                                   | (0.18      | )                                  | $          | 0.33 |   | $ | (0.64 | ) | $ | 0.08 |   |
| Pro forma                                                                                                                                    |       | $                                   | (0.24      | )                                  | $          | 0.23 |   | $ | (0.87 | ) | $ | (0.28 | ) |
|                                                                                                                                         |       |                                |       |                               |       |   |   |   |   |
| Diluted net income (loss) per share:                                                                                                         |       |                                |       |                               |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                                   | (0.18      | )                                  | $          | 0.32 |   | $ | (0.64 | ) | $ | 0.08 |   |
| Pro forma                                                                                                                                    |       | $                                   | (0.24      | )                                  | $          | 0.22 |   | $ | (0.87 | ) | $ | (0.28 | ) |
|                                                                                                                                              |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |  |

 

Thefair value of each option granted during 2004 and 2003 is estimated on the dateof grant using the Black-Scholes option-pricing model with the followingassumptions:

 
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0        | %          | 0        | %          |
| Expected volatility     |       | 69.25    | %          | 85.82    | %          |
| Risk-free interest rate |       | 3.93     | %          | 3.79     | %          |
| Expected life (years)   |       | 3.7      |       | 6.3      |       |

** **

**5.  Restructuring and lease abandonment**

 

Duringthe quarter ended September 30, 2002, the Company announced that it wasundertaking various actions to restructure its operations to improve itsoverall financial performance.  As ofDecember 31, 2004 the remaining obligation under this restructuring was relatedto the closure of a facility. The following table summarizes the activity andbalance of the

 

 

8

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restructuring liabilityduring the quarter ended December 31, 2004 (dollars in thousands):

 
| ** **                    | ** ** | **Costs to Exit Lease** | ** ** |
|-------------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **Obligations**         | ** ** |
| Balance at September 30, 2004 |       | $                       | 981        |   |
| Utilization of Reserves:      |       |                    |       |
| Cash                          |       | (68                     | )          |
| Effect of foreign exchange    |       | 72                      |       |
| Balance at December 31, 2004  |       | $                       | 985        |   |

 

During the quarterended March 31, 2004, the Company executed a restructuring plan for the purposeof making research and development activities more efficient and reducinggeneral and administrative costs.  Therestructuring effort included a reduction in workforce of 73 employees, ofwhich all had received notice of such reduction by March 31, 2004 and all ofwhich had been terminated as of June 28, 2004. As a result, restructuring related charges of approximately $2.8 millionwere recognized as operating expense during the quarter ended March 31, 2004.

 

The followingtable summarizes the activity and balance of the restructuring reserveliability during the quarter ended December 31, 2004 (dollars in thousands):

 
| ** **                    | ** ** | **Severance Cost for**   | ** ** |
|-------------------------------|------------|--------------------------|------------|
| ** **                    | ** ** | **Involuntary Employee** | ** ** |
| ** **                    | ** ** | **Terminations**         | ** ** |
| Balance at September 30, 2004 |       | $                        | 13         |   |
| Utilization of Reserves:      |       |                     |       |
| Cash                          |       | (13                      | )          |
| Balance at December 31, 2004  |       | $                        | 0          |   |

 

During the quarter endedDecember 31, 2004, the Company recorded a charge of $3.6 million related to themove of its corporate headquarters. This charge represents the future rent andrent related obligations on the former headquarters building, net of subtenantlease income.  Upon initially closing itsfinancial statements for the quarter ended December 31, 2004, the Companyincluded a restructuring charge of $4.7 million related to the relocation ofthe corporate headquarters to a new facility. This preliminary amount assumed that the Company would not be able tosublease the abandonment property.  Theassumption was based on the fact that the Company had not been successful inobtaining a subtenant for the former facility and it was uncertain that the Companywould find a subtenant in the future.  However,on February 3, 2005, the Company executed a sublease agreement with a subtenantfor the former facility.  Under the termsof the sublease agreement, Accelrys will receive from the subtenant monthlyrental payments and reimbursement of certain operating expenses related to thefacility. This subsequent event reduced the estimated lease abandonment by $1.1million, to $3.6 million, and reduced the quarterly and year-to-date loss pershare by $0.04 to $(0.18) and $(0.64) per share, respectively.

 

The followingtable summarizes the activity and balance of the lease abandonment liabilityduring the quarter ended December 31, 2004 (dollars in thousands):

 
| ** **                   | ** ** | **Costs to Exit Lease** | ** ** |
|------------------------------|------------|-------------------------|------------|
| ** **                   | ** ** | **Obligations**         | ** ** |
| Lease abandonment            |       | $                       | 3,612      |   |
| Utilization of Reserves:     |       |                    |       |
| Cash                         |       | (410                    | )          |
| Balance at December 31, 2004 |       | $                       | 3,202      |   |

 

 

**6.  Spin-off of Pharmacopeia Drug Discovery, Inc.**

 

On April 30, 2004 the Company completed the spin-off of PDDinto an independent, separately traded, publicly held company through thedistribution to the Company’s stockholders of a dividend of one share of PDDcommon stock for every two shares of Accelrys common stock. The Company hasreceived an opinion of counsel that the transaction qualified for treatment asa tax-free spin-off.  As a result of thistransaction, the Company made a capital contribution of $46.5 million to PDDand incurred costs of approximately $2.3 million which were accrued at March31, 2004, and have been paid out as of 

 

 

9

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December31, 2004. For the one-month period ended April 30, 2004, the discontinued PDDoperations had revenue of $1.3 million and a pretax loss of $(1.1) million.

 

**7.  Guarantee**

 

On April 30, 2004, the landlords of the New Jersey facilitiesrelated to the PDD operations consented to the assignment of the leases toPDD.  Despite the assignment, thelandlords required Accelrys to guarantee the remaining lease obligationsrepresenting approximately $29.2 million in future payments through April 2016.  The probability-weighted fair market value ofthis guarantee was calculated in accordance with Financial Accounting StandardBoard Interpretation No. 46 (FIN 46) “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers”andresulted in a liability which is being amortized over the lease term.  At December 31, 2004, the liability is $0.7million.

 

**8.  Restricted Cash**

 

At December 31, 2004, the Company had a restricted cashbalance of $7.1 million consisting of two separate amounts.

 

During the quarter ended June 30, 2004, the Company signed anine-year sublease agreement for corporate facilities in San Diego.  Under the terms of the sublease, the Companywas required to place $6.6 million in a restricted cash account to ensureperformance under the sublease agreement. The cash restriction periodically decreases over the term of thesublease agreement pursuant to which cash is released to Accelrys.

 

Additionally, $0.5 million of cash is restricted under thetransition services agreement with PDD in which the Company agreed to providecertain infrastructure to PDD over a one-year term.  On April 30, 2005, any remaining cash will bereleased back to Accelrys.

 

**9.  Income Taxes**

 

The Company accounts for income taxes using the liabilitymethod.  Under the liability method,deferred income taxes are recognized for the tax consequences of “temporarydifferences” by applying enacted statutory tax rates applicable to future yearsto differences between the financial carrying amounts and the tax basis ofexisting assets and liabilities.  Theprovision for income taxes is based on the Company’s estimates for taxableincome of the various legal entities and jurisdictions in which it operates. Assuch, income tax expense may vary from the customary relationship between incometax expense and pretax accounting income.

 

**10.  Variable Interest Entity**

 

In January 2003, the Financial Accounting Standards Board(FASB) issued FASB Interpretation 46, Consolidation of Variable InterestEntities, an Interpretation of ARB No. 51 (FIN 46). In December 2003, the FASBmodified FIN 46 to make certain technical corrections and address certainimplementation issues that had arisen. FIN 46 provides a new framework for identifying variable interest entities(VIEs) and determining when a company should include the assets, liabilities,noncontrolling interest and results of activities of a VIE in its consolidatedfinancial statements.

 

In general, a VIE is a corporation, partnership,limited-liability corporation, trust, or any other legal structure used toconduct activities or hold assets that either (1) has an insufficient amount ofequity to carry out its principal activities without additional subordinatedfinancial support, (2) has a group of equity owners that are unable to makesignificant decisions about its activities, or (3) has a group of equity ownersthat do not have the obligation to absorb losses or the right to receivereturns generated by its operations.

 

FIN 46 requires a VIE to be consolidated if a party with anownership, contractual or other financial interest in the VIE (a variableinterest holder) is obligated to absorb a majority of the risk of loss from theVIE’s activities, is entitled to receive a majority of the VIE’s residualreturns (if no party absorbs a majority of the VIE’s losses), or both.  A variable interest holder that consolidatesthe VIE is called the primary beneficiary. Upon consolidation, the primary beneficiary generally must initiallyrecord all of the VIE’s assets, liabilities and noncontrolling interest at fairvalue and subsequently account for the VIE as if it were consolidated based onmajority voting interest.  FIN 46 alsorequires disclosures about VIE’s that the variable interest holder is notrequired to consolidate but in which it has a significant variable interest.

 

FIN 46 was effectiveimmediately for VIE’s created after January 31, 2003.  The provisions of FIN 46, as revised, wereadopted as of December 31, 2003, for the Company’s interest in all VIE’s.  In October 2004, the FASB revised FIN 46 to 

 

 

10

----

 

include rabbitrusts as a VIE since the company sponsoring the rabbi trust is the primarybeneficiary in the event of bankruptcy. The Company established a rabbi trust in March 2000 for the benefit ofdirectors and officers of the Company under its deferred compensationplan.  Since the rabbi trust’s inception,the assets of the rabbi trust have been consolidated in the Company’s othercurrent assets and the liabilities have been consolidated in the Company’saccrued liabilities, which as of December 31, 2004 were $2.9 million.  Any losses incurred by the rabbi trust areborne by the Company’s directors and officers and not the Company.

**11.  New Accounting Pronouncement**

 

In December 2004, the FinancialAccounting Standards Board (FASB) issued Statement Financial AccountingStandard No. 123 (revised 2004), Share-Based Payment (SFAS 123R).  SFAS 123R requires all companies to measurecompensation costs for all share-based payments (including employee stockoptions) at fair value.  The effectivedate of SFAS 123R is as of the beginning of the first interim or annualreporting period that begins after June 15, 2005.  Early adoption is encouraged.  Accordingly, the Company will be required toapply SFAS 123R beginning July 1, 2005. The Company is currently evaluating the impact that this Statement willhave on its financial statements and no decision had been made with respect tothe early adoption of this Statement as of the date of filing of this Form 10-Q.

**12.  Subsequent Event**

On February 3, 2005, Accelrysexecuted a sublease agreement with a subtenant for its abandoned facility inSan Diego, Ca.  Under the terms of thesublease agreement, Accelrys will receive from the subtenant monthly rentalpayments and reimbursement for certain operating expenses related to thefacility.  These payments offset the losson abandonment of the facility recorded during the quarter ended December 31,2004.  This loss was originally reportedas $4.7 million in the financial results included in the Company’s pressrelease issued on January 26, 2005,  andfurnished on Form 8-K on January 31, 2005. The payments which Accelrys will receive under the terms of the newsublease arrangement reduced the loss on abandonment by $1.1 million, to $3.6million, and reduced the reported net loss per share for the three and ninemonth periods to $(0.18) and $(0.64), respectively, from $(0.22) and $(0.68),respectively.

 

 

11

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**Item 2.****    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

This Report contains forward-looking statements that arebased upon current expectations that are within the meaning of the PrivateSecurities Reform Act of 1995.  We intendthat such statements be protected by the safe harbor created thereby.  Forward-looking statements involve risks anduncertainties and our actual results and the timing of events may differsignificantly from the results discussed in the forward-looking statements.  Examples of such forward-looking statementsinclude, but are not limited to, statements about:

 

•                  ourquarterly financial performance;

•                  ourcapital requirements, and resources;

•                  ourstrategy to increase revenue;

•                  development ofnew products;

•                  ourintent to develop and sell products and services to companies in thenanotechnology industry;

•                  technologicalchange and uncertainty of new and emerging technologies;

•                  potentialcompetitors or products;

•                  futureemployment of our key employees;

•                  development ofstrategic relationships;

•                  ourability to add revenue, expand distribution channels, maximize research anddevelopment resources, improve our competitive position and increase marketawareness and acceptance of our products;

•                  acquiringcomplementary businesses, products or technologies and our ability to integratethose businesses, products or technologies, if any;

•                  compliance withthe Sarbanes-Oxley Act of 2002;

•                  internationalexposure for a significant percentage of future overall revenue;

•                  ourdevelopment center in India;

•                  statements aboutpotential future dividends;

•                  statements aboutprotection of our intellectual property; and

•                  possiblechanges in legislation.

 

Although forward-looking statements in this Reportreflect the good faith judgment of our management, such statements can only bebased on facts and factors currently known by us.  Consequently, forward-looking statements areinherently subject to risks and uncertainties (including those discussed in “RiskFactors” below) and actual results and outcomes may differ materially from theresults and outcomes discussed in or anticipated by the forward-lookingstatements.  We undertake no obligationto revise or update any forward-looking statements in order to reflect anyevent or circumstance that may arise after the date of this Report.  Readers are urged not toplace undue reliance on these forward-looking statements, which speak only asof the date of this Report.

 

The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with theUnaudited Financial Statements and related notes included elsewhere in thisForm 10-Q, and also in conjunction with the Consolidated Financial Statementsand related notes included in our Form 10-K for the year ended December 31,2003 (under our former name Pharmacopeia, Inc.).

 

The Report describes certain risk factors anduncertainties that may cause actual results, levels of activity, performance,or achievements to be materially different from any future results, levels ofactivity, performance, or achievements expressed or implied by suchforward-looking statements.

 

**BUSINESS OVERVIEW**

 

Weare a leading provider of software for computation, simulation, and themanagement and mining of scientific data used by biologists, chemists andmaterials scientists, including nanotechnology researchers, for product designas well as drug discovery and development. Our technology and services aredesigned to meet the needs of today’s leading research organizations.

 

OnApril 30, 2004, we spun off our drug discovery subsidiary, Pharmacopeia DrugDiscovery, Inc. (“PDD”), which integrates proprietary small moleculecombinatorial and medicinal chemistry, high-throughput screening, in-vitropharmacology, computational methods and informatics to discover and optimizelead compounds and drug candidates.  Thespin-off of PDD resulted in PDD becoming an independent, separately traded, publicly held company. This was accomplished through the distribution to our stockholders of adividend of one share of PDD common stock for every two 

 

 

12

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shares of Accelrys common stock.

 

 OnSeptember 27, 2004, the Company acquired all of the outstanding common sharesof SciTegic, Inc. (“SciTegic”).  Theresults of SciTegic’s operations have been included in the consolidatedfinancial statements since that date. SciTegic is a leading provider of workflow software solutions for theresearch science market.  The primaryreason for the acquisition was to complement our existing product offerings.

 

As of December 31, 2004,we employed approximately 560 employees. We are headquartered in San Diego, California.

 

 

13

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#####  

##### RESULTS OFOPERATIONS

 

THREE MONTHS ENDED DECEMBER 31, 2004 AND 2003

 
| ** **                                                                            | ** ** | **For the Three Months** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------|------------|------------|------------|
| ** **                                                                            | ** ** | **Ended December 31,**   | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Percent** | ** ** |
| ** **                                                                            | ** ** | **2004**                 | ** ** | ******     | ** ** | **2003** | ** ** | ****** | ** ** | **Change** | ** ** |
| Revenue                                                                               |       | $                        | 22,229     |       | 100        | % | $ | 31,577 |   | 100 | % | -30 | % |
| Cost of revenue                                                                       |       | 5,161                    |       | 23         | %          | 4,507 |   | 14 | % | 15 | % |
| Gross Margin                                                                          |       | 17,068                   |       | 77         | %          | 27,070 |   | 86 | % | -37 | % |
| Research and development                                                              |       | 4,659                    |       | 21         | %          | 4,578 |   | 14 | % | 2 | % |
| Sales and marketing                                                                   |       | 10,109                   |       | 45         | %          | 9,502 |   | 30 | % | 6 | % |
| General and administrative                                                            |       | 4,139                    |       | 19         | %          | 4,890 |   | 15 | % | -15 | % |
| Lease abandonment                                                                     |       | 3,612                    |       | 16         | %          | — |   | 0 | % | 100 | % |
| Write-off of in-process research and development                                      |       | (250                     | )          | -1         | %          | — |   | 0 | % | 100 | % |
| Total operating costs and expenses                                                    |       | 22,269                   |       | 100        | %          | 18,970 |   | 60 | % | 17 | % |
| Operating income (loss) from continuing operations                                    |       | (5,201                   | )          | -23        | %          | 8,100 |   | 26 | % | -164 | % |
| Spin-off transaction costs                                                            |       | —                   |       | 0          | %          | (700 | ) | -2 | % | -100 | % |
| Interest and other income, net                                                        |       | 184                      |       | 1          | %          | 939 |   | 3 | % | -80 | % |
| Income (loss) from continuing operations before provision (benefit)  for income taxes |       | (5,017                   | )          | -23        | %          | 8,339 |   | 26 | % | -160 | % |
| Provision (benefit) for income taxes                                                  |       | (362                     | )          | -2         | %          | 140 |   | 0 | % | -359 | % |
| Income (loss) from continuing operations                                              |       | (4,655                   | )          | -21        | %          | 8,199 |   | 26 | % | -157 | % |
| Discontinued operations:                                                              |       |                     |       |       |       |   |   |   |   |   |   |
| Loss from Discontinued Operations                                                     |       | —                   |       | 0          | %          | (347 | ) | -1 | % | -100 | % |
| Net Income (loss)                                                                     |       | $                        | (4,655     | )          | -21        | % | $ | 7,852 |   | 25 | % | -159 | % |
|                                                                                       |            |                          |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |

----

** Line items expressedas a percent of revenue in the respective periods.

 

**Revenue** decreased 30% to $22.2 million in the quarter ended December 31, 2004compared to $31.6 million reported in the quarter ended December 31, 2003.  The decrease in revenue was attributedprincipally to the transition to subscription accounting for annual andmulti-year licenses. In January 2004 we began offering a new license toour customers which requires subscription accounting. Under this new license,revenue is recognized ratably over the license term.  This contrasts with our previous annuallicense offering, whereby we recognized 64% of the license revenue in thequarter in which the license was executed and amortized the other 36% of the revenueover the remaining term of the contract to correspond to the costs ofpost-sales support.  Under this newlicense, the unrecognized revenue, amortized over the remaining term of theagreement, will be accounted for as “deferred revenue” on the balancesheet.  The Company also licenses itssoftware on perpetual licenses whereby we recognize 85% of the license revenuein the quarter in which the license is executed and amortize the remaining 15%of the revenue over the term of the maintenance agreement.  In addition to the impact of the change tosubscription accounting, consulting and contracts revenue has decreased by $1.9million as the Company transitions to repeatable and more profitable services.

 

**Cost of revenue** was 15% higher at $5.2 million in the quarter ended December 31, 2004compared to $4.5 million in the quarter ended December 31, 2003.  Higher amortization of previously capitalizedsoftware development costs, amortization of intangible assets from the SciTegicacquisition, and an increase in Client Services due to increased staffinglevels to fulfill software services were partially offset by lower royaltiesand documentation and shipping costs.

 

 

14

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**Research and development** expenses were 2% higher in the quarter ended December 31, 2004 quarterat $4.7 million when compared to the $4.6 million recorded in the quarter endedDecember 31, 2003. Higher personnel-related costs as a result of research anddevelopment activities at SciTegic were partially offset by highercapitalization of software development costs.

 

Research and development expense consistsprimarily of the employment-related costs of personnel associated withdeveloping new software products, enhancing existing products, testing anddeveloping product documentation. Software research and development expense iscapitalized in accordance with Statement of Financial Accounting Standards No.86, “Accounting for the Cost of Computer Software to be Sold, Leased orOtherwise Marketed” (SFAS 86). Capitalized software development costs consist primarily of theemployment-related costs and consulting fees paid to consultants in relation tothe development of products that have not yet been released.

 

The following table shows the breakout of research anddevelopment costs and the amount of capitalized software development for theperiods indicated (dollars in thousands):

 
| ** **                                   | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                   | ** ** | **2004**                            | ** ** | **2003** | ** ** | **% Change** | ** ** |
| Research and development:                    |       |                                |       |   |   |   |   |
| Gross software development costs             |       | $                                   | 6.0        |   | $ | 5.6 |   | 8 | % |
| Less: Capitalized software development costs |       | (1.4                                | )          | (1.0 | ) | 38 | % |
| Reported research and development expenses   |       | $                                   | 4.7        |   | $ | 4.6 |   | 2 | % |

 

**Sales and marketing** expenses increased by 6% to $10.1 million in the quarter ended December31, 2004 compared to $9.5 million in the quarter ended December 31, 2003. Theincrease in expenses was related to our New Business Development Group whichwas established during calendar 2004 and sales costs associated with SciTegic.

 

**General and administrative** expenses decreased 15% to $4.1 million in the quarter ended December 31,2004 compared to $4.9 million recorded in the quarter ended December 31,2003.  The decrease in general andadministrative is due to lower head-count and other costs as a result of thespin-off of PDD.

 

**Lease abandonment**of $3.6 million was recordedin the quarter related to the move of the corporate headquarters to a newbuilding.  This charge has been recordednet of sublease income on the former facility. The Company received a rent abatement period on the new lease thatcoincides with the with the remaining term on theformer headquarters.  Therefore, theCompany will receive free rent on its new facility, which will be accounted foras a reduction of average monthly rent over the life of the new lease.

 

**Write-off of in-process researchand development costs**. As a result of thefinalization of the valuation of the assets acquired in the acquisition ofSciTegic on September 27, 2004, we adjusted our preliminary estimate of the write-offrelated to the portion of the purchase price allocated to in-process researchand development downward by $0.3 million.

 

**Spin-off transaction costs** were $0.7 million in the quarter ended December 31, 2003 related totransaction costs associated with the spin-off of PDD.  As of December 31, 2004, all of theseexpenses have been paid.

 

**Net interest and other income** was $0.2 million in the quarter ended December 31, 2004 compared to $0.9million in the quarter ended December 31, 2003. The decrease is due to lower average investment balances as we used cashfor general operations, the acquisition of SciTegic and the spin-off of PDD.

 

**The provision (benefit) forincome tax** was a benefit of $0.4 millionin the quarter ended December 31, 2004 compared to a provision of $0.1 millionrecorded in the quarter ended December 31, 2003.  The benefit in the quarter ended December 31,2004 includes a credit of $0.9 million related to an expected refund of taxespreviously withheld in Japan.  Otherwise, changes in the tax provision are due to income recognized inforeign jurisdictions.

 

 

15

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**A loss from discontinuedoperations**of ($0.3) million****was recorded in the quarter ended December 31, 2003representing the net of revenues and expenses at PDD for such period. Since thespin-off of PDD was consummated on April 30, 2004, no amount of discontinuedoperations was realized in the quarter ended December 31, 2004.

 

**A****net loss** of($4.7) million or ($0.18) per share was reported for the quarter ended December31, 2004 compared to net income of $7.9 million or $0.32 per diluted sharereported in the quarter ended December 31, 2003. The results for the quarterended December 31, 2003 included a net loss from discontinued operations at PDDof $(0.3) million or ($0.01) per share.

 

NINE MONTHS ENDED DECEMBER 31, 2004 AND 2003

 
| ** **                                                                            | ** ** | **For the Nine Months** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                                                            | ** ** | **Ended December 31,**  | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Percent** | ** ** |
| ** **                                                                            | ** ** | **2004**                | ** ** | ******     | ** ** | **2003** | ** ** | ****** | ** ** | **Change** | ** ** |
| Revenue                                                                               |       | $                       | 50,687     |       | 100        | % | $ | 68,342 |   | 100 | % | -26 | % |
| Cost of revenue                                                                       |       | 12,084                  |       | 24         | %          | 14,676 |   | 21 | % | -18 | % |
| Gross Margin                                                                          |       | 38,603                  |       | 76         | %          | 53,666 |   | 79 | % | -28 | % |
| Research and development                                                              |       | 13,164                  |       | 26         | %          | 13,386 |   | 20 | % | -2 | % |
| Sales and marketing                                                                   |       | 25,348                  |       | 50         | %          | 25,629 |   | 38 | % | -1 | % |
| General and administrative                                                            |       | 11,827                  |       | 23         | %          | 13,579 |   | 20 | % | -13 | % |
| Lease abandonment                                                                     |       | 3,612                   |       | 7          | %          | — |   | 0 | % | 100 | % |
| Write-off of in-process research and development                                      |       | 450                     |       | 1          | %          | — |   | 0 | % | 100 | % |
| Total operating costs and expenses                                                    |       | 54,401                  |       | 107        | %          | 52,594 |   | 77 | % | 3 | % |
| Operating income (loss) from continuing operations                                    |       | (15,798                 | )          | -31        | %          | 1,072 |   | 2 | % | -1574 | % |
| Spin-off transaction costs                                                            |       | —                  |       | 0          | %          | (700 | ) | -1 | % | -100 | % |
| Interest and other income, net                                                        |       | 1,257                   |       | 2          | %          | 3,032 |   | 4 | % | -59 | % |
| Income (loss) from continuing operations before provision (benefit)  for income taxes |       | (14,541                 | )          | -29        | %          | 3,404 |   | 5 | % | -527 | % |
| Provision (benefit) for income taxes                                                  |       | 252                     |       | 0          | %          | 731 |   | 1 | % | -66 | % |
| Income (loss) from continuing operations                                              |       | (14,793                 | )          | -29        | %          | 2,673 |   | 4 | % | -653 | % |
| Discontinued operations:                                                              |       |                    |       |       |       |   |   |   |   |   |   |
| Loss from Discontinued Operations                                                     |       | (1,117                  | )          | -2         | %          | (717 | ) | -1 | % | 56 | % |
| Net Income (loss)                                                                     |       | $                       | (15,910    | )          | -31        | % | $ | 1,956 |   | 3 | % | -913 | % |
|                                                                                       |            |                         |            |            |            |  |  |  |  |  |  |  |  |  |

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** Line items expressed as a percent of revenue in the respectiveperiods.

 

**Revenue** for the nine months ended December 31, 2004 was 26% lower at $50.7million compared to revenue of $68.3 million reported in the nine months endedDecember 31, 2003.  The decrease inrevenue was attributed principally to the effects of transitioning fromup-front revenue recognition to subscription revenue accounting as a result ofcontractual changes made to our licensing agreements. In addition about $1.1million of revenue from consortia was recognized in the nine months endedDecember 31, 2003 as compared to $0.1 million recognized in the nine monthsended December 31, 2004.  This decreasein revenue from consortia was attributable primarily due to scheduled terminationsin 2003 and our launch of the Nanotechnology Consortium on July 1, 2004.Revenue from consulting was $3.0 million lower for the nine months endedDecember 31, 2004 when compared to the nine months ended December 31, 2003 as the Companyfocuses on repeatable and more profitable services.

 

InJanuary 2004 we began offering a new license to our customers which requiressubscription accounting. Under this new license, revenue is recognized ratablyover the license term.  This contrastswith our previous annual license offering, whereby we recognized 64% of thelicense revenue in the quarter in which the license was executed and amortizedthe other 36% of the revenue over the remaining term of the contract to reflectthe costs of post-sales support.  Underthis new license, the unrecognized revenue, amortized over the remaining termof the agreement, will be accounted for as “deferred revenue” on the balancesheet.  We also license oursoftware on perpetual licenses whereby we recognize 85% of the license revenuein the quarter in which the license is executed and amortize the remaining 15%of the revenue over the term of the maintenance 

 

 

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agreement.

 

**Cost of revenue** was 18% lower at $12.1 million for the nine months ended December 31,2004 compared to $14.7 million in the nine months ended December 31, 2003.  Lower royalties, client service costs anddocumentation and shipping costs were partially offset by higher amortizationof previously capitalized software development costs. In addition, $0.6 millionof amortization expense related to the amortization of intangible assets fromthe SciTegic acquisition was recorded in the nine months ended December 31,2004 as compared to $1.6 million of amortization expense related to purchased technology was recorded in the nine months endedDecember 31, 2003.

 

**Research and development** expenses were 2% lower in the nine months ended December 31, 2004 at$13.2 million compared to $13.4 million recorded in the nine months endedDecember 31, 2003. Lower personnel-related costs were partially offset by lowercapitalization of software development costs.

 

Research and development expense consistsprimarily of the employment-related costs of personnel associated withdeveloping new software products, enhancing existing products, testing anddeveloping product documentation. Software research and development expense iscapitalized in accordance with Statement of Financial Accounting Standards No.86, “Accounting for the Cost of Computer Software to be Sold, Leased orOtherwise Marketed” (SFAS 86). Capitalized software development costs consist primarily of theemployment-related costs and consulting fees paid to consultants in relation tothe development of products that have not yet been released.

 

The following table shows the breakout of research anddevelopment costs and the amount of capitalized software development for theperiods indicated (dollars in thousands):

 
| ** **                                   | ** ** | **Nine Months Ended December 31, 2004** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **2004**                                | ** ** | **2003** | ** ** | **% Change** | ** ** |
| Research and development:                    |       |                                    |       |   |   |   |   |
| Gross software development costs             |       | $                                       | 16.2       |   | $ | 16.5 |   | -2 | % |
| Less: Capitalized software development costs |       | (3.0                                    | )          | (3.1 | ) | -2 | % |
| Reported research and development expenses   |       | $                                       | 13.2       |   | $ | 13.4 |   | -2 | % |

 

**Sales and marketing** expenses decreased by 1% to $25.3 million in the nine months endedDecember 31, 2004 compared to $25.6 million in the nine months ended December31, 2003. Lower sales and marketing expenses were partially offset by theexpenses related to our New Business Development Group which was establishedduring calendar 2004.

 

**General and administrative** expenses decreased 13% to $11.8 million in the nine months endedDecember 31, 2004 compared to $13.6 million recorded in the nine months endedDecember 31, 2003.  The decrease ingeneral and administrative is due to lower head-count and other costs as aresult of the spin-off of PDD.

 

**Lease abandonment**of $3.6 million was recordedin the quarter related to the move of the corporate headquarters to a newbuilding.  This charge includes subleaseincome on the former facility.  TheCompany received a rent abatement period on the new lease that coincides with the with the remaining term on the former headquarters.  Therefore, the Company will receive free renton its new facility, which will be accounted for as a reduction of averagemonthly rent over the life of the new lease.

 

**Write-off of in-process researchand development costs**. As a result of thevaluation of the assets acquired in the acquisition of SciTegic in September2004, we recorded a write-off of $0.5 million in the nine months ended December31, 2004 related to the portion of the purchase price allocated to in-processresearch and development.

 

**Spin-off transaction costs** were $0.7 million in the nine months ended December 31, 2003 related totransaction costs associated with the spin-off of PDD.  As of December 31, 2004, all of theseexpenses have been paid.

 

**Net interest and other income** was $1.3 million in the nine months ended December 31, 2004 compared to$3.0 million in the nine months ended December 31, 2003. The decrease is due tolower average investment balances as the Company used cash for generaloperations, the acquisition of SciTegic and the spin-off of PDD.

 

**The provision for income tax** was $0.3 million in the nine months ended December 31, 2004 compared to$0.7 million in the nine months ended December 31, 2003. The decrease in theprovision for income tax expense includes a credit of $0.9 million related toan expected refund of taxes previously withheld in Japan in the nine monthsended December 31, 2004.   

 

 

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Otherwise, changes in the tax provision are due toincome recognized in foreign jurisdictions.

 

**A loss from discontinuedoperations**of ($1.1) million****was recorded in the nine months ended December 31, 2004representing the net revenues and expenses at PDD for such period. For the ninemonths ended December 31, 2003 the loss was ($0.7) million.

 

**A****net loss** of($15.9) million or ($0.64) per share was reported for the nine months endedDecember 31, 2004 compared to net income of $2.0 million or $0.08 per dilutedshare reported in the nine months ended December 31, 2003. The net loss for thenine months ended December 31, 2004 and net income for the nine months endedDecember 31, 2003 included the losses from discontinued operations at PDDrepresenting ($0.04) and ($0.03) per share, respectively.

 

**LIQUIDITY AND CAPITALRESOURCES**

 

We have funded our activities to date primarily throughthe sale of software licenses, software maintenance and related services,equity securities, and interest income. Also, prior to the spin-off of PDD, funding was provided through thesale of drug discovery services.  As of December31, 2004, we had cash, restricted cash, cash equivalents, and marketablesecurities of $59.1 million compared to $141.6 million as of March 31, 2004. OnApril 30, 2004, we made a capital contribution to PDD of $46.5 million in cashand securities and incurred costs of approximately $2.3 millionwhich were accrued at March 31, 2004 and have been paid as of December 31,2004. On September 27, 2004, we paid $10.9 million in cash as part of the totalpurchase price of $20.8 million for the acquisition of SciTegic.

 

Cash used in operations increased by $12.3 million inthe nine months ended December 31, 2004 compared to the nine months endedDecember 31, 2003.  The increase isattributable to the loss in the nine months ended December 31, 2004 compared tonet income for the nine months ended December 31, 2003 and the use of prepaidassets, both of which are partially offset by an increase in deferred revenuedue to transition to subscription accounting. Cash provided by investingactivities increased by $40.5 million in the nine months ended December 31,2004 compared to the nine months ended December 31, 2003 due to the sale ofmarketable securities to fund the capital contribution to the PDD businessunder the contractual agreements of the spin-off.  This increase is partially offset by the useof cash for the acquisition of SciTegic. Cash provided by financing activities decreased by $0.1 million in thenine months ended December 31, 2004 compared to the nine months ended December31, 2003 due to a decrease in option exercises.

 

We anticipate that our capital requirements may increasein future periods as a result of seasonal sales trends, additional research anddevelopment activities, and the acquisition of additional equipment.  Our capital requirements may also increase infuture periods as we seek to expand our technology platform throughinvestments, licensing arrangements, technology alliances, or acquisitions.

 

We anticipate that our existing capital resources willbe adequate to fund our operations at least through the next twelvemonths.  However, there can be noassurance that changes will not occur that might consume available capitalresources before then.  Our capitalrequirements depend on numerous factors, including our ability to continue togenerate software sales, competing technological and market developments, thecost of filing, prosecuting, defending, and enforcing patent claims and otherintellectual property rights and the outcome of related litigation, thepurchase of additional capital equipment, and acquisitions of other businessesor technologies.  There can be noassurance that additional funding, if necessary, will be available on favorableterms, if at all.  Our forecasts of theperiod of time through which our financial resources will be adequate tosupport our operations are forward looking information, and actual resultscould vary.  The factors describedearlier in this paragraph will impact our future capital requirements and theadequacy of our available funds.

 

Thefollowing summarizes our long-term contractual obligations as of March 31,2004. This table has been updated from the Company’s most recently filed 10-Kto include the effects of the assignment of the PDD leases to PDD, theguarantee of the PDD leases, the new corporate facility lease in San Diego andthe sublease of the former corporate facility (dollars in thousands).

 

 

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| ** **                  | ** ** | **Payments Due by Period** | ** ** |
|-----------------------------|------------|----------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                  | ** ** | **Less than 1 Year** | ** ** | **1 to 3 Years** | ** ** | **4 to 5 Years** | ** ** | **After 5 Years** | ** ** |
| Operating leases            |       | $                          | 46,399     |   | $ | 3,807 |   | $ | 6,901 |   | $ | 7,580 |   | $ | 28,111 |   |
| Total                       |       | $                          | 46,399     |   | $ | 3,807 |   | $ | 6,901 |   | $ | 7,580 |   | $ | 28,111 |   |
|                             |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

RISK FACTORS

 

*     You should carefully consider the risksdescribed below before investing in our publicly-traded securities.  The risks described below are not the only onesfacing us.  Our business is also subjectto the risks that affect many other companies, such as competition,technological obsolescence, labor relations, general economic conditions,geopolitical changes and international operations.  Additional risks not currently known to us orthat we currently believe are immaterial also may impair our businessoperations and our liquidity.*

 

CERTAINRISKS RELATED TO OUR BUSINESS

 

***Our quarterly operating results could varysignificantly*****.** We have historicallyexperienced stronger financial performance in the third and fourth calendarquarters of each year followed by a comparative decline in the first and secondquarters.  Quarterly operating resultsmay continue to fluctuate as a result of a number of factors, including lengthysales cycles, market acceptance of new products and upgrades, timing of newproduct introductions, changes in pricing policies, changes in general economicand competitive conditions, seasonal slowdowns, and the timing and integrationof acquisitions. Additionally, fluctuations in revenue recognition may resultas subscription license sales increase. We also expect to continue to experience fluctuations in quarterlyoperating results due to general and industry specific economic conditions thatmay affect the research and development expenditures of pharmaceutical andbiotechnology companies. Due to the possibility of fluctuations in our revenueand expenses, we believe that quarter-to-quarter comparisons of our operatingresults are not a good indication of our future performance.

 

***Our future profitability is uncertain.*****We generatedlosses in the twelve months ended 2001, 2002, 2003, the three months endedMarch 31, 2004 and the nine months ended December 31, 2004. Continuing netlosses may limit our ability to fund our operations and we may not generateincome from operations in the future. Our future profitability depends upon many factors, including severalthat are beyond our control. These factors include without limitation:

 

•                  the rate of adoptionby our customers of our new subscription licenses option;

•                  changes in the demandfor our products and services;

•                  the introductionof competitive software;

•                  our ability tolicense desirable technologies;

•                  changes in theresearch and development budgets of our customers and potential customers; and

•                  our ability tosuccessfully, cost effectively and timely develop, introduce and market newproducts, services and product enhancements.

 

***We face strong competition in the scientific******software sector*****.** The market for our softwareproducts is intensely competitive, subject to rapid change and significantlyaffected by new product introductions, pricing strategies and other marketactivities of industry participants. We currently face competition from the followingprincipal sources:

 

•                  other molecularsimulation software packages and software for analysis of chemical andbiological data;

•                  desktop softwareapplications, including chemical drawing, molecular modeling and analyticaldata simulation applications;

•                  consulting andoutsourcing services;

•                  other types ofsimulation software provided to engineers;

•                  firms supplyingdatabases, such as chemical or genomic information databases, databasemanagement systems and information technology; and

•                  academic and governmentsponsored institutes focused on nanotechnology.

 

 

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Inaddition, some of our software licenses grant the right to sublicense oursoftware. As a result, our software customers and third-party licensees coulddevelop specific simulation applications using our software developer’s kit andcompete with us by distributing these programs to our potential customers.Customers or licensees could also develop their own simulation technology orinformatics software and cease using our software products and services. Someof our competitors and potential competitors in this sector have longeroperating histories than us and have greater financial, technical, marketing,research and development and other resources. Many of our software competitorsoffer products and services directed at more specific markets than those wetarget, enabling these competitors to focus a greater proportion of theirefforts and resources on these markets. Some offerings that compete with oursoftware products are developed and made available at lower cost bygovernmental organizations and academic institutions, and these entities may beable to devote substantial resources to product development and also offertheir products to users for little or no charge.  Finally, we also face competition from opensource software initiatives, in which developers provide software andintellectual property free over the internet.

 

***We are subject to pricing pressures in the marketswe serve.***  In responseto competition and general adverse economic conditions in the markets we serve,we may be required to modify our pricing practices.  This development may adversely affect ourrevenue and earnings.  We generallylicense our software products and services on a “right to use” basis pursuantto licenses over a specified period of time or in perpetuity.  Changes in our pricing model or any otherfuture broadly-based changes to our prices and pricing policies could lead to adecline or delay in revenue as our sales force and customers adjust to the newpricing policies.

 

***Our investments in sales and business developmentefforts may not result in additional sales of our products and services. ***Our products and servicesinvolve lengthy sales and business development cycles, often requiring us toexpend considerable financial and personnel resources without any assurancethat revenue will be recognized.  Thesesales and business development cycles typically are long for a number ofreasons.  Software sales cycles areimpacted by the time and resources required to educate potential customerorganizations as to the value and comparative advantages of our products. As aresult, we may expend substantial funds and effort to negotiate agreements forcollaborative relationships, services and products, but may ultimately beunable to consummate the related transaction. Under such circumstances, ourresults of operations and ability to achieve profitability will be adverselyaffected.

 

***If we consume cash more quickly than expected, wemay be unable to raise additional capital and we may be forced to curtailoperations.***We anticipate that our existing capital resourceswill be adequate to fund our operations for at least the next twelve months***.*** However,

 

changes may occur thatwould consume available capital resources before that time. Our capitalrequirements will depend on numerous factors, including:

 

•                  costs associatedwith software sales;

•                  the cost offiling, prosecuting, defending and enforcing patent claims and otherintellectual property rights and the outcome of related litigation;

•                  the purchase ofadditional capital equipment; and

•                  acquisitions of otherbusinesses or technologies.

 

Ifwe determine that we must raise additional capital, we may attempt to do so throughpublic or private financings involving debt or equity. However, additionalcapital may not be available on favorable terms, or at all. If adequate fundsare not available, we may be required to curtail operations significantly or toobtain funds by entering into arrangements with collaborative partners orothers that may require us to relinquish rights to certain of our technologies,products or potential markets that we would not otherwise relinquish.

 

***Our ability to increase our software revenue maydepend upon increased market acceptance of our products and services*****.** Our productsare currently used primarily by molecular modeling and simulation specialists.Our strategy is to expand usage of our products and services by marketing anddistributing our software, in part through our desktop-based products,client-server solutions, and related services to a broader, more diversifiedgroup of biologists, chemists, and engineers. If we cannot expand our customerbase by selling our desktop-based products, client-server solutions, andrelated services, we may not be able to increase our software revenue, or suchrevenue may decline. In general, increased market acceptance and greater marketpenetration of our software products depend upon several factors, including:

 

•                  overall productperformance;

•                  ease of implementation anduse;

 

 

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•                  accuracy of simulation;

•                  breadth andintegration of product offerings;

•                  the extent towhich users achieve the intended research and development benefits from theiruse of the products and services; and

•                  willingness of customersto pay for such use.

 

Oursoftware products and services may not achieve market acceptance or penetrationin their target industries or other industries. Failure to increase marketacceptance or penetration of our products and services may restrictsubstantially the future growth of our software business and may have amaterial adverse effect on our company as a whole.

 

***We may be unable to develop and market new productsthat are necessary to increase revenue*****.** The success ofour software business plan depends heavily upon increases in revenue. Ourstrategy is to increase software revenue in a number of ways, including:

 

•                  adding morecomputational modeling, simulation, and analyses tools to our current portfolioof tools for scientists, including chemists, biologists, and materialsscientists

•                  offering moreinformatics solutions that capture and manage the data created by customers’drug discovery and chemical development activities, including the data createdby the use of computational modeling, simulation, and analysis software;

•                  creating andmarketing genomic, biological and/or chemical data content for use inconjunction with the software offered to support customers’ drug discoveryactivities;

•                  developing moreknowledge management workflow software to automate the flow of genomic,biological and chemical data and information and project status between andamong workgroups and the enterprise; and

•                  developing enhanced modeling andinformatics tools to address the needs of companies engaged in nanotechnologyresearch.

 

Wedo not have sufficient historical or comparative sales data to rely upon toindicate that our new products or data content services will achieve thedesired level of commercial success.  Asa result, we may not be able to increase revenue.

 

***Delays in release of new or enhanced software products or services orundetected errors in our software products or services may result in increasedcost to us, delayed market acceptance of our products and delayed or lostrevenue.***  To achievemarket acceptance, new or enhanced software products or services can requirelong development and testing periods, which may result in delays in scheduled introduction.  Any delays in the release schedule for new orenhanced software products or services may delay market acceptance of theseproducts or services and may result in delays in new customer orders for thesenew or enhanced software products or services or the loss of customerorders.  In addition, new or enhancedsoftware products or services may contain a number of undetected errors or “bugs”when they are first released.  As aresult, in the months following the introduction of certain releases, wegenerally devote significant resources to correct these errors.  There can be no assurance, however, that allof these errors can be corrected. Although we test each new or enhanced software product or service beforebeing released to the market, there can be no assurance that significant errorswill not be found in existing or future releases.

 

***If we are unable to license software to, or collect receivables from,our early stage biotechnology customers, it may have a material adverse effecton our operating results.***  We license our modeling, simulation, dataanalysis and informatics software to smaller, development stage biotechnologycustomers. Often these customers have limited or no operating history, andrequire considerable funding to launch their businesses. As we have experiencedin recent quarters, they often significantly scale back, or altogether cease,operations.  Therefore, there isconsiderable risk in counting on these types of entities for revenue growth.  For entities that remain in business,transactions with these customers carry a higher degree of financial risk. Ourcustomers, particularly our development stage customers, are vulnerable to, andmay be adversely impacted by, the tightening of available credit and capitalduring periods of contraction affecting the United States and our other keymarkets. As a result of these conditions, our customers may be unable tolicense or, if under a license, may be unable to pay for, Accelrys softwareproducts. If we are not able to collect such payments, we may be required towrite-off significant accounts receivable and recognize bad debt expense. As aresult of these types of exposures and other potential exposures, we recorded aprovision for doubtful accounts of $1.2 million, $0.4 million, less than $0.1million and less than $0.1 million for the twelve months ended December 31,2002, the twelve months ended December 31, 2003, the three months ended March31, 2004 and the nine months ended December 31, 2004, respectively.  Failure of these businesses, write-offs anddifficulties associated with collection of receivables from thesecustomers, could materially and adversely affect our operating results.

 

 

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***We will need to achieve commercial acceptanceof our products and services in the nanotechnology industry to obtainsignificant product revenue from that industry.**** *We intend to develop and sell our products and services to companies inthe nanotechnology industry.  We do notknow when a market for nanotechnology-enabled products will develop, if at all,and we cannot reasonably estimate the projected size of any market that maydevelop. In addition, nanotechnology-enabled products may achieve some degreeof market acceptance in one segment of the nanotechnology industry but may notachieve market acceptance in other segments of the industry for which we aredeveloping products.  If the segments ofthe market we are targeting fail to accept nanotechnology-enabled products orto determine that other products were superior, we may not be able to achievecommercial acceptance of our products and services. Even if we developnanotechnology products and those products achieve commercial acceptance, ifthe size of the potential markets for our products is not sufficient, we willbe unable to generate significant revenue from the nanotechnology industry.

 

***Defects or malfunctions in our software products, or in the products ofour software technology partners, could hurt our reputation among softwarecustomers and expose us to liability.***** **Our software business and the level of customer acceptance of ourproducts depend upon the continuous, effective and reliable operation of oursoftware and related tools and functions. Defects could occur in current orfuture Accelrys products. To the extent that our software malfunctions and ourcustomers’ use of our products is interrupted, our software reputation andbusiness could suffer. We may also be subject to liability for the defects andmalfunctions of third party technology partners and others with whom oursoftware products and services are integrated.

 

***Pharmaceutical, biotechnology and industrial chemical companies maydiscontinue or decrease their use of our services and products.*******We aredependent on pharmaceutical and biotechnology companies.  These companies (together with diversifiedchemical and other industrial companies) comprise the principal market for ourAccelrys modeling, simulation, data analysis and related software products andservices.  In addition, these companieshave frequently utilized outside software vendors for key tools used in drugdiscovery and chemical development, rather than developing needed informationand analysis tools internally.  Ourrevenue depends to a large extent on research and development expenditures bythe pharmaceutical, biotechnology, and chemical industries, particularlycompanies in these industries adding new and improved technologies toaccelerate their drug discovery and chemical development initiatives.  The willingness of these companies to expandor continue is dependent on the benefits of new software tools versus theircosts of licensure. Since a large proportion of our software customers licenseour products on an annual basis or buy maintenance contracts from us annually,if their spending priorities shift, our revenue may be impacted.  Also, general economic downturns in ourcustomers’ industries or any decrease in customers’ research and developmentexpenditures could harm our operations.

 

***Health care reform and restrictions on reimbursement may affect theability of pharmaceutical, biotechnology and industrial chemical companies topurchase or license our software products or services, which may affect ourresults of operations and financial condition.***  The continuing efforts of government andthird party payers in our markets to contain or reduce the cost of health caremay reduce the profitability of pharmaceutical, biotechnology and industrialchemical companies causing them to reduce research and developmentexpenditures. Because our products and services depend on such research anddevelopment expenditures, our revenues may be significantly reduced.  We cannot predict what actions federal, stateor private payers for health care goods and services may take in response toany health care reform proposals or legislation.

 

***Our sales forecast and/or revenue projections maynot be accurate.***  We use a “pipeline”system, a common industry practice, to forecast sales and trends in ourbusiness.  Our sales personnel monitorthe status of proposals, including the date when they estimate a customer willmake a purchase decision and the potential size of the order.  We aggregate these estimates on a quarterlybasis in order to generate a sales pipeline. While the pipeline process provides us with some guidance in businessplanning and forecasting, it is based on estimates only and is thereforesubject to risks and uncertainties.  Anyvariation in the conversion of the pipeline into revenue or the pipeline itselfcould cause us to improperly plan or budget and thereby adversely affect ourbusiness, results of operations and financial condition.

 

***We operate in business lines that change rapidlyand in unexpected ways.*** Rapid technological changeand uncertainty due to new and emerging technologies characterize the software,drug discovery and chemical development industries.  We may be unable to develop, integrate andmarket, on a timely basis, the new and enhanced products and services necessaryto keep pace with competitors. Our products and services may be renderedobsolete by the offerings of our competitors. Failure to anticipate or torespond to changing technologies, or significant delays in the development orintroduction of products or services, could cause customers to delay or decideagainst purchases of our products or services.

 

***Failure to attract and retain skilled personnelcould have a material adverse effect on us.*** Our success depends in parton the continued service of key scientific, software, sales, businessdevelopment, engineering and management personnel

 

 

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 and our ability toidentify, hire and retain additional personnel. There is intense competitionfor qualified personnel. Immigration laws may further restrict our ability toattract or hire qualified personnel. We may not be able to continue to attractand retain the personnel necessary for the development of our business. Failureto attract and retain key personnel could have a material adverse effect on ourbusiness, financial condition and results of operations. Further, we are highlydependent on the principal members of our scientific and management staff.  One or more of these key employees couldretire or otherwise leave our employ within the foreseeable future, and theloss of any of these people could have a material adverse effect on ourbusiness, financial condition and results of operations.  We do not intend to maintain key person lifeinsurance on the life of any employee.

 

***We may be unable to develop strategic relationshipswith large technology companies.***** A component of our business strategy is todevelop strategic relationships with larger technology companies.  We believe that through such relationships wecan add revenue, expand our distribution channels, maximize our research anddevelopment resources, improve our competitiveposition and increase market awareness and acceptance of scientific softwareproducts. To date, we have entered into significant strategic relationshipswith such companies as IBM, Oracle and HP. There can be no assurance that any such relationship will continue, thatrelationships with similar large organizations can be developed, or that anysuch existing or new alliances will produce substantial revenue or profitopportunities.

 

***If we choose to acquire new and complementarybusinesses, products or technologies instead of developing them ourselves, wemay be unable to complete these acquisitions or to successfully integrate anacquired business or technology in a cost-effective and non-disruptivemanner. ***From time totime, we may choose to acquire complementary businesses, products ortechnologies instead of developing them ourselves. We do not know if we will beable to complete any acquisitions, or whether we will be able to successfullyintegrate any acquired businesses, operate them profitably or retain their keyemployees. Integrating any business, product or technology we acquire could beexpensive and time-consuming, disrupt our ongoing

 

business and distractcompany management. In addition, in order to finance any acquisition, we mightneed to raise additional funds through public or private equity or debtfinancings. In that event, we could be forced to obtain financing on less thanfavorable terms and, in the case of equity financing that may result indilution to our stockholders. If we are unable to integrate any acquiredentities, products or technologies effectively, our business will suffer. Inaddition, under certain circumstances, amortization of assets or chargesresulting from the costs of acquisitions could harm our business and operatingresults.

 

***There can be no assurance as to the effect of theSciTegic acquisition or future acquisitions on our business or operatingresults.***  From time totime, we may acquire other companies that would be complementary to ourbusiness. Acquisitions may result in potentially dilutive issuances of equitysecurities, incurrence of debt and contingent liabilities, amortizationexpenses related to intangible assets and the possible impairment of goodwill,which could harm our profitability. In addition, acquisitions involve numerousrisks, including, among other things: higher than estimated acquisitionexpenses; difficulties in successfully assimilating the operations,technologies and personnel of the acquired company; diversion of management’sattention from other business concerns; risks of entering markets in which wehave no or limited direct prior experience; and the potential loss of keyemployees and customers as a result of the acquisition. In this regard, inSeptember 2004, we acquired SciTegic, Inc., a privately held company providingworkflow software solutions for the research science market. Pursuant to thistransaction, SciTegic shareholders will receive approximately $12.9 million ofcash and up to 1,166,218 shares of Accelrys common stock in exchange for theirSciTegic shares, and up to 334,324 additional Accelrys common shares over thenext two years subject to certain conditions. There can be no assurance as tothe effect of the SciTegic acquisition or future acquisitions on our businessor operating results.

 

***Recently enacted and proposed changes in securitieslaws and regulations are likely to increase our costs.*** TheSarbanes-Oxley Act of 2002 (“SOX”) requires changes in some of our corporategovernance and securities disclosure or compliance practices. The Securitiesand Exchange Commission (the “SEC”) has promulgated new rules on a variety ofsubjects and Nasdaq has issued revisions to itsrequirements for companies that are Nasdaq-listed. In June 2003 the SEC adoptedcertain rules as directed by Section 404 of SOX. These rules require thatpublicly held companies, including us, include in their annual report toshareholders a report of management on our internal controls over financialreporting. Our independent auditors will be required to attest to management’sassessment of internal controls over financial reporting. We will be requiredto comply with this new requirement in our annual report for the year endingMarch 31, 2005. If our financial reporting controls are not deemed effective,there will be an adverse impact on our reputation that could negatively impactour stock price.

 

We also expect compliancewith SOX to increase our corporate governance, legal and accounting costs.Further, SOX and the related SEC and Nasdaq compliancerules may make it more difficult and expensive for us to obtain director

 

 

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 and officer liability insurance, and we may be required toaccept reduced coverage or incur substantially higher costs to obtain coverage.These laws and regulations could make it more difficult for us to attract andretain qualified members of our board of directors, or qualified executive officers.We continually evaluate and monitor regulatory developments and cannot estimatethe timing or magnitude of additional costs we may incur as a result.

 

***We are subject to risks associated with the operation of aninternational business.**** *For the nine months ended December 31, 2004, approximately 48% of the Company’s consolidated revenue was derived fromcustomers outside the United States, both through internationalsubsidiaries and on an export basis. Approximately 25% of our revenue wasderived from customers in Europe and approximately 23% was derived fromcustomers in the Asia/Pacific region.  Weanticipate that international revenue will continue to account for asignificant percentage of future overall revenue. Our international operationscontinue to expand, with functions such as software development, sales andcustomer support increasingly being performed outside the United States.  In this connection, we intend to continue theexpansion of our development center in Bangalore, India.

 

Ournon-U.S. operations are subject to risks inherent in the conduct ofinternational business, including:

 

•                  unexpected changes inregulatory requirements;

•                  longer paymentcycles;

•                  currency exchange ratefluctuations;

•                  import and exportlicense requirements;

•                  tariffs and otherbarriers;

•                  political unrest,terrorism and economic instability;

•                  disruption of ouroperations due to local labor conditions;

•                  limited intellectualproperty protection;

•                  difficulties in collectingtrade receivables;

•                  difficulties in managingdistributors or representatives;

•                  difficulties in managing anorganization spread over various countries;

•                  difficulties in staffingforeign subsidiary or joint venture operations; and

•                  potentially adverse taxconsequences.

 

Our success depends, inpart, on our ability to anticipate and address these risks. There can be noassurance that we would do so effectively, or that these or other factors willnot adversely affect our business or operating results.

 

***We may not be able to sustain or increaseinternational revenue.*** Any of the foregoingfactors may have a material adverse effect on our international operations and,therefore, our business, financial condition and results of operations. Ourdirect international sales generally are denominated in local currencies.Fluctuations in the value of currencies in which we conduct business relativeto the United States dollar result in currency transaction gains and losses,and the impact of future exchange rate fluctuations cannot be accurately predicted.Future fluctuations in currency exchange rates may have a material adverseimpact on revenue from international sales, and thus on our business, financialcondition and results of operations. When deemed appropriate, we may engage incurrency exchange rate hedging transactions in an attempt to mitigate theimpact of adverse exchange rate fluctuations. However, currency hedgingpolicies may not be successful, and they may increase the negative impact ofexchange rate fluctuations.

 

***Consolidation within the pharmaceutical andbiotechnology industries may lead to fewer potential customers for our productsand services.**** *A significantportion of our customer base consists of pharmaceutical and biotechnologycompanies. Continued consolidation within the pharmaceutical and biotechnologyindustries may result in fewer customers for our products and services. If oneof the parties to a consolidation uses the products or services of ourcompetitors, we may lose existing customers as a result of such consolidation.

 

***We expect that our stock price willfluctuate significantly, and you may not be able to resell your shares at orabove your investment price.**** *The stock market, historically andparticularly in recent years, has experienced significant volatility and in particularwith technology company stocks.  Thevolatility of technology company stock prices often does not relate to theoperating performance of the companies represented by the stock.  Factors that could cause volatility in theprice of our common stock include without limitation:

 

•                  actual and anticipated fluctuations in ourquarterly financial and operating results;

 

 

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•                  market conditions in the technology and softwaresectors;

•                  issuance of new or changed securities analysts’reports or recommendations;

•                  developments or disputes concerning our intellectualproperty or other proprietary rights;

•                  introduction of technological innovations or newcommercial products by us or our competitors;

•                  market acceptance of our products and services; and

•                  additions or departures of key personnel.

 

Theseand other external factors may cause the market price and demand for our commonstock to fluctuate substantially, which may limit or prevent investors fromreadily selling their shares of common stock and may otherwise negativelyaffect the liquidity of our common stock. In addition, in the past, when themarket price of a stock has been volatile, holders of that stock haveinstituted securities class action litigation against the company that issuedthe stock. If any of our stockholders brought a lawsuit against us, we couldincur substantial costs defending the lawsuit. Such a lawsuit could also divertthe time and attention of our management.

 

***As institutions hold the majority of our CommonStock in large blocks, substantial sales by these stockholders could depressthe market price for our shares.***  As of January 2005, the top ten institutionalholders of our common stock held approximately 52% of our outstanding commonstock.  As a result, if one or more ofthese major stockholders were to sell all or a portion of their holdings, or ifthe market were to perceive that such sale or sales may occur, the market priceof our common stock may fall significantly.

 

***Because we do not intend to pay dividends, ourstockholders will benefit from an investment in our common stock only if ourstock price appreciates in value.***** **We have never declared or paid any cash dividends on our common stock.We currently intend to retain our future earnings, if any, to finance theexpansion of our business and do not expect to pay any cash dividends in theforeseeable future. As a result, the success of your investment in our commonstock will depend entirely upon any future appreciation in its value. There isno guarantee that our common stock will appreciate in value or even maintainthe price at which you purchased your shares.

 

***Anti-takeover provisions under the Delaware generalcorporation law, provisions in our certificate of incorporation and bylaws, andour adoption of a stockholder rights plan may render more difficult theaccomplishment of mergers or the assumption of control by a principalstockholder, making more difficult the removal of management*****.**  Certain provisions of the Delaware GeneralCorporation Law may delay or deter attempts to secure control of our companywithout the consent of our management. Also, our governing documents providefor a staggered board of directors, which will make it more difficult for apotential acquirer to gain control of our Board of Directors. In 2002, weadopted a stockholder rights plan, which is triggered upon commencement orannouncement of a hostile tender offer or when any one person or group acquires15% or more of our common stock. The rights plan, once triggered, enablesstockholders to purchase our common stock, and the stock of the entityacquiring us, at reduced prices. These provisions of our governing documentsand stockholder rights plan, and of Delaware law, could have the effect ofdelaying, deferring or preventing a change of control including withoutlimitation a proxy contest, making more difficult the acquisition of asubstantial block of our common stock. The provisions could also limit theprice that investors might be willing to pay in the future for shares of ourcommon stock. Further, the existence of these anti-takeover measures may causepotential bidders to look elsewhere, rather than initiating acquisitiondiscussions with us.

 

***Our operations may be interrupted by the occurrence of a naturaldisaster or other catastrophic event at our primary facilities.*****  **Our research and developmentoperations and administrative functions are primarily conducted at ourfacilities in San Diego, California, Cambridge, United Kingdom, and Bangalore,India.  Although we have contingencyplans in effect for natural disasters or other catastrophic events,catastrophic events could still disrupt our operations. Even though we carrybusiness interruption insurance policies, we may suffer losses as a result ofbusiness interruptions that exceed the coverage available under our insurancepolicies. Any natural disaster or catastrophic event in our facilities or theareas in which they are located could have a significant negative impact on ouroperations.

 

***Our insurance coverage may not be sufficient toavoid impacts on our financial position or results of operations resulting fromclaims or liabilities against us, and we may not be able to obtain insurancecoverage in the future.***  We maintain insurance coverage for protectionagainst many risks of liability.  Theextent of our insurance coverage is under continuous review and is modified aswe deem it necessary.  Despite thisinsurance, it is possible that claims or liabilities against us may have a materialadverse impact on our financial position or results of operations.  We may not be able to obtain any insurancecoverage, or adequate insurance coverage, when our existing insurance coverageexpires.

 

 

 

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CERTAIN RISKS RELATED TOINTELLECTUAL PROPERTY

 

***Positions taken by the U.S. patent and trademarkoffice or non-U.S. patent and trademark officials may preclude us fromobtaining sufficient or timely protection for our intellectual property. ***The patent positions ofpharmaceutical and biotechnology companies are uncertain and involve complexlegal and factual questions. The coverage claimed in a patent application canbe significantly reduced before the patent is issued. There is a significantrisk that the scope of a patent may not be sufficient to prevent third partiesfrom marketing other products or technologies with the same functionality ofour products and technologies. Consequently, some or all of our patentapplications may not issue into patents, and any issued patents may provideineffective remedies or be challenged or circumvented.

 

***Third parties may have filed patent applications ofwhich we may or may not have knowledge, and which may adversely affect ourbusiness.**** *Patentapplications in the U.S. are maintained in secrecy for 18 months from filing oruntil a patent issues. Under certain circumstances,patent applications are never published but remain in secrecy until issuance.As a result, others may have filed patent applications for products ortechnology covered by one or more pending patent applications upon which we arerelying. There may be third-party patents, patent applications and otherintellectual property or information relevant to our software, chemicalcompositions and other technologies which are not known to us and that block orcompete with our software or other technologies, or limit the scope of patentprotection available to us. Moreover, from time to time, patents may issuewhich block or compete with our software or other technologies, or limit thescope of patent protection available to us. Litigation may be necessary toenforce patents issued to us or to determine the scope and validity of theintellectual property rights of third parties.

 

***We may not be able to protect adequately the tradesecrets and confidential information that we disclose to our employees. ***We rely upon trade secrets,technical know-how and continuing technological innovation to develop andmaintain our competitive position. Competitors through their independentdiscovery (or improper means, such as unauthorized disclosure or industrialespionage) may come to know our proprietary information. We generally requireemployees and consultants to execute confidentiality andassignment-of-inventions agreements. These agreements typically provide thatall materials and confidential information

 

developed by or madeknown to the employee or consultant during his, her or its relationship with usare to be kept confidential, and that all inventions arising out of theemployee’s or consultant’s relationship with us are our exclusive property. Ouremployees and consultants may breach these agreements, and in some instances wemay not have an adequate remedy. Additionally, in some instances, we may havefailed to require that employees and consultants execute confidentiality andassignment-of-inventions agreements.

 

***Foreign laws may not afford us sufficientprotections for our intellectual property, and we may not seek patentprotection outside the United States.**** *We believe that our success depends, in part, upon our ability toobtain international protection for our intellectual property. However, thelaws of some foreign countries may not be as comprehensive as those of the U.S.and may not be sufficient to protect our proprietary rights abroad. Inaddition, we may decide not to pursue patent protection outside the UnitedStates, because of cost and confidentiality concerns. Accordingly, ourinternational competitors could obtain foreign patent protection for, andmarket overseas, products and technologies for which we are seeking U.S. patentprotection.

 

***We may not be able to adequately defend ourintellectual property from third party infringement, and third party challengesto our intellectual property may adversely affect our rights and be costly andtime consuming.**** *Some of ourcompetitors have, or are affiliated with companies having, substantiallygreater resources than we have, and those competitors may be able to sustainthe costs of complex patent litigation to a greater degree and for longerperiods of time than us. Uncertainties resulting from the initiation andcontinuation of any patent or related litigation could have a material adverseeffect on our ability to compete in the marketplace pending resolution of thedisputed matters. If our competitors prepare and file patent applications inthe United States that claim technology also claimed by us, we may have toparticipate in interference proceedings declared by the U.S. Patent andTrademark Office to determine the priority of invention, which could result insubstantial costs to us, even if the outcome is favorable to us. Similarly,opposition proceedings may occur overseas, which may result in the loss ornarrowing of the scope of claims or legal rights. Such proceedings will atleast result in delay in the issuance of enforceable claims. An adverse outcomecould subject us to significant liabilities to third parties and require us tolicense disputed rights from third parties or cease using the technology.Despite our efforts to protect our proprietary rights, unauthorized parties mayattempt to copy aspects of our products or to obtain and use information thatwe regard as proprietary. In limited instances, we have licensed source codesof certain products to customers or collaborators. For these reasons, policingunauthorized use of our software products may be difficult.

 

*** A patentissued to us may not be sufficiently broad to protect adequately our rights inintellectual property to which the patent relates.**** *Even if patents are issuedto us, these patents may not sufficiently protect our interest in our 

 

 

26

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software or othertechnologies because the scope of protection provided by any patents issued toor licensed by us are subject to the uncertainty inherent in patent law. Thirdparties may be able to design around these patents or develop unique productsproviding effects similar to our products. In addition, others may discoveruses for our software or technologies other than those uses covered in ourpatents, and these other uses may be separately patentable. A number ofpharmaceutical and biotechnology companies, software organizations and researchand academic institutions, have developed technologies, filed patentapplications or received patents on various technologies that may be related toour business. Some of these technologies, patent applications or patents mayconflict with our technologies, patent applications or patents. These conflictscould also limit the scope of patents, if any, that we may be able to obtain,or result in the denial of our patent applications.

 

***We may be subject to claims of infringement bythird parties.**** *Third partiesmay claim infringement by us of their intellectual property rights. Inaddition, to the extent our employees are involved in research areas similar tothose areas in which they were involved at their former employers, we may besubject to claims that one of our employees, or we, have inadvertently orotherwise used or disclosed the alleged trade secrets or other proprietaryinformation of a former employer. From time to time, we have received lettersclaiming or suggesting that our products or activities may infringe third partypatents or other intellectual property rights. Our products may infringe patentor other intellectual property rights of third parties. A number of patents mayhave been issued or may be issued in the future that could cover certainaspects of our technology and that could prevent us from using technology thatwe use or expect to use. We may be required to seek licenses for, or otherwiseacquire rights to, technology as a result of claims of infringement. We may notpossess proper ownership or access rights to the intellectual property we use.Third parties or other companies may bring infringement suits against us. Weexpect, in general, that software product developers will be subject to moreinfringement claims as the number of products and competitors in our industrysegments grows and the functionality of products in different industry segmentsoverlaps. Any claims, with or without merit, could be time consuming to defend,result in costly litigation, divert management’s attention and resources, causeproduct shipment delays or require us to enter into royalty or licensingagreements. Royalty or licensing agreements, if required, may not be availableon terms acceptable to us, if at all. In the event of a successful claim ofproduct infringement against us, our failure or inability to license or designaround the infringed technology could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

CERTAIN RISKS RELATED TO THESPIN-OFF OF PDD

 

***There can be no assurance that Accelrys will be successful on astand-alone basis.*****Our Board ofDirectors approved the plan to separate the Accelrys and PDD businesses throughthe spin-off to our stockholders of 100% of the outstanding shares of commonstock of PDD which was completed on April 30, 2004. The transaction resulted inPDD being an independent, publicly-traded company. Following the spin-off, wenot been able to rely on the financial and other resources and the cash flowsgenerated from the combined Accelrys and PDD operations. Previously, weoperated our businesses as part of a broader corporate organization rather thanas a stand-alone company. Historically, certain corporate functions had beencentralized for PDD and Accelrys.  As aresult of disengaging the PDD operations from our business, it has beendifficult for us to accurately forecast our future operating performance

 

***We may be required to indemnify PDD, or may not be able to collect onindemnification rights from PDD*****.** As part of the spin-off, we and PDD have agreed toindemnify one another with respect to the indebtedness, liabilities andobligations that will be retained by our respective companies. One suchobligation includes a guarantee by us of PDD’s obligations under the existingNew Jersey laboratory and headquarters leases, with respect to which PDD willindemnify us should we be required to make any payment under the guarantee.These indemnification obligations could be significant. PDD’s ability tosatisfy any such indemnification obligations (including, without limitation,PDD’s commitment to indemnify us in the event of our payment under ourguarantee of its leases) will depend upon PDD’s future financial strength. Wecannot assure you that, if PDD becomes obligated to indemnify us for anysubstantial obligations, PDD will have the ability to do so. There also can beno assurance that we will be able to satisfy any indemnification obligations toPDD. Any required payment by PDD or us could have amaterial adverse effect on its or our business, and any failure by PDD or us tosatisfy its obligations could have a material adverse effect on the othercompany’s business.

 

**SHOULDONE OR MORE OF THE ABOVE-DESCRIBED RISKS OR UNCERTAINTIES MATERIALIZE, ORSHOULD THE UNDERLYING ASSUMPTIONS PROVE INCORRECT, OUR ACTUAL RESULTS MAY VARYMATERIALLY FROM THOSE ANTICIPATED.**

 

 

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**Item 3.****Quantitative and Qualitative Disclosures about Market Risk**

 

We areexposed to various market risks including changes in foreign currency exchangerates.  The Company’s international salesgenerally are denominated in local currencies. For the nine months ended December 31, 2004, approximately 48% of ourconsolidated revenue was derived from customers outside the United States (including25% from customers in Europe and 23% from customers in the Asia/Pacificregion).  As such, our exchange rate riskis greatest for Dollar/Pound, Dollar/Euro and Dollar/Yen fluctuations.  When deemed appropriate, we may engage inexchange rate-hedging transactions in an attempt to mitigate the impact ofadverse exchange rate fluctuations.  AtDecember 31, 2004, we had no such hedging transactions in effect.

 

We do not use derivative financial instruments fortrading or speculative purposes. However, we regularly invest excess cash in short-term investments,municipal securities, commercial paper, corporate bonds, and mortgage-backedsecurities that are subject to changes in short-term interest rates.  We believe that the market risk arising fromholding these financial instruments is minimal.

 

Becausewe have minimal debt, our exposure to market risks associated with changes ininterest rates arise from increases or decreases in interest income earned onour investment portfolio.  We attempt toensure the safety and preservation of invested funds by limiting default risks,market risk, and reinvestment risk.  Wemitigate default risk by investing in investment grade securities.  A hypothetical 100 basis point decrease ininterest rates along the entire interest rate yield curve would not materiallyaffect the fair value of our interest sensitive financial instruments atDecember 31, 2004.

 

**Item 4.****  Controls and Procedures**

 

***Evaluation of disclosure controls and procedures.****** ***Our management, with theparticipation of our Chief Executive Officer and our then acting ChiefAccounting Officer, has evaluated the effectiveness of our disclosure controlsand procedures as of December 31, 2004. Based on that evaluation, our Chief Executive Officer and our thenacting Chief Accounting Officer concluded that our disclosure controls andprocedures are effective to ensure that information we are required to disclosein reports that we file or submit under the Securities Act of 1934 is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

We arecurrently undergoing a comprehensive effort to comply with Section 404 of theSarbanes-Oxley Act of 2002 (“SOX”). Compliance is required as of March 31, 2005.  The compliance process has included, withoutlimitation, the following:

 

1.               Define project scope,

2.               Perform entity levelassessment,

3.               Identify significant accountsand related processes,

4.               Document processes,transactions and controls,

5.               Test and evaluate design andoperating effectiveness of controls, and

6.               Identify control deficienciesand implement improvements.

 

As of December 31, 2004, wehave not discovered any internal control deficiencies that we would consider amaterial weakness.  There is no assurancethat internal control problems will not emerge from future testing or that wewill be able to comply with the requirements of Section 404 by the March 31,2005 deadline.

 

***Changes in Internal Control over FinancialReporting.***  There were nomaterial changes in our internal controls over financial reporting during thequarter ended December 31, 2004 that have materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

 

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**PART II - OTHER INFORMATION**

** **
| **Item  1.** |   | Legal  Proceedings —                                                                                                                                                                                                           |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   | We are not currently  subject to any material pending legal proceedings. However, we may become  subject to other lawsuits from time to time in the ordinary course of our  business, and any such lawsuit could harm our business. |
|         |   |                                                                                                                                                                                                                                |
| **Item  2**. |   | Unregistered Sales of  Equity Securities and Use of Proceeds — None                                                                                                                                                            |
|         |   |                                                                                                                                                                                                                                |
| **Item  3.** |   | Defaults  upon Senior Securities — None                                                                                                                                                                                        |
|         |   |                                                                                                                                                                                                                                |
| **Item  4.** |   | Submission  of Matters to a Vote of Security Holders — None                                                                                                                                                                    |
|         |   |                                                                                                                                                                                                                                |
| **Item 5.**  |   | Other  Information — None                                                                                                                                                                                                      |
|         |   |                                                                                                                                                                                                                                |
| **Item  6.** |   | Exhibits  - see Exhibit Index attached                                                                                                                                                                                              |

 

 

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**SIGNATURE**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

|   | ACCELRYS, INC.                 |                  |
|--------|--------------------------------|-----------------------|
|   |                           |                  |
|   | By:                            | /s/ David M. Sankaran |   |   |
|   |                           |                  |   |   |
|   | David M. Sankaran              |                  |
|   | Senior Vice President and      |                  |
|   | Chief Financial Officer  (Duly |                  |
|   | Authorized Officer and  Chief  |                  |
|   | Financial Officer)             |                  |
|   |                           |                  |
|   | Date: February 7, 2005         |                  |

 

 

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 Accelrys, Inc. and Subsidiaries 

 

 Exhibit Index 

 
| 2.1      |   | Agreement  and Plan of Merger and Reorganization dated September 13, 2004 by and among  the Company, Nashville Acquisition Corporation, SciTegic, Inc., Mathew Hahn  and David Rogers as Principal Shareholders, and Mathew Hahn as Shareholder  Representative (incorporated by reference to Exhibit 99.1 to the Company’s  Report on Form 8-K dated September 16, 2004).                                                                                                                   |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1      |   | Restated  Certificate of Incorporation of the Registrant (incorporated by Reference to  Exhibit 3.1 to the Company’s Report on Form 10-K for the year ended  December 31, 1996).                                                                                                                                                                                                                                                                                                        |
| 3.3      |   | Bylaws  of the Registrant, as amended (incorporated by Reference to Exhibit 3.3 to  the Company’s Report on Form 10-K for the year ended December 31, 1996).                                                                                                                                                                                                                                                                                                                            |
| 3.3(a)   |   | Amendment  to Bylaws of the Registrant dated July 31, 1997 (incorporated by  Reference to Exhibit 3.3(a) to the Company’s Report on Form 10-Q for the  quarter ended September 30, 1997).                                                                                                                                                                                                                                                                                          |
| 3.3(b)   |   | Amendment  to Bylaws of the Registrant dated January 17, 2002 (incorporated by  Reference to Exhibit 3.3(b) to the Company’s Report on Form 10-K for the year  ended December 31, 2001).                                                                                                                                                                                                                                                                                           |
| 4.1      |   | Rights  Agreement, dated as of September 6, 2002, between Accelrys, Inc.  and American Stock Transfer & Trust Company, as Rights Agent, which  includes as Exhibit A thereto the Certificate of Designations,  Preferences and Rights of Series A Junior Participating Preferred Stock  and Exhibit B thereto the Form of Right Certificate (incorporated by  Reference to Exhibit 4.1 to the Company’s Report on Form 8-K dated  September 4, 2002). |
| 10.1#    |   | Amended  1994 Incentive Stock Plan (incorporated by Reference to Exhibit 10.5 to the  Company’s Report on Form 10-K for the year ended December 31, 1995 (File  Number 000-27188)).                                                                                                                                                                                                                                                                                                     |
| 10.1(a)# |   | Amendment  No. 1 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(a) to the Company’s Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                           |
| 10.1(b)# |   | Amendment  No. 2 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(b) to the Company’s Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                           |
| 10.1(c)# |   | Amendment  No. 3 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.5(a) to the Company’s Report on Form 10-Q for the quarter ended  June 30, 1997).                                                                                                                                                                                                                                                                                                            |
| 10.1(d)# |   | Amendment  No. 4 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(d) to the Company’s Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                           |
| 10.1(e)# |   | Amendment  No. 5 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(e) to the Company’s Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                           |
| 10.1(f)# |   | Amendment  No. 6 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(f) to the Company’s Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                           |
| 10.1(g)# |   | Amendment  No. 7 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(g) to the Company’s Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                           |
| 10.1(h)# |   | Amendment  No. 8 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.54 to the Company’s Report on Form 10-Q for the quarter ended  June 30, 2000).                                                                                                                                                                                                                                                                                                              |
| 10.1(i)# |   | Amendment  No. 9 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit  10.1(i) to the Company’s Report on Form 10-Q for the quarter ended  March 31, 2002).                                                                                                                                                                                                                                                                                                           |
| 10.2#    |   | 1995  Employee Stock Purchase Plan (incorporated by Reference to Exhibit 10.6 to  the Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).                                                                                                                                                                                                                                                                                                                                     |
| 10.2(a)# |   | Amendment  No. 1 to the Employee Stock Purchase Plan (incorporated by reference to  Exhibit 10.2(a) to the Company’s Report on Form 10-Q for the quarter ended  March 31, 2001).                                                                                                                                                                                                                                                                                                        |
| 10.3#    |   | 1995  Director Option Plan (incorporated by reference to Exhibit 10.7 to the  Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).                                                                                                                                                                                                                                                                                                                                             |
| 10.3(a)# |   | Amendment  No. 1 to 1995 Director Option Plan (incorporated by reference to Exhibit  10.3(a) to the Company’s report on form 10-K for the year ended  December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.3(b)# |   | Amendment  No. 2 to the 1995 Director Option Plan (incorporated by reference to Exhibit  10.3(b) to the Company’s report on Form 10-Q for the quarter ended  March 31, 2001).                                                                                                                                                                                                                                                                                                           |

 

 

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| 10.4      |   | Lease  Agreement between Accelrys and Eastpark at 8A (incorporated by Reference to  Exhibit 10.13 to the Company’s Registration Statement on Form S-1 (Reg. No.  33-98246)).                                                                                                                              |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4(a)   |   | Amendment  dated as of January 22, 1996 to Lease Agreement between Accelrys and  Eastpark at 8A (incorporated by reference to Exhibit 10.13(a) to the Company’s  Report on Form 10-K for the year ended December 31, 1995 (File Number  000-27188)).                                            |
| 10.4(b)   |   | Third  Amendment to Lease Agreement dated March 31, 1996 between Accelrys and  Eastpark at 8A (incorporated by reference to Exhibit 10.13(b) to the Company’s  Report on Form 10-Q for the quarter ended June 30, 1996).                                                                        |
| 10.5#     |   | Employment  Agreement dated as of February 26, 2001 between the Company and Joseph  A. Mollica, Ph.D. (incorporated by reference to the Company’s Report on form  10-K for the year ended December 31, 2000).                                                                                   |
| 10.5(a)#  |   | Amendment,  effective as of May 1, 2003, to employment agreement between                                                                                                                                                                                                                                       |
|      |   | the Company and  Joseph A. Mollica, Ph.D. (incorporated by reference to exhibit 10.9(a) to the  Company’s report on Form 10-Q for the quarter ended March 31, 2003.)                                                                                                                                 |
| 10.6      |   | Lease  dated November 12, 1998 between Molecular Simulations Inc. and San Diego  Tech Center, LLC (incorporated by reference to Exhibit 10.47 to the Company’s  Report on Form 10-K for the year ended December 31, 1998).                                                                      |
| 10.7#     |   | Form  of Indemnity Agreement for Directors and Executive Officers (incorporated by  reference to Exhibit 10.48 to the Company’s Report on Form 10-K for the year  ended December 31, 1998).                                                                                                          |
| 10.8      |   | Lease  Agreement, dated May 1, 1999, between Accelrys and South Brunswick Rental I,  LTD (incorporated by reference to Exhibit 10.49 to the Company’s Report on  Form 10-Q for the quarter ended June 30, 1999).                                                                                     |
| 10.9#     |   | Accelrys,  Inc. 2000 Stock Option Plan (incorporated by reference to the Company’s  Report on form 10-K for the year ended December 31, 2000).                                                                                                                                                       |
| 10.10#    |   | Accelrys,  Inc. Executive Non-Qualified Deferred Compensation Plan (incorporated by  reference to Exhibit 10.52 to the Company’s Report on Form 10-Q for the  quarter ended March 31, 2000).                                                                                                         |
| 10.11     |   | Form  of Stock Purchase Agreement, dated as of March 8, 2000, among the  company and the investors set forth therein (incorporated by reference to  Exhibit 10.53 to the Company’s Report on Form 10-Q for the quarter ended  March 31, 2000.)                                                  |
| 10.12     |   | Employment  Agreement dated May 1, 2001 between the Company and Michael R. Stapleton. (incorporated by reference to the Company’s Report on form  10-Q for the quarter ended September 30, 2001).                                                                                                    |
| 10.12(a)# |   | Separation  Agreement and Release of Claims dated September 30, 2002, by and between  Accelrys, Inc. and Michael R. Stapleton (incorporated by reference to Exhibit  10.28 to the Company’s Report on Form 10-K for the year ended December 31,  2003).                                         |
| 10.13     |   | Lease  Agreement dated July 29, 2001 among the Masters, Fellows and Scholars of  Trinity College, Cambridge, Accelrys Limited, and Accelrys Inc. and Trinity  College (CJP) Limited (incorporated by reference to the Company’s Report on  form 10-Q for the quarter ended September 30, 2001). |
| 10.14#    |   | Employment  Agreement dated December 3, 2002 by and between Accelrys, Inc. and Mark  J. Emkjer (incorporated by reference to Exhibit 10.28 to the Company’s Report  on Form 10-K for the year ended December 31, 2003).                                                                         |
| 10.15     |   | Lease,  dated August 20, 2003, between Accelrys, Inc. and Eastpark at 8A  (Building 1000) (incorporated by reference to the Company’s report on form  10-Q for the quarter ended September 30, 2003)                                                                                            |
| 10.16     |   | Lease,  dated August 20, 2003, between Accelrys, Inc. and Eastpark at 8A  (Building 3000) (incorporated by reference to the Company’s report on form  10-Q for the quarter ended September 30, 2003)                                                                                            |
| 10.17     |   | Accelrys,  Inc. 2004 New-Hire Equity Incentive Plan                                                                                                                                                                                                                                                            |
| 10.18*    |   | Sublease,  dated May 18, 2004, between Accelrys, Inc. and Pfizer Inc.                                                                                                                                                                                                                                          |
| 10.19*    |   | Lease,  dated May 18, 2004, between Accelrys, Inc. and AGRRI Seaview, L.LC.                                                                                                                                                                                                                                    |
| 10.20*    |   | Sublease,  dated January 27, 2005, between Accelrys, Inc. and QUALCOMM Incorporated                                                                                                                                                                                                                            |
| 31.1*     |   | Section 302  Certification of the Principal Executive Officer                                                                                                                                                                                                                                             |
| 31.2*     |   | Section 302  Certification of the Principal Financial Officer                                                                                                                                                                                                                                             |
| 32*       |   | Section 906  Certification of the Chief Executive Officer and Chief Financial Officer                                                                                                                                                                                                                     |

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 +             Confidential treatmentgranted.

 ++          Confidential treatmentrequested.

 #             Represents a managementcontract or compensatory plan or arrangement.

 *             Filed herewith     

 

 

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