** **

**UNITED STATESSECURITIES AND 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 September 30, 2003** |
|                                                       |
| **or**                                                     |
|                                                       |
|                                                       | o      | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                       |
| **Commission File Number: 0-27118**                        |

 

**PHARMACOPEIA,INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                                        |   | **33-0557266**                       |
|-------------------------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |   | (I.R.S. Employer Identification No.) |
|                                                                                |   |                                 |
| **PO Box 5350, Princeton, New Jersey**                                              |   | **08543-5350**                       |
| (Address of principal executive offices)                                            |   | (Zip code)                           |
|                                                                                |   |                                 |
| **(609) 452-3600**                                                                  |
| (Registrant’s telephone number, including  area code)                          |
|                                                                                |   |                                 |
| **Not Applicable**                                                                  |
| (Former name, former address and former  fiscal year, if changed since last 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

 

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

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

| **Class**                      |   | **Outstanding  at October 31, 2003** |
|--------------------------------|--------|-------------------------------------------|
| Common Stock, $.0001 par value |   | 23,844,681                                |

 

#### ** **

----

 

#### **PHARMACOPEIA, INC.**

#### ** **

**Form10-Q**

 

#### **Table of Contents**

 
| **Item**                            |
|-------------------------------------|
|                                |   |
| PART I.  FINANCIAL INFORMATION |
|                                |   |
| Item 1.                        | Unaudited  Consolidated Financial Statements: |
|                                |   |
|                                | Balance  Sheets – September 30, 2003 and December 31, 2002 |
|                                |   |
|                                | Statements of  Operations – Three and Nine Months Ended September 30, 2003 and 2002 |
|                                |   |
|                                | Statements  of Cash Flows – Nine Months Ended September 30, 2003 and 2002 |
|                                |   |
|                                | Notes to Unaudited Consolidated Financial  Statements |
|                                |   |
| Item 2.                        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                |   |
| Item 3.                             | Quantitative  and Qualitative Disclosures about Market Risk |
|                                |   |
| Item 4.                             | Controls  and Procedures |
|                                |   |
| PART II.  OTHER INFORMATION    |
|                                |   |
| Item 1.                             | Legal  Proceedings |
|                                |   |
| Item 2.                             | Changes  in Securities and Use of Proceeds |
|                                |   |
| Item 3.                             | Defaults  upon Senior Securities |
|                                |   |
| Item 4.                             | Submission  of Matters to a Vote of Security Holders |
|                                |   |
| Item 5.                             | Other  Information |
|                                |   |
| Item 6.                             | Exhibits  and Reports on Form 8-K |
|                                |   |
| Signature                           |
|                                |   |
| Index to Exhibits                   |

 

2

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#### **PART I - FINANCIALINFORMATION**

#### ** **

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

 

**Pharmacopeia, Inc.****ConsolidatedBalance Sheets****(Dollarsin thousands)**
|                                                                                         |   | **September 30,  2003** |    | **December 31,  2002** |   |
|----------------------------------------------------------------------------------------------|--------|------------------------------|---------|-----------------------------|--------|
|                                                                                         |   | **(Unaudited)**              |    |                        |   |
| **ASSETS**                                                                                   |   |                         |    |                        |   |
| Current  assets:                                                                             |   |                         |    |                        |   |
| Cash  and cash equivalents                                                                   |   | $                            | 24,388  |                        | $      | 28,236 |   |
| Marketable  securities                                                                       |   | 114,924                      |    | 112,835                     |   |
| Trade  receivables, net of allowance for doubtful accounts of $269 and $1,634,  respectively |   | 15,339                       |    | 35,571                      |   |
| Prepaid  expenses and other current assets                                                   |   | 5,401                        |    | 5,505                       |   |
| Total  current assets                                                                        |   | 160,052                      |    | 182,147                     |   |
| Property  and equipment - net                                                                |   | 12,992                       |    | 14,157                      |   |
| Goodwill  - net                                                                              |   | 34,404                       |    | 34,404                      |   |
| Capitalized  software - net                                                                  |   | 7,423                        |    | 8,656                       |   |
| Other  intangibles - net                                                                     |   | —                       |    | 116                         |   |
| Other  assets                                                                                |   | 571                          |    | 625                         |   |
| Total  assets                                                                                |   | $                            | 215,442 |                        | $      | 240,105 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                |   |                         |    |                        |   |
| Current  liabilities:                                                                        |   |                         |    |                        |   |
| Accounts  payable                                                                            |   | $                            | 2,528   |                        | $      | 2,497 |   |
| Accrued  liabilities                                                                         |   | 16,510                       |    | 20,429                      |   |
| Deferred  revenue, current portion                                                           |   | 19,480                       |    | 29,076                      |   |
| Total  current liabilities                                                                   |   | 38,518                       |    | 52,002                      |   |
|                                                                                         |   |                         |    |                        |   |
| Deferred  revenue, long-term                                                                 |   | 2,831                        |    | 4,766                       |   |
|                                                                                         |   |                         |    |                        |   |
| Stockholders’  equity:                                                                  |   |                         |    |                        |   |
| Capital  stock                                                                               |   | 2                            |    | 2                           |   |
| Additional  paid-in capital                                                                  |   | 286,707                      |    | 284,733                     |   |
| Treasury  stock                                                                              |   | (8,340                       | )       | (8,340                      | )      |
| Accumulated  deficit                                                                         |   | (105,171                     | )       | (93,821                     | )      |
| Accumulated  comprehensive income                                                            |   | 895                          |    | 763                         |   |
| Total  stockholders’ equity                                                             |   | 174,093                      |    | 183,337                     |   |
| Total  liabilities and stockholders’ equity                                             |   | $                            | 215,442 |                        | $      | 240,105 |   |

 

See accompanying notes to these unauditedfinancial statements.

 

3

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**Pharmacopeia, Inc.Consolidated Statements ofOperations(Unaudited, Dollars in thousands, except per share data)**

 
|                                                  |   | **For the Three Months  Ended September 30,** |   | **For the Nine Months  Ended September 30,** |   |
|-------------------------------------------------------|--------|----------------------------------------------------|--------|---------------------------------------------------|--------|
|                                                  |   | **2003**                                           |   | **2002**                                          |   | **2003** |   | **2002** |   |
| Revenues:                                             |   |                                               |   |                                              |   |   |   |   |   |
| Software  license, service and other                  |   | $                                                  | 17,675 |                                              | $      | 22,872 |   | $ | 53,984 |   | $ | 63,906 |   |
| Drug  discovery                                       |   | 7,422                                              |   | 8,036                                             |   | 21,957 |   | 23,142 |   |
| Total  revenues                                       |   | 25,097                                             |   | 30,908                                            |   | 75,941 |   | 87,048 |   |
| Cost  of revenues:                                    |   |                                               |   |                                              |   |   |   |   |   |
| Software  license, service and other                  |   | 5,156                                              |   | 5,649                                             |   | 15,338 |   | 15,833 |   |
| Drug  discovery                                       |   | 5,535                                              |   | 4,647                                             |   | 16,707 |   | 14,704 |   |
| Total  cost of revenues                               |   | 10,691                                             |   | 10,296                                            |   | 32,045 |   | 30,537 |   |
| Gross  margin                                         |   | 14,406                                             |   | 20,612                                            |   | 43,896 |   | 56,511 |   |
| Operating  costs and expenses:                        |   |                                               |   |                                              |   |   |   |   |   |
| Research  and development                             |   | 4,991                                              |   | 7,503                                             |   | 16,223 |   | 21,809 |   |
| Sales,  general and administrative                    |   | 12,531                                             |   | 16,230                                            |   | 41,676 |   | 50,536 |   |
| Restructuring                                         |   | —                                             |   | 4,340                                             |   | (384 | ) | 4,340 |   |
| Total  operating costs and expenses                   |   | 17,522                                             |   | 28,073                                            |   | 57,515 |   | 76,685 |   |
| Operating  loss from continuing operations            |   | (3,116                                             | )      | (7,461                                            | )      | (13,619 | ) | (20,174 | ) |
| Interest  and other income, net                       |   | 1,197                                              |   | 1,309                                             |   | 3,237 |   | 3,252 |   |
| Loss  from continuing operations before tax provision |   | (1,919                                             | )      | (6,152                                            | )      | (10,382 | ) | (16,922 | ) |
| Provision  for income taxes                           |   | 215                                                |   | 178                                               |   | 968 |   | 491 |   |
| Net  loss                                             |   | $                                                  | (2,134 | )                                                 | $      | (6,330 | ) | $ | (11,350 | ) | $ | (17,413 | ) |
|                                                  |   |                                               |   |                                              |   |   |   |   |   |
| Net  loss per share                                   |   |                                               |   |                                              |   |   |   |   |   |
| Basic  and Diluted                                    |   | $                                                  | (0.09  | )                                                 | $      | (0.27 | ) | $ | (0.48 | ) | $ | (0.74 | ) |
|                                                  |   |                                               |   |                                              |   |   |   |   |   |
| Weighted  average number of common stock outstanding  |   |                                               |   |                                              |   |   |   |   |   |
| Basic  and Diluted                                    |   | 23,813                                             |   | 23,467                                            |   | 23,712 |   | 23,507 |   |

 

See accompanying notes to these unauditedfinancial statements.

 

4

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**Pharmacopeia, Inc.****ConsolidatedStatements of Cash Flows****(Unaudited,Dollars in thousands)**

 
|                                                                  |   | **For the  Nine Months  Ended September 30,** |    |
|-----------------------------------------------------------------------|--------|----------------------------------------------------|---------|
|                                                                  |   | **2003**                                           |    | **2002** |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                |   |                                               |    |   |   |
| Net  loss                                                             |   | $                                                  | (11,350 | ) | $ | (17,413 | ) |
| Adjustments  to reconcile net loss to net cash provided by operations |   |                                               |    |   |   |
| Depreciation                                                          |   | 4,618                                              |    | 4,516 |   |
| Amortization                                                          |   | 4,674                                              |    | 5,879 |   |
| Contribution  of stock to 401(k) members                              |   | 795                                                |    | 874 |   |
| Non-cash  compensation                                                |   | 30                                                 |    | 35 |   |
| Changes  in assets and liabilities:                                   |   |                                               |    |   |   |
| Accounts  receivable                                                  |   | 20,232                                             |    | 19,747 |   |
| Prepaid  and other current assets                                     |   | 103                                                |    | 1,161 |   |
| Other  assets                                                         |   | 52                                                 |    | 652 |   |
| Accounts  payable                                                     |   | 32                                                 |    | (2,322 | ) |
| Accrued  liabilities                                                  |   | (3,915                                             | )       | (577 | ) |
| Deferred  revenue                                                     |   | (11,523                                            | )       | (11,875 | ) |
| Net  cash provided by operating activities                            |   | 3,748                                              |    | 677 |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                |   |                                               |    |   |   |
| Capital  expenditures                                                 |   | (3,263                                             | )       | (7,292 | ) |
| Purchases  of marketable securities                                   |   | (61,072                                            | )       | (118,259 | ) |
| Proceeds  from sales of marketable securities                         |   | 58,795                                             |    | 84,802 |   |
| Capitalized  software development costs                               |   | (3,326                                             | )       | (1,831 | ) |
| Net  cash used in investing activities                                |   | (8,866                                             | )       | (42,580 | ) |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                |   |                                               |    |   |   |
| Proceeds  from issuance of common stock                               |   | 1,150                                              |    | 1,297 |   |
| Purchases  of treasury stock                                          |   | —                                             |    | (7,024 | ) |
| Principal  payments under capital lease obligations                   |   | (9                                                 | )       | (50 | ) |
| Net  cash provided by (used in) financing activities                  |   | 1,141                                              |    | (5,777 | ) |
| Exchange  rate effect on cash and equivalents                         |   | 129                                                |    | (42 | ) |
| Net  decrease in cash and equivalents                                 |   | (3,848                                             | )       | (47,722 | ) |
| Cash  and equivalents, beginning of period                            |   | 28,236                                             |    | 68,891 |   |
| Cash  and equivalents, end of period                                  |   | $                                                  | 24,388  |   | $ | 21,169 |   |
| SUPPLEMENTAL  SCHEDULE OF CASH FLOW INFORMATION:                 |   |                                               |    |   |   |
| Cash  paid during the period for:                                     |   |                                               |    |   |   |
| Interest                                                              |   | $                                                  | 5       |   | $ | 20 |   |
| Income  taxes                                                         |   | $                                                  | 277     |   | $ | 434 |   |

 

See accompanying notes to these unauditedfinancial statements.

 

5

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**Pharmacopeia,Inc.Notes to Unaudited ConsolidatedFinancial Statements**

** **

**1.  Basis of Presentation**

 

The accompanying unaudited 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 of the information anddisclosures required by generally accepted accounting principles for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation of the financial statements havebeen included.  Interim results are notnecessarily indicative of the results that may be expected for the year.  These financial statements should be read inconjunction with the audited financial statements and disclosures theretoincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2002.

 

Certain prior period amounts presented in the Segment Information belowhave been reclassified to conform with the current period presentation.

 

**2.  Net Loss Per Share**

** **

The Company computes net income (loss) per share in accordance withStatement of Financial Accounting Standard No. 128, “Earnings Per Share” (“SFAS128”).  Under the provisions of SFAS128, basic net income (loss) per share is computed by dividing the net income(loss) for the period by the weighted-average number of common sharesoutstanding during the period.  Dilutednet income (loss) per share is computed by dividing the net income (loss) forthe period by the weighted-average number of common and dilutive commonequivalent shares outstanding during the period.  Diluted earnings per share include the potentially dilutiveeffect of outstanding stock options, or other dilutive securities.  The Company has a net loss for the periodspresented; accordingly, 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.

 

**3.  Segment Information**

 

The Company operates in two industry segments.  The Company’s Software segment, AccelrysInc. (“Accelrys”), provides molecular modeling and simulation, bioinformaticsand cheminformatics software, and related services that facilitate the discoveryand development of new drug and chemical products and processes in thepharmaceutical, biotechnology, chemical, petrochemical and materialsindustries.  The Company’s DrugDiscovery segment, Pharmacopeia Drug Discovery, Inc. (“PDD”), provides drug discoveryservices to pharmaceutical and biotechnology companies based on proprietarycombinatorial chemistry, medicinal chemistry, high-throughput screening, andAccelrys technologies. The accounting policies of the reportable segments arethe same as those of the Company. Summarized financial information concerningindustry segments is as follows (dollars in thousands):

 

6

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|                                  |   | **Three  Months Ended  September 30, 2003** |   | **Nine Months  Ended  September 30, 2003** |   |
|---------------------------------------|--------|--------------------------------------------------|--------|-------------------------------------------------|--------|
|                                  |   | **Accelrys**                                     |   | **PDD**                                         |   | **Total** |   | **Accelrys** |   | **PDD** |   | **Total** |   |
| Revenue:                              |   |                                             |   |                                            |   |   |   |   |   |   |   |   |   |
| Software  licenses, service and other |   | $                                                | 17,675 |                                            | $      | — |   | $ | 17,675 |   | $ | 53,984 |   | $ | — |   | $ | 53,984 |   |
| Drug  discovery                       |   | —                                           |   | 7,422                                           |   | 7,422 |   | — |   | 21,957 |   | 21,957 |   |
| Total  revenue                        |   | $                                                | 17,675 |                                            | $      | 7,422 |   | $ | 25,097 |   | $ | 53,984 |   | $ | 21,957 |   | $ | 75,941 |   |
| Operating  loss                       |   | $                                                | (2,730 | )                                               | $      | (386 | ) | $ | (3,116 | ) | $ | (11,691 | ) | $ | (1,928 | ) | $ | (13,619 | ) |

 
|                                  |   | **Three  Months Ended  September 30, 2002** |   | **Nine Months  Ended  September 30, 2002** |   |
|---------------------------------------|--------|--------------------------------------------------|--------|-------------------------------------------------|--------|
|                                  |   | **Accelrys**                                     |   | **PDD**                                         |   | **Total** |   | **Accelrys** |   | **PDD** |   | **Total** |   |
| Revenue:                              |   |                                             |   |                                            |   |   |   |   |   |   |   |   |   |
| Software  licenses, service and other |   | $                                                | 22,872 |                                            | $      | — |   | $ | 22,872 |   | $ | 63,906 |   | $ | — |   | $ | 63,906 |   |
| Drug  discovery                       |   | —                                           |   | 8,036                                           |   | 8,036 |   | — |   | 23,142 |   | 23,142 |   |
| Total  revenue                        |   | $                                                | 22,872 |                                            | $      | 8,036 |   | $ | 30,908 |   | $ | 63,906 |   | $ | 23,142 |   | $ | 87,048 |   |
| Operating  income (loss)              |   | $                                                | (7,693 | )                                               | $      | 232 |   | $ | (7,461 | ) | $ | (19,202 | ) | $ | (972 | ) | $ | (20,174 | ) |

 
|                                    |   | **Accelrys** |    | **PDD** | ** ** | **Total** | ** ** |
|-----------------------------------------|--------|--------------|---------|---------|------------|-----------|------------|
| Total  assets - September 30, 2003 |   | $            | 88,159  |    | $          | 127,283   |       | $ | 215,442 |   |
| Total  assets - December 31, 2002  |   | $            | 104,143 |    | $          | 135,962   |       | $ | 240,105 |   |

 

**4.  Stock-Based Compensation**

 

Statement of Financial Accounting Standards No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”) encourages, but does not require,companies to record compensation cost for stock-based compensation plans atfair value.  As permitted by SFAS 123,the Company has elected to continue following Accounting Principles BoardOpinion No. 25 “Accounting for Stock Issued to Employees,” (“APB 25”) andrelated interpretations, to account for stock-based compensation.  Under APB 25, no compensation expense isrecognized at the time of option grant because the exercise price of theCompany’s employee stock option equals the fair market value of the underlyingcommon stock on the date of grant.

 

Had the Company followed the fair value measurement provisions of SFAS123, the following table summarizes the pro forma net loss and pro forma netloss per share that would have been recorded (in thousands, except per sharedata):

 
|                                                                                                              |   | **Three  Months Ended September 30,** |   | **Nine Months  Ended September 30,** |   |
|-------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                              |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
| Net  loss                                                                                                         |   |                                       |   |                                      |   |   |   |   |   |
| As  reported                                                                                                      |   | $                                          | (2,134 | )                                         | $      | (6,330 | ) | $ | (11,350 | ) | $ | (17,413 | ) |
| Deduct:  total stock-based employee compensation expense determined under fair value  based method for all awards |   | (3,091                                     | )      | (3,120                                    | )      | (9,274 | ) | (9,360 | ) |
| Pro  forma                                                                                                        |   | $                                          | (5,225 | )                                         | $      | (9,450 | ) | $ | (20,624 | ) | $ | (26,773 | ) |
| Basic  and diluted net loss per share:                                                                            |   |                                       |   |                                      |   |   |   |   |   |
| As  reported                                                                                                      |   | $                                          | (0.09  | )                                         | $      | (0.27 | ) | $ | (0.48 | ) | $ | (0.74 | ) |
| Pro  forma                                                                                                        |   | $                                          | (0.22  | )                                         | $      | (0.40 | ) | $ | (0.87 | ) | $ | (1.14 | ) |

 

The fair value of each option granted during 2003 and 2002 is estimatedon the date of grant using the Black-Scholes option-pricing model with thefollowing assumptions:

 
|                     |   | **2003** |   | **2002** |   |
|--------------------------|--------|----------|--------|----------|--------|
| Dividend  yield          |   | 0        | %      | 0        | %      |
| Expected  volatility     |   | 86.49    | %      | 89.84    | %      |
| Risk-free  interest rate |   | 3.74     | %      | 3.50     | %      |
| Expected  life (years)   |   | 6.5      |   | 5.5      |   |

 

7

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**5.  Restructuring**

 

During the third quarter of 2002, the Company announced that it wasundertaking various actions to restructure its operations to improve itsoverall financial performance.  Therestructuring effort included a reduction in force of 71 employees, all of whomhad been terminated as of September 30, 2003, and the closure of certainfacilities. As a result of this plan, restructuring related charges ofapproximately $4.3 million were recognized as operating expense in the thirdquarter of 2002.

 

Based on a subsequent analysis of costs incurred and remaining costs tocomplete the restructuring, the Company determined that certain costsoriginally contemplated under the plan would not be incurred, and as such, therelated amounts were reversed during the first quarter of 2003.

 

The following table summarizes the balance of the accrued restructuringreserve, which has been included in accrued liabilities at September 30,2003 (dollars in thousands):

 
|                                |   | **Severance  Costs for Involuntary  Employee Terminations** |   | **Costs to  Exit  Lease Obligations** |   | **Total** |   |
|-------------------------------------|--------|-------------------------------------------------------------|--------|---------------------------------------|--------|-----------|--------|
| Balance  at August 6, 2002     |   | $                                                           | 2,367  |                                  | $      | 1,973     |   | $ | 4,340 |   |
| Utilization  of Reserves:           |   |                                                        |   |                                  |   |      |   |
| Cash                                |   | (2,217                                                      | )      | (543                                  | )      | (2,760    | )      |
| Reserve  reductions                 |   | (95                                                         | )      | (289                                  | )      | (384      | )      |
| Balance  at September 30, 2003 |   | $                                                           | 55     |                                  | $      | 1,141     |   | $ | 1,196 |   |

 

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

 

The following discussion and analysis offinancial condition and results of operations of Pharmacopeia, Inc.(“Pharmacopeia” or the “Company”) should be read in conjunction with theUnaudited Consolidated Financial Statements and related notes includedelsewhere in this Form 10-Q, and also in conjunction with the ConsolidatedFinancial Statements and related notes included in the Company’s Form 10-K forthe year ended December 31, 2002.

 

This Report, including, without limitation,this section regarding Management’s Discussion and Analysis of FinancialCondition and Results of Operations, contains forward-looking statementsregarding the Company and its business, financial condition, results ofoperations, and prospects. Words such as “expects,” “anticipates,” “intends,”“plans,” “believes,” “seeks,” “estimates,” and similar expressions are intendedto identify forward-looking statements, but are not the exclusive means ofidentifying forward-looking statements in this report.  Additionally, statements concerning futurematters such as the development of new products, enhancements of technologies,possible changes in legislation, and other statements regarding matters thatare not historical are forward-looking statements.

 

Although forward-looking statements in thisReport reflect the good faith judgment of the Company’s management, suchstatements can only be based on facts and factors currently known by theCompany.  Consequently, forward-lookingstatements are inherently subject to risks and uncertainties and actual resultsand outcomes may differ materially from the results and outcomes discussed inor anticipated by the forward-looking statements.  The Company undertakes no obligation to revise or update anyforward-looking statements in order to reflect any event or 

 

8

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circumstance that may arise after the date ofthis Report.  Readers areurged not to place undue reliance on these forward-looking statements, whichspeak only as of the date of this Report.

 

The Company’s most recent Form 10-K, and thisReport, describe certain risk factors and uncertainties that may cause actualresults, levels of activity, performance, or achievements to be materiallydifferent from any future results, levels of activity, performance, orachievements expressed or implied by such forward-looking statements.  These risk factors and uncertainties shouldbe considered in connection with any investment in the Company’s common stock.

 

**BUSINESS OVERVIEW**

 

Pharmacopeia is a leader in enabling science and technology thataccelerates and improves the drug discovery and chemical development processes.Pharmacopeia’s drug discovery subsidiary, Pharmacopeia Drug Discovery, Inc.(“PDD”), integrates proprietary small molecule combinatorial chemistry,medicinal chemistry, high-throughput screening, in-vitro pharmacology,computational methods and informatics to discover and optimize leadcompounds.  Pharmacopeia’s softwaresubsidiary, Accelrys Inc. (“Accelrys”), develops and commercializes molecularmodeling and simulation software for the life sciences and materials researchmarkets, cheminformatics and decision support systems, and bioinformatics toolsincluding gene sequence analysis. Pharmacopeia employs approximately 700 peopleand is headquartered in Princeton, NJ.

 

##### RESULTS OFOPERATIONS

 

THREE MONTHS ENDED SEPTEMBER 30, 2003AND 2002

 

Total revenue decreased 19% to $25.1 millionin the third quarter of 2003 compared to $30.9 million in the third quarter of2002.

 

Accelrys software license, service and otherrevenue decreased 23% to $17.7 million in the third quarter of 2003 compared to$22.9 million in the third quarter of 2002. Revenue decreased 28% to $13.6 million in the European and US regionscombined, including revenue from a strategic alliance.  Excluding the effect of the strategicalliance, revenue in the European and US regions combined decreased 23%.  Revenue in Asia decreased 1% to $4.1million.  The net decrease in revenue wasdue primarily to closed consortia, continuing pricing pressure across all customertypes, and, particularly in the biotech and materials science sectorsthroughout the world, fewer renewals of annual licenses, attributable to delaysor deferrals in customers’ purchasing decisions and changes in customers’business focus from research activities towards development efforts.

 

Drug Discovery revenue decreased 8% to $7.4million in the third quarter of 2003 compared to $8.0 million in the thirdquarter of 2002.  The decrease wasprimarily due to a $1.2 million positive revenue adjustment in the thirdquarter of 2002 resulting from a decrease in the Company’s estimated costs tocomplete a project compared to total estimated costs.  Milestone revenue of $1.3 million was recorded in the thirdquarter of 2003 compared to milestone revenue of $0.3 million in the thirdquarter of 2002.  Excluding the effectof the revenue adjustment and the milestone revenues from both periods, revenuedecreased 6% to $6.2 million in the third quarter of 2003 compared to $6.6million in the third quarter of 2002. This decrease was largely attributable to decreased lead optimizationrevenue due to the expiration of a collaboration agreement.

 

Accelrys software license, service and othergross margin decreased 27% to $12.5 million (71% of related revenue) in thethird quarter of 2003 compared to $17.2 million (75% of related 

 

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revenue) in the third quarter of 2002.  The $4.7 million decrease in gross marginresulted principally from the lower revenue, offset by decreasedintangible asset amortization.  Thedecrease in gross margin as a percentage of related revenue is due to the fixedcost of the customer support function being charged against a lower revenuebase.

 

Gross margin generated from Drug Discoverydecreased 44% to $1.9 million (25% of related revenue) in the third quarter of2003 compared to $3.4 million (42% of related revenue) in the third quarter of2002 including the effect of milestone revenue.  The decrease was related to the revenue adjustment in the prioryear, partially offset by the increased milestone revenue, neither of whichcarry any significant associated cost of revenue.  Excluding the effect of the revenue adjustment in the prior yearperiod, and the milestone and license revenue from both periods, the grossmargin decreased by 69% to $0.6 million (10% of related revenue) from $1.9million (29% of related revenue).  Thelower margin resulted from the decrease in revenue, and from increased resourcesallocated to collaborations, which resulted in increased direct and allocatedfixed costs being associated with current period revenue.

 

Research and development expenses decreasedby 33% to $5.0 million in the third quarter of 2003 compared to $7.5 million inthe third quarter of 2002.  The decreasein research and development expenses was attributable to, among other things,cost efficiencies realized at Accelrys through the consolidation of researchefforts, cost reduction initiatives, increased capitalization of softwaredevelopment activities, and the reduction of internally funded drug discoveryprograms in the Drug Discovery subsidiary.

 

Sales, general and administrative expensesdecreased by 23% to $12.5 million in the third quarter of 2003 compared to$16.2 million in the third quarter of 2002. The decrease in sales, general, and administrative expenses wasattributable to the restructuring undertaken in the third quarter of 2002, andcontinuing cost reduction initiatives implemented by management.

 

A restructuring charge of $4.3 million wasrecorded in the third quarter of 2002 related to actions taken to improve theCompany’s financial performance.  SeeNote 5 to Unaudited Consolidated Financial Statements.

 

Interest and other income, net, decreased 9%to $1.2 million in the third quarter of 2003 compared to $1.3 million in thethird quarter of 2002.  The lowerinterest and other income, net, was due principally to decreases in marketinterest rates.

 

The Company recorded an income tax provisionof $0.2 million for the third quarter of 2003 and 2002.  Tax expense is based on the annual estimated effective tax rate, afterconsidering estimated taxable income for each tax jurisdiction.  Taxable income is primarily generated in theCompany’s foreign subsidiaries.

 

As a result of the lower revenue and lowercosts described above, in the third quarter of 2003 the Company generated a netloss of $2.1 million ($0.09 per diluted share), 66% lower than the net loss of$6.3 million ($0.27 per diluted share) in the third quarter of 2002.

 

NINE MONTHS ENDED SEPTEMBER 30, 2003 AND2002

 

Total revenue decreased 13% to $75.9 millionin the nine months ended September 30, 2003 compared to $87.0 million inthe nine months ended September 30, 2002.

 

Accelrys software license, service and otherrevenue decreased 16% to $54.0 million in the nine months endedSeptember 30, 2003 compared to $63.9 million in the nine months ended 

 

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September 30, 2002.  Revenue decreased 20% to $42.1 million inthe European and US regions combined, including revenue from a strategicalliance.  Excluding the effect of thestrategic alliance, revenue in the European and US regions combined decreasedby 17%.  The net decrease in revenue wasdue primarily to closed consortia, pricing pressure across all customer typesand, particularly in the bioinformatics and materials science sectors, delaysand deferrals in customers’ purchasing decisions and fewer renewals of annuallicenses, attributable to changes in customers’ business focus from researchactivities toward development efforts. Revenue in Asia increased 6% primarily due to revenue growth in thefirst quarter of 2003, Japan’s traditional fiscal year end.

 

Drug Discovery revenue decreased 5% to $22.0million in the nine months ended September 30, 2003 compared to $23.1million in the nine months ended September 30, 2002. The decrease waslargely due to a decrease in lead optimization revenue due to the expiration ofa collaboration agreement and the prior year positive revenue adjustment in thethird quarter. The decrease was partially offset by increased milestone andlicense revenue in the nine months ended September 30, 2003.  Excluding the effect of the milestones andthe revenue adjustment, revenue decreased 4%.

 

Accelrys software license, service and othergross margin decreased 20% to $38.6 million (72% of related revenue) in thenine months ended September 30, 2003 compared to $48.1 million (75% ofrelated revenue) in the nine months ended September 30, 2002.  The $9.4 million decrease in gross marginresulted principally the lower revenue, offset by decreasedintangible asset amortization.  Thedecrease in gross margin as a percentage of related revenue is due to the fixedcost of the customer support function being charged against a lower revenuebase.

 

Gross margin generated from Drug Discoverydecreased 38% to $5.3 million (24% of related revenue) in the nine months endedSeptember 30, 2003 as compared to $8.4 million (36% of related revenue) inthe nine months ended September 30, 2002. The decrease was related to therevenue adjustment in the prior year offset by the increased milestone revenue,neither of which carry any significant associated cost of revenue.  Excluding the effect of the revenueadjustment and milestone and license revenue in the prior year period, thegross margin decreased by 64% to $1.9 million (10% of related revenue) from$5.3 million (26% of related revenue). The lower margin resulted from the decreased revenue, and from increasedresources allocated to collaborations, which resulted in increased direct andallocated fixed costs being associated with current period revenue.

 

Research and development expenses decreasedby 26% to $16.2 million in the nine months ended September 30, 2003compared to $21.8 million in the nine months ended September 30,2002.  The decrease in research anddevelopment expenses was attributable to, among other things, cost efficienciesrealized at Accelrys due to the consolidation of research efforts, costreductions implemented in the prior year, increased capitalization of softwaredevelopment activities, and the reduction of internally funded drug discoveryprograms in the Drug Discovery business.

 

Sales, general and administrative expensesdecreased by 18% to $41.7 million in the nine months ended September 30,2003 compared to $50.5 million in the nine months ended September 30,2002.  The decrease in sales, general,and administrative expenses was attributable to the restructuring undertaken inthe third quarter of 2002, and continuing cost reduction initiativesimplemented by management.

 

During the nine months endedSeptember 30, 2003, the Company terminated a facility lease, the expectedremaining obligation under which had been included in the restructuringprovision taken in the third quarter of 2002, and finalized certain remainingseverance obligations.  As such, the 

 

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Company reversed an excess portion of therestructuring liability during the nine months ended September 30, 2003.

 

Interest and other income, net, was $3.2million in the nine months ended September 30, 2003 and 2002.

 

The Company recorded an income tax provisionof $1.0 million for the nine months ended September 30, 2003 compared to$0.5 million for nine months ended September 30, 2002.  Tax expense is based on the annual estimated effective tax rate, afterconsidering estimated taxable income for each tax jurisdiction.  Taxable income is primarily generated in theCompany’s foreign subsidiaries.

 

As a result of the lower revenue and lowercosts described above, in the nine months ended September 30, 2003, theCompany generated a net loss of $11.4 million ($0.48 per diluted share), 35%lower than the loss of $17.4 million ($0.74 per diluted share) in the ninemonths ended September 30, 2002.

 

**LIQUIDITY AND CAPITALRESOURCES**

** **

The Company has funded its activities to dateprimarily through the sale of equity securities, software licenses, softwaremaintenance services, drug discovery services, and the receipt of milestonepayments.  As of September 30,2003, the Company had cash, cash equivalents, and marketable securities of$139.3 million compared to $141.0 million as of December 31, 2002.

 

Cash provided by operations increased by $3.1million in the nine months ended September 30, 2003 compared to the ninemonths ended September 30, 2002. The increase was primarily attributable to the lower net loss generatedin the nine months ended September 30, 2003.  Cash used in investing activities decreased by $33.7 million inthe nine months ended September 30, 2003 compared to the nine months endedSeptember 30, 2002 due to the timing of investments and reduced capitalpurchases.  Cash used in financing activitiesdecreased by $6.9 million in the nine months ended September 30, 2003compared to the nine months ended September 30, 2002 due to purchases oftreasury stock in the prior year.

 

The Company anticipates that its capitalrequirements may increase in future periods as a result of seasonal salestrends, additional research and development activities, and the acquisition ofadditional equipment.  The Company’scapital requirements may also increase in future periods as the Company seeksto expand its technology platform through investments, licensing arrangements,technology alliances, or acquisitions.

 

The Company anticipates that its existingcapital resources will be adequate to fund the Company’s operations at leastthrough 2004.  However, there can be noassurance that changes will not occur that would consume available capitalresources before then.  The Company’scapital requirements depend on numerous factors, including the ability of theCompany to continue to generate software sales, the ability of the Company toextend existing Drug Discovery agreements and to enter into additionalarrangements, competing technological and market developments, changes in theCompany’s existing collaborative relationships, the cost of filing,prosecuting, defending, and enforcing patent claims and other intellectualproperty rights and the outcome of related litigation, the purchase ofadditional capital equipment, acquisitions of other businesses or technologies,and the progress of the Company’s customers’ milestone and royalty producingactivities.  There can be no assurancethat additional funding, if necessary, will be available on favorable terms, ifat all.  The Company’s forecasts of theperiod of time through which its financial resources will be adequate tosupport its operations are forward looking 

 

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information, and actual results couldvary.  The factors described earlier inthis paragraph will impact the Company’s future capital requirements and theadequacy of its available funds.

 

RISK FACTORS

 

*You should carefully consider the risksdescribed below before investing in our publicly-traded securities.  The risks described below are not the onlyones facing us.  Our business is alsosubject to 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 or that we currentlybelieve are immaterial also may impair our business operations and ourliquidity.*

 

CERTAIN RISKS RELATED TO OUR BUSINESS AS AWHOLE

 

*Our successdepends in part upon the successful implementation of our management’sstrategic plan.* Our management has been, and continuesto be, engaged in the consideration and exploration of strategic alternativesfor our businesses, including the possible separation by various means of ourDrug Discovery business from our Accelrys software operation.  There can be no assurance that any such strategicalternative will be implemented or, if completed, that it will enhance thevalue of either or both of our businesses. Such alternatives also may include the acquisition of businesses andtechnologies which complement or supplement our existing businesses andtechnologies. However, management may be unable to identify suitable strategicopportunities, choose the wrong technologies or businesses to pursue or beunable to negotiate suitable prices or favorable terms with respect tostrategic opportunities.  The occurrenceof any of the foregoing may have a material adverse effect on our business.

 

*Concentrationof our Drug Discovery Revenue in one Customer. *During the nine months ended September 30,2003, we earned approximately 45% of our Drug Discovery segment revenue, and13% of our consolidated revenue, under research collaboration agreements withPDD’s major customer.  These agreementshad been scheduled to expire in March 2004.  In the third quarter ofthis year, we entered into new drug discovery collaboration agreements withthis customer, which effectively supersede these agreements.  By their terms, the new agreements continuea number of programs commenced under these superseded agreements, and implementcertain new activities.  The newagreements continue our collaboration with this customer through at leastAugust 2006 and, under their terms, may be extended by the parties for upto three additional years based upon progress made in the programs governed bythe agreements.  In light of thesignificance to us of this customer relationship, the termination of these newagreements would have a material adverse effect on PDD, and our business as awhole.

 

*Pharmaceuticaland biotechnology companies may discontinue or decrease their use of ourservices and products.*** **We depend on pharmaceutical and biotechnology companies thatuse our services for a large portion of our PDD revenue. Further, thesecompanies (together with diversified chemical and other industrial companies)comprise the principal market for our Accelrys modeling, simulation, dataanalysis and related software products and services.  Although there is a history among pharmaceutical andbiotechnology companies of outsourcing drug research and development functions,this practice may not continue. Similarly, these companies have frequentlyutilized outside software vendors for key tools used in drug discovery andchemical development, rather than developing needed information and analysistools internally.  Our revenue dependsto a large extent on research and development expenditures by thepharmaceutical, biotechnology, and chemical industries, particularly companiesin these industries outsourcing research and development projects and addingnew and improved technologies to accelerate their drug discovery and chemicaldevelopment initiatives.  These 

 

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expenditures are based on awide variety of factors, including the resources available for purchasingresearch equipment, the spending priorities among various types of research,policies regarding expenditures during recessionary periods and the benefits ofnew software tools versus their costs of licensure.  Since a large proportion of our software customers license ourproducts on an annual basis or buy maintenance contracts from us annually, iftheir spending priorities shift, our revenue may be impacted.  Also, general economic downturns in ourcustomers’ industries or any decrease in research and development expenditurescould harm our operations, as could increased popularity of management theorieswhich counsel against outsourcing of critical business functions. In addition,the popularity of scientific thinking that disfavors expensive products such aslarge diversity libraries could negatively impact our revenue or our sales mix.Any decrease in drug discovery spending by pharmaceutical and biotechnologycompanies, or in chemical or materials spending by chemical and industrialcompanies, could cause our revenue to decline and adversely impact ourprofitability.

 

*Our ability toincrease revenue and grow our business is dependent upon our success in addingnew customers and expanding our existing customer relationships.*  In order to generate the additional revenueneeded to grow, we must add new customers and retain, and expand upon, ourexisting customer relationships. These efforts depend significantly upon, amongother factors:

 

•                  our successfuldevelopment of new products;

•                  the success ofour business development, sales and marketing efforts;

•                  biotechnologyand pharmaceutical company spending for the outsourcing of chemistry and otherdrug discovery services; and

•                  the willingnessof current and potential biotechnology, pharmaceutical and diversified chemicalcustomers to invest in new modeling, simulation and informatics solutions.

 

If we are unable to add revenue from additional or expanded customerrelationships, we may not be able to grow our business.

 

*Our futureprofitability is uncertain.*We generated a small profit in 2000, and we have generated losses in2001, 2002 and the first nine months of 2003. Our future profitability depends upon many factors, includingseveral that are beyond our control. These factors include:

 

•                  changes in thedemand for our products and services;

•                  the introductionof competitive drug discovery services and software;

•                  our ability tolicense desirable technologies;

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

•                  our ability tosuccessfully and timely develop, introduce and market new products, servicesand product enhancements cost effectively.

 

*We operate inbusiness lines that change rapidly and in unexpected ways.*Rapid technological change and uncertainty due to new and emerging technologiescharacterize the software, drug discovery and chemical development industries.We may be unable to develop, integrate and market, on a timely basis, the newand enhanced products and services necessary to keep pace with competitors. Ourproducts and services may be rendered obsolete by the offerings of ourcompetitors. Failure to anticipate or to respond to changing technologies, orsignificant delays in the development or introduction of products or services,could cause customers to delay or decide against purchases of our products orservices.

 

*Failure toattract and retain skilled personnel could have a material adverse effect onus.* Our success depends in part on the continuedservice of key scientific, software, sales, engineering 

 

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and management personnel andour ability to identify, hire and retain additional personnel. There is intensecompetition for qualified personnel. In particular, we believe that there is ashortage of scientists qualified to work in the Drug Discovery segment. The competitionamong drug discovery and development companies to hire such scientists isparticularly intense. 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 the Drug Discoverysegment. Failure to attract and retain key personnel could have a materialadverse effect on our business, financial condition and results of operations.Further, we are highly dependent on the principal members of our scientific andmanagement staff, including:

 

•                  Joseph A.Mollica, Ph.D., Chairman of the Board, President and Chief Executive Officer;

•                  Mark J. Emkjer,Executive Vice President and President, Accelrys; and

•                  Stephen A.Spearman, Ph.D., Executive Vice President and Chief Operating Officer, PDD,

 

and the managers reporting to these senior executives.  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, and do notintend to, maintain key person life insurance on the life of any employee.

 

*We aredependent upon some of our suppliers.* We currentlyrely on two suppliers to provide plastic filter bottom microtiter plates thatare used in the assay plate preparation process. We have, over the past year,developed a process such that we are not entirely dependent upon thesesuppliers.  Should we be unable, in someinstances, to obtain an adequate supply of these or comparable filter bottomplates at commercially reasonable rates, our ability to continue to prepareassay plates could be adversely affected, which in turn could harm our business.

 

*We may beunable to develop strategic relationships with large pharmaceutical,biotechnology, chemical and technology companies.* A component of our business strategy is todevelop strategic relationships with larger pharmaceutical, biotechnology,chemical and technology companies.  Webelieve that through such relationships we can add revenue, expand ourdistribution channels, maximize our research and development resources, improveour competitive position and increase market awareness and acceptance of DrugDiscovery and scientific software products. To date, we have entered intosignificant strategic relationships with such companies as Schering-Plough,IBM, Oracle and HP.  There can be noassurance that any such relationship will continue, that relationships withsimilar large organizations can be developed, or that any such existing or newalliances will produce substantial revenue or profit opportunities.

 

*We are subjectto risks associated with the operation of an international business.*  In the nine months ended September 30,2003, approximately 55% of the Company’sconsolidated revenue was derived from customers outside the United States,both through international subsidiaries and on an export basis. Approximately 38% of ourrevenue was derived from customers in Europe and approximately 17% wasderived from customers in the Asia/Pacific region.  We anticipate that international revenue will continue to accountfor a significant percentage of future overall revenue. Our internationaloperations, particularly at Accelrys, continue to expand, with functions suchas software development, sales and customer support increasingly beingperformed outside the United States.  Inthis connection, we intend to continue our expansion of our development centerin Bangalore, India.

 

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

 

•                  unexpectedchanges in regulatory requirements;

•                  longer paymentcycles;

•                  currencyexchange rate fluctuations;

•                  import andexport license requirements;

•                  tariffs andother barriers;

•                  politicalunrest, terrorism and economic instability;

•                  disruption ofour operations due to local labor conditions;

•                  limitedintellectual property protection;

•                  difficulties incollecting trade receivables;

•                  difficulties inmanaging distributors or representatives;

•                  difficulties in managing an organizationspread over various countries

•                  difficulties instaffing foreign subsidiary or joint venture operations; and

•                  potentiallyadverse tax consequences.

 

Our success depends, in part, on our ability to anticipate and addressthese risks. There can be no assurance that these or other factors will notadversely affect our business or operating results.

 

We may not be able to sustain or increase international revenue. Any ofthe foregoing factors may have a material adverse effect on our internationaloperations and, therefore, our business, financial condition and results ofoperations. Our direct international sales generally are denominated in localcurrencies. Fluctuations in the value of currencies in which we conductbusiness relative to the United States dollar result in currency transactiongains and losses, and the impact of future exchange rate fluctuations cannot beaccurately predicted. Future fluctuations in currency exchange rates may have amaterial adverse impact on revenue from international sales, and thus on ourbusiness, financial condition and results of operations. When deemed appropriate,we may engage in currency exchange rate hedging transactions in an attempt tomitigate the impact of adverse exchange rate fluctuations. However, currencyhedging policies may not be successful, and they may increase the negativeimpact of exchange rate fluctuations.

 

*Investments inSales Efforts.* Both our Drug Discovery and software products and services involvelengthy sales cycles, often requiring us to expend considerable financial andpersonnel resources without any assurance that revenue will be recognized.  These sales cycles typically are long for anumber of reasons.  In Drug Discovery,factors include the strategic nature of Drug Discovery partnerships, the sizeof many such transactions, the confidential and proprietary nature of the biologicaltargets against which we screen our chemical compound libraries, and the uniqueterms typically found in each services transaction.  With respect to software sales, sales cycles are impacted by thetime and resources required to educate potential customer organizations as tothe value and comparative advantages of our products. As a result, we mayexpend substantial funds and effort to negotiate agreements for services andproducts in both of our business segments, but may ultimately be unable to consummatea sale. In these circumstances, our results of operations and ability toachieve profitability are adversely affected.

 

*Consolidationwithin the pharmaceutical and biotechnology industries may lead to fewerpotential customers for our products and services. *A significant portion of our customerbase consists of pharmaceutical and biotechnology companies. Mergers betweenlarge multinational pharmaceutical companies continue to be completed.Continued consolidation within the pharmaceutical and biotechnology industriesmay result in fewer customers for our products and 

 

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services. If one of the partiesto a consolidation uses the products or services of our competitors, we maylose existing customers as a result of such consolidation.

 

*Our operationsmay be interrupted by the occurrence of a natural disaster or othercatastrophic event at our primary facilities.***  **We depend on our laboratoriesand equipment for the continued operation of our business. Our research anddevelopment operations and administrative functions are primarily conducted atour facilities in the Princeton, New Jersey area, San Diego, California,Cambridge, United Kingdom, and Bangalore, India.  Although we have contingency plans in effect for naturaldisasters or other catastrophic events, catastrophic events could still disruptour operations. Even though we carry business interruption insurance policies,we may suffer losses as a result of business interruptions that exceed the coverageavailable under our insurance policies. Any natural disaster or catastrophicevent in our facilities or the areas in which they are located could have asignificant negative impact on our operations.

 

*Terroristattacks or acts of war may seriously harm our business.***  **Terrorist attacks or acts of warmay cause damage or disruption to our company, our employees, our facilitiesand our customers, which could significantly impact our revenue, costs andexpenses and financial condition. The long-term effects on our company of theattacks that took place in the United States on September 11, 2001 areunknown. The potential for future terrorist attacks, the national andinternational responses to terrorist attacks, and other acts of war or hostilityhave created many economic and political uncertainties, which could materiallyadversely affect our business, results of operations, and financial conditionin ways that we currently cannot predict.

 

*Because ourstock price may be volatile, our stock price could experience substantialdeclines.*** **Themarket price of our common stock has historically experienced and may continueto experience volatility. Our quarterly operating results, changes in generalconditions in the economy or the financial markets and other developmentsaffecting us or our competitors could cause the market price of our commonstock to fluctuate substantially. In addition, in recent years, the stockmarket has experienced significant price and volume fluctuations. During thepast two years, the stock market, and in particular technology companies, alsohave experienced significant decreases in market value. This volatility and therecent market decline has affected the market prices of securities issued bymany companies, often for reasons unrelated to their operating performance, andmay adversely affect the price of our common stock.

 

*As institutionshold the majority of our common stock in large blocks, substantial sales bythese stockholders could depress the market price for our shares.* As of September 30, 2003, ourcompany’s seven largest stockholders held approximately 61% of our outstandingcommon stock.  As a result, if one ormore of these major stockholders were to sell all or a portion of theirholdings, or if the market were to perceive that such sale or sales may occur,the market price of our common stock may fall significantly.

 

*Because we donot intend to pay dividends, you will benefit from an investment in our commonstock only if it appreciates in value.***  **We have never declared or paidany cash dividends on our common stock. We currently intend to retain ourfuture earnings, if any, to finance the expansion of our business and do notexpect to pay any cash dividends in the foreseeable future. As a result, thesuccess of your investment in our common stock will depend entirely upon anyfuture appreciation in its value. There is no guarantee that our common stockwill appreciate in value or even maintain the price at which you purchased yourshares.

 

*Anti-takeoverprovisions under the Delaware general corporation law, provisions in ourcertificate of incorporation and bylaws, and our adoption of a stockholderrights plan may render more difficult the accomplishment of mergers or theassumption of control by a principal*

 

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*stockholder, making more difficult theremoval of management*. Certain provisions of theDelaware General Corporation Law may delay or deter attempts to secure controlof our company without the consent of our management. Also, our governingdocuments provide for a staggered board of directors, which will make it moredifficult for a potential acquirer to gain control of our Board of Directors.In 2002, we adopted a stockholder rights plan, which is triggered uponcommencement or announcement of a hostile tender offer or when any one personor group acquires 15% or more of our common stock. The rights plan, oncetriggered, enables stockholders to purchase our common stock, and the stock ofthe entity acquiring us, at reduced prices. These provisions of our governingdocuments and stockholder rights plan, and of Delaware law, could have theeffect of delaying, deferring or preventing a change of control, includingwithout limitation 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.

 

*If we consumecash more quickly than expected, we may be unable to raise additional capitaland we may be forced to curtail operations.*Weanticipate that our existing capital resources will be adequate to fund ouroperations at least through 2004***.*** However, changes may occur that would consumeavailable capital resources before that time. Our capital requirements willdepend on numerous factors, including:

 

•                  costs associatedwith software sales;

•                  costs associatedwith drug discovery services;

•                  our internalproprietary drug discovery activities;

•                  competingtechnological and market developments;

•                  changes in ourexisting collaborative relationships;

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

•                  the purchase ofadditional capital equipment;

•                  acquisitions ofother businesses or technologies; and

•                  the progress ofour milestone and royalty producing activities.

 

If we determine that we must raise additional capital, we may attemptto do so through public or private financings involving debt or equity.However, additional capital may not be available on favorable terms, or at all.If adequate funds are not available, we may be required to curtail operationssignificantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

 

CERTAIN RISKS RELATED TO INTELLECTUALPROPERTY

 

*Positions takenby the U.S. patent and trademark office or non-U.S. patent and trademarkofficials may preclude us from obtaining sufficient or timely protection forour intellectual property.*The patent positions ofpharmaceutical, biotechnology and software companies are uncertain and involvecomplex legal and factual questions. Consequently, some or all of our patent applicationsmay not issue into patents, and any issued patents may provide ineffectiveremedies or be challenged or circumvented. The coverage claimed in a patentapplication can be significantly reduced before the patent is issued. There isa significant risk that the scope of a patent may not be sufficient to preventthird parties from marketing other products or technologies with the samefunctionality of our products and technologies.

 

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*Third partiesmay have filed patent applications of which we may or may not have knowledge,and which may adversely affect our business*. Patentapplications in the U.S. are maintained in secrecy for 18 months from filing oruntil a patent issues. Under certain circumstances, patent applications arenever published but remain in secrecy until issuance. As a result, others mayhave filed patent applications for products or technology covered by one ormore pending patent applications upon which we are relying. There have been,and may continue to be, third-party patents, patent applications and otherintellectual property or information relevant to our software, chemicalcompositions and other technologies not known to us and that block or competewith our software, chemical compositions or other technologies, or limit thescope of patent protection available to us. Moreover, from time to time,patents have issued and in the future may issue which block or compete with oursoftware, chemical compositions or other technologies, or limit the scope ofpatent protection available to us.** **Litigationmay be necessary to enforce patents issued to us or to determine the scope andvalidity of the intellectual property rights of third parties.

 

*We may not beable to protect adequately the trade secrets and confidential information thatwe disclose to our employees*. We rely upon tradesecrets, technical know-how and continuing technological innovation to developand maintain our competitive position. Competitors through their independent discovery(or improper means, such as unauthorized disclosure or industrial espionage)may come to know proprietary information. We generally require employees andconsultants to execute confidentiality and assignment-of-inventions agreements.These agreements typically provide that all materials and confidentialinformation developed by or made known to the employee or consultant duringthat party’s relationship with us are to be kept confidential, and that allinventions arising out of the employee’s or consultant’s relationship with usare our exclusive property. Our employees and consultants may breach theseagreements, and in some instances we may not have an adequate remedy.Additionally, in some instances, we may have failed to require that employees andconsultants execute confidentiality and assignment-of-inventions agreements.

 

*Foreign lawsmay not afford us sufficient protections for our intellectual property, and wemay not seek patent protection outside the United States*.We believe that our success depends, in part, upon our ability to obtaininternational protection for our intellectual property. However, the laws ofsome foreign countries may not be as comprehensive as those of the U.S. and maynot be sufficient to protect our proprietary rights abroad. In addition, we maydecide not to pursue patent protection outside the United States, because ofcost and confidentiality concerns. Accordingly, our international competitorscould obtain foreign patent protection for, and market overseas, products andtechnologies for which we are seeking U.S. patent protection.

 

*We may not beable to adequately defend our intellectual property from third partyinfringement, and third party challenges to our intellectual property mayadversely affect our rights and be costly and time consuming*.Some of our competitors have, or are affiliated with companies having,substantially greater resources than we have, and those competitors may be ableto sustain the costs of complex patent litigation to a greater degree and forlonger periods 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 

 

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liabilities to third partiesand require us to license disputed rights from third parties or cease using thetechnology. Despite our efforts to protect our proprietary rights, unauthorizedparties may attempt to copy aspects of our products or to obtain and useinformation that we regard as proprietary. In limited instances, we have licensedsource codes of certain products to customers or collaborators. For thesereasons, policing unauthorized use of our software products may be difficult.

 

*A patent issuedto us may not be sufficiently broad to protect adequately our rights inintellectual property to which the patent relates*.Even if patents are issued to us, these patents may not sufficiently protectour interest in our software, chemical compositions or other technologiesbecause the scope of protection provided by any patents issued to or licensedby us are subject to the uncertainty inherent to patent law. Third parties maybe able to design around these patents or develop unique products providingeffects similar to our products. In addition, others may discover uses for oursoftware, chemical compositions or technologies other than those uses coveredin our patents, 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 besubject to claims of infringement by third parties*.Third parties may claim infringement by us of their intellectual propertyrights. In addition, to the extent our employees are involved in research areassimilar to those areas in which they were involved at their former employers,we may be subject to claims that 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.  We expect, in general, that software productdevelopers will be subject to more infringement claims as the number of productsand competitors in our industry segments grows and the functionality ofproducts in different industry segments overlaps. Any claims, with or withoutmerit, could adversely affect our ability to market and sell our products andservices, be time consuming to defend, result in costly litigation, divertmanagement’s attention and resources, cause product shipment delays or requireus to enter into royalty or licensing agreements. Royalty or licensingagreements, if required, may not be available on terms acceptable to us, if atall. In the event of a successful claim of product infringement against us, ourfailure or inability to license or design around the infringed technology couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

CERTAIN RISKS RELATED TO ACCELRYS

 

*Our ability toincrease Accelrys software revenue may depend upon increased market acceptanceof our products and services*. Accelrys products arecurrently used primarily by molecular modeling and simulation and gene sequenceanalyses specialists. Our strategy is to expand usage of our products andservices by marketing and distributing our software, in part 

 

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through our desktop-basedproducts, client-server solutions, and related services to a broader, morediversified group of biologists, chemists, and engineers. If we cannot expandour customer base by selling our desktop-based products, client-serversolutions, and 

related services, we may not beable to increase our software revenue, or such revenue may decline. In general,increased market acceptance and greater market penetration of our softwareproducts depend upon several factors, including:

 

•                  overall productperformance;

•                  ease ofimplementation and use;

•                  accuracy ofsimulation;

•                  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 ofcustomers to pay for such use.

 

Our software products and services may not achieve market acceptance orpenetration in their target industries or other industries. Failure to increasemarket acceptance or penetration may restrict substantially the future growthof our software business and may have a material adverse effect on our companyas a whole.

 

*We may beunable to develop and market new Accelrys products that are necessary toincrease revenue*. The success of our software businessplan depends heavily upon increases in revenue. Our strategy is to increasesoftware revenue in a number of ways, including:

 

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

•                  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; and

•                  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.

 

We do not have sufficient historical or comparative sales data to relyupon to indicate that our new products or data content services will achievethe desired level of commercial success.

 

*We face strongcompetition in the scientific software sector*. Themarket for our software products is intensely competitive, subject to rapidchange and significantly affected by new product introductions, pricingstrategies and other market activities of industry participants. Competitioncurrently comes from the following principal 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; and

 

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

 

In addition, some of our software licenses grant the right tosublicense our software. As a result, our software customers and third-partylicensees could develop specific simulation applications using our softwaredeveloper’s kit and compete with us by distributing these programs to ourpotential customers. Customers or licensees could also develop their ownsimulation technology or informatics software and cease using our softwareproducts and services. Some of our competitors and potential competitors inthis sector have longer operating histories than us and have greater financial,technical, marketing, research and development and other resources. Many of oursoftware competitors offer products and services directed at more specificmarkets than those we target, enabling these competitors to focus a greaterproportion of their efforts on these markets. Some offerings that compete withour software 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.

 

*If we areunable to license software to, or collect receivables from, our early stagebiotechnology customers, it may have a material adverse effect on our operatingresults.*  Wefrequently license our modeling, simulation, data analysis and informaticssoftware to smaller, development stage biotechnology customers. Often thesecustomers have limited or no operating history, and require considerablefunding to launch their businesses. As we have experienced in recent quarters,they often significantly scale back, or altogether cease, operations.  Therefore, there is considerable risk incounting 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 impacted by, the current tightening of available credit and capital, andgeneral economic slowdown occurring in 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 amounts, we may be required towrite-off significant accounts receivable and recognize bad debt expense. Werecorded a provision for doubtful accounts of $1.3 million in fiscal 2002compared to $0.3 million in fiscal 2001. For the period ended September 30, 2003, we recorded a provision of$0.1 million.  Failure of thesebusinesses, write-offs and difficulties associated with collection ofreceivables from these customers, could materially adversely affect ouroperating results.

 

*Defects ormalfunctions in our software products, or in the products of our softwaretechnology partners, could hurt our reputation among software customers andexpose us to liability.* Our software business and thelevel of customer acceptance of our products depend upon the continuous,effective and reliable operation of our computer software and related tools andfunctions. Defects could occur in current or future Accelrys products. To theextent that our software malfunctions and our customers’ use of our products isinterrupted, our software reputation and business could suffer. We may also besubject to liability for the defects and malfunctions of third party technologypartners and others with whom our software products and services areintegrated.

 

*Our quarterlyoperating results in the software business could vary significantly*. We have historically experiencedstronger financial performance in the third and fourth calendar quarters ofeach 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

 

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conditions, seasonal slowdowns,and the timing and integration of acquisitions. Additionally, changes in thetiming of revenue recognition may result if subscription sales increase.  We also expect to continue to experiencefluctuations in quarterly operating results due to general and industryspecific economic conditions that may affect the research and developmentexpenditures of pharmaceutical and biotechnology companies. Due to thepossibility of fluctuations in our revenue and expenses, we believe thatquarter-to-quarter comparisons of our operating results are not a goodindication of our future performance.

 

CERTAIN RISKS RELATED TO PHARMACOPEIA DRUGDISCOVERY, INC.

 

*The agreementwith a second key PDD customer is terminable under certain circumstances.*** **During the nine months ended September 30,2003, we earned approximately 13% of our PDD revenue, and 4% of ourconsolidated revenue, from a second key customer in our Drug Discoverybusiness.  The agreement with thissignificant customer has a stated term of five years; however, the customer hasthe right to terminate the agreement as early as the first quarter of 2005 inthe event we are unable to deliver to the customer a lead compound meetingcriteria specified in the agreement by a certain deadline.  Thereafter, the customer again has the rightto terminate the agreement prior to the expiration of its stated term if wecannot deliver additional lead compounds meeting these criteria prior to datesset forth in the agreement.  Thetermination of this agreement will have a material adverse effect on PDD, andmay have a material adverse effect on our company’s business as a whole.  We have timely delivered the first compoundsrequired under this agreement for inspection and verification by the customer.  However, there can be no assurance thatthese compounds will be compliant, or that future compliant compounds will bedelivered to the customer before the enumerated dates.

 

*Some of thedevelopment and marketing activities of PDD are, or will be, conducted by thirdparties. If these third parties fail to perform their functions satisfactorily,our revenue and earnings from PDD could be delayed, reduced or eliminated.* The ultimate success of the business plan forour Drug Discovery subsidiary heavily depends upon the successful discovery,development and commercialization of pharmaceutical products. Our drugdiscovery endeavors will result in commercialized pharmaceutical products, ifat all, only after significant pre-clinical and clinical development, requisiteregulatory approvals, establishment of manufacturing capabilities andsuccessful marketing. We do not currently have the technology, facilities,personnel or experience to accomplish all of these tasks on our own, and wewill likely not have all the necessary resources in the foreseeable future.Therefore, we continue to depend heavily upon the expertise and dedication ofsufficient resources by collaborative partners and/or by third parties underservice contracts to develop and commercialize products primarily based on leadcompounds discovered by us. If a third party working for us under a servicecontract fails to perform the contracted services adequately, our efforts withrespect to the drug candidate under contract could be delayed or terminated.Further, if a collaborative partner fails to develop or commercialize acompound or product with respect to which it has rights from us, we may notreceive any future milestone payments or royalties associated with thatcompound or product. Similarly, because we rely heavily on our strategiccollaborators and service providers, our revenue could be adversely affected ifour collaborators and/or service providers:

 

•                  fail to select atarget or product candidate we have identified for subsequent development;

•                  fail to gain therequisite regulatory approvals of product candidates;

•                  do notsuccessfully commercialize products that we originate;

•                  do not conducttheir service or collaborative activities in a timely manner;

•                  do not devotesufficient time or resources to our partnered programs or potential products;

•                  terminate theiralliances or arrangements with us;

 

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•                  develop, eitheralone or with others, products that may compete with our product candidates;

•                  dispute ourrespective allocations of rights to any products or technology developed duringour collaborations; or

•                  merge with athird party that may wish to terminate our collaboration or service contract.

 

*Disputes mayarise between our collaborative partners and us as to royalties and milestonesto which we are entitled.*  The compound basis for drugs developed by a customer may be aderivative or optimized version of the compound provided to the customer by us.While our existing collaborative agreements provide that we will receive milestonepayments and royalties with respect to certain products developed from certainderivative compounds, there can be no assurance that disputes will not ariseover the application of payment provisions to such products. There can be noassurance that current or future collaborative partners will not pursuealternative technologies, or develop alternative products either on their ownor in collaboration with others, including our competitors, as a means fordeveloping treatments based on the targets which are the subject of thecollaborative arrangements with us.

 

*There may beonly a limited market for PDD’s drug discovery services.*  The pricing and nature of PDD’s drugdiscovery services are such that there may only be a limited number ofpotential customers for these services. Continued consolidation in thepharmaceutical and biotechnology industries may further decrease the number ofpotential customers. The acceptance by potential customers of our services isimportant in determining profitability. Historically, pharmaceutical companieshave conducted lead compound identification and optimization within their ownresearch departments due to the highly proprietary nature of the activitiesbeing conducted, the central importance of these activities to their drugdiscovery and development efforts, and the desire to obtain maximum patent andother proprietary protection on the results of their internal programs. Inorder to achieve our business objectives for PDD, we must convince thesecompanies that our technology and expertise justify the outsourcing of theseprograms to us. There can be no assurance that we will be able to attractcustomers on acceptable terms for our products and services or to develop asustainable profitable business. Moreover, the pricing and nature of ourcombinatorial libraries is such that there may only be a limited number ofpharmaceutical companies that are potential customers for such libraries. Therecan be no assurance that we will be able to establish additional collaborativeor licensing arrangements, that any such arrangements or licenses will be onterms favorable to us, or that current or future collaborative or licensingarrangements will ultimately be successful.

 

*We may beunable to manage the multiple relationships and interests involved in ourcollaborative arrangements and drug discovery programs.*  We may need to successfully structure andmanage multiple drug discovery programs and collaborative relationships,including maintaining confidentiality of the research being performed formultiple customers. We may be unable to manage successfully conflicts betweencompeting drug development programs of third parties to which we offerservices. Conflicts also may arise between customers as to proprietary rightsto particular compounds in our libraries or as to proprietary rights tobiological targets such as receptors or enzymes against which we screencompounds in our libraries. The occurrence of conflicts could have a materialadverse effect on our business, financial condition or results of operations.

 

*Our current andpotential customers are primarily from, and are subject to risks faced by, thepharmaceutical, biotechnology and chemical industries*.  For the foreseeable future, we will derive asubstantial portion of our revenue from fees paid by pharmaceutical companies,chemical companies and larger biotechnology companies for our products andservices. As a result, we are subject to risks and uncertainties that affectthe pharmaceutical, chemical and biotechnology 

 

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industries and to possiblereduction and delays in research and development expenditures by companies inthese industries. Our revenue may also be adversely affected by mergers andconsolidation in the pharmaceutical, biotechnology and chemical industries,which will reduce the number of potential customers.

 

*We may beunsuccessful in producing and licensing proprietary technology developed fromour internal research and development efforts or acquired from a third party.*** **We have expended and continue toexpend time and money on internal research and development with the intentionof producing proprietary technologies in order to patent and then license themto other companies. However, we may not be successful in producing any valuabletechnology or successful in licensing it to a third party. To the extent we areunable to produce technology that we can license, we may not receive anyrevenue related to our internal research and development efforts.

 

*If we usebiological and hazardous materials in a manner that causes injury or violateslaws, we may be liable for damages.* Our Drug Discoveryactivities may involve the use of potentially harmful biological materials aswell as hazardous materials, chemicals and various radioactive compounds. Wecannot completely eliminate the risk of accidental contamination or injury fromthe use, storage, handling or disposal of these materials. In the event ofcontamination or injury, we could be held liable for damages that result, andany liability could exceed our resources. We are subject to federal, state andlocal laws and regulations governing the use, storage, handling and disposal ofthese materials and specified waste products. The cost of compliance with theselaws and regulations could be significant.

 

**SHOULD ONE OR MORE OFTHE ABOVE-DESCRIBED RISKS OR UNCERTAINTIES MATERIALIZE, OR SHOULD THEUNDERLYING ASSUMPTIONS PROVE INCORRECT, OUR ACTUAL RESULTS MAY VARYMATERIALLY FROM THOSE ANTICIPATED.**

 

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

 

The Company is exposed to various marketrisks consisting primarily of changes in foreign currency exchange rates.  The Company’s international sales generallyare denominated in local currencies.  Inthe first nine months of 2003, approximately 55% of the Company’s consolidatedrevenue was derived from customers outside the United States (including 38%from customers in Europe and 17% from customers in the Asia/Pacific region).  As such, the Company’s exchange rate risk isgreatest for Dollar/Euro and Dollar/Yen fluctuations.  When deemed appropriate, the Company engages in exchangerate-hedging transactions in an attempt to mitigate the impact of adverseexchange rate fluctuations.  AtSeptember 30, 2003, the Company had no hedging transactions in effect.

 

The Company does not use derivative financialinstruments for trading or speculative purposes.  However, the Company regularly invests excess cash in overnightrepurchase agreements that are subject to changes in short-term interestrates.  The Company believes that themarket risk arising from holding these financial instruments is minimal.

 

The Company’s exposure to market risksassociated with changes in interest rates relates primarily to the increase ordecrease in the amount of interest income earned on its investment portfoliosince the Company has minimal debt.  TheCompany ensures the safety and preservation of invested funds by limitingdefault risks, market risk, and reinvestment risk.  The Company mitigates default risk by investing in investmentgrade securities.  A hypothetical 100basis point 

 

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adverse move in interest rates along theentire interest rate yield curve would not materially affect the fair value ofthe Company’s interest sensitive financial instruments at September 30,2003.

 

**Item 4****.  Controls andProcedures**

 

Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of the effectiveness ofthe design and operation of our disclosure controls and procedures, as suchterm is defined under Rule 13a-14(c) promulgated under the Securities ExchangeAct of 1934, as amended. Based on their evaluation, our principal executiveofficer and principal financial officer concluded that our disclosure controlsand procedures were effective as of the end of the period covered by thisquarterly report.

 

There have been no significant changes(including corrective actions with regard to significant deficiencies ormaterial weaknesses) in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of the evaluationdescribed above.

 

**PART II - OTHER INFORMATION**

 
| **Item 1.** | Legal Proceedings                                                                                                                                                                                                                                        |
|-------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |                                                                                                                                                                                                                                                     |
|        | We are a party to certain litigation in the ordinary course of our  business, and we do not believe these matters, even if adversely adjudicated  or settled, would have a material adverse effect on our financial condition  or results of operations. |
|        |                                                                                                                                                                                                                                                     |
| **Item 2**. | Changes in 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                                                                                                                                                                                                                                        |
|        |                                                                                                                                                                                                                                                     |
| **Item 6.** | Exhibits and Reports on Form 8-K                                                                                                                                                                                                                         |
|        |                                                                                                                                                                                                                                                     |
|        | (a)  Exhibits –                                                                                                                                                                                                                           |
|        |                                                                                                                                                                                                                                                     |
|        | 10.32++                                                                                                                                                                                                                                                  | Collaboration and License Agreement, dated as of July 9, 2003  and effective August 8, 2003, between Pharmacopeia, Inc. and  Schering-Plough Ltd. |
|        |                                                                                                                                                                                                                                                     |   |
|        | 10.33++                                                                                                                                                                                                                                                  | Collaboration and License Agreement, dated as of July 9, 2003  and effective August 8, 2003, between Pharmacopeia, Inc. and Schering  Corporation. |
|        |                                                                                                                                                                                                                                                     |   |
|        | 10.34                                                                                                                                                                                                                                                    | Guarantee, dated July 9, 2003, between Pharmacopeia, Inc. and  Schering-Plough Corporation. |
|        |                                                                                                                                                                                                                                                     |   |
|        | 10.35                                                                                                                                                                                                                                                    | Lease, dated August 20, 2003, between Pharmacopeia, Inc. and  Eastpark at 8A (Building 1000) |

 

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|   | 10.36  | Lease, dated August 20, 2003, between Pharmacopeia, Inc. and  Eastpark at 8A (Building 3000)                                                                                                                                    |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                 |
|   | 31.1   | Certification  of the Principal Executive Officer of Pharmacopeia, Inc. Pursuant to  Rule 13a-14 of the Securities Exchange Act of 1934, as amended, as  Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
|   |   |                                                                                                                                                                                                                                 |
|   | 31.2   | Certification  of the Principal Financial Officer of Pharmacopeia, Inc. Pursuant to  Rule 13a-14 of the Securities Exchange Act of 1934, as amended, as  Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
|   |   |                                                                                                                                                                                                                                 |
|   | 32.1   | Certification of the Chief Executive Officer of Pharmacopeia, Inc.  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (*)                                          |
|   |   |                                                                                                                                                                                                                                 |
|   | 32.2   | Certification  of the Chief Financial Officer of Pharmacopeia, Inc. Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (*)                                         |

 

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|   | ++          Confidential treatment requested                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | *                 This certification shall not be deemed  “filed” for purposes of Section 18 of the Securities Exchange Act of  1934, as amended, or otherwise subject to liability pursuant to that section.  Such certification shall not be deemed to be incorporated by reference into  any filing under the Securities Act of 1933, as amended, or the Securities  Exchange Act of 1934, as amended, except to the extent that the Company  specifically incorporates it by reference. |

 
|   | (b) Reports on Form 8-K –                                                                                                                                                                                                   |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                             |
|   | On August 5, 2003, the Company filed a current report on Form  8-K reporting that a press release was issued and a conference call was held  regarding the Company’s financial results for the second quarter of 2003. |

 

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**SIGNATURE**

 

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

 

 
|   | PHARMACOPEIA, INC. |
|--------|--------------------|
|   |               |
|   | By:                | /s/John J. Hanlon |   |
|   |               |   |
|   |               | John J. Hanlon |
|   |               | Executive Vice President and  Chief Financial Officer (Duly Authorized  Officer and Chief Financial Officer) |
|   |               |   |
|   |               | Date:  November 10, 2003 |

 

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**PHARMACOPEIA,INC.**

 

**INDEX TO EXHIBITS**

 
| **No.** |   | **EXHIBIT**                                                                                                                                                  |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                         |
| 10.32++ |   | Collaboration and License Agreement, dated as of July 9, 2003  and effective August 8, 2003, between Pharmacopeia, Inc. and  Schering-Plough Ltd.  |
|    |   |                                                                                                                                                         |
| 10.33++ |   | Collaboration and License Agreement, dated as of July 9, 2003  and effective August 8, 2003, between Pharmacopeia, Inc. and Schering  Corporation. |
|    |   |                                                                                                                                                         |
| 10.34   |   | Guarantee, dated July 9, 2003, between Pharmacopeia, Inc. and  Schering-Plough Corporation.                                                             |
|    |   |                                                                                                                                                         |
| 10.35   |   | Lease, dated August 20, 2003, between Pharmacopeia, Inc. and  Eastpark at 8A (Building 1000)                                                            |
|    |   |                                                                                                                                                         |
| 10.36   |   | Lease, dated August 20, 2003, between Pharmacopeia, Inc. and  Eastpark at 8A (Building 3000)                                                            |
|    |   |                                                                                                                                                         |
| 31.1    |   | Section 302 Certification of the Principal Executive Officer                                                                                            |
|    |   |                                                                                                                                                         |
| 31.2    |   | Section 302 Certification of the Principal Financial Officer                                                                                            |
|    |   |                                                                                                                                                         |
| 32.1    |   | Section 906 Certification of the Chief Executive Officer                                                                                                |
|    |   |                                                                                                                                                         |
| 32.2    |   | Section 906 Certification of the Chief Financial Officer                                                                                                |

 

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++ Confidential treatment requested

 

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