**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**FORM 10-Q**

**(Mark One)**

o                                  **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**or**

 

ý                                  **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

# **For the transition period from January 1, 2004 through March31, 2004**

 

**Commission File Number: 0-27118**

 

**PHARMACOPEIA, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                                        |   | **33-0557266**                       |
|-------------------------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |   | (I.R.S. Employer Identification No.) |
|                                                                                |   |                                 |
| **9685 Scranton Road, San Diego, CA**                                               |   | **92121**                            |
| (Address of principal executive offices)                                            |   | (Zip code)                           |
|                                                                                |   |                                 |
| **(858) 799-5000**                                                                  |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |   |                                 |
| **Former fiscal year end: December 31, 2003**                                       |
| **Former address: PO Box 5350, Princeton, New  Jersey 08543-5350**                  |
| (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 whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes ý         No o

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:

 

| **Class**                      |   | **Outstanding  at April 30, 2004** |
|--------------------------------|--------|------------------------------------|
| Common Stock, $.0001 par value |   | 24,362,943 shares                  |

 

 

----

 

**PHARMACOPEIA, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**                            |                                                                                        |
|-------------------------------------|---------------------------------------------------------------------------------------------|
|                                |                                                                                        |
| PART I.  FINANCIAL INFORMATION |                                                                                        |
|                                |                                                                                        |
| Item 1.                        | Unaudited Consolidated Financial  Statements:                                               |   |
|                                |                                                                                        |   |
|                                | Balance Sheets – March 31, 2004 and December 31, 2003                             |   |
|                                |                                                                                        |   |
|                                | Statements of Operations – Three Months  Ended March 31, 2004 and 2003                 |   |
|                                |                                                                                        |   |
|                                | Statements of Cash Flows – Three Months  Ended March 31, 2004 and 2003                 |   |
|                                |                                                                                        |   |
|                                | 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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**PARTI - FINANCIAL INFORMATION**

 

**Item 1. Unaudited Consolidated Financial Statements**

 

**Pharmacopeia,Inc.**

**ConsolidatedBalance Sheets**

**(Dollars inthousands)**

 
|                                                                                                                      |   | **March 31,  2004** |    | **December  31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
| **ASSETS**                                                                                                                |   |                |    |                    |   |
| Current assets:                                                                                                           |   |                |    |                    |   |
| Cash and cash equivalents                                                                                                 |   | $                   | 40,072  |                    | $      | 27,509 |   |
| Marketable securities                                                                                                     |   | 101,557             |    | 106,546                 |   |
| Trade receivables, net of allowance for  doubtful accounts of $191 and $505, respectively                                 |   | 11,358              |    | 42,082                  |   |
| Prepaid expenses and other current assets                                                                                 |   | 5,370               |    | 5,365                   |   |
| Total current assets                                                                                                      |   | 158,357             |    | 181,502                 |   |
|                                                                                                                      |   |                |    |                    |   |
| Property and equipment, net                                                                                               |   | 19,327              |    | 15,398                  |   |
| Goodwill, net of accumulated amortization  of $13,201                                                                     |   | 34,072              |    | 34,072                  |   |
| Software development costs, net of  accumulated amortization of $27,443 and $26,555, respectively                         |   | 7,748               |    | 7,634                   |   |
| Other assets                                                                                                              |   | 974                 |    | 1,061                   |   |
| Total assets                                                                                                              |   | $                   | 220,478 |                    | $      | 239,667 |   |
|                                                                                                                      |   |                |    |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                             |   |                |    |                    |   |
| Current liabilities:                                                                                                      |   |                |    |                    |   |
| Accounts payable                                                                                                          |   | $                   | 5,483   |                    | $      | 4,659 |   |
| Accrued liabilities                                                                                                       |   | 20,954              |    | 19,762                  |   |
| Deferred revenue, current portion                                                                                         |   | 25,330              |    | 27,255                  |   |
| Leases payable, current portion                                                                                           |   | 38                  |    | 8                       |   |
| Total current liabilities                                                                                                 |   | 51,805              |    | 51,684                  |   |
|                                                                                                                      |   |                |    |                    |   |
| Restructuring reserve, long-term                                                                                          |   | 2,655               |    | —                  |   |
| Deferred revenue, long-term                                                                                               |   | 5,767               |    | 5,249                   |   |
|                                                                                                                      |   |                |    |                    |   |
| Stockholders’ equity:                                                                                                |   |                |    |                    |   |
| Preferred stock, $.0001 par value, 2,000  shares authorized, none issued and outstanding                                  |   | —              |    | —                  |   |
| Common stock, $.0001 par value, 40,000  shares authorized, 24,949 and 24,568 shares issued and outstanding,  respectively |   | 2                   |    | 2                       |   |
| Additional paid-in capital                                                                                                |   | 291,977             |    | 287,592                 |   |
| Unearned compensation                                                                                                     |   | (862                | )       | (536                    | )      |
| Treasury stock                                                                                                            |   | (8,340              | )       | (8,340                  | )      |
| Accumulated deficit                                                                                                       |   | (124,088            | )       | (97,318                 | )      |
| Accumulated comprehensive income                                                                                          |   | 1,562               |    | 1,334                   |   |
| Total stockholders’ equity                                                                                           |   | 160,251             |    | 182,734                 |   |
| Total liabilities and stockholders’ equity                                                                           |   | $                   | 220,478 |                    | $      | 239,667 |   |

 

See accompanying notes to these unaudited financial statements.

 

3

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

 
|                                                  |   | **For the  Three Months  Ended March 31,** |    |
|-------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                  |   | **2004**                                   |    | **2003** |   |
| Revenues:                                             |   |                                       |    |   |   |
| Software license, service and other                   |   | $                                          | 11,135  |   | $ | 17,219 |   |
| Drug discovery                                        |   | 5,369                                      |    | 7,521 |   |
| Total revenues                                        |   | 16,504                                     |    | 24,740 |   |
|                                                  |   |                                       |    |   |   |
| Cost of revenues:                                     |   |                                       |    |   |   |
| Software license, service  and other             |   | 4,107                                      |    | 5,169 |   |
| Drug discovery                                        |   | 5,550                                      |    | 5,776 |   |
| Total cost of revenues                                |   | 9,657                                      |    | 10,945 |   |
|                                                  |   |                                       |    |   |   |
| Gross margin                                          |   | 6,847                                      |    | 13,795 |   |
|                                                  |   |                                       |    |   |   |
| Operating costs and expenses:                         |   |                                       |    |   |   |
| Research and development                              |   | 5,654                                      |    | 5,733 |   |
| Sales, general and administrative                     |   | 15,288                                     |    | 14,658 |   |
| Restructuring and other charges                       |   | 11,147                                     |    | (384 | ) |
| Total operating costs and expenses                    |   | 32,089                                     |    | 20,007 |   |
| Operating loss                                        |   | (25,242                                    | )       | (6,212 | ) |
| Spin-off transaction costs                            |   | (2,321                                     | )       | — |   |
| Interest and other income, net                        |   | 924                                        |    | 1,136 |   |
| Loss before tax provision                             |   | (26,639                                    | )       | (5,076 | ) |
| Provision for income taxes                            |   | 131                                        |    | 377 |   |
| Net loss                                              |   | $                                          | (26,770 | ) | $ | (5,453 | ) |
|                                                  |   |                                       |    |   |   |
| Net loss per share:                                   |   |                                       |    |   |   |
| - Basic and diluted                                   |   | $                                          | (1.11   | ) | $ | (0.23 | ) |
|                                                  |   |                                       |    |   |   |
| Weighted average number of common stock  outstanding: |   |                                       |    |   |   |
| - Basic and diluted                                   |   | 24,090                                     |    | 23,617 |   |

 

See accompanying notes to these unaudited financial statements.

 

4

----

 

**Pharmacopeia,Inc.**

**ConsolidatedStatements of Cash Flows**

**(Dollarsin thousands)**

 
|                                                                            |   | **For the  Three Months  Ended March 31,** |    |
|---------------------------------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                                            |   | **2004**                                   |    | **2003** |   |
| OPERATING ACTIVITIES:                                                           |   |                                       |    |   |   |
| Net loss                                                                        |   | $                                          | (26,770 | ) | $ | (5,453 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities |   |                                       |    |   |   |
| Depreciation                                                                    |   | 1,583                                      |    | 1,586 |   |
| Amortization                                                                    |   | 882                                        |    | 1,882 |   |
| Contribution of stock to 401(k) members                                         |   | 257                                        |    | 281 |   |
| Amortization of unearned compensation                                           |   | 28                                         |    | — |   |
| Non-cash compensation                                                           |   | 8                                          |    | 10 |   |
| Loss on disposal of capital assets                                              |   | 523                                        |    | — |   |
| Changes in assets and liabilities:                                              |   |                                       |    |   |   |
| Trade receivables                                                               |   | 30,783                                     |    | 20,732 |   |
| Prepaid expenses and other current assets                                       |   | 19                                         |    | (704 | ) |
| Other assets                                                                    |   | 101                                        |    | 15 |   |
| Accounts payable                                                                |   | 805                                        |    | (113 | ) |
| Accrued liabilities                                                             |   | 3,825                                      |    | (4,458 | ) |
| Deferred revenue                                                                |   | (1,477                                     | )       | (6,554 | ) |
| Net cash provided by operating activities                                       |   | 10,567                                     |    | 7,224 |   |
| INVESTING ACTIVITIES:                                                           |   |                                       |    |   |   |
| Capital expenditures                                                            |   | (5,942                                     | )       | (800 | ) |
| Increase in capitalized software development costs                              |   | (956                                       | )       | (1,158 | ) |
| Purchases of marketable securities                                              |   | (61,319                                    | )       | (18,552 | ) |
| Proceeds from sales of marketable securities                                    |   | 66,256                                     |    | 16,638 |   |
| Net cash used in investing activities                                           |   | (1,961                                     | )       | (3,872 | ) |
| FINANCING ACTIVITIES:                                                           |   |                                       |    |   |   |
| Proceeds from issuance of common stock                                          |   | 3,765                                      |    | 57 |   |
| Principal payments on leases payable                                            |   | (4                                         | )       | (3 | ) |
| Net cash provided by financing activities                                       |   | 3,761                                      |    | 54 |   |
| Exchange rate effect on cash and equivalents                                    |   | 196                                        |    | (63 | ) |
| Net increase in cash and equivalents                                            |   | 12,563                                     |    | 3,343 |   |
| Cash and equivalents, beginning of period                                       |   | 27,509                                     |    | 28,236 |   |
| Cash and equivalents, end of period                                             |   | $                                          | 40,072  |   | $ | 31,579 |   |
|                                                                            |   |                                       |    |   |   |
| SUPPLEMENTAL INFORMATION:                                                       |   |                                       |    |   |   |
| Cash paid during the period for:                                                |   |                                       |    |   |   |
| Interest expense                                                                |   | $                                          | 2       |   | $ | 5 |   |
| Income tax expense                                                              |   | $                                          | 163     |   | $ | 141 |   |

 

 

See accompanying notes to these unauditedfinancial statements.

 

5

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**Pharmacopeia, Inc.**

**Notesto Unaudited Consolidated Financial Statements**

 

**1.  Basis of Presentation**

 

Theaccompanying unaudited financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, theseunaudited 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, 2003.

 

On April 1,2004 the Company changed its fiscal year end from December 31 to March 31.  The consolidated financial statements andthe accompanying notes include the “transition period” for the three monthsended March 31, 2004.

 

On April 30,2004 the Company completed the spin-off of the Company’s Drug Discoverysegment, Pharmacopeia Drug Discovery, Inc. (“PDD”), see Note 6.

 

**2.  Net Loss Per Share**

 

The Companycomputes net income (loss) per share in accordance with Statement of FinancialAccounting Standard No. 128, “Earnings Per Share” (“SFAS 128”).  Under the provisions of SFAS 128, basic netincome (loss) per share is computed by dividing the net income (loss) for theperiod by the weighted-average number of common shares outstanding during theperiod.  Diluted net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted-average number of common and dilutive common equivalent sharesoutstanding during the period.  Dilutedearnings per share include the potentially dilutive effect of outstanding stockoptions, or other dilutive securities. The Company has a net loss for the periods presented; accordingly, theinclusion of common stock equivalents for outstanding stock options would beanti-dilutive and therefore the weighted-average shares used to calculate bothbasic and diluted loss per share are the same.

 

**3.  Segment Information**

 

The Company operates in twoindustry segments.  The Company’sSoftware segment, Accelrys Inc. (“Accelrys”), provides molecular modeling andsimulation, bioinformatics and cheminformatics software, and related servicesthat facilitate the discovery and development of new drug and chemical productsand processes in the pharmaceutical, biotechnology, chemical, petrochemical andmaterials industries.  PDD provides drugdiscovery services to pharmaceutical and biotechnology companies based onproprietary combinatorial chemistry, medicinal chemistry, high-throughputscreening, and Accelrys technologies. The Company completed a spin-off of PDD on April 30, 2004, see Note6.  The accounting policies of thereportable segments are the same as those of the Company. Summarized financialinformation concerning industry segments is as follows (dollars in thousands):

 

6

----

 
|                                 |   | **Three  Months Ended  March 31, 2004** |       |
|--------------------------------------|--------|-----------------------------------------|------------|
|                                 |   | **Accelrys**                            |       | **PDD** |   | **Total** |   |
| Revenues:                            |   |                                    |       |   |   |   |   |
| Software licenses services and other |   | $                                       | 11,135     |   | $ | — |   | $ | 11,135 |   |
| Drug discovery services              |   | —                                  |       | 5,369 |   | 5,369 |   |
| Total revenues                       |   | $                                       | 11,135     |   | $ | 5,369 |   | $ | 16,504 |   |
| Operating loss                       |   | $                                       | (15,306    | ) | $ | (9,936 | ) | $ | (25,242 | ) |
|                                 |   |                                    |       |   |   |   |   |
|                                 |   | **Three  Months Ended  March 31, 2003** | ** ** |
|                                 |   | **Accelrys**                            |       | **PDD** | ** ** | **Total** | ** ** |
| Revenues:                            |   |                                    |       |   |   |   |   |
| Software licenses services and other |   | $                                       | 17,219     |   | $ | — |   | $ | 17,219 |   |
| Drug discovery services              |   | —                                  |       | 7,521 |   | 7,521 |   |
| Total revenues                       |   | $                                       | 17,219     |   | $ | 7,521 |   | $ | 24,740 |   |
| Operating loss                       |   | $                                       | (5,372     | ) | $ | (840 | ) | $ | (6,212 | ) |

 

**4.  Stock-Based Compensation**

 

Statement of FinancialAccounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”) encourages, but does not require, companies to record compensation costfor stock-based compensation plans at fair value.  As permitted by SFAS 123, the Company has elected to continuefollowing Accounting Principles Board Opinion No. 25 “Accounting for StockIssued to Employees,” (“APB 25”) and related interpretations, to account forstock-based compensation.  Under APB 25,no compensation expense is recognized at the time of option grant because theexercise price of the Company’s employee stock option equals the fair marketvalue of the underlying common stock on the date of grant.

 

Had the Company followed thefair value measurement provisions of SFAS 123, the following table summarizesthe pro forma net loss and pro forma net loss per share that would have beenrecorded (in thousands, except per share data):

 
|                                                                                                                                          |   | **Three  Months Ended March 31,** |    |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                                                                                                          |   | **2004**                          |    | **2003** |   |
| Net loss:                                                                                                                                     |   |                              |    |   |   |
| As reported                                                                                                                                   |   | $                                 | (26,770 | ) | $ | (5,453 | ) |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (1,876                            | )       | (3,053 | ) |
| Pro forma                                                                                                                                     |   | $                                 | (28,646 | ) | $ | (8,506 | ) |
| Basic and diluted net loss per common  share:                                                                                                 |   |                              |    |   |   |
| As reported                                                                                                                                   |   | $                                 | (1.11   | ) | $ | (0.23 | ) |
| Pro forma                                                                                                                                     |   | (1.19                             | )       | (0.36 | ) |

 

The fair value of each optiongranted during 2004 and 2003 is estimated on the date of grant using theBlack-Scholes option-pricing model with the following assumptions:

 

7

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|                    |   | **2004** |   | **2003** |   |
|-------------------------|--------|----------|--------|----------|--------|
| Dividend yield          |   | 0        | %      | 0        | %      |
| Expected volatility     |   | 85.24    | %      | 88.28    | %      |
| Risk-free interest rate |   | 3.31     | %      | 3.25     | %      |
| Expected life (years)   |   | 5.8      |   | 6.5      |   |

 

**5.  Restructuring**

 

During the third quarter of 2002, the Company announced that it wasundertaking various actions to restructure its Accelrys operations to improveits overall financial performance.  Asof March 31, 2004 the remaining obligation under this restructuring was relatedto the closure of certain facilities. The following table summarizes theactivity and balance of the restructuring liability during the quarter endedMarch 31, 2004 (dollars in thousands):

 
|                         |   | **Costs to  Exit Lease  Obligations** |   |
|------------------------------|--------|---------------------------------------|--------|
| Balance at December 31, 2003 |   | $                                     | 1,161  |   |
| Ultization of Reserves:      |   |                                  |   |
| Cash                         |   | (65                                   | )      |
| Balance at March 31, 2004    |   | $                                     | 1,096  |   |

 

During the quarter ended March31, 2004, the Company executed a restructuring plan for the purpose of makingResearch and Development activities more efficient and eliminating unnecessaryfacilities.  The restructuring effortincluded a reduction in force of 73 Accelrys employees, of which 67 had beenterminated as of March 31, 2004. Additionally, an excess facility of the PDD business was abandoned and areduction in force of 6 administrative PDD employees occurred during thequarter, of which 5 employees were terminated as of March 31, 2004.  As a result, restructuring related chargesof approximately $8.7 million were recognized as operating expense during thequarter ended March 31, 2004.

 

The following table summarizesthe activity and balance of the restructuring reserve liability during thequarter ended March 31, 2004 (dollars in thousands):

 
|                             |   | **Accelrys  Severance Cost  for Involuntary  Employee Terminations** |   | **PDD  Severance Cost for  Involuntary Employee  Terminations** |   | **PDD Costs  to Exit Lease  Obligations** |   | **Total** |   |
|----------------------------------|--------|----------------------------------------------------------------------|--------|-----------------------------------------------------------------|--------|-------------------------------------------|--------|-----------|--------|
| Restructuring Charges            |   | $                                                                    | 2,813  |                                                            | $      | 132                                       |   | $         | 5,718  |   | $ | 8,663 |   |
| Utilization of Reserves:         |   |                                                                 |   |                                                            |   |                                      |   |      |   |
| Cash                             |   | (2,197                                                               | )      | (44                                                             | )      | —                                    |   | (2,241    | )      |
| Write-off Leasehold Improvements |   | —                                                               |   | —                                                          |   | (458                                      | )      | (458      | )      |
| Balance at March 31, 2004        |   | $                                                                    | 616    |                                                            | $      | 88                                        |   | $         | 5,260  |   | $ | 5,964 |   |

 

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

 

On April 30, 2004 theCompany completed the spin-off of PDD into an independent, separately traded,publicly held company through the distribution to its stockholders a dividendof one share of PDD common stock for every two shares of Pharmacopeia commonstock. The Company has received an opinion of counsel that the transaction willqualify for treatment as a tax-free spin-off. As a result of this transaction, the Company made a capital contributionof $46.5 million to PDD.

 

Subsequent to April 30, 2004the Company agreed to guarantee PDD’s lease obligation of approximately $33.2million in conjunction with the assignment of the leases to PDD in event PDDdoes not perform under the terms of the lease.

 

8

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

 

Thefollowing discussion and analysis of financial condition and results ofoperations of Pharmacopeia, Inc. (“Pharmacopeia” or the “Company”) should beread in conjunction with the Unaudited Financial Statements and related notesincluded elsewhere in this Form 10-Q, and also in conjunction with theConsolidated Financial Statements and related notes included in the Company’sForm 10-K for the year ended December 31, 2003.

 

Thisreport, including, without limitation, this section regarding Management’sDiscussion and Analysis of Financial Condition and Results of Operations,contains forward-looking statements regarding the Company and its business,financial condition, results of operations, and prospects. Words such as“expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,”and similar expressions are intended to identify forward-looking statements,but are not the exclusive means of identifying forward-looking statements inthis Report.  Additionally, statementsconcerning future matters such as the development of new products, enhancementsof technologies, possible changes in legislation, and other statementsregarding matters that are not historical are forward-looking statements.

 

Althoughforward-looking statements in this Report reflect the good faith judgment ofthe Company’s management, such statements can only be based on facts andfactors currently known by the Company. Consequently, forward-looking statements are inherently subject to risksand uncertainties and actual results and outcomes may differ materially fromthe results and outcomes discussed in or anticipated by the forward-lookingstatements.  The Company undertakes noobligation to revise or update any forward-looking statements in order toreflect any event or circumstance that may arise after the date of thisReport.  Readers are urgednot to place undue reliance on these forward-looking statements, which speakonly as of the date of this Report.

 

The Company’sregistration statements on Form S-1 (Reg. No. 33-98246), most recent Form 10-K,and this Report, describe certain risk factors and uncertainties that may causeactual results, levels of activity, performance, or achievements to bematerially different from any future results, levels of activity, performance,or achievements 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 aleader in enabling science and technology that accelerates and improves thedrug discovery and chemical development processes.  The Company’s software subsidiary, Accelrys Inc., (“Accelrys”)develops and commercializes molecular modeling and simulation software for thelife sciences and materials research markets, cheminformatics and decisionsupport systems, and bioinformatics tools including gene sequenceanalysis.  On April 30, 2004, theCompany spun off its drug discovery subsidiary, Pharmacopeia Drug Discovery,Inc. (“PDD”), which integrated proprietary small molecule combinatorial andmedicinal chemistry, high-throughput screening, in-vitro pharmacology,computational methods and informatics to discover and optimize lead compoundsand drug candidates.  The spin-off of PDD resulted in PDD becomingan independent, separately traded, publicly held company.  This was accomplished through thedistribution to its stockholders a dividend of one share of PDD common stockfor every two shares of Pharmacopeia common stock.

 

As of March 31,2004 the Company employed approximately 700 people and was headquartered inPrinceton, NJ.  Subsequent to thespin-off of PDD, the Company employed approximately 530 employees and is headquarteredin San Diego, CA.

 

9

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RESULTS OF OPERATIONS

 

THREE MONTHS ENDED MARCH 31, 2004 AND 2003

 

Total revenue decreased 33% to $16.5 millionin the quarter ended March 31,2004 compared to $24.7 million in the quarterended March 31, 2003.

 
|                                |   | **For the  Three Months Ended March 31,** |   |
|-------------------------------------|--------|-------------------------------------------|--------|
|                                |   | **2004**                                  |   | **2003** |   | **% Change** |   |
| Revenues:                           |   |                                      |   |   |   |   |   |
| Software license, service and other |   | $                                         | 11.1   |   | $ | 17.2 |   | -35 | % |
| Drug discovery                      |   | 5.4                                       |   | 7.5 |   | -29 | % |
| Total revenues                      |   | $                                         | 16.5   |   | $ | 24.7 |   | -33 | % |

 

**Software license,service and other revenue** decreased 35% to $11.1 million in the quarter ended March 31, 2004compared to $17.2 million in the quarter ended March 31, 2003.  The decrease in revenue was related todecreased orders, the discontinuance of delivering unprofitable one-offconsulting work, finalization of our last consortium in 2003, and the effectsof subscription revenue accounting as a result of our new licensing agreement.

 

In January 2004 we issued a new licenseoffering at Accelrys, which will require subscription accounting. Under this new license, revenue will berecognized ratably over the license term. This contrasts with our typical annual license offering, in which werecognize 64% of the license revenue in the quarter in which the license isexecuted and amortize the other 36% of the revenue over the remaining term ofthe contract to reflect the value based on vendor-specific evidence.  The revenue recognition for the new licenseis even more dramatic when compared to our traditional perpetual licenseoffering, in which we recognize 85% of the license revenue in the quarter inwhich the contract is executed and amortize the remaining 15% of the revenueover the term of a one-year maintenance agreement. The unrecognized revenue,amortized over the remaining term of the agreement, will be accounted for as“deferred revenue” on the Accelrys balance sheet.

 

**Drug discovery** revenue decreased 29% to $5.4 million in thequarter ended March 31, 2004 compared to $7.5 million in the quarter endedMarch 31, 2003.  The decrease wasprimarily due to a decrease in milestone and other one-time revenuetransactions, as well as a decrease in lead optimization revenue, and reducedrevenue from our collaboration with Schering Plough.  Milestone and other one-time revenue transactions recorded in thequarters ended March 31, 2004 and 2003 was $1.0 million, and $1.9 million,respectively.  Excluding the revenuefrom milestones and other one-time revenue transactions, revenue decreased 22%to $4.4 million in the quarter ended March 31, 2004 compared to $5.6 million inthe quarter ended March 31, 2003.

 

Gross margin decreased 51% to $6.8 million(41% of related revenues) in the quarter ended March 31, 2004 compared to $13.8million (56% of related revenues) in the quarter ended March 31, 2003.

 

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|                                |   | **For the  Three Months Ended March 31,** |   |              |   |
|-------------------------------------|--------|-------------------------------------------|--------|-------------------|--------|
|                                |   | **2004**                                  |   | **2003**          |   |   |   |
|                                |   | **$**                                     |   | **% of  Revenue** |   | **$** |   | **% of  Revenue** |   | **% Change** |   |
| Gross margin:                       |   |                                      |   |              |   |   |   |   |   |   |   |
| Software license, service and other |   | $                                         | 7.1    |              | 63     | % | $ | 12.1 |   | 70 | % | -42 | % |
| Drug discovery                      |   | (0.2                                      | )      | -3                | %      | 1.7 |   | 23 | % | -110 | % |
| Total gross margin                  |   | $                                         | 6.8    |              | 41     | % | $ | 13.8 |   | 56 | % | -51 | % |

 

**Software license,service and other**gross margin decreased 42% to $7.1 million (63% of related revenue) in thequarter ended March 31, 2004 compared to $12.1 million (70% of related revenue)in the quarter ended March 31, 2003. The $5.0 million decrease in gross margin resulted from the 35% decreasein revenue, offset by decreased direct costs for distribution and royalties.

 

**Drug discovery** gross margin decreased 110% to ($.02) million ((3%) of related revenue)in the quarter ended March 31, 2004 compared to $1.7 million (23% of relatedrevenue) in the quarter ended March 31, 2003. The gross margin decreased substantially due to the decrease in revenueresulting in the under absorption of fixed costs allocated to collaborativepartnerships.

 

Research and development expenses remainedconsistent at $5.7 million in the quarter ended March 31, 2004 and 2003.

 

Softwareresearch and development expense consists primarily of the employment-relatedcosts of personnel associated with developing new products, enhancing existingproducts, testing software products and developing product documentation. PDDresearch and development expense includes the employment-related costs ofscientific staff working on unfunded internal drug discovery projects focusedon the creation of new small molecule therapeutics.

 

Softwareresearch and development expense is capitalized in accordance with Statement ofFinancial Accounting Standards No. 86, “Accounting for the Cost of ComputerSoftware to be Sold, Leased or Otherwise Marketed” (SFAS 86).  Capitalized software development costsconsist primarily of the employment-related costs and consulting fees paid toconsultants in relation to the development of Accelrys’ products that have notyet been released.

 

Thefollowing table shows the breakout of research and development costs bydivision and the amount of capitalized software development for the periodsindicated:

 
|                                   |   | **For the  Three Months Ended March 31,** |   |
|----------------------------------------|--------|-------------------------------------------|--------|
|                                   |   | **2004**                                  |   | **2003** |   | **% Change** |   |
| Research and development:              |   |                                      |   |   |   |   |   |
| Gross software development costs       |   | $                                         | 5.3    |   | $ | 5.9 |   | -10 | % |
| Capitalized software development costs |   | (1.0                                      | )      | (1.2 | ) | -16 | % |
| Internal drug discovery                |   | 1.4                                       |   | 1.0 |   | 33 | % |
| Total research and development costs   |   | $                                         | 5.7    |   | $ | 5.7 |   | -1 | % |

 

Thedecrease in software research and development expenses was primarilyattributable to a restructuring at Accelrys in January 2004, offset by lowercapitalization of software development activities.  The increase in drug discovery research and development isprimarily due to the increased investment in internal drug discovery programs.

 

Sales, general and administrative expensesincreased by 4% to $15.3 million in the quarter ended March 31, 2004 comparedto $14.7 million in the quarter ended March 31, 2003.  The increase in sales, general and administrative expenses isprimarily attributable to moving costs incurred in the

 

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Company’s New Jersey and Tokyo facilities of$0.7 million and $0.2 million, respectively. Excluding the moving costs of $0.9 million, Sales, general andadministrative expenses decreased by 2%.

 

During the quarter ended March 31, 2004, theCompany undertook a restructuring and certain other actions.  Accordingly restructuring and other chargesof $11.1 million were incurred.  The charge included several bonuses andseverance payments, including the retirement of the Chief Executive Officer,the cost to exit certain lease obligations, and the acceleration of a deferredcompensation charge.  The Company was able to reverse an excessportion of the 2002 restructuring liability during the quarter ended March 31,2003.

 

The Company incurred $2.3 million forprofessional fees related to the spin-off of PDD during the quarter ended March31, 2004.

 

Net interest and other income decreased 19%to $0.9 million in the quarter ended March 31, 2004 compared to $1.1 million inthe quarter ended March 31, 2003.  Thedecrease is due to lower average investment balances and decreases in marketinterest rates, and the effect of foreign exchange.

 

The Company recorded an income tax provisionof $0.1 million for the quarter ended March 31, 2004 compared to $0.4 millionfor quarter ended March 31, 2003.  Thedecrease is due to the increased loss.

 

As a result of the lower revenues and lowercosts described above, the Company generated a net loss of $26.8 million ($1.11per diluted share) in the quarter ended March 31, 2004 compared to a net lossof $5.5 million ($0.23 per diluted share) in the quarter ended March 31, 2003.

 

LIQUIDITYAND CAPITAL RESOURCES

 

The Company has funded its activities to dateprimarily through the sale of equity securities, software licenses, softwaremaintenance services, and drug discovery services.  As of March 31, 2004, the Company had cash, cash equivalents, andmarketable securities of $141.6 million compared to $134.1 million as ofDecember 31, 2003. On April 30, 2004, the Company made a capital contributionto PDD of $46.5 million in cash and marketable securities.

 

Cash provided by operations increased by $3.3million in the quarter ended March 31, 2004 compared to the quarter ended March31, 2003.  The increase is primarilyattributable to the collection of high dollar accounts receivable balancesgenerated during the fourth quarter of 2003. Cash used in investing activities decreased by $1.9 million in thequarter ended March 31, 2004 compared to the quarter ended March 31, 2003 dueto the timing of investments and offset by increased capital purchases,substantially all of which were related to the build-out of new facilities atPDD.  Cash used in financing activitiesincreased by $3.7 million in the quarter ended March 31, 2004 compared to thequarter ended March 31, 2003 due to option exercises.

 

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 itsexisting capital resources will be adequate to fund the Company’s operations atleast through the next twelve months. However, there can be no assurance that changes will not occur thatwould consume available capital resources before then.

 

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TheCompany’s capital requirements depend on numerous factors, including theability of the Company to continue to generate software sales, the ability ofthe Company to extend existing Drug Discovery agreements and to enter intoadditional arrangements, competing technological and market developments,changes in the Company’s existing collaborative relationships, the cost offiling, 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 to supportits operations are forward looking 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 carefullyconsider the risks described below before investing in our publicly-tradedsecurities.  The risks described beloware not the only ones facing us.  Ourbusiness is also subject to the risks that affect many other companies, such ascompetition, technological obsolescence, labor relations, general economicconditions, geopolitical changes and international operations.  Additional risks not currently known to usor that we currently believe are immaterial also may impair our businessoperations and our liquidity.*

 

CERTAIN RISKS RELATED TO THE SPIN-OFF OF PDD

 

*There can be noassurance that neither PDD nor Accelrys will be successful on a stand-alonebasis.*OurBoard of Directors approved the plan to separate our Accelrys and PDDbusinesses through the spin-off to our stockholders of 100% of the outstandingshares of common stock of PDD which transaction was completed on April 30,2004. The transaction has resulted in PDD being an independent, publicly-tradedcompany owning and operating our Drug Discovery business; we retain ownershipof and operate the Accelrys software business.

 

We believethat separating PDD from Pharmacopeia will resolve difficulties we haveencountered regarding the effective operation and development of our twobusinesses within a single publicly-traded corporation.  We further believe the spin-off will enhancethe performance of Pharmacopeia and PDD by providing each company with greaterfocus on its respective business, with a publicly traded equity security foruse in compensation programs and as “currency” in strategic transactions, andwith a clearer story to enable investors to better evaluate each company andassign each entity an appropriate market valuation. There can be no assurancethat PDD and Pharmacopeia, as stand-alone entities, will be able to benefit fromthese items.

 

PDD andAccelrys have not been independent companies, and will no longer be able torely on the financial and other resources and the cash flows generated fromeach other’s operations. Currently, we operate our businesses as part of a broadercorporate organization rather than as separate stand-alone companies.Historically, certain corporate functions have been centralized for PDD andAccelrys; after a transition period following the distribution, each companywill be responsible for fulfilling these functions independently. Our estimatesconcerning the costs for independent corporate administrative functions (suchas overhead functions, corporate governance, securities compliance, exchangelisting and investor relations services) may be substantially lower than theactual costs incurred.  As a result, itwill be difficult for anyone to accurately forecast future operatingperformance for either company. Further, either company may need to obtain financingon a stand-alone basis after the spin-off, which may be difficult becausefinancial and other resources may not be as strong as the Company’s prior tothe distribution. Any future financing

 

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will have to be raised withoutreference to or reliance on the financial condition of the consolidatedcompany. There can be no assurance that either company will be able to obtainfinancing after the distribution on acceptable terms, or at all.

 

*The combined market value of our shares andthose of PDD after the spin-off may not be equal to or greater than the marketvalue of our shares prior to the distribution.* Thereis no assurance that an active public market for PDD’s or our common stock willdevelop or be sustained. In addition, the smaller size of the marketcapitalization of each company after the distribution compared to our marketcapitalization prior to the distribution may result in our loss of, and PDD’sfailure to obtain, stock research analyst coverage, which could adverselyimpact each entity’s stock market following. Consequently, there can be noassurance that the combined market value of our shares and those of PDD afterthe spin-off will be equal to or greater than the market value of our sharesprior to the distribution. Further, the market price of PDD’s and our stock mayfluctuate substantially, as in recent years the stock market has experiencedsignificant price and volume changes and the Company’s stock price has beenvolatile. In addition, following the distribution, our current stockholderswill now own separate securities in PDD and the Company. It is possible thatsome stockholders will sell shares of PDD or our common stock for variousreasons, including the fact that the business profile or market capitalizationof that entity as a stand-alone company does not fit their investmentobjectives. Given the large concentration of our stockholdings among our topseven stockholders, substantial sales of shares by one or more of thesestockholders could depress the market price for PDD’s or our shares. We cannotpredict whether substantial amounts of PDD’s or our stock will be sold in theopen market following the spin-off.

 

*If the distributionis taxable, stockholders could be required to pay tax on the fair market valueof the shares of PDD common stock you receive, and we could incur a corporatetax liability.* If the spin-off fails to qualify as atax-free distribution for U.S. federal income tax purposes, our stockholderswho receive PDD shares would be treated as if they had received a taxabledistribution in an amount equal to the fair market value of the PDD commonstock received. In such event, a corporate income tax could also be payable byus on the excess of the fair market value of the PDD stock over our adjustedtax basis in the stock. Further, even if the distribution is tax-free to ourstockholders, we could be subject to corporate income tax on any gain inherentin PDD’s stock if one or more persons acquire a 50% or greater interest in PDDas part of a plan or series of related transactions that included the spin-off.

 

*We may be requiredto indemnify PDD, or may not be able to collect on indemnification rights fromPDD*. As partof the spin-off, we and PDD have agreed to indemnify one another afterthe distribution with respect to the indebtedness, liabilities and obligationsthat will be retained by our respective companies. One such obligation is aguarantee by us of PDD’s obligations under the existing New Jersey laboratoryand headquarters leases, with respect to which PDD will indemnify us should webe required to make any payment under the guarantee. These indemnificationobligations could be significant. PDD’s ability to satisfy any suchindemnification obligations (including, without limitation, PDD’s commitment toindemnify us in the event of our payment under our guarantee of its leases)will depend upon PDD’s future financial strength. We cannot assure you that, ifPDD becomes obligated to indemnify us for any substantial obligations, PDD willhave the ability to do so. There also can be no assurance that we will be ableto satisfy any indemnification obligations to PDD. Any required payment by PDDor us could have a material adverse effect on its or our business, and anyfailure by PDD or us to satisfy its obligations could have a material adverseeffect on the other company’s business.

 

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CERTAIN RISKS RELATED TO OUR BUSINESS AS A WHOLE

 

*Our PDD revenue ishighly concentrated in its largest collaborators; the termination of thecollaboration with PDD’s largest collaborator would have a material adverseeffect on our business, financial condition and results of operations.*Duringthe year ended December 31, 2003, we earned approximately 47% of PDD’s revenue,and 12% of our consolidated revenue, under PDD’s research collaborationagreements with Schering-Plough Corporation. In the third quarter of 2003, PDDentered into new multiyear drug discovery collaboration agreements withSchering-Plough, which continue certain existing programs and implement anumber of new activities. The new agreements continue PDD’s collaboration withthis partner through at least August 2006 and, under their terms, may beextended by the parties for up to three additional years based upon progressmade in the programs governed by the agreements. The agreements may beterminated at the end of the third year, and Schering-Plough’s fundingobligations may be reduced significantly before that time, under thecircumstances summarized previously. There can be no assurance that the resultsof PDD’s collaboration with Schering-Plough would be sufficient to causeSchering-Plough not to exercise its rights to terminate the agreements. Inlight of the significance to us of the Schering-Plough relationship, thetermination of PDD’s collaboration agreements would have a material adverseeffect on PDD and our business as a whole.

 

*Pharmaceutical andbiotechnology companies may discontinue or decrease their use of our servicesand products.*****We are dependent on pharmaceutical andbiotechnology companies continuing to collaborate with outside companies toobtain drug discovery expertise. Our capabilities include aspects of the drugdiscovery process that pharmaceutical companies have traditionally performedinternally. Further, these companies (together with diversified chemical andother industrial companies) comprise the principal market for our Accelrysmodeling, simulation, data analysis and related software products and services.  Although there is a history amongpharmaceutical and biotechnology companies of outsourcing drug research anddevelopment functions, this practice may not continue. Similarly, thesecompanies have frequently utilized outside software vendors for key tools usedin drug discovery and chemical development, rather than developing neededinformation and analysis tools internally. Our revenue depends to a large extent on research and developmentexpenditures by the pharmaceutical, biotechnology, and chemical industries,particularly companies in these industries outsourcing research and developmentprojects and adding new and improved technologies to accelerate their drugdiscovery and chemical development initiatives.  The willingness of these companies to expand or continue drugdiscovery collaborations or outsourcing of services to enhance their researchand development activities is based on certain factors that are beyond ourcontrol. Examples of relevant factors include customers’ and collaborators’spending priorities among various types of research activities, their abilityto hire and retain qualified scientists, their approach regarding expendituresduring recessionary periods, their policies regarding the balance of researchexpenditures versus cost containment and the benefits of new software toolsversus their costs of licensure. Since a large proportion of our softwarecustomers license our products on an annual basis or buy maintenance contractsfrom us annually, if their spending priorities shift, our revenue may beimpacted.  Also, general economicdownturns in our customers’ industries or any decrease in research anddevelopment expenditures could harm our operations, as could increasedpopularity of management theories which counsel against outsourcing of criticalbusiness functions. In addition, the popularity of scientific thinking thatdisfavors expensive products such as large diversity libraries could negativelyimpact our revenue or our sales mix. Any decrease in drug discovery spending bypharmaceutical and biotechnology companies, or in chemical or materialsspending by chemical and industrial companies, could cause our revenue todecline and adversely impact our profitability.

 

*Our ability toincrease revenue and grow our business is dependent upon our success in adding newcustomers and expanding our existing customer relationships.*  In order to generate

 

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the additional revenue neededto grow, we must add new customers and retain, and expand upon, our existingcustomer relationships. These efforts depend significantly upon, among otherfactors:

 

•                  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, chemical, petrochemicaland diversified technology customers to invest in new modeling, simulation andinformatics solutions.

 

If we areunable to add revenue from additional or expanded customer relationships, wemay not be able to grow our business.

 

*Our futureprofitability is uncertain.*We generated losses in2002, 2003 and the three months ended March 31, 2004. Continuing net losses maylimit our ability to fund our operations and we may not generate income fromoperations in the future.  Our futureprofitability depends upon many factors, including several that are beyond ourcontrol. These factors include:

 

•                  changes in thedemand for our products and services, or for collaborative relationships withPDD;

•                  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, cost effectively and timely develop, introduce and market newcollaborative arrangements, products, services and product enhancements.

 

On a quarterlybasis, our future profitability is likely to be highly volatile because, amongother reasons, it is impacted by our receipt of milestone payments from ourcollaborators. We may not receive milestone payments on a regular basis, or atall.

 

*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 to attractand retain skilled personnel could have a material adverse effect on us.*Our success depends in part on the continued service of key scientific,software, sales, business development, engineering 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 for PDD. The competition among drugdiscovery and development companies to hire such scientists is particularlyintense. Immigration laws may further restrict our ability to attract or hirequalified personnel. We may not be able to continue to attract and retain thepersonnel necessary for the development of our business. Failure to attract andretain key personnel could have a material adverse effect on our business,financial condition and results of operations. Further, we are highly dependenton the principal members of our scientific and management staff.  One or more of these key employees couldretire or otherwise leave our employ within the foreseeable future, and theloss of any of

 

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these people could have amaterial adverse effect on our business, financial condition and results ofoperations. We are currently conducting a search to hire a chief executive officerof PDD. Dr. Joseph A. Mollica, Ph.D., the former Chairman of the Board,President and Chief Executive Officer of Pharmacopeia, is expected to serve asPDD’s President and Chief Executive Officer until a successor is appointed.  We do not, and do not intend to, maintainkey person life insurance on the life of any employee.

 

*We are dependentupon some of our suppliers.* We currently rely on twosuppliers to provide plastic filter bottom microtiter plates that are used inthe assay plate preparation process. We have, over the past year, developed aprocess such that we are not entirely dependent upon these suppliers.  Should we be unable, in some instances, toobtain an adequate supply of these or comparable filter bottom plates atcommercially reasonable rates, our ability to continue to prepare assay platescould be adversely affected, which in turn could harm our business.

 

*We may be unable todevelop 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,N.V. Organon, IBM, Oracle and HP.  Therecan be no assurance that any such relationship will continue, thatrelationships with similar large organizations can be developed, or that anysuch existing or new alliances will produce substantial revenue or profitopportunities.

 

*We are subject torisks associated with the operation of an international business. *In 2003, approximately 53% of the Company’s consolidatedrevenue was derived from customers outside the United States, both throughinternational subsidiaries and on an export basis. Approximately 36% of ourrevenue was derived from customers in Europe and approximately 17% was derivedfrom customers in the Asia/Pacific region. We anticipate that international revenue will continue to account for asignificant percentage of future overall revenue. Our international operations,particularly at Accelrys, continue to expand, with functions such as softwaredevelopment, sales and customer support increasingly being performed outside theUnited States.  In this connection, weintend to continue the expansion of our development center in Bangalore, India.

 

Our non-U.S.operations are subject to risks inherent in the conduct of internationalbusiness, 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 inmanaging an organization spread over various countries;

•                  difficulties instaffing foreign subsidiary or joint venture operations; and

•                  potentiallyadverse tax consequences.

 

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Our success depends, in part,on our ability to anticipate and address these risks. There can be no assurancethat these or other factors will not adversely affect our business or operatingresults.

 

We may not beable to sustain or increase international revenue. Any of the foregoing factorsmay have a material adverse effect on our international operations and,therefore, our business, financial condition and results of operations. Ourdirect international sales generally are denominated in local currencies.Fluctuations in the value of currencies in which we conduct business relativeto the United States dollar result in currency transaction gains and losses,and the impact of future exchange rate fluctuations cannot be accuratelypredicted. Future fluctuations in currency exchange rates may have a materialadverse impact on revenue from international sales, and thus on our business,financial condition and results of operations. When deemed appropriate, we mayengage in currency exchange rate hedging transactions in an attempt to mitigatethe impact of adverse exchange rate fluctuations. However, currency hedgingpolicies may not be successful, and they may increase the negative impact ofexchange rate fluctuations.

 

*Investments in Salesand Business Development Efforts.*  Both Accelrys and PDD products and servicesinvolve lengthy sales and business development cycles, often requiring us toexpend considerable financial and personnel resources without any assurancethat revenue will be recognized.  Thesesales and business development cycles typically are long for a number ofreasons.  In drug discovery, factorsinclude the strategic nature of drug discovery partnerships, the size of manysuch transactions, the confidential and proprietary nature of the biologicaltargets against which we screen our chemical compound libraries, and the uniqueterms typically found in each collaborative transaction.  With respect to software sales, sales cyclesare impacted by the time and resources required to educate potential customerorganizations as to the value and comparative advantages of our products. As aresult, we may expend substantial funds and effort to negotiate agreements forcollaborative relationships, services and products in both of our businesssegments, but may ultimately be unable to consummate the related transaction.In these circumstances, our results of operations and ability to achieveprofitability are adversely affected.

 

*Consolidation withinthe pharmaceutical and biotechnology industries may lead to fewer potentialcustomers for our products and services. *A significant portion of our customer baseconsists of pharmaceutical and biotechnology companies. Mergers between largemultinational pharmaceutical companies have accelerated in recent years.Continued consolidation within the pharmaceutical and biotechnology industriesmay result in fewer customers for our products and services. If one of theparties to a consolidation uses the products or services of our competitors, wemay lose existing customers as a result of such consolidation.

 

*Our operations maybe interrupted by the occurrence of a natural disaster or other catastrophicevent at our primary facilities.***  **We depend on our laboratories and equipment for the continuedoperation of our business. Our research and development operations andadministrative functions are primarily conducted at our facilities in thePrinceton, New Jersey area, San Diego, California, Cambridge, United Kingdom,and Bangalore, India.  Although we havecontingency plans in effect for natural disasters or other catastrophic events,catastrophic events could still disrupt our operations. Even though we carrybusiness interruption insurance policies, we may suffer losses as a result ofbusiness interruptions that exceed the coverage available under our insurancepolicies. Any natural disaster or catastrophic event in our facilities or theareas in which they are located could have a significant negative impact on ouroperations.

 

*Because our stockprice may be volatile, our stock price could experience substantial declines.*** **The market price of our commonstock has historically experienced and may continue to experience volatility.Our quarterly operating results, changes in general conditions in the economyor the financial markets and other developments affecting us or our competitorscould

 

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cause the market price of ourcommon stock to fluctuate substantially. In addition, in recent years, thestock market has experienced significant price and volume fluctuations and,during the past two years, the stock market (and in particular technologycompanies) has experienced significant decreases in market value. Thisvolatility and the recent market decline has affected the market prices ofsecurities issued by many companies, often for reasons unrelated to their operatingperformance, and may adversely affect the price of our common stock.

 

*As institutions holdthe majority of our Common Stock in large blocks, substantial sales by thesestockholders could depress the market price for our shares.*  As of April 30, 2004, our company’s sevenlargest stockholders held approximately 58% of our outstanding commonstock.  As a result, if one or more ofthese major stockholders were to sell all or a portion of their holdings, or ifthe market were to perceive that such sale or sales may occur, the market priceof our common stock may fall significantly.

 

*Because we do notintend 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 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 acquisition discussionswith us.

 

*If we consume cashmore quickly than expected, we may be unable to raise additional capital and wemay be forced to curtail operations.*We anticipatethat our existing capital resources will be adequate to fund our operations atleast through 2005***.*** 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 other intellectualproperty rights and the outcome of related litigation;

 

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•                  the purchase ofadditional capital equipment;

•                  acquisitions ofother businesses or technologies; and

•                  the progress ofour milestone and royalty producing activities.

 

If wedetermine that we must raise additional capital, we may attempt to do sothrough public or private financings involving debt or equity. However,additional capital may not be available on favorable terms, or at all. If adequatefunds are not available, we may be required to curtail operations significantlyor to obtain funds by entering into arrangements with collaborative partners orothers that may require us to relinquish rights to certain of our technologies,products or potential markets that we would not otherwise relinquish.

 

*If we choose toacquire new and complementary businesses, products or technologies instead ofdeveloping them ourselves, we may be unable to complete these acquisitions orto successfully integrate an acquired business or technology in acost-effective and non-disruptive manner. *From time to time, we may choose to acquirecomplementary businesses, products or technologies instead of developing themourselves. We do not know if we will be able to complete any acquisitions, orwhether we will be able to successfully integrate any acquired businesses,operate them profitably or retain their key employees. Integrating anybusiness, product or technology we acquire could be expensive and time-consuming,disrupt our ongoing business and distract company management. In addition, inorder to finance any acquisition, we might need to raise additional fundsthrough public or private equity or debt financings. In that event, we could beforced to obtain financing on less than favorable terms and, in the case ofequity financing, that may result in dilution to our stockholders. If we areunable to integrate any acquired entities, products or technologieseffectively, our business will suffer. In addition, under certaincircumstances, amortization of assets or charges resulting from the costs ofacquisitions could harm our business and operating results.

 

CERTAIN RISKS RELATED TOINTELLECTUAL PROPERTY

 

*Positions taken bythe U.S. patent and trademark office or non-U.S. patent and trademark officialsmay preclude us from obtaining sufficient or timely protection for ourintellectual property. *Thepatent positions of pharmaceutical and biotechnology companies are uncertainand involve complex legal and factual questions. The coverage claimed in apatent application can be significantly reduced before the patent is issued.There is a significant risk that the scope of a patent may not be sufficient toprevent third parties from marketing other products or technologies with thesame functionality of our products and technologies. Consequently, some or allof our patent applications may not issue into patents, and any issued patentsmay provide ineffective remedies or be challenged or circumvented.

 

*Third parties may havefiled patent applications of which we may or may not have knowledge, and whichmay 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 may be third-partypatents, patent applications and other intellectual property or informationrelevant to our software, chemical compositions and other technologies whichare not known to us and that block or compete with our software, chemicalcompositions or other technologies, or limit the scope of patent protectionavailable to us. Moreover, from time to time, patents may issue which block orcompete with our software, chemical compositions or other technologies, orlimit the scope of patent protection available to us. Litigation may benecessary to enforce patents issued to us or to determine the scope andvalidity of the intellectual property rights of third parties.

 

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*We may not be ableto protect adequately the trade secrets and confidential information that wedisclose to our employees. *Werely upon trade secrets, technical know-how and continuing technologicalinnovation to develop and maintain our competitive position. Competitorsthrough their independent discovery (or improper means, such as unauthorizeddisclosure or industrial espionage) may come to know our proprietaryinformation. We generally require employees and consultants to executeconfidentiality and assignment-of-inventions agreements. These agreementstypically provide that all materials and confidential information developed byor made known to the employee or consultant during his, her or its relationshipwith us are to be kept confidential, and that all inventions arising out of theemployee’s or consultant’s relationship with us are our exclusive property. Ouremployees and consultants may breach these agreements, and in some instances wemay not have an adequate remedy. Additionally, in some instances, we may havefailed to require that employees and consultants execute confidentiality andassignment-of-inventions agreements.

 

*Foreign laws may notafford us sufficient protections for our intellectual property, and we may notseek patent protection outside the United States. *We believe that our success depends, inpart, upon our ability to obtain international protection for our intellectualproperty. However, the laws of some foreign countries may not be ascomprehensive as those of the U.S. and may not be sufficient to protect ourproprietary rights abroad. In addition, we may decide not to pursue patentprotection outside the United States, because of cost and confidentialityconcerns. Accordingly, our international competitors could obtain foreignpatent protection for, and market overseas, products and technologies for whichwe are seeking U.S. patent protection.

 

*We may not be ableto adequately defend our intellectual property from third party infringement,and third party challenges to our intellectual property may adversely affect ourrights and be costly and time consuming. *Some of our competitors have, or are affiliatedwith companies having, substantially greater resources than we have, and thosecompetitors may be able to sustain the costs of complex patent litigation to agreater degree and for longer periods of time than us. Uncertainties resultingfrom the initiation and continuation of any patent or related litigation couldhave a material adverse effect on our ability to compete in the marketplacepending resolution of the disputed matters. If our competitors prepare and filepatent applications in the United States that claim technology also claimed byus, we may have to participate in interference proceedings declared by the U.S.Patent and Trademark Office to determine the priority of invention, which couldresult in substantial costs to us, even if the outcome is favorable to us.Similarly, opposition proceedings may occur overseas, which may result in theloss or narrowing of the scope of claims or legal rights. Such proceedings willat least result in delay in the issuance of enforceable claims. An adverseoutcome could subject us to significant liabilities to third parties andrequire 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 havelicensed source codes of certain products to customers or collaborators. Forthese reasons, policing unauthorized use of our software products may bedifficult.

 

*A patent issued tous may not be sufficiently broad to protect adequately our rights inintellectual property to which the patent relates. *Even if patents are issued to us, thesepatents may not sufficiently protect our interest in our software, chemicalcompositions or other technologies because the scope of protection provided byany patents issued to or licensed by us are subject to the uncertainty inherentin patent law. Third parties may be able to design around these patents ordevelop unique products providing effects similar to our products. In addition,others may discover uses for our software, chemical compositions ortechnologies other than those uses covered in our patents, and these other usesmay be separately patentable. A number of pharmaceutical and biotechnologycompanies, software organizations and research and academic

 

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institutions, have developedtechnologies, filed patent applications or received patents on varioustechnologies that may be related to our business. Some of these technologies,patent applications or patents may conflict with our technologies, patentapplications or patents. These conflicts could also limit the scope of patents,if any, that we may be able to obtain, or result in the denial of our patentapplications.

 

*We may be subject toclaims of infringement by third parties. *Third parties may claim infringement by us oftheir intellectual property rights. In addition, to the extent our employeesare involved in research areas similar to those areas in which they wereinvolved at their former employers, we may be subject to claims that one of ouremployees, or we, have inadvertently or otherwise used or disclosed the allegedtrade secrets or other proprietary information of a former employer. From timeto time, we have received letters claiming or suggesting that our products oractivities may infringe third party patents or other intellectual propertyrights. Our products may infringe patent or other intellectual property rightsof third parties. A number of patents may have been issued or may be issued inthe future that could cover certain aspects of our technology and that couldprevent us from using technology that we use or expect to use. We may berequired to seek licenses for, or otherwise acquire rights to, technology as aresult of claims of infringement. We may not possess proper ownership or accessrights to the intellectual property we use. Third parties or other companiesmay bring infringement suits against us. We expect, in general, that softwareproduct developers will be subject to more infringement claims as the number ofproducts and competitors in our industry segments grows and the functionalityof products in different industry segments overlaps. Any claims, with orwithout merit, could be time consuming to defend, result in costly litigation,divert management’s attention and resources, cause product shipment delays orrequire us 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 TOACCELRYS

 

*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 through ourdesktop-based products, client-server solutions, and related services to abroader, more diversified group of biologists, chemists, and engineers. If wecannot expand our customer base by selling our desktop-based products,client-server solutions, and related services, we may not be able to increaseour software revenue, or such revenue may decline. In general, increased marketacceptance and greater market penetration of our software products depend uponseveral 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 softwareproducts and services may not achieve market acceptance or penetration in theirtarget industries or other industries. Failure to increase market acceptance orpenetration may

 

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restrict substantially thefuture growth of our software business and may have a material adverse effecton our company as a whole.

 

*We may be unable todevelop and market new Accelrys products that are necessary to increase revenue*.The success of our software business plan depends heavily upon increases inrevenue. Our strategy is to increase software 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.

•                  Developingenhanced modeling and informatics tools to address the needs of companiesengaged in nanotechnology research.

 

We do not havesufficient historical or comparative sales data to rely upon to indicate thatour new products or data content services will achieve the desired level ofcommercial 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;

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

•                  academic andgovernment sponsored institutes focused on nanotechnology.

 

In addition,some of our software licenses grant the right to sublicense our software. As aresult, our software customers and third-party licensees could develop specificsimulation applications using our software developer’s kit and compete with usby distributing these programs to our potential customers. Customers orlicensees could also develop their own simulation technology or informaticssoftware and cease using our software products and services. Some of ourcompetitors and potential competitors in this sector have longer operatinghistories than us and have greater financial, technical, marketing, researchand development and other resources. Many of our software competitors offerproducts and services directed at more specific markets than those we target,enabling these competitors to focus a greater proportion of their efforts on thesemarkets. Some offerings that compete with our software products are developedand made available at lower cost by governmental organizations and academicinstitutions, and these entities may be able to devote substantial resources toproduct development and also offer their products to users for little or nocharge.

 

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Finally, wealso face competition from open source software initiatives, in whichdevelopers provide software and intellectual property free over the internet.

 

*If we are unable tolicense software to, or collect receivables from, our early stage biotechnologycustomers, it may have a material adverse effect on our operating results.*  We license our modeling, simulation, dataanalysis and informatics software to smaller, development stage biotechnologycustomers. Often these customers have limited or no operating history, andrequire considerable funding to launch their businesses. As we have experiencedin recent quarters, they often significantly scale back, or altogether cease,operations.  Therefore, there isconsiderable risk in counting on these types of entities for revenuegrowth.  For entities that remain inbusiness, transactions with these customers carry a higher degree of financialrisk. Our customers, particularly our development stage customers, arevulnerable to, and may be impacted by, the current tightening of availablecredit and capital, and general economic slowdown occurring in the UnitedStates and our other key markets. As a result of these conditions, ourcustomers may be unable to license or, if under a license, may be unable to payfor, Accelrys software products. If we are not able to collect such amounts, wemay be required to write-off significant accounts receivable and recognize baddebt expense. As a result of the exposures above and other potential exposures,we recorded a provision for doubtful accounts of $1.3 million and $0.4 millionin 2002 and 2003, respectively.  Failureof these businesses, 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 experienced stronger financial performance in the thirdand fourth calendar quarters of each year followed by a comparative decline inthe first and second quarters. Quarterly operating results may continue to fluctuate as a result of anumber of factors, including lengthy sales cycles, market acceptance of newproducts and upgrades, timing of new product introductions, changes in pricingpolicies, changes in general economic and competitive conditions, seasonalslowdowns, and the timing and integration of acquisitions. Additionally,changes in the timing of revenue recognition may result if subscription salesincrease.  We also expect to continue toexperience fluctuations in quarterly operating results due to general andindustry specific economic conditions that may affect the research anddevelopment expenditures of pharmaceutical and biotechnology companies. Due tothe possibility of fluctuations in our revenue and expenses, we believe thatquarter-to-quarter comparisons of our operating results are not a good indicationof our future performance.

 

CERTAIN RISKS RELATED TO PDD

 

*Our PDD revenue ishighly concentrated in its largest collaborators; the termination of thecollaborations with certain of PDD’s large collaborators would have a materialadverse effect on PDD’s business, financial condition and results ofoperations. *Duringthe year ended December 31, 2003, we earned approximately $5.5 million, or18.5% of our PDD revenue, and 4.8% of our consolidated revenue, under PDD’sresearch collaboration agreements with N.V. Organon, its

 

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second largest customer. Theprincipal agreement with Organon, entered into in February 2002, has a statedterm of five years; however, Organon has the right to terminate the agreementin 2005 if PDD is unable to deliver compounds meeting the criteria specified inthe agreement. We have timely delivered the first compound required under thisagreement for inspection and verification by Organon. However, there can be noassurance that these compounds will be compliant, or that future compliantcompounds will be delivered before the enumerated dates. The termination ofthis agreement would have a material adverse effect on PDD, and may have amaterial adverse effect on our business as a whole.

 

*The development ofour products is at an early stage and is uncertain. *Drug development is a highly uncertainprocess. Our approach and technology may never result in a commercial drug.None of our compounds are contained in products that have received regulatoryapproval for commercial sale, and currently we have only four candidates withrespect to which clinical trials (i.e., human testing) have been commenced. Allof our therapeutic candidates, including these clinical candidates, are indevelopment, and face the substantial risks of failure inherent in the drugdevelopment process. Any potential pharmaceutical product emanating from one ofour internal or collaborative programs must satisfy rigorous standards ofsafety and efficacy before the FDA and foreign regulatory authorities willapprove them for commercial use. To satisfy these standards, significantadditional research, preclinical studies (i.e., animal testing) and clinicaltrials will be required. Preclinical and clinical development of drugcandidates is a long, expensive and uncertain process. Failure can occur at anystage of testing. Success in preclinical testing does not ensure that clinicaltrials will be successful. Based on results at any stage of productdevelopment, we or our development collaborators may decide to discontinuedevelopment of our product candidates.

 

Our productcandidates and research programs are in the early stages of development andrequire significant, time-consuming and costly research and development, testingand regulatory approvals. We do not expect that our product candidates will becommercially available for many years, if ever. In addition, we pursue thediscovery and initial development of product candidates using our integratedtechnology platform in both our internal and collaborative programs toimplement our strategy of reducing the cost and time incurred by thepharmaceutical industry in developing drug candidates. To date, we have notidentified a therapeutic candidate that has been developed into a commercialdrug using our platform. It is uncertain whether our technology platform willachieve these goals at all or whether it will be competitive with platformsused by our competitors.

 

*We and ourcollaborators may not be able to successfully develop our existing clinicalcandidates. *Ourcollaborators, Bristol-Myers Squibb Company, Daiichi Pharmaceutical Co. andSchering-Plough Corporation, currently are performing clinical trials ofprospective pharmaceutical products containing our proprietary compounds. Ineach case, the collaborator is responsible for the development of thesepotential products as well as the decision as to when, or whether, suchdevelopment should cease. Numerous additional studies are necessary to supportthe further development of these product candidates. Results from preclinicalstudies conducted to date on these product candidates are not necessarilyindicative of the results that may be obtained in clinical studies. Resultsfrom additional studies could cause our collaborators to discontinue or limitdevelopment of these product candidates. There can be no assurance thatBristol-Myers Squibb, Daiichi or Schering-Plough will continue to develop theseprograms. In addition, our collaborators may pursue alternative technologies ordrug candidates, either on their own or in collaboration with others, thatcompete with our clinical candidates. If our collaborators do not continuetheir development efforts, we will not receive additional milestone and royaltypayments from those efforts.

 

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*Disputes may arisebetween our collaborative partners and us as to royalties and milestones towhich we are entitled.*  The compound basis for drugs developed by a customer may be aderivative or optimized version of the compound screened or optimized by us.While our existing collaborative agreements provide that we will receivemilestone payments and royalties with respect to certain products developedfrom certain derivative compounds, there can be no assurance that disputes willnot arise over the application of payment provisions to such products. Therecan be no assurance that current or future collaborative partners will notpursue alternative technologies, or develop alternative products either ontheir own or in collaboration with others, including our competitors, as ameans for developing treatments based on the targets which are the subject ofthe collaborative arrangements with us.

 

*Our collaborationsand internal programs may not result in the discovery of potential drugcandidates that will be safe or effective.*Although wehave received license and milestone fees to date, we may never receive anyroyalty payments, or any additional license and milestone fees, under ourcurrent or any future collaborations. Our receipt of any future milestone,royalty or license payments depends on many factors, including whether ourcollaborators desire to or are able to continue to pursue a potential drugcandidate and the ultimate commercial success of the drug. Development andcommercialization of potential drug candidates depend not only on theachievement of research objectives by us and our collaborators, but also oneach collaborator’s financial, competitive, marketing and strategic considerationsand regulation in the United States and other countries. If these or unforeseencomplications arise in the development or commercialization of the potentialdrug candidates by our collaborators, we may not realize milestone, royalty orlicense payments.

 

*The drug researchand development industry is highly competitive and subject to technologicalchange, and we may not have the resources necessary to competesuccessfully. *Manyof our competitors have access to greater financial, technical, research, marketing,sales, distribution, service and other resources than we do. Moreover, thepharmaceutical and biotechnology industries are characterized by continuoustechnological innovation. We anticipate that we will face increased competitionin the future as new companies enter the market and our competitors makeadvanced technologies available. Technological advances or entirely differentapproaches that we or one or more of our competitors develop may render ourproducts, services and expertise obsolete or uneconomical. Additionally, theexisting approaches of our competitors or new approaches or technologies thatour competitors develop may be more effective than those we develop. We may notbe able to compete successfully with existing or future competitors.

 

In addition,due to improvements in global communications, combined with the supply of lowercost Ph.D. level scientific talent in offshore locations such as China, Indiaand Eastern Europe, we face the growing threat of competition for our services.

 

*If we cannot managethe multiple relationships and interests involved in our collaborativearrangements and drug discovery programs, our business, financial condition andresults of operations may be materially adversely affected. *We may need tosuccessfully structure and manage multiple drug discovery programs andcollaborative relationships, including maintaining confidentiality of theresearch being performed for multiple customers. We may be unable to managesuccessfully conflicts between competing drug development programs of thirdparties to which we offer services. Conflicts also may arise between customersas to proprietary rights to particular compounds in our libraries or as toproprietary rights to biological targets such as receptors or enzymes againstwhich we screen compounds in our libraries. The occurrence of conflicts couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

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*If we use hazardous materialsin a manner that causes injury or violates laws, we may be liable for damages.*  PDD’s activities involve the use ofpotentially harmful hazardous materials, chemicals and various radioactivecompounds. These materials are utilized in the performance of PDD’s assaydevelopment, high throughput screening and chemistry optimization services, andinclude common organic solvents, such as acetone, hexane, methylene chloride,acetonitrile, and isopropyl and methyl alcohol as well as common acids and bases.  The waste from utilization of these solventsand other materials is disposed of through licensed third partycontractors.  Further, PDD utilizes anextremely wide variety of chemicals in the performance of its assaydevelopment, screening and optimization services.  These chemicals, such as reagents, buffers and inorganic salts,typically are employed in extremely small amounts in connection with the workperformed in its laboratories.  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. Wemaintain insurance coverage against environmental hazards arising from thestorage and disposal of the materials utilized in our business. Although ourmanagement believes that such insurance has terms, including coverage limits,which are appropriate for our business, liabilities arising from the use,storage, handling or disposal of these materials could exceed our insurancecoverage as well as our resources. We are subject to federal, state and locallaws and regulations governing the use, storage, handling and disposal of thesematerials and specified waste products. The cost of compliance with these lawsand regulations could be significant. To our knowledge, we have not been, andcurrently are not, the subject of any governmental investigation concerning theviolation of these federal, state and local laws and regulations. There can be noassurance that we will not be the subject of future investigations bygovernmental authorities.

 

*We may notsuccessfully enter into additional collaborations or services agreements thatallow us to participate in the future success of our product candidates throughmilestone, royalty and/or license payments, and we may never receive anymilestone royalty and/or license payments under our current or any futurecollaborations. *Oneof our business strategies is to expand our proprietary pipeline of drug candidatesand to then enter into collaborations for the development of these drugcandidates that will allow us to earn milestone, royalty and/or licensepayments. Our proprietary drug discovery program is in its early stage ofdevelopment and is unproven. Although we have expended, and continue to expend,time and money on internal research and development programs, we may beunsuccessful in creating valuable proprietary drug candidates that would enableus to form additional collaborations and receive milestone, royalty and/orlicense payments.

 

*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 ultimatesuccess of our business plan for PDD heavily depends upon the successfuldiscovery, development and commercialization of pharmaceutical products. Ourdrug discovery endeavors will result in commercialized pharmaceutical products,if at all, only after significant preclinical and clinical development,requisite regulatory 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 to develop and commercializeproducts primarily based on lead compounds discovered by us. If a collaborativepartner fails to develop or commercialize a compound or product with respect towhich it has rights from us, we may not receive any future milestone paymentsor royalties associated with that compound or product. Similarly, because werely heavily on our strategic collaborators, our revenue could be adverselyaffected if our collaborators:

 

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•                  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 based on the compounds that we originate;

•                  do not conducttheir 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;

•                  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 orare acquired by a third party that may wish to terminate our collaboration.

 

*There may be only alimited 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. The acceptance by potential customersof our services is important in determining revenue. Historically,pharmaceutical companies have conducted lead compound identification andoptimization within their own research departments due to the highlyproprietary nature of the activities being conducted, the central importance ofthese activities to their drug discovery and development efforts, and thedesire to obtain maximum patent and other proprietary protection on the resultsof their internal programs. In order to achieve our business objectives forPDD, we must convince these companies that our technology and expertise justifythe outsourcing of these programs to us. There can be no assurance that we willbe able to attract customers on acceptable terms for our products and services orto develop a sustainable profitable business. Moreover, the pricing and natureof our combinatorial libraries is such that there may only be a limited numberof pharmaceutical companies that are potential customers for such libraries.There can be no assurance that we will be able to establish additionalcollaborative or licensing arrangements, that any such arrangements or licenseswill be on terms favorable to us, or that current or future collaborative orlicensing arrangements will ultimately be successful.

 

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

 

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**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 quarter ended March 31, 2004, approximately 54% of the Company’sconsolidated revenue was derived from customers outside the United States(including 36% from customers in Europe and 18% from customers in theAsia/Pacific region).  As such, theCompany’s exchange rate risk is greatest for Dollar/Euro and Dollar/Yenfluctuations.  When deemed appropriate,the Company engages in exchange rate-hedging transactions in an attempt tomitigate the impact of adverse exchange rate fluctuations.  At March 31, 2004, the Company had nohedging 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 risks associated with changes ininterest rates relates primarily to the increase or decrease in the amount ofinterest income earned on its investment portfolio since the Company hasminimal debt.  The Company ensures thesafety and preservation of invested funds by limiting default risks, marketrisk, and reinvestment risk.  TheCompany mitigates default risk by investing in investment gradesecurities.  A hypothetical 100 basispoint adverse move in interest rates along the entire interest rate yield curvewould not materially affect the fair value of the Company’s interest sensitivefinancial instruments at March 31, 2004.

 

**Item 4.  Controls and Procedures**

 

The Company’smanagement, with the participation of the Company’s Chief Executive Officer andChief Financial Officer, has evaluated the effectiveness of the Company’sdisclosure controls and procedures as of March 31, 2004.  Based on that evaluation, the Company’sChief Executive Officer and Chief Financial Officer concluded that theCompany’s disclosure controls and procedures were effective as of March 31,2004.  There were no material changes inthe Company’s internal control over financial reporting during the transitionperiod from January 1, 2004 through March 31, 2004.

 

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**PART II - OTHERINFORMATION**

 
| **Item 1.** |   | Legal Proceedings                                                                                               |
|-------------|--------|-----------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                            |
|        |   | The Company is  not a party to any material litigation and is not aware of any threatened  material litigation. |
|        |   |                                                                                                            |
| **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 – None                                                                                   |
|        |   |                                                                                                            |
| **Item 6.** |   | Exhibits and Reports on Form 8-K                                                                                |
|        |   |                                                                                                            |
|        |   | (a) Exhibits  – See Exhibit Index                                                                          |
|        |   |                                                                                                            |
|        |   | (b) Reports  on Form 8-K                                                                                        |

 

(i)                                     Current report on Form 8-K filed February9, 2004 reporting that a press release was issued and a conference call washeld regarding the Company’s financial results for 2003.

 

(ii)                                  Current report on Form 8-K filed February27, 2004 reporting a change to the Company’s ticker symbol.

 

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**SIGNATURE**

 

 

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

 

 
|   | ACCELRYS,  INC. |
|--------|-----------------|
|   |            |
|   | By:             | /s/John J.  Hanlon |   |
|   |            |   |
|   |            | John J.  Hanlon |
|   |            | Executive  Vice President and |
|   |            | Chief  Financial Officer (Duly Authorized  Officer and Chief Financial Officer) |
|   |            |   |
|   |            | Date:  May 10, 2004 |

 

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**PHARMACOPEIA,INC.**

 

**INDEX TO EXHIBITS**

 
| **No.** |   | **EXHIBIT**                                                   |
|---------|--------|---------------------------------------------------------------|
|    |   |                                                          |
| 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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