**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**Washington,DC 20549

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**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the quarterly period ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For thetransition periodfrom            to            **

 

**Commission File Number: 0-27188**

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**ACCELRYS, INC.**(Exactname of registrant as specified in its charter)

| **Delaware**                                               |   | **33-0557266**                        |
|------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of                           |   | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)                            |   |                                  |
|                                                       |   |                                  |
| **10188  Telesis Court, Suite 100, San Diego, California** |   | **92121-4779**                        |
| (Address of  principal executive offices)                  |   | (Zip Code)                            |

 

**(858) 799-5000**

(Registrant’stelephone number, including area code)

Indicate by checkmark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes x   No o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Largeaccelerated filer o   Acceleratedfiler x   Non-accelerated filer o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o   Nox

The number of outstanding shares of the registrant’s common stock, parvalue $0.0001 per share, as of January 12, 2007 was 26,472,890, net of treasuryshares.

 

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**ACCELRYS, INC.FORM 10-Q — QUARTERLY REPORTFor The Quarterly Period Ended December 31, 2006Table of Contents**
| **PART I — FINANCIAL  INFORMATION** |
|------------------------------------------|
| Item 1.                                  |   | Financial Statements |
|                                     |   | Condensed consolidated balance sheets as of December  31, 2006 (unaudited) and March 31, 2006 |
|                                     |   | Condensed consolidated statements of operations  (unaudited) for the three- and nine-month periods ended December 31, 2006 and  2005 |
|                                     |   | Condensed consolidated statements of cash flows  (unaudited) for the nine-month periods ended  December 31, 2006 and 2005 |
|                                     |   | Notes to condensed consolidated financial statements  (unaudited) |
| 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 1A.                                 |   | Risk Factors |
| Item 5.                                  |   | Other Information |
| Item 6.                                  |   | Exhibits |
| **Signature**                            |   |   |

 

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**PARTI — FINANCIAL INFORMATION**

**Item1. Consolidated Financial Statements**

**Accelrys, Inc.**

**Condensed Consolidated Balance Sheets**

**(Inthousands, except per share amounts)**
| ** **                                                                                                                                         | ** ** | **December 31, 2006** | ** ** | **March 31, 2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **(Unaudited)**                 | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                         |       |                            |       |                         |       |
| Current assets:                                                                                                                                    |       |                            |       |                         |       |
| Cash and cash  equivalents                                                                                                                         |       | $                               | 16,604     |                         | $          | 24,656 |   |
| Marketable  securities                                                                                                                             |       | 35,194                          |       | 34,733                       |       |
| Trade  receivables, net of allowance for doubtful accounts of $207 and $351 as of  December 31, 2006 and March 31, 2006, respectively              |       | 27,418                          |       | 17,289                       |       |
| Prepaid expenses  and other current assets                                                                                                         |       | 3,646                           |       | 3,438                        |       |
| Total current assets                                                                                                                               |       | 82,862                          |       | 80,116                       |       |
| Restricted cash                                                                                                                                    |       | 8,171                           |       | 6,633                        |       |
| Property and equipment,  net                                                                                                                       |       | 6,682                           |       | 7,860                        |       |
| Goodwill                                                                                                                                           |       | 42,663                          |       | 42,663                       |       |
| Intangible assets, net                                                                                                                             |       | 7,519                           |       | 8,671                        |       |
| Other assets                                                                                                                                       |       | 745                             |       | 812                          |       |
| Total assets                                                                                                                                       |       | $                               | 148,642    |                         | $          | 146,755 |   |
| **Liabilities and stockholders’  equity**                                                                                                     |       |                            |       |                         |       |
| Current liabilities:                                                                                                                               |       |                            |       |                         |       |
| Accounts payable                                                                                                                                   |       | $                               | 1,077      |                         | $          | 1,676 |   |
| Accrued  liabilities                                                                                                                               |       | 6,925                           |       | 4,939                        |       |
| Accrued  compensation and benefits                                                                                                                 |       | 7,745                           |       | 7,009                        |       |
| Current portion  of accrued restructuring charges                                                                                                  |       | 714                             |       | 2,936                        |       |
| Current portion  of deferred revenue                                                                                                               |       | 52,917                          |       | 51,710                       |       |
| Total current  liabilities                                                                                                                         |       | 69,378                          |       | 68,270                       |       |
| Deferred revenue, net  of current portion                                                                                                          |       | 2,557                           |       | 9,559                        |       |
| Accrued restructuring  charges, net of current portion                                                                                             |       | 1,425                           |       | 1,338                        |       |
| Lease-related  liabilities, net of current portion                                                                                                 |       | 6,605                           |       | 4,380                        |       |
|                                                                                                                                               |       |                            |       |                         |       |
| Stockholders’ equity:                                                                                                                         |       |                            |       |                         |       |
| Preferred stock,  $0.0001 par value; 2,000 shares authorized; no shares issued and outstanding                                                     |       | —                          |       | —                       |       |
| Common stock,  $0.0001 par value; 40,000 shares authorized; 27,109 and 26,856 shares issued  at December 31, 2006 and March 31, 2006, respectively |       | 3                               |       | 3                            |       |
| Additional  paid-in capital                                                                                                                        |       | 258,271                         |       | 254,224                      |       |
| Deferred  stock-based compensation                                                                                                                 |       | —                          |       | (522                         | )          |
| Lease guarantee                                                                                                                                    |       | (588                            | )          | (635                         | )          |
| Treasury stock;  644 shares at each of December 31, 2006 and March 31, 2006, respectively                                                          |       | (8,340                          | )          | (8,340                       | )          |
| Accumulated  deficit                                                                                                                               |       | (181,631                        | )          | (181,156                     | )          |
| Accumulated  other comprehensive income (loss)                                                                                                     |       | 962                             |       | (366                         | )          |
| Total stockholders’  equity                                                                                                                   |       | 68,677                          |       | 63,208                       |       |
| Total liabilities and stockholders’ equity                                                                                                    |       | $                               | 148,642    |                         | $          | 146,755 |   |

 

See accompanying notes tothese condensed consolidated financial statements.

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**Accelrys, Inc.**

**CondensedConsolidated Statements of Operations**

**(In thousands, except per shareamounts)**

**(Unaudited)**
| ** **                                                                    | ** ** | **Three Months Ended December 31,** | ** ** | **Nine Months Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                                | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                    | ** ** | ** **                                              | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                       |       | $                                                       | 20,684     |                                                   | $          | 20,433 |   | $ | 61,066 |   | $ | 62,572 |   |
| Operating costs  and expenses:                                                |       |                                                    |       |                                                   |       |   |   |   |   |
| Cost of revenue                                                               |       | 4,526                                                   |       | 4,361                                                  |       | 12,248 |   | 12,669 |   |
| Product development                                                           |       | 4,697                                                   |       | 4,952                                                  |       | 14,739 |   | 16,374 |   |
| Sales and marketing                                                           |       | 8,616                                                   |       | 8,675                                                  |       | 21,720 |   | 24,560 |   |
| General and administrative                                                    |       | 4,077                                                   |       | 3,612                                                  |       | 13,168 |   | 11,304 |   |
| Restructuring charges (recoveries)                                            |       | 252                                                     |       | —                                                 |       | 247 |   | (4 | ) |
| Total operating  costs and expenses                                           |       | 22,168                                                  |       | 21,600                                                 |       | 62,122 |   | 64,903 |   |
| Operating loss                                                                |       | (1,484                                                  | )          | (1,167                                                 | )          | (1,056 | ) | (2,331 | ) |
| Interest and  other income, net                                               |       | 601                                                     |       | 530                                                    |       | 1,444 |   | 1,630 |   |
| Income (loss)  before taxes                                                   |       | (883                                                    | )          | (637                                                   | )          | 388 |   | (701 | ) |
| Income tax  expense (benefit)                                                 |       | 198                                                     |       | (70                                                    | )          | 863 |   | 611 |   |
| Net loss                                                                      |       | $                                                       | (1,081     | )                                                      | $          | (567 | ) | $ | (475 | ) | $ | (1,312 | ) |
|                                                                          |       |                                                    |       |                                                   |       |   |   |   |   |
| Basic and  diluted net loss per share                                         |       | $                                                       | (0.04      | )                                                      | $          | (0.02 | ) | $ | (0.02 | ) | $ | (0.05 | ) |
| Weighted average shares  used to compute basic and diluted net loss per share |       | 26,387                                                  |       | 26,143                                                 |       | 26,297 |   | 26,090 |   |

 

See accompanying notes tothese condensed consolidated financial statements.

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**Accelrys, Inc.Condensed Consolidated Statements of Cash Flows**

**(In thousands)**

**(Unaudited)**
| ** **                                                                   | ** ** | **Nine Months Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                       |       |                                                   |       |   |   |
| Net loss                                                                     |       | $                                                      | (475       | ) | $ | (1,312 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                                   |       |   |   |
| Depreciation                                                                 |       | 2,295                                                  |       | 2,931 |   |
| Amortization of acquired intangible assets                                   |       | 1,152                                                  |       | 1,314 |   |
| Share-based compensation                                                     |       | 3,344                                                  |       | 775 |   |
| Other                                                                        |       | 1,152                                                  |       | 1,020 |   |
| Changes in operating assets and liabilities:                                 |       |                                                   |       |   |   |
| Trade receivables                                                            |       | (9,294                                                 | )          | (18,311 | ) |
| Prepaid expenses and other current assets                                    |       | (54                                                    | )          | 2,378 |   |
| Restricted cash and other assets                                             |       | (1,200                                                 | )          | (377 | ) |
| Accounts payable                                                             |       | (663                                                   | )          | (675 | ) |
| Accrued liabilities                                                          |       | 1,091                                                  |       | (2,864 | ) |
| Deferred revenue                                                             |       | (7,264                                                 | )          | 4,526 |   |
| Net cash used in  operating activities                                       |       | (9,916                                                 | )          | (10,595 | ) |
| Cash flows from  investing activities:                                       |       |                                                   |       |   |   |
| Purchases of property and equipment, net                                     |       | (847                                                   | )          | (2,555 | ) |
| Purchases of marketable securities                                           |       | (24,580                                                | )          | (5,377 | ) |
| Proceeds from sales and maturities of marketable  securities                 |       | 24,391                                                 |       | 13,102 |   |
| Net cash  provided by (used in) investing activities                         |       | (1,036                                                 | )          | 5,170 |   |
| Cash flows from  financing activities:                                       |       |                                                   |       |   |   |
| Proceeds from issuance of common stock                                       |       | 1,230                                                  |       | 857 |   |
| Net cash  provided by financing activities                                   |       | 1,230                                                  |       | 857 |   |
| Exchange rate  effect on cash and cash equivalents                           |       | 1,670                                                  |       | (944 | ) |
| Decrease in cash  and cash equivalents                                       |       | (8,052                                                 | )          | (5,562 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 24,656                                                 |       | 21,256 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                      | 16,604     |   | $ | 15,694 |   |

 

See accompanying notes tothese condensed consolidated financial statements.

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**Accelrys, Inc.Notes to Condensed Consolidated Financial Statements**

**1.****                       Basis of Presentation andSignificant Accounting Policies**

*FinancialStatement Preparation*

The condensed consolidated financial statements as of December 31, 2006, and for the threeand nine months ended December 31,2006 and 2005 are unaudited. We have condensed or omitted certain informationand disclosures normally included in financial statements presented inaccordance with accounting principles generally accepted in the United States.We believe the disclosures made are adequate to make the information presentednot misleading. However, you should read these condensed consolidated financialstatements in conjunction with the consolidated financial statements and notesthereto included in our Annual Report on Form 10-K for the fiscal year endedMarch 31, 2006.

In the opinion of management, these condensedconsolidated financial statements include all adjustments, consisting of normalrecurring adjustments, necessary for a fair presentation of results for theinterim periods presented.

Ourbusiness is subject to seasonal variations. Historically, we have received approximately two-thirds of our annualcustomer orders in the second half of our fiscal year. In accordance with ourrevenue recognition policies, the revenue associated with these orders isgenerally recognized over the contractual license term. Therefore, because weaccrue sales commissions and royalties upon the invoicing of customer orders,we have historically experienced an increase in operating costs and expensesduring the second half of our fiscal year with only a minimal correspondingincremental increase in revenue. Additionally, our cash flows from operationshave historically been positive in the fiscal quarter ended March 31 as wecollect the accounts receivable generated from these customer orders, while wehave historically experienced negative cash flows from operations in the otherthree fiscal quarters. As a result of these seasonal variations, we believethat quarter-to-quarter comparisons of our operating results are not a goodindication of our future performance and that the interim financial results forthe periods presented in this quarterly report are not necessarily indicativeof results for a full year or for any subsequent interim period.

*Principlesof Consolidation*

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of our wholly-owned subsidiaries. Allintercompany accounts and transactions have been eliminated in consolidation.

*Useof Estimates*

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requires usto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying notes. On an on-going basis, we evaluateour estimates, including those related to revenue recognition, income taxes andthe valuation of goodwill, intangibles and other long-lived assets. We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances. Actual future results coulddiffer from those estimates.

# *RevenueRecognition*

Werecognize revenues in accordance with the American Institute of CertifiedPublic Accountants Statement of Position No. 97-2, *Software Revenue Recognition*(“SOP No. 97-2”), as amended,U.S. Securities and Exchange Commission (the “SEC”) Staff Accounting BulletinNo. 104, *Revenue Recognition*(“SABNo. 104”), and Emerging Issues Task Force Issue No. 00-21 (“EITF No. 00-21”), *Revenue Arrangements with Multiple Deliverables*.

We generate revenue from the following primarysources:

·     softwarelicenses,

·                    provisionof support and maintenance services on licensed software, referred to aspost-contract customer support (“PCS”), and

·                    training,installation and implementation services.

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Customer billings generated in connection with ourrevenue-generating activities are intitially recorded as deferred revenue. Wethen recognize the revenue from these customer billings as set forth below andwhen all of the following criteria are met:

·                    afully executed written contract and/or purchase order has been obtained fromthe customer (i.e., persuasive evidence of an arrangement exists),

·                    thecontractual price of the product or services has been defined and agreed to inthe contract (i.e., price is fixed or determinable),

·                    deliveryof the product or service has occurred and no material uncertainties regardingcustomer acceptance of the delivered product or service exist, and

·                    collectionof the purchase price from the customer is deemed probable.

*SoftwareLicenses*

We license software either perpetually or on a termbasis. Our standard perpetual software licensing arrangements include twelvemonths of bundled PCS, while our standard term-based software licensingarrangements typically include PCS for the full duration of the term license.Because we do not have vendor specific objective evidence (“VSOE”) of the fairvalue of these elements, we recognize as revenue the entire fee for allsoftware licenses ratably over the term of the bundled PCS. Certain of ourterm-based licenses also allow the customer to substitute purchased productsfor other products of equal value throughout the term. We account for these arrangementsas in-substance subscriptions and, accordingly, we recognize as revenue theentire fee for licenses ratably over the contractual term of the arrangement,which is typically the same as the term of the bundled PCS.

*Renewal of PCS under Perpetual Software Licenses*

Our PCS includes the right to receive unspecifiedupgrades or enhancements and technical support. Fees from customer renewals ofPCS related to previously purchased perpetual licenses are recognized ratablyover the term of the PCS.

*Training, Installation and Implementation Services*

We provide certain services to our customers,including product training, non-complex product installation and non-compleximplementation services which are non-essential to the operation of thesoftware. When sold separately, revenue from these services is generallyrecognized as the services are delivered according to the contractual terms.Amounts billed but not yet recognized as revenue, and other payments receivedprior to recognition of revenue, are recorded as deferred revenue.

*Multi-Element Arrangements*

For multi-element arrangements which include softwarelicenses, PCS and non-complex training, installation and implementationservices which are non-essential to the operation of the software, the entire feefor such arrangements is recognized as revenue ratably over the term of the PCSor delivery of the services, whichever is longer.

# *SoftwareDevelopment Costs*

Weaccount for costs incurred to develop our software products in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 86, *Accounting for the Cost of Computer Software to beSold, Leased or Otherwise Marketed*. Accordingly, costs incurred inthe research and development of new software products and significantenhancements to existing software products are expensed as incurred, until thetechnological feasibility of the product has been established. Technologicalfeasibility occurs shortly before our software products are available forgeneral release, and we have determined that costs eligible for capitalizationare not material. Accordingly, there were no capitalized software developmentcosts as of December 31, 2006 and March 31, 2006.

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*Adoptionof SFAS No. 123R*

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123 (revised 2004), *Share-BasedPayment* (“SFAS No. 123R”). SFAS No. 123R requiresthat employee stock-based compensation is measured based on the grant date fairvalue of the related employee equity awards and is treated as an expense that isreflected in the financial statements over the related service period. Theprovisions of SFAS No. 123R were effective for us beginning April 1, 2006.Prior to April 1, 2006, we accounted for our share-based awards to employeesand directors under the recognition and measurement principles of AccountingPrinciples Board Opinion No. 25, *Accountingfor Stock Issued to Employees,* and related interpretations andadopted the pro forma disclosure provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*.Accordingly, stock-based compensation expense related to employee stock optionswas recognized only if, on the date of grant, the exercise price of theemployee stock option was less than the fair market value of the underlyingcommon stock.

EffectiveApril 1, 2006, we adopted SFAS No. 123R using the modified prospectivetransition method. Under the modified prospective transition method, theestimated grant date fair value of awards granted to employees and directors onor after April 1, 2006 is recognized as a charge against income over therequisite service period. Additionally, the remaining unrecognized compensationexpense associated with the unvested portion of awards granted prior to April1, 2006, determined under the provisions of SFAS No. 123, is recognized as acharge against income beginning April 1, 2006. In accordance with the modifiedprospective transition method, our consolidated financial statements forperiods prior to April 1, 2006 have not been restated to reflect, and do notinclude, the impact of our adoption of SFAS No. 123R.

Pursuantto the provisions of SFAS No. 123R, deferred stock-based compensation is nolonger reflected as a separate component of stockholders’ equity. As a result,we reversed our remaining deferred stock-based compensation balance as of April1, 2006 of $0.5 million against additional paid-in capital.

Theimpact of our adoption of SFAS No. 123R on the condensed consolidated financialstatements and the related footnote disclosure information are provided in Note3.

*IncomeTaxes*

We recognize income tax expense (benefit) based onestimates of our consolidated taxable income (loss) taking into account thevarious legal entities through which, and jurisdictions in which, we operate.As such, income tax expense (benefit) may vary from the customary relationshipbetween income tax expense (benefit) and income (loss) before taxes.

*Newand Recently Adopted Accounting Standards*

InSeptember 2006, the SEC issued Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements*(“SAB No. 108”).SAB No. 108 provides interpretive guidance on how the effects of the carryoveror reversal of prior year misstatements should be considered in quantifying acurrent year misstatement. Specifically, SAB No. 108 states that registrantsshould quantify errors using both a balance sheet and an income statementapproach and evaluate whether either approach results in quantifying amisstatement that, when all relevant quantitative and qualitative factors areconsidered, is material. SAB No. 108 is effective for fiscal years ending afterNovember 15, 2006. We are currently evaluating the impact, if any, SAB No. 108will have on our results of operations and financial position.

InJune 2006, the FASB issued Interpretation (“FIN”) No. 48, *Accounting for Uncertainty in Income Taxes.*FIN No. 48, which is effective for fiscal years beginning afterDecember 15, 2006, addresses the accounting for income taxes by prescribingthe minimum recognition threshold a tax position is required to meet beforebeing recognized in the financial statements. In addition, FIN No. 48 expandsthe disclosure requirements concerning unrecognized tax benefits as well as anysignificant changes that may occur in the next twelve months associated withsuch unrecognized tax benefits. We will adopt the provisions of FIN No. 48 inthe first quarter of fiscal year 2008. We are currently evaluating the impact,if any, FIN No. 48 will have on our results of operations and financialposition.

InNovember 2005, the FASB issued Staff Position Nos. FAS 115-1 and FAS 124-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*(“FSP Nos. 115-1 and 124-1”),which provide guidance on determining when investments in certain debt andequity securities are considered impaired and whether that impairment isother-than-temporary, and on the measurement of such impairment loss. FSP Nos.115-1 and 124-1 also include accounting considerations subsequent to therecognition of other-than-temporary impairments and require certain disclosuresabout unrealized losses that have not been recognized as other-than-temporaryimpairments. Our adoption of FSP Nos. 115-1 and

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124-1 as of April 1, 2006 did not have a significantimpact on our results of operations and financial position.

In May2005, the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20 and SFAS No.3*. Although SFAS No. 154 carries forward the guidance in APB No. 20and SFAS No. 3 with respect to accounting for changes in estimates, changes inreporting entities, and the correction of errors, SFAS No. 154 establishes newstandards for accounting for changes in accounting principles, whereby all suchchanges must be accounted for by retrospective application to the financialstatements of prior periods unless it is impracticable to do so. SFAS No. 154is effective for accounting changes and error corrections made in fiscal yearsbeginning after December 15, 2005, with early adoption permitted for changesand corrections made in years beginning after May 2005. Our adoption of SFASNo. 154 as of April 1, 2006 did not have a material impact on our financialposition, results of operations or cash flows.

**2.****                       NetLoss Per Share**

Wecompute net loss per share pursuant to SFAS No. 128, *Earnings Per Share*. Accordingly, basic and diluted net lossper share is computed by dividing the net loss for the period by the weightedaverage number of common shares outstanding during the period, withoutconsideration for common share equivalents. Potentially dilutive common share equivalents consist of common stockoptions and unvested restricted stock awards and restricted stock units (“RSUs”).

Potentiallydilutive common share equivalents that were excluded from the basic and dilutednet loss per share calculations as their effect would be anti-dilutive totaledapproximately 3.7 million shares and 3.8 million shares for the three and ninemonths ended December 31, 2006,respectively, and 2.6 million shares and 3.7 million shares for the three andnine months ended December 31,2005, respectively.

**3.****                       Share-BasedPayments**

*Share-BasedCompensation Plans*

OnAugust 2, 2005, our stockholders approved the Amended and Restated 2004Stock Incentive Plan (the “2004 Plan”). The 2004 Plan authorizes the grant ofequity awards to purchase the number of shares of our common stock equal to thesum of (i) 1,900,000 shares and (ii) the number of shares of commonstock underlying any stock awards granted under certain prior share-basedcompensation plans that expire or are cancelled or forfeited without havingbeen exercised in full or that are repurchased by us. Potential types of equityawards that may be granted under the 2004 Plan to our officers, directors,employees and consultants include stock options, restricted stock awards,common stock awards, stock appreciation rights, performance awards and deferredstock units. Pursuant to the 2004 Plan, any shares of common stock that areawarded under the 2004 Plan as restricted stock awards, common stock awards,performance awards or deferred stock units (but not as stock options or stockappreciation rights) are counted against the maximum number of shares of commonstock available for issuance under the 2004 Plan based on a 1.15-to-1ratio. The terms and conditions of specific awards are set at the discretion ofour board of directors although generally awards vest over not more than fiveyears, expire no later than ten years from the date of grant and do not haveexercise prices less than the fair market value of the underlying common stockon the date of grant. At December 31,2006, approximately 1,813,000 shares of our common stock remain available forissuance pursuant to awards granted under the 2004 Plan.

On August 2, 2005, our stockholders also approvedthe 2005 Employee Stock Purchase Plan (the “ESPP”), under which we havereserved 1,000,000 shares of our common stock for issuance. Under the ESPP,employees may defer up to 10% of their base salary to purchase shares of ourcommon stock. The purchase price of the common stock is equal to 85% of thelower of the fair market value per share of our common stock on thecommencement date of the applicable offering period or the applicable purchasedate. To date, we have issued 69,000 shares under the ESPP and 931,000 sharesremain available for future issuance under the ESPP as of December 31, 2006.

Wealso maintain certain other share-based compensation plans, under which we didnot grant awards during fiscal year 2007 and do not intend to grant any furtherawards in the future.

Ourshare-based compensation plans contain a provision that allows eligibleparticipants to continue to vest in their stock options upon their retirement,as that term is defined in the plans. To be eligible for continued vesting,participants must be at least 55 years of age and have 5 years of service atthe time of their retirement.

During the second quarterof fiscal year 2007, we offered eligible employees the one-time opportunity tosurrender any and all stock options granted pursuant to any of our stock planswith an exercise price greater than $9.00 per share in exchange for RSUs (the “ExchangeOffer”) based on an exchange ratio determined by our board of directors. TheRSUs vest

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in three equal annual installments commencing on thedate of grant and are subject to the terms and conditions set forth in the 2004Plan. The offer period commenced on July 28, 2006 and expired on August 25, 2006.  On August 26, 2006, all eligible stockoptions tendered by eligible employees in accordance with the terms of theExchange Offer were cancelled and RSUs were issued to such eligible employeesin accordance with the exchange ratios established by the board ofdirectors.  In total, stock options forthe purchase of approximately 410,000 shares of our common stock were tenderedand cancelled, and RSUs for approximately 105,000 shares of our common stockwere granted.  Any eligible stock optionsnot tendered remain issued and outstanding in accordance with their originalterms and conditions.

Pursuantto SFAS No. 123R, we accounted for the cancellation of the tendered stockoptions and concurrent grant of RSUs as a modification of the cancelled stockoptions. Accordingly, we measured the excess of the grant-date fair value ofthe RSUs over the fair value of the cancelled stock options at cancellation(the “incremental value”) and are recognizing the aggregate of the incrementalvalue and the remaining unamortized grant-date fair value of the cancelledstock options of approximately $0.4 million as share-based compensation expenseover the requisite service period of the RSUs.

*Share-BasedAward Activity*

Our stock options generally vest over four years andhave a contractual term of 10 years.  Asummary of stock option activity under our share-based compensation plans is asfollows:
| ** **                       | ** ** | **Number of  Shares**                                                                | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate   Intrinsic   Value** | ** ** | **Weighted  Average  Remaining  Contractual   Life** | ** ** |
|----------------------------------|------------|-------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                       | ** ** | **(In thousands, except per share amounts and years)** | ** ** |
| Outstanding at  April 1, 2006    |       | 4,306                                                                                     |       | $                                      | 9.78       |                                        |       |                                                      |       |   |
| Granted                          |       | 1,055                                                                                     |       | 6.97                                   |       |                                        |       |                                                      |       |
| Exercised                        |       | (186                                                                                      | )          | 4.67                                   |       |                                        |       |                                                      |       |
| Expired/Forfeited                |       | (1,352                                                                                    | )          | 14.39                                  |       |                                        |       |                                                      |       |
| Outstanding at December 31, 2006 |       | 3,823                                                                                     |       | 7.65                                   |       | $                                           | 611        |                                                      | 7.3        |   |
| Exercisable at December 31, 2006 |       | 2,193                                                                                     |       | 8.20                                   |       | $                                           | 451        |                                                      | 6.0        |   |
|                                  |            |                                                                                           |            |                                        |            |                                             |            |                                                           |            |  |  |

 

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Theaggregate intrinsic value of stock options outstanding and exercisable at December 31, 2006 was based on theclosing price of our common stock on December29, 2006 of $6.01 per share. The total intrinsic value of stock optionsexercised during the nine months ended December31, 2006 was $0.4 million and the total cash received from the exerciseof stock options during the nine months ended December 31, 2006 was $0.9 million.

Infiscal year 2007, we granted RSUs under the 2004 Plan that vest annually overthree years and, once vested, do not expire. Upon vesting of an RSU, employeesare issued an equivalent number of shares of our common stock. A summary of RSUactivity under our share-based compensation plans is as follows:
| ** **                     | ** ** | **Number of  Shares**                                       | ** ** | **Weighted  Average  Grant Date   Fair Value** | ** ** |
|--------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                     | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Unvested at April 1,  2006     |       | —                                                           |       | $                                                             | —     |   |
| Granted                        |       | 481                                                              |       | 6.73                                                          |       |
| Vested                         |       | —                                                           |       | —                                                        |       |
| Forfeited                      |       | (29                                                              | )          | 6.97                                                          |       |
| Unvested at December 31,  2006 |       | 452                                                              |       | $                                                             | 6.72       |   |

 

Wealso have remaining unvested restricted stock awards of approximately 8,000shares as of December 31, 2006that were granted under a prior plan. These restricted stock awards vestannually over three years and, once vested, do not expire. Upon vesting of arestricted stock award, the company’s right to repurchase the underlying sharesexpires.

*Valuationof Share-Based Awards*

Weestimate the fair value of our share-based awards on the date of grant usingthe Black-Scholes option-pricing model. The Black-Scholes option-pricing modelrequires the use of certain input variables, as follows:

*Expected Volatility.* Volatility is ameasure of the amount the stock price will fluctuate during the expected lifeof an award. We determine volatility based on our historical stock pricevolatility over the most recent period equivalent to the expected life of theaward and the historical stock price volatilities of comparable publicly tradedcompanies, giving consideration to company-specific events impacting historicalvolatility that are unlikely to occur in the future as well as anticipatedfuture events that may impact volatility.

*Risk-Free Interest Rate.*Our assumption ofthe risk-free interest rate is based on the interest rates on U.S. constantrate treasury securities with contractual terms approximately equal to theexpected life of the award.

*Expected Dividend Yield.*Because we havenot paid any cash dividends since our inception and do not anticipate payingdividends in the foreseeable future, we assume a dividend yield of zero.

*Expected Award Life.*We determine theexpected life of an award by considering various relevant factors, includingthe vesting period and contractual term of the award, our employees’ historicalexercise patterns and length of service, the expected future volatility of ourstock price, tax implications of exercising an award and employeecharacteristics. We also consider the expected terms of comparable publiclytraded companies.

Under SFAS No. 123R, we are also required to estimateat grant the likelihood that the award will ultimately vest (the “pre-vestingforfeiture rate”) and revise the estimate, if necessary, in future periods ifthe actual forfeiture rate differs. We determine the pre-vesting forfeiturerate of an award based on our historical pre-vesting award forfeitureexperience. For purposes of calculating pro forma information under SFAS No.123 for periods prior to fiscal year 2007, we accounted for pre-vestingforfeitures as they occurred.

Ourdetermination of the input variables used in the Black-Scholes option pricingmodel as well as the pre-vesting forfeiture rate is based on various underlyingestimates and assumptions that are highly subjective and are affected by ourstock price, among other factors. Changes in these underlying estimates andassumptions could materially affect the fair value of our share-based awardsand, therefore, the amount of share-based compensation expense to be recognizedin our results of operations.

Thefair value of stock options and ESPP purchase rights granted during the ninemonths ended December 31, 2006and

11

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2005 was estimatedat the date of grant using the Black-Scholes option pricing model with thefollowing weighted average assumptions:
| ** **                                        | ** ** | **Nine Months Ended  December 31. 2006** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Stock Options**                                                 | ** ** | **ESPP   Purchase   Rights** | ** ** |
| Expected  volatility                              |       | 60                                                                     | %          | 60 | % |
| Risk-free  interest rate                          |       | 4.9                                                                    | %          | 5.1 | % |
| Expected option  life in years                    |       | 5.0                                                                    |       | 0.5 |   |
| Expected  dividend yield                          |       | 0                                                                      | %          | 0 | % |
| Weighted average per  share grant date fair value |       | $                                                                      | 3.89       |   | $ | 2.18 |   |
|                                                   |            |                                                                        |            |  |  |  |  |

 
| ** **                                        | ** ** | **Nine Months Ended December 31,  2005** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Stock Options**                                       | ** ** | **ESPP   Purchase   Rights** | ** ** |
| Expected  volatility                              |       | 66                                                           | %          | 69 | % |
| Risk-free  interest rate                          |       | 4.1                                                          | %          | 3.7 | % |
| Expected option  life in years                    |       | 4.0                                                          |       | 0.5 |   |
| Expected  dividend yield                          |       | 0                                                            | %          | 0 | % |
| Weighted average per  share grant date fair value |       | $                                                            | 3.08       |   | $ | 1.23 |   |
|                                                   |            |                                                              |            |  |  |  |  |

 

Thefair value of RSUs and restricted stock awards is based on the market price ofour common stock on the date of grant.

*Share-BasedCompensation Expense*

The estimated fair value of our share-based awards isrecognized as a charge against income on a straight-line basis over therequisite service period, which is the shorter of the vesting period of theaward or the period until the participant becomes eligible for retirement. Theestimated fair value of share-based awards granted to retirement-eligibleparticipants is recognized as a charge against income immediately upon grant.Total share-based compensation expense recognized in our condensed consolidatedstatements of operations for the three and nine months ended December 31, 2006and 2005 was as follows:
| ** **                              | ** ** | **Three Months Ended December 31,** | ** ** | **Nine Months Ended December 31,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                                | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                    |       |                                                    |       |                                                   |       |   |   |   |   |
| Cost of revenue                         |       | $                                                       | 90         |                                                   | $          | 8 |   | $ | 245 |   | $ | 23 |   |
| Product  development                    |       | 236                                                     |       | 181                                                    |       | 977 |   | 544 |   |
| Sales and  marketing                    |       | 211                                                     |       | 17                                                     |       | 590 |   | 52 |   |
| General and  administrative             |       | 467                                                     |       | 2                                                      |       | 1,532 |   | 23 |   |
| Total share-based  compensation expense |       | $                                                       | 1,004      |                                                   | $          | 208 |   | $ | 3,344 |   | $ | 642 |   |

 

Share-basedcompensation expense recognized in the three and nine months ended December 31,2006 reflects our adoption of SFAS No. 123R effective April 1, 2006 using themodified prospective transition method. Share-based compensation expenserecognized in the three and nine months ended December 31, 2005 relates toshare-based awards granted in prior periods accounted for under the provisionsof APB No. 25. No share-based compensation expense was capitalized in theperiods presented. At December 31, 2006, the gross amount of unrecognizedshare-based compensation expense relating to unvested share-based awards wasapproximately $8.2 million, which we anticipate recognizing as a charge againstincome over a weighted average period of 1.43 years.

*ProForma Information Under SFAS No. 123 For Periods Prior to April 1, 2006*

Thefollowing table illustrates the effect on net loss and loss per share for thethree and nine months ended December 31, 2005 if we had applied the fair valuerecognition provisions of SFAS No. 123 to our employee stock awards. Forpurposes of the SFAS No. 123 pro forma disclosures, the estimated fair value ofemployee stock awards has been charged against income over the related vestingperiod of the award on a straight-line basis.

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| ** **                                                                                                      | ** ** | **Three Months  Ended  December 31, 2005**             | ** ** | **Nine Months  Ended  December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net loss, as  reported                                                                                          |       | $                                                                | (567       | )                                                        | $          | (1,312 | ) |
| Add: Stock-based  employee compensation expense included in net loss, as reported                               |       | 209                                                              |       | 643                                                      |       |
| Deduct:  Stock-based employee compensation expense determined under the fair value  based method for all awards |       | (996                                                             | )          | (4,290                                                   | )          |
| Pro forma net  loss                                                                                             |       | $                                                                | (1,354     | )                                                        | $          | (4,959 | ) |
| Net loss per  share:                                                                                            |       |                                                             |       |                                                     |       |
| Basic and  diluted - as reported                                                                                |       | $                                                                | (0.02      | )                                                        | $          | (0.05 | ) |
| Basic and diluted - pro  forma                                                                                  |       | $                                                                | (0.05      | )                                                        | $          | (0.19 | ) |

 

**4.****                       Comprehensive Income (Loss)**

Forthe three and nine months ended December 31, 2006 and 2005, comprehensiveincome (loss) consists of the following:
| ** **                                | ** ** | **Three Months Ended December 31,** | ** ** | **Nine Months Ended December 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                                | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(In thousands)**                                 | ** ** |
| Net loss                                  |       | $                                                       | (1,081     | )                                                      | $          | (567 | ) | $ | (475 | ) | $ | (1,312 | ) |
| Foreign currency  translation adjustment  |       | 61                                                      |       | (171                                                   | )          | 915 |   | (831 | ) |
| Unrealized gain  on marketable securities |       | 118                                                     |       | 21                                                     |       | 413 |   | 63 |   |
| Total comprehensive  income (loss)        |       | (902                                                    | )          | (717                                                   | )          | 853 |   | (2,080 | ) |
|                                           |            |                                                         |            |                                                        |            |  |  |  |  |  |  |  |  |

 

**5.****                       Segment Information**

Inaccordance with SFAS No. 131, *Disclosuresabout Segments of an Enterprise and Related Information*, ouroperations have been aggregated into one reportable segment given thesimilarities of economic characteristics between the operations and the commonnature of the products, services and customers.

**6.****                       Guarantees**

*Guaranteeof Lease Obligation of Others*

On April30, 2004, we spun-off our drug discovery subsidiary, Pharmacopeia DrugDiscovery, Inc. (“PDD”), into an independent, separately traded, publicly heldcompany through the distribution to our stockholders of a dividend of one shareof PDD common stock for every two shares of our common stock. In connectionwith this spin-off, the landlords of the New Jersey facilities which were usedby our PDD operations consented to the assignment of the leases to PDD. Despitethe assignment, the landlords required us to guarantee the remaining leaseobligations, which totaled approximately $23 million as of December 31, 2006.In accordance with FIN No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others,* we recognized a liability andcorresponding charge to stockholders’ equity for the probability-weighted fairmarket value of the guarantee. Changes to the fair market value of theliability are recognized in stockholders’ equity. At each of December 31, 2006and March 31, 2006, the liability for our guarantee of the lease obligation was$0.6 million.

*OtherGuarantees and Indemnifications*

Weprovide indemnifications of varying scope and size to certain customers againstclaims of intellectual property infringement made by third parties arising fromthe use of our products. We have also entered into indemnification agreementswith our officers and directors. Although the maximum potential amount offuture payments we could be required to make under these indemnifications isunlimited, to date we have not incurred material costs to defend lawsuits orsettle claims related to these indemnification provisions. Additionally, wehave insurance policies that, in most cases, would limit our exposure and enableus to recover a portion of any amounts paid. Therefore, we believe theestimated fair value of these agreements is minimal and likelihood of incurringan obligation is remote. Accordingly, we have not accrued any liabilities inconnection with these indemnification obligations as of December 31, 2006.

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**7.****                       Restructuring Activities**

Thefollowing summarizes the changes in our accrued restructuring chargesliability:
| ** **                    | ** ** | **Severance and Related Costs** | ** ** | **Lease  Obligation Exit  and Facility  Closure Costs** | ** ** | **Total** | ** ** |
|-------------------------------|------------|------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------|------------|
| ** **                    | ** ** | **(In thousands)**                        | ** ** |
| Balance at  December 31, 2002 |       | $                                              | 544        |                                                                   | $          | 1,731     |       | $ | 2,275 |   |
| Cash payments                 |       | (449                                           | )          | (281                                                                   | )          | (730      | )          |
| Liability adjustments         |       | (95                                            | )          | (289                                                                   | )          | (384      | )          |
| Balance at  December 31, 2003 |       | —                                         |       | 1,161                                                                  |       | 1,161     |       |
| Restructuring charges         |       | 2,813                                          |       | —                                                                 |       | 2,813     |       |
| Cash payments                 |       | (2,197                                         | )          | (65                                                                    | )          | (2,262    | )          |
| Balance at March  31, 2004    |       | 616                                            |       | 1,096                                                                  |       | 1,712     |       |
| Restructuring charges         |       | 1,358                                          |       | 3,956                                                                  |       | 5,314     |       |
| Cash payments                 |       | (907                                           | )          | (1,342                                                                 | )          | (2,249    | )          |
| Liability adjustments         |       | —                                         |       | (167                                                                   | )          | (167      | )          |
| Effect of foreign exchange    |       | —                                         |       | (17                                                                    | )          | (17       | )          |
| Balance at March  31, 2005    |       | 1,067                                          |       | 3,526                                                                  |       | 4,593     |       |
| Restructuring charges         |       | 1,766                                          |       | 1,412                                                                  |       | 3,178     |       |
| Cash payments                 |       | (1,745                                         | )          | (1,662                                                                 | )          | (3,407    | )          |
| Effect of foreign exchange    |       | (23                                            | )          | (67                                                                    | )          | (90       | )          |
| Balance at March  31, 2006    |       | 1,065                                          |       | 3,209                                                                  |       | 4,274     |       |
| Restructuring charges         |       | 397                                            |       | —                                                                 |       | 397       |       |
| Cash payments                 |       | (1,135                                         | )          | (1,678                                                                 | )          | (2,813    | )          |
| Liability adjustments         |       | —                                         |       | (101                                                                   | )          | (101      | )          |
| Effect of foreign exchange    |       | 85                                             |       | 297                                                                    |       | 382       |       |
| Balance at December 31,  2006 |       | $                                              | 412        |                                                                   | $          | 1,727     |       | $ | 2,139 |   |

 

Duringfiscal year 2002, we implemented various actions designed to improve ouroperations and overall financial performance through workforce reductions andthe abandonment of two leased facilities. As a result of the implementation ofthese actions, we recognized a charge of $4.3 million, consisting of $2.3million in severance benefits from the termination of 71 employees and $2.0million related to the abandonment of the two leased facilities. The severancebenefits were paid in full in fiscal year 2003. During fiscal year 2003, wenegotiated the termination of the operating lease for one of the abandonedleased facilities and finalized certain remaining severance obligations whichresulted in a $0.4 million reduction to the original $2.0 million liability.Additionally, during fiscal year 2005, we subleased the other abandoned leasedfacility which resulted in a $0.2 million reduction to the original $2.0million liability. Our lease obligation for this facility terminates in fiscalyear 2008.

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Duringfiscal year 2005, as a result of the relocation of our corporate headquarters,we recorded a lease abandonment charge of $3.6 million representing the futurelease obligations, net of estimated future sublease income. Our leaseobligation for this facility terminated in the third quarter of fiscal year2007.

Additionally,during fiscal year 2005, we implemented various actions designed to improve theefficiency of our sales department and eliminate duplicative general andadministrative personnel through workforce reductions and the abandonment of aleased facility in Germany. As a result of the implementation of these actions,we recognized a charge of $1.7 million, consisting of $1.4 million in severancebenefits from the termination of 42 employees and $0.3 million related  to the abandonment of the leased facility.The severance benefits were paid in full in fiscal year 2006. In the secondquarter of fiscal year 2007, we made a $0.1 million lease buy-out payment tothe landlord of the abandoned facility that terminates our obligations underthe lease. As a result of the termination of the lease, we reduced theremaining liability for the abandoned facility to a negligible amount.

In March 2006, we implemented various actions designedto realign our resources with our portfolio of products and services, eliminateredundancies in our workforce and streamline our operations through workforcereductions and abandoning a portion of a leased facility in the United Kingdom.As a result of the implementation of these actions, in March 2006, werecognized a charge of $3.2 million, consisting of $1.8 million in severancebenefits from the termination of approximately 50 employees and $1.4 millionfor our future lease obligations related to the abandoned facility, net ofestimated future sublease income. In fiscal year 2007, we recognized a chargeof $0.2 million for estimated additional severance benefits to be paid tocertain employees terminated under the original restructuring plan andassociated legal expenses. We anticipate completing the workforce reductionsand payment of severance benefits in fiscal year 2007. The lease obligation forthe abandoned facility terminates in fiscal year 2016.

In December 2006, we commenced the implementation of arestructuring plan pursuant to which we will be closing our research anddevelopment facility in Bangalore, India.  The restructuring plan wasundertaken as a result of the substantial completion of our productmodernization and integration efforts, and will result in the termination ofapproximately 60 research and development employees in Bangalore.  As aresult of the implementation of the restructuring plan, in the third quarter offiscal year 2007 we recognized a charge of $0.2 million for the postemploymentbenefits guaranteed to each affected employee under Indian labor law in accordancewith SFAS No. 112, *Employers’ Accounting forPostemployment Benefits*.  Weestimate that we will incur between $0.5 and $0.7 million in additionalrestructuring charges in the fourth quarter of fiscal year 2007, the majorityof which will be cash expenditures.  We anticipate these actions to besubstantially completed in the fourth quarter of fiscal year 2007.

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**Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

When used anywhere inthis Quarterly Report on Form 10-Q (this “Report”), the words “expect”, “believe”,“anticipate”, “estimate”, “intend”, “plan” and similar expressions are intendedto identify forward-looking statements. These forward-looking statements mayinclude statements addressing our future financial and operating results. Wehave based these forward-looking statements on our current expectations about futureevents. Such statements are subject to certain risks and uncertaintiesincluding those related to execution upon our strategic plans, the successfulrelease and**acceptance of newproducts, the demand for new and existing products, additional competition,changes in economic conditions and those described in documents we have filedwith the Securities and Exchange Commission, including this Report in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and “RiskFactors,” and in our subsequent reports on Form 10-Q and Form 10-K. Allforward-looking statements in this Report are qualified entirely by thecautionary statements included in this Report and such other filings. Theserisks and uncertainties could cause actual results to differ materially fromresults expressed or implied by forward-looking statements contained in thisReport. These forward-looking statements speak only as of the date of thisReport. We disclaim any undertaking to publicly update or revise anyforward-looking statements contained herein to reflect any change in ourexpectations with regard thereto or any change in events, conditions orcircumstances on which any such statement is based.

The following discussionand analysis of our financial condition and results of operations should beread in conjunction with our condensed consolidated financial statements andrelated notes thereto included elsewhere in this Report.

**Overview**

***Our Business***

We design, develop,market, and support software and related services that facilitate the discoveryand development of new and improved products and processes in thepharmaceutical, biotechnology, chemical, petrochemical and materialsindustries. Using our products, researchers may increase the speed and efficiencyof the research and development cycle, thereby reducing product developmentcosts and shortening the time to market for new product introductions andprocess improvements. Our customers include leading commercial, government andacademic organizations. Many of the largest pharmaceutical, biotechnology,chemical, and petroleum companies worldwide use our products. We market ourproducts and services worldwide, principally through our direct sales force,augmented by the use of third-party distributors.

***Our Marketplace***

Historically, we haveprimarily sold molecular modeling and simulation software. The market formolecular modeling and simulation products in the pharmaceutical andbiotechnology industries is challenging due to the maturity of the market, industryconsolidation, reduction in the level of discovery research activity, andincreased competition, including competition from open source software. We alsosell modeling and simulation products to the chemical, petrochemical andmaterials industries. We believe these industries are in the early stages ofadoption of these technologies. Thus we believe the market for our productswithin these industries is nascent and has experienced modest growth over thepast several years. On September 27, 2004, we acquired all of theoutstanding common shares of SciTegic, Inc., a leading provider ofworkflow software solutions for the scientific research market.  Following the acquisition of SciTegic, webegan to offer data-pipelining and workflow software. This technology is widelyapplicable within our target industries and represents a significant growthopportunity. There is currently limited competition to this technology in ourtargeted industries, and we are experiencing strong adoption rates within ourcustomer base.

***Our Strategy***

Our objective is tostrengthen our position as a leading provider of software-based scientificcomputation, analysis, informatics, knowledge management, workflow products andservices. We plan to accomplish our objective by providing a comprehensive setof integrated products and services that are central to the enterprise-wideresearch and development activities of our customers, and by connecting thesetools within an information technology framework. This framework makes iteasier for research and development organizations to manage data, information,knowledge, and collaborative processes.

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Our strategy for growthis to expand usage of our products and services by marketing and distributingour solutions to a broader group of users, including scientists, engineers andinformation technology professionals, within our existing customers, as well asto new customers in other industries.

A key enabler of thisstrategy is the data pipelining and workflow technology we acquired through ourSciTegic acquisition. We are utilizing this technology to enable our customersto build solutions which allow them to integrate scientific software andcontent from across the research and development spectrum. Selling solutions isfundamentally different than our traditional sale of stand-alone modeling andsimulation products. We are focused on enhancing our sales processes toemphasize solutions selling and strategic account management. We are alsoexpanding our professional services capabilities to enable our customers todeploy these solutions.

In addition to theactivities underway in our sales and service functions, we continue to focus onthe componentization of our entire suite of products on our Discovery Studioand Materials Studio platforms. In fiscal year 2007, we continue to migrate ourlife sciences applications to the Discovery Studio platform.

Finally, in addition toour focus on revenue growth, we continuously evaluate our personnelrequirements and cost structure. Over the past several years we havesignificantly reduced our operating costs through workforce reductions andother cost-savings measures. We will continue our focus on cost control, aswell as working capital management as we strive to improve our financialperformance.

**Critical Accounting Policies**

The critical accountingpolicies and estimates used in the preparation of our consolidated financialstatements are described in Item 6, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” of our Annual Report on Form10-K for the fiscal year ended March 31, 2006. There have been  no significant changes in our criticalaccounting policies and estimates from March 31, 2006, other than as describedbelow.

*Valuation of Share-Based Awards*

We adopted SFAS No. 123R,effective April 1, 2006, using the modified prospective transition method.Accordingly, beginning in the first quarter of fiscal year 2007, we arerecognizing as a charge against income the estimated grant date fair value ofshare-based awards granted to employees and directors. We estimate the fairvalue of our share-based stock awards on the date of grant using theBlack-Scholes option-pricing model. The Black-Scholes option-pricing modelrequires the use of certain input variables, as follows:

*ExpectedVolatility.* Volatility is a measure of the amount the stockprice will fluctuate during the expected life of an award. We determinevolatility based on our historical stock price volatility over the most recentperiod equivalent to the expected life of the award and the historical stockprice volatilities of comparable publicly traded companies, givingconsideration to company-specific events impacting historical volatility thatare unlikely to occur in the future as well as anticipated future events thatmay impact volatility.

*Risk-FreeInterest Rate.* Our assumption of the risk-free interest rateis based on the interest rates on U.S. constant rate treasury securities withcontractual terms approximately equal to the expected life of the award.

*ExpectedDividend Yield.* Because we have not paid any cash dividendssince our inception and do not anticipate paying dividends in the foreseeablefuture, we assume a dividend yield of zero.

*ExpectedAward Life.* We determine the expected life of an award by consideringvarious relevant factors, including the vesting period and contractual term ofthe award, our employees’ historical exercise patterns and length of service,the expected future volatility of our stock price, tax implications ofexercising an award and employee characteristics. We also consider the expectedaward lives of comparable publicly traded companies. For ESPP purchase rights,the expected life is equal to the current ESPP offering period.

Under SFAS No. 123R, weare also required to estimate at grant the likelihood that the award willultimately vest (the “pre-vesting forfeiture rate”) revise the estimate, ifnecessary, in future periods if the actual forfeiture rate differs. Wedetermine the pre-vesting forfeiture rate of an award based on our historicalpre-vesting award forfeiture experience.

Our determination of theinput variables used in the Black-Scholes option pricing model as well as thepre-vesting

17

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forfeiture rate is based on various underlyingestimates and assumptions that are highly subjective and are affected by ourstock price, among other factors. Changes in these underlying estimates andassumptions could materially affect the fair value of our share-based awardsand, therefore, the amount of share-based compensation expense to be recognizedin our results of operations.

**Results of Operations**

Historically, we havereceived approximately two-thirds of our annual customer orders in the secondhalf of our fiscal year. In accordance with our revenue recognition policies,the revenue associated with these orders is generally recognized over thecontractual license term. Therefore, because we accrue sales commissions androyalties upon the invoicing of customer orders, we have historicallyexperienced an increase in operating costs and expenses during the second halfof our fiscal year with only a minimal corresponding incremental increase inrevenue. As a result of these seasonal variations, we believe thatquarter-to-quarter comparisons of our operating results are not a good indicationof our future performance and that the interim financial results for theperiods presented in this Report are not necessarily indicative of results fora full year or for any subsequent interim period.

**Comparison of the Three Months Ended December 31, 2006 and2005**

The following tablesummarizes our results of operations as a percentage of revenue for therespective periods:

| ** **                          | ** ** | **Three Months Ended December 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| ** **                          | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                                                | %          | 100 | % |
| Operating costs  and expenses:      |       |                                               |       |   |   |
| Cost of revenue                     |       | 22                                                 | %          | 21 | % |
| Product development                 |       | 23                                                 | %          | 24 | % |
| Sales and marketing                 |       | 42                                                 | %          | 43 | % |
| General and administrative          |       | 20                                                 | %          | 18 | % |
| Restructuring charges               |       | 1                                                  | %          | 0 | % |
| Total operating  costs and expenses |       | 107                                                | %          | 106 | % |
| Operating loss                      |       | (7                                                 | )%         | (6 | )% |
| Interest and  other income, net     |       | 3                                                  | %          | 3 | % |
| Loss before  income taxes           |       | (4                                                 | )%         | (3 | )% |
| Income tax  expense                 |       | 1                                                  | %          | 0 | % |
| Net loss                            |       | (5                                                 | )%         | (3 | )% |

 

***Revenue***

Revenue increased  1% to $20.7 million for the three monthsended December 31, 2006, as compared to $20.4 million for the three monthsended December 31, 2005. The increase in revenue was primarily attributable tocontinued growth in our scientific operating platform product line, offset byreduced sales of certain legacy products that were deemphasized in connectionwith our restructuring and product line adjustments that have occurred over thepast two fiscal years.

***Operating Costs and Expenses***

*Cost of Revenue.*Cost of revenue increased 4% to $4.5million for the three months ended December 31, 2006, as compared to $4.4million for the three months ended December 31, 2005. As a percentage ofrevenue, cost of revenue increased to 22% for the three months ended December31, 2006, as compared to 21% for the three months ended December 31, 2005.  The increase in cost of revenue was primarily attributable to higher royalties due tothe mix of products sold and a $0.1 million increase in share-basedcompensation expense resulting from our adoption of SFAS No. 123R.

*Product DevelopmentExpenses.*Productdevelopment expenses decreased 5% to $4.7 million for the threemonths ended December 31, 2006, as compared to $5.0 million for the threemonths ended December 31, 2005. As a percentage of revenue, product developmentdecreased to 23% for the three months ended December 31, 2006, as compared to 24%for the three months ended December 31, 2005. The decrease in productdevelopment expenses was primarily attributable to lower personnel expenses resulting from headcount reductions duringfiscal year 2006, offset by a $0.1 million increase in share-based compensationexpense resulting from our adoption of SFAS No. 123R.

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*Sales and MarketingExpenses.*Sales andmarketing expenses decreased 1% to $8.6 million for the threemonths ended December 31, 2006, as compared to $8.7 million for the threemonths ended December 31, 2005. As a percentage of revenue, sales and marketingexpenses decreased to 42% for the three months ended December 31, 2006, ascompared to 43% for the three months ended December 31, 2005. The decrease in sales and marketing expenses wasprimarily attributable to lower personnel and other sales-related expensesresulting from headcount reductions during fiscal year 2006, offset by a$0.2 million increase in share-based compensation expense resulting from ouradoption of SFAS No. 123R.

*General and AdministrativeExpenses.*General andadministrative expenses increased 13% to $4.1 million for the threemonths ended December 31, 2006, as compared to $3.6 million for the threemonths ended December 31, 2005. As a percentage of revenue, general and administrativeexpenses increased to 20% for the three months ended December 31, 2006, ascompared to 18% for the three months ended December 31, 2005. The increase ingeneral and administrative costs was primarily attributable to a $0.5 millionincrease in share-based compensation expense resulting from our adoption ofSFAS No. 123R and a $0.2 million incentive compensation accrual reversal in thethird quarter of fiscal year 2006, offset by $0.2 million of outside consultingand accounting fees which were incurred during the third quarter of fiscal year2006 in relation to the restatement of our previously issued consolidatedfinancial statements.

*Restructuring charges.*We incurred restructuring charges of$0.2 million for the three months ended December 31, 2006 primarilyresulting from the closure of our research and development facility inBangalore, India and the related termination of approximately 60 employees.

***Net Interest and OtherIncome***

Net interest and otherincome was $0.6 million for the three months ended December 31,2006, as compared to $0.5 million for the three months ended December 31, 2005.The increase in net interest and other income was primarily attributableto  higher cash and marketable securitiesbalances during the three months ended December 31, 2006, offset by unfavorablefluctuations in the value of the U.S. dollar.

***Income Tax Expense***

We recognized income taxexpense of $0.2 million for the three months ended December 31, 2006, ascompared to an income tax benefit of $0.1 million for the three months endedDecember 31, 2005. The increase in income tax expense was primarilyattributable to the increase in the deferred tax liability associated with taxdeductible goodwill and indefinite-lived intangible assets recognized in thethree months ended December 31, 2006.

**Comparison of the Nine Months Ended December 31,2006 and 2005**

The following table summarizes our results ofoperations as a percentage of revenue for the respective periods:

| ** **                          | ** ** | **Nine Months Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| ** **                          | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                                                    | %          | 100 | % |
| Operating costs  and expenses:      |       |                                                   |       |   |   |
| Cost of revenue                     |       | 20                                                     | %          | 20 | % |
| Product development                 |       | 24                                                     | %          | 26 | % |
| Sales and marketing                 |       | 36                                                     | %          | 39 | % |
| General and administrative          |       | 22                                                     | %          | 18 | % |
| Restructuring charges (recoveries)  |       | 0                                                      | %          | (0 | )% |
| Total operating  costs and expenses |       | 102                                                    | %          | 104 | % |
| Operating loss                      |       | (2                                                     | )%         | (4 | )% |
| Interest and  other income, net     |       | 2                                                      | %          | 3 | % |
| Income (loss)  before income taxes  |       | 1                                                      | %          | (1 | )% |
| Income tax  expense                 |       | 1                                                      | %          | 1 | % |
| Net loss                            |       | (1                                                     | )%         | (2 | )% |

 

***Revenue***

Revenue decreased 2%to $61.1 million for the nine months ended December 31, 2006, as compared to$62.6 million for the nine months ended December 31, 2005. The decrease inrevenue was primarily attributable to a decrease in revenues from certainproducts that were de-emphasized in connection with our restructuring andproduct line adjustments that have occurred over the past two fiscal years.

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***Operating Costs and Expenses***

*Cost of Revenue.*Costof revenue decreased 3% to $12.2 million for the nine months ended December 31,2006, as compared to $12.7 million for the nine months ended December 31, 2005.As a percentage of revenue, cost of revenue was consistent at 20% for each ofthe nine months ended December 31, 2006 and 2005. The decrease in cost ofrevenue was primarily attributable to lower distribution costs, offset by a$0.2 million increase in share-based compensation expense resulting from ouradoption of SFAS No. 123R.

*Product Development Expenses.*Productdevelopment expenses decreased 10% to $14.7 million for the nine monthsended December 31, 2006, as compared to $16.4 million for the nine monthsended December 31, 2005. As a percentage of revenue, product developmentdecreased to 24% for the nine months ended December 31, 2006, as compared to26% for the nine months ended December 31, 2005. The decrease in productdevelopment expenses was primarily attributable to lower personnel expensesresulting from headcount reductions during fiscal year 2006, offset by a $0.4million increase in share-based compensation expense resulting from ouradoption of SFAS No. 123R.

*Sales and Marketing Expenses.*Salesand marketing expenses decreased 12% to $21.7 million for the nine monthsended December 31, 2006, as compared to $24.6 million for the nine monthsended December 31, 2005. As a percentage of revenue, sales and marketingexpenses decreased to 36% for the nine months ended December 31, 2006, ascompared to 39% for the nine months ended December 31, 2005. The decrease insales and marketing expenses was primarily attributable to lower personnel andother sales-related expenses resulting from headcount reductions during fiscalyear 2006, offset by a $0.5 million increase in share-based compensationexpense resulting from our adoption of SFAS No. 123R.

*General and Administrative Expenses.*General and administrative expenses increased 17% to$13.2 million for the nine months ended December 31, 2006, as compared to$11.3 million for the nine months ended December 31, 2005. As a percentageof revenue, general and administrative expenses increased to 22% for the ninemonths ended December 31, 2006, as compared to 18% for the nine months endedDecember 31, 2005. The increase in general and administrative costs wasprimarily attributable to a $1.5 million increase in share-based compensationexpense resulting from our adoption of SFAS No. 123R and a $0.3 millionincrease in outside consulting and accounting fees related to the restatementof our previously issued consolidated financial statements.

*Restructuring charges.*We incurred restructuring charges of$0.2 million for the nine months ended December 31, 2006 primarilyresulting from the closure of our research and development facility inBangalore, India and the related termination of approximately 60 employees.

***Net Interest and Other Income***

Net interest and other income was $1.4 millionfor the nine months ended December 31, 2006, as compared to $1.6 million forthe nine months ended December 31, 2005. The decrease in net interest and otherincome was primarily attributable to unfavorable fluctuations in the value ofthe U.S. dollar, offset by higher cash and marketable securities balancesduring the nine months ended December 31, 2006.

***Income Tax Expense***

We recognized income tax expense of $0.9 million forthe nine months ended December 31, 2006, as compared to $0.6 million for thenine months ended December 31, 2005.  Theincrease in income tax expense was primarily attributable to the increase inthe deferred tax liability associated with tax deductible goodwill andindefinite-lived intangible assets recognized in the nine months ended December31, 2006.

**Liquidityand Capital Resources**

We had cash, cash equivalents, restricted cash andmarketable securities of $60.0 million as of December 31, 2006, as compared to$66.0 million as of March 31, 2006, a decrease of $6.0 million. The decrease incash, cash equivalents, restricted cash and marketable securities during thenine months ended December 31, 2006 was primarily attributable to cash used inoperations of $9.9 million, offset by a $1.7 million favorable effect on cashand cash equivalents of changes in foreign currency rates, $1.2 million inproceeds from the issuance of our common stock under employee stock plans, andan increase in restricted cash of $1.5 million resulting from the receipt of asubtenant security deposit. Our operating cash flows on a

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quarterly basis are significantly impacted by changesin accounts receivable balances. Due to the seasonality of our business,accounts receivable balances have historically increased significantly in thethird quarter of each fiscal year as a result of higher order intake. Thecollection of these accounts receivable balances has historically resulted inpositive cash flows from operations in the fourth quarter of each fiscal year,while we have historically experienced negative cash flows from operations inthe other three fiscal quarters.

Net cash used in operating activities was $9.9 millionfor the nine months ended December 31, 2006, as compared to $10.6 million forthe nine months ended December 31, 2005. The decrease in cash used in operatingactivities was primarily attributable to reduced operating expenditures.

Netcash used in investing activities was $1.0 million for the nine months endedDecember 31, 2006, as compared to net cash provided by investing activities of$5.2 million for the nine months ended December 31, 2005. Significantcomponents of cash flows from investing activities for the nine months endedDecember 31, 2006 included net purchases of property and equipment of $0.8million and a net increase in our marketable securities portfolio of $0.2million. Significant components of cash flows from investing activities for thenine months ended December 31, 2005 included $2.6 million of net purchases ofproperty and equipment and a net decrease in our marketable securitiesportfolio of $7.7 million.

Netcash provided by financing activities was $1.2 million for the nine monthsended December 31, 2006, compared to $0.9 million for the nine months endedDecember 31, 2005. Cash flows from financing activities for the nine monthsended December 31, 2006 and 2005 consisted solely of proceeds from the issuanceof our common stock under employee stock plans.

In December 2006, we commenced the implementation of arestructuring plan pursuant to which we will be closing our research anddevelopment facility in Bangalore, India.  The restructuring plan wasundertaken as a result of the substantial completion of our productmodernization and integration efforts, and will result in the termination of approximately60 research and development employees in Bangalore.  As a result of theimplementation of the restructuring plan, in the third quarter of fiscal year2007 we recognized a charge of $0.2 million for the postemployment benefitsguaranteed to each affected employee under Indian labor law in accordance withSFAS No. 112, *Employers’ Accounting for PostemploymentBenefits*.  We estimate that wewill incur between $0.5 and $0.7 million in additional restructuring charges inthe fourth quarter of fiscal year 2007, the majority of which will be cashexpenditures.  We anticipate these actions to be substantially completedin the fourth quarter of fiscal year 2007.  While we anticipate near term savings inresearch and development expenses as a result of the closure of the Bangalorefacility, we may reinvest such savings in other research and developmentopportunities in fiscal year 2008.

Wehave funded our activities to date primarily through the sales of softwarelicenses and related services and the issuance of equity securities.

Weanticipate that our capital requirements may increase in future periods as aresult of seasonal sales trends, additional product development activities, andthe acquisition of additional equipment. Our capital requirements may alsoincrease in future periods as we seek to expand our technology platform throughinvestments, licensing arrangements, technology alliances, or acquisitions.

Weanticipate that our existing capital resources will be adequate to fund ouroperations for at least the next 12 months. However, there can be no assurancethat changes will not occur that would consume available capital resourcesbefore then. Our capital requirements depend on numerous factors, including ourability to continue to generate software sales, the purchase of additionalcapital equipment and acquisitions of other businesses or technologies. Therecan be no assurance that additional funding, if necessary, will be available tous on favorable terms, if at all. Our forecast for the period of time throughwhich our financial resources will be adequate to support our operations isforward looking information, and actual results could vary.

**Item 3. Quantitative and Qualitative Disclosures About MarketRisk**

The information called for by this item is provided inItem 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of ourAnnual Report on Form 10-K for the fiscal year ended March 31, 2006. Ourexposures to market risk have not changed materially since March 31, 2006.

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**Item 4. Controls and Procedures**

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

Wemaintain disclosure controls and procedures, as such term is defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended(the “Exchange Act”), that are designed to provide reasonable assurance thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC rules and forms, and that suchinformation is accumulated and communicated to our management, including ourprincipal executive officer and principal financial officer, as appropriate, toallow timely decisions regarding required financial disclosures. Because ofinherent limitations, our  disclosurecontrols and procedures, no matter how well designed and operated, can provideonly reasonable, and not absolute, assurance that the objectives of suchdisclosure controls and procedures are met.

Asmore fully described in Item 9A of our Annual Report on Form 10-K forthe year ended March 31, 2006, we reported that our management identifiedcertain control deficiencies that represent material weaknesses in our internalcontrol over financial reporting. The material weaknesses identified bymanagement related to the application of software revenue recognitionprinciples to our term-based and perpetual software license arrangements andthe application of SFAS No. 86 to our software development projects. As aresult of the identification of these material weaknesses, our principalexecutive officer and principal financial officer concluded that as of March31, 2006, our disclosure controls and procedures were not effective pursuant toExchange Act Rules 13a-15(f) and 15d-15(f).

As ofthe end of the period covered by this Report, we conducted an evaluation, underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based onthis evaluation, our principal executive officer and principal financialofficer concluded that, although the remediation actions set forth below hadbeen initiated as of December 31, 2006, these remediation actions had not beenin operation for a sufficient period of time and had not yet been tested.Therefore, the identified material weaknesses in our internal control overfinancial reporting had not been fully remediated and, as a result, ourdisclosure controls and procedures were not considered to be effective as ofDecember 31, 2006. Notwithstanding the material weaknesses described above,management believes that the consolidated financial statements included in thisReport fairly present in all material respects our financial condition, resultsof operations and cash flows for the periods presented.

**Changesin Internal Control Over Financial Reporting**

Infiscal year 2007, in order to remediate the identified material weaknesses inour internal control over financial reporting, we initiated the followingremediation actions:

| (1)    |   | We hired three senior-level accounting employees in  March and April 2006 who have significant expertise in financial controls and  the application of generally accepted accounting principles relevant to our  business, including software revenue recognition.                                                         |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                       |
| (2)    |   | We designed a program of additional training  regarding our revenue recognition policies intended to ensure all relevant  personnel involved in software revenue recognition transactions understand  and apply applicable generally accepted accounting principles, and have set  an annual minimum training requirement. |
|   |   |                                                                                                                                                                                                                                                                                                                       |
| (3)    |   | We implemented an enhanced quarterly financial  statement close, review and reporting process to include additional levels of  analysis and review.                                                                                                                                                                        |

 

Notwithstandingthe initiation of these remediation actions, the identified material weaknessesin our internal control over financial reporting will not be consideredremediated until the new controls are fully implemented, in operation for asufficient period of time, are tested and our management concludes that the newcontrols are operating effectively.

Exceptas described above, there were no changes in our internal control overfinancial reporting during the three months ended December 31, 2006 thatmaterially affected, or are reasonably likely to materially affect, thosecontrols.

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**PART II— OTHER INFORMATION**

**Item 1A. Risk Factors**

*You should carefully consider the risks described belowbefore investing in our publicly-traded securities. The risks described beloware not the only ones facing us. Our business is also subject to the risks thataffect many other companies, such as competition, technological obsolescence,labor relations, general economic conditions, geopolitical changes andinternational operations. Additional risks not currently known to us or that wecurrently believe are immaterial also may impair our business operations andour liquidity. The risks described below could cause our actual results todiffer materially from those contained in forward-looking statements we havemade in this Report, the information incorporated herein by reference and thosewe may make from time to time.*

**CertainRisks Related to Our Marketplace and Environment**

***Our revenue from the sale of modeling,simulation and informatics software to the life science discovery researchmarketplace, which has historically constituted a significant portion of ouroverall revenue, has been declining over the past several years and maycontinue to decline in future years.***Historically we havederived a significant portion of our revenue from the sale of modeling,simulation and informatics software to the discovery research departments inpharmaceutical and biotechnology companies. Such revenues have been decliningover the past several years. We believe this decline is due to several factors,including industry consolidation, a general reduction in the level of discoveryresearch activity by our customers, increased competition, includingcompetition from open source software, and reductions in profit and relatedinformation technology spending by our customers, due in part to the expirationof patents on profitable drugs. If such declines continue and we do notincrease the revenue we derive from our other product and service offerings,our business could be adversely impacted.

***Our ability to sustain or increase revenueswill depend upon our success in developing, marketing and selling software andservice solutions to both our existing customers and to new customers.***Our strategy involves transforming our product and service offerings byproviding tools and components to our customers which allow our customers tointegrate software applications and data more easily. A key enabler of thisstrategy is the data pipelining and workflow technology we acquired through theSeptember 2004 acquisition of SciTegic, Inc. We are utilizing SciTegic’sPipeline Pilot technology to enable our customers to build solutions whichallow them to receive greater value from their data, information and knowledge.Selling this type of solution is fundamentally different than our historicalsale of modeling and simulation products, and this type of offering isdependant upon our ability to build a successful services offering. Our salesand services management are focused on transforming our sales process to allowus to be successful with this type of sale. In addition, we are addingpersonnel and defining services offerings to enable our customers tosuccessfully deploy these solutions. There can be no assurance that we will besuccessful in this transformation of our sales processes and in the building ofour services capabilities. If we are not successful, our ability to sustain orincrease revenue may be adversely impacted.

***Our ability to sustain or increase revenueswill depend upon our success in entering new markets and in deriving additionalrevenues from our existing customers.***Our products arecurrently used primarily by molecular modeling and simulation specialists indiscovery research organizations. Our strategy is to expand usage of ourproducts and services by marketing and distributing our software to a broader,more diversified group of biologists, chemists, engineers and informaticianswithin our existing pharmaceutical and biotechnology customers, as well as tonew customers in other industries. However, our products and services may notachieve market acceptance or penetration in targeted new departments within ourcustomers or in new industries. As a result, we may not be able to sustain orincrease revenue.

***We may be unable to develop strategicrelationships with our customers.***Our strategy is toexpand usage of our products and services by marketing and distributingsolutions to a broader, more diversified group of biologists, chemists,engineers and informaticians throughout our customers’ research and developmentorganizations. A key component of our business strategy is to become apreferred provider of scientific software and solutions. Becoming a preferredvendor will require substantial re-training and new skills development withinour sales and service personnel and deployment of a successfulaccount-management sales model. We believe that developing strategicrelationships with our customers may lead to additional revenue opportunities.However, there can be no assurance that any such relationships will develop orthat such relationships will produce additional revenue or profitopportunities.

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***Consolidation within the pharmaceutical andbiotechnology industries may continue to lead to fewer potential customers forour products and services.***A significant portion of ourcustomer base consists of pharmaceutical and biotechnology companies. Continuedconsolidation within the pharmaceutical and biotechnology industries may resultin fewer customers for our products and services. If one of the parties to aconsolidation uses the products or services of our competitors, we may loseexisting customers as a result of such consolidation.

***Health care reform and restrictions onreimbursement may affect the ability of pharmaceutical, biotechnology andindustrial chemical companies to purchase or license our products or services,which may affect our results of operations and financial condition.***Thecontinuing efforts of government and third-party payers in the markets we serveto contain or reduce the cost of health care may reduce the profitability ofpharmaceutical, biotechnology and industrial chemical companies causing them toreduce research and development expenditures. Because our products and servicesdepend on such research and development expenditures, our revenues may be significantlyreduced. We cannot predict what actions federal, state or private payers forhealth care goods and services may take in response to any health care reformproposals or legislation.

***We face strong competition in thescientific software sector*.** The market for our productsis competitive. We currently face competition from other scientific softwareproviders, larger technology and solutions companies, in-house development byour customers, as well as academic and government institutions and the opensource community.

Someof our competitors and potential competitors in this sector have longeroperating histories than us and have greater financial, technical, marketing,research and development and other resources. Many of our competitors offer productsand services directed at more specific markets than those we target, enablingthese competitors to focus a greater proportion of their efforts and resourceson these markets. Some offerings that compete with our products are developedand made available at lower cost by government 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. We also face competition from open source software initiatives, inwhich developers provide software and intellectual property free over theInternet. In addition, many of our customers spend significant internalresources in order to develop their own software.

Therecan be no assurance that our current or potential competitors will not developproducts, services or technologies that are comparable to, superior to, orrender obsolete, the products, services and technologies we offer. There can beno assurance that our competitors will not adapt more quickly than us totechnological advances and customer demands, thereby increasing suchcompetitors’ market share relative to ours. Any material decrease in demand forour technologies or services may have a material adverse effect on our business,financial condition and results of operations.

***We are subject to pricing pressures in themarkets we serve.***We operate in a competitive marketplacewhich has led to significant pricing pressure and declines in average sellingprice over the past several years. In response to competition and generaladverse economic conditions in the markets we serve, we may be required tomodify our pricing practices. Changes in our pricing model could lead to adecline or delay in revenue as our sales force and customers adjust to the newpricing policies. This development may adversely affect our revenue andearnings.

***Our operations may be interrupted by theoccurrence of a natural disaster or other catastrophic event at our primaryfacilities.***Our research and development operations andadministrative functions are primarily conducted at our facilities in SanDiego, California, and Cambridge, United Kingdom. We also conduct sales andcustomer support activities at our facilities in Burlington, Massachusetts,Paris, France, and Tokyo, Japan. Although we have contingency plans in effectfor natural disasters or other catastrophic events, catastrophic events couldstill disrupt our operations. For example, our San Diego and Tokyo facilitiesare located in areas that are particularly susceptible to earthquakes. Anynatural disaster or catastrophic event in our facilities or the areas in whichthey are located could have a significant negative impact on our operations.

***Our insurance coverage may not besufficient to avoid material impact on our financial position or results ofoperations resulting from claims or liabilities against us, and we may not beable to obtain insurance coverage in the future.***Wemaintain insurance coverage for protection against many risks of liability. Theextent of our insurance coverage is under continuous review and is modified aswe deem it necessary. Despite this insurance, it is possible that claims orliabilities against us may have a material adverse impact on our financialposition or results of operations. In addition, we may not be able to obtainany insurance coverage, or adequate insurance coverage, when our existinginsurance coverage expires. For example, we do not carry earthquake insurancefor our facilities in Tokyo, Japan or San Diego, California, because we wereunable to obtain such insurance on commercially reasonable terms.

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**CertainRisks Related to Our Operations**

***Defects or malfunctions in our productscould hurt our reputation among our customers, result in delayed or lost revenueand expose us to liability.***Our business and the level ofcustomer acceptance of our products depend upon the continuous, effective andreliable operation of our software and related tools and functions. To theextent that defects cause our software to malfunction and our customers’ use ofour products is interrupted, our reputation could suffer and our revenue coulddecline or be delayed while such defects are remedied. We may also be subjectto liability for the defects and malfunctions of third-party technologypartners and others with whom our products and services are integrated.

***Delays in the release of new or enhancedproducts or services or undetected errors in our products or services mayresult in increased cost to us, delayed market acceptance of our products anddelayed or lost revenue.***To achieve market acceptance,new or enhanced products or services can require long development and testingperiods, which may result in delays in scheduled introduction. Any delays inthe release schedule for new or enhanced products or services may delay marketacceptance of these products or services and may result in delays in newcustomer orders for these new or enhanced products or services or the loss ofcustomer orders. In addition, new or enhanced products or services may containa number of undetected errors or “bugs” when they are first released. Althoughwe test each new or enhanced software product or service before being releasedto the market, there can be no assurance that significant errors will not befound in existing or future releases. As a result, in the months following theintroduction of certain releases, we may need to devote significant resourcesto correct these errors. There can be no assurance, however, that all of theseerrors can be corrected.

***We are subject to risks associated with theoperation of a global business.*****Our non-U.S. operations are subject to risks inherent inthe conduct of international business, including:

·               unexpectedchanges in regulatory requirements;

·               longerpayment cycles;

·               currencyexchange rate fluctuations;

·               importand export license requirements;

·               tariffsand other barriers;

·               politicalunrest, terrorism and economic instability;

·               disruptionof our operations due to local labor conditions;

·               limitedintellectual property protection;

·               difficultiesin collecting trade receivables;

·               difficultiesin managing distributors or representatives;

·               difficultiesin managing an organization spread over various countries;

·               difficultiesin staffing foreign subsidiary or joint venture operations; and

·               potentiallyadverse tax consequences.

Oursuccess depends, in part, on our ability to anticipate and address these risks.There can be no assurance that we will do so effectively or that these or otherfactors relating to our international operations will not adversely affect ourbusiness or operating results.

***In order to improve our financial position,we have reduced our headcount, which could negatively impact our business.***Wehave undergone several reductions-in-force over the past few years, and ourworkforce has declined. While we believe we have sufficient staff to operateour business, we do not have duplicative or redundant resources in many of ourfunctions or operations. As a result, there can be no assurance that furtherattrition will not impact our ability to operate our business, or adverselyimpact our revenues.

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***Failure to attract and retain skilledpersonnel, including the personnel necessary to address the identified materialweaknesses in our internal control over financial reporting, could have amaterial adverse effect on us.*** Our success depends inpart on the continued service of key scientific, sales, business development,marketing, engineering, management and accounting personnel and our ability toidentify, hire and retain additional personnel. There is intense competitionfor qualified personnel. Immigration laws may further restrict our ability toattract or hire qualified personnel. We may not be able to continue to attractand retain the personnel necessary for the development of our business. Failureto attract and retain key personnel could have a material adverse effect on ourbusiness, financial condition and results of operations. Further, we are highlydependent on the principal members of our technical, scientific and managementstaff. One or more of these key employees could retire or otherwise leave ouremploy within the foreseeable future, and the loss of any of these people couldhave a material adverse effect on our business, financial condition and resultsof operations. We do not intend to maintain key person life insurance on thelife of any employee.

Inaddition to the foregoing, as described in greater detail elsewhere in thisReport and in our Annual Report on Form 10-K for the fiscal year ended March31, 2006, we concluded that our internal control over financial reporting wasnot effective as of March 31, 2006. In particular, in connection with therestatement of our previously issued financial statements, management identifiedcertain control deficiencies that represented material weaknesses in ourinternal control over financial reporting. These material weaknesses, whichprincipally arose due to our lack of a sufficient number of employees with anappropriate level of accounting knowledge, experience and training in theapplication of generally accepted accounting principles relevant to ourbusiness, were at least partially responsible for our need to restate ourpreviously issued consolidated financial statements. In order to remediate theidentified material weaknesses in our internal control over financialreporting, we implemented certain actions, including the hiring of threesenior-level accounting employees in March and April 2006 who have significantexpertise in financial controls and the application of generally acceptedaccounting principles relevant to our business, including software revenuerecognition. However, one or more of these qualified recruits or existingpersonnel could leave our employ within the foreseeable future. If not timelyand adequately addressed, the loss of any of these individuals could impair ourability to maintain effective internal control over financial reporting andthereby cause a material adverse effect on our business.

***If we choose to acquire businesses,products or technologies instead of developing them ourselves, we may be unableto complete these acquisitions or to successfully integrate an acquiredbusiness or technology in a cost-effective and non-disruptive manner.***Fromtime to time, we may choose to acquire businesses, products or technologiesinstead of developing them ourselves. We do not know if we will be able tocomplete any acquisitions, or whether we will be able to successfully integrateany acquired businesses, operate them profitably or retain their key employees.Integrating any business, product or technology we acquire could be expensiveand time-consuming, disrupt our ongoing business and distract companymanagement. In addition, in order to finance any acquisition, we might need toraise additional funds through public or private equity or debt financings. Inthat event, we could be forced to obtain financing on less than favorable termsand, in the case of equity financing that may result in dilution to ourstockholders. If we are unable to integrate any acquired entities, products ortechnologies effectively, 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.

**CertainRisks Related To Our Financial Performance**

***We have a history of losses and our futureprofitability is uncertain.*****We generated net losses for the nine months ended December31, 2006 and for the years ended March 31, 2006 and 2005 and December 31, 2003,and the three months ended March 31, 2004. Continuing net losses may limit ourability to fund our operations and we may not generate income from operationsin the future. Our future profitability depends upon many factors, includingseveral that are beyond our control. These factors include without limitation:

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·     changesin the demand for our products and services;

·               theintroduction of competitive software;

·               ourability to license desirable technologies;

·               changesin the research and development budgets of our customers and potentialcustomers; and

·               ourability to successfully, cost effectively and timely develop, introduce andmarket new products, services and product enhancements.

***Our sales forecast and/or revenue projectionsmay not be accurate.***We use a “pipeline” system, a commonindustry practice, to forecast sales and trends in our business. Our salespersonnel monitor the status of proposals, including the date when theyestimate a customer will make a purchase decision and the potential size of theorder. We aggregate these estimates on a quarterly basis in order to generate asales pipeline. While the pipeline process provides us with some guidance inbusiness planning and forecasting, it is based on estimates only and istherefore subject to risks and uncertainties. Any variation in the conversionof the pipeline into revenue or the pipeline itself could cause us toimproperly plan or budget and thereby adversely affect our business, results ofoperations and financial condition.

***If we are unable to license software to, or collectreceivables from our customers our operating results may be adversely affected.***The majority of our current customers arewell-established, large pharmaceutical customers and universities, and othercustomers include smaller biotechnology companies. We have not experiencedsignificant customer defaults during the past three fiscal years and haverecorded a provision for bad debts of less than $0.5 million in each of thoseperiods. Our financial success depends upon the creditworthiness and ultimatecollection of amounts due from our customers. If we are not able to collectfrom our customers, we may be required to write-off significant accountsreceivable and recognize bad debt expenses which could materially and adverselyaffect our operating results.

***Our quarterly operating results, particularly our quarterlycash flows, will fluctuate.***Quarterly operating resultsmay fluctuate as a result of a number of factors including lengthy sales cycles,market acceptance of new products and upgrades, timing of new productintroductions, changes in pricing policies, changes in general economic andcompetitive conditions, and the timing and integration of acquisitions. We mayalso experience fluctuations in quarterly operating results due to general andindustry specific economic conditions that may affect the research anddevelopment expenditures of pharmaceutical and biotechnology companies. Inparticular, historically we have received approximately two-thirds of ourannual customer orders in the second half of our fiscal year. In accordancewith our revenue recognition policies, the revenue associated with these ordersis generally recognized over the contractual license term. Therefore, becausewe accrue sales commissions and royalties upon the receipt of customer orders,we generally experience an increase in operating costs and expenses during thesecond half of our fiscal year with only a minimal corresponding incrementalincrease in revenue. Additionally, our cash flows from operations havehistorically been positive in the fiscal quarter ended March 31 as we collectthe accounts receivable generated from these customer orders, while we havehistorically experienced negative cash flows from operations in the other threefiscal quarters. As a result of these seasonal variations, we believe thatquarter-to-quarter comparisons of our operating results are not a goodindication of our future performance and that the interim financial results forthe periods presented in this Report are not necessarily indicative of resultsfor a full year or for any subsequent interim period.

***Changes in the accounting treatment of employee stock-basedcompensation has and will continue to adversely affect our results ofoperations.*****InDecember 2004, the FASB issued SFAS No. 123R, which revises SFAS No. 123, *Accounting for Stock-Based Compensation*.SFAS No. 123R requires that employee stock-based compensation is measured basedon the grant-date fair value of the related employee equity award and istreated as an expense that is reflected in the financial statements over therelated service period. SFAS No. 123R applies to all employee equity awardsgranted after adoption and to the unvested portion of employee equity awardsoutstanding as of adoption. We adopted SFAS No. 123R using themodified-prospective method on April 1, 2006. As a result of the adoption ofSFAS No. 123R, we recognized a charge against our earnings of $1.0 million and$3.3 million for the three and nine months ended December 31, 2006. Weanticipate that the continued application of the accounting provisions of SFASNo. 123R will adversely impact on our future reported results of operations.

***The recently completed restatement of our historicalfinancial statements has already consumed, and may continue to consume, asignificant amount of our resources and may have a material adverse effect onour business and stock price.*** In December 2005, weannounced that our previously issued consolidated financial statements would berestated to reflect certain accounting adjustments. The restatement process washighly time and resource-intensive and involved substantial attention frommanagement and significant legal and accounting costs. Although we have nowcompleted the restatement, we

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cannot guarantee that we will have no furtherinquiries from the SEC or NASDAQ regarding our restated financial statements ormatters relating thereto. Likewise, many companies that have been required torestate their historical financial statements have subsequently experiencedstockholder lawsuits relating to their restatements. Any future inquiries fromthe SEC or NASDAQ as a result of the restatement of our historical financialstatements will, regardless of the outcome, likely consume a significant amountof our resources in addition to those resources already consumed in connectionwith the restatement itself.

***If we fail to maintain an effective system of internalcontrol over financial reporting, we may not be able to accurately report ourfinancial results, and current and potential stockholders may lose confidencein our financial reporting.*** We are required by the SEC toestablish and maintain adequate internal control over financial reporting thatprovides reasonable assurance regarding the reliability of our financialreporting and the preparation of financial statements in accordance withgenerally accepted accounting principles. We are likewise required, on aquarterly basis, to evaluate the effectiveness of our internal controls and todisclose any changes, significant deficiencies or material weaknesses in thoseinternal controls.

Asdescribed in greater detail elsewhere in this Report and in our Annual Reporton Form 10-K for the fiscal year ended March 31, 2006, in connection with therestatement process, we identified certain control deficiencies thatrepresented material weaknesses in our internal control over financialreporting. These material weaknesses generally relate to our historical lack ofa sufficient number of employees with appropriate levels of accountingknowledge, experience and training in the application of generally acceptedaccounting principles relevant to our business. Given these materialweaknesses, our principal executive officer and principal financial officerconcluded that we did not maintain effective internal control over financialreporting as of March 31, 2006.

Sincethe determination regarding our material weaknesses, we have devotedsignificant effort and resources to the remediation and improvement of ourinternal control over financial reporting. In particular, as describedelsewhere in this Report, we have recruited a number of qualified individualsto assist in maintaining adequate internal controls, we have initiated arevenue recognition training program and we have implemented an enhancedquarterly and annual financial statement close, review and reporting process.Notwithstanding the implementation of these remediation initiatives, theidentified material weaknesses in our internal control over financial reportingwill not be considered remediated until the new controls are fully implemented,in operation for a sufficient period of time, are tested and our managementconcludes that the new controls are operating effectively. Because theremediation initiatives are not yet fully implemented, our principal executiveofficer and principal financial officer concluded that the identified materialweaknesses in our internal control over financial reporting had not been fullyremediated and, therefore, our disclosure controls and procedures were noteffective as of December 31, 2006.

Althoughwe believe that these efforts and resources have strengthened our internalcontrol over financial reporting, we cannot be certain that these measures willensure that we maintain adequate internal control over our financial reportingin future periods. Any failure to maintain such internal controls couldadversely impact our ability to report our financial results on a timely andaccurate basis. If our financial statements are not accurate, investors may nothave a complete understanding of our operations. Likewise, if our financialstatements are not filed on a timely basis as required by the SEC and NASDAQ,we could face severe consequences from those authorities. In either case, therecould result a material adverse affect on our business. Inferior internalcontrols could also cause investors to lose confidence in our reportedfinancial information, which could have a negative effect on the trading price ofour stock.

***We may be required to indemnify PDD, or maynot be able to collect on indemnification rights from PDD*.**On April 30, 2004, we spun-off our drug discovery subsidiary, PDD, into anindependent, separately traded, publicly held company through the distributionto our stockholders of a dividend of one share of PDD common stock for everytwo shares of our common stock. As part of the spin-off, we agreed to indemnifythe indebtedness, liabilities and obligations of PDD. One such obligationincludes a guarantee by us to the landlord of PDD’s obligations under theexisting New Jersey laboratory and headquarters leases, with respect to whichPDD will indemnify us should we be required to make any payment under theguarantee. These indemnification obligations could be as significant as theremaining future minimum lease payments, which totaled approximately $23million as of December 31, 2006. 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 failure by PDD tosatisfy its obligations and any required payment by us could have a materialadverse effect on our business.

***Enacted and proposed changes in securitieslaws and regulations have increased our costs and may continue to increase ourcosts in the future.*** Sarbanes-Oxley required changes insome of our corporate governance and securities

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disclosure and compliance practices. Under Sarbanes-Oxley,publicly held companies, including us, are required to, among other things,furnish independent annual audit reports regarding the existence andreliability of their internal control over financial reporting and have theirchief executive officer and chief financial officer certify as to the accuracyand completeness of their financial reports.

We expect continuedcompliance with Sarbanes-Oxley to remain costly. Further, Sarbanes-Oxley andthe related SEC and NASDAQ compliance rules may make it more difficult andexpensive for us to obtain director and officer liability insurance, and we maybe required to accept reduced coverage or incur substantially higher costs toobtain coverage. These laws and regulations could also make it more difficult forus to attract and retain qualified members of our board of directors, orqualified executive officers. We continually evaluate and monitor regulatorydevelopments and cannot estimate the timing or magnitude of additional costs wemay incur as a result.

***Our business, financial condition andresults of operations may be adversely impacted by fluctuations in foreigncurrency exchange rates.*** Our international salesgenerally are denominated in local currencies. Fluctuations in the value ofcurrencies in which we conduct business relative to the United States dollarresult in currency transaction gains and losses, and the impact of futureexchange rate fluctuations cannot be accurately predicted. Future fluctuationsin currency exchange rates may have a material adverse impact on revenue frominternational sales, and thus on our business, financial condition and resultsof operations. When deemed appropriate, we may engage in currency exchange ratehedging transactions in an attempt to mitigate the impact of adverse exchangerate fluctuations. However, currency hedging policies may not be successful,and they may increase the negative impact of exchange rate fluctuations.

***If we consume cash more quickly thanexpected, we may be unable to raise additional capital and we may be forced tocurtail operations.***We anticipate that our existingcapital resources will be adequate to fund our operations for at least the nexttwelve months***.***However,changes may occur that would consume available capital resources before thattime. Our capital requirements will depend on numerous factors, including:

·               costsassociated with software sales;

·               thepurchase of additional capital equipment;

·               acquisitionsof other businesses or technologies; and

·               costsassociated with addressing the material weaknesses in our internal control overfinancial reporting as described elsewhere in this Report.

If we determinethat we must raise additional capital, we may attempt to do so through publicor private financings involving debt or equity. However, additional capital maynot be available on favorable terms, or at all. If adequate funds are notavailable, we may be required to curtail operations significantly or to obtainfunds by entering into arrangements with collaborative partners or others thatmay require us to relinquish rights to certain of our technologies, products orpotential markets that we would not otherwise relinquish.

**CertainRisks Related to Owning Our Stock**

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

·               actualand anticipated fluctuations in our quarterly financial and operating results;

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·               marketconditions in the technology and software sectors;

·               issuanceof new or changed securities analysts’ reports or recommendations;

·               developmentsor disputes concerning our intellectual property or other proprietary rights orother legal claims;

·               introductionof technological innovations or new commercial products by us or ourcompetitors;

·               marketacceptance of our products and services;

·               additionsor departures of key personnel; and

·               thedisclosure of the material weaknesses in our internal control over financialreporting as described elsewhere in this Report.

Theseand other external factors may cause the market price and demand for our commonstock to fluctuate substantially, which may limit or prevent investors fromreadily selling their shares of common stock and may otherwise negativelyaffect the liquidity of our common stock. In addition, in the past, when themarket price of a stock has been volatile, holders of that stock haveperiodically instituted securities class action litigation against the issuer.

***As institutions hold the majority of ourcommon stock in large blocks, substantial sales by these stockholders coulddepress the market price for our shares.***As of January12, 2007, the top ten institutional holders of our common stock heldapproximately 53% of our outstanding common stock. As a result, if one or moreof these major stockholders were to sell all or a portion of their holdings, orif the market were to perceive that such sale or sales may occur, the marketprice of our common stock may fall significantly.

***Because we do not intend to pay dividends,our stockholders will benefit from an investment in our common stock only ifour stock price appreciates in value.***We have neverdeclared or paid any cash dividends on our common stock. We currently intend toretain our future earnings, if any, to finance the expansion of our businessand do not expect to pay any cash dividends in the foreseeable future. As aresult, the success of an investment in our common stock will depend entirelyupon any future appreciation in its value. There is no guarantee that ourcommon stock will appreciate in value or even maintain the price at which itwas purchased.

***Anti-takeover provisions under the DelawareGeneral Corporation Law, provisions in our certificate of incorporation andbylaws, our stockholder rights plan and the employment agreements with ourexecutives 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 the DelawareGeneral Corporation Law may delay or deter attempts to secure control of ourcompany without the consent of our management. Also, our governing documentsprovide for a staggered board of directors, which will make it more difficultfor a potential acquirer to gain control of our board of directors. Ourstockholder rights plan is triggered upon commencement or announcement of ahostile tender offer or when any one person or group acquires 15% or more ofour common stock. The rights plan, once triggered, enables our stockholders(other than the stockholder responsible for triggering the rights plan) topurchase our common stock at reduced prices. In 2006, we entered into substantiallyidentical employment agreements with our executives. These employmentagreements contain provisions whereby if an executive’s employment with us isterminated upon the occurrence of a change of control, the executive will beentitled to receive certain severance payments and benefits.

Theseprovisions of our governing documents, stockholder rights plan and employmentagreements with our executives, and of Delaware law, could have the effect ofdelaying, deferring or preventing a change of control, including withoutlimitation a proxy contest, making more difficult the acquisition of asubstantial block of our common stock. The provisions could also limit theprice that investors might be willing to pay in the future for shares of ourcommon stock. Further, the existence of these anti-takeover measures may causepotential bidders to look elsewhere, rather than initiating acquisitiondiscussions with us.

**CertainRisks Related to Intellectual Property**

***We may not be able to protect adequatelythe trade secrets and confidential information that we disclose to ouremployees.***We rely upon trade secrets, technical know-howand continuing technological innovation to develop and maintain our competitiveposition. Competitors through their independent discovery (or improper means,such as unauthorized disclosure or industrial espionage) may come to know ourproprietary information. We generally require employees and consultants toexecute confidentiality and assignment-of-inventions agreements. These agreementstypically provide that all

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materials and confidential information developed by ormade 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 not afford us sufficientprotections for our intellectual property, and we may not seek patentprotection outside the United States.***We believe that oursuccess depends, in part, upon our ability to obtain international protectionfor our intellectual property. However, the laws of some foreign countries maynot be as comprehensive as those of the United States and may not be sufficientto protect our proprietary rights abroad. In addition, we generally do notpursue patent protection outside the United States because of cost andconfidentiality concerns. Accordingly, our international competitors couldobtain foreign patent protection for, and market overseas, products andtechnologies for which we are seeking patent protection in the United States.

***A patent issued to us may not besufficiently broad to protect adequately our rights in intellectual property towhich the patent relates.***Due to cost and other considerations,we generally do not rely on patent protection to enforce our intellectualproperty rights, and have filed only a limited number of patent applications.Even if patents are issued to us, these patents may not sufficiently protectour interest in our software or other technologies because the scope ofprotection provided by any patents issued to or licensed by us are subject tothe uncertainty inherent in patent law. Third parties may be able to designaround these patents or develop unique products providing effects similar toour products. In addition, others may discover uses for our software 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 institutions, havedeveloped technologies, filed patent applications or received patents onvarious technologies that may be related to our business. Some of thesetechnologies, patent applications or patents may conflict with ourtechnologies, patent applications or patents. These conflicts could also limitthe scope of patents, if any, that we may be able to obtain, or result in thedenial of our patent applications.

***We may be subject to claims of infringementby third parties.*****Anumber of patents may have been issued or may be issued in the future thatcould cover certain aspects of our technology or functionality of our productsand could prevent us from using technology that we use or expect to use, ormaking or selling certain of our products. In addition, to the extent ouremployees are involved in research areas similar to those areas in which theywere involved at their former employers, we may inadvertently use or disclosealleged trade secrets or other proprietary information of their formeremployer. Thus, our products may infringe patent or other intellectual propertyrights of third parties, and we may be subject to infringement claims by thirdparties. Any such claims, with or without merit, could be time consuming todefend, result in costly litigation, divert management’s attention andresources, cause product shipment delays or require us to enter into royalty orlicensing agreements. Such licenses may not be available on terms acceptable tous, if at all. In the event of a successful claim of product infringementagainst us, our failure or inability to license or design around the infringedtechnology could have a material adverse effect on our business, financialcondition and results of operations.

***Third-party software codes incorporatedinto our products could subject us to liability or limit our ability to sellsuch products.***Some of our products include softwarecodes licensed from third parties, including the open source community. Some ofthese licenses impose certain obligations upon us, including royalty andindemnification obligations. In the case of codes licensed from the open sourcecommunity, the licenses may also limit our ability to sell products containingsuch code. Though we generally review the applicable licenses prior toincorporating third party code into our software products, there can be noassurance that such third party codes incorporated into our products would notsubject us to liability or limit our ability to sell the products containingsuch code, thereby having a material adverse affect upon our business.

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**Item 5. Other Information**

On February 1, 2007, we amended the employmentagreement with Nicholas Austin, our Vice President, Research and Development,to reflect the fact that Mr. Austin has relocated to Cambridge, United Kingdomand Mr. Austin’s employment has transferred to our United Kingdom subsidiary,Accelrys Limited.  Mr. Austin’s basesalary and target bonus percentage are unchanged, although now paid in Britishpounds.  The foregoing description isintended only as a summary of the material terms of the amendment to Mr.Austin’s employment agreement and is qualified in its entirety by reference tothe full amendment attached as Exhibit 10.2 of this Report.

**Item 6.Exhibits**
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                        |
|--------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                |       | Restated Certificate of Incorporation of  Pharmacopeia, Inc. (incorporated by reference to Exhibit 3.1 to Accelrys,  Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 1996).                              |
| 3.2                |       | Certificate of Amendment of the Restated Certificate  of Incorporation of Pharmacopeia, Inc. (incorporated by reference to Exhibit  3.1 to Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended  March 31, 2005. |
| 3.3                |       | Amended and Restated Bylaws of Accelrys, Inc. as  amended on June 9, 2005. (incorporated by reference to Exhibit 3.2 to  Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended March  31, 2005)              |
| 10.1               |       | Form of Employment Agreement between Accelrys, Inc.  and certain of its executives (incorporated by reference to Exhibit 10.5 to  Accelrys, Inc.’s Form 10-Q for the quarter ended September 30, 2006)                            |
| 10.2*              |       | Amendment to Employment Agreement, dated February 1,  2007, between Accelrys, Inc. and Nicholas Austin                                                                                                                                 |
| 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 and Chief Financial Officer                                                                                                                                                  |

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*                    Filedherewith

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**SIGNATURE**

Pursuant to therequirements of section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|        |   | ACCELRYS, INC. |
|--------|--------|----------------|
|   |   |           |
|   |   | By:            | /s/ RICK E. RUSSO |
|   |   |           | Rick E. Russo |
|   |   |           | Senior Vice President and Chief Financial  Officer (Duly Authorized Officer and Chief  Financial Officer) |
|   |   |           |   |
|   |   |           | Date: February 2, 2007 |

 

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