**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

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**FORM 10-Q**

 

**x  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**For the quarterly period ended June30, 2006**

**OR**

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

 

**For the transition period from            to**

**Commission File Number: 0-27188**

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** **

**ACCELRYS, INC.**

(Exact name 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’s telephone 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    Accelerated filer ý    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    No x

The number ofoutstanding shares of the registrant’s common stock, par value $0.0001 pershare, as of July 17, 2006 was 26,284,694, net of treasury shares.

 

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**ACCELRYS, INC.FORM 10-Q — QUARTERLY REPORTFor The Quarterly Period Ended June 30, 2006Table of Contents**

 
| **PART I — FINANCIAL  INFORMATION** |
|------------------------------------------|
| Item 1.                                  | Financial  Statements |
|                                     | Condensed consolidated  balance sheets as of June 30, 2006 (unaudited) and March 31, 2006 |
|                                     | Condensed consolidated statements of operations  (unaudited) for the three-month periods ended June 30, 2006 and 2005 |
|                                     | Condensed consolidated statements of cash flows  (unaudited) for the three-month periods ended June 30, 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  6.                                 | Exhibits |
| **Signature**                            |   |

 

 

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**PART I —FINANCIAL INFORMATION**

**Item 1. Consolidated FinancialStatements**

**Accelrys, Inc.Condensed Consolidated Balance Sheets(In thousands, except per share amounts)**

** **
| ** **                                                                                                                                     | ** ** | **June 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **(Unaudited)**             | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                     |       |                        |       |                         |       |
| Current assets:                                                                                                                                |       |                        |       |                         |       |
| Cash and cash  equivalents                                                                                                                     |       | $                           | 17,837     |                         | $          | 24,656 |   |
| Marketable  securities                                                                                                                         |       | 37,683                      |       | 34,733                       |       |
| Trade  receivables, net of allowance for doubtful accounts of $347 and $351 as of  June 30, 2006 and March 31, 2006, respectively              |       | 12,636                      |       | 17,289                       |       |
| Prepaid expenses  and other current assets                                                                                                     |       | 4,062                       |       | 3,438                        |       |
| Total current assets                                                                                                                           |       | 72,218                      |       | 80,116                       |       |
| Restricted cash                                                                                                                                |       | 7,784                       |       | 6,633                        |       |
| Property and equipment,  net                                                                                                                   |       | 7,284                       |       | 7,860                        |       |
| Goodwill                                                                                                                                       |       | 42,663                      |       | 42,663                       |       |
| Intangible assets, net                                                                                                                         |       | 8,287                       |       | 8,671                        |       |
| Other assets                                                                                                                                   |       | 743                         |       | 812                          |       |
| Total assets                                                                                                                                   |       | $                           | 138,979    |                         | $          | 146,755 |   |
| **Liabilities and stockholders’  equity**                                                                                                 |       |                        |       |                         |       |
| Current liabilities:                                                                                                                           |       |                        |       |                         |       |
| Accounts payable                                                                                                                               |       | $                           | 1,115      |                         | $          | 1,676 |   |
| Accrued  liabilities                                                                                                                           |       | 4,735                       |       | 4,939                        |       |
| Accrued  compensation and benefits                                                                                                             |       | 5,395                       |       | 7,009                        |       |
| Current portion  of accrued severance and lease abandonment                                                                                    |       | 1,679                       |       | 2,936                        |       |
| Current portion  of deferred revenue                                                                                                           |       | 47,276                      |       | 51,710                       |       |
| Total current  liabilities                                                                                                                     |       | 60,200                      |       | 68,270                       |       |
| Deferred revenue, net  of current portion                                                                                                      |       | 6,641                       |       | 9,559                        |       |
| Accrued severance and  lease abandonment, net of current portion                                                                               |       | 1,354                       |       | 1,338                        |       |
| Lease-related  liabilities, net of current portion                                                                                             |       | 5,855                       |       | 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; 26,919 and 26,856 shares issued  at June 30, 2006 and March 31, 2006, respectively |       | 3                           |       | 3                            |       |
| Additional  paid-in capital                                                                                                                    |       | 255,022                     |       | 254,224                      |       |
| Deferred  stock-based compensation                                                                                                             |       | —                      |       | (522                         | )          |
| Lease guarantee                                                                                                                                |       | (619                        | )          | (635                         | )          |
| Treasury stock;  644 shares at each of June 30, 2006 and March 31, 2006, respectively                                                          |       | (8,340                      | )          | (8,340                       | )          |
| Accumulated  deficit                                                                                                                           |       | (181,485                    | )          | (181,156                     | )          |
| Accumulated  other comprehensive income (loss)                                                                                                 |       | 348                         |       | (366                         | )          |
| Total stockholders’  equity                                                                                                               |       | 64,929                      |       | 63,208                       |       |
| Total liabilities and stockholders’ equity                                                                                                |       | $                           | 138,979    |                         | $          | 146,755 |   |

 

See accompanying notes tothese consolidated financial statements.

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**Accelrys, Inc.Condensed Consolidated Statements of Operations(In thousands, except per share amounts)(Unaudited)**

 
| ** **                                                                     | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Revenue                                                                        |       | $                                                   | 20,150     |   | $ | 20,404 |   |
| Operating costs  and expenses:                                                 |       |                                                |       |   |   |
| Cost of revenue                                                                |       | 3,900                                               |       | 4,136 |   |
| Product development                                                            |       | 5,126                                               |       | 5,855 |   |
| Sales and marketing                                                            |       | 6,822                                               |       | 8,499 |   |
| General and administrative                                                     |       | 4,718                                               |       | 4,069 |   |
| Total operating costs  and expenses                                            |       | 20,566                                              |       | 22,559 |   |
| Operating loss                                                                 |       | (416                                                | )          | (2,155 | ) |
| Interest and  other income, net                                                |       | 484                                                 |       | 698 |   |
| Income (loss)  before income taxes                                             |       | 68                                                  |       | (1,457 | ) |
| Income tax  expense                                                            |       | 397                                                 |       | 440 |   |
| Net loss                                                                       |       | $                                                   | (329       | ) | $ | (1,897 | ) |
|                                                                           |       |                                                |       |   |   |
| Basic and  diluted net loss per share                                          |       | $                                                   | (0.01      | ) | $ | (0.07 | ) |
| Weighted averaged  shares used to compute basic and diluted net loss per share |       | 26,208                                              |       | 26,022 |   |

 

See accompanying notes tothese consolidated financial statements.

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**Accelrys, Inc.Condensed Consolidated Statements of Cash Flows(In thousands)(Unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                       |       |                                                |       |   |   |
| Net loss                                                                     |       | $                                                   | (329       | ) | $ | (1,897 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                                |       |   |   |
| Depreciation                                                                 |       | 820                                                 |       | 1,059 |   |
| Amortization of acquired intangible assets                                   |       | 384                                                 |       | 469 |   |
| Share-based compensation                                                     |       | 1,009                                               |       | 218 |   |
| Other                                                                        |       | 406                                                 |       | 464 |   |
| Changes in operating assets and liabilities:                                 |       |                                                |       |   |   |
| Trade receivables                                                            |       | 4,855                                               |       | 3,555 |   |
| Prepaid expenses and other current assets                                    |       | (556                                                | )          | 1,637 |   |
| Restricted cash and other assets                                             |       | (937                                                | )          | (91 | ) |
| Accounts payable                                                             |       | (588                                                | )          | (274 | ) |
| Accrued liabilities                                                          |       | (2,178                                              | )          | (4,601 | ) |
| Deferred revenue                                                             |       | (7,820                                              | )          | (6,423 | ) |
| Net cash used in operating activities                                        |       | (4,934                                              | )          | (5,884 | ) |
| Cash flows from  investing activities:                                       |       |                                                |       |   |   |
| Purchases of property and equipment, net                                     |       | (156                                                | )          | (1,049 | ) |
| Purchases of marketable securities                                           |       | (16,757                                             | )          | (2,736 | ) |
| Proceeds from sales and maturities of marketable  securities                 |       | 13,800                                              |       | 4,594 |   |
| Net cash provided by (used in) investing activities                          |       | (3,113                                              | )          | 809 |   |
| Cash flows from  financing activities:                                       |       |                                                |       |   |   |
| Proceeds from issuance of common stock                                       |       | 311                                                 |       | 479 |   |
| Net cash provided by financing activities                                    |       | 311                                                 |       | 479 |   |
| Exchange rate effect on cash and cash equivalents                            |       | 917                                                 |       | (682 | ) |
| Decrease in cash and cash equivalents                                        |       | (6,819                                              | )          | (5,278 | ) |
| Cash and cash equivalents at beginning of period                             |       | 24,656                                              |       | 21,256 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                   | 17,837     |   | $ | 15,978 |   |

 

See accompanying notes tothese consolidated financial statements.

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

**1.****                       Basis ofPresentation and Significant Accounting Policies**

*FinancialStatement Preparation*

The condensed consolidated financial statements as ofJune 30, 2006, and for the three months ended June 30, 2006 and 2005 areunaudited. We have condensed or omitted certain information and disclosuresnormally included in financial statements presented in accordance withaccounting principles generally accepted in the United States. We believe thedisclosures made are adequate to make the information presented not misleading.However, you should read these condensed consolidated financial statements inconjunction with the consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended March 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.

*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.

*Use ofEstimates*

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. Interim results are not necessarily indicative ofresults for a full year or for any subsequent interim period.

# ***Revenue Recognition***

We recognize revenues in accordance with the AmericanInstitute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”)No. 97-2, *Software Revenue Recognition*, asamended, U.S. Securities and Exchange Commission (the “SEC”) Staff AccountingBulletin (“SAB”) No. 104, *Revenue Recognition*,and Emerging Issues Task Force (“EITF”) Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*.

We generate revenue from the following primarysources:

·                    softwarelicenses,

·                    provision of support and maintenance serviceson licensed software, referred to as post-contract customer support (“PCS”),and

·                    training, installation and implementationservices.

Customer payments received in connection with ourrevenue-generating activities are recorded as deferred revenue. We recognizerevenue as set forth below and when all of the following criteria are met:

·                    a fully executed written contract and/orpurchase order has been obtained from the customer (i.e., persuasive evidenceof an arrangement exists),

·                    the contractual price of the product orservices has been defined and agreed to in the contract (i.e., price is fixedor determinable),

·                    delivery of the product or service hasoccurred and no material uncertainties regarding customer acceptance of thedelivered product or service exist, and

·                    collection of the purchase price from thecustomer is deemed probable.

*Software Licenses*

We license software either perpetually or on a termbasis. Our standard perpetual software licensing arrangements include twelve monthsof bundled PCS, while our standard term-based software licensing arrangementstypically include PCS for the full duration of the term license. Because we donot have vendor specific objective evidence (“VSOE”) of the fair value of theseelements, we recognize as revenue the entire fee for such licenses ratably overthe term of the bundled PCS. Certain of 

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ourterm-based licenses also allow the customer to substitute purchased productsfor other products of equal value throughout the term. We account for thesearrangements as in-substance subscriptions and, accordingly, we recognize asrevenue the entire fee for such licenses ratably over the contractual term ofthe 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 entirefee for such arrangements is recognized as revenue ratably over the term of thePCS or delivery of the services, whichever is longer.

# ***Software Development Costs***

We account for costs incurred to develop our softwareproducts in accordance with Statement 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 significant enhancementsto existing software products are expensed as incurred, until the technologicalfeasibility of the product has been established. Technological feasibilityoccurs shortly before our software products are available for general release,and we have determined that costs eligible for capitalization are not material.Accordingly, there were no capitalized software development costs as of June30, 2006 and March 31, 2006.

*Adoptionof SFAS No. 123R*

In December 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS 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 thatis reflected in the financial statements over the related service period. Theprovisions of SFAS No. 123R are effective for us beginning April 1, 2006. Priorto April 1, 2006, we accounted for our share-based awards to employees anddirectors under the recognition and measurement principles of AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees,* and related interpretations and adopted the proforma disclosure provisions of SFAS No. 123, *Accountingfor Stock-Based Compensation*. Accordingly, stock-based compensationexpense related to employee stock options was recognized only if, on the dateof grant, the exercise price of the employee stock option was less than thefair market value of the underlying common stock.

Effective April 1, 2006, we adopted SFAS No. 123Rusing the modified prospective transition method. Under the modifiedprospective transition method, the estimated grant date fair value of awardsgranted to employees and directors on or after April 1, 2006 is recognized as acharge against income over the requisite service period. Additionally, theremaining unrecognized compensation expense associated with the unvestedportion of awards granted prior to April 1, 2006, determined under theprovisions of SFAS No. 123, is recognized as a charge against income beginningApril 1, 2006. In accordance with the modified prospective transition method,our consolidated financial statements for historical periods have not beenrestated to reflect, and do not include, the impact of our adoption of SFAS No.123R.

Pursuant to the provisions of SFAS No. 123R, deferredstock-based compensation is no longer reflected as a separate component ofstockholders’ equity. As a result, we reversed our remaining deferredstock-based compensation balance as of April 1, 2006 of $0.5 million againstadditional paid-in capital.

The impact of ouradoption of SFAS No. 123R on the condensed consolidated financial statementsand the related footnote disclosure information are provided in Note 3.

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*Income Taxes*

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) from continuingoperations before taxes.

*Effect ofNew Accounting Standards*

In June 2006, the FASB issued Interpretation (“FIN”)No. 48, *Accounting for Uncertainty inIncome Taxes.* FIN No. 48, which is effective for fiscal yearsbeginning after December 15, 2006, addresses the accounting for incometaxes by prescribing the minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements. Inaddition, FIN No. 48 expands the disclosure requirements concerningunrecognized tax benefits as well as any significant changes that may occur inthe next twelve months associated with such unrecognized tax benefits. We willadopt the provisions of FIN No. 48 in the first quarter of fiscal year 2008. Weare currently evaluating the impact, if any, FIN No. 48 will have on ourresults of operations and financial position.

In November 2005, the FASB issued Staff Position Nos. FAS 115-1 and FAS124-1, *The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments*(“FSP Nos.115-1 and 124-1”), which provide guidance on determining when investments incertain debt and equity securities are considered impaired and whether thatimpairment is other-than-temporary, and on the measurement of such impairmentloss. FSP Nos. 115-1 and 124-1 also include accounting considerationssubsequent to the recognition of other-than-temporary impairments and requirecertain disclosures about unrealized losses that have not been recognized asother-than-temporary impairments. Our adoption of FSP Nos. 115-1 and 124-1during the three months ended June 30, 2006 did not have a significant impacton our results of operations and financial position.

In May 2005, the FASB issuedSFAS No. 154, *Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20 and SFAS No. 3*. Although SFAS No.154 carries forward the guidance in APB No. 20 and SFAS No. 3 with respect to accountingfor changes in estimates, changes in reporting entities, and the correction oferrors, SFAS No. 154 establishes new standards for accounting for changes inaccounting principles, whereby all such changes must be accounted for byretrospective application to the financial statements of prior periods unlessit is impracticable to do so. SFAS No. 154 is effective for accounting changesand error corrections made in fiscal years beginning after December 15, 2005,with early adoption permitted for changes and corrections made in yearsbeginning after May 2005. Our adoption of SFAS No. 154 as of April 1, 2006 didnot have a material impact on our financial position, results of operations orcash flows.

**2.****                       Net LossPer Share**

We compute net loss per share pursuant to SFAS No.128, *Earnings Per Share*. Accordingly, basicand diluted net loss per share is computed by dividing the net loss for theperiod by the weighted average number of common shares outstanding during theperiod, without consideration for common stock equivalents.

Potentially dilutive common stock equivalents consistof common stock options and restricted stock that has not yet fully vested.Potentially dilutive common stock equivalents that were excluded from the basicand diluted net loss per share calculations as their effect would beanti-dilutive totaled approximately 2.1 million shares and 4.6 million sharesfor the three months ended June 30, 2006 and 2005, respectively.

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

*Share-BasedCompensation Plans*

On August 2, 2005, our stockholders approved theAmended and Restated 2004 Stock Incentive Plan (the “2004 Plan”). The 2004 Planauthorizes the grant of equity awards to purchase the number of shares of ourcommon stock equal to the sum of (i) 1,900,000 shares and (ii) thenumber of shares of common stock underlying any stock awards granted undercertain prior share-based compensation plans that expire or are canceled orforfeited without having been exercised in full or that are repurchased by us.Potential types of equity awards that may be granted under the 2004 Plan to ourofficers, directors, employees and consultants include stock options,restricted stock awards, common stock awards, stock appreciation rights,performance awards and deferred stock units. Pursuant to the 2004 Plan, anyshares of common stock that are awarded under the 2004 Plan as restricted stockawards, common stock awards, performance awards or deferred stock units (butnot as stock options or stock appreciation rights) are counted against the maximumnumber of shares of common stock available for issuance under the 2004 Planbased on a 1.15-to-1 ratio. The terms and conditions of specificawards are set at the discretion of our board of directors although generallyawards vest over not more than five years, expire no later than ten years fromthe date of grant and do not have exercise prices less than the fair marketvalue of the underlying common stock. At June 30, 

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2006, approximately 1,475,000shares of our common stock remain available for issuance pursuant to awardsgranted 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, employeesmay defer up to 10% of their base salary to purchase shares of our commonstock. The purchase price of the common stock is equal to 85% of the lower ofthe fair market value per share of our common stock on the commencement date ofthe applicable offering period or the purchase date. To date, we have notissued shares under the ESPP and 1,000,000 shares remain available for futureissuance under the ESPP as of June 30, 2006.

We also maintain certainother share-based compensation plans, under which we did not grant awardsduring the first quarter of fiscal year 2007 and do not intend to grant anyfurther awards in the future.

Our share-based compensation plans contain a provisionthat allows eligible participants to continue to vest in their stock optionsupon their retirement, as that term is defined in the plans. To be eligible forcontinued vesting, participants must be at least 55 years of age and have 5years of service at the time of their retirement.

*Share-BasedAward Activity*

Ourstock options generally vest over four years and have a contractual term of 10years.  A summary of stock optionactivity under our share-based compensation plans is as follows:

 
| ** **                    | ** ** | **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                       |       | 760                                                                                       |       | 7.29                                   |       |                                        |       |                                                      |       |
| Exercised                     |       | (65                                                                                       | )          | 4.78                                   |       |                                        |       |                                                      |       |
| Expired/Forfeited             |       | (561                                                                                      | )          | 13.54                                  |       |                                        |       |                                                      |       |
| Outstanding at  June 30, 2006 |       | 4,440                                                                                     |       | $                                      | 8.97       |                                        | $          | 2,231                                                     |       | 7.3 |   |
| Exercisable at June 30,  2006 |       | 2,584                                                                                     |       | $                                      | 10.32      |                                        | $          | 1,293                                                     |       | 6.0 |   |

 

The aggregateintrinsic value of stock options outstanding and exercisable at June 30, 2006was based on the closing price of our common stock on June 30, 2006 of $7.13per share. The total intrinsic value of stock options exercised during thethree months ended June 30, 2006 was $0.2 million and the total cash receivedfrom the exercise of stock options during the three months ended June 30, 2006was $0.3 million.

In the firstquarter of fiscal year 2007, we granted restricted stock units (“RSUs”) underthe 2004 Plan. The RSUs vest annually over three years and, once vested, do notexpire. Upon vesting of an RSU, employees are issued an equivalent number ofshares of our common stock. A summary of RSU activity under our share-basedcompensation 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                    |       | 322                                                               |       | 7.20                                                          |       |
| Vested                     |       | —                                                            |       | —                                                        |       |
| Forfeited                  |       | —                                                            |       | —                                                        |       |
| Unvested at June 30,  2006 |       | 322                                                               |       | $                                                             | 7.20       |   |

 

We also haveremaining unvested restricted stock awards of approximately 8,000 shares as ofJune 30, 2006 that were granted under a prior plan. These restricted stockawards vest annually over three years and, once vested, do not expire. Uponvesting of a restricted stock awards, employees are issued an equivalent numberof shares of our common stock.

*Valuation of Share-Based Awards*

We estimate thefair value of our share-based 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 stock pricewill fluctuate during the expected life of an award. We determine volatilitybased on our historical stock price volatility over the most recent periodequivalent to the expected life of the award and the historical stock pricevolatilities of comparable publicly traded companies, giving 

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consideration tocompany-specific events impacting historical volatility that are unlikely tooccur in the future as well as anticipated future events that may impactvolatility.

*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 dividends sincein 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 byconsidering various relevant factors, including the vesting period andcontractual term of the award, our employees’ historical exercise patterns andlength of service, the expected future volatility of our stock price, taximplications of exercising an award and employee characteristics. We alsoconsider the expected terms of comparable publicly traded 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 if theactual forfeiture rate differs. We determine the pre-vesting forfeiture rate ofan award based on our historical pre-vesting award forfeiture experience. Forpurposes of calculating pro forma information under SFAS No. 123 for periodsprior to fiscal year 2007, we accounted for pre-vesting forfeitures as theyoccurred.

Our determination of the input variables used in theBlack-Scholes option pricing model as well as the pre-vesting forfeiture rateis based on various underlying estimates and assumptions that are highlysubjective and are affected by our stock price, among other factors. Changes inthese underlying estimates and assumptions could materially affect the fairvalue of our share-based awards and, therefore, the amount of share-basedcompensation expense to be recognized in our results of operations.

The fair value of stock options and ESPP purchaserights granted during the three months ended June 30, 2006 and 2005 wasestimated at the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions:

 
| ** **                                        | ** ** | **Three Months Ended June 30.   2006** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Stock Options**                                          | ** ** | **ESPP   Purchase   Rights** | ** ** |
| Expected  volatility                              |       | 60                                                              | %          | 60 | % |
| Risk-free  interest rate                          |       | 5.1                                                             | %          | 5.2 | % |
| Expected option  life in years                    |       | 5.0                                                             |       | 0.5 |   |
| Expected dividend  yield                          |       | 0                                                               | %          | 0 | % |
| Weighted average per  share grant date fair value |       | $                                                               | 4.08       |   | $ | 2.42 |   |
|                                                   |            |                                                                 |            |  |  |  |  |

 
| ** **                                        | ** ** | **Three Months Ended June 30,   2005** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Stock Options**                                          | ** ** | **ESPP   Purchase   Rights** | ** ** |
| Expected  volatility                              |       | 69                                                              | %          | 69 | % |
| Risk-free  interest rate                          |       | 3.7                                                             | %          | 3.4 | % |
| Expected option  life in years                    |       | 3.4                                                             |       | 0.5 |   |
| Expected  dividend yield                          |       | 0                                                               | %          | 0 | % |
| Weighted average per  share grant date fair value |       | $                                                               | 2.77       |   | $ | 1.36 |   |
|                                                   |            |                                                                 |            |  |  |  |  |

 

The fair value ofRSUs and restricted stock awards is based on the market price of our commonstock on the date of grant.

*Share-BasedCompensation Expense*

The estimated fairvalue of our share-based awards is recognized as a charge against income on astraight-line basis over the requisite service period, which is the shorter ofthe vesting period of the award or the period until the participant becomeseligible for retirement. The estimated fair value of share-based awards grantedto retirement-eligible participants is recognized as a charge against incomeimmediately upon grant. Total share-based compensation expense recognized in ourcondensed consolidated statements of operations for the three months ended June30, 2006 and 2005 was as follows:

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| ** **                              | ** ** | **Three Months Ended  June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| ** **                              | ** ** | **(In thousands)**                         | ** ** |
| Cost of revenue                         |       | $                                               | 71         |   | $ | 2 |   |
| Product  development expenses           |       | 345                                             |       | 183 |   |
| Sales and  marketing expenses           |       | 159                                             |       | 22 |   |
| General and  administrative expenses    |       | 434                                             |       | 11 |   |
| Total share-based  compensation expense |       | $                                               | 1,009      |   | $ | 218 |   |

 

Share-basedcompensation expense recognized in the three months ended June 30, 2006reflects our adoption of SFAS No. 123R effective April 1, 2006 using themodified prospective transition method. Share-based compensation expenserecognized in the three months ended June 30, 2005 relates to share-basedawards granted in prior periods accounted for under the provisions of APB No.25. No share-based compensation expense was capitalized in the periodspresented. At June 30, 2006, we had unrecognized share-based compensationexpense relating to unvested share-based awards of approximately $9.2 million,which we anticipate recognizing as a charge against income over a weightedaverage period of 1.6 years.

*Pro Forma Information Under SFASNo. 123 For Periods Prior to April 1, 2006*

The following table illustrates the effect on net lossand loss per share for the three months ended June 30, 2005 if we had appliedthe fair value recognition provisions of SFAS No. 123 to our employee stockawards. For purposes of the SFAS No. 123 pro forma disclosures, the estimatedfair value of employee stock awards has been charged against income over therelated vesting period of the award on a straight-line basis.

 
| ** **                                                                                                      | ** ** | **Three Months Ended  June 30, 2005**         | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **(In thousands, except  per share amounts)** | ** ** |
| Net loss, as  reported                                                                                          |       | $                                                                 | (1,897     | ) |
| Add: Stock-based  employee compensation expense included in net loss, as reported                               |       | 218                                                               |       |
| Deduct:  Stock-based employee compensation expense determined under the fair value  based method for all awards |       | (1,339                                                            | )          |
| Pro forma net  loss                                                                                             |       | $                                                                 | (3,018     | ) |
| Net loss per  share:                                                                                            |       |                                                              |       |
| Basic and  diluted - as reported                                                                                |       | $                                                                 | (0.07      | ) |
| Basic and diluted - pro  forma                                                                                  |       | $                                                                 | (0.12      | ) |

 

**4.****                       ComprehensiveLoss**

For the three months ended June 30, 2006 and 2005,comprehensive loss consists of the following:

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **(In thousands)**                         | ** ** |
| Net loss                                  |       | $                                               | (329       | ) | $ | (1,897 | ) |
| Foreign currency  translation adjustment  |       | 654                                             |       | (479 | ) |
| Unrealized gain  on marketable securities |       | 60                                              |       | 159 |   |
| Total comprehensive  income (loss)        |       | $                                               | 385        |   | $ | (2,217 | ) |

 

**5.****                       SegmentInformation**

In accordance with SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information*,our operations 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**

***Guarantee of Lease Obligation ofOthers***

On April 30, 2004, we spun-off our drug discovery subsidiary,Pharmacopeia Drug Discovery, Inc. (“PDD”), into an independent, separately traded, publicly held company throughthe distribution to our stockholders of a dividend of one share of PDD commonstock for every two shares of our common stock. In connection with thisspin-off, the landlords of the New Jersey facilities which were used by our PDDoperations consented to the assignment of the leases to PDD. Despite theassignment, the landlords required us to guarantee the remaining leaseobligations, which totaled approximately $24 million as of June 30, 2006. Inaccordance with FIN No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including Indirect Guaranteesof Indebtedness of Others,* we recognized a liability andcorresponding charge to stockholders’

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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 June 30, 2006 andMarch 31, 2006, the liability for our guarantee of the lease obligation was$0.6 million.

*Other Guarantees and Indemnifications*

We provideindemnifications of varying scope and size to certain customers against claimsof intellectual property infringement made by third parties arising from theuse of our products. We have also entered into indemnification agreements withour officers and directors. Although the maximum potential amount of futurepayments 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 andenable us 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 in connectionwith these indemnification obligations as of June 30, 2006.

**7.****                       Severanceand Lease Abandonment**

The following summarizes the changes in our severanceand lease abandonment liability:

 
| ** **                                         | ** ** | **Severance Costs  for Involuntary  Employee  Terminations** | ** ** | **Costs to  Exit Lease  Obligations** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------|------------|
| ** **                                         | ** ** | **(In thousands)**                                                | ** ** |
| Balance at  December 31, 2002                      |       | $                                                                      | 544        |                                            | $          | 1,731     |       | $ | 2,275 |   |
| Cash payments                                      |       | (449                                                                   | )          | (281                                            | )          | (730      | )          |
| Adjustment to liability                            |       | (95                                                                    | )          | (289                                            | )          | (384      | )          |
| Balance at  December 31, 2003                      |       | —                                                                 |       | 1,161                                           |       | 1,161     |       |
| Additional severance charges                       |       | 2,813                                                                  |       | —                                          |       | 2,813     |       |
| Cash payments                                      |       | (2,197                                                                 | )          | (65                                             | )          | (2,262    | )          |
| Balance at March  31, 2004                         |       | 616                                                                    |       | 1,096                                           |       | 1,712     |       |
| Additional severance and lease abandonment charges |       | 1,358                                                                  |       | 3,956                                           |       | 5,314     |       |
| Cash payments                                      |       | (907                                                                   | )          | (1,342                                          | )          | (2,249    | )          |
| Adjustment to liability                            |       | —                                                                 |       | (167                                            | )          | (167      | )          |
| Effect of foreign exchange                         |       | —                                                                 |       | (17                                             | )          | (17       | )          |
| Balance at March  31, 2005                         |       | 1,067                                                                  |       | 3,526                                           |       | 4,593     |       |
| Additional severance and lease abandonment 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     |       |
| Cash payments                                      |       | (862                                                                   | )          | (620                                            | )          | (1,482    | )          |
| Effect of foreign exchange                         |       | 68                                                                     |       | 173                                             |       | 241       |       |
| Balance at June 30,  2006                          |       | $                                                                      | 271        |                                            | $          | 2,762     |       | $ | 3,033 |   |

 

During fiscal year 2002, we implemented various actionsdesigned to improve our operations and overall financial performance throughworkforce reductions and the abandonment of two leased facilities. As a resultof the implementation of these actions, we recognized a charge of $4.3 million,consisting of $2.3 million in severance benefits from the termination of 71employees and $2.0 million related to the abandonment of the two leasedfacilities. The severance benefits were paid in full in fiscal year 2003.During fiscal year 2003, we negotiated the termination of the operating leasefor one of the abandoned leased facilities and finalized certain remainingseverance obligations which resulted in a $0.4 million reduction to theoriginal $2.0 million liability. Additionally, during fiscal year 2005, we subleasedthe other abandoned leased facility which resulted in a $0.2 million reductionto the original $2.0 million liability. Our lease obligation for this facilityterminates in fiscal year 2008.

During fiscal year 2005, as a result of the relocationof our corporate headquarters, we recorded a lease abandonment charge of $3.6million representing the future lease obligations, net of estimated futuresublease income. Our lease obligation for this facility terminates in fiscalyear 2007.

Additionally, during fiscal year 2005, we implementedvarious actions designed to improve the efficiency of our sales department andeliminate duplicative general and administrative personnel through workforcereductions and the abandonment of a leased facility in Germany. As a result ofthe implementation of these actions, we recognized a charge of $1.7 million,consisting of $1.4 million in severance benefits from the termination of 42employees and $0.3 million related 

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to theabandonment of the leased facility. The severance benefits were paid in full infiscal year 2006. Our lease obligation for the abandoned facility terminates infiscal year 2010.

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. We anticipate completing the workforcereductions and payment of severance benefits in fiscal year 2007. The leaseobligation for the abandoned facility terminates in fiscal year 2016.

 

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**Item 2. Management’s Discussion and Analysis ofFinancial Condition 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 new products, the demandfor new and existing products, additional competition, changes in economicconditions and those described in documents we have filed with the Securitiesand Exchange Commission, including this Report in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” “Risk Factors,” andsubsequent reports on Form 10-Q and Form 10-K. All forward-looking statementsin this document are qualified entirely by the cautionary statements includedin this document and such other filings. These risks and uncertainties couldcause actual results to differ materially from results expressed or implied byforward-looking statements contained in this document. These forward-lookingstatements speak only as of the date of this document. We disclaim anyundertaking to publicly update or revise any forward-looking statementscontained herein to reflect any change in our expectations with regard theretoor any change in events, conditions or circumstances on which any suchstatement 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 have primarily sold molecular modeling and simulation software. The marketfor molecular 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. Following the acquisition of SciTegic, we began to offerdata-pipelining and workflow software. This technology is widely applicablewithin our target industries and represents a significant growth opportunity.There is currently limited competition to this technology in our targetedindustries, and we are experiencing strong adoption rates within our customerbase.

***Our Strategy***

Ourobjective is to strengthen our position as a leading provider of software-basedscientific computation, analysis, informatics, knowledge management, workflowproducts and services. We plan to accomplish our objective by providing acomprehensive set of integrated products and services that are central to theenterprise-wide research and development activities of our customers, and byconnecting these tools within an information technology framework. Thisframework makes it easier for research and development organizations to managedata, information, knowledge, and collaborative processes.

Ourstrategy for growth is to expand usage of our products and services bymarketing and distributing our solutions to a broader group of users, includingscientists, engineers and information technology professionals, within ourexisting customers, as well as to new customers in other industries.

Akey enabler of this strategy is the data pipelining and workflow technology weacquired through our SciTegic acquisition. We are utilizing this technology toenable our customers to build solutions which allow them to integratescientific software and content from across the research and developmentspectrum. Selling solutions is fundamentally different than our traditionalsale of stand-alone modeling and simulation products. We are focused onenhancing our sales processes to emphasize solutions selling and strategicaccount management. We are also expanding our professional services

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capabilities to enableour customers to deploy these solutions.

Inaddition to the activities underway in our sales and service functions, wecontinue to focus on the componentization of our entire suite of products onour Discovery Studio and Materials Studio platforms. In fiscal year 2007, weexpect to continue the migration of our life sciences applications to theDiscovery Studio platform with the expected launch of Discovery Studio 1.7 bythe end of the fiscal year.

Finally,in addition to our focus on revenue growth, we continuously evaluate ourpersonnel requirements 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**

Thecritical accounting policies and estimates used in the preparation of ourconsolidated financial statements are described in Item 6, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” ofour Annual Report on Form 10-K for the year ended March 31, 2006. There havebeen  no significant changes in ourcritical accounting policies and estimates from March 31, 2006, other than asdescribed below.

*Valuation of Share-Based Awards*

Weadopted SFAS No. 123R, effective April 1, 2006, using the modified prospectivetransition method. Accordingly, beginning in the first quarter of fiscal year2007, we are recognizing as a charge against income the estimated grant datefair value of share-based awards granted to employees and directors. Weestimate the fair value of our share-based stock awards on the date of grantusing the Black-Scholes option-pricing model. The Black-Scholes option-pricingmodel requires the use of certain input variables, as follows:

*Expected Volatility.* Volatilityis a measure of the amount the stock price will fluctuate during the expectedlife of 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.*Ourassumption of the risk-free interest rate is based on the interest rates onU.S. constant rate treasury securities with contractual terms approximatelyequal to the expected life of the award.

*Expected Dividend Yield.*Becausewe have not paid any cash dividends since in our inception and do notanticipate paying dividends in the foreseeable future, we assume a dividendyield of zero.

*Expected Award Life.*We determinethe expected life of an award by considering various relevant factors,including the vesting period and contractual term of the award, our employees’historical exercise patterns and length of service, the expected futurevolatility of our stock price, tax implications of exercising an award andemployee characteristics. We also consider the expected award lives ofcomparable publicly traded companies. For ESPP purchase rights, the expectedlife is equal to the current ESPP offering period.

Under SFAS No. 123R, we are also required to estimateat grant the likelihood that the award will ultimately vest (the “pre-vestingforfeiture rate”) revise the estimate, if necessary, in future periods if theactual forfeiture rate differs. We determine the pre-vesting forfeiture rate ofan award based on our historical pre-vesting award forfeiture experience.

Our determination of the input variables used in theBlack-Scholes option pricing model as well as the pre-vesting forfeiture rateis based on various underlying estimates and assumptions that are highlysubjective and are affected by our stock price, among other factors. Changes inthese underlying estimates and assumptions could materially affect the fairvalue of our share-based awards and, therefore, the amount of share-basedcompensation expense to be recognized in our results of operations.

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**Results of Operations**

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

 
| ** **                          | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005** | ** ** |
| ** **                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                              | %          | 100 | % |
| Operating costs  and expenses:      |       |                             |       |   |   |
| Cost of revenue                     |       | 19                               | %          | 20 | % |
| Product development                 |       | 25                               | %          | 29 | % |
| Sales and marketing                 |       | 34                               | %          | 42 | % |
| General and administrative          |       | 23                               | %          | 20 | % |
| Total operating  costs and expenses |       | 102                              | %          | 111 | % |
| Operating loss                      |       | (2                               | )%         | (11 | )% |
| Interest and  other income, net     |       | 2                                | %          | 3 | % |
| Income (loss)  before income taxes  |       | 0                                | %          | (7 | )% |
| Income tax  expense                 |       | 2                                | %          | 2 | % |
| Net loss                            |       | 2                                | %          | (9 | )% |

 

***Revenue***

Revenue decreased $0.3million or 1% to $20.2 million for the three months ended June 30, 2006, ascompared to $20.4 million for the three months ended June 30, 2005. Thedecrease in revenue was primarily attributable to the impact of fluctuations inforeign currency exchange rates.

***Operating Costs and Expenses***

*Cost of Revenue.*Cost of revenue decreased $0.2 millionor 6% to $3.9 million for the three months ended June 30, 2006, as compared to$4.1 million for the three months ended June 30, 2005. As a percentage ofrevenue, cost of revenue decreased to 19% for the three months ended June 30,2006, as compared to 20% for the three months ended June 30, 2005. The decreasein cost of revenue was primarilyattributable to a slight decline in royalties.

*Product DevelopmentExpenses.*Productdevelopment expenses decreased $0.7 million or 12% to $5.1 millionfor the three months ended June 30, 2006, as compared to $5.9 million forthe three months ended June 30, 2005. As a percentage of revenue, productdevelopment decreased to 25% for the three months ended June 30, 2006, ascompared to 29% for the three months ended June 30, 2005. The decrease inproduct development expenses was primarily attributable to lower personnel expenses resulting from headcountreductions during fiscal year 2006.

*Sales and MarketingExpenses.*Sales andmarketing expenses decreased $1.7 million or 20% to $6.8 millionfor the three months ended June 30, 2006, as compared to $8.5 million forthe three months ended June 30, 2005. As a percentage of revenue, sales andmarketing expenses decreased to 34% for the three months ended June 30, 2006,as compared to 42% for the three months ended June 30, 2005. The decrease in sales and marketing expenses wasprimarily attributable to lower personnel expenses resulting from headcountreductions during fiscal year 2006.

*General and AdministrativeExpenses.*General andadministrative expenses increased $0.6 million or 16% to $4.7 millionfor the three months ended June 30, 2006, as compared to $4.1 million forthe three months ended June 30, 2005. As a percentage of revenue, general andadministrative expenses increased to 23% for the three months ended June 30,2006, as compared to 20% for the three months ended June 30, 2005. The increasein general and administrative costs was primarily attributable to $0.5 millionof outside consulting and accounting fees incurred during the three monthsended June 30, 2006 related to the restatement of our previously issuedconsolidated financial statements, which was completed in May 2006, and $0.4million of share-based compensation expense recognized during the three monthsended June 30, 2006 resulting from our adoption of SFAS No. 123R, offset by lower personnel expenses resulting from headcountreductions during fiscal year 2006 and lower outside legal fees.

***Net Interest and OtherIncome***

Net interest and otherincome was $0.5 million for the three months ended June 30, 2006,as compared to $0.7 million for the three months ended June 30, 2005. Thedecrease in net interest and other income was primarily attributable tounfavorable fluctuations in the value of the U.S dollar.

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***Income Tax Expense***

We recognized income taxexpense of $0.4 million for each of the three months ended June 30, 2006and 2005, respectively. Income tax expense for the three months ended June 30,2006 was primarily attributable to deferred taxes associated with taxdeductible goodwill. Income tax expense for the three months ended June 30,2005 is primarily attributable to taxable income generated by our foreignoperations.

**Liquidity and Capital Resources**

We had cash, cash equivalents,restricted cash and marketable securities of $63.3 million as of June30, 2006, as compared to $66.0 million asof March 31, 2006, a decrease of $2.7 million. The decrease in cash, cashequivalents, restricted cash and marketable securities was primarilyattributable to cash used in operations of $4.9 million during the three monthsended June 30, 2006, offset by an increase in restricted cash of $1.2 millionresulting from the receipt of a subtenant security deposit. A correspondingrefundable deposit liability was recognized for the security deposit, which isincluded in lease-related liabilities, net of current portion in theaccompanying condensed consolidated balance sheet as of June 30, 2006.

Netcash used in operating activities was $4.9 million for the three months endedJune 30, 2006, as compared to $5.9 million for the three months ended June 30,2005. The decrease in cash used in operating activities was primarilyattributable to reduced operating expenditures.

Netcash used in investing activities was $3.1 million for the three months endedJune 30, 2006, as compared to net cash provided by investing activities of $0.8million for the three months ended June 30, 2005. Significant components ofcash flows from investing activities for the three months ended June 30, 2006included net purchases of property and equipment of $0.2 million and a netincrease in our marketable securities portfolio of $3.0 million. Significantcomponents of cash flows from investing activities for the three months endedJune 30, 2005 included $1.0 million of net purchases of property and equipmentand a net decrease in our marketable securities portfolio of $1.9 million.

Netcash provided by financing activities was $0.3 million for the three monthsended June 30, 2006, compared to $0.5 million for the three months ended June30, 2005. Cash flows from financing activities for the three months ended June30, 2006 and 2005 consisted solely of proceeds from the issuance of our commonstock under employee stock plans.

We have funded our activities todate primarily through the sales of software licenses and related services, theissuance of equity securities, and, prior to the spin-off of PDD, drugdiscovery services.

We anticipate that our capitalrequirements may increase in future periods as a result of seasonal salestrends, additional product development activities, and the acquisition ofadditional equipment. Our capital requirements may also increase in futureperiods as we seek to expand our technology platform through investments,licensing arrangements, technology alliances, or acquisitions.

We anticipate that our existingcapital resources will be adequate to fund our operations for at least the next12 months. However, there can be no assurance that changes will not occur thatwould consume available capital resources before then. Our capital requirementsdepend on numerous factors, including our ability to continue to generatesoftware sales, the purchase of additional capital equipment and acquisitionsof other businesses or technologies. There can be no assurance that additionalfunding, if necessary, will be available to us on favorable terms, if at all.Our forecast for the period of time through which our financial resources willbe adequate to support our operations is forward looking information, andactual results could vary.

**Item 3. Quantitative and Qualitative DisclosuresAbout Market Risk**

The information calledfor by this item is provided in Item 7A, “Quantitative and QualitativeDisclosures About Market Risk,” of our Annual Report on Form 10-K for the yearended March 31, 2006. Our exposures to market risk have not changed materiallysince March 31, 2006.

**Item 4. Controls and Procedures**

**Conclusion Regarding theEffectiveness of Disclosure Controls and Procedures**

We maintaindisclosure controls and procedures, as such term is defined in Rules 13a-15(e)and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), that are designed to provide reasonable assurance that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the SEC rules and forms, and that such information isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate, to allowtimely decisions regarding required financial disclosures. Because of inherentlimitations, our 

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disclosure controls and procedures, nomatter how well designed and operated, can provide only reasonable, and notabsolute, assurance that the objectives of such disclosure controls andprocedures are met.

As more fully described in Item 9A of our AnnualReport on Form 10-K for the year ended March 31, 2006, we reported thatour management identified certain control deficiencies that represent materialweaknesses in our internal control over financial reporting. Thematerial weaknesses identified by management related to the application ofsoftware revenue recognition principles to our term-based and perpetualsoftware license arrangements and the application of SFAS No. 86 to oursoftware development projects. As a result of the identification ofthese material weaknesses, our principal executive officer and principalfinancial officer concluded that as of March 31, 2006, our disclosure controlsand procedures were not effective pursuant to Exchange Act Rules 13a-15(f)and 15d-15(f).

As of the end of the period covered by this Report, we conducted anevaluation, under the supervision and with the participation of our management,including our principal executive officer and principal financial officer, ofthe effectiveness 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 the identified material weaknesses in our internalcontrol over financial reporting had not been fully remediated and, therefore,our disclosure controls and procedures were not effective as of June 30, 2006. Notwithstandingthe material weaknesses described above, management believes that theconsolidated financial statements included in this Report fairly present in allmaterial respects our financial condition, results of operations and cash flowsfor the periods presented.

**Changes in Internal Control OverFinancial Reporting**

In the first quarter of fiscal year 2007, in order toremediate the identified material weaknesses in our internal control overfinancial reporting, we implemented the following remediation initiatives:

(1)       We hired three senior-levelaccounting employees in March and April 2006 who have significant expertise infinancial controls and the application of generally accepted accountingprinciples relevant to our business, including software revenue recognition.

(2)       We initiated a program ofadditional training regarding our revenue recognition policies designed toensure all relevant personnel involved in software revenue recognitiontransactions understand and apply applicable generally accepted accountingprinciples, and have set an annual minimum training requirement.

(3)       We implemented an enhancedquarterly and annual financial statement close, review and reporting process toinclude additional levels of analysis and review.

Notwithstanding the implementation of theseremediation initiatives, the identified material weaknesses in our internalcontrol over financial reporting will not be considered remediated until thenew controls are fully implemented, in operation for a sufficient period oftime, are tested and our management concludes that the new controls areoperating effectively.

Except as described above, there were no changes inour internal control over financial reporting during the three months endedJune 30, 2006 that materially affected, or are reasonably likely to materiallyaffect, those controls.

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** **

**PART II —OTHER INFORMATION**

**Item 1A.Risk Factors**

*You should carefully consider the risks describedbelow before investing in our publicly-traded securities. The risks describedbelow are not the only ones facing us. Our business is also subject to therisks that affect many other companies, such as competition, technologicalobsolescence, labor relations, general economic conditions, geopoliticalchanges and international operations. Additional risks not currently known tous or that we currently believe are immaterial also may impair our businessoperations and our liquidity. Therisks described below could cause our actual results to differ materially fromthose contained in forward-looking statements we have made in this Report, theinformation incorporated herein by reference and those we may make from time totime.*

**Certain Risks Related to Our Marketplace and Environment**

***Our revenue from the sale ofmodeling, simulation and informatics software to the life science discoveryresearch marketplace, which has historically constituted a significant portionof our overall 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 orincrease revenues will depend upon our success in developing, marketing andselling software and service solutions to both our existing customers and tonew customers.*** Our strategy involves transforming ourproduct and service offerings by providing tools and components to ourcustomers which allow our customers to integrate software applications and datamore easily. A key enabler of this strategy is the data pipelining and workflowtechnology we acquired through the September 2004 acquisition of SciTegic, Inc.We are utilizing SciTegic’s Pipeline Pilot technology to enable our customersto build solutions which allow them to receive greater value from their data,information and knowledge. Selling this type of solution is fundamentallydifferent than our historical sale of modeling and simulation products, andthis type of offering is dependant upon our ability to build a successfulservices offering. Our sales and services management are focused ontransforming our sales process to allow us to be successful with this type ofsale. In addition, we are adding personnel and defining services offerings toenable our customers to successfully deploy these solutions. There can be noassurance that we will be successful in this transformation of our salesprocesses and in the building of our services capabilities. If we are notsuccessful, our ability to sustain or increase revenue may be adverselyimpacted.

***Our ability to sustain orincrease revenues will depend upon our success in entering new markets and inderiving additional revenues from our existing customers.***Ourproducts are currently used primarily by molecular modeling and simulationspecialists in discovery research organizations. Our strategy is to expandusage of our products and services by marketing and distributing our softwareto a broader, more diversified group of biologists, chemists, engineers andinformaticians within our existing pharmaceutical and biotechnology customers,as well as to new customers in other industries. However, our products andservices may not achieve market acceptance or penetration in targeted newdepartments within our customers or in new industries. As a result, we may notbe able to sustain or increase revenue.

***We may be unable to developstrategic relationships with our customers.***Our strategyis to expand 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.

***Consolidation within thepharmaceutical and biotechnology industries may continue to lead to fewerpotential customers for our products and services.***Asignificant portion of our customer base consists of pharmaceutical andbiotechnology companies. Continued consolidation within the pharmaceutical andbiotechnology industries may result in fewer customers for our products andservices. If one of the parties to a consolidation uses the products orservices of our competitors, we may lose existing customers as a result of suchconsolidation.

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***Health care reform andrestrictions on reimbursement may affect the ability of pharmaceutical,biotechnology and industrial chemical companies to purchase or license ourproducts or services, which may affect our results of operations and financialcondition.***The continuing efforts of government and third-partypayers in the markets we serve to contain or reduce the cost of health care mayreduce the profitability of pharmaceutical, biotechnology and industrialchemical companies causing them to reduce research and developmentexpenditures. Because our products and services depend on such research anddevelopment expenditures, our revenues may be significantly reduced. We cannotpredict what actions federal, state or private payers for health care goods andservices may take in response to any health care reform proposals orlegislation.

***We face strong competition in thescientific software sector*.** The market for our productsis intensely competitive. We currently face competition from other scientificsoftware providers, larger technology and solutions companies, in-housedevelopment by our customers, as well as academic and government institutionsand the open source community.

Some of our competitors and potential competitors inthis sector have longer operating histories than us and have greater financial,technical, marketing, research and development and other resources. Many of ourcompetitors offer products and services directed at more specific markets thanthose we target, enabling these competitors to focus a greater proportion oftheir efforts and resources on these markets. Some offerings that compete withour products are developed and made available at lower cost by governmentorganizations and academic institutions, and these entities may be able todevote substantial resources to product development and also offer theirproducts to users for little or no charge. We also face competition from opensource software initiatives, in which developers provide software andintellectual property free over the Internet. In addition, many of our customersspend significant internal resources 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 ourbusiness, financial condition and results of operations.

***We are subject to pricingpressures in the markets we serve.***We operate in anintensely competitive marketplace which has led to significant pricing pressureand declines in average selling price over the past several years. In responseto competition and general adverse economic conditions in the markets we serve,we may be required to modify our pricing practices. Changes in our pricingmodel could lead to a decline or delay in revenue as our sales force andcustomers adjust to the new pricing policies. This development may adverselyaffect our revenue and earnings.

***Our operations may be interruptedby the occurrence of a natural disaster or other catastrophic event at ourprimary facilities.***Our research and developmentoperations and administrative functions are primarily conducted at ourfacilities in San Diego, California, Cambridge, United Kingdom, and Bangalore,India. We also conduct sales and customer support activities at our facilitiesin Burlington, Massachusetts, Paris, France, and Tokyo, Japan. Although we havecontingency plans in effect for natural disasters or other catastrophic events,catastrophic events could still disrupt our operations. For example, our SanDiego and Tokyo facilities are located in areas that are particularlysusceptible to earthquakes. Any natural disaster or catastrophic event in ourfacilities or the areas in which they are located could have a significantnegative 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.

**CertainRisks Related to Our Operations**

***Defects or malfunctions in ourproducts could hurt our reputation among our customers, result in delayed orlost revenue and expose us to liability.***Our business andthe level of customer acceptance of our products depend upon the continuous,effective and reliable operation of our software and related tools andfunctions. To the extent that defects cause our software to malfunction and ourcustomers’ use of our products is interrupted, our reputation could suffer andour revenue could decline or be delayed while such defects are remedied. We mayalso be subject to liability for the defects and malfunctions of third-partytechnology partners and others with whom our products and services areintegrated.

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***Delays in the release of new orenhanced products or services or undetected errors in our products or servicesmay result in increased cost to us, delayed market acceptance of our productsand delayed or lost revenue.***To achieve marketacceptance, new or enhanced products or services can require long developmentand testing periods, which may result in delays in scheduled introduction. Anydelays in the release schedule for new or enhanced products or services maydelay market acceptance of these products or services and may result in delaysin new customer orders for these new or enhanced products or services or theloss of customer orders. In addition, new or enhanced products or services maycontain a number of undetected errors or “bugs” when they are first released.Although we test each new or enhanced software product or service before beingreleased to the market, there can be no assurance that significant errors willnot be found in existing or future releases. As a result, in the monthsfollowing the introduction of certain releases, we may need to devotesignificant resources to correct these errors. There can be no assurance,however, that all of these errors can be corrected.

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

·               unexpected changesin regulatory requirements;

·               longer paymentcycles;

·               currency exchangerate fluctuations;

·               import and exportlicense requirements;

·               tariffs and otherbarriers;

·               political unrest,terrorism and economic instability;

·               disruption of ouroperations due to local labor conditions;

·               limitedintellectual property protection;

·               difficulties incollecting trade receivables;

·               difficulties inmanaging distributors or representatives;

·               difficulties inmanaging an organization spread over various countries;

·               difficulties instaffing foreign subsidiary or joint venture operations; and

·               potentially adversetax consequences.

Our success depends, in part, on our ability toanticipate and address these risks. There can be no assurance that we will doso effectively, or that these or other factors relating to our internationaloperations will not adversely affect our business or operating results.

***In order to improve our financialposition, we have reduced our headcount, which could negatively impact ourbusiness.***We have undergone several reductions-in-forceover the past few years, and our workforce has declined by approximately 200people since March 2002. 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.

***Failure to attract and retainskilled personnel, including the personnel necessary to address the identifiedmaterial weaknesses in our internal control over financial reporting, couldhave a material adverse effect on us.*** Our success dependsin part on the continued service of key scientific, sales, businessdevelopment, marketing, engineering, management and accounting personnel andour ability to identify, hire and retain additional personnel. There is intensecompetition for qualified personnel. Immigration laws may further restrict ourability to attract or hire qualified personnel. We may not be able to continueto attract and retain the personnel necessary for the development of ourbusiness. Failure to attract and retain key personnel could have a materialadverse effect on our business, financial condition and results of operations.Further, we are highly dependent on the principal members of our technical,scientific and management staff. One or more of these key employees couldretire or otherwise leave our employ within the foreseeable future, and theloss of any of these people could have a material adverse effect on ourbusiness, financial condition and results of operations. We do not intend tomaintain key person life insurance on the life of any employee.

In addition to the foregoing, as described in greaterdetail elsewhere in this Report and in our Annual Report on Form 10-K for theyear ended March 31, 2006, we concluded that our internal control over financialreporting was not effective as of March 31, 2006. In particular, in connectionwith the restatement of our previously issued financial statements, managementidentified certain control deficiencies that represented material weaknesses inour internal 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 our 

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business,were at least partially responsible for our need to restate our previouslyissued consolidated financial statements. In order to remediate the identifiedmaterial weaknesses in our internal control over financial reporting, weimplemented certain actions, including the hiring of three senior-levelaccounting employees in March and April 2006 who have significant expertise infinancial controls and the application of generally accepted accountingprinciples relevant to our business, including software revenue recognition.However, one or more of these qualified recruits or existing personnel couldleave our employ within the foreseeable future. If not timely and adequatelyaddressed, the loss of any of these individuals could impair our ability tomaintain effective internal control over financial reporting and thereby causea material adverse effect on our business.

***If we choose to acquirebusinesses, products or technologies instead of developing them ourselves, wemay be unable to complete these acquisitions or to successfully integrate anacquired business or technology in a cost-effective and non-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 andour future profitability is uncertain.*****We generated net losses for the three months ended June 30,2006, the years ended March 31, 2006 and 2005 and December 31, 2003, and thethree months ended March 31, 2004. Continuing net losses may limit our abilityto fund our operations and we may not generate income from operations in thefuture. Our future profitability depends upon many factors, including severalthat are beyond our control. These factors include without limitation:

·               changes in thedemand for our products and services;

·               the introduction ofcompetitive software;

·               our ability tolicense desirable technologies;

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

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

***Our sales forecast and/or revenueprojections may not be accurate.***We use a “pipeline”system, a common industry practice, to forecast sales and trends in ourbusiness. Our sales personnel monitor the status of proposals, including thedate when they estimate a customer will make a purchase decision and thepotential size of the order. We aggregate these estimates on a quarterly basisin order to generate a sales pipeline. While the pipeline process provides uswith some guidance in business planning and forecasting, it is based onestimates only and is therefore subject to risks and uncertainties. Anyvariation in the conversion of the pipeline into revenue or the pipeline itselfcould cause us to improperly plan or budget and thereby adversely affect ourbusiness, results of operations and financial condition.

***If we are unable to licensesoftware to, or collect receivables from our customers our operating resultsmay be adversely affected.***The majority of our currentcustomers are well-established, large pharmaceutical customers anduniversities, and other customers include smaller biotechnology companies. Wehave not experienced significant customer defaults during the past three fiscalyears and have recorded a provision for bad debts of less than $0.5 million ineach of those periods. Our financial success depends upon the creditworthinessand ultimate collection of amounts due from our customers. If we are not ableto collect from our customers, we may be required to write-off significantaccounts receivable and recognize bad debt expenses which could materially andadversely affect our operating results.

***Our quarterly operating results,particularly our quarterly cash flows, will fluctuate.***Quarterlyoperating results may fluctuate as a result of a number of factors, includinglengthy sales cycles, market acceptance of new products and upgrades, timing ofnew product introductions, changes in pricing policies, changes in generaleconomic and competitive conditions, and the timing and integration ofacquisitions. We may also experience fluctuations in quarterly operatingresults due to general and industry specific economic conditions that mayaffect the research and development expenditures of pharmaceutical andbiotechnology companies. In particular, we historically received approximately40% of our annual orders in the fiscal quarter ended December 31. As a result,our cash flows from operations generally are positive in the fiscal quarterended March 31, and we generally experience negative cash flows from operationsin the other three fiscal quarters. Due to the possibility of fluctuations inour revenue and expenses, we believe that quarter-to-quarter comparisons of ouroperating results are not a good indication of our future performance.

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***Changes in the accountingtreatment of employee stock-based compensation has and will continue toadversely affect our results of operations.*****In December 2004, the FASB issued SFAS No. 123R, whichrevises SFAS No. 123, *Accounting for Stock-BasedCompensation*. SFAS No. 123R requires that employee stock-basedcompensation is measured based on the grant-date fair value of the relatedemployee equity award and is treated as an expense that is reflected in thefinancial statements over the related service period. SFAS No. 123R applies toall employee equity awards granted after adoption and to the unvested portionof employee equity awards outstanding as of adoption. We adopted SFAS No. 123Rusing the modified-prospective method on April 1, 2006. As a result of theadoption of SFAS No. 123R, we recognized a charge against our earnings of $1.0million, or $0.04 per share, in the first quarter of fiscal year 2007. Weanticipate that the continued application of the accounting provisions of SFASNo. 123R will adversely impact on our future reported results of operations.

***The recently completedrestatement of our historical financial statements has already consumed, andmay continue to consume, a significant amount of our resources and may have amaterial adverse effect on our business and stock price.***In December 2005, we announced that our previously issued consolidatedfinancial statements would be restated to reflect certain accountingadjustments. The restatement process was highly time and resource-intensive andinvolved substantial attention from management and significant legal andaccounting costs. Although we have now completed the restatement, we cannotguarantee that we will have no further inquiries from the SEC or NASDAQregarding our restated financial statements or matters relating thereto.Likewise, many companies that have been required to restate their historicalfinancial statements have subsequently experienced stockholder lawsuitsrelating to their restatements. Any future inquiries from the SEC or NASDAQ asa result of the restatement of our historical financial statements will,regardless of the outcome, likely consume a significant amount of our resourcesin addition to those resources already consumed in connection with therestatement itself.

***If we fail to maintain aneffective system of internal control over financial reporting, we may not beable to accurately report our financial results, and current and potentialstockholders may lose confidence in our financial reporting.***We are required by the SEC to establish and maintain adequate internal controlover financial reporting that provides reasonable assurance regarding thereliability of our financial reporting and the preparation of financialstatements in accordance with generally accepted accounting principles. We arelikewise required, on a quarterly basis, to evaluate the effectiveness of ourinternal controls and to disclose any changes, significant deficiencies ormaterial weaknesses in those internal controls.

As described in greater detail elsewhere in thisReport and in our Annual Report on Form 10-K for the year ended March 31, 2006,in connection with the restatement process, we identified certain controldeficiencies that represented material weaknesses in our internal control overfinancial reporting. These material weaknesses generally relate to ourhistorical lack of a sufficient number of employees with appropriate levels ofaccounting knowledge, experience and training in the application of generallyaccepted accounting 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.

Since the determination regarding our materialweaknesses, we have devoted significant effort and resources to the remediationand improvement of our internal control over financial reporting. Inparticular, as described elsewhere in this Report, we have recruited a numberof qualified individuals to assist in maintaining adequate internal controls,we have initiated a revenue recognition training program and we have implementedan enhanced quarterly and annual financial statement close, review andreporting process. Notwithstanding the implementation of these remediationinitiatives, the identified material weaknesses in our internal control overfinancial reporting will not be considered remediated until the new controlsare fully implemented, in operation for a sufficient period of time, are testedand our management concludes that the new controls are operating effectively.Because the remediation initiatives are not yet fully implemented, ourprincipal executive officer and principal financial officer concluded that theidentified material weaknesses in our internal control over financial reportinghad not been fully remediated and, therefore, our disclosure controls andprocedures were not effective as of June 30, 2006.

Although we believe that these efforts and resourceshave strengthened our internal control over financial reporting, we cannot becertain that these measures will ensure that we maintain adequate internalcontrol over our financial reporting in future periods. Any failure to maintainsuch internal controls could adversely impact our ability to report ourfinancial results on a timely and accurate basis. If our financial statementsare not accurate, investors may not have a complete understanding of ouroperations. Likewise, if our financial statements are not filed on a timelybasis as required by the SEC and NASDAQ, we could face severe consequences fromthose authorities. In either case, there could result a material adverse affecton our business. Inferior internal controls could also cause investors to loseconfidence in our reported financial information, which could have a negativeeffect on the trading price of our stock.

***We may be required to indemnifyPDD, or may not be able to collect on indemnification rights from PDD*.** On April 30, 2004, we spun-off our drug discovery subsidiary, PDD,into an independent, separately traded, publicly held company 

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through the distribution toour stockholders of a dividend of one share of PDD common stock for every twoshares of our common stock. As part of the spin-off, we agreed toindemnify the indebtedness, liabilities and obligations of PDD. One suchobligation includes a guarantee by us to the landlord of PDD’s obligationsunder the existing New Jersey laboratory and headquarters leases, with respectto which PDD will indemnify us should we be required to make any payment underthe guarantee. These indemnification obligations could be as significant as theremaining future minimum lease payments, which totaled approximately $24million as of June 30, 2006. PDD’s ability to satisfy any such indemnificationobligations (including, without limitation, PDD’s commitment to indemnify us inthe event of our payment under our guarantee of its leases) will depend uponPDD’s future financial strength. We cannot assure you that, if PDD becomesobligated to indemnify us for any substantial obligations, PDD will have theability to do so. There also can be no assurance that we will be able tosatisfy any indemnification obligations to PDD. Any failure by PDD to satisfyits obligations and any required payment by us could have a material adverseeffect on our business.

***Enacted and proposed changes insecurities laws and regulations have increased our costs and may continue toincrease our costs in the future.*** Sarbanes-Oxley requiredchanges in some of our corporate governance and securities disclosure andcompliance practices. Under Sarbanes-Oxley, publicly held companies, includingus, are required to, among other things, furnish independent annual auditreports regarding the existence and reliability of their internal control overfinancial reporting and have their chief executive officer and chief financialofficer certify as to the accuracy and completeness of their financial reports.

We expect continued compliance with Sarbanes-Oxley toremain costly. Further, Sarbanes-Oxley and the related SEC and NASDAQcompliance rules may make it more difficult and expensive for us to obtaindirector and officer liability insurance, and we may be required to acceptreduced coverage or incur substantially higher costs to obtain coverage. Theselaws and regulations could also make it more difficult for us to attract andretain qualified members of our board of directors, or qualified executiveofficers. We continually evaluate and monitor regulatory developments andcannot estimate the timing or magnitude of additional costs we may incur as aresult.

***Our business, financial conditionand results 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 from internationalsales, and thus on our business, financial condition and results of operations.When deemed appropriate, we may engage in currency exchange rate hedgingtransactions in an attempt to mitigate the impact of adverse exchange ratefluctuations. However, currency hedging policies may not be successful, andthey may increase the negative impact of exchange rate fluctuations.

***If we consume cash more quicklythan expected, we may be unable to raise additional capital and we may beforced to curtail operations.***We anticipate that ourexisting capital resources will be adequate to fund our operations for at leastthe next twelve months***.***However,changes may occur that would consume available capital resources before thattime. Our capital requirements will depend on numerous factors, including:

·               costs associatedwith software sales;

·               the purchase ofadditional capital equipment;

·               acquisitions ofother businesses or technologies;

·               costs associatedwith the restatement of our historical financial statements as describedelsewhere in this Report; and

·               costs associatedwith addressing the material weaknesses in our internal control over financialreporting as described elsewhere in this Report.

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

**CertainRisks Related to Owning Our Stock**

***We expect that our stock price will fluctuate significantly, and youmay not be able to resell your shares at or above your investment price.***Thestock market, historically and in recent years, has experienced significantvolatility particularly with technology company stocks. The volatility oftechnology company stock prices often does not relate to the operatingperformance of the companies represented by the stock. Factors that could causevolatility in the price of our common stock include without limitation:

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

·               market conditions in the technology andsoftware sectors;

·               issuance of new or changed securitiesanalysts’ reports or recommendations;

·               developments or disputes concerning ourintellectual property or other proprietary rights or other legal claims;

·               introduction of technologicalinnovations or new commercial products by us or our competitors;

·               market acceptance of our products andservices;

·               additions or departures of keypersonnel;

·               public perception of the impact of therestatement of our historical consolidated financial statements as describedelsewhere in this Report; and

·               the disclosure of the materialweaknesses in our internal control over financial reporting as describedelsewhere in this Report.

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These and otherexternal factors may cause the market price and demand for our common stock tofluctuate substantially, which may limit or prevent investors from readilyselling their shares of common stock and may otherwise negatively affect theliquidity of our common stock. In addition, in the past, when the market priceof a stock has been volatile, holders of that stock have periodicallyinstituted securities class action litigation against the issuer.

***As institutions hold the majorityof our common stock in large blocks, substantial sales by these stockholderscould depress the market price for our shares.***As of July17, 2006, the top ten institutional holders of our common stock held approximately50% of our outstanding common stock. As a result, if one or more of these majorstockholders were to sell all or a portion of their holdings, or if the marketwere to perceive that such sale or sales may occur, the market price of ourcommon stock may fall significantly.

***Because we do not intend to paydividends, our stockholders will benefit from an investment in our common stockonly if our stock price appreciates in value.***We havenever declared or paid any cash dividends on our common stock. We currentlyintend to retain our future earnings, if any, to finance the expansion of ourbusiness and do not expect to pay any cash dividends in the foreseeable future.As a result, the success of an investment in our common stock will dependentirely upon any future appreciation in its value. There is no guarantee thatour common stock will appreciate in value or even maintain the price at whichit was purchased.

***Anti-takeover provisions underthe Delaware General Corporation Law, provisions in our certificate ofincorporation and bylaws, and our adoption of a stockholder rights plan mayrender more difficult the accomplishment of mergers or the assumption ofcontrol by a principal stockholder, making more difficult the removal ofmanagement*.**Certain provisions of the Delaware GeneralCorporation Law may delay or deter attempts to secure control of our companywithout the consent of our management. Also, our governing documents providefor a staggered board of directors, which will make it more difficult for apotential acquirer to gain control of our board of directors. In 2002, weadopted a stockholder rights plan, which is triggered upon commencement orannouncement of a hostile tender offer or when any one person or group acquires15% or more of our common stock. The rights plan, once triggered, enables ourstockholders (other than the stockholder responsible for triggering the rightsplan) to purchase our common stock at reduced prices. These provisions of ourgoverning documents and stockholder rights plan, and of Delaware law, couldhave the effect of delaying, deferring or preventing a change of control,including without limitation a proxy contest, making more difficult theacquisition of a substantial block of our common stock. The provisions couldalso limit the price that investors might be willing to pay in the future forshares of our common stock. Further, the existence of these anti-takeovermeasures may cause potential bidders to look elsewhere, rather than initiatingacquisition discussions with us.

**CertainRisks Related to Intellectual Property**

***We may not be able to protectadequately the trade secrets and confidential information that we disclose toour employees.***We rely upon trade secrets, technicalknow-how and continuing technological innovation to develop and maintain ourcompetitive position. Competitors through their independent discovery (orimproper means, such as unauthorized disclosure or industrial espionage) maycome to know our proprietary information. We generally require employees andconsultants to execute confidentiality and assignment-of-inventions agreements.These agreements typically provide that all materials and confidentialinformation developed by or made known to the employee or consultant duringhis, her or its relationship with us are to be kept confidential, and that allinventions arising out of the employee’s or consultant’s relationship with usare our exclusive property. Our employees and consultants may breach theseagreements, and in some instances we may not have an adequate remedy.Additionally, in some instances, we may have failed to require that employeesand consultants execute confidentiality and assignment-of-inventionsagreements.

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***Foreign laws may not afford ussufficient protections for our intellectual property, and we may not seekpatent protection outside the United States.***We believethat our success depends, in part, upon our ability to obtain internationalprotection for our intellectual property. However, the laws of some foreigncountries may not be as comprehensive as those of the United States and may notbe sufficient to protect our proprietary rights abroad. In addition, wegenerally do not pursue patent protection outside the United States because ofcost and confidentiality concerns. Accordingly, our international competitorscould obtain foreign patent protection for, and market overseas, products andtechnologies for which we are seeking 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 otherconsiderations, we generally do not rely on patent protection to enforce ourintellectual property rights, and have filed only a limited number of patentapplications. Even if patents are issued to us, these patents may notsufficiently protect our interest in our software or other technologies becausethe scope of protection provided by any patents issued to or licensed by us aresubject to the uncertainty inherent in patent law. Third parties may be able todesign around these patents or develop unique products providing effectssimilar to our products. In addition, others may discover uses for our softwareor technologies other than those uses covered in our patents, and these otheruses may 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 ofinfringement by 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 codesincorporated into our products could subject us to liability or limit ourability to sell such products.***Some of our productsinclude software codes licensed from third parties, including the open sourcecommunity. Some of these licenses impose certain obligations upon us, includingroyalty and indemnification obligations. In the case of codes licensed from theopen source community, the licenses may also limit our ability to sell productscontaining such code. Though we generally review the applicable licenses priorto incorporating 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 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           |       | Employment Transition  and Separation Agreement, dated June 14, 2006, between Accelrys, Inc. and  David M. Sankaran (incorporated by reference to Exhibit 99.1 to Accelrys,  Inc.’s Form 8-K dated June 15, 2006)                 |
| 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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*  Filed herewith

 

 

 

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**SIGNATURE**

Pursuant to the requirements of section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|        |   | ACCELRYS, INC. |
|--------|--------|----------------|
|   |   |           |   |   |
|   |   | By:            |   | /s/ DAVID M. SANKARAN |
|   |   |           |   | David M. Sankaran |
|   |   |           |   | Senior Vice President and Chief Financial   Officer (Duly Authorized Officer and Chief   Financial Officer) |
|   |   |           |   |   |
|   |   |           |   | Date: August 4, 2006 |

 

 

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