**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, DC 20549**

 

----

 

**FORM 10-Q**

** **

| **ý**                                                                                                                                                                | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                | ** ** | ** **                                                                                              |
| **For the quarterly period ended June  30, 2005**                                                                                                                    |
| ** **                                                                                                                                                                | ** ** | ** **                                                                                              |
| **OR**                                                                                                                                                                    |
| ** **                                                                                                                                                                | ** ** | ** **                                                                                              |
| **o**                                                                                                                                                                     | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                | ** ** | ** **                                                                                              |
| **For the transition period  from           to           ** |

 

**Commission File Number: 0-27188**

 

----

 

**ACCELRYS, INC.**

(ExactName of Registrant as Specified in Its Charter)

 

| **Delaware**                                                     | ** ** | **33-0557266**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State  or Other Jurisdiction of  Incorporation or Organization) | ** ** | (I.R.S.  Employer Identification No.) |
|                                                             | ** ** | ** **                            |
| **10188 Telesis Court, Suite 100**                               | ** ** | **92121-4779**                        |
| (Address  of Principal Executive Offices)                        | ** ** | (Zip  Code)                           |

 

**(858) 799-5000**

Registrant’sTelephone Number, Including Area Code

 

| **Title of Each Class**                    | ** ** | **Name of Each  Exchange on Which Registered** |
|--------------------------------------------|------------|------------------------------------------------|
| Common  stock, par value $0.0001 per share |       | Nasdaq  National Market                        |

 

Securities registered pursuant toSection 12(g) of the Act: None

 

Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange ActRule 12b-2). Yes ý  No o

Indicate the number of shares outstanding ofeach of the registrant’s classes of common stock, as of the latest practicabledate.

 

| **Class**                                  | ** ** | **Outstanding at June 30, 2005**     |
|--------------------------------------------|------------|--------------------------------------|
| Common  stock, par value $0.0001 per share |       | 26,126,999  (Net of treasury shares) |

 

 

----

 

**ACCELRYS, INC.**

**Form 10-Q**

**For TheQuarter Ended June 30, 2005**

 

**Table of Contents**

 
| PART I – FINANCIAL INFORMATION       | 2                                                                                           |
|-------------------------------------------|---------------------------------------------------------------------------------------------|
|                                      |                                                                                        |
| Item 1. Consolidated Financial Statements | 2                                                                                           |
|                                      | Consolidated Balance Sheets                                                                 | 2 |
|                                      | Consolidated  Statements of Operations                                                      | 3 |
|                                      | Consolidated Statements of Cash Flows                                                       | 4 |
|                                      | Notes to Consolidated Financial Statements                                                  | 5 |
|                                      |                                                                                        |   |
| ITEM 2.                                   | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 11 |
|                                      |                                                                                        |   |
| ITEM 3.                                   | QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK                                 | 25 |
|                                      |                                                                                        |   |
| ITEM 4.                                   | CONTROLS AND PROCEDURES                                                                     | 25 |
|                                      |                                                                                        |   |
| PART II – OTHER  INFORMATION         | 25                                                                                          |
|                                      | ITEM 1.                                                                                     | Legal Proceedings | 25 |
|                                      | ITEM 2.                                                                                     | Unregistered Sales of Equity Securities and Use of  Proceeds | 25 |
|                                      | ITEM 3.                                                                                     | Defaults upon Senior Securities | 25 |
|                                      | ITEM 4.                                                                                     | Submission of Matters to a Vote of Security Holders | 25 |
|                                      | ITEM 5.                                                                                     | Other Information | 25 |
|                                      | ITEM 6.                                                                                     | Exhibits | 25 |
|                                      |                                                                                        |   |
| SIGNATURE                                 | 26                                                                                          |
|                                           |                                                                                             |  |  |  |

 

----

 

**PART I — FINANCIAL INFORMATION**

 

**Item 1.  ConsolidatedFinancial Statements**

 

**Accelrys, Inc.**

**Consolidated Balance Sheets**

(inthousands)

 
| ** **                                                                                                                 | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                                                                                 | ** ** | **(unaudited)**   | ** ** | ** **         | ** ** |
| **ASSETS**                                                                                                                 | ** ** | ** **        | ** ** | ** **         | ** ** |
| Current assets:                                                                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Cash and cash equivalents                                                                                                  |       | $                 | 16,981     |               | $          | 24,010 |   |
| Marketable securities                                                                                                      |       | 32,713            |       | 32,662             |       |
| Trade receivables, net of allowance for  doubtful accounts of $312 and $315, respectively                                  |       | 16,128            |       | 20,006             |       |
| Prepaid expenses and other current assets                                                                                  |       | 4,144             |       | 5,835              |       |
| Total current assets                                                                                                       |       | 69,966            |       | 82,513             |       |
|                                                                                                                       |       |              |       |               |       |
| Restricted cash                                                                                                            |       | 6,633             |       | 6,632              |       |
| Property and equipment, net                                                                                                |       | 8,896             |       | 9,043              |       |
| Goodwill                                                                                                                   |       | 42,612            |       | 42,609             |       |
| Other intangible assets, net of accumulated  amortization of $1,600 and $1,131, respectively                               |       | 9,900             |       | 10,369             |       |
| Software development costs, net of accumulated  amortization of $7,927 and $8,041, respectively                            |       | 8,583             |       | 8,553              |       |
| Other assets                                                                                                               |       | 823               |       | 835                |       |
| Total assets                                                                                                               |       | $                 | 147,413    |               | $          | 160,554 |   |
|                                                                                                                       |       |              |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                              |       |              |       |               |       |
| Current liabilities:                                                                                                       |       |              |       |               |       |
| Accounts payable                                                                                                           |       | $                 | 1,509      |               | $          | 1,821 |   |
| Accrued liabilities                                                                                                        |       | 4,522             |       | 5,570              |       |
| Accrued compensation and benefits                                                                                          |       | 6,212             |       | 8,874              |       |
| Accrued severance and lease abandonment,  current portion                                                                  |       | 2,232             |       | 2,809              |       |
| Deferred revenue, current portion                                                                                          |       | 29,707            |       | 35,005             |       |
| Total current liabilities                                                                                                  |       | 44,182            |       | 54,079             |       |
|                                                                                                                       |       |              |       |               |       |
| Deferred revenue, long-term                                                                                                |       | 7,690             |       | 7,591              |       |
| Accrued severance and lease abandonment,  long-term                                                                        |       | 1,122             |       | 1,784              |       |
| Lease concessions and guarantee, long-term                                                                                 |       | 3,856             |       | 3,347              |       |
|                                                                                                                       |       |              |       |               |       |
| Stockholders’ equity:                                                                                                 |       |              |       |               |       |
| Preferred stock, $0.0001 par value, 2,000  shares authorized, none issued and outstanding                                  |       | —            |       | —             |       |
| Common stock, $0.0001 par value, 40,000  shares authorized, 26,127 and 26,643 shares issued and outstanding,  respectively |       | 2                 |       | 2                  |       |
| Additional paid-in capital                                                                                                 |       | 253,875           |       | 253,328            |       |
| Unearned compensation                                                                                                      |       | (1,186            | )          | (1,469             | )          |
| Lease guarantee                                                                                                            |       | (682              | )          | (698               | )          |
| Treasury stock, 644 shares                                                                                                 |       | (8,340            | )          | (8,340             | )          |
| Accumulated deficit                                                                                                        |       | (152,976          | )          | (149,260           | )          |
| Accumulated comprehensive income (loss)                                                                                    |       | (130              | )          | 190                |       |
| Total stockholders’ equity                                                                                            |       | 90,563            |       | 93,753             |       |
| Total liabilities and stockholders’ equity                                                                            |       | $                 | 147,413    |               | $          | 160,554 |   |

 

Seeaccompanying notes to these consolidated financial statements.

 

2

----

 

**Accelrys, Inc.**

**ConsolidatedStatements of Operations**

(inthousands, except per share data)

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** |
| ** **                                                              | ** ** | **(unaudited)**        | ** ** | **(unaudited)** | ** ** |
|                                                                    |       |                   |       |   |   |
| Revenue                                                                 |       | $                      | 18,555     |   | $ | 14,181 |   |
|                                                                    |       |                   |       |   |   |
| Cost of revenue                                                         |       | 5,030                  |       | 3,786 |   |
| Product development                                                     |       | 4,931                  |       | 4,123 |   |
| Sales and marketing                                                     |       | 8,499                  |       | 7,769 |   |
| General and administrative                                              |       | 4,069                  |       | 4,009 |   |
| Total operating costs and expenses                                      |       | 22,529                 |       | 19,687 |   |
| Operating loss from continuing operations                               |       | (3,974                 | )          | (5,506 | ) |
| Interest and other income (expense), net                                |       | 698                    |       | 585 |   |
| Loss from continuing operations before  taxes                           |       | (3,276                 | )          | (4,921 | ) |
| Provision for income taxes                                              |       | 440                    |       | 135 |   |
| Loss from continuing operations                                         |       | (3,716                 | )          | (5,056 | ) |
| Loss from discontinued operations                                       |       | —                 |       | (1,117 | ) |
| Net loss                                                                |       | $                      | (3,716     | ) | $ | (6,173 | ) |
|                                                                    |       |                   |       |   |   |
| Per share amounts (basic and diluted):                                  |       |                   |       |   |   |
| Loss from continuing operations                                         |       | $                      | (0.14      | ) | $ | (0.21 | ) |
| Loss from discontinued operations                                       |       | —                 |       | (0.05 | ) |
| Net loss                                                                |       | $                      | (0.14      | ) | $ | (0.25 | ) |
|                                                                    |       |                   |       |   |   |
| Weighted average shares of common stock  outstanding basic and diluted: |       | 26,022                 |       | 24,323 |   |

 

Seeaccompanying notes to these consolidated financial statements.

 

3

----

 

**Accelrys, Inc.**

**Consolidated Statements of Cash Flows**

(inthousands)

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                  | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** |
| ** **                                                                  | ** ** | **(unaudited)**        | ** ** | **(unaudited)** | ** ** |
| OPERATING ACTIVITIES:                                                       |       |                   |       |   |   |
| Net loss                                                                    |       | $                      | (3,716     | ) | $ | (6,173 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |       |                   |       |   |   |
| Depreciation                                                                |       | 1,059                  |       | 1,117 |   |
| Amortization of capitalized software                                        |       | 936                    |       | 884 |   |
| Amortization of purchased intangibles                                       |       | 469                    |       | — |   |
| Amortization of unearned compensation                                       |       | 218                    |       | 143 |   |
| Contribution of stock to 401(k) members                                     |       | 134                    |       | 159 |   |
| Non-cash rent expense                                                       |       | 330                    |       | — |   |
| Changes in assets and liabilities:                                          |       |                   |       |   |   |
| Trade receivables                                                           |       | 3,555                  |       | (179 | ) |
| Prepaid expenses and other current assets                                   |       | 1,637                  |       | (1,681 | ) |
| Other assets                                                                |       | (91                    | )          | 3 |   |
| Accounts payable                                                            |       | (274                   | )          | (2,348 | ) |
| Accrued liabilities                                                         |       | (4,601                 | )          | (333 | ) |
| Deferred revenue                                                            |       | (4,574                 | )          | 556 |   |
| Net cash used in operating activities                                       |       | (4,918                 | )          | (7,852 | ) |
| INVESTING ACTIVITIES:                                                       |       |                   |       |   |   |
| Capital expenditures, net                                                   |       | (1,049                 | )          | (1,194 | ) |
| Increase in capitalized software  development costs                         |       | (1,034                 | )          | (975 | ) |
| Purchases of marketable securities                                          |       | (1,733                 | )          | (31,079 | ) |
| Proceeds from sales of marketable securities                                |       | 1,840                  |       | 36,326 |   |
| Net cash provided by (used in) investing  activities                        |       | (1,976                 | )          | 3,078 |   |
| FINANCING ACTIVITIES:                                                       |       |                   |       |   |   |
| Proceeds from issuance of common stock                                      |       | 479                    |       | 1,364 |   |
| Net cash provided by financing activities                                   |       | 479                    |       | 1,364 |   |
| Exchange rate effect on cash and  equivalents                               |       | (614                   | )          | (350 | ) |
| Cash remitted to PDD in spinoff                                             |       | —                 |       | (5,445 | ) |
| Net cash used in discontinued operations                                    |       | —                 |       | (147 | ) |
| Net decrease in cash and equivalents                                        |       | (7,029                 | )          | (9,352 | ) |
| Cash and cash equivalents, beginning of  period                             |       | 24,010                 |       | 40,072 |   |
| Cash and cash equivalents, end of period                                    |       | $                      | 16,981     |   | $ | 30,720 |   |
|                                                                        |       |                   |       |   |   |
| SUPPLEMENTAL INFORMATION:                                                   |       |                   |       |   |   |
| Cash paid during the period for:                                            |       |                   |       |   |   |
| Interest expense                                                            |       | $                      | 1          |   | $ | 3 |   |
| Income tax expense                                                          |       | $                      | 383        |   | $ | 69 |   |

 

Seeaccompanying notes to these consolidated financial statements.

 

4

----

 

**Accelrys, Inc.**

**Notes to Consolidated Financial Statements**

 

**1.****                      ****Basis of Presentation**

 

In theopinion of management, the accompanying consolidated balance sheets and relatedstatements of operations and cash flows for Accelrys, Inc. (Accelrys or theCompany) include all adjustments, consisting only of normal recurring items,necessary for their fair presentation in conformity with accounting principlesgenerally accepted in the United States (U.S. GAAP). Preparing financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenue and expenses. Examplesinclude estimates of loss contingencies, product life cycles and stock optionforfeiture rates; and assumptions such as the elements comprising a softwarearrangement, including the distinction between upgrades/enhancements and newproducts; when technological feasibility is achieved for our products; thepotential tax consequences of events that have been recognized in our financialstatements or tax returns; and determining when investment impairments areother-than-temporary. Actual results and outcomes may differ from management’sestimates and assumptions.

 

Interimresults are not necessarily indicative of results for a full year. Theinformation included in this quarterly report on Form 10-Q should be read inconjunction with Management’s Discussion and Analysis and financial statementsand notes thereto included in the Company’s annual report on Form 10-K for thefiscal year ended March 31, 2005.

 

Certainprior period amounts have been reclassified to conform to the current periodpresentation.

 

**2.****                      ****Income Taxes**

 

TheCompany accounts for income taxes using the liability method. Under theliability method, deferred income taxes are recognized for the tax consequencesof “temporary differences” by applying enacted statutory tax rates applicableto future years to differences between the financial carrying amounts and thetax basis of existing assets and liabilities. The provision for income taxes isbased on the Company’s estimates of its aggregate taxable income taking intoaccount the various legal entities through which, and jurisdictions in which, theCompany operates. As such, income tax expense may vary from the customaryrelationship between income tax expense and pre-tax accounting income (loss).

 

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

 

TheCompany computes net income (loss) per share pursuant to Statement of FinancialAccounting Standards (SFAS) No. 128, “Earnings Per Share” (SFAS 128).Under the provisions of SFAS 128, basic net income (loss) per share iscomputed by dividing the net income (loss) available to common stockholders forthe period by the weighted average number of common shares outstanding duringthe period. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted average number of common andcommon equivalent shares outstanding during the period. Common equivalentshares, composed of unvested restricted common shares and common sharesissuable upon the exercise of incrementally vesting stock options, are includedin the calculation of diluted net income (loss) per share to the extent theseshares are dilutive.

 

Thefollowing table sets forth the computation of basic and diluted net loss pershare as follows (in thousands, except per share amounts):

 

5

----

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                        | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** |
| ** **                                                                        | ** ** | **(Unaudited)**        | ** ** | **(Unaudited)** | ** ** |
|                                                                              |       |                   |       |   |   |
| Net loss                                                                          |       | $                      | (3,716     | ) | $ | (6,173 | ) |
|                                                                              |       |                   |       |   |   |
| Weighted average shares outstanding and  denominator for basic earnings per share |       | 26,022                 |       | 24,323 |   |
|                                                                              |       |                   |       |   |   |
| Effect of dilutive securities:                                                    |       |                   |       |   |   |
| Employee stock options                                                            |       | —                 |       | — |   |
|                                                                              |       |                   |       |   |   |
| Denominator for diluted earnings per share                                        |       | 26,022                 |       | 24,323 |   |
|                                                                              |       |                   |       |   |   |
| Net loss per share, basic and diluted                                             |       | $                      | (0.14      | ) | $ | (0.25 | ) |

 

Dilutivecommon stock equivalents would normally include the dilutive effects of commonstock options and restricted stock that have not fully vested. Potentiallydilutive common stock equivalents totaled approximately 4,552,000 and 1,272,000for the three months ended June 30, 2005 and June 30, 2004, respectively,but were excluded from the June 30, 2005 and June 30, 2004 dilutedearnings per share calculations because of their anti-dilutive effect.

 

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

 

TheCompany has adopted the provisions of SFAS No. 130, “ReportingComprehensive Income” (SFAS 130). SFAS 130 establishes standards forreporting comprehensive income (loss) and its components in financialstatements. Comprehensive income (loss) includes all changes in equity (netassets) during a period from non-owner sources. According to SFAS 130, income(loss) and other comprehensive income (loss), including foreign currencytranslation adjustments and unrealized gains and losses on investments, shallbe reported, net of their related tax effect, to arrive at comprehensive loss.The Company’s net income (loss) and total comprehensive income (loss) will beincluded in the statement of stockholders’ equity in the Company’s annualreport on Form 10-K.  Comprehensiveincome (loss) was ($4.0) million and $(7.6) million in the three months endedJune 30, 2005 and June 30, 2004, respectively. The primary decrease in comprehensive loss was due to a decrease in netloss between periods.

 

**5.****                      ****Stock-Based Compensation**

 

Aspermitted by SFAS No. 123, “Accounting for Stock-Based Compensation”(SFAS 123), the Company elected to follow Accounting Principles Board (APB)Opinion No. 25, “Accounting for Stock Issued to Employees” (APB25) and related interpretations in accounting for its employee stockoption plans. Under APB 25, no compensation expense is recognized at the timeof a stock option grant if the exercise price of the option equals the fairmarket value of the underlying common stock on the date of grant.

 

SFAS 123requires pro forma information regarding net income (loss) and earnings pershare as if the Company had accounted for stock options granted subsequent toDecember 31, 1994 and shares of common stock purchased by employees inconnection with the Company’s Employee Stock Purchase Plan (“equity awards”)under the fair value method. The fair value of these equity awards wasestimated at the date of grant using a Black-Scholes option pricing modelwith the following weighted average assumptions for the periods below:

 
| ** **                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------|------------|------------------------|------------|
| ** **                   | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** |
| ** **                   | ** ** | **(Unaudited)**        | ** ** | **(Unaudited)** | ** ** |
|                         |       |                   |       |   |   |
| Expected volatility          |       | 69                     | %          | 69 | % |
| Risk-free interest rate      |       | 3.7                    | %          | 4.4 | % |
| Expected option life (years) |       | 3.4                    |       | 3.4 |   |

 

6

----

 

Forpurposes of pro forma disclosures, the estimated fair value of the equityawards would be amortized over the awards’ vesting periods. The Company’s proforma net loss and net loss per share information would be as follows (inthousands, except per share amounts):

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|
| ** **                                    | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** |
| ** **                                    | ** ** | **(Unaudited)**        | ** ** | **(Unaudited)** | ** ** |
| Net Loss:                                     |       |                   |       |   |   |
| As reported                                   |       | $                      | (3,716     | ) | $ | (6,173 | ) |
| Plus: Reported stock-based compensation       |       | 218                    |       | 143 |   |
| Less: Fair value stock-based compensation     |       | (1,339                 | )          | (1,141 | ) |
| Pro forma                                     |       | $                      | (4,837     | ) | $ | (7,171 | ) |
|                                          |       |                   |       |   |   |
| Basic and diluted net loss per common  share: |       |                   |       |   |   |
| As reported                                   |       | $                      | (0.14      | ) | $ | (0.25 | ) |
| Pro forma                                     |       | (0.19                  | )          | (0.29 | ) |

 

**6.****                      ****Effect of New AccountingStandards**

 

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123(revised 2004), “Share-Based Payment”.  SFAS 123R requires all companies tomeasure compensation costs for all share-based payments (including stockoptions) at fair value. The Company is required to comply with SFAS 123R as ofthe beginning of the first interim or annual reporting period of the Company’sfirst fiscal year beginning on or after June 15, 2005. Accordingly, wewill be required to apply SFAS 123R for the year beginning April 1,2006. The adoption of SFAS 123R will have a significant adverse impact onour reported results of operations because the stock-based compensationexpense will be charged directly against our reported earnings.

 

**7.****                      ****Segment Information**

 

TheCompany sells software and services worldwide through a direct sales force,augmented by selective use of third-party distributors. In accordance with SFASNo. 131, “Disclosures about Segments of an Enterprise and RelatedInformation,” the Company’s operations are aggregated into one reportablesegment given the similarities of economic characteristics between theoperations and the common nature of the products, services and customers.

 

Summarizedfinancial information concerning geographic revenues follows (in thousands):

 
| ** **   | ** ** | **Three Months Ended** | ** ** |
|--------------|------------|------------------------|------------|
| ** **   | ** ** | **June 30, 2005**      | ** ** | **%** | ** ** | **June 30, 2004** | ** ** | **%** | ** ** |
| ** **   | ** ** | **(unaudited)**        | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Revenues     |       |                   |       |   |   |   |   |   |   |
| U.S.         |       | $                      | 10,291     |   | 55 | % | $ | 6,237 |   | 44 | % |
| EMEA         |       | 4,259                  |       | 23 | % | 3,651 |   | 26 | % |
| Asia-Pacific |       | 4,005                  |       | 22 | % | 4,293 |   | 30 | % |
| Total        |       | $                      | 18,555     |   |   |   | $ | 14,181 |   |   |   |

 

7

----

 

Thefollowing table sets forth net assets by geographic region (in thousands):

 
| ** **   | ** ** | **June 30, 2005** | ** ** | **%**      | ** ** | **March 31, 2005** | ** ** | **%**      | ** ** |
|--------------|------------|-------------------|------------|------------|------------|--------------------|------------|------------|------------|
| ** **   | ** ** | **(unaudited)**   | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** |
| Net assets   |       |              |       |       |       |               |       |       |       |
| U.S.         |       | 117,268           |       | 80         | %          | 126,882            |       | 79         | %          |
| EMEA         |       | 23,792            |       | 16         | %          | 26,889             |       | 17         | %          |
| Asia-Pacific |       | 6,353             |       | 4          | %          | 6,783              |       | 4          | %          |
| Total        |       | $                 | 147,413    |       |       |               | $          | 160,554    |       |   |   |
|              |            |                   |            |            |            |                    |            |            |            |  |  |

 

**8.****                      ****Contingencies**

 

**Guaranteeof Lease Obligation of Others**

 

OnApril 30, 2004, in connection with our spin-off of Pharmacopeia DrugDiscovery (PDD), the landlords of the New Jersey facilities consented to theassignment of the underlying leases to PDD. Despite the assignment, thelandlords required Accelrys to guarantee the remaining lease obligations, whichamount to approximately $28.5 million in future payments throughApril 2016. The probability-weighted fair market value of thisguarantee was calculated in accordance with FASB Interpretation No. 46(FIN 46) ”Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” andresulted in a liability and a charge to stockholders’ equity. The liability isbeing adjusted against stockholders’ equity to reflect the change in the fairmarket value of the obligation over the lease term. At June 30, 2005, theliability was $0.7 million.

 

 

**Litigation**

 

Inthe ordinary course of business, the Company may be subject to claims and, fromtime to time, is named in various legal proceedings. The Company is currentlynot involved in any material litigation.

 

**Indemnifications**

 

TheCompany has entered into indemnification agreements with its officers anddirectors. The Company has not incurred any costs to defend lawsuits or settleclaims related to these indemnification provisions. As of June 30, 2005,the Company had not accrued a liability for this obligation, because managementbelieves that the likelihood of incurring a liability in connection with this obligationis neither probable nor estimable.

 

**9.****                      ****Severance and Lease Abandonment**

 

**QuarterEnded September 2002 Severance and Lease Abandonment**

 

Duringthe quarter ended September 30, 2002, the Company announced that it wasundertaking various actions to improve its operations and overall financialperformance by reducing its workforce and abandoning two leased facilities.This action resulted in a charge of $4.3 million, consisting of$2.3 million for severance for 71 employees and $2.0 million relatedto lease abandonment.

 

During2003, the Company negotiated a termination of the lease for one of thefacilities and finalized certain remaining severance obligations which resultedin a reduction of the liability by $0.4 million. Further, during thequarter ended March 31, 2005, the Company was able to sublease the otherleased facility that was abandoned for a portion of the future lease payments,resulting in a reduction to the abandoned lease liability of $0.2 million.The following table summarizes the activity and balance of the severance andlease abandonment liability (in thousands):

 

8

----

 
| ** **                   | ** ** | **Severance Costs for  Involuntary  Employee  Terminations** | ** ** | **Costs to Exit Lease  Obligations** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| Balance at inception         |       | $                                                            | 2,367      |                                 | $          | 1,973     |       | $ | 4,340 |   |
| Utilization of Reserves:     |       |                                                         |       |                                 |       |      |       |
| Cash payments                |       | (1,823                                                       | )          | (242                                 | )          | (2,065    | )          |
| Balance at December 31, 2002 |       | 544                                                          |       | 1,731                                |       | 2,275     |       |
| Utilization of Reserves:     |       |                                                         |       |                                 |       |      |       |
| Cash payments                |       | (449                                                         | )          | (281                                 | )          | (730      | )          |
| Reserve reduction            |       | (95                                                          | )          | (289                                 | )          | (384      | )          |
| Balance at December 31, 2003 |       | —                                                       |       | 1,161                                |       | 1,161     |       |
| Utilization of Reserves:     |       |                                                         |       |                                 |       |      |       |
| Cash payments for rent       |       | —                                                       |       | (65                                  | )          | (65       | )          |
| Balance at March 31, 2004    |       | —                                                       |       | 1,096                                |       | 1,096     |       |
| Utilization of Reserves:     |       |                                                         |       |                                 |       |      |       |
| Cash payments for rent       |       | —                                                       |       | (333                                 | )          | (333      | )          |
| Expected sublease income     |       | —                                                       |       | (167                                 | )          | (167      | )          |
| Effect of foreign exchange   |       | —                                                       |       | (17                                  | )          | (17       | )          |
| Balance at March 31, 2005    |       | —                                                       |       | 579                                  |       | 579       |       |
| Utilization of Reserves:     |       |                                                         |       |                                 |       |      |       |
| Cash payments for rent       |       | —                                                       |       | (36                                  | )          | (36       | )          |
| Effect of foreign exchange   |       | —                                                       |       | (13                                  | )          | (13       | )          |
| Balance at June 30, 2005     |       | $                                                            | —     |                                 | $          | 530       |       | $ | 530 |   |

 

 

**QuarterEnded December 2004 Lease Abandonment**

 

Duringthe quarter ended December 31, 2004, the Company recorded a leaseabandonment charge of $3.6 million related to the relocation of itscorporate headquarters. This charge represents the future rent and rent-relatedobligations relating to the former headquarters, net of subtenant lease income.Under the terms of a sublease agreement, Accelrys will receive from thesubtenant monthly rental payments and reimbursement of certain operatingexpenses related to the facility.

 

Thefollowing table summarizes the activity and balance of the lease abandonmentliability (in thousands):

 
| ** **                | ** ** | **Costs to Exit Lease  Obligations** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| Balance at inception      |       | $                                    | 3,612      |   |
| Utilization of Reserves:  |       |                                 |       |
| Cash payments             |       | (1,009                               | )          |
| Balance at March 31. 2005 |       | $                                    | 2,603      |   |
| Utilization of Reserves:  |       |                                 |       |
| Cash payments             |       | $                                    | (376       | ) |
| Balance at June 30, 2005  |       | $                                    | 2,227      |   |

 

9

----

 

**QuarterEnded March 2005 Severance and Lease Abandonment**

 

Duringthe quarter ended March 31, 2005, the Company incurred a severance chargefor the purpose of making the sales department more efficient, reducingduplicative general and administrative personnel, and discontinuing our Mat-Informaticsproduct line.  As a result of thereduction in force of the sales department, the Company incurred a leaseabandonment charge for the costs to close the Company’s office in Germany.

 

Thefollowing table summarizes the activity and balance of the severance and leaseabandonment liability (in thousands):

 
| ** **                 | ** ** | **Severance Costs for  Involuntary  Employee  Terminations** | ** ** | **Costs to Exit Lease  Obligations** | ** ** | **Total** | ** ** |
|----------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| Balance at inception       |       | $                                                            | 1,358      |                                 | $          | 344       |       | $ | 1,702 |   |
| Utilization of Reserves:   |       |                                                         |       |                                 |       |      |       |
| Cash payments              |       | (291                                                         | )          | —                               |       | (291      | )          |
| Balance at March 31, 2005  |       | 1,067                                                        |       | 344                                  |       | 1,411     |       |
| Utilization of Reserves:   |       |                                                         |       |                                 |       |      |       |
| Cash payments              |       | (736                                                         | )          | (65                                  | )          | (801      | )          |
| Effect of foreign exchange |       | (7                                                           | )          | (6                                   | )          | (13       | )          |
| Balance at June 30, 2005   |       | $                                                            | 324        |                                 | $          | 273       |       | $ | 597 |   |

 

 

**10.****               ****Restricted Cash**

 

Duringthe quarter ended June 30, 2004, the Company entered into a nine-yearlease agreement for corporate facilities in San Diego, California. Under theterms of the lease, the Company was required to place $6.6 million in arestricted cash account, consisting entirely of marketable securities, toensure performance under the lease agreement. The cash restriction periodicallydecreases and cash is periodically released to the Company over the term of thelease.

 

**11.****               ****Variable Interest Entity**

 

InJanuary 2003, the Financial Accounting Standards Board (FASB) issued FASBInterpretation 46, “Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51” (FIN 46).  FIN 46 was effective immediately for avariable interest entities (VIE) created after January 31, 2003. Theprovisions of FIN 46, as revised, were adopted as of December 31, 2003,for the Company’s interest in all VIEs. In October 2004, the FASB revisedFIN 46 to include rabbi trusts as VIEs.  TheCompany established a rabbi trust in March 2000 for the benefit ofdirectors and officers of the Company under its deferred compensation plan.Since the rabbi trust’s inception, the assets of the rabbi trust have beenconsolidated in the Company’s other current assets and the liabilities havebeen consolidated in the Company’s accrued compensation and benefits. As of June 30,2005, both the asset and liabilities were $0.5 million. Changes in valuesof assets held by the rabbi trust accrue to the Company’s directors andofficers and not to the Company.

 

10

----

 

**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thisquarterly report on Form 10-Q contains forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995.  Examples of such forward-lookingstatements include, but are not limited to, statements about:

 

•                  our quarterly financial performance;

 

•                  our capital requirements and resources;

 

•                  our strategy to increase revenue;

 

•                  development of new products;

 

•                  our intent to develop and sell products andservices to companies in the nanotechnology industry;

 

•                  technological change and uncertainty of newand emerging technologies;

 

•                  potential competitors or products;

 

•                  future employment of our key employees;

 

•                  development of strategic relationships;

 

•                  our ability to add revenue, expanddistribution channels, maximize research and development resources, improve ourcompetitive position and increase market awareness and acceptance of ourproducts;

 

•                  acquiring complementary businesses, productsor technologies and our ability to integrate those businesses, products ortechnologies, if any;

 

•                  compliance with the Sarbanes-Oxley Actof 2002;

 

•                  international exposure for a significantpercentage of future overall revenue;

 

•                  our development center in India;

 

•                  statements about potential future dividends;

 

•                  statements about protection of ourintellectual property; and

 

•                  possible changes in legislation.

 

Althoughforward-looking statements in this report reflect the good-faith judgmentof our management, such statements can only be based on facts and factorscurrently known by us. Consequently, forward-looking statements areinherently subject to risks and uncertainties (including, without limitation,the risks discussed in the “Certain Risks Related to Our Business” section ofthis report) and actual results and outcomes may differ materially from theresults and outcomes discussed in or anticipated by the forward-lookingstatements. We undertake no obligation to revise or update any forward-lookingstatements in order to reflect any event or circumstance that may arise afterthe date of this report. Readers are urged not to place undue reliance on theseforward-looking statements, which speak only as of the date of thisreport.

 

Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with consolidated financial statementsand related note disclosures included elsewhere in this report.

 

Inthe section entitled “Certain Risks Related to Our Business”, this reportdescribes certain risk factors and uncertainties that may cause actual results,levels of activity, performance, or achievements to be materially differentfrom any future results, levels of activity, performance, or achievementsexpressed or implied by such forward-looking statements.

 

11

----

 

**BUSINESS OVERVIEW**

 

Wedesign, develop, market and support software and related services thatfacilitate the discovery and development of new and improved products andprocesses in the pharmaceutical, biotechnology, chemical, petrochemical andmaterials industries. Using our products, researchers may increase the speedand efficiency of the research and development cycle, thereby reducing productdevelopment costs and shortening the time to market for new productintroductions and process improvements. Our customers include leadingcommercial, government and academic organizations. Many of the largestpharmaceutical, biotechnology, chemical and petroleum companies worldwide useour products. We market our products and services worldwide, principallythrough our global direct sales force and the selective use of third-party distributors.

 

 

**RESULTS OFOPERATIONS**

 

**ThreeMonths Ended June 30, 2005 and 2004 (in thousands)**

 

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | ** **          | ** ** |
|-----------------------------------------------|------------|------------------------|------------|---------------------|------------|
| ** **                                    | ** ** | **June 30, 2005****    | ** ** | **June 30, 2004**** | ** ** | **Percent Change** | ** ** |
| ** **                                    | ** ** | **(unaudited)**        | ** ** | **(unaudited)**     | ** ** | ** ** | ** ** |
| Revenue                                       |       | $                      | 18,555     |                | 100        | % | $ | 14,181 |   | 100 | % | 31 | % |
|                                          |       |                   |       |                |       |   |   |   |   |   |   |
| Cost of revenue                               |       | 5,030                  |       | 27                  | %          | 3,786 |   | 27 | % | 33 | % |
| Product development                           |       | 4,931                  |       | 27                  | %          | 4,123 |   | 29 | % | 20 | % |
| Sales and marketing                           |       | 8,499                  |       | 46                  | %          | 7,769 |   | 55 | % | 9 | % |
| General and administrative                    |       | 4,069                  |       | 22                  | %          | 4,009 |   | 28 | % | 1 | % |
| Total operating expenses                      |       | 22,529                 |       | 121                 | %          | 19,687 |   | 139 | % | 14 | % |
| Operating loss from continuing operations     |       | (3,974                 | )          | -21                 | %          | (5,506 | ) | -39 | % | -28 | % |
| Interest and other income, net                |       | 698                    |       | 4                   | %          | 585 |   | 4 | % | 19 | % |
| Loss from continuing operations before  taxes |       | (3,276                 | )          | -18                 | %          | (4,921 | ) | -35 | % | -33 | % |
| Provision for income taxes                    |       | 440                    |       | 2                   | %          | 135 |   | 1 | % | 226 | % |
| Loss from continuing operations               |       | (3,716                 | )          | -20                 | %          | (5,056 | ) | -36 | % | -27 | % |
| Loss from discontinued operations             |       | —                 |       | 0                   | %          | (1,117 | ) | -8 | % | -100 | % |
| Net loss                                      |       | $                      | (3,716     | )                   | -20        | % | $ | (6,173 | ) | -44 | % | -40 | % |

 

----

**                   Line items expressed as a percent of revenuein the respective periods.

 

**Revenue** increased 31% to $18.6 million for the three months ended June 30,2005 compared to $14.2 million for the three months ended June 30,2004. The increase in revenue is attributed to recognizing more revenue fromdeferrals as a result of our transition to subscription accounting for annualand multi-year licenses and to the addition of revenue from our acquisition ofSciTegic, Inc. in September 2004.

 

**Cost of revenue** was 33% higher at $5.0 million for the three months ended June 30,2005 compared to $3.8 million for the three months ended June 30, 2004.The increase in cost of revenue was due to a $0.2 million increase in royaltiesdue to product mix, a $0.4 million increase in client services costs due toincreased staffing levels, a $0.1 million increase in documentation andshipping costs due to more product releases in the current quarter compared tothe year ago quarter, and a $0.5 million increase in amortization of purchasedintangibles as a result of the SciTegic acquisition.

 

**Product development** expenses were 20% higher at $4.9 million for the three monthsended June 30, 2005 compared to $4.1 million for the three months endedJune 30, 2004. The increase in product development expenses was due to theincrease in product development workforce as a result of the SciTegicacquisition.

 

Productdevelopment expenses consist primarily of the employment-related costs ofpersonnel associated with developing new products, enhancing existing products,testing and developing product documentation. Certain software developmentcosts are capitalized in accordance with SFAS No. 86, “Accounting for theCost of Computer Software to be Sold, Leased or Otherwise

 

12

----

 

Marketed”(SFAS 86). Capitalized software development costs consist primarily of theemployment-related costs and consulting fees paid to consultants inrelation to the development of products that have not yet been released.

 

Thefollowing table shows software development costs and the amounts of capitalizedsoftware development for the periods indicated (in thousands):

 
| ** **                             | ** ** | **Three Months Ended** | ** ** | ** **        | ** ** |
|----------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                             | ** ** | **June 30, 2005**      | ** ** | **June 30, 2004** | ** ** | **Percent Change** | ** ** |
| ** **                             | ** ** | **(unaudited)**        | ** ** | **(unaudited)**   | ** ** | ** ** | ** ** |
| Product development:                   | ** ** | ** **             | ** ** | ** **        | ** ** | ** ** | ** ** |
| Gross software development costs       |       | $                      | 5,929      |              | $          | 5,055 |   | 17 | % |
| Capitalized software development costs |       | (998                   | )          | (932              | )          | 7 | % |
| Total product development costs        |       | $                      | 4,931      |              | $          | 4,123 |   | 20 | % |

 

 

**Sales and marketing** expenses were 9% higher at $8.5 million for the three monthsended June 30, 2005 compared to $7.8 million for the three monthsended June 30, 2004. The increase in expenses was due to a $1.0 millionincrease in sales and marketing costs as a result of the SciTegic acquisitionplus $0.6 for sales meeting and travel costs, partially offset by a $0.9million reduction in sales and marketing costs as a result of the reduction in forcein March 2005.

 

**General and administrative** expenses were 1% higher at $4.1 millionfor the three months ended June 30, 2005 compared to $4.0 million forthe three months ended June 30, 2004. The increase in general andadministrative costs was primarily due to the increase in costs associated withSarbanes-Oxley compliance.

 

**Interest and other income, net** was 19% higher at $0.7 million for thethree months ended June 30, 2005 compared to $0.6 million for thethree months ended June 30, 2004. The increase was primarily due to aforeign exchange gain of $0.2 million for the three months ended June 30,2005 compared to a foreign exchange gain of $42 thousand for the threemonths ended June 30, 2004.

 

**Provision for income taxes** was $0.4 million for the three monthsended June 30, 2005 compared to $0.1 million for the three monthsended June 30, 2004. The change in the tax provision was due to income taxincurred in foreign jurisdictions.

 

**Loss from discontinued operations** was $(1.1) million or $(0.05) per share forthe three months ended June 30, 2004, which consisted of $1.3 millionin revenue and $2.4 million in expenses. There was no revenue or costs associatedwith discontinued operations in the three months ended June 30, 2005.

 

**Net loss** was $(3.7) million or $(0.14) per share for the three months ended June 30,2005 compared to $(6.2) million or $(0.25) per share for the three moths ended June 30,2004.

 

**Liquidityand Capital Resources**

 

Inrecent years we have funded our activities to date primarily through the salesof software licenses and software maintenance services.  Historically, we have obtained funds for ouractivities through public markets.  Wehad cash, cash equivalents, restricted cash and marketable securities of $56.3 millionas of June 30, 2005 compared to $63.3 million as of March 31,2005, a decrease of $7.0 million. Significant components of this decrease arecash used in operations of $4.9 million, cash used for softwaredevelopment costs of $1.0 million and capital expenditures of $1.0 million.

 

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

 

Weanticipate that our existing capital resources will be adequate to fund ouroperations for at least the next 12 months. However, there can be no assurancethat changes will not occur that would consume available capital resourcesbefore then. Our capital requirements depend on numerous factors, including ourability to continue to generate software sales, competing

 

13

----

 

technological and market developments, thecost of filing, prosecuting, defending and enforcing patent claims and otherintellectual property rights and the outcome of related litigation, thepurchase of additional capital equipment and acquisitions of other businessesor technologies. There can be no assurance that additional funding, ifnecessary, will be available to us on favorable terms, if at all. Our forecastfor the period of time through which our financial resources will be adequateto support our operations is forward-looking information, and actual resultscould vary.

 

**Off-BalanceSheet Arrangements**

 

Asof June 30, 2005 and March 31, 2005, we did not have anyrelationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in such relationships.

 

**CriticalAccounting Policies**

 

Thepreparation of our consolidated financial statements and disclosures involvesthe use of judgments and estimates. We believe the following criticalaccounting policies involve the more significant judgments and estimates used.

 

*Revenue Recognition*—Revenues are recognized in accordance with the American Institute ofCertified Public Accountants (AICPA) Statement of Position (SOP) 97-2, asamended by SOP 98-4 and SOP 98-9 and SEC Staff Accounting Bulletin (SAB)No. 101, as amended by SAB No. 104.

 

Werecognize software license revenue upon delivery if no significant obligationsremain deliverable to the customer, if the sales contract fee is fixed ordeterminable, if amounts are due within one year and collection is probable,and when no material uncertainties regarding customer acceptance exist.Customer payments received in connection with license sales are recorded asdeferred revenue until such time as all of the above criteria are met. Prepaidpost-contract support and maintenance (PCS) revenue bundled with softwarelicense agreements is unbundled and deferred based on objective,vendor-specific evidence. PCS revenue is recognized pro-rata over the relatedservice period, which is generally one year. Consulting and training fees arerecognized upon rendering of service. Support revenues are recognized ratablyover the applicable contract periods or as services are performed. Amountsbilled but not yet recognized as revenue, and other payments received prior torecognition of revenue, are recorded as deferred revenue.

 

InJanuary 2004, we changed our license contracts with terms less thanperpetual. The change was to allow our customers to swap software modules. Thiscontract modification results in the annual license revenue under an annualsubscription model being recognized ratably over the license term. Thiscontrasts with our former annual license offering, in which we recognize 64% ofthe license revenue in the quarter during which the license is executed andamortize the other 36% of the revenue over the remaining term of the contractto reflect the costs of post-sales support. The revenue recognition for the newlicense structure is even more dramatic when compared to our traditionalperpetual license offering, in which we recognize 85% of the license revenue inthe quarter in which the contract is executed and amortize the remaining 15% ofthe revenue over the term of a one-year maintenance agreement. For example,under our former annual license structure, if we entered into a one-yearlicense generating $100,000 in revenue, we would have recognized $64,000 of therevenue when the software was shipped and recognized the remaining $36,000 ofthe revenue ratably over the remaining contract term. Similarly, in the case ofour existing perpetual license offering, completed on similar terms, we wouldhave recognized $85,000 of the revenue when the product was shipped and theremaining $15,000 of the revenue ratably over the term of the one-yearmaintenance agreement. In contrast to both our annual and perpetual licensestructures, given a licensing arrangement with similar terms, under the newlicense structure we would recognize only one-twelfth of the revenue, or$8,333, in the month following shipment, and $8,333 in each of the remainingmonths during the term of the one-year contract. The unrecognized revenue,amortized over the remaining term of the agreement, will be accounted for as“deferred revenue” on the balance sheet.

 

Finally,we also earn revenue under consortia agreements pursuant to which severalunrelated parties enter into a joint software development agreement with us.These agreements are generally one to three years in length, require an annualmembership fee, and contain best-efforts development milestones. Customersreceive a consortium membership and are required to license related software.The consortium revenue associated with the initial software library is recognizedupon delivery, while consortium revenue associated with consortium membershipis recognized ratably over the term of the agreement. The software revenue isrecognized as described above. We are not required to deliver specifiedproducts under the agreements, and the consortium fees are generallynon-refundable. If we are successful in developing software under a consortiaagreement as described above, a non-transferable license is typically awardedto the consortium members.

 

14

----

 

Asdescribed above, recognition of software license, service and other revenue isdependent, in part, on management judgment, and thus, changes in our estimatesor assumptions could impact revenue recognition in the future.

 

*Product Development Costs*—We capitalize product development costs inaccordance with SFAS No. 86, “Accounting for the Cost of Computer Softwareto be Sold, Leased or Otherwise Marketed” (SFAS 86). Such costs are stated atthe lower of cost or net realizable value. Capitalized software costs arecomprised of costs incurred in the development of new products and enhancementsto existing products after technological feasibility has been established. Weamortize capitalized costs over the estimated product life, not to exceed threeyears from the date on which the product is available for general release. Theestimated product life may be reduced based on obsolescence or other factors,which could affect the carrying value of capitalized software and result incharges to operating results. These estimates are based on management’sjudgment, and thus, any change in our estimates could impact operating resultsin the future.

 

*Goodwill*—The Company’s goodwill resulted from acquisitions made in 2000, 2001and fiscal year 2005. We assess goodwill for impairment in accordance with SFASNo. 142, “Goodwill and Other Intangible Assets” (SFAS 142). UnderSFAS 142, goodwill and intangible assets with indefinite lives are nolonger amortized but are assessed annually (or more frequently if impairmentindicators arise) for impairment by comparing fair market value of the netassets to the carrying value. In making this annual assessment, which we do inthe fourth quarter, we rely on a number of factors including operating results,business plans, economic projections, anticipated future cash flows and marketplace data. There are inherent uncertainties related to these factors andmanagement’s judgment in applying them to the analysis of goodwill impairment.We completed our annual intangible asset impairment test during the quarterended March 31, 2005, and concluded that the carrying value of ourgoodwill was not impaired. Continued economic weakness, unexpected significantdeclines in operating results of reporting units, and additional non-temporarymarket capitalization declines may be indicative of goodwill impairment andcause us to perform additional valuation analyses for our reporting units priorto the next required annual assessment. These types of events and the resultinganalyses could result in charges for goodwill expense in the future.

 

*Deferred Taxes*—Income tax expense is based on pre-tax financial accounting incomeunder the liability method. Deferred tax assets and liabilities are determinedbased on the difference between the financial statement and tax basis of assetsand liabilities using enacted tax rates in effect for the year in which thedifferences are expected to reverse. We must then assess the likelihood thatthe resulting deferred tax assets will be realized. To the extent we believethat realization is not more likely than not, we establish a valuationallowance. To date, the Company has provided a full valuation allowance for allnet deferred tax assets.

 

*Impairment of Long-Lived Assets—*We review long-lived assets, includingpurchased intangibles, leasehold improvements, property and equipment, andcapitalized software development costs for impairment whenever events orchanges in business circumstances indicate that the carrying amount of the assetsmay not be fully recoverable. This review requires us to estimate future cashflows related to these assets. Actual results could differ from theseestimates, which may affect the carrying amount of assets and the actualamortization expense. The Company has identified no such impairment losses asof June 30, 2005.

 

**NewAccounting Standards**

 

InDecember 2004, the FASB issued SFAS 123R. SFAS 123R requires all companies to measure compensation costs forall share-based payments (including stock options) at fair value. TheCompany is required to comply with SFAS 123R effective as of the beginning ofthe first interim or annual reporting period of the Company’s first fiscal yearbeginning on or after June 15, 2005. Accordingly, we will be required to applySFAS 123R for the fiscal year beginning April 1, 2006. The adoptionof SFAS 123R will have a significant adverse impact on our reportedresults of operations because the stock-based compensation expense willbe charged directly against our reported earnings.

 

***CERTAIN RISKS RELATED TO OUR BUSINESS***

 

*You should carefully consider the risks described belowbefore investing in our securities. The risks described below are not the onlyones we face. Our business is also subject to the risks that affect many other companies,such as competition, technological obsolescence, labor relations, generaleconomic conditions, geopolitical changes and international operations.*

 

15

----

 

*Additional risks not currently known to us or that wecurrently believe are immaterial also may impair our business operations or ourliquidity.*

 

***Our quarterly operating results could varysignificantly.***  We have historically experienced strongerfinancial performance in the December quarter of the year followed by acomparative decline in the other quarters. In the twelve months endedMarch 31, 2005 and the twelve months ended December 31, 2003, theCompany recognized 32% and 37% of its revenue for these fiscal years in theDecember quarters, respectively. Quarterly operating results may continue tofluctuate as a result of a number of factors, including lengthy sales cycles,market acceptance of new products and upgrades, timing of new productintroductions, changes in pricing policies, changes in general economic andcompetitive conditions, and the timing and integration of acquisitions.Additionally, fluctuations in revenue recognition may result as the mix ofcontracts continues to shift from perpetual licenses to subscription licenses.We also expect to continue to experience fluctuations in quarterly operatingresults due to general and industry-specific economic conditions that mayaffect the research and development expenditures of pharmaceutical andbiotechnology companies. Due to the possibility of fluctuations in our revenueand expenses, we believe that quarter-to-quarter comparisons of our operatingresults are not a good indication of our future performance.

 

***Changes in the accounting treatment ofstock options will adversely affect our results of operations.***  InDecember 2004, the FASB issued SFAS 123R. SFAS 123R requires all share-based payments to employees,including grants of stock options, to be recognized in the financial statementsbased on their fair values and does not permit pro forma disclosure as analternative to financial statement recognition. We currently plan to adoptSFAS 123R in our fiscal quarter ending June 30, 2006. The adoption ofthe SFAS 123R fair value method will have a significant adverse impact onour reported results of operations because the stock-based compensationexpense will be charged directly against our reported earnings. The impact ofour adoption of SFAS 123R cannot be predicted at this time because it willdepend on the future fair values and the number of share-based paymentsgranted in the future. However, had we adopted SFAS 123 in prior periods,the magnitude of the impact of that standard would have approximated the impactof SFAS 123, assuming the application of the Black-Scholes model asdescribed in the disclosure of pro forma net loss and pro forma net loss pershare in our notes to consolidated financial statements set forth in thisquarterly report.

*** ***

***Our future profitability is uncertain.***  Wegenerated losses in the three months ended June 30, 2005 and June 30,2004.  Continuing net losses may limitour ability to fund our operations, and we may not generate income fromoperations in the future. Our future profitability depends upon many factors,including several that are beyond our control. These factors include withoutlimitation:

 

•                  changes in the demand for our products andservices;

 

•                  the introduction of competitive software;

 

•                  our ability to license desirabletechnologies;

 

•                  the rate of adoption by our customers of ournew subscription license option;

 

•                  changes in the research and developmentbudgets of our customers and potential customers; and

 

•                  our ability to successfully, cost effectivelyand timely develop, introduce and market new products, services and productenhancements.

*** ***

***We face strongcompetition in the scientific software sector.***  The market for our products is intenselycompetitive, subject to rapid change and significantly affected by new productintroductions, pricing strategies and other market activities of industry participants.We currently face competition from the following principal sources:

 

•                  other simulation software packages andsoftware for simulation and analysis of chemical and biological data;

 

•                  desktop software applications, includingchemical drawing, molecular modeling and analytical data simulationapplications;

 

•                  consulting and outsourcing services;

 

•                  firms supplying databases, such as chemicalor genomic information databases, database management systems and

 

16

----

 

informationtechnology; and

 

•                  academic and government sponsoredinstitutions focused on scientific research.

 

Inaddition, some of our software licenses grant the right to sublicense oursoftware. As a result, our software customers and third-party licenseescould develop specific simulation applications using our software developer’skit and compete with us by distributing these programs to our potentialcustomers. Customers or licensees could also develop their own simulationtechnology or informatics software and cease using our products and services.Some of our competitors and potential competitors in this sector have longeroperating histories than us and have greater financial, technical, marketing,research and development and other resources. Many of our competitors offerproducts and services directed at more specific markets than those we target,enabling these competitors to focus a greater proportion of their efforts andresources on these markets. Some offerings that compete with our products aredeveloped by governmental organizations and academic institutions. Theseentities may be able to devote substantial resources to product development andalso offer their products to users for little or no charge. Finally, we alsoface competition from open-source software initiatives, in which developersprovide software and intellectual property free over the Internet.

 

***We are subject to pricing pressures in themarkets we serve.***  We operate in an intensely competitivemarketplace which has led to significant pricing pressures and declines inaverage selling price over the past several years. In response to competitionand general adverse economic conditions in the markets we serve, we may berequired to modify our pricing practices. This development may adversely affectour revenue and earnings. We generally license our products and services on a“right to use” basis pursuant to licenses over a specified period of time or inperpetuity. Changes in our pricing model or any other future broadly-basedchanges to our prices and pricing policies could lead to a decline or delay inrevenue as our sales force and customers adjust to the new pricing policies.

 

***Our investments in sales and businessdevelopment efforts may not result in additional sales of our products andservices.***  Our products and services involve lengthysales and business development cycles, often requiring us to expendconsiderable financial and personnel resources without any assurance thatrevenue will be recognized. These sales and business development cyclestypically are long for a number of reasons. Sales cycles are impacted by the time and resources required to educatepotential customer organizations as to the value and comparative advantages ofour products. As a result, we may expend substantial funds in an effort tonegotiate agreements for collaborative relationships, services and products,but may ultimately be unable to consummate the related transaction. Under suchcircumstances, our results of operations and ability to achieve profitabilitywill be adversely affected.

 

***If we consume cash more quickly thanexpected, we may be unable to raise additional capital and we may be forced tocurtail operations.***  We anticipate that our existing capitalresources will be adequate to fund our operations for at least the next twelvemonths. However, changes may occur that would consume available capitalresources before that time. Our capital requirements will depend on numerousfactors, including:

 

•                  costs associated with software developmentand sales;

 

•                  the purchase of additional capital equipment;

 

•                  demand for our products; and

 

•                  acquisitions of other businesses ortechnologies.

 

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

 

***Our ability toincrease our revenue may depend upon increased market acceptance of ourproducts and services.***  Our products are currently used primarily bymolecular modeling and simulation specialists. Our strategy is to expand usageof our products and services by marketing and distributing our software to abroader, more diversified group of biologists, chemists and engineers. If wecannot expand our customer base, we may not be able to increase our revenue, orsuch revenue may decline. In general, increased market acceptance and greatermarket penetration of our products depend upon several factors, including:

 

17

----

 

•                  overall product performance;

 

•                  timely introduction of new products andservices;

 

•                  ease of implementation and use;

 

•                  accuracy of simulation;

 

•                  breadth and integration of product offerings;

 

•                  the extent to which users achieve theintended research and development benefits from their use of the products andservices; and

 

•                  willingness and ability of customers to payfor such use.

 

Ourproducts and services may not achieve market acceptance or penetration in theirtarget industries or other industries. Failure to increase market acceptance orpenetration of our products and services may restrict substantially the futuregrowth of our business and may have a material adverse effect on our company asa whole.

 

***We may be unable to develop and market newproducts and services that are necessary to sustain and increase revenue.***  Thesuccess of our business plan depends heavily upon increases in revenue. Our strategyis to increase revenue in a number of ways, including:

 

•                  adding more computational modeling,simulation and analysis tools to our current portfolio of tools for scientists,including chemists, biologists and materials scientists;

 

•                  offering more informatics solutions thatcapture and manage the data created by customers’ drug discovery and chemicaldevelopment activities, including the data created by the use of computationalmodeling, simulation and analysis software;

 

•                  creating and marketing genomic, biologicaland/or chemical data content for use in conjunction with the software offeredto support customers’ drug discovery activities;

 

•                  developing strategic relationships withlarger technology companies;

 

•                  developing more knowledge-management workflowsoftware to automate the flow of genomic, biological and chemical data andinformation and project status between and among workgroups and the enterprise;

 

•                  developing enhanced modeling and informaticstools to address the needs of companies engaged in scientific research; and

 

•                  developing software products for new andemerging markets such as the nanotechnology market.

 

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

*** ***

***Delays in release of new or enhancedproducts or services may result in increased cost to us, delayed marketacceptance of our products or services and delayed or lost revenue.***  Toachieve market acceptance, new or enhanced products or services can requirelong development and testing periods, which may result in delays in scheduledintroduction. Any delays in the release schedule for new or enhanced productsor services may delay market acceptance of these products or services and mayresult in delays in customer orders for these new or enhanced products orservices or the loss of customer orders.

*** ***

***If we are unable to license software to, orto collect receivables from, our early stage biotechnology customers or othercustomers, our operating results may be adversely affected.***  Someof our licensees are small, development-stage biotechnology companies. Oftenthese customers have limited or no operating history and require considerablefunding to launch their businesses. As we have experienced in recent years,they often significantly scale back, or altogether cease, operations.Therefore,

 

18

----

 

thereis considerable risk in counting on such customers for revenue growth, becausetransactions with these customers carry financial risk. Such customers areespecially vulnerable to, and may be adversely impacted by, the tightening ofavailable credit and capital during periods of contraction affecting the UnitedStates and our other key markets. As a result of these conditions, thesecustomers may be unable to license or, if under a license, may be unable to payfor, Accelrys products. If we are not able to collect such payments, we may berequired to write-off significant accounts receivable and recognize bad debtexpense which could materially and adversely affect our operating results. As aresult of these types of exposures and other potential exposures, we havemaintained an allowance for doubtful accounts as follows (in thousands):

 
| ** **                      | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
|---------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                      | ** ** | **(Unaudited)**   | ** ** | ** **         | ** ** |
| Allowance for Doubtful Accounts |       | $                 | 312        |               | $          | 315 |   |
|                                 |            |                   |            |                    |            |  |  |

 

***Defects or malfunctions in our products, orin the products of our software technology partners, could hurt our reputationamong customers and expose us to liability.***  Ourbusiness and the level of customer acceptance of our products depend upon thecontinuous, effective and reliable operation of our software and related toolsand functions. Defects could occur in our current or future products. To theextent that our software malfunctions and our customers’ use of our products isinterrupted, our software reputation and business could suffer. We may also besubject to liability for the defects and malfunctions of third party technologypartners and others with whom our products and services are integrated.

 

***Pharmaceutical, biotechnology andindustrial chemical companies may discontinue or decrease their use of our products.*** Pharmaceutical, biotechnology, and industrial chemical companiescomprise the principal market for our modeling, simulation, data analysis andrelated products and services. In addition, these companies have frequentlyutilized outside software vendors for key tools used in drug discovery andchemical development, rather than developing needed information and analysistools internally. Our revenue depends to a large extent on research anddevelopment expenditures by the pharmaceutical, biotechnology and chemicalindustries, particularly companies in these industries adding new and improvedtechnologies to accelerate their drug discovery and chemical developmentinitiatives. The willingness and ability of these companies to expand orcontinue is dependent on the benefits of new software tools versus their costsof licensing and on their ability to purchase or license our products andservices. Because a large proportion of our software customers license ourproducts on an annual basis or buy maintenance contracts from us annually, ourrevenue may be impacted if their spending priorities shift.  Also, general economic downturns in ourcustomers’ industries or any decrease in customers’ research and development expenditurescould harm our operations.

 

***Our sales forecast and/or revenueprojections may not be accurate.***  As is common practice in ourindustry, we use a “pipeline” system to forecast sales and trends in ourbusiness. Our sales personnel monitor the status of proposals, including thedate when we 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 could cause us toimproperly plan or budget and thereby adversely affect our business, results ofoperations and financial condition.

 

***We operate in business lines that changerapidly and in unexpected ways.***  Rapid technological change anduncertainty due to new and emerging technologies characterize the software,drug discovery and chemical development industries. We may be unable todevelop, integrate and market, on a timely basis, the new and enhanced productsand services necessary to keep pace with competitors. Our products and servicesmay be rendered obsolete by the offerings of our competitors. Failure toanticipate or to respond to changing technologies, or significant delays in thedevelopment or introduction of products or services, could cause customers todelay or decide against purchasing our products or services.

*** ***

***Failure to attract and retain skilledpersonnel could have a material adverse effect on us.***  Oursuccess depends in part on the continued service of key scientific, software,sales, business development, engineering and management personnel and ourability 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. Given these factors, we may notbe able to continue to attract and retain the personnel necessary for thedevelopment of our business. Failure to attract and retain key personnel couldhave a material adverse effect on our business, financial condition and resultsof operations. Further, we are highly dependent on the

 

19

----

 

principalmembers of our scientific and management staff. One or more of these keyemployees could retire or otherwise leave our employ within the foreseeablefuture, and the loss of any of these people could have a material adverseeffect on our business, financial condition and results of operations. We donot currently maintain, nor do we intend to maintain, key person life insuranceon the life of any employee.

 

***If we choose to acquire new andcomplementary businesses, products or technologies instead of developing themourselves, we may be unable to complete these acquisitions or to successfullyintegrate an acquired business or technology in a cost-effective andnon-disruptive manner.***  From time to time, we may chooseto acquire businesses, products or technologies instead of developing themourselves. We do not know if we will be able to complete any acquisitions, orwhether we will be able to successfully integrate any acquired businesses,operate them profitably or retain their key employees. Integrating anybusiness, product or technology we acquire could be expensive andtime-consuming, disrupt our ongoing business and distract company management.In addition, in order to finance any acquisition, we might need to raiseadditional funds through public or private equity or debt financings. In thatevent, we could be forced to obtain financing on less than favorable termswhich, in the case of equity financing, 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.

 

***There can be no assurance as to the effectof the SciTegic acquisition on our business or operating results.***  InSeptember 2004, we acquired SciTegic. The acquisition involved numerous risks,including, among other things: potentially higher than estimated acquisitionexpenses; difficulties in successfully assimilating the operations,technologies and personnel of SciTegic; diversion of management’s attentionfrom other business concerns; risks of entering markets in which we have no orlimited direct prior experience; and the potential loss of key employees andcustomers as a result of the acquisition. Though to date we believe these riskshave not materialized, there can be no assurance as to the continuing effect ofthe SciTegic acquisition or future acquisitions on our business or operatingresults.

 

***Enacted and proposed changes in securitieslaws and regulations are likely to increase our costs.***  TheSarbanes-Oxley Act of 2002 required changes in some of our corporategovernance and securities disclosure or compliance practices. The Securitiesand Exchange Commission (SEC) has promulgated new rules on a variety ofsubjects and the NASDAQ National Market (NASDAQ) on which our commons stock islisted has issued revisions to its requirements for companies that are listed.In June 2003, the SEC adopted certain rules as directed bySection 404 of Sarbanes-Oxley. These rules require that publicly heldcompanies, including us, include in their report to shareholders a report ofmanagement on our internal controls over financial reporting. Our independentauditors are required to attest to management’s assessment of internal controlsover financial reporting. We are obligated to comply with this requirement, andwith further related requirements and interpretations, in our annual reports.If our financial reporting controls are not deemed effective, there will be anadverse impact on our reputation that could negatively impact our stock price.

 

Wealso expect continued compliance with Sarbanes-Oxley to increase our corporategovernance, legal and accounting costs. Further, Sarbanes-Oxley and the relatedSEC and NASDAQ compliance rules may make it more difficult and expensive for usto obtain director and officer liability insurance, and we may be required toaccept reduced coverage or incur substantially higher costs to obtain coverage.These laws and regulations could make it more difficult for us to attract andretain qualified members of our board of directors, or qualified executiveofficers. We continually evaluate and monitor regulatory developments but, atany given time, cannot estimate the timing or magnitude of additional costs wemay incur as a result.

 

***We are subject to risks associated with theoperation of an international business.***  Weanticipate that international revenue will continue to account for asignificant percentage of our future revenue. We believe that twelve-monthperiods are more indicative of the sale activities for each region givencertain budgeting cycles and other local customs in the countries in which wesell products.

 

The following table depicts our region-specificrevenue as a percent of total revenue for each period:

 

20

----

 
| ** **   | ** ** | **Three Months Ended** | ** ** |
|--------------|------------|------------------------|------------|
| ** **   | ** ** | **June 30,**           | ** ** | **June 30,** | ** ** |
| **Region**   | ** ** | **2005**               | ** ** | **2004** | ** ** |
| US           |       | 55                     | %          | 44 | % |
| EMEA         |       | 23                     | %          | 26 | % |
| Asia Pacific |       | 22                     | %          | 30 | % |

 

Someof our functions, such as software development, sales and customer support, arebeing performed outside the United States.

 

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

 

•                  unexpected changes in regulatoryrequirements;

 

•                  longer payment cycles;

 

•                  currency exchange rate fluctuations;

 

•                  import and export license requirements;

 

•                  tariffs and other barriers;

 

•                  political unrest, terrorism and economicinstability;

 

•                  disruption of our operations due to locallabor conditions;

 

•                  limited intellectual property protection;

 

•                  difficulties in collecting trade receivables;

 

•                  difficulties in managing distributors orrepresentatives;

 

•                  difficulties in managing an organizationspread over various countries;

 

•                  difficulties in staffing foreign subsidiaryor joint venture operations; and

 

•                  potentially adverse tax consequences.

 

Oursuccess depends, in part, on our ability to anticipate and address these risks.There can be no assurance that we would do so effectively, or that these orother factors will not adversely affect our business or operating results.

 

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

 

***Consolidation within the pharmaceutical andbiotechnology industries may lead to fewer potential customers for our productsand services.***  A significant portion of our customer baseconsists of pharmaceutical and biotechnology companies. Continued consolidationwithin the pharmaceutical and biotechnology industries may result in fewercustomers for our products and services. If one of the parties to aconsolidation uses the products or services of our competitors, we may loseexisting customers as a result of such consolidation.

 

21

----

 

***We expect that our stock price willfluctuate significantly, and you may not be able to resell your shares at orabove your investment price.***  The stock market, especially inrecent years, has experienced significant volatility particularly withtechnology company stocks. The volatility of technology company stock pricesoften does not relate to the operating performance of the companies representedby the stock. We could experience volatility in the price of our common stockas a result of:

 

•                  actual and anticipated fluctuations in ourquarterly 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;

 

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

 

•                  market acceptance of our products andservices; and

 

•                  additions or departures of key personnel.

 

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

 

***As institutions hold the majority of ourcommon stock in large blocks, substantial sales by these stockholders coulddepress the market price for our shares.***  As ofJune 30, 2005, the top ten institutional holders of our common stock heldapproximately 48% of our outstanding common stock. As a result, if one or moreof these major stockholders were to sell all or a portion of their holdings, orif the market were to perceive that such sale or sales may occur, the market priceof our common stock may fall significantly.

 

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

 

***Anti-takeover provisions under the DelawareGeneral Corporation Law, provisions in our certificate of incorporation andbylaws, and our adoption of a stockholder rights plan may render more difficultthe accomplishment of mergers, the assumption of control by a principalstockholder, and the removal of management.*** Certain provisions of the Delaware General Corporation Law may delay ordeter attempts to secure control of our company without the consent of ourmanagement. Also, our governing documents provide for a staggered board ofdirectors, which will make it more difficult for a potential acquirer to gaincontrol of our board of directors. In 2002, we adopted a stockholder rightsplan, which is triggered upon commencement or announcement of a hostile tenderoffer or when any one person or group acquires 15% or more of our common stock.The rights plan, once triggered, enables our stockholders (other than thestockholder responsible for triggering the rights plan) to purchase our commonstock at reduced prices. These provisions of our governing documents and stockholderrights plan, and of Delaware law, could have the effect of delaying, deferringor preventing a change of control, including without limitation a proxycontest, making more difficult the acquisition of a substantial block of ourcommon stock. The provisions could also limit the price that investors might bewilling to pay in the future for shares of our common stock. Further, theexistence of these anti-takeover measures may cause potential bidders to lookelsewhere, rather than initiating acquisition discussions with us.

 

***Our operations may be interrupted by theoccurrence of a natural disaster or other catastrophic event at our primaryfacilities.***  Our research and development operations andadministrative functions are primarily conducted at our facilities in SanDiego, California, Cambridge, United Kingdom, and Bangalore, India. Although wehave contingency plans in effect for natural 

 

22

----

 

disastersor other catastrophic events, catastrophic events could still disrupt ouroperations. Even though we carry business interruption insurance policies, wemay suffer losses as a result of business interruptions that exceed thecoverage available under our insurance policies. Any natural disaster or othercatastrophic event in our facilities or the areas in which they are locatedcould have a significant negative impact on our operations.

 

***Our insurance coverage may not besufficient to avoid material impact on our financial position or results ofoperations resulting from claims or liabilities against us, and we may not beable to obtain insurance coverage in the future.***  Wemaintain insurance coverage for protection against many types 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. We may not be able to obtain any insurancecoverage, or adequate insurance coverage, when our existing insurance coverageexpires.

 

***CERTAIN RISKS RELATED TO INTELLECTUAL PROPERTY***

 

***P******atent rights offer limited protection forour intellectual property.***  The patent positions of software andbiotechnology companies are uncertain and involve complex legal and factualquestions. The coverage claimed in a patent application can be significantlyreduced before the patent is issued. There is a significant risk that the scopeof a patent may not be sufficient to prevent third parties from marketing otherproducts or technologies with the same functionality of our products andtechnologies. Consequently, some or all of our patent applications may notissue into patents, and any issued patents may provide ineffective remedies orbe challenged or circumvented. In addition, to date, we have not investedsignificant funds or resources in obtaining patent protection.

 

***Third parties may have filed patentapplications of which we may or may not have knowledge and which may adverselyaffect our business.***  Patent applications in the U.S. aremaintained in secrecy for 18 months from filing or until a patent isissued. Under certain circumstances, patent applications are never publishedbut remain in secrecy until issuance. As a result, others may have filed patentapplications for products or technologies covered by one or more pending patentapplications upon which we are relying. There may be third-party patents,patent applications and other intellectual property or information relevant toour software and other technologies which are not known to us and that block orcompete with our software or other technologies or that limit the scope ofpatent protection available to us. Moreover, from time to time, patents mayissue which block or compete with our software or other technologies, or limitthe scope of patent protection available to us. Litigation may be necessary toenforce patents issued to us or to determine the scope and validity of theintellectual property rights of third parties.

 

***We may not be able to protect adequatelythe trade secrets and confidential information that we disclose to ouremployees.***  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 we may not have an adequate remedy. Additionally, in someinstances, we may have failed to require that employees and consultants executeconfidentiality and assignment-of-inventions agreements.

 

***Foreign laws may not afford us sufficientprotections for our intellectual property, and we may not seek patentprotection outside the United States.***  Thelaws of some foreign countries may not be as comprehensive as those of theUnited States and may not be sufficient to protect our proprietary rightsabroad. In addition, we generally do not pursue patent protection outside the UnitedStates because of cost and confidentiality concerns. Accordingly, ourinternational competitors could obtain foreign patent protection for, andmarket overseas, products and technologies for which we are seeking patentprotection in the United States.

 

***We may not be able to adequately defend ourintellectual property from third party infringement, and third party challengesto our intellectual property may adversely affect our rights and be costly andtime consuming.***  Some of our competitors have, or areaffiliated with companies having, substantially greater resources than we have,and those competitors may be able to sustain the costs of complex patentlitigation to a greater degree and for longer periods of time than we can.Uncertainties resulting from the initiation and continuation of any patent orrelated litigation could have a material adverse effect on our ability tocompete in the marketplace pending resolution of the disputed matters. If ourcompetitors prepare and file patent applications in the United States thatclaim technology also claimed by us, we may have to participate in interferenceproceedings declared by the U.S. Patent and Trademark Office to determine thepriority of invention, which could result in substantial costs to

 

23

----

 

us,even if the outcome is favorable to us. Similarly, opposition proceedings mayoccur overseas, which may result in the loss or narrowing of the scope ofclaims or legal rights. Such proceedings will at least result in delay in theissuance of enforceable claims. An adverse outcome could subject us tosignificant liabilities to third parties and require us to license disputedrights from third parties or cease using the technology. Despite our efforts toprotect our proprietary rights, unauthorized parties may attempt to copyaspects of our products or to obtain and use information that we regard asproprietary. In limited instances, we have licensed source codes of certainproducts to customers or collaborators. For these reasons, policingunauthorized use of our products may be difficult.

 

***We may be subject to claims of infringementby third parties.***  Third parties may claim infringement by us oftheir intellectual property rights From time to time, we have received lettersclaiming or suggesting that our products or activities may infringe third partypatents or other intellectual property rights. Our products may infringe patentor other intellectual property rights of third parties. A number of patents mayhave been issued or may be issued in the future that could cover certainaspects of our technology and that could prevent us from using technology thatwe use or expect to use. We may be required to seek licenses for, or otherwiseacquire rights to, technology as a result of claims of infringement. We may notpossess proper ownership or access rights to the intellectual property weuse.  We expect that software productdevelopers will be subject to more infringement claims as the number ofproducts and competitors in our industry segments grows and the functionalityof products in different industry segments overlaps. Any claims, with orwithout merit, could be time consuming to defend, result in costly litigation,divert management’s attention and resources, cause product shipment delays orrequire us to enter into royalty or licensing agreements. Royalty or licensingagreements, if required, may not be available on terms acceptable to us, if atall. In the event of a successful claim of product infringement against us, ourfailure or inability to license or design around the infringed technology couldhave a material adverse effect on our business, financial condition and resultsof operations.  In addition, we use thirdparty code in our products, either licensed from third parties or pursuant toopen source licenses.  These licenses,especially in the case of open source code, may limit our ability to distributeor charge for our products.  In addition,to the extent our employees are involved in research areas similar to thoseareas in which they were involved at their former employers, we may be subjectto claims that one of our employees, or we, have inadvertently or otherwiseused or disclosed the alleged trade secrets or other proprietary information ofa former employer.

 

***CERTAIN RISKS RELATED TO THE SPIN-OFF OF PDD***

 

***There can be no assurance that Accelryswill be successful on a stand-alone basis.***  Wehave separated the Accelrys and PDD businesses through the spin-off to ourstockholders of 100% of the outstanding shares of common stock of PDD onApril 30, 2004. The transaction resulted in PDD being an independent,publicly-traded company. Previously, we operated our businesses as part of a broader corporateorganization rather than as a stand-alone company.  Historically, certain corporate functions hadbeen centralized for PDD and Accelrys. Following the spin-off, we have not been able to rely on the financialand other resources and the cash flows generated from the combined Accelrys andPDD operations.

 

***We may be required to indemnify PDD, or maynot be able to collect on indemnification rights from PDD.***  Aspart of the spin-off, we and PDD have agreed to indemnify one another withrespect to the indebtedness, liabilities and obligations that will be retainedby our respective companies. One such obligation includes a guarantee by us tothe landlord of PDD’s obligations under the existing New Jersey laboratory andheadquarters leases, with respect to which PDD has agreed to indemnify usshould we be required to make any payment under the guarantee. Theseindemnification obligations could be significant as the future minimum leasepayments as of June 30, 2005 was $28.5 million. PDD’s ability tosatisfy any such indemnification obligations (including, without limitation,PDD’s commitment to indemnify us in the event that we are required to make anypayment under our guarantee of its leases) will depend upon PDD’s futurefinancial strength. We cannot be sure that, if PDD becomes obligated toindemnify us for any substantial obligations, PDD will have the ability to doso. There also can be no assurance that we will be able to satisfy anyindemnification obligations to PDD. Any required payment by PDD or us couldhave a material adverse effect on our business, and any failure by PDD or us tosatisfy our respective obligations could have a material adverse effect on theother company’s business.

 

**SHOULD ONE OR MORE OF THE ABOVE-DESCRIBED RISKS ORUNCERTAINTIES MATERIALIZE, OR SHOULD THE UNDERLYING ASSUMPTIONS PROVEINCORRECT, OUR ACTUAL RESULTS MAY VARY MATERIALLY FROM THOSE ANTICIPATED.**

 

24

----

 

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Ourforeign currency exchange rate risk is greatest for Dollar/Sterling,Dollar/Euro and Dollar/Yen fluctuations. When deemed appropriate, we engage inexchange rate-hedging transactions in an attempt to mitigate the impact ofadverse exchange rate fluctuations. At June 30, 2005, we had no hedgingtransactions in effect.

 

Ourexposure to market risks associated with changes in interest rates relatesprimarily to the increase or decrease in the amount of interest income earnedon our investment portfolio, since we have no debt. We ensure the safety andpreservation of invested funds by limiting default risks, market risk andreinvestment risk. We mitigate default risk by investing in investment gradesecurities. A hypothetical 100 basis point adverse move in interest rates alongthe entire interest rate yield curve would not materially affect the fair valueof our interest sensitive financial instruments at June 30, 2005.

 

**ITEM 4.CONTROLS AND PROCEDURES**

 

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

 

Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures, as such term is definedunder Rule 13a-15(e) and 15d-15(e) promulgated under the SecuritiesExchange Act of 1934, as amended. Based on this evaluation, our principalexecutive officer and our principal financial officer concluded that ourdisclosure controls and procedures were effective as of the end of the periodcovered by this report.  There were nochanges in our internal control over financial reporting during the quarterended June 30, 2005 that have materially effected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

**PART II– OTHER INFORMATION**

 
| **ITEM 1.** |   | Legal Proceedings - None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **ITEM 2.** |   | Unregistered Sales of  Equity Securities and Use of Proceeds – None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **ITEM 3.** |   | Defaults upon Senior  Securities - None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **ITEM 4.** |   | Submission of Matters to a  Vote of Security Holders - None                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **ITEM 5.** |   | Other Information                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|        |   | On August 2, 2005, our  Board of Directors approved an increase in the annual retainers for the  Company’s directors.  The annual  retainer for the Company’s lead director has been increased from $50,000 to  $75,000.  The annual retainer for the  Company’s other directors has been increased from $20,000 to $25,000.  The retainers will be payable in arrears in  equal quarterly installments.  

 

On August 2, 2005, the  Human Resources Committee of our Board of Directors approved a management  incentive plan for fiscal year 2006 (the "Bonus Plan"), pursuant to  which management-level employees of the Company and its subsidiaries are  eligible to receive cash bonuses based on the Company’s achievement of  certain corporate goals specified in the Bonus Plan. These bonuses are  designed to attract, motivate, retain and reward the Company's  management-level employees.  Under the  Bonus Plan, the Chief Executive Officer has an annual bonus target equal to  80% of base salary and Vice Presidents have an annual bonus target equal to  40% of base salary.  Payouts under the  Bonus Plan will vary dependant upon the level of achievement of the specified  corporate goals, and will range from zero to two times the targeted bonus  amount.  The Human Resources Committee  will make all final determinations regarding the achievement of goals and the  payment of bonuses pursuant to the Bonus Plan.  Likewise, the Human Resources Committee has  the ability to modify, suspend or terminate the Bonus Plan at any time.  |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **ITEM 6.** |   | Exhibits – see Exhibit  Index attached                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |

 

25

----

 

**SIGNATURE**

 

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

 

 
|   | ACCELRYS, INC.       |
|--------|----------------------|
|   |                 |
|   | By:                  | /s/  David M. Sankaran

David M. Sankaran  Senior Vice President and Chief Financial  Officer (Duly Authorized Officer and Chief  Financial Officer) |
|   |                 |   |
|   | Date: August 4, 2005 |

 

26

----

 

**Accelrys,Inc. and Subsidiaries**

 

**ExhibitIndex**

 
|    |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1     |   | Restated Certificate of  Incorporation of Pharmacopeia, Inc. (incorporated by reference to Exhibit 3.1  to the Company’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 the Company’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 of the Company’s Annual Report on Form 10-K for the  fiscal year ended March 31, 2005)                                                                                                                                                                                                                                           |
| 4.1     |   | Rights Agreement, dated as  of September 6, 2002, between Pharmacopeia, Inc. and American Stock Transfer  & Trust Company, as Rights Agent, which includes as Exhibit A thereto the  Certificate of Designation, Preferences and Rights of Series A Junior  Participating Preferred Stock and Exhibit B thereto the Form of Right  Certificate (incorporated by reference to Exhibit 4.1 to the Company’s Report  on Form 8-K dated September 4, 2002). |
| 10.26#* |   | FY06 Management Incentive  Plan Form                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 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                                                                                                                                                                                                                                                                                                                                                                            |

 

----

| *      |   | Filed herewith                                                        |
|--------|--------|-----------------------------------------------------------------------|
| #      |   | Represents a management  contract or compensatory plan or arrangement |
|   |   |                                                                  |

 

27

----