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

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**FORM 10-Q**
| **x**                                                                                                                                                                                  | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                             | ** **                                                                                              |
| **For the  quarterly period ended September 30, 2006**                                                                                                                                 |
| ** **                                                                                                                                                                             |
| **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**

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

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

 

**(858) 799-5000**(Registrant’s telephone number, including area code)

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

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

Largeaccelerated filer o     Acceleratedfiler x     Non-acceleratedfiler o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o     No x

The number ofoutstanding shares of the registrant’s common stock, par value $0.0001 pershare, as of October 13, 2006 was 26,342,120, net of treasury shares.

 

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**ACCELRYS, INC.FORM 10-Q — QUARTERLY REPORTFor The Quarterly Period Ended September 30, 2006Table of Contents**
| **PART I — FINANCIAL INFORMATION** |   |
|-----------------------------------------|--------|
| Item 1.                                 |   | Financial Statements |   |
|                                    |   | Condensed consolidated balance sheets as of September  30, 2006 (unaudited) and March 31, 2006 |   |
|                                    |   | Condensed consolidated  statements of operations (unaudited) for the three- and six-month periods  ended September 30, 2006 and 2005 |   |
|                                    |   | Condensed  consolidated statements of cash flows (unaudited) for the six-month periods  ended September 30, 2006 and 2005 |   |
|                                    |   | Notes to condensed consolidated financial statements  (unaudited) |   |
| Item 2.                                 |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |   |
| Item 3.                                 |   | Quantitative and Qualitative Disclosures About Market  Risk |   |
| Item 4.                                 |   | Controls and Procedures |   |
| **PART  II — OTHER INFORMATION**   |   |
| Item  1A.                               |   | Risk Factors |   |
| Item 4.                                 |   | Submission of Matters to a Vote of Security Holders |   |
| Item  5.                                |   | Other  Information |   |
| Item 6.                                 |   | Exhibits |   |
| **Signature**                           |   |   |   |

 

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**PARTI — FINANCIAL INFORMATION**

**Item1. Consolidated Financial Statements**

**Accelrys, Inc.**

**Condensed Consolidated Balance Sheets**

**(Inthousands, except per share amounts)**
| ** **                                                                                                                                          | ** ** | **September 30,  2006** | ** ** | **March 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                          | ** ** | **(Unaudited)**              | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                          |       |                         |       |                         |       |
| Current assets:                                                                                                                                     |       |                         |       |                         |       |
| Cash and cash  equivalents                                                                                                                          |       | $                            | 16,873     |                         | $          | 24,656 |   |
| Marketable  securities                                                                                                                              |       | 36,203                       |       | 34,733                       |       |
| Trade  receivables, net of allowance for doubtful accounts of $186 and $351 as of  September 30, 2006 and March 31, 2006, respectively              |       | 9,993                        |       | 17,289                       |       |
| Prepaid expenses  and other current assets                                                                                                          |       | 3,507                        |       | 3,438                        |       |
| Total current assets                                                                                                                                |       | 66,576                       |       | 80,116                       |       |
| Restricted cash                                                                                                                                     |       | 8,110                        |       | 6,633                        |       |
| Property and equipment,  net                                                                                                                        |       | 7,160                        |       | 7,860                        |       |
| Goodwill                                                                                                                                            |       | 42,663                       |       | 42,663                       |       |
| Intangible assets, net                                                                                                                              |       | 7,903                        |       | 8,671                        |       |
| Other assets                                                                                                                                        |       | 731                          |       | 812                          |       |
| Total assets                                                                                                                                        |       | $                            | 133,143    |                         | $          | 146,755 |   |
| **Liabilities and stockholders’  equity**                                                                                                      |       |                         |       |                         |       |
| Current liabilities:                                                                                                                                |       |                         |       |                         |       |
| Accounts payable                                                                                                                                    |       | $                            | 814        |                         | $          | 1,676 |   |
| Accrued  liabilities                                                                                                                                |       | 4,787                        |       | 4,939                        |       |
| Accrued  compensation and benefits                                                                                                                  |       | 5,947                        |       | 7,009                        |       |
| Current portion  of accrued severance and lease abandonment                                                                                         |       | 1,047                        |       | 2,936                        |       |
| Current portion  of deferred revenue                                                                                                                |       | 38,115                       |       | 51,710                       |       |
| Total current  liabilities                                                                                                                          |       | 50,710                       |       | 68,270                       |       |
| Deferred revenue, net  of current portion                                                                                                           |       | 6,980                        |       | 9,559                        |       |
| Accrued severance and  lease abandonment, net of current portion                                                                                    |       | 1,325                        |       | 1,338                        |       |
| Lease-related  liabilities, net of current portion                                                                                                  |       | 6,232                        |       | 4,380                        |       |
|                                                                                                                                                |       |                         |       |                         |       |
| Stockholders’ equity:                                                                                                                          |       |                         |       |                         |       |
| Preferred stock,  $0.0001 par value; 2,000 shares authorized; no shares issued and outstanding                                                      |       | —                       |       | —                       |       |
| Common stock,  $0.0001 par value; 40,000 shares authorized; 26,974 and 26,856 shares issued  at September 30, 2006 and March 31, 2006, respectively |       | 3                            |       | 3                            |       |
| Additional  paid-in capital                                                                                                                         |       | 256,604                      |       | 254,224                      |       |
| Deferred  stock-based compensation                                                                                                                  |       | —                       |       | (522                         | )          |
| Lease guarantee                                                                                                                                     |       | (604                         | )          | (635                         | )          |
| Treasury stock;  644 shares at each of September 30, 2006 and March 31, 2006, respectively                                                          |       | (8,340                       | )          | (8,340                       | )          |
| Accumulated  deficit                                                                                                                                |       | (180,550                     | )          | (181,156                     | )          |
| Accumulated  other comprehensive income (loss)                                                                                                      |       | 783                          |       | (366                         | )          |
| Total stockholders’  equity                                                                                                                    |       | 67,896                       |       | 63,208                       |       |
| Total liabilities and stockholders’ equity                                                                                                     |       | $                            | 133,143    |                         | $          | 146,755 |   |

 

See accompanying notes tothese condensed consolidated financial statements.

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**Accelrys, Inc.**

**CondensedConsolidated Statements of Operations**

**(Inthousands, except per share amounts)(Unaudited)**
| ** **                                                            | ** ** | **Three Months Ended September 30,** | ** ** | **Six Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                                 | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                            | ** ** | ** **                                               | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                               |       | $                                                        | 20,232     |                                                   | $          | 21,736 |   | $ | 40,382 |   | $ | 42,139 |   |
| Operating costs  and expenses:                                        |       |                                                     |       |                                                   |       |   |   |   |   |
| Cost of revenue                                                       |       | 3,822                                                    |       | 4,171                                                  |       | 7,722 |   | 8,308 |   |
| Product development                                                   |       | 4,916                                                    |       | 5,567                                                  |       | 10,042 |   | 11,421 |   |
| Sales and marketing                                                   |       | 6,283                                                    |       | 7,388                                                  |       | 13,105 |   | 15,885 |   |
| General and administrative                                            |       | 4,367                                                    |       | 3,619                                                  |       | 9,085 |   | 7,688 |   |
| Total operating  costs and expenses                                   |       | 19,388                                                   |       | 20,745                                                 |       | 39,954 |   | 43,302 |   |
| Operating income  (loss)                                              |       | 844                                                      |       | 991                                                    |       | 428 |   | (1,163 | ) |
| Interest and  other income, net                                       |       | 360                                                      |       | 402                                                    |       | 844 |   | 1,100 |   |
| Income (loss)  before taxes                                           |       | 1,204                                                    |       | 1,393                                                  |       | 1,272 |   | (63 | ) |
| Income tax  expense                                                   |       | 269                                                      |       | 241                                                    |       | 666 |   | 682 |   |
| Net income  (loss)                                                    |       | $                                                        | 935        |                                                   | $          | 1,152 |   | $ | 606 |   | $ | (745 | ) |
|                                                                  |       |                                                     |       |                                                   |       |   |   |   |   |
| Net income  (loss) per share:                                         |       |                                                     |       |                                                   |       |   |   |   |   |
| Basic                                                                 |       | $                                                        | 0.04       |                                                   | $          | 0.04 |   | $ | 0.02 |   | $ | (0.03 | ) |
| Diluted                                                               |       | $                                                        | 0.04       |                                                   | $          | 0.04 |   | $ | 0.02 |   | $ | (0.03 | ) |
| Weighted average  shares used to compute net income (loss) per share: |       |                                                     |       |                                                   |       |   |   |   |   |
| Basic                                                                 |       | 26,293                                                   |       | 26,107                                                 |       | 26,252 |   | 26,063 |   |
| Diluted                                                               |       | 26,420                                                   |       | 26,276                                                 |       | 26,387 |   | 26,063 |   |

 

See accompanying notes tothese condensed consolidated financial statements.

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

**(Inthousands)(Unaudited)**
| ** **                                                                            | ** ** | **Six Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| ** **                                                                            | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                |       |                                                   |       |   |   |
| Net income  (loss)                                                                    |       | $                                                      | 606        |   | $ | (745 | ) |
| Adjustments to  reconcile net income (loss) to net cash used in operating activities: |       |                                                   |       |   |   |
| Depreciation                                                                          |       | 1,576                                                  |       | 1,953 |   |
| Amortization of acquired intangible assets                                            |       | 768                                                    |       | 902 |   |
| Share-based compensation                                                              |       | 2,340                                                  |       | 434 |   |
| Other                                                                                 |       | 791                                                    |       | 829 |   |
| Changes in operating assets and liabilities:                                          |       |                                                   |       |   |   |
| Trade receivables                                                                     |       | 7,595                                                  |       | 7,566 |   |
| Prepaid expenses and other current assets                                             |       | 39                                                     |       | 2,028 |   |
| Restricted cash and other assets                                                      |       | (1,204                                                 | )          | (157 | ) |
| Accounts payable                                                                      |       | (905                                                   | )          | (469 | ) |
| Accrued liabilities                                                                   |       | (2,363                                                 | )          | (5,018 | ) |
| Deferred revenue                                                                      |       | (17,009                                                | )          | (15,236 | ) |
| Net cash used in  operating activities                                                |       | (7,766                                                 | )          | (7,913 | ) |
| Cash flows from  investing activities:                                                |       |                                                   |       |   |   |
| Purchases of property and equipment, net                                              |       | (703                                                   | )          | (2,194 | ) |
| Purchases of marketable securities                                                    |       | (22,538                                                | )          | (5,418 | ) |
| Proceeds from sales and maturities of marketable  securities                          |       | 21,250                                                 |       | 13,033 |   |
| Net cash  provided by (used in) investing activities                                  |       | (1,991                                                 | )          | 5,421 |   |
| Cash flows from  financing activities:                                                |       |                                                   |       |   |   |
| Proceeds from issuance of common stock                                                |       | 566                                                    |       | 521 |   |
| Net cash  provided by financing activities                                            |       | 566                                                    |       | 521 |   |
| Exchange rate  effect on cash and cash equivalents                                    |       | 1,408                                                  |       | (914 | ) |
| Decrease in cash  and cash equivalents                                                |       | (7,783                                                 | )          | (2,885 | ) |
| Cash and cash  equivalents at beginning of period                                     |       | 24,656                                                 |       | 21,256 |   |
| Cash and cash  equivalents at end of period                                           |       | $                                                      | 16,873     |   | $ | 18,371 |   |

 

See accompanying notes tothese condensed consolidated financial statements.

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

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

*FinancialStatement Preparation*

The condensed consolidated financial statements as ofSeptember 30, 2006, and for the three and six months ended September 30, 2006and 2005 are unaudited. We have condensed or omitted certain information anddisclosures normally included in financial statements presented in accordancewith accounting principles generally accepted in the United States. We believethe disclosures made are adequate to make the information presented notmisleading. However, you should read these condensed consolidated financialstatements in conjunction with the consolidated financial statements and notesthereto included in our Annual Report on Form 10-K for the fiscal year endedMarch 31, 2006.

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

Our business is subject to seasonal variations. As aresult, the interim financial results for the periods presented are notnecessarily indicative of results for a full year or for any subsequent interimperiod.

*Principlesof Consolidation*

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

*Useof Estimates*

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

# *RevenueRecognition*

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

We generate revenue from the following primarysources:

·     softwarelicenses,

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

·                    training,installation and implementation services.

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

·                    afully executed written contract and/or purchase order has been obtained fromthe customer (i.e., persuasive

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evidence of an arrangement exists),

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

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

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

*SoftwareLicenses*

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

*Renewal of PCS under Perpetual Software Licenses*

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

*Training, Installation and Implementation Services*

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

*Multi-Element Arrangements*

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

# *SoftwareDevelopment Costs*

Weaccount for costs incurred to develop our software products in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 86, *Accounting for the Cost of Computer Software to beSold, Leased or Otherwise Marketed*. Accordingly, costs incurred inthe research and development of new software products and significantenhancements to existing software products are expensed as incurred, until thetechnological feasibility of the product has been established. Technologicalfeasibility occurs shortly before our software products are available forgeneral release, and we have determined that costs eligible for capitalizationare not material. Accordingly, there were no capitalized software developmentcosts as of September 30, 2006 and March 31, 2006.

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*Adoptionof SFAS No. 123R*

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123 (revised 2004), *Share-BasedPayment* (“SFAS No. 123R”). SFAS No. 123R requiresthat employee stock-based compensation is measured based on the grant date fairvalue of the related employee equity awards and is treated as an expense thatis reflected in the financial statements over the related service period. The provisionsof SFAS No. 123R were effective for us beginning April 1, 2006. Prior to April1, 2006, we accounted for our share-based awards to employees and directorsunder the recognition and measurement principles of Accounting Principles BoardOpinion No. 25, *Accounting for StockIssued to Employees,* and related interpretations and adopted the proforma disclosure provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*. Accordingly,stock-based compensation expense related to employee stock options wasrecognized only if, on the date of grant, the exercise price of the employeestock option was less than the fair market value of the underlying commonstock.

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

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

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

*IncomeTaxes*

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

*Effectof New Accounting Standards*

InJune 2006, the FASB issued Interpretation (“FIN”) No. 48, *Accounting for Uncertainty in Income Taxes.*FIN No. 48, which is effective for fiscal years beginning afterDecember 15, 2006, addresses the accounting for income taxes byprescribing the minimum recognition threshold a tax position is required tomeet before being recognized in the financial statements. In addition, FIN No.48 expands the disclosure requirements concerning unrecognized tax benefits aswell as any significant changes that may occur in the next twelve monthsassociated with such unrecognized tax benefits. We will adopt the provisions ofFIN No. 48 in the first quarter of fiscal year 2008. We are currently evaluatingthe impact, if any, FIN No. 48 will have on our results of operations andfinancial position.

InNovember 2005, the FASB issued Staff Position Nos. FAS 115-1 and FAS 124-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*(“FSP Nos. 115-1 and 124-1”),which provide guidance on determining when investments in certain debt andequity securities are considered impaired and whether that impairment isother-than-temporary, and on the measurement of such impairment loss. FSP Nos.115-1 and 124-1 also include accounting considerations subsequent to therecognition of other-than-temporary impairments and require certain disclosuresabout unrealized losses that have not been recognized as other-than-temporaryimpairments. Our adoption of FSP Nos. 115-1 and 124-1 as of April 1, 2006 didnot have a significant impact on our results of operations and financialposition.

In May2005, the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20 and SFAS No.3*. Although SFAS No. 154 carries forward the guidance in APB No. 20and SFAS No. 3 with

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respect toaccounting for changes in estimates, changes in reporting entities, and thecorrection of errors, SFAS No. 154 establishes new standards for accounting forchanges in accounting principles, whereby all such changes must be accountedfor by retrospective application to the financial statements of prior periodsunless it is impracticable to do so. SFAS No. 154 is effective for accountingchanges and error corrections made in fiscal years beginning after December 15,2005, with early adoption permitted for changes and corrections made in yearsbeginning after May 2005. Our adoption of SFAS No. 154 as of April 1, 2006 didnot have a material impact on our financial position, results of operations orcash flows.

**2.****                       NetIncome (Loss) Per Share**

Wecompute net income (loss) per share pursuant to SFAS No. 128, *Earnings Per Share*. Accordingly, basic netincome (loss) per share and diluted net loss per share is computed by dividingthe net income (loss) for the period by the weighted average number of commonshares outstanding during the period, without consideration for common shareequivalents. Diluted net income per share is computed by dividing the netincome for the period by the weighted average number of common shares andcommon share equivalents outstanding during the period. Potentially dilutivecommon share equivalents consist of common stock options and unvestedrestricted stock awards and restricted stock units (“RSUs”). 
| ** **                                                    | ** ** | **Three Months Ended September 30,**              | ** ** | **Six Months Ended September 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                                              | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                    |       |                                                                  |       |                                                   |       |   |   |   |   |
| Net income (loss)                                             |       | $                                                                     | 935        |                                                   | $          | 1,152 |   | $ | 606 |   | $ | (745 | ) |
|                                                          |       |                                                                  |       |                                                   |       |   |   |   |   |
| Denominator:                                                  |       |                                                                  |       |                                                   |       |   |   |   |   |
| Weighted average common shares oustanding                     |       | 26,293                                                                |       | 26,107                                                 |       | 26,252 |   | 26,063 |   |
| Dilutive potential common stock equivalents                   |       | 127                                                                   |       | 169                                                    |       | 135 |   | — |   |
| Weighted average shares and dilutive potential  common shares |       | 26,420                                                                |       | 26,276                                                 |       | 26,387 |   | 26,063 |   |
|                                                          |       |                                                                  |       |                                                   |       |   |   |   |   |
| Net income  (loss) per share:                                 |       |                                                                  |       |                                                   |       |   |   |   |   |
| Basic                                                         |       | $                                                                     | 0.04       |                                                   | $          | 0.04 |   | $ | 0.02 |   | $ | (0.03 | ) |
| Diluted                                                       |       | $                                                                     | 0.04       |                                                   | $          | 0.04 |   | $ | 0.02 |   | $ | (0.03 | ) |

 

Potentiallydilutive common share equivalents that were excluded from the basic and dilutednet income (loss) per share calculations as their effect would be anti-dilutivetotaled approximately 3.3 million shares and 3.1 million shares for the threeand six months ended September 30, 2006, respectively, and 1.0 million sharesand 2.8 million shares for the three and six months ended September 30, 2005,respectively.

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

*Share-BasedCompensation Plans*

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

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grant. AtSeptember 30, 2006, approximately 1,919,000 shares of our common stock remainavailable for issuance pursuant to awards granted under the 2004 Plan.

On August 2, 2005, our stockholders also approvedthe 2005 Employee Stock Purchase Plan (the “ESPP”), under which we havereserved 1,000,000 shares of our common stock for issuance. Under the ESPP,employees may defer up to 10% of their base salary to purchase shares of ourcommon stock. The purchase price of the common stock is equal to 85% of thelower of the fair market value per share of our common stock on thecommencement date of the applicable offering period or the applicable purchasedate. To date, we have not issued shares under the ESPP and 1,000,000 sharesremain available for future issuance under the ESPP as of September 30, 2006.

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

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

During the second quarterof fiscal year 2007, we offered eligible employees the one-time opportunity tosurrender any and all stock options granted pursuant to any of our stock planswith an exercise price greater than $9.00 per share in exchange for RSUs (the “ExchangeOffer”) based on an exchange ratio determined by our board of directors. TheRSUs vest in three equal annual installments commencing on the date of grantand are subject to the terms and conditions set forth in the 2004 Plan. Theoffer period commenced on July 28, 2006 and expired on August 25, 2006.  On August 26, 2006, all eligible stockoptions tendered by eligible employees in accordance with the terms of theExchange Offer were cancelled and RSUs were issued to such eligible employeesin accordance with the exchange ratios established by the board ofdirectors.  In total, stock options forthe purchase of approximately 410,000 shares of our common stock were tenderedand cancelled, and RSUs for approximately 105,000 shares of our common stockwere granted.  Any eligible stock optionsnot tendered remain issued and outstanding in accordance with their originalterms and conditions.

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

*Share-BasedAward Activity*

Our stock options generally vest over four years andhave a contractual term of 10 years.  Asummary of stock option activity under our share-based compensation plans is asfollows:
| ** **                         | ** ** | **Number of  Shares**                                                                | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate   Intrinsic   Value** | ** ** | **Weighted  Average  Remaining  Contractual   Life** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                         | ** ** | **(In thousands, except per share amounts and years)** | ** ** |
| Outstanding at  April 1, 2006      |       | 4,306                                                                                     |       | $                                      | 9.78       |                                        |       |                                                      |       |   |
| Granted                            |       | 815                                                                                       |       | 7.22                                   |       |                                        |       |                                                      |       |
| Exercised                          |       | (121                                                                                      | )          | 4.68                                   |       |                                        |       |                                                      |       |
| Expired/Forfeited                  |       | (1,186                                                                                    | )          | 15.43                                  |       |                                        |       |                                                      |       |
| Outstanding at  September 30, 2006 |       | 3,814                                                                                     |       | $                                      | 7.66       |                                        | $          | 964                                                       |       | 7.3 |   |
| Exercisable at  September 30, 2006 |       | 2,197                                                                                     |       | $                                      | 8.16       |                                        | $          | 628                                                       |       | 6.2 |   |

 

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Theaggregate intrinsic value of stock options outstanding and exercisable atSeptember 30, 2006 was based on the closing price of our common stock onSeptember 29, 2006 of $6.29 per share. The total intrinsic value of stockoptions exercised during the six months ended September 30, 2006 was $0.2million and the total cash received from the exercise of stock options duringthe six months ended September 30, 2006 was $0.6 million.

Infiscal year 2007, we granted RSUs under the 2004 Plan that vest annually overthree years and, once vested, do not expire. Upon vesting of an RSU, employeesare issued an equivalent number of shares of our common stock. A summary of RSUactivity under our share-based compensation plans is as follows:
| ** **                      | ** ** | **Number of  Shares**                                        | ** ** | **Weighted  Average  Grant Date   Fair Value** | ** ** |
|---------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                      | ** ** | **(In thousands, except per  share amounts)** | ** ** |
| Unvested at  April 1, 2006      |       | —                                                            |       | $                                                             | —     |   |
| Granted                         |       | 431                                                               |       | 6.80                                                          |       |
| Vested                          |       | —                                                            |       | —                                                        |       |
| Forfeited                       |       | (5                                                                | )          | 7.44                                                          |       |
| Unvested at September  30, 2006 |       | 426                                                               |       | $                                                             | 6.80       |   |

 

Wealso have remaining unvested restricted stock awards of approximately 8,000shares as of September 30, 2006 that were granted under a prior plan. Theserestricted stock awards vest annually over three years and, once vested, do notexpire. Upon vesting of a restricted stock award, employees are issued anequivalent number of shares of our common stock.

*Valuationof Share-Based Awards*

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

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

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

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

*Expected Award Life.*We determine the expectedlife of an award by considering various relevant factors, including the vestingperiod and contractual term of the award, our employees’ historical exercisepatterns and length of service, the expected future volatility of our stockprice, tax implications of exercising an award and employee characteristics. Wealso consider the expected terms of comparable publicly traded companies.

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

Ourdetermination of the input variables used in the Black-Scholes option pricingmodel as well as the pre-vesting forfeiture rate is based on various underlyingestimates and assumptions that are highly subjective and are affected by our

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stock price, amongother factors. Changes in these underlying estimates and assumptions couldmaterially affect the fair value of our share-based awards and, therefore, theamount of share-based compensation expense to be recognized in our results ofoperations.

Thefair value of stock options and ESPP purchase rights granted during the sixmonths ended September 30, 2006 and 2005 was estimated at the date of grantusing the Black-Scholes option pricing model with the following weightedaverage assumptions:
| ** **                                        | ** ** | **Six Months Ended September 30. 2006** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Stock Options**                                           | ** ** | **ESPP   Purchase   Rights** | ** ** |
| Expected  volatility                              |       | 60                                                               | %          | 60 | % |
| Risk-free  interest rate                          |       | 5.0                                                              | %          | 5.2 | % |
| Expected option  life in years                    |       | 5.0                                                              |       | 0.5 |   |
| Expected  dividend yield                          |       | 0                                                                | %          | 0 | % |
| Weighted average per  share grant date fair value |       | $                                                                | 4.03       |   | $ | 2.42 |   |
|                                                   |            |                                                                  |            |  |  |  |  |

 
| ** **                                        | ** ** | **Six Months Ended September 30,  2005** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                        | ** ** | **Stock Options**                                       | ** ** | **ESPP   Purchase   Rights** | ** ** |
| Expected  volatility                              |       | 69                                                           | %          | 69 | % |
| Risk-free  interest rate                          |       | 3.8                                                          | %          | 3.7 | % |
| Expected option  life in years                    |       | 3.6                                                          |       | 0.5 |   |
| Expected  dividend yield                          |       | 0                                                            | %          | 0 | % |
| Weighted average per  share grant date fair value |       | $                                                            | 2.81       |   | $ | 1.23 |   |
|                                                   |            |                                                              |            |  |  |  |  |

 

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

*Share-BasedCompensation Expense*

Theestimated fair value of our share-based awards is recognized as a chargeagainst income on a straight-line basis over the requisite service period,which is the shorter of the vesting period of the award or the period until theparticipant becomes eligible for retirement. The estimated fair value ofshare-based awards granted to retirement-eligible participants is recognized asa charge against income immediately upon grant. Total share-based compensationexpense recognized in our condensed consolidated statements of operations forthe three and six months ended September 30, 2006 and 2005 was as follows:
| ** **                              | ** ** | **Three Months Ended September 30,** | ** ** | **Six Months Ended September 30,** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                                 | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                    |       |                                                     |       |                                                   |       |   |   |   |   |
| Cost of revenue                         |       | $                                                        | 83         |                                                   | $          | 8 |   | $ | 154 |   | $ | 16 |   |
| Product  development                    |       | 393                                                      |       | 182                                                    |       | 741 |   | 363 |   |
| Sales and  marketing                    |       | 221                                                      |       | 17                                                     |       | 379 |   | 34 |   |
| General and  administrative             |       | 630                                                      |       | 10                                                     |       | 1,066 |   | 21 |   |
| Total share-based  compensation expense |       | $                                                        | 1,327      |                                                   | $          | 217 |   | $ | 2,340 |   | $ | 434 |   |

 

Share-basedcompensation expense recognized in the three and six months ended September 30,2006 reflects our adoption of SFAS No. 123R effective April 1, 2006 using themodified prospective transition method. Share-based compensation expenserecognized in the three and six months ended September 30, 2005 relates toshare-based awards granted in prior periods accounted for under the provisionsof APB No. 25. No share-based compensation expense was capitalized in theperiods presented. At September 30, 2006, we had unrecognized share-basedcompensation expense 

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relating tounvested share-based awards of approximately $8.4 million, which we anticipaterecognizing as a charge against income over a weighted average period of 1.5years.

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

Thefollowing table illustrates the effect on net loss and loss per share for thethree and six months ended September 30, 2005 if we had applied the fair valuerecognition provisions of SFAS No. 123 to our employee stock awards. Forpurposes of the SFAS No. 123 pro forma disclosures, the estimated fair value ofemployee stock awards has been charged against income over the related vestingperiod of the award on a straight-line basis.
| ** **                                                                                                      | ** ** | **Three  Months  Ended  September  30, 2005**                | ** ** | **Six Months  Ended  September  30, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **(In thousands, except per  share amounts)** | ** ** |
| Net income  (loss), as reported                                                                                 |       | $                                                                 | 1,152      |                                                 | $          | (745 | ) |
| Add: Stock-based  employee compensation expense included in net loss, as reported                               |       | 217                                                               |       | 434                                                  |       |
| Deduct:  Stock-based employee compensation expense determined under the fair value  based method for all awards |       | (1,230                                                            | )          | (2,935                                               | )          |
| Pro forma net  income (loss)                                                                                    |       | $                                                                 | 139        |                                                 | $          | (3,246 | ) |
| Net income (loss)  per share:                                                                                   |       |                                                              |       |                                                 |       |
| Basic - as  reported                                                                                            |       | $                                                                 | 0.04       |                                                 | $          | (0.03 | ) |
| Diluted - as  reported                                                                                          |       | $                                                                 | 0.04       |                                                 | $          | (0.03 | ) |
| Basic - pro  forma                                                                                              |       | $                                                                 | 0.01       |                                                 | $          | (0.12 | ) |
| Diluted - pro forma                                                                                             |       | $                                                                 | 0.01       |                                                 | $          | (0.12 | ) |

 

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

Forthe three and six months ended September 30, 2006 and 2005, comprehensiveincome (loss) consists of the following:
| ** **                                       | ** ** | **Three Months Ended September 30,** | ** ** | **Six Months Ended September 30,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                 | ** ** | **2005**                                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                                  | ** ** |
| Net income  (loss)                               |       | $                                                        | 935        |                                                   | $          | 1,152 |   | $ | 606 |   | $ | (745 | ) |
| Foreign currency  translation adjustment         |       | 200                                                      |       | (180                                                   | )          | 854 |   | (659 | ) |
| Unrealized gain  (loss) on marketable securities |       | 235                                                      |       | (118                                                   | )          | 295 |   | 41 |   |
| Total comprehensive  income (loss)               |       | 1,370                                                    |       | 854                                                    |       | 1,755 |   | (1,363 | ) |
|                                                  |            |                                                          |            |                                                        |            |  |  |  |  |  |  |  |  |

 

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

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

**6.****                       Guarantees**

*Guaranteeof Lease Obligation of Others*

OnApril 30, 2004, we spun-off our drug discovery subsidiary, Pharmacopeia DrugDiscovery, Inc. (“PDD”), into an independent, separately traded, publicly heldcompany through the distribution to our stockholders of a dividend of one shareof PDD common stock for every two shares of our common stock. In connectionwith this spin-off, the landlords of the New Jersey facilities which were usedby our PDD operations consented to the assignment of the leases to PDD. Despitethe assignment, the landlords required us to guarantee the remaining leaseobligations, which totaled approximately $23 million as of September 30, 2006.In accordance with FIN No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others,* we recognized a liability andcorresponding charge to

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stockholders’equity for the probability-weighted fair market value of the guarantee. Changesto the fair market value of the liability are recognized in stockholders’equity. At each of September 30, 2006 and March 31, 2006, the liability for ourguarantee of the lease obligation was $0.6 million.

*OtherGuarantees and Indemnifications*

Weprovide indemnifications of varying scope and size to certain customers againstclaims of intellectual property infringement made by third parties arising fromthe use of our products. We have also entered into indemnification agreementswith our officers and directors. Although the maximum potential amount offuture payments we could be required to make under these indemnifications isunlimited, to date we have not incurred material costs to defend lawsuits orsettle claims related to these indemnification provisions. Additionally, wehave insurance policies that, in most cases, would limit our exposure andenable us to recover a portion of any amounts paid. Therefore, we believe theestimated fair value of these agreements is minimal and likelihood of incurringan obligation is remote. Accordingly, we have not accrued any liabilities inconnection with these indemnification obligations as of September 30, 2006.

**7.****                       Severance and Lease Abandonment**

Thefollowing summarizes the changes in our severance and lease abandonmentliability:
| ** **                                         | ** ** | **Severance Costs  for Involuntary  Employee  Terminations** | ** ** | **Costs to  Exit Lease  Obligations** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------|------------|
| ** **                                         | ** ** | **(In thousands)**                                                | ** ** |
| Balance at  December 31, 2002                      |       | $                                                                      | 544        |                                            | $          | 1,731     |       | $ | 2,275 |   |
| Cash payments                                      |       | (449                                                                   | )          | (281                                            | )          | (730      | )          |
| Adjustment to liability                            |       | (95                                                                    | )          | (289                                            | )          | (384      | )          |
| Balance at  December 31, 2003                      |       | —                                                                 |       | 1,161                                           |       | 1,161     |       |
| Additional severance charges                       |       | 2,813                                                                  |       | —                                          |       | 2,813     |       |
| Cash payments                                      |       | (2,197                                                                 | )          | (65                                             | )          | (2,262    | )          |
| Balance at March  31, 2004                         |       | 616                                                                    |       | 1,096                                           |       | 1,712     |       |
| Additional severance and lease abandonment charges |       | 1,358                                                                  |       | 3,956                                           |       | 5,314     |       |
| Cash payments                                      |       | (907                                                                   | )          | (1,342                                          | )          | (2,249    | )          |
| Adjustment to liability                            |       | —                                                                 |       | (167                                            | )          | (167      | )          |
| Effect of foreign exchange                         |       | —                                                                 |       | (17                                             | )          | (17       | )          |
| Balance at March  31, 2005                         |       | 1,067                                                                  |       | 3,526                                           |       | 4,593     |       |
| Additional severance and lease abandonment charges |       | 1,766                                                                  |       | 1,412                                           |       | 3,178     |       |
| Cash payments                                      |       | (1,745                                                                 | )          | (1,662                                          | )          | (3,407    | )          |
| Effect of foreign exchange                         |       | (23                                                                    | )          | (67                                             | )          | (90       | )          |
| Balance at March  31, 2006                         |       | 1,065                                                                  |       | 3,209                                           |       | 4,274     |       |
| Additional severance charges                       |       | 83                                                                     |       | —                                          |       | 83        |       |
| Cash payments                                      |       | (976                                                                   | )          | (1,236                                          | )          | (2,212    | )          |
| Adjustment to liability                            |       | —                                                                 |       | (89                                             | )          | (89       | )          |
| Effect of foreign exchange                         |       | 77                                                                     |       | 239                                             |       | 316       |       |
| Balance at September  30, 2006                     |       | $                                                                      | 249        |                                            | $          | 2,123     |       | $ | 2,372 |   |

 

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

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Duringfiscal year 2005, as a result of the relocation of our corporate headquarters,we recorded a lease abandonment charge of $3.6 million representing the futurelease obligations, net of estimated future sublease income. Our leaseobligation for this facility terminates in fiscal year 2007.

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

In March 2006, we implemented various actions designedto realign our resources with our portfolio of products and services, eliminateredundancies in our workforce and streamline our operations through workforcereductions and abandoning a portion of a leased facility in the United Kingdom.As a result of the implementation of these actions, in March 2006, werecognized a charge of $3.2 million, consisting of $1.8 million in severancebenefits from the termination of approximately 50 employees and $1.4 millionfor our future lease obligations related to the abandoned facility, net ofestimated future sublease income. In the second quarter of fiscal year 2007, werecognized a charge of $0.1 million for estimated additional severance benefitsto be paid to certain employees terminated under the original restructuringplan. We anticipate completing the workforce reductions and payment ofseverance benefits in fiscal year 2007. The lease obligation for the abandonedfacility terminates in fiscal year 2016.

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**Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

When used anywhere in this Quarterly Report on Form10-Q (this “Report”), the words “expect”, “believe”, “anticipate”, “estimate”, “intend”,“plan” and similar expressions are intended to identify forward-lookingstatements. These forward-looking statements may include statements addressingour future financial and operating results. We have based these forward-lookingstatements on our current expectations about future events. Such statements aresubject to certain risks and uncertainties including those related to executionupon our strategic plans, the successful release and**acceptance of new products, the demand for new and existingproducts, additional competition, changes in economic conditions and thosedescribed in documents we have filed with the Securities and ExchangeCommission, including this Report in “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and “Risk Factors,” and in oursubsequent reports on Form 10-Q and Form 10-K. All forward-looking statementsin this Report are qualified entirely by the cautionary statements included inthis Report and such other filings. These risks and uncertainties could causeactual results to differ materially from results expressed or implied byforward-looking statements contained in this Report. These forward-lookingstatements speak only as of the date of this Report. We disclaim anyundertaking to publicly update or revise any forward-looking statementscontained herein to reflect any change in our expectations with regard theretoor any change in events, conditions or circumstances on which any suchstatement is based.

The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with ourcondensed consolidated financial statements and related notes thereto includedelsewhere in this Report.

**Overview**

***Our Business***

We design, develop, market, and support software andrelated services that facilitate the discovery and development of new andimproved products and processes in the pharmaceutical, biotechnology, chemical,petrochemical and materials industries. Using our products, researchers mayincrease the speed and efficiency of the research and development cycle,thereby reducing product development costs and shortening the time to marketfor new product introductions and process improvements. Our customers includeleading commercial, 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 direct sales force, augmented by the use of third-partydistributors.

***Our Marketplace***

Historically, we have primarily sold molecularmodeling and simulation software. The market for molecular modeling andsimulation products in the pharmaceutical and biotechnology industries ischallenging due to the maturity of the market, industry consolidation,reduction in the level of discovery research activity, and increasedcompetition, including competition from open source software. We also sellmodeling and simulation products to the chemical, petrochemical and materialsindustries. We believe these industries are in the early stages of adoption ofthese technologies. Thus we believe the market for our products within theseindustries is nascent and has experienced modest growth over the past severalyears. Following the acquisition of SciTegic, we began to offer data-pipeliningand workflow software. This technology is widely applicable within our targetindustries and represents a significant growth opportunity. There is currentlylimited competition to this technology in our targeted industries, and we areexperiencing strong adoption rates within our customer base.

***Our Strategy***

Our objective is to strengthen our position as aleading provider of software-based scientific computation, analysis,informatics, knowledge management, workflow products and services. We plan toaccomplish our objective by providing a comprehensive set of integratedproducts and services that are central to the enterprise-wide research anddevelopment activities of our customers, and by connecting these tools withinan information technology framework. This framework makes it easier forresearch and development organizations to manage data, information, knowledge,and collaborative processes.

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Our strategy for growth is to expand usage of ourproducts and services by marketing and distributing our solutions to a broadergroup of users, including scientists, engineers and information technologyprofessionals, within our existing customers, as well as to new customers inother industries.

A key enabler of this strategy is the data pipeliningand workflow technology we acquired through our SciTegic acquisition. We areutilizing this technology to enable our customers to build solutions whichallow them to integrate scientific software and content from across theresearch and development spectrum. Selling solutions is fundamentally differentthan our traditional sale of stand-alone modeling and simulation products. Weare focused on enhancing our sales processes to emphasize solutions selling andstrategic account management. We are also expanding our professional servicescapabilities to enable our customers to deploy these solutions.

In addition to the activities underway in our salesand service functions, we continue to focus on the componentization of ourentire suite of products on our Discovery Studio and Materials Studioplatforms. In fiscal year 2007, we continue to migrate our life sciencesapplications to the Discovery Studio platform.

Finally, in addition to our focus on revenue growth,we continuously evaluate our personnel requirements and cost structure. Overthe past several years we have significantly reduced our operating coststhrough workforce reductions and other cost-savings measures. We will continueour focus on cost control, as well as working capital management as we striveto improve our financial performance.

**Critical Accounting Policies**

The critical accounting policies and estimates used inthe preparation of our consolidated financial statements are described in Item6, “Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” of our Annual Report on Form 10-K for the year ended March 31,2006. There have been  no significantchanges in our critical accounting policies and estimates from March 31, 2006,other than as described below.

*Valuation of Share-Based Awards*

We adopted SFAS No. 123R, effective April 1, 2006,using the modified prospective transition method. Accordingly, beginning in thefirst quarter of fiscal year 2007, we are recognizing as a charge againstincome the estimated grant date fair value of share-based awards granted toemployees and directors. We estimate the fair value of our share-based stockawards on the date of grant using the Black-Scholes option-pricing model. TheBlack-Scholes option-pricing model requires the use of certain input variables,as follows:

*Expected Volatility.*Volatility is a measure of the amount the stock price will fluctuate during theexpected life of an award. We determine volatility based on our historicalstock price volatility over the most recent period equivalent to the expectedlife of the award and the historical stock price volatilities of comparablepublicly traded companies, giving consideration to company-specific eventsimpacting historical volatility that are unlikely to occur in the future aswell as anticipated future events that may impact volatility.

*Risk-Free Interest Rate.*Ourassumption of the risk-free interest rate is based on the interest rates onU.S. constant rate treasury securities with contractual terms approximatelyequal to the expected life of the award.

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

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

Under SFAS No. 123R, we are also required to estimateat grant the likelihood that the award will ultimately vest (the

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“pre-vestingforfeiture rate”) revise the estimate, if necessary, in future periods if theactual forfeiture rate differs. We determine the pre-vesting forfeiture rate ofan award based on our historical pre-vesting award forfeiture experience.

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

**Results of Operations**

**Comparison of the Three Months Ended September 30, 2006 and2005**

The following table summarizes our results ofoperations as a percentage of revenue for the respective periods:
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                          | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                                                  | %          | 100 | % |
| Operating costs  and expenses:      |       |                                                 |       |   |   |
| Cost of revenue                     |       | 19                                                   | %          | 19 | % |
| Product development                 |       | 24                                                   | %          | 26 | % |
| Sales and marketing                 |       | 31                                                   | %          | 34 | % |
| General and administrative          |       | 22                                                   | %          | 17 | % |
| Total operating  costs and expenses |       | 96                                                   | %          | 95 | % |
| Operating income                    |       | 4                                                    | %          | 5 | % |
| Interest and  other income, net     |       | 2                                                    | %          | 2 | % |
| Income before  income taxes         |       | 6                                                    | %          | 6 | % |
| Income tax  expense                 |       | 1                                                    | %          | 1 | % |
| Net income                          |       | 5                                                    | %          | 5 | % |

 

***Revenue***

Revenue decreased $1.5 million or 7% to $20.2 millionfor the three months ended September 30, 2006, as compared to $21.7 million forthe three months ended September 30, 2005. The decrease in revenue wasprimarily attributable to a decrease in revenues from certain products thatwere de-emphasized in connection with our restructuring and product lineadjustments that have occurred over the past two fiscal years.

***Operating Costs and Expenses***

*Cost of Revenue.*Cost of revenue decreased $0.3 millionor 8% to $3.8 million for the three months ended September 30, 2006, ascompared to $4.2 million for the three months ended September 30, 2005. As apercentage of revenue, cost of revenue was consistent at 19% for each of thethree months ended September 30, 2006 and 2005, respectively. The decrease incost of revenue was primarily attributableto lower royalties and distribution costs.

*Product DevelopmentExpenses.*Productdevelopment expenses decreased $0.7 million or 12% to $4.9 millionfor the three months ended September 30, 2006, as compared to $5.6 millionfor the three months ended September 30, 2005. As a percentage of revenue,product development decreased to 24% for the three months ended September 30,2006, as compared to 26% for the three months ended September 30, 2005. Thedecrease in product development expenses was primarily attributable to lower personnel expenses resulting from headcountreductions during fiscal year 2006, offset by a $0.2 million increase inshare-based compensation expense recognized during the three months ended September30, 2006 resulting from our adoption of SFAS No. 123R.

*Sales and MarketingExpenses.*Sales andmarketing expenses decreased $1.1 million or 15% to $6.3 millionfor the three

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months ended September 30, 2006, as compared to $7.4 millionfor the three months ended September 30, 2005. As a percentage of revenue,sales and marketing expenses decreased to 31% for the three months ended September30, 2006, as compared to 34% for the three months ended September 30, 2005. The decrease in sales and marketing expenses wasprimarily attributable to lower personnel and other sales-related expensesresulting from headcount reductions during fiscal year 2006, offset by a$0.2 million increase in share-based compensation expense recognized during thethree months ended September 30, 2006 resulting from our adoption of SFAS No.123R.

*General and AdministrativeExpenses.*General andadministrative expenses increased $0.8 million or 21% to $4.4 millionfor the three months ended September 30, 2006, as compared to $3.6 millionfor the three months ended September 30, 2005. As a percentage of revenue,general and administrative expenses increased to 22% for the three months endedSeptember 30, 2006, as compared to 17% for the three months ended September 30,2005. The increase in general and administrative costs was primarilyattributable to a $0.6 million increase in share-based compensation expenserecognized during the three months ended September 30, 2006 resulting from ouradoption of SFAS No. 123R.

***Net Interest and OtherIncome***

Net interest and otherincome was $0.4 million for each of the three months ended September30, 2006 and 2005, respectively. 

***Income Tax Expense***

We recognized income taxexpense of $0.3 million for the three months ended September 30, 2006,as compared to $0.2 million for the three months ended September 30, 2005. Theslight increase in income tax expense was primarily attributable to theincrease in the deferred tax liability associated with tax deductible goodwillrecognized in the three months ended September 30, 2006. 

**Comparison of the Six Months Ended September 30,2006 and 2005**

The following table summarizes our results ofoperations as a percentage of revenue for the respective periods:
| ** **                          | ** ** | **Six Months Ended September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                               | ** ** | **2005** | ** ** |
| ** **                          | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                                                    | %          | 100 | % |
| Operating costs  and expenses:      |       |                                                   |       |   |   |
| Cost of revenue                     |       | 19                                                     | %          | 20 | % |
| Product development                 |       | 25                                                     | %          | 27 | % |
| Sales and marketing                 |       | 32                                                     | %          | 38 | % |
| General and administrative          |       | 22                                                     | %          | 18 | % |
| Total operating  costs and expenses |       | 99                                                     | %          | 103 | % |
| Operating income  (loss)            |       | 1                                                      | %          | (3 | )% |
| Interest and  other income, net     |       | 2                                                      | %          | 3 | % |
| Income (loss)  before income taxes  |       | 3                                                      | %          | (0 | )% |
| Income tax  expense                 |       | 2                                                      | %          | 2 | % |
| Net income (loss)                   |       | 2                                                      | %          | (2 | )% |

 

***Revenue***

Revenue decreased $1.8million or 4% to $40.4 million for the six months ended September 30, 2006, ascompared to $42.1 million for the six months ended September 30, 2005. Thedecrease in revenue was primarily attributable to a decrease in revenues from certain products that werede-emphasized in connection with our restructuring and product line adjustmentsthat have occurred over the past two fiscal years.

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***Operating Costs and Expenses***

*Cost of Revenue.*Cost of revenue decreased$0.6 million or 7% to $7.7 million for the six months ended September 30, 2006,as compared to $8.3 million for the six months ended September 30, 2005. As apercentage of revenue, cost of revenue decreased to 19% for the six monthsended September 30, 2006, as compared to 20% for the six months ended September30, 2005. The decrease in cost of revenue was primarily attributable to lowerroyalties and distribution costs.

*Product Development Expenses.*Productdevelopment expenses decreased $1.4 million or 12% to $10.0 million forthe six months ended September 30, 2006, as compared to $11.4 million forthe six months ended September 30, 2005. As a percentage of revenue, productdevelopment decreased to 25% for the six months ended September 30, 2006, ascompared to 27% for the six months ended September 30, 2005. The decrease inproduct development expenses was primarily attributable to lower personnelexpenses resulting from headcount reductions during fiscal year 2006, offset bya $0.4 million increase in share-based compensation expense recognized duringthe six months ended September 30, 2006 resulting from our adoption of SFAS No.123R.

*Sales and Marketing Expenses.*Sales andmarketing expenses decreased $2.8 million or 18% to $13.1 million for thesix months ended September 30, 2006, as compared to $15.9 million for thesix months ended September 30, 2005. As a percentage of revenue, sales andmarketing expenses decreased to 32% for the six months ended September 30,2006, as compared to 38% for the six months ended September 30, 2005. Thedecrease in sales and marketing expenses was primarily attributable to lowerpersonnel and other sales-related expenses resulting from headcount reductionsduring fiscal year 2006, offset by a $0.3 million increase in share-basedcompensation expense recognized during the six months ended September 30, 2006resulting from our adoption of SFAS No. 123R.

*General and Administrative Expenses.*Generaland administrative expenses increased $1.4 million or 18% to $9.1 millionfor the six months ended September 30, 2006, as compared to $7.7 millionfor the six months ended September 30, 2005. As a percentage of revenue,general and administrative expenses increased to 23% for the six months endedSeptember 30, 2006, as compared to 18% for the six months ended September 30,2005. The increase in general and administrative costs was primarilyattributable to a $1.0 million increase in share-based compensation expenserecognized during the six months ended September 30, 2006 resulting from ouradoption of SFAS No. 123R and $0.5 million of outside consulting and accountingfees related to the restatement of our previously issued consolidated financialstatements, which was completed in May 2006.

***Net Interest and Other Income***

Netinterest and other income was $0.8 million for the six months endedSeptember 30, 2006, as compared to $1.1 million for the six months endedSeptember 30, 2005. The decrease in net interest and other income was primarilyattributable to unfavorable fluctuations in the value of the U.S. dollar.

***Income Tax Expense***

Werecognized income tax expense of $0.7 million for each of the six months endedSeptember 30, 2006 and 2005, respectively.

**Liquidityand Capital Resources**

We hadcash, cash equivalents, restricted cash and marketable securities of $61.2million as of September 30, 2006, as compared to $66.0 million as of March 31,2006, a decrease of $4.8 million. The decrease in cash, cash equivalents,restricted cash and marketable securities during the six months ended September30, 2006 was primarily attributable to cash used in operations of $7.8 million,offset by a $1.4 million favorable effect on cash and cash equivalents ofchanges in foreign currency rates and an increase in restricted cash of $1.5million resulting from the receipt of a subtenant security deposit. Our cashused in operations on a quarterly basis is significantly impacted by changes indeferred revenue balances. Due to the seasonality of our business, deferredrevenue balances generally increase significantly in the third quarter of eachfiscal year as a result of higher order intake and then decline over thefollowing three quarters as deferred revenue is recognized as revenue. Acorresponding refundable deposit liability was recognized for the subtenantsecurity deposit, which is included in lease-related liabilities, net ofcurrent portion in the accompanying condensed consolidated balance sheet as ofSeptember 30, 2006.

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Net cashused in operating activities was $7.8 million for the six months endedSeptember 30, 2006, as compared to $7.9 million for the six months endedSeptember 30, 2005. The decrease in cash used in operating activities wasprimarily attributable to reduced operating expenditures.

Netcash used in investing activities was $2.0 million for the six months endedSeptember 30, 2006, as compared to net cash provided by investing activities of$5.4 million for the six months ended September 30, 2005. Significant componentsof cash flows from investing activities for the six months ended September 30,2006 included net purchases of property and equipment of $0.7 million and a netincrease in our marketable securities portfolio of $1.3 million. Significantcomponents of cash flows from investing activities for the six months endedSeptember 30, 2005 included $2.2 million of net purchases of property andequipment and a net decrease in our marketable securities portfolio of $7.6million.

Netcash provided by financing activities was $0.6 million for the six months endedSeptember 30, 2006, compared to $0.5 million for the six months ended September30, 2005. Cash flows from financing activities for the six months endedSeptember 30, 2006 and 2005 consisted solely of proceeds from the issuance ofour common stock under employee stock plans.

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

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

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

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

Theinformation called for by this item is provided in Item 7A, “Quantitative andQualitative Disclosures About Market Risk,” of our Annual Report on Form 10-Kfor the year ended March 31, 2006. Our exposures to market risk have notchanged materially since March 31, 2006.

**Item 4. Controls and Procedures**

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

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

Asmore fully described in Item 9A of our Annual Report on Form 10-K forthe year ended March 31, 2006, we reported that our management identifiedcertain control deficiencies that represent material weaknesses in our internalcontrol over financial reporting. The material weaknesses identified bymanagement related to the application of software revenue

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recognitionprinciples to our term-based and perpetual software license arrangements andthe application of SFAS No. 86 to our software development projects. As aresult of the identification of these material weaknesses, our principalexecutive officer and principal financial officer concluded that as of March31, 2006, our disclosure controls and procedures were not effective pursuant toExchange Act Rules 13a-15(f) and 15d-15(f).

As ofthe end of the period covered by this Report, we conducted an evaluation, underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based onthis evaluation, our principal executive officer and principal financialofficer concluded that, although the remediation actions set forth below hadbeen initiated as of September 30, 2006, these remediation actions had not beenin operation for a sufficient period of time and had not yet been tested.Therefore, the identified material weaknesses in our internal control overfinancial reporting had not been fully remediated and, as a result, ourdisclosure controls and procedures were not considered to be effective as ofSeptember 30, 2006. Notwithstanding the material weaknesses described above,management believes that the consolidated financial statements included in thisReport fairly present in all material respects our financial condition, resultsof operations and cash flows for the periods presented.

**Changesin Internal Control Over Financial Reporting**

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

(1)       Wehired three senior-level accounting employees in March and April 2006 who havesignificant expertise in financial controls and the application of generallyaccepted accounting principles relevant to our business, including softwarerevenue recognition.

(2)       Wedesigned a program of additional training regarding our revenue recognitionpolicies intended to ensure all relevant personnel involved in software revenuerecognition transactions understand and apply applicable generally acceptedaccounting principles, and have set an annual minimum training requirement.

(3)       Weimplemented an enhanced quarterly financial statement close, review and reportingprocess to include additional levels of analysis and review.

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

Exceptas described above, there were no changes in our internal control over financialreporting during the three months ended September 30, 2006 that materiallyaffected, or are reasonably likely to materially affect, those controls.

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**PART II — OTHER INFORMATION**

**Item 1A. Risk Factors**

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

**CertainRisks Related to Our Marketplace and Environment**

***Our revenue from the sale of modeling,simulation and informatics software to the life science discovery researchmarketplace, which has historically constituted a significant portion of ouroverall revenue, has been declining over the past several years and maycontinue to decline in future years.***Historically we havederived a significant portion of our revenue from the sale of modeling,simulation and informatics software to the discovery research departments inpharmaceutical and biotechnology companies. Such revenues have been decliningover the past several years. We believe this decline is due to several factors,including industry consolidation, a general reduction in the level of discoveryresearch activity by our customers, increased competition, includingcompetition from open source software, and reductions in profit and relatedinformation technology spending by our customers, due in part to the expirationof patents on profitable drugs. If such declines continue and we do not increasethe revenue we derive from our other product and service offerings, ourbusiness could be adversely impacted.

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

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

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

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

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

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

Someof our competitors and potential competitors in this sector have longeroperating histories than us and have greater financial, technical, marketing,research and development and other resources. Many of our competitors 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 and made available at lower cost by government organizations andacademic institutions, and these entities may be able to devote substantialresources to product development and also offer their products to users forlittle or no charge. We also face competition from open source softwareinitiatives, in which developers provide software and intellectual propertyfree over the Internet. In addition, many of our customers spend significantinternal resources in order to develop their own software.

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

***We are subject to pricing pressures in themarkets we serve.***We operate in an intensely competitivemarketplace which has led to significant pricing pressure 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. Changes in our pricing model couldlead to a decline or delay in revenue as our sales force and customers adjustto the new pricing policies. This development may adversely affect our revenueand earnings.

***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. We alsoconduct sales and customer support activities at our facilities in Burlington,Massachusetts, Paris, France, and Tokyo, Japan. Although we have contingencyplans in effect for natural disasters or other catastrophic events,catastrophic events could still disrupt our operations. For example, our SanDiego and Tokyo facilities are located in areas that are particularlysusceptible to earthquakes. Any natural disaster or catastrophic event in ourfacilities or the areas in which they are located could have a significantnegative impact on our operations.

***Our insurance coverage may not besufficient to avoid material impact on our financial position or results ofoperations resulting from claims or liabilities against us, and we may not beable to obtain insurance coverage in the future.***Wemaintain insurance coverage for protection against many risks of liability. Theextent of our insurance coverage is under continuous review and is modified aswe deem it necessary. Despite this insurance, it is possible that claims orliabilities against us may have a material adverse impact on our financialposition or results of operations. In addition, we may not be able to obtainany insurance coverage, or adequate insurance coverage, when our existinginsurance coverage

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expires. Forexample, we do not carry earthquake insurance for our facilities in Tokyo,Japan or San Diego, California, because we were unable to obtain such insuranceon commercially reasonable terms.

**CertainRisks Related to Our Operations**

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

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

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

·               unexpectedchanges in regulatory requirements;

·               longerpayment cycles;

·               currencyexchange rate fluctuations;

·               importand export license requirements;

·               tariffsand other barriers;

·               politicalunrest, terrorism and economic instability;

·               disruptionof our operations due to local labor conditions;

·               limitedintellectual property protection;

·               difficultiesin collecting trade receivables;

·               difficultiesin managing distributors or representatives;

·               difficultiesin managing an organization spread over various countries;

·               difficultiesin staffing foreign subsidiary or joint venture operations; and

·               potentiallyadverse tax consequences.

Oursuccess depends, in part, on our ability to anticipate and address these risks.There can be no assurance that we will

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do so effectivelyor that these or other factors relating to our international operations willnot adversely affect our business or operating results.

***In order to improve our financial position,we have reduced our headcount, which could negatively impact our business.***Wehave undergone several reductions-in-force over the past few years, and ourworkforce has declined by approximately 200 people since March 2002. While webelieve we have sufficient staff to operate our business, we do not haveduplicative or redundant resources in many of our functions or operations. As aresult, there can be no assurance that further attrition will not impact ourability to operate our business, or adversely impact our revenues.

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

In addition to theforegoing, as described in greater detail elsewhere in this Report and in ourAnnual Report on Form 10-K for the year ended March 31, 2006, we concluded thatour internal control over financial reporting was not effective as of March 31,2006. In particular, in connection with the restatement of our previouslyissued financial statements, management identified certain control deficienciesthat represented material weaknesses in our internal control over financialreporting. These material weaknesses, which principally arose due to our lackof a sufficient number of employees with an appropriate level of accountingknowledge, experience and training in the application of generally acceptedaccounting principles relevant to our business, were at least partiallyresponsible for our need to restate our previously issued consolidatedfinancial statements. In order to remediate the identified material weaknessesin our internal control over financial reporting, we implemented certainactions, including the hiring of three senior-level accounting employees inMarch and April 2006 who have significant expertise in financial controls andthe application of generally accepted accounting principles relevant to ourbusiness, including software revenue recognition. However, one or more of thesequalified recruits or existing personnel could leave our employ within theforeseeable future. If not timely and adequately addressed, the loss of any ofthese individuals could impair our ability to maintain effective internalcontrol over financial reporting and thereby cause a material adverse effect onour business.

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

**CertainRisks Related To Our Financial Performance**

***We have a history of losses and our futureprofitability is uncertain.*****While we attained net income for the six months endedSeptember 30, 2006, we generated net losses for the years ended March 31, 2006and 2005 and December 31, 2003, and the three months ended March 31, 2004.Continuing net losses may limit our ability to fund our operations and we maynot generate income from operations in the future. Our future profitabilitydepends upon many factors, including several that are beyond our control. Thesefactors include without limitation:

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·               changesin the demand for our products and services;

·               theintroduction of competitive software;

·               ourability to license desirable technologies;

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

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

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

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

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

***Changes in the accounting treatment ofemployee stock-based compensation has and will continue to adversely affect ourresults of operations.*****In December 2004, the FASB issued SFAS No. 123R, which revises SFASNo. 123, *Accounting for Stock-BasedCompensation*. SFAS No. 123R requires that employee stock-based compensationis measured based on the grant-date fair value of the related employee equityaward and is treated as an expense that is reflected in the financialstatements over the related service period. SFAS No. 123R applies to allemployee equity awards granted after adoption and to the unvested portion ofemployee equity awards outstanding as of adoption. We adopted SFAS No. 123Rusing the modified-prospective method on April 1, 2006. As a result of theadoption of SFAS No. 123R, we recognized a charge against our earnings of $1.3million and $2.3 million for the three and six months ended September 30, 2006.We anticipate that the continued application of the accounting provisions ofSFAS No. 123R will adversely impact on our future reported results of operations.

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

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cannot guarantee that wewill have no further inquiries from the SEC or NASDAQ regarding our restatedfinancial statements or matters relating thereto. Likewise, many companies thathave been required to restate their historical financial statements havesubsequently experienced stockholder lawsuits relating to their restatements.Any future inquiries from the SEC or NASDAQ as a result of the restatement of ourhistorical financial statements will, regardless of the outcome, likely consumea significant amount of our resources in addition to those resources alreadyconsumed in connection with the restatement itself.

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

As described ingreater detail elsewhere in this Report and in our Annual Report on Form 10-Kfor the year ended March 31, 2006, in connection with the restatement process,we identified certain control deficiencies that represented material weaknessesin our internal control over financial reporting. These material weaknessesgenerally relate to our historical lack of a sufficient number of employeeswith appropriate levels of accounting knowledge, experience and training in theapplication of generally accepted accounting principles relevant to ourbusiness. Given these material weaknesses, our principal executive officer andprincipal financial officer concluded that we did not maintain effectiveinternal control over financial reporting as of March 31, 2006.

Sincethe determination regarding our material weaknesses, we have devotedsignificant effort and resources to the remediation and improvement of ourinternal control over financial reporting. In particular, as describedelsewhere in this Report, we have recruited a number of qualified individualsto assist in maintaining adequate internal controls, we have initiated arevenue recognition training program and we have implemented an enhancedquarterly and annual financial statement close, review and reporting process.Notwithstanding the implementation of these remediation initiatives, theidentified material weaknesses in our internal control over financial reportingwill not be considered remediated until the new controls are fully implemented,in operation for a sufficient period of time, are tested and our management concludesthat the new controls are operating effectively. Because the remediationinitiatives are not yet fully implemented, our principal executive officer andprincipal financial officer concluded that the identified material weaknessesin our internal control over financial reporting had not been fully remediatedand, therefore, our disclosure controls and procedures were not effective as ofSeptember 30, 2006.

Although webelieve that these efforts and resources have strengthened our internal controlover financial reporting, we cannot be certain that these measures will ensurethat we maintain adequate internal control over our financial reporting infuture periods. Any failure to maintain such internal controls could adverselyimpact our ability to report our financial results on a timely and accuratebasis. If our financial statements are not accurate, investors may not have acomplete understanding of our operations. Likewise, if our financial statementsare not filed on a timely basis as required by the SEC and NASDAQ, we couldface severe consequences from those authorities. In either case, there couldresult a material adverse affect on our business. Inferior internal controlscould also cause investors to lose confidence in our reported financial information,which could have a negative effect on the trading price of our stock.

***We may be required to indemnify PDD, or maynot be able to collect on indemnification rights from PDD*.**On April 30, 2004, we spun-off our drug discovery subsidiary, PDD, into anindependent, separately traded, publicly held company through the distributionto our stockholders of a dividend of one share of PDD common stock for everytwo shares of our common stock. As part of the spin-off, we agreed to indemnifythe indebtedness, liabilities and obligations of PDD. One such obligationincludes a guarantee by us to the landlord of PDD’s obligations under theexisting New Jersey laboratory and headquarters leases, with respect to whichPDD will indemnify us should we be required to make any payment under theguarantee. These indemnification obligations could be as significant as theremaining future minimum lease payments, which totaled approximately $23million as of September 30, 2006. PDD’s ability to satisfy any such indemnificationobligations (including, without limitation, PDD’s commitment to indemnify us inthe event of our payment under our guarantee of its leases) will depend uponPDD’s future financial strength. We cannot assure you that, if PDD becomesobligated to indemnify us for any substantial obligations, PDD will have theability to do so. There also can be no assurance that we will be able tosatisfy any indemnification obligations to PDD. Any failure by PDD to satisfyits obligations and any required payment by us

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could have amaterial adverse effect on our business.

***Enacted and proposed changes in securitieslaws and regulations have increased our costs and may continue to increase ourcosts in the future.*** Sarbanes-Oxley required changes insome of our corporate governance and securities disclosure and compliancepractices. Under Sarbanes-Oxley, publicly held companies, including us, arerequired to, among other things, furnish independent annual audit reportsregarding the existence and reliability of their internal control overfinancial reporting and have their chief executive officer and chief financialofficer certify as to the accuracy and completeness of their financial reports.

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

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

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

·               costsassociated with software sales;

·               thepurchase of additional capital equipment;

·               acquisitionsof other businesses or technologies; and

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

If wedetermine that we must raise additional capital, we may attempt to do sothrough public or private financings involving debt or equity. However,additional capital may not be available on favorable terms, or at all. 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.

**CertainRisks Related to Owning Our Stock**

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

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

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·               marketconditions in the technology and software sectors;

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

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

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

·               marketacceptance of our products and services;

·               additionsor departures of key personnel; and

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

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

***As institutions hold the majority of ourcommon stock in large blocks, substantial sales by these stockholders coulddepress the market price for our shares.***As of October13, 2006, the top ten institutional holders of our common stock heldapproximately 53% of our outstanding common stock. As a result, if one or moreof these major stockholders were to sell all or a portion of their holdings, orif the market were to perceive that such sale or sales may occur, the marketprice of our common stock may fall significantly.

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

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

**CertainRisks Related to Intellectual Property**

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

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consultants toexecute confidentiality and assignment-of-inventions agreements. Theseagreements typically provide that all materials and confidential informationdeveloped by or made known to the employee or consultant during his, her or itsrelationship with us are to be kept confidential, and that all inventionsarising out of the employee’s or consultant’s relationship with us are ourexclusive property. Our employees and consultants may breach these agreements,and in some instances 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.***We believe that oursuccess depends, in part, upon our ability to obtain international protectionfor our intellectual property. However, the laws of some foreign countries maynot be as comprehensive as those of the United States and may not be sufficientto protect our proprietary rights abroad. In addition, we generally do notpursue patent protection outside the United States because of cost andconfidentiality concerns. Accordingly, our international competitors couldobtain foreign patent protection for, and market overseas, products andtechnologies for which we are seeking patent protection in the United States.

***A patent issued to us may not besufficiently broad to protect adequately our rights in intellectual property towhich the patent relates.***Due to cost and otherconsiderations, we generally do not rely on patent protection to enforce ourintellectual property rights, and have filed only a limited number of patentapplications. Even if patents are issued to us, these patents may notsufficiently protect our interest in our software or other technologies becausethe scope of protection provided by any patents issued to or licensed by us aresubject to the uncertainty inherent in patent law. Third parties may be able todesign around these patents or develop unique products providing effectssimilar to our products. In addition, others may discover uses for our softwareor technologies other than those uses covered in our patents, and these otheruses may be separately patentable. A number of pharmaceutical and biotechnologycompanies, software organizations and research and academic institutions, havedeveloped technologies, filed patent applications or received patents onvarious technologies that may be related to our business. Some of thesetechnologies, patent applications or patents may conflict with our technologies,patent applications or patents. These conflicts could also limit the scope ofpatents, if any, that we may be able to obtain, or result in the denial of ourpatent applications.

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

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

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**Item 4. Submission of Matters toa Vote of Security Holders**

On August 4, 2006, we held our Annual Meeting ofStockholders at which the stockholders approved all of the proposals listedbelow:

(1)            The election of MarkJ. Emkjer and Christopher J. Steffen to the Board of Directors, in each case toserve for a three-year term to expire at the 2009 Annual Meeting ofStockholders.

(2)            The selection of Ernst& Young LLP as our independent public accountants for the fiscal yearending March 31, 2007.

The following directors received the number of votesset opposite their respective names: 
| ** **             | ** ** | ** **            | ** ** | **Votes Against** | ** ** |
|------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **             | ** ** | **For Election** | ** ** | **or Withheld**   | ** ** |
| Mark J. Emkjer         |       | 23,772,228            |       | 90,581                 |       |
| Christopher J. Steffen |       | 22,730,377            |       | 1,132,142              |       |

 

The proposal to select Ernst & Young LLP as ourindependent public accountants received 22,873,901 affirmative votes (for theselection), 709,439 negative votes (against the selection), and 279,469 votesabstained.

Kenneth L. Coleman and Ricardo B. Levy, Ph.D.,continued in office as members of the Board of Directors, with their termsexpiring at the 2007 Annual Meeting of Stockholders. Gary E. Costley, Ph.D.,also continued in office as a member of the Board of Directors, with his term expiringat the 2008 Annual Meeting of Stockholders.

**Item 5. Other Information**

On October 26, 2006, we entered into substantiallyidentical employment agreements (each, an “Employment Agreement”) with the following of our executives:  
| **Name**               | ** ** | **Title**                                             | ** ** | **Base Salary** | ** ** | **Target Bonus %** | ** ** |
|------------------------|------------|-------------------------------------------------------|------------|----------------------|------------|------------------------------|------------|
| ** **             | ** ** | ** **                                            | ** ** | ** **           | ** ** | ** **                   | ** ** |
| Rick E. Russo          |       | Senior  Vice President and Chief Financial Officer    |       | $                    | 250,000    |                         | 50         | % |
| Richard C.G.  Murphy   |       | Senior  Vice President, Worldwide Sales and Services  |       | 250,000              |       | 60                           | %          |
| David R. Mersten       |       | Senior  Vice President, General Counsel and Secretary |       | 240,000              |       | 40                           | %          |
| Frank K. Brown,  Ph.D. |       | Vice  President and Chief Science Officer             |       | 240,000              |       | 40                           | %          |
| R. William  Taylor     |       | Vice  President, Marketing and Corporate Development  |       | 240,000              |       | 40                           | %          |
| Nicholas Austin        |       | Vice  President, Research and Development             |       | 240,000              |       | 40                           | %          |
| Judith  Ohrn-Hicks     |       | Vice  President, Human Resources                      |       | 205,000              |       | 40                           | %          |
| Kathy C. Hollister     |       | Vice President,  Worldwide Client Services            |       | 205,000              |       | 40                           | %          |
|                        |            |                                                       |            |                      |            |                              |            |  |

 

Pursuant to each respective Employment Agreement, eachexecutive will continue to receive such executive’s annual base salary as setforth in the table above, which amount is subject to annual review by the HumanResources Committee of the Board of Directors, and will continue to be entitledto participate in our management incentive plan, which will allow suchexecutive to receive an incentive bonus in an amount up to the percentage ofsuch executive’s annual base salary set forth in the table above for each yearsuch executive remains employed with us, subject to the criteria set forth inthe management incentive plan,.

We may terminate each Employment Agreement upon twoyears notice. Such notice may be given to the applicable executive commencingtwelve months after execution of such executive’s Employment Agreement.However, even during the term of each Employment Agreement, each executive’semployment with us will be at-will, meaning that either we or such executivemay terminate the employment relationship at any time. If an executive’semployment with us is terminated by us during the term without “cause” or bythe executive for “good reason” (each as defined in each Employment Agreement),such executive will be entitled to receive, subject to such executive’scontinued compliance with certain non-

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competition, non-solictation and non-disparagementprovisions contained in such executive’s Employment Agreement, severancepayments and benefits consisting of: (1) an amount equal to such executive’sthen-current base salary, payable in equal monthly installments over twelvemonths following the date of termination; (2) a pro-rated amount equal tothe incentive bonus that such executive would otherwise have been entitled toreceive under the management incentive plan for the then-current fiscal year,payable as a lump sum; (3) an amount equal to such executive’sthen-current target bonus amount under the management incentive plan, payablein equal monthly installments over a period of twelve months following the dateof termination; and (4) reimbursements for COBRA payments made under ourmedical and dental insurance plans for a period of up to twelve monthsfollowing the date of termination.

In addition, if an executive’s employment with us isterminated within the period commencing two months prior to, and extendingeighteen months following, the occurrence of a “change of control”(as defined in each Employment Agreement) which takes place during theterm of the applicable Employment Agreement, such executive will be entitled toreceive, subject to such executive’s continued compliance with certainnon-competition, non-solictation and non-disparagement provisions contained insuch executive’s Employment Agreement, severance payments and benefitsconsisting of: (1) an amount equal to twice the amount of such executive’sthen-current base salary, payable in equal monthly installments over a periodof one year following the date of termination; (2) a pro-rated amountequal to the incentive bonus that such executive would otherwise have beenentitled to receive under the management incentive plan for the then-currentfiscal year, payable as a lump sum; (3) an amount equal to twice theamount of such executive’s then-current target bonus amount under themanagement incentive plan, payable in equal monthly installments over a periodof one year following the date of termination; and (4) reimbursements forCOBRA payments made under our medical and dental insurance plans for a periodof up to one year following the date of termination. In addition, all stockawards issued to such executive pursuant to our stock incentive plans willautomatically accelerate and become vested in full as of the date oftermination.

The timing of severance payments and benefits under the Employment Agreement may bedeferred to avoid incurring additional taxes and penalties pursuant toSection 409A of the Internal Revenue Code of 1986 (the “Code”). Paymentsare generally subject certain gross-up provisions in the event that they arecharacterized as “excess parachute payments” within the meaning ofSection 280G of the Code.

The foregoing description of is intended only as asummary of the material terms of each Employment Agreement and is qualified inits entirety by reference to the full form of Employment Agreement attached asExhibit 10.5 of this Report.

**Item 6. Exhibits**
| Exhibit Number | ** ** | **Description**                                                                                                                                                                                                                        |
|----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1            |       | Restated Certificate of Incorporation of  Pharmacopeia, Inc. (incorporated by reference to Exhibit 3.1 to Accelrys,  Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31,  1996).                             |
| 3.2            |       | Certificate of Amendment of the Restated Certificate  of Incorporation of Pharmacopeia, Inc. (incorporated by reference to Exhibit  3.1 to Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended  March 31, 2005. |
| 3.3            |       | Amended and Restated Bylaws of Accelrys, Inc. as  amended on June 9, 2005. (incorporated by reference to Exhibit 3.2 to  Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended March  31, 2005)              |
| 10.1           |       | Employment Transition and Separation Agreement,  dated June 14, 2006, between Accelrys, Inc. and David M. Sankaran  (incorporated by reference to Exhibit 99.1 to Accelrys, Inc.’s Form 8-K dated  June 15, 2006)                 |
| 10.2           |       | Letter of Employment, dated September 1, 2006,  between Accelrys, Inc. and Rick E. Russo (incorporated by reference to  Exhibit 99.1 to Accelrys, Inc.’s Form 8-K dated September 6, 2006)                                        |
| 10.3           |       | Letter of Employment, dated September 6, 2006,  between Accelrys, Inc. and Frank K. Brown, Ph.D. (incorporated by reference  to Exhibit 99.3 to Accelrys, Inc.’s Form 8-K dated September 28, 2006)                               |
| 10.4           |       | Second Amendment to Employment Agreement, dated  September 26, 2006, between Accelrys, Inc. and Mathew Hahn, Ph.D.  (incorporated by reference to Exhibit 99.2 to Accelrys, Inc.’s Form 8-K dated  September 28, 2006)            |
| 10.5*          |       | Form of Employment Agreement between Accelrys, Inc.  and certain of its executives                                                                                                                                                     |
| 31.1*          |       | Section 302 Certification of the Principal Executive  Officer                                                                                                                                                                          |
| 31.2*          |       | Section 302 Certification of the Principal Financial  Officer                                                                                                                                                                          |
| 32.1*          |       | Section 906 Certification of the Chief Executive  Officer and Chief Financial Officer                                                                                                                                                  |

 

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*  Filed herewith

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**SIGNATURE**

Pursuant to therequirements of section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|        |   | ACCELRYS, INC. |
|--------|--------|----------------|
|   |   |           |
|   |   | By:            | /s/ RICK E. RUSSO |
|   |   |           | Rick E. Russo |
|   |   |           | Senior Vice President and Chief Financial  Officer (Duly Authorized Officer and Chief  Financial Officer) |
|   |   |           |   |
|   |   |           | Date: October 27, 2006 |

 

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