**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**(MarkOne)**

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

**Forthe fiscal year ended December 31, 2006**

**or**

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

**Forthe transition period from**               to

**CommissionFile Number 000-30469**

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**deCODE genetics, Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                      |   | **04-3326704**                        |
|-------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of   incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**Sturlugata8, Reykjavik, Iceland**

(Addressof principal executive offices)

**+ 354-570-1900**

(Registrant’stelephone number, including area code)

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**Securities registered pursuant toSection 12(b) of the Act:**

|                                | **Title  of each class** | ** **                   |   | ** ** | **Name  of each exchange on which registered** | ** ** |
|--------------------------------|--------------------------|------------------------------|--------|------------|------------------------------------------------|------------|
| Common Stock,  $.001 par value |                     | The NASDAQ Stock Market  LLC |

 

**Securities registered pursuant to Section 12(g) ofthe Act:**

**None**

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Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes o   No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes o   No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.Yes x   No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer” and “large accelerated filer” in Rule 12b-2of the Exchange Act.

Large accelerated filer o      Accelerated filer x      Non-acceleratedfiler o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).Yes o   No x

The aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant, based on theclosing price of the common stock ($6.19 per share), as of June 30, 2006,was $326,681,490.

Indicate the number of sharesoutstanding of each of the registrant’s classes of common stock, as of February 28,2007.

|                                          | **Class** | ** ** |   | ** ** | **Number of Shares** | ** ** |
|------------------------------------------|-----------|------------|--------|------------|--------------------------------|------------|
| Common Stock,  $.001 par value |      | 61,697,833 |

 

**DOCUMENTS INCORPORATED BYREFERENCE**

Portions of the definitive proxy statement for theregistrant’s 2007 Annual Meeting of Stockholders are incorporated by referenceinto Part III.

 

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**PART I**

**Item 1.**                        *Business*

**Overview**

Headquartered in Reykjavik, Iceland, deCODE is abiopharmaceutical company applying its discoveries in human genetics to developdrugs and diagnostics for common diseases. Our population approach andresources enable us to isolate genes and drug targets directly involved in thedevelopment of many of the diseases which pose the biggest challenges to publichealth. We are turning these discoveries into a growing pipeline oftherapeutics and diagnostic tests taking aim at the causes of disease, not justthe signs and symptoms. As these diseases are common and current therapies areof limited effectiveness, we believe that our strategy represents a significantopportunity to create better medicine with major potential in the globalmarketplace.

We believe that deCODE’s advantage derives from ourunique competence in human genetics and the ability to apply our findingsdirectly to drug and diagnostic development. In Iceland, we have comprehensivepopulation resources that enable our scientists to isolate key genes and genevariants contributing to common diseases. The proteins encoded by these genes,and other proteins with which they interact in the disease pathway, offer drugtargets that we believe are directly involved in the onset and progression ofdisease. Because these genes affect disease risk by up regulating or downregulating the activity of common biological pathways relevant to thepopulation as a whole, drugs that can modulate the activity of these pathwaysmay have broad potential medical utility. Moreover, these pathways oftenprovide biomarkers that can be used to assess the efficacy and appropriate progressingof a compound from preclinical to mid-stage clinical testing. We are alsoapplying our findings to create DNA-based clinical diagnostic tests for riskprediction. Because such tests analyze the same links between genetic variationand disease that we have used to identify drug targets, they can be employed asan aid in developing more effective disease prevention strategies by helpingindividuals to better understand their inherited risk of a given condition, aswell as to identify patients likely to respond well to a given drug.

Through our chemistry and structural biology units,based in the United States, we are able to discover novel small-moleculetherapeutic compounds, take candidate compounds through pre-clinical testing,and manufacture sufficient quantities for early-stage clinical trials.Our product development group, which has expertise in drug and diseasemodeling, designs and implements our clinical trials. We actively explorein-licensing and co-development opportunities, and in certain programs havebrought directly into clinical trials compounds that address targets we haveidentified through our genetics research, but which were originally developedby other companies for other indications. deCODE also leverages its genotypingand product development infrastructure to offer services to fee-payingcustomers.

At the beginning of 2007, we are analyzing the resultsfrom a Phase IIa clinical trial for DG041, our developmental lesion-specificanti-platelet compound for arterial thrombosis. This study, which is examiningsafety, tolerability, and the effect of various dose levels on biomarkers ofplatelet activation in patients with peripheral artery disease, builds upon theresults of our previous clinical work indicating that DG041 can effectivelyinhibit platelet aggregation without increasing bleeding time. We expect toinitiate a second phase II study in patients with other vascular disease byyear end. In our program targeting the leukotriene pathway for the preventionof heart attack, we have completed a Phase I single dose-ranging study for  our developmental compound DG051, showing itto be safe and well-tolerated in the doses tested; to have a pharmacokineticprofile that supports its suitability for once-a-day dosing; and to lower in adose-dependent manner, levels of leukotriene B4, the pro-inflammatory biomarkerthat deCODE believes confers the increased risk of heart attack through thispathway. deCODE is completing a multiple-dose Phase I trial for DG051 inthe first quarter of 2007 and expects to begin Phase II testing by year end. Weare currently reformulating the tablets for DG031, our Phase III compound forthe prevention of heart attack, and expects to be in a position to restart itsPhase III testing by year end or the 

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first quarter of 2008.deCODE is conducting drug discovery work on its targets in stroke and vasculardisease, the most advanced of its preclinical programs.

We expect to receive CLIA-certification of the deCODEDiagnolstics Laboratory by end of Q1 2007 and thereafter, to begin offering ourfirst DNA-based clinical diagnostic test, for risk of type 2 diabetes.

deCODE is a Delaware corporation, incorporated in1996. Our principal executive offices are located at Sturlugata 8, Reykjavik,Iceland. Our telephone number is +354 570-1900 and our website address iswww.decode.com. We make available free of charge through the Investor Relationssection of our website our Annual Reports on Form 10-K, QuarterlyReports on Form 10-Q, Current Reports on Form 8-K and allamendments to those reports as soon as reasonably practicable after suchmaterial is electronically filed with or furnished to the Securities andExchange Commission, or the SEC. We include our website address in this AnnualReport on Form 10-K only as an inactive textual reference and do notintend it to be an active link to our website. You may read and copy materialswe file with the SEC at the SEC’s Public Reference Room at 100 F Street,NE, Room 1580, Washington, D.C. 20549. You may get information on theoperation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.The SEC maintains on internet site that contains reports, proxy and informationstatements, and other information regarding issuers that file electronicallywith the SEC at www.sec.gov.

References in this reportto deCODE, the “Company”, “we” and “us” refer to deCODE genetics, Inc., aDelaware company, and its wholly owned subsidiaries, Islensk erfdagreiningehf., an Iceland company registered in Reykjavik,, and its subsidiaries,and  Medichem Life Sciences, Inc., aDelaware corporation, and its subsidiaries.

***Our target discovery programsand drug development pipeline***

We have actively studied the genetics and pathology ofover 50 different common diseases using our population genetics approach. Ourclinical and pre-clinical programs are based upon our discoveries of genevariants associated with increased risk of developing a disease. We andindependent researchers routinely validate our gene discoveries in populationsoutside of Iceland. We use a variety of biological methods to gain anunderstanding of how the genes we discover affect the disease process, and theproteins encoded by these genes, or others in the pathway, serve as our drugtargets. This information, along with medical and business considerations, isused to prioritize our drug discovery and development efforts.

Basedon our findings and prioritization criteria we are actively pursuing targetdiscovery, pre-clinical and clinical development in several differentindications. Our most advanced programs are already in clinical trials and arelisted in the following table. Squares indicate the phases in which at leastone clinical trial has been completed and dates reflect the earliest expectedtime based on deCODE’s own expectations that the compound may enter the nextphase of clinical trials.

| **Therapy area**                                 | ** ** | ** ** | ** ** | **Compound** | ** ** | **IND** | ** ** | **Phase I**                                                                                                     | ** ** | **Phase II**                                                                                                                      | ** ** | **Phase III** |
|--------------------------------------------------|------------|------------|------------|--------------|------------|---------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|---------------|
| *Cardiovascular*                                 |       |       |       |         |       |    |       |                                                                                                            |       |                                                                                                                              |
| Heart attack                                     |       | DG031      |       | n            |       | n       |       | n                                                                                                               |       | Reinitiate Q407                    Q108 |
| Heart attack                                     |       | DG051      |       | n            |       | n       |       | 2H07                                                                                                            |       |                                                                                                                              |
| Arterial thrombosis (heart attack,  stroke) |       | DG041      |       | n            |       | n       |       | n  Additional       Ph. II  Studies       2H07 |       |                                                                                                                              |
| *Inflammatory*                                   |       |       |       |         |       |    |       |                                                                                                            |       |                                                                                                                              |
| Asthma                                           |       | CEPH-1347  |       | n            |       | n       |       | n                                                                                                               |       |                                                                                                                              |

 

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In addition to late stageprograms in drug discovery and development, deCODE is actively pursuing genediscovery and target validation in the following programs: addiction toalcohol, addiction to nicotine, Alzheimer’s disease, anxiety, atopy/allergy,atrial fibrillation, autism, benign prostatic hypertrophy, coronary arteryrestenosis, endometriosis, hypertension, infectious diseases, migraine, type 2diabetes, osteoporosis, deep vein thrombosis, Parkinson’s disease, restlesslegs syndrome, preeclampsia, endometriosis, psoriasis,  rheumatoid arthritis, schizophrenia, vasculardisease/stroke and several forms of cancer. These programs provide us with drugand diagnostic targets, and we will take the programs forward based oncommercial potential and our priorities and resources.

***Our strategy and approach: From genes to drugs***

The focus of deCODE’s business strategy is thediscovery and commercialization of novel therapeutics and DNA-based diagnosticsbased upon our gene discoveries. We believe our population approach and uniquecompetence in human genetics give us a competitive advantage, one which we areable to apply across the breadth of drug development, from target discoverythrough clinical trials.

Human genetics offers several advantages as afoundation for developing better medicine. We believe most drugs today arecompounds that are aimed at treating the symptoms of disease, seldom theunderlying causes. The reason is that to date the basic biology andpathogenesis of most of the big public health challenges—such as heart attack,stroke, obesity, diabetes or asthma—are poorly understood. These diseases arecommon and complex, and arise due to the interplay of both genetic andenvironmental factors. Human genetics offers a means of unraveling thiscomplexity and a window into the biology of disease. Through the identificationof key genes involved in predisposition to a given disease, it is possible tostudy the proteins these genes encode and to develop an understanding of thebiological pathway of the disease. Drugs targeting key elements in the pathwaymay be able to effectively disrupt the disease process. Diagnostics that testfor at-risk gene variants may enable a better understanding of an individual’slikelihood of developing a disease, and can be used to develop more effectivedisease prevention regimes. Such tests may also be useful for identifying thosewho may derive particular benefit from a certain drug therapy.

deCODE has put together a unique set of resources forfinding genes that contribute to risk of common diseases. These include agenealogy database linking together the entire current-day population; detailedgenetic and medical information from the more than 110,000 Icelanders (55%percent of the adult population) taking part in one or more of our researchprograms; and proprietary bioinformatics and statistical tools to correlateinformation on disease with specific genetic variations. To confirm itsfindings throughout the world, deCODE has samples and medical information fromover 120,000 patients from the U.S., Europe, and Asia.

Unlike companies studying predetermined genes, geneexpression patterns, or genes in animal models, deCODE’s approach allows for avirtually hypothesis-free discovery process that can pinpoint key inheritedcauses of human disease in a human population. This discovery engine hasenabled deCODE to isolate key genes involved in more than a dozen commondiseases in several major therapeutic areas including myocardial infarction,stroke, type 2 diabetes, asthma, prostate and breast cancer, and schizophrenia.deCODE’s discoveries are routinely replicated by independent research groups inmany populations around the world. In the latter half of 2006 alone, publishedstudies based upon our work in myocardial infarction, stroke, type 2 diabetesand schizophrenia have replicated our gene discoveries in dozens of populationsand validated the biological pathways modulated by the proteins coded for bythese genes. For example, our type 2 diabetes gene, TCF7L2, has now beenconfirmed in multiple independent populations.

These capabilities drive an approach to drug discoverythat sets deCODE apart from other companies. Genes affect biology by encodingproteins, and the genes deCODE has linked to increased risk 

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of disease make proteinswhich, by definition, represent potential drug targets rooted in key biologicalpathways underlying these diseases. Moreover because these genes are linked tothe common forms of disease, they confer risk not by encoding dysfunctionalproteins but by up regulating or down regulating the activity of a biologicalpathway. They identify individuals who are at one end of a spectrum of riskthat encompasses the population as a whole. Drugs that can safely andeffectively regulate the activity of these pathways therefore have broadpotential utility. This is a paradigm similar to that used in the developmentof the statins. In that case the most pressing medical need was to lower thecholesterol levels of those with severely elevated LDL; however it has now beenshown that these drugs also reduce risk of cardiovascular disease in those withaverage LDL levels.

deCODE’s approach enables development of drugs to beused along with genetic information on the target and its effect, for both tobe used analogus to the statin model and at the same time the geneticinformation and associated biomarkers that can be used to assess the efficacyof a compound from preclinical to midstage clinical trials. This enables trials that are smaller and moreefficient than traditional trials, and the results can be applied to understandnot just whether people respond to a drug but who responds best and why. Webelieve this offers a means for better managing risk in the developmentprocess, for lowering cost and maximizing the patient benefit from and marketpotential of new drugs.

deCODE has demonstrated its ability to identify noveltherapeutic targets and compounds in major therapeutic indications. We havealso shown that we can efficiently advance these compounds into and throughmid-stage clinical trials providing a clear and detailed association to thebiology of disease. Our biology group works to elucidate how a target—usuallythe protein made by a disease gene—influences the pathway, and can then screencompound libraries to identify molecules to address the target. The chemistrygroup then carries out lead-compound optimization and manufacturessmall-molecule drug candidates for use in preclinical and clinical studies.Structure based-design using structures of protein target with or without drugcandidate, solved by our structural biology group, accelerates development ofhigh-potency drugs. deCODE’s product development group, utilizing the latesttechniques in drug and disease modeling and simulation, designs and conductsour clinical trials, utilizing both compounds deCODE has discovered as well asthird-party compounds which effectively address deCODE targets but which havebeen developed by other companies for other indications.

This comprehensiveinfrastructure for drug discovery and clinical development allows deCODE topursue product development in-house; to partner projects on favorable terms;and to pursue in-licensing and co-development opportunities for existingcompounds with specific qualities we wish to see in a developmental drug. At thesame time, we are also leveraging our capabilities in genotyping, structuralbiology and chemistry to generate revenue in the near-term through ourfee-for-service offerings.

***Our clinical .programs***

The descriptions below ofour clinical development programs illustrate what we believe to be theadvantages of our approach for making better drugs.

***DG031 and DG051 for the prevention of heart attack***

Our program in heart attack (also called myocardialinfarction or MI) is an example of how our population genetics approach ispointing the way toward the discovery and development of new drugs targetingthe root biological causes of common diseases.

Heart attack is the leading killer in theindustrialized world. Nearly half of men and one-third of women who reach theage of forty will suffer a heart attack in their lifetime. Currently, there areeffective drugs for treating some of the contributing risk factors for heartattack, such as high-cholesterol, diabetes and hypertension. However, webelieve that there are no existing drugs aimed at preventing the 

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pathogenesis of thedisease itself. Our work is focused on meeting this need based upon a betterunderstanding of the biological processes that lead to heart attack.

Through a population-based, genome-wide study involvinghundreds of heart attack patients from across Iceland, deCODE scientistsdiscovered common variants in the gene encoding FLAP, or 5-lipoxygenaseactivating protein, that confer a nearly twofold increased risk of the disease.This represents a risk at least as great as elevated cholesterol. The FLAPprotein regulates the synthesis of leukotrienes, molecules known to be potentdrivers of inflammation. Our functional studies showed that the at-riskvariants of the FLAP gene led specifically to increased production ofleukotriene B4 (LTB4) which is a pro-inflammatory molecule. LTB4 is produced bycells in the atherosclerotic plaques that build up inside artery walls.Inflammation in plaques contributes to their instability and propensity torupture, the event directly preceding most heart attacks.

Our isolation of the FLAP gene therefore providedcompelling evidence that we had identified a basic mechanism increasing risk ofheart attack. Further research in genetics and biology added weight to thisdiscovery. We found that individuals who had previously suffered a heart attackbut who did not have one of the at-risk versions of the FLAP gene also producedmore LTB4 than do people with no history of heart disease. This findingsupports our belief that we have identified a major biological process involvedin heart attack in general—and a pathway through which both genetic andenvironmental risk factors act.

deCODE scientists also isolated another gene furtherdown the leukotriene pathway from FLAP, one variant of which, referred to asHapK, confers increased risk of heart attack. The protein encoded by this gene,the leukotriene A4 hydrolase (LTA4H), is directly involved in producing LTB4.In line with the functional work on the at-risk variants of the FLAP gene, HapKappears to confer increased risk of heart attack by increasing the productionof LTB4. The role of the at-risk versions of both the FLAP and LTA4H genes inincreasing risk of heart attack has been confirmed in studies in Europe and theUnited States.

These findings have pointed us to a novel, direct andpotentially powerful therapeutic approach for preventing heart attack:inhibiting the activity of the branch of the leukotriene pathway that producesLTB4. In October of 2003, deCODE in-licensed a compound from Bayer AG, nowknown as DG031, that inhibits leukotriene synthesis through its binding toFLAP. Because of the extensive safety and clinical data already gathered on thecompound through previous clinical testing in another indication, in-licensingenabled us to advance directly into Phase II clinical testing. Our Phase IIclinical studies demonstrated that DG031 was well-tolerated and reducedproduction of LTB4 in a dose-dependent manner. This effect was seen on top ofthe effects of the current standard of care, which included statin therapy fora majority of patients in our trials.

The Phase II program thus demonstrated that DG031 caneffectively help correct the biological process through which geneticpredisposition to heart attack manifests itself. Moreover, the nature of thisprocess has an important bearing on the therapeutic potential of DG031 andother compounds targeting the products of disease genes in common diseases. Inour work in heart attack, as in virtually all of the programs in which we haveidentified genes, genetic susceptibility appears to act primarily by either upregulating or down regulating the activity of an important biological pathway.That is, the genetic variants correlated with common diseases appear to push individualsto one extreme or other of what is probably a normal distribution of theactivity of a given biological pathway. We believe that this is the reason whyin many instances we find both at-risk and protective variants of the samegenes. This is important from a therapeutic perspective because it means thatwhile it may be most efficient and of greatest immediate medical benefit tofirst develop such treatments for those at highest risk, in order to bring themdown the risk spectrum, the eventual therapeutic goal from a public healthperspective may be much broader: to bring everyone, even those at “average”risk, down to the risk profile of those who are least likely to suffer thedisease.

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In May 2006 we began a Phase III clinical trialfor DG031. The trial was a multicenter Phase III study focusing on AfricanAmericans who carry HapK and have a history of heart disease. The primaryendpoint of the trial is to measure DG031’s effectiveness in reducing thecomposite endpoint for cardiovascular death, non-fatal heart attack, stoke,hospitalization for heart attack and the need for urgent revascularization. In October 2006,we temporarily suspended this trial due to an unexpected formulation problemwith the tablets. In routine testing of clinical supplies we discovered that,over time, the drug tablets appeared to dissolve more slowly, potentiallyproviding lessening amounts of active drug the longer they were stored. Thisphenomenon raised the possibility that as the trial progressed patients wouldbe receiving too little drug, undermining the trial’s chances of success. Thecompany is currently reformulating the compound to resolve this issue andexpects to be in a position to re-initiate Phase III testing by year end or thefirst quarter of 2008.

As afollow-on to DG031, we are developing DG051, an inhibitor of LTA4H, a differenttarget in the leukotriene pathway.  DG051,discovered by deCODE’s chemistry unit, is a small-molecule inhibitor of LTA4H,which is directly involved in the synthesis of LTB4. In December 2006 wecompleted a single-dose ranging Phase I study, the results of whichdemonstrated that DG051 was safe and well tolerated at all doses tested, has apharmacokinetic profile suited for potential once-a-day dosing, and that itsignificantly reduces LTB4 levels in a concentration-dependent manner. Weinitiated a multi-dose ranging Phase I study early in the first quarter of 2007and anticipate beginning a Phase II trial by year end.

***DG041 for the treatment of arterial thrombosis***

DG041 is deCODE’s novel anti-platelet compound beingdeveloped to offer a lesion-specific means of preventing arterial thrombosis. Themarket for drugs for arterial vascular diseases is increasing rapidly due tothe aging of the population in the industrialized world. In the United Statesalone, approximately eight million people have been diagnosed with peripheralartery disease (PAD), over 30 million with coronary artery disease (CAD); andmore than 5 million have suffered stroke. The antiplatelet and antithromboticdrug market currently exceeds $10 billion in annual worldwide sales and isexpected to grow to $19 billion by 2010 as referenced in the Cowen and Company,LLC, Therapeutic Categories Outlook, October 2006. The current oraltherapies for the treatment of these diseases include aspirin and platelet ADPreceptor inhibitors, including clopidogrel (Plavix).

DG041 is a novel, first-in-class, orally-administeredsmall molecule anti-platelet compound developed by deCODE and which we haveshown to be a selective and potent antagonist of the EP3 receptor forprostaglandin E2 (PGE2). deCODE identified EP3 as a target through itspopulation genetics research linking variations in the gene encoding EP3 toincreased risk of various vascular diseases including stroke, MI and PAD. PGE2amplifies platelet aggregation stimulated by collagen, adenin di-phosphate(ADP) or a thromboxane receptor agonist. PGE2 is produced by inflammatory cellsin atherosclerotic plaques and may therefore increase the likelihood of aninflammatory-mediated thrombosis over plaque lesions. By selectively inhibitingthe inflammatory pathway in platelet amplification and subsequent aggregationmediated by PGE2, DG041 may prevent thrombosis where it is needed—overatherosclerosis plaques. Development results to date suggest DG041 is welltolerated and appears to be essentially lesion-specific inhibiting plateletaggregation (demonstrated *in vitro* and *ex vivo*) involved in inflammatory mediated thrombosis, butwithout increasing bleeding time. Therefore, this novel anti-platelet agent mayhave a better benefit to risk profile than current agents and may be usefuleither alone or in combination with other anti-platelet agents.

DG041 is currently inPhase II clinical development. At the end of 2006, deCODE completed a Phase IIaclinical trial that enrolled approximately 150 cardiovascular patients with andwithout the EP3 genetic risk variant. The patients were given two dose levelsof DG041 versus a placebo for thirty days. The dose-ranging trial is designedto evaluate safety and efficacy using biomarkers related to atherosclerosis toevaluate its efficacy in platelet inhibition. The study is evaluating plasmalevels of the biomarker pVASP 

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(vasodilatorstimulated phosphoprotein), which measures the degree of platelet activation. Inaddition, a pharmacokinetic/pharmacodynamic analysis is being performed usingthe data from this study. This is also the first study in which DG041 wasadministered to a significant number of patients also taking aspirin. Thecompany expects to release top-line results from the Phase IIa trial by thesecond quarter of 2007.

***Our clinical programs: Third party compound in asthma***

In2006, deCODE completed a Phase II clinical trial in asthma of Cephalon, Inc.’scompound CEP-1347. This compound inhibits MAP3K9, a kinase encodedby a gene we have linked to risk of asthma. In the Phase IIa trial we foundthat the compound had a dose-related effect on both lung function andbiomarkers associated with lung inflammation and severity of disease inpatients with asthma who were already being treated with inhaledcorticosteroids and long-acting beta agonist (LABA). Cephalon is currentlyevaluating the next steps in development for CEP-1347.

***Diagnostics***

Diagnostics represent an additional avenue forgenerating medical and commercial value from our genetic discoveries. Sincegenetic variants linked to disease are by definition markers of diseasesusceptibility, we can apply the same findings we employ in our drug discoveryefforts to the development of DNA-based diagnostic tests. We believe that suchtests may be useful as a means for identifying patients who are at aparticularly high risk of a given disease, and those who are likely to respondwell to drugs that target the same disease pathway.

We believe that DNA-based diagnostic tests are a newtool for improving disease prevention, and that they will be used in tandemwith existing approaches to increase the success of prevention efforts. Commondiseases occur at the interface of genes and the environment, as both inheritedas well as lifestyle and environmental risk factors play important roles in thedisease process. Carrying a genetic risk variant for a common disease does notmean that one will necessarily develop the disease; and not having a certainrisk variant does not eliminate all risk of developing the disease. Rather, inthe common diseases, genetic risk variants impact the likelihood that one maydevelop a given condition. Understanding this inherited risk is empoweringinformation with potentially important clinical utility, as it is possible totake preventive action—through lifestyle modification or by taking certainmedications—to minimize the likelihood of an inherited predisposition everdeveloping into a disease. This is similar to the approach that is taken toaddress other risk factors for common diseases, such as high cholesterol, whichis commonly treated using statin drugs to lower the risk of heart disease ifdietary change is not enough.

The first genetic test deCODE plans to offer is todetermine risk of type 2 diabetes so that a patient and his/her doctor mayattempt to prevent its onset. The test measures a variant in the TCF7L2 genethat deCODE has tightly associated to increased risk of type 2 diabetes (T2D).deCODE’s analysis of cohorts from Europe and United States found thatindividuals who have two copies of this risk variant have more than double theaverage risk of developing T2D. This discovery has thus far been replicated inpublished studies in at least 25 independent populations and multiple ethnicgroups by various research groups around the world. Additional support for theclinical utility of this discovery comes from analysis of data from a U.S.government-sponsored clinical trial, which prospectively studied prediabetics(that is, individuals with blood glucose levels that are intermediate betweennormal and type 2 diabetes) and their progression to type 2 diabetes. About athird of prediabetics in this study progressed to type 2 diabetes within 3years. However, among prediabetics who carried two copies of the gene variantin the deCODE diabetes test, the risk was substantially greater—1.8 foldcompared to those who were negative for the test. Weight loss and drugtreatment with either metformin or glitazone drugs have been shown to reduceprogression rates of prediabetics to T2D. Therefore, this genetic test may beclinically useful as a means to help physicians to decide which prediabeticsthey wish to treat more aggressively either through lifestyle change or throughdrug treatment.

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deCODE expects to have acertified reference laboratory ready to offer DNA testing services early in thesecond quarter of 2007. deCODE and Illumina, Inc., have also established apartnership to develop FDA-approved DNA diagnostic test kits based upon deCODE’sgene discoveries in heart attack, type 2 diabetes and breast cancer, utilizingIllumina’s Vericode clinical genotyping platform.

***Drug discovery and development services***

In order to offsetthe cost of maintaining its proprietary drug development infrastructure, deCODEutilizes its capabilities in chemistry, structural biology and clinical trialsto offer contract services to fee-paying customers, principally pharmaceuticaland biotechnology companies.

·       Ourchemistry subsidiary, deCODE chemistry, Inc., based in Woodridge,Illinois, provides a full range of drug discovery technology and services usingmultiple integrated high-throughput technologies to streamline the drug discoveryprocess.

·       Ourstructural biology subsidiary, deCODE biostructures, Inc., based inBainbridge Island, near Seattle, determines three-dimensional X-raycrystal structures of target proteins for structure-based drug design anddevelopment.

·       Our clinical researchorganization subsidiary Encode conducts information-rich clinical trials forour proprietary programs and for contract customers, principally pharmaceuticaland biotechnology companies.

***Additional service offerings***

At our research facility inReykjavik, we have one of the largest and most advanced genotyping laboratoryin the world. We have extensive expertise in microsatellite genotyping and alsoconduct genome-wide single nucleotide polymorphisms (SNP) association analyses,utilizing the Illumina platform. We utilize these capabilities both forin-house gene discovery work and contract genotyping services to fee payingcustomers. We have in place efficient, automated systems for all stages of thegenotyping process, from DNA isolation and amplification to plate preparationand the generation, storage and analysis of volumes of genotypic data. Ourcustomers for genotyping services include pharmaceutical companies, researchconsortia and academic institutions.

**SignificantCollaborations**

*F. Hoffmann-LaRoche (Roche).*

*Therapeutics.**  *In 2002, we entered into an agreement with Roche tocollaborate on four diseases that had been the subject of an earliercollaboration with Roche. Under this agreement, which expired on February 1,2005, we are entitled to receive royalties on the sales of any drugs that aredeveloped coming out of work conducted under this alliance. Under thisagreement we discovered genes linked to diabetes and Roche continues drugdiscovery based on one of these discoveries. We may receive milestone paymentsif Roche advances compounds through the development process as well asroyalties on successfully marketed drugs.

In November 2004, wesigned a new three-year agreement with Roche to co-develop inhibitors of PDE4for the prevention and treatment of vascular disease, including stroke. Thisagreement continues work advanced under the 2002 agreement, and we will focuson optimizing lead compounds identified under the previous agreement andbeginning clinical development. Under the agreement, as of the end of 2006, wereceived $4.0 million of research funding. We and Roche will share drugdiscovery and clinical trials costs under this agreement, and we may receive anadditional $2.0 million of research funding over the remaining term of theagreement as well as milestone payments and royalties based on drug sales.

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*Merck &Co, Inc. (Merck).*

*Obesity.**  *InSeptember 2002, we entered into an alliance with Merck aimed at developingnew treatments for obesity. The research and development portion of theagreement expired in September 2005. Under this agreement we discoveredthree genes linked to obesity, and Merck has generated lead series of compoundsagainst one of the targets we have validated through our genetics research. Wemay receive milestone payments if Merck advances compounds developed under thealliance through the development process, as well as royalties on successfullymarketed drugs.

*Information-Rich ClinicalTrials.**  *InFebruary 2004, we entered into an agreement with Merck to conductinformation-rich clinical trials on a range of Merck’s developmental compoundsthat Merck selects for inclusion in the program. The term of the alliance isseven years, subject to termination by Merck after five years. Under the termsof the agreement, we may receive royalties on sales of drugs and diagnosticsdeveloped as part of the alliance. We received a one-time technology access feeof $10.0 million, will share research funding for the clinical development ofcompounds and pharmacogenomic analysis, and will receive milestone payments ascompounds or pharmacogenomic tests reach the market. To date, Merck has notselected any compounds for development under the agreement.

*National Instituteof Allergy and Infectious Diseases (NIAID).*

In September 2004, wewere awarded a five-year $23.9 million contract by the NIAID, part of theU.S. National Institutes of Health. Under the contract, we are applying ourpopulation approach and resources to discover genetic factors associated withsusceptibility to certain infectious diseases and with responsiveness tovaccines targeting such diseases. The University of New Mexico is working withus to conduct functional validation of biological pathways discovered throughour genetic research. The National Center for Genome Resources is providingbioinformatics resources to make study information and results available to thescientific community.

*Bayer HealthCare AG(Bayer).*

In 2003, Bayer granted usan exclusive worldwide license to develop, make and sell DG031. Under theagreement, we will pay Bayer milestone payments upon the achievement ofspecified developmental milestones and royalties on sales of the drug.

**Patents andProprietary Rights**

Patents and other proprietary rights protections arean essential element of our business. We rely on patents, trade secret law andcontractual non-disclosure and confidentiality arrangements to protect ourproprietary information and technology. We will be able to protect ourproprietary rights from unauthorized use by third parties only to the extentthat our proprietary rights are covered by valid and enforceable patents,contractual confidentiality obligations, or if they are effectively maintainedas trade secrets.

Accordingly, we actively seek patent protection in theUnited States and other jurisdictions to protect technology, inventions andimprovements to inventions that are commercially important to the developmentof our business. These include, among other things, the compounds that weinvent and will develop as potential drugs, the genes and related drug targetswe discover; mutations and variants of genes and related processes; new uses ofexisting third party compounds that may be used to manipulate those genes,mutations and drug targets; technologies which may be used to discover andcharacterize genes; therapeutic or diagnostic processes, tests and otherinventions based on those genes; as well as methods developed in ourbiostructures and pharmaceutical groups for the discovery and development ofdrugs. As of year-end 2006, we had approximately 32 issued U.S. patents andapproximately 11 issued patents in non-U.S. jurisdictions. We also hadapproximately 57 pending patent applications in the U.S. as well as 

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approximately 95 PCTnational patent applications in non-U.S. jurisdictions that we have deemed tobe of commercial interest.

We have filed a series ofcomposition of matter type patent applications for the compounds we havediscovered ourselves and are the main focus of our pre-clinical and clinicaldevelopment, including DG041 and DG051.

We have licensed fromBayer a composition of matter patent and a manufacturing process patent forDG031. The licensed patents expire in 2009 and 2012, respectively.

We have also filedadditional patent applications that claim specific uses of DG031 and othercompounds with similar mode of action, and methods for selecting those patientsthat we believe are most likely to benefit from administration of thosecompounds due to their specific genetic composition. Such patents coveringapproved uses of DG031, if issued and found to be valid and enforceable, couldextend the life cycle of DG031 for several years beyond the expiry of thepatents that we licensed from Bayer. However, it is not certain that suchpatents will ultimately be issued, and even if issued, that they will beenforceable in infringement proceedings before the courts.

TheUnited States Drug Price Competition and Patent Term Restoration Act of 1984,known as the Hatch-Waxman Act, provides for the restoration of up to 5 years ofpatent term for a patent that covers a new product or its use, to compensatefor time lost from the effective life of the patent due to the regulatoryreview process of the FDA. An application for patent term restoration issubject to approval by the U.S. Patent and Trademark Office in conjunction withthe FDA. While the composition of matter patent we licensed from Bayer thatexpires in 2009 would be eligible for patent term restoration, because we donot expect to receive FDA approval for DG031 prior to the expiration of theterm of this patent, we will not benefit from applying for patent restorationwith respect to that patent since any such restoration would run concurrentlywith any NCE marketing exclusivity we obtain, as discussed in the nextparagraph. The manufacturing process patent we licensed from Bayer is noteligible for patent term restoration.

The Hatch­Waxman Act alsoestablishes a 5 year period of marketing exclusivity from the date of NDAapproval for new chemical entities (NCE) approved after September 24, 1984. We believe that DG031 isan NCE, and if the NDA for DG031 is approved, we expect to receive suchmarketing exclusivity. Under the Hatch-Waxman Act generic versions ofinnovative medicines may be approved without the complete safety and efficacystudies contained in an NDA. Instead, the generic manufacturer may submit anAbbreviated New Drug Application (ANDA) or a so-called Section 505(b)(2) (or“paper”) NDA. During the 5 year marketing exclusivity period for an NCE, a manufacturer that proposes tosell a generic version of DG031 may not submit to the FDA an ANDA or a paperNDA except that such applications may be submitted after 4 years if theycontain a certification of patent invalidity or noninfringement. If at the timesuch an application is submitted we have received a use patent for DG031 thatis listed in the FDA’s Approved Drug Products with Therapeutic EquivalenceEvaluations, or Orange Book, and if we commence a suit alleging patentinfringement in a timely manner after the ANDA or paper NDA for a generic drugis submitted, FDA approval of the generic drug will automatically be stayed forup to 30 months from the expiration of the 5 year marketing exclusivity periodto allow a judicial resolution of the infringement action. Thus, under theHatch-Waxman Act, the combination of NCE marketing exclusivity and the 30 monthstay may create as much as a 7 1/2 exclusivity period for our marketing andsale of DG031.

Other jurisdictions havestatutory provisions similar to those of the Hatch-Waxman Act, thatafford both patent extensions and market exclusivity for drugs that haveobtained market authorizations, such as European Supplementary ProtectionCertificates that extend effective patent life and European data exclusivity rules thatcreate marketing exclusivity for certain time periods following marketingauthorization. European data exclusivity is more generous than the equivalentNCE marketing exclusivity in the U.S., providing exclusivity for as long as 11years. We believe that if we obtain marketing 

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authorizationfor DG031 in Europe or other jurisdictions with similar statutory provisions,DG031 may be eligible for patent term extension and marketing exclusivity underthese provisions and we plan to seek such privileges.

**Competition**

We face, and will continue to face, intensecompetition in our gene discovery programs from pharmaceutical companies,biotechnology companies, universities and other research institutions. A numberof entities are attempting to rapidly identify and patent genes responsible forcausing diseases or an increased susceptibility to diseases and to developproducts based on these discoveries.

We also face intense competition in drug development,particularly from pharmaceutical and biotechnology companies. Certain of thesecompanies may, using other approaches, identify and decide to pursue thediscovery and development of new drugs targets or disease pathways that we haveidentified through our human population genetics research. Many of ourcompetitors, either alone or together with their collaborative partners, havesubstantially greater financial resources and larger research and developmentoperations than we do. These competitors may discover, characterize or developimportant genes, drug targets or drug leads before we or our collaborators door may obtain regulatory approvals of their drugs more rapidly than we or ourcollaborators do.

Developments by others may render pharmaceuticalproduct candidates or technologies that we or our collaborators developobsolete or non-competitive. Any product candidate that we or our collaboratorssuccessfully develop may compete with existing therapies that have longhistories of safe and effective use.

Our competitors may obtain patent protection or otherintellectual property rights that could limit our rights, or our customers’ability, to use our technologies or databases, or commercialize therapeutic ordiagnostics products. In addition, we face, and will continue to face, intensecompetition from other companies for collaborative arrangements withpharmaceutical and biotechnology companies, for establishing relationships withacademic and research institutions and for licenses to proprietary technology.

Our ability to competesuccessfully will depend, in part, on our ability, and that of ourcollaborators, to: develop proprietary products; develop and maintain productsthat reach the market first, and are technologically superior to and more costeffective than other products on the market; obtain patent or other proprietaryprotection for our products and technologies; attract and retain scientific andproduct development personnel; obtain required regulatory approvals; andmanufacture, market and sell products that we develop.

**GovernmentRegulation**

Regulation by governmental authorities will be asignificant factor in our ongoing research and development activities. Inaddition, the development, production and marketing of any pharmaceutical anddiagnostic products which we or a partner may develop is subject to regulationby governmental authorities. Strict regulatory controls govern the pre-clinicaland clinical testing, design, manufacture, labeling, supply, distribution,recordkeeping, reporting, sale, advertising and marketing of the products.These regulatory controls will influence our and our partners’ ability tosuccessfully manufacture and market therapeutic or diagnostic products.

Our success will depend, in part, on the development andmarketing of products based on our research and development. Most countriesrequire a company to obtain and maintain regulatory approval for a product fromthe relevant regulatory authority to enable the product to be marketed.Obtaining regulatory approval and complying with appropriate statutes andregulations is time-consuming and requires the expenditure of substantialresources.

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Inthe United States we and our products are subject to comprehensive regulationby the United States Food and Drug Administration (FDA). The process requiredby the FDA before our drug products may be approved for marketing in the UnitedStates generally involves (i) pre-clinical new drug laboratory and animaltests, (ii) submission to the FDA of an investigational new drug (IND)application, which must become effective before clinical trials may begin, (iii) adequateand well-controlled human clinical trials to establish the safety and efficacyof the drug for its intended indication, (iv) submission to the FDA of anew drug application (NDA), (v) review by an advisory committee to FDA forrecommendations regarding whether the NDA should be approved, and (vi) FDAreview of the NDA in order to determine, among other things, whether the drugis safe and effective for its intended uses. There is no assurance that the FDAreview process will result in product approval on a timely basis, if at all.

Pre-clinicaltests include laboratory evaluation of product chemistry and formulation, aswell as animal studies to assess the potential safety and efficacy of theproduct. Pre-clinical tests are generally subject to FDA regulations regardingGood Laboratory Practice. The results of the pre-clinical tests are submittedto the FDA as part of an IND and are reviewed by the FDA prior to the commencementof clinical trials or during the conduct of the clinical trials, asappropriate.

Clinicaltrials are conducted under protocols that detail such matters as the objectivesof the study, the parameters to be used to monitor safety and the efficacycriteria to be evaluated. Each protocol must be submitted to the FDA as part ofthe IND. Further, each protocol must be reviewed and approved by aninstitutional review board (IRB), and study subjects must provide informedconsent to participation in the study. Clinical trials are subject to oversightby the IRB at each study site and by the FDA. An IRB or the FDA may prevent astudy from being initiated, or may suspend or terminate studies once initiated.

Clinicaltrials are typically conducted in three sequential phases, which may overlap.During Phase I, when the drug is initially given to human subjects, theproduct is tested for safety, dosage tolerance, absorption, distribution,metabolism and excretion. Phase II involves safety, tolerability and efficacyof the product across a range of doses with the goal of identifying appropriatedoses and patients for further study. Phase III trials are undertaken in orderto further evaluate clinical efficacy and to further test for safety within anexpanded patient population. The FDA may suspend clinical trials at any pointin this process if it concludes that clinical subjects are being exposed to anunacceptable health risk.

Clinicaltrials must be conducted and monitored in accordance with good clinical practice(GCP) and other regulatory requirements. For applications to the FDA, clinicalstudies must be adequate and well controlled. Following the clinical trials, wewill analyze the data and determine whether the clinical trials successfullydemonstrated the safety and efficacy of the product. If they do, we willprepare and submit a new drug application (NDA). The FDA conducts a preliminaryreview of the NDA to determine whether to file the application and beginsubstantive review, or to refuse to file the application on the ground that FDAconsiders it incomplete.

Wewill need FDA approval of our products, including a pre-approval inspection ofthe manufacturing processes and facilities used to produce such products toassess conformance with current good manufacturing practices (cGMP), beforesuch products may be marketed in the United States. The FDA may also inspectthe clinical trial sites to ensure their conformance with GCP. The process ofobtaining approvals from the FDA can be costly, time-consuming and subject tounanticipated delays. There can be no assurance that the FDA will grantapprovals of our proposed products, processes or facilities on a timely basis,if at all. Any delay or failure to obtain such approvals would have a materialadverse effect on our business, financial condition and results of operations.Moreover, even if regulatory approval is granted, such approval may includeconditions of approval such as additional studies or significant limitations onindicated uses for which a product could be marketed.

Amongthe conditions for NDA approval is the requirement that the prospectivemanufacturer’s operating procedures conform to cGMP requirements, which must befollowed at all times. In complying with those requirements, manufacturers (includinga drug sponsor’s third party contract manufacturers) 

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must continue to expend time, money and effort in thearea of production and quality control to ensure compliance. Domesticmanufacturing establishments are subject to periodic inspections by the FDA inorder to assess, among other things, cGMP compliance. To supply a product foruse in the United States, foreign manufacturing establishments also must complywith cGMP and are subject to periodic inspection by the FDA or by regulatoryauthorities in certain other countries under reciprocal agreements with theFDA.

Bothbefore and after approval is obtained, a product, its manufacturer and theholder of the NDA for the product are subject to comprehensive regulatoryoversight. FDA regulations impose requirements for recordkeeping, periodicreporting, and reporting of adverse experiences with the product. Violations ofregulatory requirements at any stage, including the pre-clinical and clinicaltesting process, the approval process, or thereafter (including after approval)may result in various adverse consequences, including the FDA’s delay inapproving or refusal to approve a product, withdrawal of an approved productfrom the market, seizure of the product, injunction against the company, and/orthe imposition of criminal penalties against the manufacturer and/or NDA holderand/or officers and employees. In addition, later discovery of previouslyunknown problems may result in restrictions on such product, manufacturer orNDA holder, including withdrawal of the product from the market. Also, newgovernment requirements may be established that could delay or preventregulatory approval of our products under development.

TheFDA has implemented accelerated approval procedures for certain pharmaceuticalagents that treat serious or life-threatening diseases and conditions,especially where no satisfactory alternative therapy exists. We cannot predictthe ultimate impact, however, of the FDA’s accelerated approval procedures onthe timing or likelihood of approval of any of our potential products or thoseof any competitor. In addition, the approval of a product under the acceleratedapproval procedures may be subject to various conditions, including therequirement to verify clinical benefit in post-marketing studies, and theauthority on the part of the FDA to withdraw approval under streamlinedprocedures if such studies do not verify clinical benefit.

Diagnosticproducts are regulated as medical devices in the United States. Devices aresubject to similar types of FDA regulatory controls and enforcement actions asapply to drugs, but many aspects of device regulation differ. Medical devicesare classified into one of three classes, Class I, II or III, on thebasis of their risk and the controls deemed necessary to assure their safetyand effectiveness, with Class I presenting the least risk. Regulatorycontrols for devices include labeling, recordkeeping, reporting, and adherenceto the FDA’s quality system requirements, or QSR, including good manufacturingpractices.

MostClass I devices and some Class II devices are exempt from FDApremarket review. Most Class II devices and some Class III devicesrequire FDA review and clearance of a premarket notification under Section 510(k) ofthe Federal Food, Drug, and Cosmetic Act (FDC Act) prior to marketing. A 510(k) notificationmust demonstrate that the device is substantially equivalent to a predicatedevice, which is a device marketed prior to 1976 or to a marketed device shownto be substantially equivalent under the 510(k) notification process. Inaddition, Class II devices are subject to special controls, such asperformance standards, patient registries, and FDA guidance. Class IIIdevices, and devices determined to be not substantially equivalent to a predicatedevice, require FDA approval of a premarket approval application (PMA) prior tomarketing. A PMA must contain manufacturing data, pre-clinical data, and datafrom clinical testing that demonstrates the device is safe and effective forits intended use. The FDA may refer a PMA for review by an advisory panel ofoutside experts for a recommendation regarding approval. FDA approval of thePMA is required prior to marketing and distribution. The FDA may imposeconditions of approval or restrictions on the sale, distribution, or use of thedevice.

Theconduct of device clinical trials is subject to FDA regulation, includingrequirements for IRB approval, informed consent, recordkeeping, and reporting.In addition, a significant risk device requires FDA approval of aninvestigational device exemption (IDE) application. A nonsignificant riskdevice does not require IDE approval and is subject to abbreviatedrecordkeeping and reporting requirements. 

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Significant risk devices include implants,life-supporting and life-sustaining devices, devices of substantial importancein diagnosing, curing, mitigating or treating disease, and devices thatotherwise present a potential for serious risk to the health, safety, orwelfare of a subject.

Tothe extent our diagnostic products may be intended for use as prognostic testsfor selecting patients most likely to benefit from drug therapies, suchproducts may be studied in the clinical trials of the related drug productunder the regulatory provisions governing pharmaceutical clinical trials, butrequire a separate PMA approval or 510(k) clearance under the medicaldevice requirements. The FDA’s policy for co-development of therapeutic anddiagnostic products is evolving, and changes in FDA’s regulatory policy canaffect the development, testing, regulatory approval pathway, and marketing ofour products.

FDAhas developed special rules for *invitro* reagents that are not approved or cleared as diagnosticproducts. FDA has imposed restrictions on the manufacture, labeling, sale,distribution, advertising, promotion and use of analyte specific reagents(ASRs). FDA defines ASRs as antibodies, specific receptor proteins, ligands,nucleic acid sequences, and similar reagents which, through specific binding orchemical reaction with substances in a specimen, are intended for use in adiagnostic application for identification and quantification of an individualchemical substance or ligand in biological specimens. An ASR can be used by aclinical laboratory to develop in-house (“home brew”) laboratory assays if thelaboratory is certified for high complexity testing under the ClinicalLaboratory Improvement Act of 1998 as amended (CLIA). Most, but not all, ASRsare exempt from 510(k) premarket notification or PMA approval, and all aresubject to good manufacturing practices (GMP) requirements and to therestrictions on their sale, distribution and use imposed by FDA regulation. Inaddition, FDA regulates Research Use Only (RUO) diagnostic products, which bytheir mandatory labeling are not intended for use in diagnostic procedures. Theclinical usefulness of RUO products is unknown and thus their use is limited toresearch purposes only. Diagnostic products and reagents that we develop nowand in the future may be subject to these and other applicable FDA regulations.

Fordevices with an approved PMA, the manufacturer must submit periodic reportscontaining information on safety and effectiveness and other informationspecified in FDA regulations, and modifications to the product or its intendeduse can trigger the need to file a PMA Supplement for approval by FDA. Fordevices with a cleared 510(k) notification, modifications to the devicethat can affect its safety or effectiveness may require the submission of a new510(k) prior to marketing the modified device. All devices are subject tocontinuing regulation by the FDA, including record-keeping and reportingrequirements, and reporting when a device may have caused or contributed to adeath or serious injury or has malfunctioned in a way that would be likely tocause or contribute to a death or serious injury if the malfunction were torecur.

Productlabeling and promotional activities for drug and device products are subject toscrutiny by the FDA, and products may be promoted only for their approvedindications. Violations of promotional requirements for drugs and devices mayalso involve violations of the federal False Claims Act, anti-kickback laws,and other federal or state laws. In addition to the government bringing claimsunder the federal False Claims Act, *qui tam*,or “whistleblower,” actions may be brought by private individuals on behalf ofthe government. Also, competitors may bring litigation under the Lanham Act orchallenges under industry self-regulation groups relating to productadvertising.

Clinicallaboratory tests that are developed and validated by a laboratory for use inexaminations the laboratory performs itself are called “home brew” tests. Mosthome brew tests currently are not subject to premarket review by FDA.   The DNA-based diagnostics we propose tooffer, starting with our test for risk of type 2 diabetes, will be home brewtests. As a clinical laboratory, we are required to hold certain federal, stateand local licenses, certifications and permits to conduct our business. UnderCLIA, we are required to hold a certificate applicable to the type of work weperform and to comply with standards covering personnel, facilitiesadministration, quality systems and proficiency testing.

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Weoperate under CLIA accreditation standards. To renew our CLIA certificate, weare subject to survey and inspection every two years to assess compliance withprogram standards. The standards applicable to the testing which we perform maychange over time. We cannot assure you that we will be able to operateprofitably should regulatory compliance requirements become substantially morecostly in the future.

Ifour laboratory is out of compliance with CLIA requirements, we may be subjectto sanctions such as suspension, limitation or revocation of our CLIAcertificate, as well as directed plan of correction, state on-site monitoring,civil money penalties, civil injunctive suit or criminal penalties. We mustmaintain CLIA compliance and certification to be eligible to bill for services providedto Medicare beneficiaries. If we were to be found out of compliance with CLIAprogram requirements and subjected to sanction, our business could be harmed.

TheEuropean Community (EC) and EC member states maintain drug regulatory systemsfor medicinal products and medical devices that are comparable in their rigorto those in the United States. Clinical trials of medicinal products requiregovernment authorizations (based on evidence of safety from pre-clinical testsand other sources), must be reviewed and approved by ethics committees, andmust be carried out in compliance with good clinical practice. There is noguarantee that permission will be granted for clinical trials of new medicinalproducts, and permission can be withdrawn if safety issues arise during aclinical trial.

Medicinalproducts may not be introduced to the market in the EC unless a marketingauthorization has been granted by a competent authority. Marketingauthorization applications for new chemical entities may be submitted to multipleEC member states under the mutual recognition system (which results inharmonized conditions of approval) or to the European Medicines Agency (EMEA),which administers a system that leads to a single marketing authorization thatis valid in all EC member states. For certain new chemical entities, as well asall biotechnology products, submission to the EMEA is mandatory. Requirementsfor marketing authorization applications are similar to those for NDAs in theUnited States, including requirements for proof of safety, efficacy andquality. These requirements are demanding, and there is no assurance that aproduct for which a marketing authorization application is submitted will beapproved. Manufacturing facilities must also comply with EC requirements forgood manufacturing practice, and if located in the EC must be licensed by thecompetent authority of the relevant member state. Requirements may be imposedfor post-marketing studies, and there are detailed requirements for post-marketsurveillance of safety (pharmacovigilance). Advertising and promotion arescrutinized by authorities in each member state, and in some cases by the EMEAas well. Products may be removed from the market, permanently or temporarily,if safety questions arise, and there are only limited procedural requirementsbefore such actions can be taken.

Inaddition to these controls under Medicines Law, most EC member states maintainsome form of control over the pricing or reimbursement of medicinal products.In many member states, marketing may not commence until a price orreimbursement level has been determined, and in some member states products arealso subject to cost-effectiveness reviews that can, for practical purposes,determine whether they will be utilized.

The EC maintains a separate system for medicaldevices, including *in vitro*diagnostic devices that may be developed in conjunction with medicinal productswhose use depends on biomarkers. Manufacturers must meet requirements forquality control, which may entail interaction with quasi-governmentalNotified Bodies, and comply with essential requirements and standards adoptedunder EC law. There is no harmonized system of control on the advertising andpromotion of medical devices, and requirements vary from country to country. Inaddition, many EC member states maintain systems to evaluate new medicaldevices to determine whether they are cost-effective or otherwise appropriatefor use in national health systems, other maintain other systems to controlpricing or reimbursement of medical devices.

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**Environmental**

deCODE’sprimary research facilities and laboratory are located in Reykjavik, Iceland.We operate under applicable Icelandic and European Union laws and standards,with which we believe that we comply, relating to environmental, hazardousmaterials and other safety matters. Our research and manufacturing activitiesinvolve the generation, use and disposal of hazardous materials and wastes,including various chemicals and radioactive compounds. These activities are subjectto standards prescribed by Iceland and the EU. We do not believe thatcompliance with these laws and standards will have any material effect upon ourcapital expenditures, earnings or competitive position, or that we will haveany material capital expenditures in relation to environmental controlfacilities for the remainder of this fiscal year or any succeeding fiscal year.

Our activities in the U.S. involve the controlled useof hazardous materials. We are subject to U.S. federal, state and local lawsand regulations governing the use, manufacture, storage, handling and disposalof such materials and certain waste products. Although we believe that ouractivities in the U.S. currently comply with the standards prescribed by suchlaws and regulations, the risk of accidental contamination or injury from thesematerials cannot be eliminated. In the event of such an accident, we could beheld liable for any damages that result and any such liability could exceed ourresources. In addition, there can be no assurance that we will not be requiredto incur significant costs to comply with environmental laws and regulations inthe future.

**Employees**

As of December 31, 2006, deCODE and all of itssubsidiaries employed 429 full-time staff. Of the total number, approximately143 were employed in the United States and 286 in Iceland. More than 97 heldPh.D. or M.D. degrees and approximately 362 held college degrees. 334 employeeswere engaged in, or directly supported, research and development activities, ofwhom 281 worked within the laboratory facilities and 53 held positionsassociated with the development and support of informatics. 64 employees wereengaged in various professional support functions such as Finance, BusinessDevelopment, Legal, Communications, Human Resources and ClinicalCollaborations, and 31 were employed in administrative support, facilitiesmanagement, cleaning and security. In addition, we utilized part-time employeesand outside contractors and consultants as needed and plan to continue to doso.

**Certain FinancialInformation**

***Researchand Development and Cost of Revenue Expenses***

Ourcost of research and development for 2006, 2005 and 2004, was $57.1 million,$43.7 million and $24.9 million, respectively.

Our cost of revenue for 2006, 2005 and 2004, was $42.7million, $37.3 million and $43.4 million, respectively. Our cost ofrevenue, includes costs incurred in connection with collaborative programs andrepresents our customer-sponsored research and development activities.

***GeographicInformation***

Long-livedassets located in the United States and Iceland were $25,356,000 and$20,457,000, respectively at December 31, 2006 and $26,231,000 and$13,494,000, respectively at December 31, 2005.

Revenues attributed to the United States and toIceland were $16,816,000 and $23,694,000, respectively, for 2006, $15,486,000and $28,469,000, respectively for 2005, and $13,680,000 and $28,447,000,respectively, for 2004.

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***Significant Customers***

Historically, asubstantial portion of deCODE’s revenue has been derived from contracts with alimited number of significant customers. Roche accounted for approximately 17%,23% and 30% of the company’s consolidated revenue in 2006, 2005 and 2004,respectively. Merck accounted for approximately 3%, 15% and 22% of the company’sconsolidated revenue in 2006, 2005 and 2004, respectively. Divisions of theNational Institute of Health (NIH) represented 33%, 13% and 1% of consolidatedrevenue in 2006, 2005 and 2004, respectively. The loss of any significantcustomer may significantly lower deCODE’s revenues which could affect theresources available to support our drug discovery programs.

**Item 1A.**                *Risk Factors*

In addition to the other information contained in thisForm 10-K, you should consider the following risk factors inevaluating our business and prospects. We also note that this annual report on Form 10-Kcontains forward-looking statements. These statements relate to future eventsor our future financial performance. In some cases, forward-looking statementscan be identified by terminology such as “may, “should,” “could,” “expect,” “plan,”“anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue”or the negative of such terms or other comparable terminology. These statementsare only expectations. We cannot assure our investors that our expectations andassumptions will prove to have been correct. We undertake no intention orobligation to update or revise any forward-looking statements, whether as aresult of future events, new information or otherwise. Actual events or resultsmay differ materially due to a number of factors, including those set forth inthis section and elsewhere in this Form 10-K.

These factors include, butare not limited to, the risks set forth below.

**Risks Related toOur Development of DG031**

***Suspension of ourPhase III trial for DG031 may delay the completion of the trial and possiblecommercialization of the drug, which may hurt our future financial results.***

On October 5, 2006,we announced that we were voluntarily suspending our Phase III clinical trialfor DG031 in order to address an unexpected formulation problem with thetablets being used in the trial. We cannot guarantee that we will be able toreformulate the tablets successfully. While we are working to resolve thisissue with a view to resuming the trial by year end or the first quarter of2008, because the resumption of the trial is dependent on successfulreformulation and the execution of new agreements with various serviceproviders in connection with the trial, we cannot provide assurance that wewill meet this goal and we cannot predict with certainty when, if at all, thetrial will resume; however, the suspension will cause the trial to exceed theminimum 36 months duration from the recruitment of the first patient that wepreviously estimated. This delay in the development of this drug couldadversely impact our financial results and commercial prospects.

***The Phase IIIclinical trial for DG031 will require the recruitment of patients based onethnicity and haplotype status; upon re-initiation of the study, recruitmentrates could still be lower than we expect, the trial may be delayed and ourcommercial prospects may be hurt.***

In our Phase III clinicaltrial for DG031, we were originally testing the hypothesis whether AfricanAmerican patients who (a) carry the HapK haplotype in LTA4H and (b) haveexperienced a hospitalization and/or admission for procedures and testing forunstable angina or myocardial infarction will experience reduced rates of acutecardiovascular events when treated with DG031, as compared to placebo on top ofconcomitantly administered standard of care. In order to recruit a sufficientnumber of patients to obtain statistically significant evidence for theefficacy of DG031, we require the participation of a large number of AfricanAmerican patients willing to be tested for haplotype status and to participate 

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in theclinical trial for at least 12 months. Many factors outside our controlmay reduce the willingness of patients to be tested and participate in theclinical trial. Based on experience gathered to date, we are evaluating thestrategy for patient recruitment and will consider alternative enrollmentstrategies based on haplotype status that would accelerate the overallenrollment plan. This will require discussions with the United States Food andDrug Administration (FDA) and agreement on strategy through the SpecialProtocol Assessment process. However, upon re-initiation of the study, we mayfail to recruit a sufficient number of patients in a timely manner, the trialmay be delayed or we may fail to show the efficacy of the drug. This may delayor prevent the marketing approval of DG031, which could adversely impact ourfinancial results and commercial prospects.

***We have onlyindirect evidence from biomarkers studies about the effectiveness of DG031 andthis data may not be validated in the Phase III clinical trial.***

The data collected duringthe Phase I and Phase II clinical trials for DG031, which is the basis for ourcontinuing development of this drug, does not provide evidence of whether DG031will prove to be an effective treatment to reduce the rate of acutecardiovascular events in the prospective treatment population. In order toprove or disprove the validity of our assumption about the efficacy of DG031,we must conduct the Phase III trial. We temporarily suspended the trial inearly October, 2006 due to formulation stability issues. We will need tore-initiate the study after resolution of the formulation issues. There aredelays in the program as a result, with resulting delays of validation of thehypothesis being tested. Various factors that we do or do not control may causethe trial to be lengthier or costlier than anticipated. Until data from thetrial can be collected and analyzed we will not know whether DG031 is aneffective treatment, and regulatory review by the FDA will ultimately determinewhether the drug gains marketing approval. The outcome of this process isuncertain and delays or failure to gain market approval could adversely impactour financial results and commercial prospects.

***If DG031 is approved by the FDA, we may have marketingexclusivity for only a limited term.***

The patents we licensedfrom Bayer for DG031 expire in 2009 and 2012. While we will seek to obtain oneor more use patents protecting our proprietary rights to specific uses of thiscompound for a longer period, we cannot be certain that we will obtain suchpatents or that they will adequately protect us. In addition, although we may seekto obtain 5 year marketing exclusivity under the Hatch-Waxman Act andequivalent foreign statutes, we cannot be certain that we will be successful. Weexpect we will not obtain regulatory approval for DG031 before the compositionof matter patent we licensed from Bayer expires in 2009. Accordingly, if wecannot obtain new patents or obtain 5 year marketing exclusivity, the amount ofrevenues that we will be able to derive from an approved product based on thesepatents may be adversely affected.

**Risks Related toOur Diagnostic Tests**

***We may not derive revenues from our diagnostic tests***

We are developingDNA-based diagnostic tests and expect to offer a DNA-based diagnostic test forrisk of type-2 diabetes in 2007. Our ability to derive revenues from thistest will depend, among other things, on certification of our referencelaboratory under the Clinical Laboratory Improvement Amendments of 1988 by theState of New York and our continued compliance with applicable regulatoryrequirements and on acceptance of the test by physicians.  In addition, we do not expect that third-partyinsurance or other reimbursement will be available for the test. Accordingly,unless patients are willing to pay for the test themselves, we will not be ableto market it successfully. As a result of these factors, we cannot predictwhether or not we will be able to derive revenues from this test.

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**Risks Related toOur Business**

***If we are notsuccessful in our pending litigation regarding misappropriation of tradesecrets and breach of related non-competition, non-solicitation andnon-disclosure agreements, our ability to protect our confidential informationand to enforce non-competition and non-solicitation agreements against formeremployees may be impaired, which could adversely affect our business andprospects.***

On August 4, 2006 wecommenced an action in the U.S. District Court for the Eastern District ofPennsylvania against five former employees for misappropriation of our tradesecrets and intellectual property, related breach of non-competition,non-solicitation, and non-disclosure provisions of their employment agreements,and violation of the federal Computer Fraud and Abuse Act in connection withtheir employment by The Children’s Hospital of Philadelphia (CHOP). It ispossible that a judgment against us with respect to our allegations of tradesecret misappropriation may negatively affect our ability to protect some ofwhat we consider to be our confidential information under the law of tradesecrets. Also, it is possible that a judgment against us with respect to thenon-competition, non-solicitation, or non-disclosure agreements with theindividual defendants (1) would allow the defendants to engage incompetition with us, (2) may cause other current or former employees to testthe validity of their non-competition, non-solicitation, and non-disclosureagreements when they might otherwise have refrained from doing so, or (3) maycause other institutions besides CHOP to hire our current or former employeeswhen they might otherwise have refrained from doing so. Any of these eventscould impair our ability to compete for collaborative arrangements, for accessto DNA samples or for product or technology licensing arrangements andultimately could adversely affect our ability to develop and market products.

***We may not successfully develop or derive revenuesfrom any products.***

We use ourtechnology and research capabilities to identify genes and gene variations thatcontribute to certain diseases and then develop small molecule drugs thattarget proteins produced by these genes. Although we have identified genes thatwe believe are likely to cause certain diseases, we may not be correct and maynot be successful in identifying any other similar genes or in developing drugsbased on these discoveries. Many experts believe that some of the diseases weare targeting are caused by both genetic and environmental factors. Even if weidentify specific genes that are partly responsible for causing diseases, anytherapeutic or diagnostic products we develop as a result of our genetic workmay not detect, prevent, treat or cure a particular disease. Any pharmaceuticalor diagnostic products that we or our collaborators are able to develop willfail to produce revenues unless we:

·       establishthat they are safe and effective;

·       successfullycompete with other technologies and products;

·       ensurethat they do not infringe on the proprietary rights of others;

·       establishthat they can be manufactured in sufficient quantities at reasonable costs;

·       obtainand maintain regulatory approvals for them; and

·       canmarket them successfully.

We may not be able to meetthese conditions. We expect that it will be years, if ever, before we willrecognize significant revenue from the development of therapeutic or diagnosticproducts.

***If we continue toincur operating losses longer than anticipated, or in amounts greater thananticipated, we may be unable to continue our operations.***

We incurred a net loss of$85.5 million, $62.8 million and $57.3 million for the years ended December 31,2006, 2005 and 2004, respectively, and had an accumulated deficit of $535.7million at 

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December 31,2006. We have never generated a profit and we have not generated revenuesexcept for payments received in connection with our research and developmentcollaborations with Roche, Merck and others, from contract services, from salesof Emerald BioSystems products and instruments, and grant funding. Our researchand development expenditures and selling, general and administrative costs haveexceeded our revenue to date, and we expect to spend significant additionalamounts to fund research and development in order to enhance our coretechnologies and undertake product development (including drug development andrelated clinical trials). We do not expect to receive royalties or otherrevenues from commercial sales of products developed using our technology inthe near term. It may be several years before product revenuesmaterialize, if they do at all. As a result, we expect to incur net losses forseveral years. If the time required to generate product revenues and achieveprofitability is longer than we currently anticipate, or if the level of lossesis greater than we currently anticipate, we may not be able to continueour operations.

***If our assumption about the role of genes in diseasesis wrong, we may not be able to develop useful products.***

The products we hope todevelop involve new and unproven approaches. They are based on the assumptionthat information about genes may help scientists to better understand complexdisease processes. Scientists generally have a limited understanding of therole of genes in diseases, and few products based on gene discoveries have beendeveloped. Of the products that exist, all are diagnostic products. To date, weknow of no therapeutic products based on disease-gene discoveries. If ourassumption about the role of genes in the disease process is wrong, our genediscovery programs may not result in products.

***In order to conductclinical trials and to market our drugs, we will have to develop methods toproduce these drugs using approved methods and at commercially viable rates.***

In order to conductclinical trials and ultimately to market any drugs we may develop, we or ourthird party contractors will need to obtain chemicals and components, and insome cases licenses for proprietary formulation technology, necessary for themanufacture of the products from third parties.  We or our contractors will then need toimplement the necessary technology in order to produce the drugs to exactingstandards set by us and the regulatory bodies. This is an uncertain and timeconsuming process, and any disruption in it may delay or harm our ability tocontinue clinical development. For drugs which have reached the last stage ofclinical trials, we or our contractors will have to develop methods to scale upthe production of the drug at commercially viable rates  If we are notable to scale the process in a timely manner or do not have the ability toproduce the drug economically, we may not be able to enter the market with aviable product. This would harm our financial and commercial prospects.

***If we cannotsuccessfully form and maintain suitable arrangements with third parties for themanufacturing of the products we may develop, our ability to develop or deliverproducts may be impaired.***

We have no experience in manufacturing products forcommercial purposes and do not have manufacturing facilities that can producesufficient quantities of drugs for large scale clinical trials. Accordingly, wemust either develop such facilities, which will require substantial additionalfunds, or rely on contract manufacturers for the production of products fordevelopment and commercial purposes. In order to conduct our Phase IIIclinical trial of DG031, we will have to contract with third parties tomanufacture a sufficient supply of the drug for the trial and to producetablets containing DG031 in amounts sufficient for the clinical trial. While wesigned contracts with suppliers for the production of DG031 material andtablets for the launch of our Phase III clinical trial and received sufficientmaterials to initiate the trial, following the reformulation and resumption ofthe trial, we may fail to secure sufficient supply of the drug in a timelymanner over the duration of the trial. Reformulation work may requirecontracting for new quantities of tablets, and the timing of the manufacturingof such new quantities of 

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tablets, as well asadditional testing for stability and other properties of the new tablets, maydelay the resumption of the clinical trial

The manufacture of ourproducts for clinical trials and commercial purposes is subject to GoodManufacturing Practices (cGMP) regulations promulgated by the FDA. Themanufacture of diagnostic products is subject to the FDA’s quality systemrequirements (QSR). In the event that we are unable to develop satisfactorymanufacturing facilities or obtain or retain third party manufacturing for ourproducts, we will not be able to commercialize such products as planned. We maynot be able to enter into agreements for the manufacture of future productswith manufacturers whose facilities and procedures comply with cGMP, QSR andother regulatory requirements. Our current dependence upon others for themanufacture of our products may adversely affect our ability to develop anddeliver such products on a timely and competitive basis and, in the longerterm, the profit margin, if any, on the sale of future products and our abilityto develop and deliver such products on a timely and competitive basis.

***Clinical trialsrequired for our product candidates or the products of our customers andpartners are expensive and time-consuming, their outcome is uncertain and wemay not achieve our projected development goals in the timeframes we haveannounced and expect.***

Before obtainingregulatory approvals for the commercial sale of any of our products underdevelopment, we must demonstrate through pre-clinical studies and clinicaltrials that the product is safe and effective for use in each target indication.Pre-clinical testing and clinical development are long, expensive and uncertainprocesses. It may take several years to complete testing for a product andfailure can occur at any stage of testing. The length of time necessary tocomplete clinical trials varies significantly and may be difficult to predict. Factorsthat can cause delay or termination of our clinical trials include:

·       slowerthan expected patient enrollment due to the nature of the protocol, theproximity of patients to clinical sites, the eligibility criteria for thestudy, competition with clinical trials for other drug candidates or otherfactors;

·       lowerthan expected retention rates of patients in a clinical trial;

·       delayedapproval of study protocol and pharmacogenomic components of studies byregulatory agencies in different countries, some of which are still developingpolicies with respect to pharmacogenomic testing;

·       inadequatelytrained or insufficient personnel at the study site to assist in overseeing andmonitoring clinical trials;

·       delaysin approvals or failure to obtain approval from the pertinent review boards orregulatory authorities;

·       longertreatment time required to demonstrate effectiveness or determine theappropriate product dose;

·       lackof sufficient supply of the product candidate;

·       adversemedical events or side effects in treated patients;

·       lackof effectiveness of the product candidate being tested; and

·       regulatorychanges.

Even if we obtain positiveresults from pre-clinical or clinical trials for a particular product, we maynot achieve the same success in future trials of that product. In addition,some or all of the clinical trials we undertake may not demonstrate sufficientsafety and efficacy to obtain the requisite regulatory approvals, which couldprevent the creation of marketable products. Our product development costs willincrease if 

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we havedelays in testing or approvals, if we need to perform more or larger clinicaltrials than planned, or if our trials are not successful. Delays in ourclinical trials may harm our financial results and the commercial prospects forour products. Delays or termination of clinical trials that we conduct for ourpartners or customers may also harm our financial results as payments underthese contracts may be delayed, reduced or curtailed.

***Co-development oftherapeutic and diagnostic products may be required, and delays in thedevelopment and approval of a commercially available diagnostic may delay drugapproval or impede market acceptance of the therapeutic product.***

The use of some of ourtherapeutic products may be dependent upon the selection of patients using bothclinical and genetic markers. This may require co-development and clinicaltesting of the therapeutic drug and a related diagnostic product. In the UnitedStates, drug approval could be delayed until we successfully obtain FDAapproval of the related diagnostic product. In addition, if the diagnostic testcannot be performed on a commercially viable basis, it may impede marketacceptance of our approved therapeutic products. To successfully co-develop andmarket a drug and diagnostic we may also need to establish and maintainsuccessful partnerships with manufacturing and marketing partners fordiagnostic products. If necessary partnerships cannot be established ormaintained, the development of our therapeutics and/or diagnostics may bedelayed or may fail.

***If we are not ableto obtain sufficient additional funding to meet our capital requirements, wemay be forced to reduce or terminate our research and product developmentprograms.***

We have spentsubstantial amounts of cash to fund our research and development activities andexpect to continue to spend substantial amounts for these activities over thenext several years. We expect to use cash to collect, generate and analyzegenotypic and disease data from volunteers in our disease-gene researchprograms; to conduct drug discovery and development activities (includingclinical trials); and to continue other research and development activities. Manyfactors will influence our future capital needs, including:

·       thenumber, breadth and progress of our discovery and research programs;

·       ourability to attract customers;

·       ourability to commercialize our discoveries and the resources we devote tocommercialization;

·       theamount we spend to enforce patent claims and other intellectual propertyrights; and

·       thecosts and timing of regulatory approvals.

We have relied on, and may continue to rely on,revenues generated by our corporate alliances and fee-paying customers forsignificant funding of our research efforts. Historically, a substantialportion of our revenue has been derived from contracts with a limited number ofsignificant customers. Revenue under our alliances with Roche, accountedfor approximately 17%, 23% and 30% of our consolidated revenue in the yearsended December 31, 2006, 2005 and 2004, respectively. Revenue under ouralliances with Merck accounted for approximately 3%, 15% and 22% of ourconsolidated revenue in the years ended December 31, 2006, 2005 and 2004,respectively. Divisions of the NIH accounted for approximately 33%, 13%and 1% of our consolidated revenue in the years ended December 31, 2006,2005 and 2004, respectively. Work under our agreement with Merck aimed atdeveloping new treatments for obesity and our 2002 agreement with Roche hasbeen completed.

In addition, we may seek additional fundingthrough public or private equity offerings and debt financings. We may notbe able to obtain additional financing when we need it or the financingmay not be 

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on terms favorable to usor our stockholders. Stockholders’ ownership will be diluted if we raiseadditional capital by issuing equity securities.

If we raise additionalfunds through collaborations and licensing arrangements, we may have torelinquish rights to some of our technologies or product candidates, or grantlicenses on unfavorable terms. If adequate funds are not available, we wouldhave to scale back or terminate our discovery and research programs and productdevelopment.

***The commercialsuccess of any products that we may develop will depend upon the degree ofmarket acceptance among physicians, patients, healthcare payors and the medicalcommunity.***

Any products thatwe may develop may not gain market acceptance among physicians, patients,healthcare payors and the medical community. If these products do not achievean adequate level of acceptance, we may not generate material product revenuesand we may not become profitable. The degree of market acceptance of any of ourproduct candidates, if approved for commercial sale, will depend on a number offactors, including:

·       demonstrationof efficacy and safety in clinical trials;

·       theprevalence and severity of any side effects;

·       potentialor perceived advantages over alternative treatments;

·       thetiming of market entry relative to competitive treatments;

·       theability to offer our product candidates for sale at competitive prices;

·       relativeconvenience and ease of administration;

·       thestrength of marketing and distribution support;

·       sufficientthird party coverage or reimbursement; and

·       theproduct labeling or product insert required by the FDA or regulatoryauthorities in other countries.

***If we cannotsuccessfully develop a marketing and sales force or maintain suitablearrangements with third parties to market and sell our products, our ability todeliver products may be impaired.***

We currently have noexperience in marketing or selling pharmaceutical products. In order to achievecommercial success for any approved product, we must either develop a marketingand sales force, which will require substantial additional funds and personnel,or, where appropriate or permissible, enter into arrangements with thirdparties to market and sell our products. We might not be successful indeveloping marketing and sales capabilities. Further, we may not be able toenter into marketing and sales agreements with others on acceptable terms, andany such arrangements, if entered into, may be terminated. If we develop ourown marketing and sales capability, it will compete with other companies thatcurrently have experienced, well-funded and larger marketing and salesoperations. To the extent that we enter into co-promotion or other sales andmarketing arrangements with other companies, revenues will depend on theefforts of others, which may not be successful.

***Our reliance on the Icelandic population may limit theapplicability of our discoveries to certain populations.***

The genetic make-up and prevalenceof disease generally varies across populations around the world. Common complexdiseases generally occur with a similar frequency in Iceland and other Europeanpopulations. However, the populations of other nations may be geneticallypredisposed to certain diseases because of mutations not present in theIcelandic population. As a result, we and our partners may be unable to developdiagnostic and therapeutic products that are effective on all or a portion ofpeople with 

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suchdiseases. For our business to succeed, we must be able to apply discoveriesthat we make on the basis of the Icelandic population to other markets.

***If a substantialportion of participants in our genetics research studies withdraw theirinformed consent, our ongoing research may suffer.***

We depend on thewillingness of Icelandic volunteers to participate in our genetics researchstudies. All of the participants in our genetic studies have signed an informedconsent form, which gives deCODE permission to process data and blood samplesthat the participant has donated for research purposes. Participants may at anytime revoke this permission by withdrawing their consent. If, for any reason, asubstantial portion of participants in our studies were to withdraw theirconsent, we would not be able to continue population genetic research in someor all of the diseases that we are studying. This would diminish our ability todiscover new drug targets and to develop products based on these discoveries. Ifour ability to use population genetic data is impaired, we also may not be ableto fulfill some contractual obligations with our partners.

***If we fail to protect confidential data adequately, wecould incur a liability.***

Under laws and regulationsin force in Iceland, including applicable European laws, directives andregulations, all information on individuals that is used in our populationresearch is anonymized under the protocols and supervision of the DataProtection Authority of Iceland. If we fail to comply with these laws andregulations, we could lose public support for participation in our research andwe could be liable to legal action. Any failure to comply fully with allconfidentiality requirements could lead to liability for damages incurred byindividuals whose privacy is violated, the loss of our customers and reputationand the loss of the goodwill and participation of the Icelandic population,including healthcare professionals. These eventualities could materiallyadversely affect our work in Iceland.

***Some parts of ourproduct development services create a risk of liability from clinical trialparticipants and the parties with whom we contract.***

Through our whollyowned subsidiary Encode ehf., we conduct clinical trials of products we aredeveloping and contract with drug companies and clinical research organizationsto perform a wide range of services to assist them in bringing new drugs tomarket. Our services include:

·       supervisingclinical trials;

·       dataand laboratory analysis;

·       patientrecruitment; and

·       actingas investigators in conducting clinical trials.

If, in the course of these trials or activities,

·       wedo not perform our services to contractual or regulatory standards;

·       wefail to obtain permission to conduct trials from the appropriate authorities inIceland;

·       patientsor volunteers suffer personal injury caused by or death from adverse reactionsto the test drugs or otherwise;

·       thereare deficiencies in the professional conduct of the investigators with whom wecontract;

·       ourlaboratories inaccurately report or fail to report lab results; or

·       ourinformatics products violate rights of third parties,

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then we could be heldliable for these eventualities by the regulatory agencies or the drug companiesand clinical research organizations with whom we contract or by studyparticipants. We maintain product liability insurance for claims arising fromthe use of products we are developing in clinical trials conducted by Encodeand are covered by the product liability insurance of the drug companies andclinical research organizations for which we provide clinical trial servicesfor claims arising from the use of their products in such trials. Suchinsurance may be inadequate and in any event would not cover the risk of acustomer deciding not to do business with us as a result of poor performance orclaims for a customer’s financial loss as the result of our failure to performour contractual obligations properly.

***Use of therapeutic or diagnostic products developed asa result of our programs may result in product liability claims for which wehave inadequate insurance.***

The users of anytherapeutic or diagnostic products developed by us or our collaborators as aresult of our discovery or research programs (including participants in ourclinical trials) may bring product liability claims against us. Except asdescribed above with respect to clinical trials conducted by Encode and exceptwith respect to our Phase III trial of DG031, we currently do not carryliability insurance to cover such claims. We are not certain that we or ourcollaborators will be able to obtain such insurance or, if obtained, thatsufficient coverage can be acquired at a reasonable cost. If we cannot protectagainst potential liability claims, we or our collaborators may find itdifficult or impossible to commercialize products.

***Our fee-for-servicework bears certain risks of liability to our customers.***

Our subsidiaries, deCODEchemistry, Inc., deCODE biostructures, Inc., and Emerald Biosystems, Inc.,provide services, equipment and products (including software) for third partycustomers who pay us on a fee-for-service or product basis. In this function,we often synthesize compounds, manufacture active pharmaceutical ingredientmaterial and provide recommendations for research direction for our customers. Wealso provide contract research services in X-ray crystallographic structuredetermination of protein-ligand complexes for customers, and often recommendtargets to customers based on these determinations. In addition, we sellinstruments and software to these customers.

We may be liable to ourcustomers for damages if we perform such services negligently or with willfulmisconduct, or if we provide customers with defective products, equipment orsoftware. We also may be held liable for failure to meet specifications orfailure to comply with other contractual conditions. While our agreements withcustomers limit our liability and while we carry general commercial liabilityinsurance, such contractual limitations may not be effective in the event ofour material breach of the agreements, gross negligence, or willful misconductand such insurance may not be adequate. We also supply compounds for clinicaltrials conducted by our customers. In doing so, we may provide materialsrequiring certification of compliance with cGMP regulations applicable toproduction of such materials. If we are found not to have complied with suchrequirements, we may incur liabilities related to such failures. Ifparticipants in these trials suffer personal injury or death from adversereactions to the test drugs, we could be held liable to our customers or theparticipants. We maintain product liability insurance for claims arising fromthe use of products we supply. However, such insurance may be inadequate. Failureto perform to customer expectation also may limit future business from ourexisting customers, or could result in the holdback of certain payments due tous. We integrate software and products purchased or licensed from third partiessuppliers into certain of our products, equipment and software sold to ourcustomers. While we evaluate such items for defects and possible intellectualproperty infringement issues, and attempt to obtain contractual protectionsfrom suppliers, in the event any such items purchased or licensed fromsuppliers are defective or violate intellectual property rights of thirdparties, we may not be able to fully recover any of our damages or ourcustomers’ damages from suppliers of such items.

Our facilities where workfor customers is conducted are subject to audits by the FDA and by customers. Inthe event we are found in non-compliance by the FDA, there is a risk that suchfacility may be subject to corrective measures up to and including the closureof the facility. Such closure would have 

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impacton our ability to meet customer obligations as well as obligations relating toour internal programs. Customer audits may lead to disputes regardingcompliance with contractual terms, which could lead to potential disputesand/or liabilities as described above.

In addition, we typicallyhave the obligation to maintain the confidentiality of proprietary informationof our customers. While we have systems in place to ensure that suchconfidentiality is protected, we do conduct work on our internal projects atthe same facilities where we work for our customers; therefore, there is anincreased risk that customers may claim that we have violated ourconfidentiality obligations or used their proprietary information in ourproprietary projects.

***Increased leverageas a result of our convertible debt may harm our financial condition andresults of operations.***

On December 31,2006 we had $218.3 million of outstanding debt as reflected in our balancesheet. Pursuant to generally accepted accounting principles, this amount is netof $24 million original issue discount related to the issuance of $80 millionface amount of 3.50% Senior Convertible Notes in November 2006. We mayincur additional indebtedness in the future and neither our 3.50% SeniorConvertible Notes issued in 2004 nor our 3.50% Senior Convertible Notes issuedin 2006 (collectively, the “Notes”) restrict our future issuance ofindebtedness. Our level of indebtedness will have several important effects onour future operations, including, without limitation:

·       aportion of our cash flow from operations will be dedicated to the payment ofany interest required with respect to outstanding indebtedness;

·       increasesin our outstanding indebtedness and leverage will increase our vulnerability toadverse changes in general economic and industry conditions, as well as tocompetitive pressure; and

·       dependingon the levels of our outstanding debt, our ability to obtain additionalfinancing for working capital, capital expenditures, general corporate and otherpurposes may be limited.

Ourability to make payments of principal and interest on our indebtedness dependsupon our future performance, which will be subject to the success of ourdevelopment and commercialization of new pharmaceutical products, generaleconomic conditions, industry cycles and financial, business and other factorsaffecting our operations, many of which are beyond our control. If we are notable to generate sufficient cash flow from operations in the future to serviceour debt, we may be required, among other things:

·       toseek additional financing in the debt or equity markets;

·       torefinance or restructure all or a portion of our indebtedness, including theNotes;

·       tosell selected assets; or

·       toreduce or delay expenditures on planned activities, including but not limitedto clinical trials, and development and commercialization activities.

Such measures might not besufficient to enable us to service our debt. In addition, any such financing,refinancing or sale of assets might not be available on economically favorableterms.

***We may be unable tohire and retain the key personnel upon whom our success depends.***

We depend on the principalmembers of our management and scientific staff, including Dr. KariStefansson, Chairman, President and Chief Executive Officer. We have notentered into agreements with any of these people that bind them to a specificperiod of employment. If any of these people leave, our ability to conduct ouroperations may be negatively affected. Our future success also will depend inpart on our ability to attract, hire and retain additional personnel. There isintense competition for such qualified personnel and we cannot be certain thatwe will be able to continue to attract and retain such personnel. Failure to attractand retain key personnel could have a material adverse effect on us.

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***Currency fluctuations may negatively affect ourfinancial condition.***

We primarily expend andgenerate cash in U.S. dollars, our functional currency. We also publish ourconsolidated financial statements in U.S. dollars. Currency fluctuations canaffect our financial results because a portion of our cash reserves, our debtand our operating costs are in Icelandic kronas. A fluctuation of theexchange rates of the Icelandic krona against the U.S. dollar can thusadversely affect the “buying power” of our cash reserves and revenues. Most ofour long-term liabilities are U.S. dollar denominated. However, we may enterinto hedging transactions if we have substantial foreign currency exposure inthe future. We may have increased exposure as a result of investments,payments from collaborative partners or the decrease in value of Icelandickronas.

***Our contracts may terminate upon short notice.***

Many of our contracts forresearch services are terminable on short notice. This means that our contractscould be terminated for numerous reasons, any of which may be beyond ourcontrol, such as a reduction or reallocation of a customer’s research anddevelopment budget or a change in a customer’s overall financial condition. Theloss of a large contract or multiple smaller contracts, or a significantdecrease in revenue derived from a contract, could significantly reduce ourprofitability and require us to reallocate under-utilized physical andprofessional resources.

**Risks Related toOur Collaborative Relationships**

***If we are unable toform and maintain the collaborative relationships that our business strategyrequires, our programs will suffer and we may not be able to develop products.***

Our strategy for developing products and derivingrevenues from them is dependent, in part, upon our ability to enter intocollaborative arrangements with research collaborators, corporate partners andothers. We may rely on these arrangements both to provide funding necessary toour product development and to obtain goods and services that we require forour product development. We do not have the capacity to conduct large scalePhase III clinical trials and will rely on partnerships or third partycontractors to conduct our Phase III trials, including our Phase IIItrial of DG031. We will rely on these third parties to provide us with clinicalmaterial for the trial and various services necessary to organize and conduct amulti-center, multinational study, as well as other goods and services. We havenot entered into contracts for all of the goods and services that will berequired upon the resumption of the Phase III trial of DG031. Our arrangementfor this and other Phase III trials will be subject to risks described below,with respect to our collaborative relationships.

If our collaborations arenot successful or if we are not able to manage multiple collaborationssuccessfully, our programs may suffer. If we increase the number ofcollaborations, it will become more difficult to manage the variouscollaborations successfully and the potential for conflicts among thecollaborators as to rights to the technology and products generated under workconducted with us will increase.

***Dependence oncollaborative relationships may lead to delays in product development, productdefects and disputes over rights to technology.***

We have formed, and may in the future form additional,collaborative relationships (including relationships with clinical researchorganizations to conduct clinical trials on our behalf) that will, in somecases, make us dependent on collaborators for the pre-clinical studies and/orclinical trials and for regulatory approval of any products that we aredeveloping. Failure of such collaborators to perform under these agreementsproperly in a timely manner, or at all, may lead to delays in our productdevelopment. In addition, if participants in the trials conducted by ourcollaborators suffer personal injury or death as a result of actions of thecollaborators, we could be held liable. In some cases, our agreements with 

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collaborators typicallyallow them significant discretion in electing whether and how to pursue suchactivities. We cannot control the amount and timing of resources collaboratorswill devote to these programs or potential products. In addition, collaborativeagreements may contain exclusivity provisions that may prevent us from workingin a particular field or on a particular disease even when our collaboratorselect not to pursue activities under the agreements. Upon resumption of ourPhase III clinical trial of DG031, we expect to continue relationships withclinical research organizations and other organizations providing services, butthere is no guarantee that the parties will come to an agreement, or thatreaching such agreements will not result in additional delays.

Our collaborators may stopsupporting our products or providing services to us if they develop or obtainrights to competing products. Disputes may arise in the future over theownership of rights to any technology developed with collaborators. These andother possible disagreements between our collaborators and us could lead todelays in the collaborative research, development or commercialization ofproducts. Such disagreements could also result in litigation or requirearbitration to resolve.

**Risks Related toOur Industry**

***Concerns regardingthe use of genetic testing results may limit the commercial viability of anyproducts we develop.***

Other companies havedeveloped genetic predisposition tests that have raised ethical concerns. It ispossible that employers or others could discriminate against people who have agenetic predisposition to certain diseases. Concern regarding possiblediscrimination may result in governmental authorities enacting restrictions orbans on the use of all, or certain types of, genetic testing. Similarly, suchconcerns may lead individuals to refuse to use genetic tests even ifpermissible. These factors may limit the market for, and therefore thecommercial viability of, products that our collaborators and/or we may develop.

***We may not be ableto compete successfully with other companies and government agencies in thedevelopment and marketing of products and services.***

A number of companies are attempting to rapidlyidentify and patent genes that cause diseases or an increased susceptibility todiseases. Competition in this field and our other areas of business, includingdrug discovery and development, is intense and is expected to increase. We havenumerous competitors, including major pharmaceutical and diagnostic companies,specialized biotechnology firms, universities and other research institutions,and other government-sponsored entities and companies providing healthcareinformation products. Our collaborators, including Roche and Merck, may alsocompete with us. Many of our competitors, either alone or with collaborators,have considerably greater capital resources, research and development staffsand facilities, and technical and other resources than we do, which may allowthem to discover important genes or develop drugs based on such discoveriesbefore we do. We believe that a number of our competitors are developingcompeting products and services that may be commercially successful and thatare further advanced in development than our potential products and services. Tosucceed, we, together with our collaborators, must discoverdisease-predisposing genes, characterize their functions, develop genetic testsor therapeutic products and related information services based on suchdiscoveries, obtain regulatory and other approvals, and launch such services orproducts before our competitors. Even if we or our collaborators are successfulin developing effective products or services, our products and services may notsuccessfully compete with those of our competitors, including cases where thecompeting drugs use the same mechanism of action as our products. Ourcompetitors may succeed in developing and marketing products and services thatare more effective than ours or that are marketed before ours.

Competitors have established, and in the future mayestablish, patent positions with respect to gene sequences related to ourresearch projects. Such patent positions or the public availability of gene 

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sequences comprisingsubstantial portions of the human genome could decrease the potential value ofour research projects and make it more difficult for us to compete. We may alsoface competition from other entities in gaining access to DNA samples used forresearch and development purposes. Our competitors may also obtain patent protectionor other intellectual property rights that could limit our rights, or ourcustomers’ ability, to use our technologies or databases, or commercializetherapeutic or diagnostics products. In addition, we face, and will continue toface, intense competition from other companies for collaborative arrangementswith pharmaceutical and biotechnology companies, for establishing relationshipswith academic and research institutions and for licenses to proprietarytechnology.

We expect competition to intensify as technicaladvances are made and become more widely known. Our future success will dependin large part on maintaining a competitive position in the genomic field. Rapidtechnological development may result in products or technologies becomingobsolete before we recover the expenses we incur in developing them.

Our ability tocompete successfully will depend, in part, on our ability, and that of ourcollaborators, to:

·       developproprietary products;

·       developand maintain products that reach the market first, and are technologicallysuperior to, and more cost effective than, other products on the market;

·       obtainpatent or other proprietary protection for our products and technologies;

·       attractand retain scientific and product development personnel;

·       obtainrequired regulatory approvals; and

·       manufacture, market andsell products that we develop.

***Changes inoutsourcing trends and economic conditions in the pharmaceutical andbiotechnology industries could adversely affect our growth.***

Economic factors andindustry trends that affect our primary customers, pharmaceutical andbiotechnology companies, also affect our business. For example, the practice ofmany companies in these industries has been to outsource to organizations likeus the conduct of genetic research, clinical research, sales and marketingprojects and chemistry and structural biology research and development projects.If these industries reduce their present tendency to outsource those projects,our operations, financial condition and growth rate could be materially andadversely affected. These alliances and arrangements are both time consumingand complex and we face substantial competition in establishing theserelationships. In addition, our ability to generate new business could be impairedby general economic downturns in our customers’ industries. We have experiencedincreasing pressure on the part of our customers to reduce expenses, includingthe use of our services as a result of negative economic trends generally andin the pharmaceutical industry. If pharmaceutical and biotechnology companiesdiscontinue or decrease their usage of our services, for example, as a resultof an economic slowdown or increased competition from outsourcing companies inIndia and China, our revenues and earnings could be lower than we expect, andour revenues may decrease or not grow at historical rates.

***If regulatoryapprovals for products resulting from our gene discovery programs are notobtained, we will not be able to derive revenues from these products.***

Government agencies must approve new drugs anddiagnostic products in the countries in which they are to be marketed. Wecannot be certain that we can obtain regulatory approval for any drugs ordiagnostic products resulting from our gene discovery programs. The regulatoryprocess can take many years and require substantial resources. Because some ofthe products likely to result from our disease 

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research programs involvethe application of new technologies and may be based upon a new therapeuticapproach, various government regulatory authorities may subject such productsto substantial additional review. As a result, these authorities may grantregulatory approvals for these products more slowly than for products usingmore conventional technologies. Furthermore, regulatory approval may imposelimitations on the use of a drug or diagnostic product.

Even if a product isapproved for marketing, it and its manufacturer must undergo continuing review.Discovery of previously unknown problems with a product may require theperformance of additional clinical trials or the change of the labeling of theproduct and may have adverse effects on our business, financial condition andresults of operations, including withdrawal of the product from the market.

***Third party reimbursement and healthcare reformpolicies may reduce market acceptance of our products.***

Our success will depend in part on the price andextent to which we will be paid for our products by government and healthadministration authorities, private health insurers and other third partypayers. Reimbursement for newly approved healthcare products is uncertain. Thirdparty payers, including Medicare in the United States, are increasinglychallenging the prices charged for medical products and services. They areincreasingly attempting to contain healthcare costs by limiting both coverageand the level of reimbursement for new therapeutic products. We cannot becertain that any third party insurance coverage will be available to patientsfor any products we discover or develop. If third party payers do not provideadequate coverage and reimbursement levels for our products, the marketacceptance of these products may be materially reduced.

Numerous governments haveundertaken efforts to control growing healthcare costs through legislation,regulation and voluntary agreements with medical care providers andpharmaceutical companies. If cost containment efforts limit the profits thatcan be derived from new drugs, our customers may reduce their research anddevelopment spending which could reduce the business they outsource to us.

***Our corporatecompliance program cannot guarantee that we are in compliance with allapplicable federal and state regulations in the United States, Iceland, theEuropean Union and elsewhere.***

The development,manufacturing, distribution, pricing, sales, marketing and reimbursement of ourproducts, together with our general operations are subject to extensive federaland state regulations in the United States and national or supra-national lawsand regulations in Europe and other parts of the world. While we have developedand instituted a corporate compliance program based on current best practices,we cannot assure you that we or our employees are or will be in compliance withall potentially applicable regulations and/or laws. If we fail to comply withany of these regulations and/or laws, a range of actions could result,including, but not limited to, the termination of clinical trials, the failureto approve a product candidate, restrictions on our products or manufacturingprocesses, including withdrawal of our products from the market, significantfines, exclusion from government healthcare programs or other sanctions orlitigations.

***Our operationsinvolve a risk of injury or damage from hazardous materials, and if an accidentwere to occur, we could be subject to costly and damaging liability claims.***

In the course of our work,we handle and produce hazardous materials and chemicals as well as compoundswhich may have known or unknown characteristics such as toxicity and reactivitywith other compounds. Although we have systems in place to manage suchcompounds and their characteristics, the risk of accidental contamination orinjury from these materials cannot be completely eliminated. Any suchcontamination or injury could result in negative effects to our personnel orfacilities, which could lead to liabilities as well as impacting our ability tomeet customer obligations and conduct our internal programs.

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**Risks Related toOur Intellectual Property**

***We may not be able to protect the proprietary rightsthat are critical to our success.***

Our success will depend in part on our ability toprotect our products, our genealogy database and genotypic data and any otherproprietary databases that we develop and our proprietary software and otherproprietary methods and technologies. Despite our efforts to protect ourproprietary rights, unauthorized parties may be able to obtain and useinformation that we regard as proprietary.

While we require employees, business partners,academic collaborators and consultants to enter into confidentialityagreements, there can be no assurance that proprietary information will not bedisclosed, that others will not independently develop substantially equivalentproprietary information and techniques, otherwise gain access to our tradesecrets or disclose such technology, or that we can meaningfully protect ourtrade secrets.

Our commercialsuccess will depend in part on obtaining patent protection. The patentpositions of pharmaceutical, biopharmaceutical and biotechnology companies,including deCODE, are generally uncertain and involve complex legal and factualconsiderations that are constantly evolving. We cannot be sure that:

·       anyof our pending patent applications will result in issued patents;

·       wewill develop additional proprietary technologies that are patentable;

·       anypatents issued to us or our partners will provide a basis for commerciallyviable products, will provide us with any competitive advantages or will not bechallenged by third parties; or

·       thepatents of others will not have an adverse effect on our ability to dobusiness.

If we are unable to obtain patent protection for ourtechnology or discoveries, the value of our proprietary resources may beadversely affected.

In addition, patent law relating to the scope ofclaims in the area of genetics and gene discovery is still evolving and subjectto uncertainty, including in areas important to us such as patenting ofdiscoveries for the development of therapeutic methods, diagnostic methods andproducts that predict inherited susceptibility to diseases and diagnosticmethods and products that predict drug response and disease progression. Accordingly,the degree of future protection for our proprietary rights is uncertain and, wecannot predict the breadth of claims allowed in any patents issued to us orothers. We could also incur substantial costs in litigation if we are requiredto defend ourselves in patent suits brought by third parties or if we initiatesuch suits to enforce our own patents against potential infringers.

Others may have filed and in the future are likely tofile patent applications covering products or technology that are similar oridentical to our products and technology. The fact that patent applications ofothers may not publish until they issue as patents in the United States, or arenot published until 18 months after filing in the United States and otherjurisdictions may have adverse effect on our own patent filings and business,particularly if they claim subject matter similar to that of our clinicalprograms. In addition, others may develop competitive products outside theprotection that may be afforded by the claims of our patents. We cannot becertain that our patent applications will have priority over any patentapplications of others. The mere issuance of a patent does not guarantee thatit is valid or enforceable; thus even if we are holding or are granted patents,we cannot be sure that they would be valid and enforceable against thirdparties. Further, a patent does not provide the patent holder with freedom tooperate in a way that infringes the patent rights of others. Any legal actionagainst us or our partners claiming damages and seeking to enjoin commercialactivities relating to the affected products and processes could, in additionto subjecting us to potential liability for damages, require us or our partnersto obtain a license in order to continue to manufacture or market the affectedproducts and processes. There can be no assurance that 

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we or our partners wouldprevail in any action or that any license required under any patent would bemade available on commercially acceptable terms, if at all. If licenses are notavailable, we or our partners may be required to cease marketing our productsor practicing our methods.

If expressed sequencetags, SNPs, or other sequence information become publicly available before weapply for patent protection on the uses of a corresponding full-length partialgene or associated genetic markers, our ability to obtain patent protection foruses of those genes or gene sequences could be adversely affected. In addition,other parties are attempting to rapidly identify and characterize genes throughthe use of SNP genotyping, gene expression analysis and other technologies. Ifany patents are issued to other parties on these partial or full-length genesor gene products or uses for such genes or gene products, the risk increasesthat the sale of our or our collaborators’ potential products or processes maygive rise to claims of patent infringement. The amount of supportive datarequired for issuance of patents for human therapeutics is highly uncertain. Ifmore data than we have available is required, our ability to obtain patentprotection could be delayed or otherwise adversely affected. Even withsupportive data, the ability to obtain patents is uncertain in view of evolvingexamination guidelines, such as the utility and written description guidelinesthat the USPTO has adopted. Moreover, patenting of genes and their uses facesconsiderable public opposition as demonstrated by the submission of the recentintroduction in the U.S. House of Representatives of a bill entitled “GenomicResearch and Accessibility Act”, which seeks to ban the practice of patentinggenes found in nature. Enactment of this bill into law could adversely affectour abilities to attain patent protection for some of our genetic inventions.

***Our patent applications covering DG041 and DG051 havenot issued yet as patents.***

We have filed compositionof matter type patent applications covering DG041 and DG051 in the UnitedStates as well as international applications through the Patent CooperationTreaty. However, these patent applications are in the early stages of patentprosecution before the United States Patent and Trademark Office (USPTO) and wehave no certainty or indication from the USPTO that these patent applicationswill issue as patents. The USPTO is currently facing considerable backlog forexamining pending patent applications so considerable time may elapse before wewill have more certainty as to the patentability of the compounds. Should theUSPTO (or any other national patent offices where we choose to fileapplications) ultimately reject our patent applications covering thesecompounds, or should others have filed or obtained issued patent covering thesame, the value and potential of these programs for our business would beadversely affected.

***Any patent protection we obtain for our products maynot prevent marketing of similar competing products.***

Patents on our productsmay not prevent our competitors from designing around and developing similarcompounds or compounds with similar modes of action that may competesuccessfully with our products. Such third party compounds may prove to besuperior to our products or gain wider market acceptance and thus adverselyaffect any revenue stream that we could otherwise expect from sales of ourproducts.

***Any patents we obtain may be challenged by producersof generic drugs.***

Patents coveringinnovative drugs, which are also commonly referred to as “branded drugs” or “pioneerdrugs,” face increased scrutiny and challenges in the courts from manufacturersof generic drugs who may receive benefits such as limited marketingco-exclusivity if the challenge is successful. Such patent challenges typicallyoccur when the generic manufacturer files an Abbreviated New Drug Applicationwith the FDA and asserts that the patent or patents covering the branded drugare invalid or unenforceable, forcing the owner or licensee of the branded drugto file suit for patent infringement. If any patents we obtain covering ourpharmaceutical products are subject to such successful patent challenges, our 

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marketingexclusivity may be eliminated or reduced in time, which would thus adverselyaffect any revenue stream that we could otherwise expect from sales of ourproducts.

**Risks Related toInvesting in Our Common Stock**

***Future sales of common stock may dilute ourstockholders.***

We may sell common stockin the future in one or more transactions at prices and in a manner wedetermine from time to time. If we sell common stock in more than onetransaction, existing stockholders who previously purchased stock may bematerially diluted by subsequent sales of common stock.

***The price of our common stock is volatile and themarket value of your investment may decrease.***

The market pricesfor common stock of biotechnology and pharmaceutical companies, including ours,have historically been highly volatile, and the market has from time to timeexperienced significant price and volume fluctuations that are unrelated to theactual performance of particular companies. In addition to the various risksdescribed elsewhere in this Form 10-K, the following factors couldhave an adverse effect on the market price of our common stock:

·       fluctuationsin our operating results;

·       announcementof technological innovations or new therapeutic products by us or others;

·       clinicaltrial results;

·       developmentsconcerning agreements with collaborators;

·       actualor threatened litigation;

·       governmentalregulation and regulatory actions;

·       changesin patent laws;

·       developmentsconcerning patent or other proprietary rights;

·       publicconcern as to the safety of drugs developed by us or others;

·       futuresales of substantial amounts of common stock by existing stockholders; and

·       general market conditionsand economic and other external factors, including disasters, wars and othercrises.

***We may issue preferred stock with rights that couldaffect your rights and prevent a takeover of the business.***

Our board of directors hasthe authority, without further approval of our stockholders, to fix the rightsand preferences, and to issue up to 6,716,666 shares of preferred stock. Inaddition, Delaware corporate law imposes limitations on certain businesscombinations. These provisions could, under certain circumstances, delay orprevent a change in control of deCODE and, accordingly, could adversely affectthe price of our common stock.

***We currently do notintend to pay dividends on our common stock and consequently, your onlyopportunity to achieve a return on your investment is if the price of ourcommon stock appreciates.***

We currently do not planto pay dividends on shares of our common stock in the near future.Consequently, your only opportunity to achieve a return on your investment inour company will be if the market price of our common stock appreciates.

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**Item 1B.**               *Unresolved Staff Comments*

None

**Item 2.**                        *Properties*

Our headquarters are in Iceland in an approximately150,000 square-foot, three-story building, used both for our laboratoriesand offices. The building is leased under a fifteen year operating leaseexpiring in 2020. We also lease a total of 31,000 square feet in a building atKrokhals 5, Reykjavik, to house additional laboratory facilities and storage,including Encode’s operation. The Krokhals 5 lease is also leased under afifteen year operating lease expiring in 2020.

Our principal executive offices and discoverylaboratories in the United States are located in Woodridge, Illinois, andencompass approximately 103,000 square feet with the capability to expand ouroffices and laboratories to 200,000 square feet. In February 2007, weentered into an agreement regarding the sale and leaseback of this property(land and facilities). Pursuant to the agreement and subject to satisfaction ofcontingencies, including, without limitation, negotiations of a satisfactorylease, we will sell the Woodridge property and lease it back under a 17 yearlease with 2 five year renewal options. Additionally, we occupy approximately a19,000 square foot leased office and laboratory facility in Bainbridge Island,Washington.

We lease approximately 5,100 square feet of officespace in Brighton, Michigan which houses our product development group.

We also leaseapproximately 750 square feet of office space in Waltham, Massachusetts, forfinance and 1,600 square feet of office space in New York, New York forinvestor relations and corporate communications.

**Item 3.**                        *Legal Proceedings*

Other than claims and legal proceedings that ariseform time to time in the ordinary course of business which are not material,deCODE has no pending legal proceedings except as follows:

On or about April 20, 2002, an amended classaction complaint, captioned *In re deCODE genetics, Inc.Initial Public Offering Securities Litigation* (01 Civ. 11219(SAS)),alleging violations of federal securities laws in connection with deCODE’sinitial public offering was filed in the United States District Court for theSouthern District of New York (the “District Court”) on behalf of certainpurchasers of deCODE common stock. The complaint names deCODE, two individualswho were executive officers of deCODE at the time of its initial publicoffering (the “Individual Defendants”), and the two lead underwriters (the “UnderwriterDefendants”) for our initial public offering in July 2000 (the “IPO”) asdefendants.

deCODE is aware that similar allegations have beenmade in hundreds of other lawsuits filed (many by some of the same plaintifflaw firms) against numerous underwriter defendants and issuer companies (andcertain of their current and former officers) in connection with various publicofferings conducted in recent years. All of the lawsuits that have been filedin the Southern District of New York have been consolidated for pretrialpurposes before United States District Judge Shira Scheindlin. Pursuant to theunderwriting agreement executed in connection with our IPO, deCODE has demandedindemnification from the Underwriter Defendants. The Underwriter Defendantshave asserted that our request for indemnification is premature.

Pursuant to an agreement the Individual Defendantshave been dismissed from the case without prejudice.

On July 31, 2003, our Board of Directors (otherthan our Chairman and Chief Executive Officer, who recused himself because hewas an Individual Defendant) approved a proposed partial settlement with the 

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plaintiffs in this matter,subject to a number of conditions, including the participation of a substantialnumber of other issuer defendants in the proposed settlement, the consent ofdeCODE’s insurers to the settlement, and the completion of acceptable finalsettlement documentation. Any direct financial impact of the proposedsettlement is expected to be borne by deCODE’s insurers.

In conjunction with the plaintiffs, the settlingissuer defendants filed a motion seeking the court’s preliminary approval ofthe settlement. The court grantedpreliminary approval of the settlement on February 15, 2005, subject tocertain modifications. On August 31, 2005, the court issued a preliminaryorder further approving the modifications to the settlement and certifying thesettlement classes. The court also appointed the Notice Administrator for thesettlement and ordered that notice of the settlement be distributed to allsettlement class members beginning on November 15, 2005. Thesettlement fairness hearing was held on April 24, 2006, and the DistrictCourt reserved decision. On December 5, 2006, the United StatesCourt of Appeals for the Second Circuit (the “Second Circuit”) issued anopinion vacating the District Court’s certification of a litigation class inthat portion of the case between the Plaintiffs and the underwriter defendants.Because the Second Circuit’s opinion was directed to the class certified by theDistrict Court for the Plaintiffs’ litigation against the underwriterdefendants, the opinion’s effect on the class certified by the District Courtfor the Company’s settlement is unclear. On January 5, 2007, Plaintiffsfiled a petition for rehearing en banc by the Second Circuit. Theproposed settlement is pending final approval by the District Court.

There can be no assurance that this proposedsettlement will be approved and implemented in its current form, if at all. Ifthe settlement of the IPO litigation is not consummated, deCODE expects tocontest the allegations in the action vigorously. Due to the inherentuncertainties of litigation, and the fact that the settlement of the litigationrelating to our IPO remains subject to court approval, the ultimate outcome ofthis matter cannot be predicted. If deCODE were required to pay significantmonetary damages in the event that the IPO settlement is unconsummated or as aresult of an adverse determination in the other actions described above (or anyother lawsuits alleging similar claims filed against deCODE and deCODE’sdirectors and officers in the future), deCODE’s business could be significantlyharmed. Even if such litigations conclude in deCODE’s favor, deCODE may berequired to expend significant funds to defend against the allegations. deCODEis unable to estimate the range of possible loss from the above litigations andno amounts have been provided for such matters in deCODE’s financialstatements.

On August 4, 2006 deCODE commenced an action inthe U.S. District Court for the Eastern District of Pennsylvania against fiveformer employees for misappropriation of deCODE’s trade secrets and intellectualproperty, related breach of non-competition, non-solicitation, andnon-disclosure provisions of their employment agreements, and violation of thefederal Computer Fraud and Abuse Act. The suit alleges that the defendants,including Hákon Hákonarson, formerly deCODE’s Vice President, BusinessDevelopment, were recruited, and at least four are currently employed, by theCenter for Applied Genomics, a business unit of the Children’s Hospital ofPhiladelphia (CHOP). Also, the suit alleges that while still deCODE employeesand with the knowledge of senior CHOP staff, these defendants copied or sentdirectly to CHOP deCODE proprietary methods, tools, business plans and researchresults. CHOP has intervened as a defendant in the case.

deCODE is seeking preliminary and permanentinjunctions restraining, among other things, the individual defendants fromworking at CHOP in any capacity competitive with deCODE for two years, and theindividual defendants and CHOP from soliciting our employees for a period ofone year and from using or disclosing our confidential information. Inaddition, deCODE is seeking unspecified amounts of compensatory, special andpunitive damages and attorney’s fees.

On August 11, 2006 the court issued a temporaryrestraining order prohibiting the individual defendants from using, altering,destroying or transferring possession of any information taken from deCODE, andfrom destroying, using, altering, copying or transferring possession of one ormore 

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250 gigabyte harddrives or any other removable storage devices that contained any deCODEinformation. On August 22, 2006, the court entered an order extending thetemporary restraining order until the court rules on deCODE’s motion for apreliminary injunction. The hearing on plaintiffs’ motion for a preliminaryinjunction concluded on November 22, 2006. Post-hearing briefs have beensubmitted. The court has stated that it will schedule a date for argument onthe motion, but no date has been scheduled yet for the argument. Accordingly,the temporary restraining order remains in place.

On September 5, 2006 deCODE filed a motion for anorder to show cause why defendant Robert Skraban should not be held in contemptfor violating the temporary restraining order. On December 1, 2006 deCODEfiled a similar contempt motion as to defendant Hákon Hákonarson. The court hasnot yet ruled on these motions.

On December 13, 2006 CHOP filed counterclaimsagainst deCODE asserting claims for defamation, trade libel, abuse of process,breach of contract, promissory estoppel, intentional interference withprospective contractual relations, and fraud. CHOP’s counterclaims fordefamation, trade libel, intentional interference with prospective contractualrelations, and fraud are asserted against Dr. Kári Stefánsson as well asdeCODE. CHOP’s counterclaims seek unspecified amounts of compensatory, specialand punitive damages, and attorney’s fees.

On December 22, 2006 four individual defendants(Hákon Hákonarson, Struan Grant, Robert Skraban and Jonathan Bradfield) filedcounterclaims against deCODE asserting claims for defamation, trade libel,abuse of process, breach of contract, promissory estoppel, fraud, breach ofimplied contract, breach of covenant of good faith and fair dealing, and falselight. The individual defendants’ counterclaims for defamation, trade libel,abuse of process, fraud, breach of implied contract, and false light areasserted against Dr. Kári Stefánsson as well as deCODE. The individualdefendants’ counterclaims seek unspecified amounts of compensatory, special andpunitive damages, and attorney’s fees.

deCODE and Dr. Stefánsson have filed motions todismiss the counterclaims of CHOP and the individual defendants. The court hasnot yet ruled upon the motions to dismiss.

If deCODE is required to defend the counterclaimsfiled by CHOP and the individual defendants, deCODE believes that it has validdefenses to such counterclaims. If the counterclaims of CHOP or the individualdefendants are resolved against deCODE, it is possible that monetary damages couldbe awarded against deCODE that would materially affect the business of deCODE.

The fifth individualdefendant, Jesus Sainz, was served with deCODE’s complaint but has not filedany response. The court entered Sainz’s default on September 21, 2006.

**Item 4.**                        *Submission of Matters to a Vote of Security Holders*

None.

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**PART II**

**Item 5.**                        *Market for the Company’s Common Equity and Related Stockholder Matters*

Ourcommon stock is traded on the Nasdaq Global Market under the symbol “DCGN”. Thefollowing table sets forth, for the calendar periods indicated, the range ofhigh and low sale prices for the common stock on the Nasqaq Global Market orits predecessor the Nasdaq National Market:

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 8.04       |    | $          | 5.57 |   |
| Second Quarter |       | $        | 9.97       |    | $          | 5.09 |   |
| Third Quarter  |       | $        | 10.67      |    | $          | 7.83 |   |
| Fourth Quarter |       | $        | 9.94       |    | $          | 7.14 |   |
| **2006**       |       |     |       |    |       |
| First Quarter  |       | $        | 10.77      |    | $          | 7.66 |   |
| Second Quarter |       | $        | 8.85       |    | $          | 5.50 |   |
| Third Quarter  |       | $        | 6.37       |    | $          | 4.70 |   |
| Fourth Quarter |       | $        | 5.99       |    | $          | 4.08 |   |

 

We have neither declared nor paid dividends on ourcommon stock since our inception and do not plan to pay dividends in theforeseeable future. Any earnings that we may realize will be retained tofinance our growth.

As of February 28, 2007, there were 4,233 holdersof record of the Common Stock.

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**Item 6.**                        *Selected Financial Data*

Thefollowing selected consolidated financial data should be read in conjunctionwith our consolidated financial statements and the notes to those statementsand “Management’s Discussion and Analysis of Financial Condition and Results ofOperations” included elsewhere in this Annual Report. The following data withregard to the consolidated balance sheets at December 31, 2006, 2005 and2004 and the related statements of operations and cash flows for the yearsended December 31, 2006, 2005 and 2004 have been derived from consolidatedfinancial statements audited by Deloitte & Touche LLP, an independentregistered public accounting firm. The following data with regard to theconsolidated balance sheets at December 31, 2003 and 2002 and the relatedstatements of operations and cash flows for the two years ended December 31,2003 have been derived from consolidated financial statements audited byanother independent registered public accounting firm. Consolidated balancesheets at December 31, 2006 and 2005 and the related statements ofoperations and cash flows for each of the three years in the period ended December 31,2006 and the notes thereto appear elsewhere in this annual report.

| ** **                                                           | ** ** | **For the Year Ended December 31,**                                                    | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                                                                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                           | ** ** | **(Tabular amounts in thousands,  except share and per share amounts)** | ** ** |
| Revenue                                                              |       | $                                                                                                               | 40,510     |   | $ | 43,955 |   | $ | 42,127 |   | $ | 46,811 |   | $ | 41,065 |   |
| Operating expenses                                                   |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Research and  development, including cost of revenue            |       | 99,768                                                                                                          |       | 81,011 |   | 68,349 |   | 63,466 |   | 89,612 |   |
| Selling, general  and administrative                                 |       | 25,206                                                                                                          |       | 20,118 |   | 20,187 |   | 17,178 |   | 18,685 |   |
| Impairment,  employee termination and other charges                  |       | —                                                                                                          |       | — |   | — |   | 951 |   | 64,790 |   |
| Total operating  expenses                                            |       | 124,974                                                                                                         |       | 101,129 |   | 88,536 |   | 81,595 |   | 173,087 |   |
| Operating loss                                                       |       | (84,464                                                                                                         | )          | (57,174 | ) | (46,409 | ) | (34,784 | ) | (132,022 | ) |
| Interest income                                                      |       | 6,685                                                                                                           |       | 6,397 |   | 2,903 |   | 1,151 |   | 2,954 |   |
| Interest expense                                                     |       | (7,808                                                                                                          | )          | (7,484 | ) | (8,983 | ) | (3,478 | ) | (3,079 | ) |
| Other non-operating  income and (expense), net                       |       | 114                                                                                                             |       | (4,489 | ) | (4,766 | ) | 1,988 |   | (72 | ) |
| Loss before  cumulative effect of change in accounting principle     |       | (85,473                                                                                                         | )          | (62,750 | ) | (57,255 | ) | (35,123 | ) | (132,219 | ) |
| Cumulative effect  of change in milestone revenue recognition method |       | —                                                                                                          |       | — |   | — |   | — |   | 333 |   |
| Net loss                                                             |       | $                                                                                                               | (85,473    | ) | $ | (62,750 | ) | $ | (57,255 | ) | $ | (35,123 | ) | $ | (131,886 | ) |
| Basic and diluted net  loss per share:                               |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Loss before  cumulative effect of change in accounting principle     |       | $                                                                                                               | (1.49      | ) | $ | (1.17 | ) | $ | (1.07 | ) | $ | (0.68 | ) | $ | (2.69 | ) |
| Cumulative effect  of change in milestone revenue recognition method |       | —                                                                                                          |       | — |   | — |   | — |   | 0.01 |   |
| Net loss                                                             |       | $                                                                                                               | (1.49      | ) | $ | (1.17 | ) | $ | (1.07 | ) | $ | (0.68 | ) | $ | (2.68 | ) |
| Shares used in computing  basic and diluted net loss per share       |       | 57,465                                                                                                          |       | 53,824 |   | 53,423 |   | 51,508 |   | 49,098 |   |

 

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| ** **                                              | ** ** | **As of December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                              | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                              | ** ** | **(In thousands)**               | ** ** |
| Cash and cash  equivalents                              |       | $                                     | 21,882     |   | $ | 65,943 |   | $ | 70,238 |   | $ | 68,669 |   | $ | 87,244 |   |
| Investments                                             |       | 130,134                               |       | 89,611 |   | 122,082 |   | — |   | — |   |
| Total  assets(1) (2)                               |       | 215,609                               |       | 206,758 |   | 288,252 |   | 183,475 |   | 213,417 |   |
| Total long-term  liabilities                            |       | 247,490                               |       | 190,572 |   | 197,950 |   | 49,874 |   | 56,533 |   |
| Total stockholders’  (deficit) equity (1) (2) |       | (55,379                               | )          | (9,337 | ) | 52,396 |   | 93,407 |   | 125,246 |   |
|                                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          In March 2002,deCODE completed the acquisition of MediChem Life Sciences, Inc.(MediChem) in a stock-for-stock exchange accounted for as apurchase transaction. Total consideration for the acquisition was $85,845,000.deCODE’s Statements of Operations include the results of MediChem from March 18,2002, the date of acquisition.

(2)          InJanuary 2006, deCODE completed the acquisition of Urdur Verandi Skuld ehf.(UVS) in stock-for stock exchange accounted for as a purchase transaction.Total consideration for the acquisition was $6,137,000. deCODE’s Statements ofOperations include the results of UVS from January 17, 2006, the date ofacquisition.

**Item 7.**                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*

This Management’s Discussion and Analysis of FinancialCondition and Results of Operations as of December 31, 2006 and for eachof the three years in the period then ended should be read in conjunction withthe audited consolidated financial statements and notes thereto set forthelsewhere in this report.

This Annual Report on Form 10-Kcontains forward-looking statements, including our expectations of futureindustry conditions, strategic plans and forecasts of operational results.Various risks may cause our actual results to differ materially. A list anddescription of some of the risks and uncertainties is contained below and inthe summary of risk factors included in Item 1A.

**Overview**

Headquartered in Reykjavik, Iceland, deCODE is abiopharmaceutical company applying its discoveries in human genetics to developdrugs and diagnostics for common diseases. Our population approach and resourcesenable us to isolate genes and drug targets directly involved in thedevelopment of many of the diseases which pose the biggest challenges to publichealth. We are turning these discoveries into a growing pipeline oftherapeutics and diagnostic tests taking aim at the causes of disease, not justthe signs and symptoms. As these diseases are common and current therapies areof limited effectiveness, we believe that our strategy represents a significantopportunity to create better medicine with major potential in the globalmarketplace.

We believe that deCODE’s advantage derives from ourpopulation approach to human genetics and the ability to apply this approachdirectly to drug and diagnostic development. In Iceland, we have comprehensivepopulation resources that enable our scientists to isolate key genes and genevariants contributing to common diseases. The proteins encoded by these genes,and other proteins with which they interact in the disease pathway, offer drugtargets that we believe are directly involved in the onset and progression ofdisease. Our work indicates that these genes confer risk by increasing ordecreasing the activity of common biological pathways, placing individuals on aspectrum of risk that encompasses the population as a whole. Small-moleculedrugs that can modulate the activity of the pathway in question may thereforehave broad potential utility, not only to those at highest risk but perhapsalso to those at average risk, which in the common diseases may be unacceptablyhigh. Moreover, these pathways often provide biomarkers that can be used toassess the efficacy of a compound from preclinical to mid-stage clinicaltesting.

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We are also applying our findings to create DNA-baseddiagnostics. Because such tests analyze the same links between geneticvariation and disease that we have used to identify drug targets, they can beemployed as an aid in developing more effective disease prevention strategiesby helping individuals to better understand their inherited risk of a givencondition, as well as to identify patients likely to respond well to a givendrug. We expect to begin offering DNA-based diagnostic testing early in thesecond quarter of 2007.

Through our chemistry and structural biology units, basedin the United States, we are able to discover novel small-moleculetherapeutic compounds, take candidate compounds through pre-clinical testing,and manufacture sufficient quantities for early-stage clinical trials.Our product development group, which has expertise in drug and diseasemodeling, designs and implements our clinical trials. We also actively explorein-licensing and co-development opportunities, and in certain programs havebrought directly into clinical trials compounds that address targets we haveidentified through our genetics research, but were originally developed byother companies for other indications.

deCODE has demonstrated its ability to discover noveltherapeutic targets and compounds in major indications. The company has alsoshown that it can efficiently advance these compounds into and throughmid-stage clinical trials providing a clear and detailed association to thebiology of disease.

At the beginning of 2007, we havecompleted and are analyzing the results of a Phase IIa clinical trial for DG041,our developmental anti-platelet compound for arterial thrombosis. Phase Istudies showed DG041 to be well-tolerated and to effectively reduce plateletaggregation without increasing bleeding time. The Phase II study is examiningsafety, tolerability, dosing, and the effect of various dose levels onbiomarkers of platelet activation in patients with peripheral artery disease,and we expect to initiate a second Phase II study in patients with othervascular disease by year end.

In deCODE’s program targeting the leukotriene pathwayfor the prevention of heart attack, we recently completed a Phase I single doseranging study for one of its developmental compounds, DG051, showing it to besafe and well-tolerated in the doses tested; to have a pharmacokinetic profilethat supports its suitability for once-a-day dosing; and to lower, in adose-dependent manner, levels of leukotriene B4, the pro-inflammatory biomarkerthat deCODE believes confers the increased risk of heart attack through thispathway. deCODE began a multiple-dose Phase I trial for DG051 early this yearand expects to begin Phase II testing by year end. We are currentlyreformulating the tablets for DG031, our Phase III compound for the preventionof heart attack, and expect to be in a position to restart our Phase IIItesting by year end or the first quarter of 2008. deCODE is conductingpreclinical drug discovery work on its targets in stroke and vascular disease,which are the most advanced of its preclinical programs.

deCODE has a partnership with Roche focused on thediscovery and development of PDE4 inhibitors for vascular disease, and apartnership with Merck in obesity. deCODE and Illumina, Inc. are workingtogether to develop DNA-based diagnostic kits utilizing deCODE’s genediscoveries in heart attack, type 2 diabetes and breast cancer and Illumina’splatform for SNP genotyping. The company is also actively exploring drugdevelopment partnerships in its most advanced therapeutic programs, in order tospread risk and cost, and to focus resources on the advancement of its drugdiscovery work and preclinical candidates.

deCODE also leverages its capabilities to provideservices to fee-paying customers. Our services and products include medicinalchemistry, process chemistry, structural biology, clinical trials, genotyping,and instruments and software. Revenue from these activities helps to supportour drug discovery and development infrastructure, and conserve our cashresources for use in our proprietary therapeutics programs

The goal of our business strategy is to maximize thecreation of value from our human genetics, drug discovery and diagnostics workand to capture that value for us and our stockholders. Our product 

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development pipeline nowincludes drug development programs in heart attack, and arterial thrombosis,and are advancing our diagnostics programs in type 2 diabetes, arterialfibrillation, heart attack and prostate and breast cancer. Executing on our strategy—advancingthese programs swiftly while continuing our discovery work in a broad range ofcommon diseases—requires us to spread risk and manage cost. We are constantlyevaluating the optimal balance between proprietary and partnered productdevelopment, the level of our investment in research and development, thedeployment of cash resources for product development, and the financingenvironment. As we invest in proprietary programs, we leverage our capabilitiesto form corporate alliances and to provide services to fee-paying customers. Wealso receive contract and grant funding from various governmental agencies. Wehave formed drug and other product development alliances with Roche, Merck, andIllumina, among others. Our chemistry subsidiary provides drug discovery andcontract manufacturing services to fee-for-service customers, and our otherservice offerings include protein crystallography products and instruments aswell as protein structure analysis contract services through our structural biologysubsidiary; clinical trials services through our Encode CRO; and DNA analysisservices through our genotyping laboratory in Reykjavik.

We derive revenues primarily from research funding andother fees from our service customers and collaborative partners, as well asfrom research grants. Milestone payments and upfront, exclusivity,technology-access and technology-development fees under our collaborationagreements constitute another source of our revenues. Our expenses consistprimarily of research and development expenses such as, salaries and relatedemployee costs, materials and supplies, and contractor services.

We believe that our ongoing work in genetics, theadvancement of our drug and diagnostic programs, and in particular the conductof clinical trials, will require significant ongoing expenditures. In 2006, wecompleted our Phase I dose-ranging, pharmacokinetic and safety clinical programfor DG041, our developmental anti-platelet compound for arterial thrombosis andconcluded a Phase IIa trial; filed an IND and conducted a single-dose rangingPhase I study for DG051 for the prevention of heart attack; concluded our PhaseII trial of Cephalon’s developmental compound CEP-1347 in asthma; anddesigned and initiated a Phase III trial for DG031 for the prevention of heartattack, a trial that we voluntarily suspended in October in order toaddress a formulation problem with the tablets. We are also developingreference-laboratory diagnostic testing services. We anticipate incurringadditional net losses at least through the next several years, due to, inaddition to the above-mentioned factors, depreciation and amortization, as wellas stock-based compensation and other non-cash charges. We expect that ourrevenues and losses will fluctuate from quarter to quarter and that suchfluctuations may be substantial, especially because progress in our scientificwork and milestone payments that are related to progress can fluctuate betweenquarters. We do not believe that comparisons of our quarter-to-quarterperformance are a good indication of future performance.

At December 31, 2006, we had $152.0 million incash, cash equivalents and investments and as we advance and broaden our drugdevelopment pipeline we will require significant additional capital for productdevelopment and so we will continue to investigate additional avenues offinancing. Our ability to obtain capital in the future will be affected byconditions in the global financial markets and in the pharmaceutical industry.We expect that more favorable conditions in those markets will presentopportunities for us, while downturns in the market valuations of biotechnologycompanies and of the equity markets more generally will restrict our ability toraise additional capital on attractive terms.

The difficulties facingthe pharmaceutical industry present for us both near-term challenges andsignificant longer-term opportunities. One of the main issues confronting bigpharmaceutical companies is their lack of promising new drugs to treat majorindications. As many leading brand-name drugs come off patent and face genericcompetition, developing successful new medicines will become critical forfilling the gap. We believe that companies such as ours may be well positionedto play an important role in filling the gap in the pipeline of new drugs,either alone or as partners of pharmaceutical companies. Recent 

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announcementsdemonstrate that the industry is already investing in the development of newtherapeutics based on our approach.

**Drug Development Programs**

The following is asummary of the development of our drug candidates in late pre-clinical orclinical development. Because of uncertainties involved in the drug developmentprocess, the actual timing for the events described below may differ materiallyfrom that provided in this summary.

·       Wehave two compounds in development for the prevention of heart attack. Theseprograms come out of our discovery of major risk variants in two genes encodingproteins in the leukotriene pathway. These variants—in the genes that code for 5-lipoxygenaseactivating protein (FLAP) and leukotriene A4 Hydrolase (LTA4H)—appear to conferrisk in the same way: by causing an upregulation in the production ofleukotriene B4, a potent pro-inflammatory molecule that is the end product ofone branch of the pathway. The therapeutic goal of both compounds is to inhibitthe activity of the pathway, lowering the production of LTB4 and therebydecreasing the inflammatory activity in atherosclerotic plaques and reducingthe risk of heart attack. DG051, discovered by deCODE’s chemistry unit, is asmall-molecule inhibitor of LTA4H, which is directly involved in the synthesisof LTB4. The results of our development work to date on DG051 indicates that itis well tolerated, provides potent inhibition of LTB4 production, is orallybioavailable, has potential for once-daily dosing, and appears to have minimalpotential for drug-interaction. We completed a single-dose ranging Phase Istudy for DG051 in December and have initiated a multiple dose rangingPhase I study. The results from this study demonstrated well-characterizedpharmacokinetic parameters and a reduction of LTB4 in a dose-dependent manner.

In May 2006 we begana Phase III clinical trial for DG031, an inhibitor of FLAP which we licensedfrom Bayer AG, but temporarily suspended this trial in October 2006 due toan unexpected formulation problem with the tablets. In routine testing ofclinical supplies we discovered that, over time, the drug tablets appeared todissolve more slowly, potentially providing lessening amounts of active drugthe longer they were stored. This raised the possibility that as the trialprogressed patients would be receiving too little drug, undermining the trial’schances of success. We are currently reformulating the compound to resolve thisissue and expect to be able to resume Phase III testing by year end or thefirst quarter of 2008.

·       DG041is being developed as a lesion-specific anti-platelet compound for theprevention of arterial thrombosis. DG041 is a first-in-class small moleculeinhibitor of the EP3 receptor for prostaglandin E2, a G-protein coupledreceptor (GPCR) encoded by a gene we have shown to be associated with increasedrisk of arterial disease. We believe that PGE2 may have additive stimulatoryeffects on platelet aggregation beyond those of other potent agonists such asADP or thromboxane A2, targeted by clopidogrel and aspirin, respectively. Inearly 2006, we concluded the Phase Iclinical program for DG041. Nearly 200 healthy subjects were exposed to DG041in these studies. The results of the Phase I program showed DG041 to bewell-tolerated across the entire dose range studied, and that DG041 caneffectively inhibit platelet aggregation in a dose-dependent manner withoutincreasing bleeding time. In the second quarter of 2006, we began a Phase IIaclinical trial that examined the effect of DG041 on certain plasma biomarkers. Weconcluded this trial at the end of 2006 and expect to present the data duringthe second quarter of 2007. Based on the results of our clinical trials thusfar, we believe that DG041 may offer a focused means of preventing theformation of thrombi, with anti-platelet activity specifically at the site ofatherosclerotic lesions.

·       In asthma, we completed aPhase IIa trial of Cephalon’s compound CEP-1347, originally developed fortreatment of Parkinson’s disease. This compound inhibits MAP3K9, a kinaseencoded by a gene we have linked to risk of asthma. In the Phase IIa trial wefound that the compound had a dose-

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related effect on bothlung function and biomarkers associated with lung inflammation and severity ofdisease in patients with asthma who were already being treated with inhaledcorticosteroids and long-acting beta agonist (LABA). Cephalon is currentlyreviewing clinical development plans for this compound.

·       Among our most advanced preclinical programs, we are pursuing aPDE4 inhibitor program for vascular disease/stroke pursuant to our 2004agreement with Roche and are working on identifying and advancing a leadpre-clinical compound.

We use many of our employee and infrastructureresources across several programs, and many of our research and developmentcosts are indirectly attributable to an individually named program or are directedbroadly to applicable research programs. However, taking into account coststhat are specifically attributable to individual programs and allocations ofour research and development program costs based upon those direct costs, wehave cumulatively invested $33.5 million, $16.0 million, $7.8 million and $8.8million in our heart attack (Myocardial Infarction, or MI), PAD, stroke andasthma programs, respectively, from the beginning of 2003 to date. Inceptionto-date costs are not available as these costs were not historically tracked byprogram. 

We have not applied for or received marketing approvalfrom the applicable regulatory authorities in any country for any of our drugcandidates. In order for us to achieve marketing approval in the United States,the FDA must conclude that our clinical data establish the safety and efficacyof our drug candidate. Other countries have similar requirements. Historically,the results from pre-clinical testing and early clinical trials (through PhaseII) have often not been predictive of success in later clinical trials.Many new compounds have shown promising results in early clinical trials, butsubsequently failed to establish sufficient safety and efficacy data to obtainnecessary marketing approvals. Additional risks and uncertainties involved inthe development and commercialization of any products are described above underthe caption “Risk Factors”. We expect that it will be several years, if ever,before we receive revenues from the commercial sale of our therapeuticproducts.

Furthermore, our strategy includes the option ofentering into collaborative arrangements with third parties to participate inthe development and commercialization of our products. Entering into acollaboration with a partner at any point in the development orcommercialization of a product is a business decision. When making thisdecision we do and will consider, among other matters, the complexity of theindication, the size, complexity and expense of necessary development and/orcommercialization efforts, competition in the market and size of the applicablemarket, an assessment of our own resources—financial and operational, and anassessment of the resources of a potential partner. In the event that we docollaborate on any of the above programs in the future, a partner will have alevel of control, which may be significant, over the pre-clinical developmentor clinical trial process for a product. As a result the completion date ofsuch a partnered program could largely be under control of that third partyrather than under our control. We cannot forecast with any degree of certaintywhich proprietary drug candidate will be subject to future collaborativearrangements or how such arrangements would affect our development plan or capitalrequirements.

As a result of theuncertainties discussed above, we are unable to determine the duration andcompletion costs of our research and development projects or when and to whatextent we will receive cash inflows from the commercialization and sale of aproduct.

**Acquisitions, JointDevelopment Programs and In-licensing**

As part of our business strategy, we continue toconsider joint development programs and merger and acquisition opportunitiesthat may provide us with products in late-stage development, intellectualproperty or financial resources or with capabilities that will help accelerateour downstream drug discovery efforts.

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*UVS.*   InJanuary 2006, we acquired all of the outstanding shares of Urdur VerdandiSkuld ehf. (“UVS”), a privately-held cancer research firm, from IcelandGenomics Corporation, Inc. (“IGC”), both companies having their principaloffices in Reykjavik, Iceland. As consideration for the purchase, we issued635,006 shares of deCODE common stock valued at $6,082,000 to IGC. Thisacquisition has enabled us to broaden our cancer program by applying our genediscovery and drug development efforts to a larger set of population resources.

*Illumina.*   InMay 2006, we entered into a strategic alliance with Illumina, Inc. (“Illumina”)to develop and commercialize molecular diagnostic products. Under the terms ofthe agreement, deCODE and Illumina will share development costs equally andsplit operating profits from the sales of diagnostic tests. Our initial focuswill be developing diagnostics for heart attack, breast cancer and type 2diabetes. Also as part of the agreement, we have installed Illumina’s SNPgenotyping platform to carry-out high-density, whole-genome studies utilizingour comprehensive population genetics resources in Iceland, thereby, enablingus to expand our contract genotyping business to offer Illumina’s platform andassay technologies together with our proprietary analytical services forcustomers.

In certain programs wehave taken advantage of the fact that drug targets we have identified throughour genetics research have already been employed by other companies to makedevelopmental compounds for other indications. By licensing these compounds orentering into co-development arrangements we have been able to leapfrog overseveral steps of drug discovery, entering directly into Phase II clinicaltrials. DG031, our most advanced compound for the prevention of heart attack,was licensed from Bayer HealthCare AG, which was initially developing it forasthma. We also recently concluded a Phase II trial in asthma, working withCephalon on their compound CEP-1347, originally developed for Parkinson’sdisease. We continue to investigate additional such possibilities forco-development of promising existing compounds that may effectively act againsttargets we have identified through our gene discovery work.

**Results ofOperations from the Years Ended December 31, 2006, 2005 and 2004**

Our results of operations have fluctuated from periodto period and may continue to fluctuate in the future based upon, among otherthings, the pace and progress of our proprietary research and clinicaldevelopment efforts, the timing and composition of funding under our variouscollaborative agreements, and the progress of our own research and developmentefforts. Results of operations for any period may be unrelated to results ofoperations for any other period. In addition, historical results should not beviewed as indicative of future operating results. We are subject to riskscommon to companies in our industry and at our stage of development, includingrisks inherent in our research and development efforts, reliance uponcollaborative partners, development by us or our competitors of newtechnological innovations, ability to market products or services, dependenceon key personnel, dependence on key suppliers, protection of proprietarytechnology, ability to obtain additional financing, ability to negotiate collaborativearrangements, and compliance with governmental and other regulations. In orderfor a product to be commercialized based on our research, we and ourcollaborators must conduct pre-clinical tests and clinical trials, demonstratethe efficacy and safety of our product candidates, obtain regulatory approvalsor clearances and enter into manufacturing, distribution and marketingarrangements, as well as obtain market acceptance. We do not expect to receiverevenues or royalties based on therapeutic or diagnostic products for a periodof years, if at all.

Financialhighlights as of and for the year ended December 31, 2006 include:

·       AtDecember 31, 2006, we had $152.0 million in cash, cash equivalents andinvestments compared to $155.6 million at December 31, 2005. The netutilization of our cash and investments in 2006 reflects principally the costsassociated with the advancement of our drug development programs as reflectedin the $85.2 million of cash we used in operating activities together with two financingcampaigns raising a combined net total of approximately $80.7 million.

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·       Researchand development expense was $57.1 million in 2006 as compared to $43.7 millionin 2005 and $24.9 million in 2004. These increases are principally the resultof costs associated with the advancement of our product development programs.In May 2006, we began a Phase III clinical trial for DG031 our leaddevelopmental compound for the prevention of heart attack, and then in October 2006we voluntarily suspended the trial in order to address an unexpectedformulation problem with the tablets. In August 2006 we began enrollingpatients in a Phase I clinical trial for DG051, our follow-on developmentcompound for the prevention of heart-attack. Earlier in 2006, we initiated aPhase IIa trial for DG041, our developmental compound in Peripheral ArteryDisease. Additionally, we have progressed proprietary pre-clinical programs instroke, obesity, and pain, among other indications. In August 2006 weinstalled the Illumina SNP genotyping platform and have begun our high-density,whole-genome studies utilizing the platform together with our comprehensivepopulation genetics resources in Iceland.

·       Ourrevenue was $40.5 million in 2006 as compared to $44.0 million in 2005 and$42.1 million in 2004. The decline of our revenue is due principally to loweralliance revenues in 2006, chiefly on account of the completion of the Merckobesity research program in September 2005 and the more recent completionof research funding under the 2002 agreement with Roche (June 2006).

·       InJuly we completed the sale of 6,000,000 shares of common stock at apurchase price of $5.00 per share for aggregate net proceeds, after costs ofthe transaction, of $27.8 million.

·       In November 2006 wecompleted the sale of $80,000,000 principal amount of 3.5% Senior ConvertibleNotes due 2011 at a price of 70% of par pursuant to Rule 144A under theSecurities Act of 1933. After the discount on the notes and the offering costswe received $52.9 million in cash. The 2006 Notes are convertible into deCODEcommon stock at an initial conversion rate of 71.4286 shares per $1,000principal amount of notes, equivalent to an initial conversion price of $14 pershare. deCODE may redeem the notes beginning April 20, 2009. The Noteshave the same interest rate and initial conversion price as the existing 3.5%Senior Convertible Notes due 2011 issued in April 2004 and otherwise havesubstantially similar terms. 

***Revenue***

Revenuefor the years ended December 31, 2006, 2005 and 2004 is as follows:

| ** ** | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared to 2005** | ** ** | **2005 as Compared to 2004** | ** ** |
|------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** ** | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                                | ** ** | **% Change**                                | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except %)** | ** ** |
| Revenue    |       | $                                           | 40,510     |       | $          | 43,955     |       | $                                                | 42,127     |                                             |       | $ | (3,445 | ) |   |   | (8 | )% |   |   | $ | 1,828 |   |   |   | 4 | % |   |
|            |            |                                             |            |            |            |            |            |                                                  |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our business strategy is focused on turning ourdiscoveries into new drugs and diagnostics for the treatment of commondiseases. At the same time, we leverage our capabilities to generate revenuethrough corporate alliances, through service contracts and increasingly throughresearch grants. In the majority of our programs we are pursuing drugdevelopment on our own. In certain others, we have formed alliances withpharmaceutical and biotechnology firms through which we can cover some of thecost of conducting basic research and spread the risk and investment involvedin product development. Increasingly, we have also sought and received researchgrant funding. We have entered into research, development, commercialization,and fee for service alliances and contracts across our business. Depending onthe nature of each prospective business opportunity, the key components of thecommercial terms of such arrangements typically include one or more of thefollowing: research funding; up-front, exclusivity, technology access, andtechnology development fees; fees for particular services; milestone payments;license or commercialization fees; and royalties or profit sharing from thecommercialization of products.

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Collaborationswith our most significant partners include:

***F.Hoffmann-La Roche (Roche)***

*Therapeutics.*   In2002, we entered into an agreement with Roche to collaborate on four diseasesthat had been the subject of an earlier collaboration with Roche. During 2004and through January 2005, we collaborated with Roche on two of thosediseases. Under this agreement we discovered genes linked to diabetes and Rochecontinues drug discovery based on one of these discoveries. Under the 2002agreement, which expired on February 1, 2005, we received $20.0 million inresearch funding and we are entitled to receive royalties on the sales of anydrugs that are developed coming out of work conducted under this agreement.

In November 2004, we signed a new three-yearagreement with Roche to co-develop inhibitors of PDE4 for the prevention andtreatment of vascular disease, including stroke. This agreement continues workadvanced under the 2002 agreement, and we will focus on optimizing leadcompounds identified under the previous agreement and beginning clinicaldevelopment. Under this agreement, as of the end of 2006, we received $4.0million of research funding. We will share drug discovery and clinical trialscosts under this new agreement, and we may receive an additional $2.0 millionof research funding over the remaining term of the agreement as well asmilestone payments and royalties based on drug sales.

*Diagnostics.**  *In June 2001, we signed afive-year alliance with Roche’s diagnostics division and through June 2006we collaborated to develop and market DNA-based diagnostics for major diseases.During the term of the alliance, which has now expired, we received $44.3million in research funding, up-front fees and milestone payments under theagreement and we may receive additional milestone payments upon the achievementof research and development milestones by Roche and royalties on the sales ofdiagnostic products developed by Roche.

Revenues from thesealliances with Roche amounted to $6.7 million, $10.0 million and $12.6 millionfor the years ended December 31, 2006, 2005 and 2004, respectively. Costsincurred with these collaborative programs with Roche amounted to $6.4 million,$8.3 million and $19.5 million for the years ended December 31, 2006, 2005and 2004, respectively.

***Merck &Co, Inc. (Merck)***

*Obesity.**  *In September 2002, we enteredinto a three year alliance with Merck aimed at developing new treatments forobesity. Under the alliance, we combined research efforts with Merck in thegenetics of obesity to identify, validate and prioritize a series of drugtargets to take into development. During the three-year research program, whichhas now expired, we have received research funding, technology access fees andmilestone payments in the aggregate amount of $26.3 million. In addition, wemay receive further technology access fees in the total aggregate amount of$1.0 million. Subject to Merck’s developing products based on collaborationdiscoveries, we may also receive development milestones and royalties. We havediscovered three genes linked to obesity under this alliance, and Merck hasgenerated a lead series of compounds against one of the targets we validatedthrough our genetics research.

Revenues from this alliance with Merck amounted $1.0million, $6.3 million and $7.9 million for the years ended December 31,2006, 2005 and 2004, respectively. Costs incurred in connection with thisalliance with Merck amounted to $0, $2.9 million and $4.6 million for the yearsended December 31, 2006, 2005 and 2004, respectively.

*Information-RichClinical Trials.**  *InFebruary 2004, we entered into an agreement with Merck which provides thatdeCODE will conduct information-rich clinical trials on a range of Merck’sdevelopmental compounds that Merck selects for inclusion in the program. Theterm of the alliance is seven years, subject to termination by Merck after fiveyears. The collaboration involved three agreements: (a) a License and 

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Research CollaborationAgreement; (b) a Stock and Warrant Purchase Agreement; and (c) aWarrant Agreement. Under the terms of the License and Research CollaborationAgreement, we will receive royalties on sales of drugs and diagnosticsdeveloped as part of the alliance, will receive milestone payments as compoundsor pharmacogenomic tests reach the market, will receive research funding forthe clinical development of compounds and pharmacogenomic analysis, andreceived a one-time technology access fee of $10.0 million. A contingencyclause on the technology access fee provides that if deCODE rejects the firsttwo non-exclusive development compounds that Merck presents to thecollaboration, then Merck has the right to request a refund of $2,500,000 ofthe technology access fee. The remaining amount of the technology access fee isnon-refundable. To date, Merck has not selected any compounds for developmentunder the agreement.

Revenues from thisalliance with Merck amounted to $0, $0.2 million and $0.8 million for the yearsended December 31, 2006, 2005 and 2004, respectively. Costs incurred inconnection with this alliance with Merck amounted to $0, $0.1 million and $1.3million for the years ended December 31, 2006, 2005 and 2004,respectively.

*Government ResearchContracts and Grant Funding*

We have received various research grants fromdivisions of the United States National Institutes of Health (NIH), theCommission of the European Communities (EC) and other government agencies andprivate foundations. Research grants for multiple years are based on approvedbudgets with budgeted amounts subject to approval on an annual basis. NIHgrants generally provide for 100% reimbursement of allowable expenditures whilegrants under the EC generally provides for fifty percent reimbursement ofallowable research and development related expenditures. Our significantresearch contracts include:

*NationalInstitutes of Allergy and Infectious Diseases (NIAID).**  *In September 2004, deCODE wasawarded a five-year $23,900,000 contract by the NIAID, a division of NIH. Underthe contract, deCODE will apply its population approach and resources todiscover genetic factors associated with susceptibility to certain infectiousdiseases and with responsiveness to vaccines targeting such diseases. deCODEmay receive $13.6 million in additional research funding over the remainingterm of the agreement.

For the years ended December 31, 2006, 2005 and2004, we recognized revenue of $16.7 million, $7.3 million and $2.0 millionfrom research grants. Costs incurred with research grants amounted to $19.1million, $7.7 million and $2.0 million for the years ended December 31,2006, 2005 and 2004, respectively.

Significantelements of our revenue are summarized as follows:

| ** **                                                                 | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                      | ** ** |
| Research funding  and service fees                                         |       | $                                                            | 18,907     |   | $ | 29,111 |   | $ | 31,723 |   |
| Milestone  payments                                                        |       | 702                                                          |       | 1,216 |   | 1,835 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | 2,000                                                        |       | 4,538 |   | 4,116 |   |
| Government  research contracts and grant funding                           |       | 16,734                                                       |       | 7,287 |   | 2,032 |   |
| Other                                                                      |       | 2,167                                                        |       | 1,803 |   | 2,421 |   |
|                                                                       |       | $                                                            | 40,510     |   | $ | 43,955 |   | $ | 42,127 |   |

 

Our revenue for the periods presented generally reflectsour strategic focus on proprietary drug discovery and development, includingthat performed under contracts and grants with the NIH and EC, and also a shiftaway from corporate funded research broadly. The decline in revenue in2006 is due principally to lower alliance revenues, principally on account ofthe completion of the Merck obesity research program in 2005 and the morerecent completion of research funding under the 2002 agreement with Roche(June 2006).

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At December 31, 2006we had $9.8 million in deferred revenue, compared to $12.3 million atthe close of the 2005. Of this deferred revenue, $6.2 million relates to ouragreement with Merck to conduct information-rich clinical trials in Icelandand, to date, Merck has not selected any compounds for development under theagreement. We expect that our revenues will fluctuate from period to period andthat such fluctuations may be substantial especially because progress in ourscientific work, including milestone payments that are related to progress, canfluctuate between periods.

***Cost of Revenue***

Costof revenue for the years ended December 31, 2006, 2005 and 2004 is asfollows:

| ** **      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared  to 2005** | ** ** | **2005 as Compared  to 2004** | ** ** |
|-----------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **      | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                            | ** ** | **% Change**                            | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)** | ** ** |
| Cost of Revenue |       | $                                           | 42,660     |       | $          | 37,263     |       | $                                            | 43,407     |                                         |       | $ | 5,397 |   |   |   | 14 | % |   |   | $ | (6,144 | ) |   |   | (14 | )% |   |
|                 |            |                                             |            |            |            |            |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our cost of revenue consists of the costs of servicesprovided to customers and collaborators and the costs of programs underresearch contracts and grants, including: (i) the entirety of the costsincurred in connection with programs that have been partnered and on which wereceive research funding; (ii) costs associated with other service feerevenues; and (iii) the total amount of those costs incurred in connectionwith discovery and development work performed under research contracts andgrants.

At times, we invested in addition to costs covered byresearch funding received in such collaborative programs and in addition tomonies received under research contracts and grants.

Increases in our cost of revenue for 2006 as comparedto 2005 are largely on account of (i) the shift away from corporate fundedresearch broadly, but specifically the completion of the Merck obesity researchprogram and more recently the completion of research funding under the 2002agreement with Roche, and also (ii) the growing amount of discovery anddevelopment work performed under ongoing contracts and grants with the NIH andEC, including those obtained in connection with the acquisition of UVS in January 2006.Of late, some of the growth in the cost of discovery and development workperformed under contracts and grants with the NIH and EC is due to thebeginnings of our high-density, whole-genome studies utilizing the Illumina SNPgenotyping platform and our comprehensive population genetics resources inIceland. Further, in 2006 we conducted a Phase II trial in asthma for acompound developed by Cephalon and we have stepped-up our continuing efforts inthe PDE4 inhibitor program for vascular disease/stroke pursuant to our 2004agreement with Roche.

Our cost of revenue for 2006 as compared to 2005 hasincreased principally due to the greater usage of chemicals and consumables($5.6 million) primarily related to beginning our high-density, whole-genomestudies, offset somewhat by a decrease in contractor services ($0.8 million)and depreciation and amortization ($0.6 million). Also, our cost of revenue for2006 now includes stock-based compensation expense under SFAS 123R ($0.6million).

Our cost of revenue,including costs incurred in connection with collaborative programs in 2005 ascompared to 2004 included (i) an overall decrease in direct salary andemployee related expenses ($0.9 million), (ii) less in chemicals andconsumables ($1.3 million), which drove (iii) lower allocation ofoverheads ($0.4 million) and depreciation and amortization ($4.4 million) andalso an increase in contractor services ($0.9 million). The lower depreciationand amortization was also due to the sale-leaseback of our facilities inIceland during 2005 which reduced our depreciation expense.

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***Research and Development***

Researchand development for the years ended December 31, 2006, 2005 and 2004 is asfollows:

| ** **                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared  to 2005** | ** ** | **2005 as Compared  to 2004** | ** ** |
|---------------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                            | ** ** | **% Change**                            | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                | ** ** | **(In thousands, except %)** | ** ** |
| Research and  Development |       | $                                           | 57,108     |       | $          | 43,748     |       | $                                            | 24,942     |                                         | $          | 13,360 |   |   | 31 | % |   | $ | 18,806 |   |   | 75 | % |   |
|                           |            |                                             |            |            |            |            |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in our research and development expensesresults from our emphasis on and increasing expenditures in productdevelopment, including pre-clinical and clinical work on our lead drugdiscovery and development programs and DNA diagnostics. In May 2006, webegan a Phase III clinical trial for DG031, our lead developmental compound forthe prevention of heart attack, and then in October 2006 voluntarilysuspended the trial in order to address an unexpected formulation problem withthe tablets. In August 2006 we began enrolling patients in a Phase Iclinical trial for DG051, our follow-on development compound for the preventionof heart-attack. Earlier in 2006, we initiated, and have substantiallyconcluded, a Phase IIa clinical trial for DG041, our lead anti-plateletcompound for the prevention of arterial thrombosis. Additionally, we haveprogressed proprietary pre-clinical programs in stroke, inflammation, obesityand pain, among other indications. More recently, we have installed theIllumina SNP genotyping platform and have begun our high-density, whole-genomestudies utilizing the platform together with our comprehensive populationgenetics resources in Iceland. Based upon the range of our current research anddevelopment activities but excluding any significant new collaborations, webelieve that our overall investment in research and development for the fiscalyear 2007 may be in the range of $55 to $60 million.

Ourresearch and development expenses for the years ended December 31, 2006,2005 and 2004 consist of the following:

| ** **                                       | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Salaries and  other personnel costs              |       | $        | 20,597     |     | $          | 18,072   |       | $ | 10,233 |   |
| Materials and  supplies                          |       | 7,495    |       | 4,600    |       | 3,671    |       |
| Contractor  services and other third party costs |       | 19,109   |       | 13,285   |       | 3,938    |       |
| Overhead expenses                                |       | 5,107    |       | 4,630    |       | 1,603    |       |
| Depreciation and  amortization                   |       | 3,287    |       | 3,089    |       | 5,123    |       |
| Stock-based  compensation                        |       | 1,513    |       | 72       |       | 374      |       |
|                                             |       | $        | 57,108     |     | $          | 43,748   |       | $ | 24,942 |   |

 

Increases in research anddevelopment costs of our proprietary programs (e.g., contractor services andother third party costs, salaries and related costs, and usage of materials andsupplies) may continue, particularly as we advance our clinical development andproprietary drug development programs. However, we have voluntarily suspendedour Phase III clinical trial for DG031 and are beginning re-formulation work. Thissuspension may serve to reduce the rate of acceleration of the increases in ourresearch and development costs, and even reduce the overall cost of ourresearch and development expenses as we enter into 2007. Additionally, in 2006we began our high-density, whole-genome studies utilizing the Illumina SNPgenotyping platform, we granted salary increases to our personnel and during2005 added clinical development executives to our staff, actions which wouldgenerally contribute to future increases in our research and development costs.Further, our cost of research and development for proprietary programs in 2006now also includes stock-based compensation expense under SFAS 123R.

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***Selling, General and Administrative Expenses***

Selling,general and administrative expenses for the years ended December 31, 2006,2005 and 2004 are as follows:

| ** **                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared  to 2005** | ** ** | **2005 as Compared  to 2004** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                            | ** ** | **% Change**                            | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In thousands, except %)** | ** ** |
| Selling, General  and Administrative |       | $                                           | 25,206     |       | $          | 20,118     |       | $                                            | 20,187     |                                         |       | $ | 5,088 |   |   |   | 25 | % |   |   | $ | (69 | ) |   |   | — | % |   |
|                                      |            |                                             |            |            |            |            |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Increases in our selling,general and administrative expenses for 2006 compared to 2005 is the resultprincipally of legal fees incurred in relation to our lawsuit to protectintellectual property ($3.9 million). In addition, our selling, general andadministrative expenses include a $0.8 million gain on the sale of property.Further, our selling, general and administrative expense now also includesstock-based compensation expense under SFAS 123R ($2.2 million). Ourselling, general and administrative expenses for 2005 compared to 2004 wereessentially unchanged, with relatively small increase in some cost categoriesoffset with decreases in other cost categories but with no general or specifictrend thereof. 

***Interest Income***

Interestincome for the years ended December 31, 2006, 2005 and 2004 is as follows:

| ** **      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared  to 2005** | ** ** | **2005 as Compared  to 2004** | ** ** |
|-----------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **      | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                            | ** ** | **% Change**                            | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)** | ** ** |
| Interest Income |       | $                                           | 6,685      |       | $          | 6,397      |       | $                                            | 2,903      |                                         |       | $ | 288 |   |   |   | 5 | % |   |   | $ | 3,494 |   |   |   | 120 | % |   |
|                 |            |                                             |            |            |            |            |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest income hasincreased in 2006 as compared to 2005 and 2004. Our interest income is afunction of both the balance of our cash and investments (which generally havebeen declining as resources are deployed in operations but then added to withtwo financing campaigns in 2006) and the rate of return we are able to garnerunder our investment policy (which average rate of return has been increasingin 2006). We expect to use our cash and investments principally for advancingour discovery and development programs. In the meantime, we will invest themonies received in accordance with our policy, having the objective ofpreserving principal and maintaining a high degree of liquidity to meetoperating needs and obtaining competitive returns subject to prevailing marketconditions. We expect to maintain our portfolio of cash equivalents andinvestments in a variety of securities, including auction rate securities,commercial paper, money market funds, mutual fund investments and governmentand non-government debt securities.

***Interest Expense***

Interestexpense for the years ended December 31, 2006, 2005 and 2004 is asfollows:

| ** **       | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared  to 2005** | ** ** | **2005 as Compared  to 2004** | ** ** |
|------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **       | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                            | ** ** | **% Change**                            | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest Expense |       | $                                           | 7,808      |       | $          | 7,484      |       | $                                            | 8,983      |                                         |       | $ | 324 |   |   |   | 4 | % |   |   | $ | (1,499 | ) |   |   | (17 | )% |   |
|                  |            |                                             |            |            |            |            |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest expense hasincreased in 2006 as compared to 2005 and decreased as compared to 2004. Ourinterest expense is primarily attributable to interest on our 3.5% SeniorConvertible Notes due in 2011 that we issued in April 2004 ($150 millionof principal at a full par price) and then again in November 2006 

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(afurther $80 million of principal at a price of 70% of par). With the additional$80 million of notes added in 2006, our future cash interest payments will beapproximately $8.1 million on an annual basis for the Senior Convertible Notes.Taking into account also the accretion of the discount of the notes and theamortization of offering costs, our total interest expense related to theSenior Convertible Notes is expected to be approximately $14.0 million for2007.

***Other Non-Operating Income and Expense, Net***

Othernon-operating income and expense for the years ended December 31, 2006,2005 and 2004 is as follows:

| ** **                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 as Compared  to 2005** | ** ** | **2005 as Compared  to 2004** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **$ Change**                            | ** ** | **% Change**                            | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **(In thousands, except %)** | ** ** |
| Other  Non-Operating Income and Expense, Net |       | $                                           | 114        |       | $          | (4,489     | )          | $                                            | (4,766     | )                                            |       | $ | 4,603 |   |   |   | 103 | % |   |   | $ | 277 |   |   |   | 6 | % |   |
|                                              |            |                                             |            |            |            |            |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our other non-operating income and expense, includesthe net impact of foreign exchange in 2006. In 2005 and 2004 othernon-operating income and expense, net consists of the net impact of foreignexchange, unrealized and realized gains and losses on derivative financialinstruments and, in 2005, loss on early extinguishment of debt and a realizedloss on the sale of investments.

As a consequence of the nature of our business andoperations, our reported financial results and cash flows are exposed to therisks associated with fluctuations in the exchange rates of the U.S. dollar,the Icelandic krona and other world currencies. The net impact of foreignexchange on the translated amount of our non-US dollar denominated liabilities,net together with transaction gains and losses, amounted to a gain (loss) of$0.1  million, $(0.1) million and $(3.3)million in 2006, 2005 and 2004, respectively

Our losses on derivative financial instruments in 2005($0.2 million) resulted from three forward foreign currency exchange options weentered into as economic hedges against foreign exchange rate fluctuations onour ISK-denominated operating expenses but that did not qualify for hedgeaccounting. Our losses on derivative financial instruments in 2004 stem fromthe two cross-currency swaps we entered into as economic hedges against foreignexchange rate fluctuations on our foreign currency debt but that did notqualify for hedge accounting. In March 2004, we liquidated our twocross-currency swaps receiving $9.7 million in proceeds. We realized a loss onthis early termination that, together with unrealized losses on the swapsduring the 2004, amounted to $1.5 million.

As a result of having prepaid the short and long-termdebts that were secured by mortgages on Sturlugata 8 we recorded a loss onearly extinguishment debt during 2005 amounting to $3.1 million and consistingof (i) prepayment fees ($1.4 million), (ii) write-off of remainingunamortized finance costs ($1.4 million), and (iii) remainingunamortized discount on the long-term debt ($0.3 million).

In December 2005, wesold investments and realized a loss on the sale of $1.0 million.

**Liquidity andCapital Resources**

We have financed our operations primarily throughfunding from research and development collaborative agreements, and theissuance of equity securities and long-term financing instruments ($950.9 millionfrom the beginning of 1999 to-date). Future funding under terms of our existingagreements is approximately $46 million excluding milestone payments,royalties and other payments that we may earn under such collaborations. Of the$46 million, approximately $27 million is expected to be received in2007, with the remaining amount due through 2010.

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We make significant investments in proprietaryresearch and development and we incur the costs of such activities. In the nearterm, this requires us to devote resources to our in-house drug and clinicaldevelopment which we believe will better position us to capture the most valueto us in our discoveries. As we identify promising discoveries for furtherdevelopment, we may choose to continue the development ourselves into andthrough clinical trials, regulatory approvals, manufacturing, distribution andmarketing. In other cases we are or will be working to varying degrees withpartners. The decisions we make as to these matters will affect our cashrequirements.

Our cash requirements depend on numerous factors,including the level and timing of our research and development expenditures;our ability: to access the capital markets; to obtain new research anddevelopment collaboration agreements; to obtain and maintain contract serviceagreements in our pharmaceuticals, biostructures, clinical research trials andgenotyping service groups; expenditures in connection with alliances, licenseagreements and acquisitions of and investments in complementary technologiesand businesses; competing technological and market developments; the cost offiling, prosecuting, defending and enforcing patent claims and otherintellectual property rights; the purchase of additional capital equipment; andcapital expenditures at our facilities. Changes in our research and developmentplans, notably the entry into clinical trials of drugs based on ourdiscoveries, or other changes affecting our operating expenses may result inchanges in the timing and amount of expenditures of our capital resources.

At December 31,2006, we had $152.0 million of cash, cash equivalents and investments. Excludingany significant new alliances or financing activities, we believe that ouroverall use of cash resources in 2007 may be in the range of $75 to $85million. As we advance and broaden our drug development pipeline we willrequire significant additional capital for product development and so we willcontinue to investigate additional avenues of financing, such as further publicor private equity offerings, additional debt financing, other forms offinancing or added collaborations and licensing arrangements. However, noassurance can be given that additional financing or collaborations andlicensing arrangements will be available when needed, or that if available,will be obtained on favorable terms. If adequate funds are not available whenneeded, we may have to curtail operations or attempt to raise funds onunattractive terms.

| ** **                                   | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                      | ** ** |
| **Cash provided by (used in):**              |       |                                                         |       |   |   |   |   |
| Operating  activities                        |       | $                                                            | (85,179    | ) | $ | (54,033 | ) | $ | (29,936 | ) |
| Investing  activities                        |       | (44,424                                                      | )          | 95,832 |   | (124,653 | ) |
| Financing  activities                        |       | 85,542                                                       |       | (46,094 | ) | 156,158 |   |
| Cash and cash equivalents,  at end of period |       | 21,882                                                       |       | 65,943 |   | 70,238 |   |
|                                              |            |                                                              |            |  |  |  |  |  |  |  |

 

*Cashand Cash Equivalents.**  *AtDecember 31, 2006, we had $21.9 million in cash and cash equivalents.Together with our investments at December 31, 2006 ($130.1 million),this balance ($152.0 million) is $3.5 million less than at December 31,2005. Significant cash flows during the year ended December 31, 2006include, the net proceeds from the sale of 3.5% senior convertible debt ($52.9 million),net proceeds from the sale of 6.0 million shares of our common stock ($27.7million), capital expenditures ($6.3 million), the net proceeds from the saleand leaseback financing of equipment and other equipment financings ($5.9million) and costs associated with the advancement of our drug developmentprograms as reflected in the $85.2 million of cash we used in operatingactivities during the year ended December 31, 2006.

Available cash is investedin accordance with our investment policy having primary objectives of liquidityand safety of principal while maximizing the income we receive from ourinvestments without significantly increasing risk. Our cash is deposited onlywith financial institutions in Iceland, the United 

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Kingdom and the UnitedStates having a high credit standing (A-/A3 or better). We expect to maintainour portfolio of cash equivalents and investments in a variety of securities,including auction rate securities commercial paper, money market funds, mutualfund investments and government and non-government debt securities.

At December 31, 2006, our cash is largelyinvested in U.S. dollar denominated money market and checking accounts and alsoin Icelandic krona denominated accounts. At December 31, 2006, ourinvestments are in auction rate securities, a municipal bond, US governmentsecurities and a corporate bond.

*OperatingActivities.*   Net cash used in operatingactivities increased to $85.2 million for the year ended December 31, 2006as compared to $54.0 million for the year ended December 31, 2005 and$29.9 million for the year ended December 31, 2004. As morefully described above, the increase in use of cash in operating activities ismost importantly attributable to the significant research and developmentinvestments being made in advancing our drug and clinical development programs.The balance of our deferred revenue has decreased during 2006 as we recognizerevenue as work progresses under collaborative contracts with significantup-front monies paid.

*InvestingActivities.*   Our investing activities haveconsisted of short-term investments in marketable securities (consisting mainlyof auction rate securities, US government securities and in an intermediateterm bond mutual fund) and capital expenditures. Additionally, in 2006, wepurchased UVS and, in doing so, we acquired $1.3 million of cash to be used tofund the acquired liabilities of UVS. Also, in 2005 we completed the sale andleaseback of our Reykjavik, Iceland facilities at Sturlugata 8 and Krokhals 5Dand 5E. In July 2006, we commenced installation of Illumina SNP genotypingplatform and financed the equipment purchased ($4.1 million) with a thee-yearcapital lease with an Icelandic financial institution. With the exception ofthe Illumina equipment purchase, we principally made replacement capitalexpenditures during 2006, 2005 and 2004 and invested in certain computer andlaboratory equipment. We have experienced an increase in the pace ofnecessary capital expenditures and this trend may continue. Although we believewe will continue to make largely replacement capital expenditures in thenear-term, net cash used in investing activities may in the future fluctuatesignificantly from period to period due to timing of our capital expendituresand other investments as well as changing business needs.

*FinancingActivities.*   Net cash of $85.5 million wasprovided by financing activities in the year ended December 31, 2006, ascompared to $46.1 million that was used in the year ended December 31,2005 and $156.2 million that was provided in the year ended December 31,2004.

More significant financing activities for the yearended December 31, 2006, include our sale of $80,000,000 principal amountof 3.5% Senior Convertible Notes due 2011 at a price of 70% of par (netting $52.9million), our sale of 6,000,000 shares of common stock (netting $27.7 million),the sale-and-leaseback of Illumina and other equipment and proceeds from otherequipment financings ($5.9 million) and debt service ($2.8 million).

Financing activities for the year ended December 31,2005 largely consisted of prepayments of short and long-term debts secured bymortgages on Sturlugata 8 ($38.6 million), prepayments of long-term debtssecured by mortgages on Krokhals 5D and 5E ($1.8 million) refinancing of themortgage on our Woodridge, IL facility ($4.0 million) which freed-up $6.0million of previously restricted cash (reflected above in investingactivities), the sale-and-leaseback of certain equipment ($1.2 million) andother debt service ($3.0 million).

In February 2007, we entered into an agreementregarding the sale and leaseback of our property (land and facility)in Woodridge, Illinois. Pursuant to the agreement and subject to thesatisfaction of contingencies including, without limitation, negotiation of asatisfactory lease, we will sell the Woodridge property for $25,000,000 in cashand lease the property back under a 17 year lease at an initial rent of 

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$163,000 per month,subject to annual rent increases of 2.5%. Under the lease contemplated bythe agreement, we will have two 5 year renewal options with rent at the thenprevailing market rate. The lease will be an absolute net lease and we willcontinue to pay all expenses relating to the property, including taxes,utilities, insurance and maintenance. Our obligations under the lease areto be secured by a letter of credit in the amount of $5,000,000. The agreementregarding the sale and leaseback of the property is subject to the satisfactionof various contingencies, including, without limitation, the negotiation of asatisfactory lease, the buyer’s ability to obtain financing for its purchase ofthe property and the buyer’s satisfaction with its due diligence review of theproperty. The transaction is expected to close in May 2007 if suchcontingencies are satisfied, however, in light of the contingencies, there canbe no assurance that the closing will occur.

*Contractual Commitmentsand Off-Balance Sheet Arrangements.**  *The following summarizes ourcontractual obligations at December 31, 2006, and the effects suchobligations are expected to have on our liquidity and cash flows in futureperiods:

| ** **                                         | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Total**                                 | ** ** | **Less Than  1 Year** | ** ** | **1-2 Years** | ** ** | **2-3 Years** | ** ** | **3-4 Years** | ** ** | **4-5 Years** | ** ** | **More Than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                   | ** ** |
| 3.5% Senior  convertible notes, including interest |       | $                                         | 266,225    |   |   | $ | 8,050 |   |   | $ | 8,050 |   | $ | 8,050 |   | $ | 8,050 |   | $ | 234,025 |   |   | $ | — |   |   |
| Long-term debt,  including interest (1)            |       | 7,340                                     |       |   | 1,089 |   |   | 5,902 |   | 272 |   | 77 |   | — |   |   | — |   |   |
| Capital lease  obligations, including interest     |       | 6,103                                     |       |   | 2,418 |   |   | 2,286 |   | 1,399 |   | — |   | — |   |   | — |   |   |
| Operating leases  (2)                              |       | 63,245                                    |       |   | 5,131 |   |   | 4,921 |   | 4,829 |   | 4,706 |   | 4,706 |   |   | 38,952 |   |   |
| Total                                              |       | $                                         | 342,913    |   |   | $ | 16,688 |   |   | $ | 21,159 |   | $ | 14,550 |   | $ | 12,833 |   | $ | 238,731 |   |   | $ | 38,952 |   |   |

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(1)          Balance includes a $5,611,000mortgage loan at December 31, 2006, which has a variable interest rate ofLIBOR + 2.25% (7.62% at December 31, 2006). A hypothetical 100 basis pointincrease or decrease in the interest rate would result in an increase of ourinterest payments related to this amount of approximately $0.06 millionper year.

(2)          Balance includes$62,482,000 of Icelandic krona (ISK) denominated lease obligations which arevariable based on the exchange rate of the ISK versus the U.S. dollar and alsothis amount is subject to periodic adjustments based on the Icelandic Consumer PriceIndex (ICPI). A hypothetical 10% increase or decrease in the ISK and U.S.dollar exchange rate would result in an increase or decrease of our annuallease payments of $0.4 million. A hypothetical 100 basis point increase ofthe ICPI would result in an increase or decrease of our annual lease paymentsof $0.04 million.

Under the terms of certain technology licensingagreements, deCODE is obligated to make payments upon the achievement ofestablished milestones leading to the discovery of defined products. Thesepayments could total $5.0 million, with the timing of payments not determinableat the current time. These potential payments are not included in the abovetable.

All material intercompanybalances and transactions have been eliminated. We do not have any othersignificant relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. As such, we are not exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.Additionally, holders of our 3.5% senior convertible notes may elect to converttheir notes into shares of our common stock at any time at a price of $14.00per share.

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**Critical AccountingPolicies**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of America(GAAP) requires us to make certain estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingent assetsand liabilities at the date of the financial statements, and the reportedamounts of revenues and expenses during the reported period. On an ongoingbasis we evaluate our estimates, which include, among others, those related torevenue recognition, property and equipment, goodwill and intangible assets,materials and supplies, derivative financial instruments, income taxes,litigation and other contingencies. We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form our basis for makingjudgments about carrying values of assets and liabilities that are not readilyapparent from other sources. The impact and any associated risks related tothese and our other accounting policies on our business or operations isdiscussed throughout “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” where such policies affect our reportedand expected financial results. For a detailed discussion on the application ofthese and other accounting policies, please refer to our notes to theConsolidated Financial Statements. There can be no assurance that actualresults will not differ from the estimates referred to above.

We believe the followingpolicies to be the most critical to an understanding of our financial conditionand results of operations because they require us to make estimates,assumptions and judgments about matters that are inherently uncertain.

***Collaborations and Revenue***

Our collaborative arrangements and the recognition ofrevenue in such arrangements is the accounting policy most critical to us. Asubstantial portion of our revenues relate to funded research collaborations.Our revenues from research and development collaboration agreements arerecorded and recognized in accordance with the applicable performancerequirements and terms of the respective contracts, generally either (i) ascontract research costs are incurred, usually ratably over the period ofeffort, (ii) according to the level of efforts expended based on the ratioof contract research costs incurred to expected total costs, or (iii) uponthe achievement of substantive milestones. Our accounting recognition policieswith respect to each significant element of our revenue is summarized asfollows:

*Researchfunding and other service fees.*   Research fundingis recognized as earned, typically ratably over the period of effort. Fundingpayments are not refundable in the event that the related efforts are notsuccessful. Other service revenues from negotiated rate contracts arerecognized based upon the terms of the underlying contract generally either (i) ona per diem basis as services are rendered; (ii) on the basis of effortsexpended, generally upon the ratio of costs incurred to total expected costs ofproviding the service; or (iii) upon completion of the service rendered.Any losses on contracts are provided for when they are determinable. Includedin revenue are billings to customers for the cost of materials purchased bydeCODE.

*Milestonepayments.*   Under the substantive milestone methoddeCODE records revenue when the milestone has been achieved and payment is dueand payable under the terms of the respective agreement and deCODE recognizesrevenue when acknowledgement of achievement of applicable performancerequirements is received from the collaborator. Milestone payments without theabove characteristics are recognized on a retrospective basis over thecontractual term of the underlying agreement.

In arrangements with multiple elements, if the milestoneis substantive in nature and there is uncertainty in the achievement of themilestone and there is no further obligation on the part of deCODE, deCODErecords revenue when the milestone has been achieved and payment is due andpayable under the terms of the respective agreement and deCODE recognizesrevenue when acknowledgement of achievement of applicable performancerequirements is received from the collaborator (“Milestone 

55

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Payment Method”). If themilestone is earned and there is further obligation under the contract forperformance by deCODE, then deCODE will record revenue when the milestone hasbeen achieved and payment is due and payable under the terms of the respectiveagreement and deCODE retroactively recognizes revenue through the currentperiod based on the total contractual term and amortizes the balance over theremaining contractual term.

*Up-front,exclusivity, technology access, and technology development fees.*   Werecognize revenue from non-refundable fees not specifically tied to a separateearnings process ratably over the expected customer relationship period orestimated period of performance. Changes in estimates could impact revenue inthe period the estimate is changed. If our estimate of the period ofperformance shortens or lengthens, the amount of revenue we recognize from suchnon-refundable fees not specifically tied to a separate earnings process couldincrease or decrease in the period the change in estimate becomes known; futurerelated revenues would be adjusted accordingly.

Revenue estimates arereviewed and revised throughout the lives of our contracts and are made basedupon current facts and circumstances. If changes in these estimates or othermaterial adjustments to revenue are identified, the adjustments to profitsresulting from such revisions will be recorded on a cumulative basis in theperiod in which the revisions are made.

***Long-Lived Assets, Goodwill and Intangibles***

We periodically reviewproperty and equipment, goodwill and intangibles for potential impairments andto assess whether their service lives have been affected by continuedtechnological change and development. There were no events in 2006, 2005 and2004 that triggered an impairment review nor did our annual review of goodwillindicate any recoverability issues. Should we determine that there has been animpairment of our fixed assets, goodwill or other intangible assets in thefuture we would suffer an increase to our net loss or a reduction of our netincome in the period such a determination is made. In light of experience andthe current technological environment, in 2004 we changed certain of oursalvage value and useful life estimates for equipment and furniture andfixtures for purposes of depreciation. These changes in estimates had the effectof increasing depreciation expense in 2004 by $2.2 million. Should wedetermine that the pace of technological change or other matters dictate thatwe change the service lives or other estimates inherent in determining thecarrying-values of our long-lived assets, there will be an impact ondepreciation expense from the date of the change. 

***Litigation and Other Contingencies***

We consider litigation andother claims and potential claims or contingencies in preparing our financialstatements under generally accepted accounting principles in the United Statesof America. We maintain accruals for litigation and other contingencies when webelieve a loss to be probable and reasonably estimated. In doing so, we assessthe likelihood of any adverse judgments or outcomes with respect to legal andother matters as well as potential of probable losses. We base our accruals oninformation available at the time of such determination. Changes ordevelopments in the relevant action or our strategy in such proceedings could materiallyaffect our results of operations for any particular quarterly or annual period.Since the recognition of a loss is dependent upon factors not completely in thecontrol of management, timing of a charge, if any, is difficult to predict withcertainty.

***Share Based Payments***

We grant stock options to purchase our common stock toour employees and directors under our 2002 and 2006 Equity Incentive Plans. Thebenefits provided under these plans are subject to the provisions of Statementof Financial Accounting Standards No. 123R (“SFAS 123R”), *Share-Based Payment*, which we adopted effective January 1,2006. We elected to use the modified prospective application in adopting 

56

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SFAS 123R andtherefore have not restated results for prior periods. The valuation provisionsof SFAS 123R apply to new awards and to awards that are outstanding on theadoption date and subsequently modified or cancelled. Our results of operationsfor the year ended December 31, 2006 were impacted by the recognition ofnon-cash expense related to the fair value of our share-based compensationawards. Share-based compensation expense recognized under SFAS 123R forthe year ended December 31, 2006 was $4.3 million.

Stock option awards and restricted stock unitsgenerally vest over a three to four year period and expense is ratablyrecognized over those same time periods. The determination of fair value ofstock-based payment awards on the date of grant using the Black-Scholes modelis affected by our stock price, as well as the input of other assumptions.These assumptions include, but are not limited to, the expected term of stockoptions and our expected stock price volatility over the term of the awards.Changes in the assumptions can materially affect the fair value estimates.

SFAS 123R requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. If actualforfeitures vary from our estimates, we will recognize the difference in compensationexpense in the period the actual forfeitures occur or when options vest. 

***Recent Accounting Pronouncements***

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48,*Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(“FIN 48”). FIN 48 clarifies the accounting for uncertainties in incometaxes recognized in an enterprise’s financial statements. FIN 48 requirescompanies to determine whether it is more likely than not that a tax positionwill be sustained upon examination by the appropriate taxing authority. If atax position meets the “more likely than not” recognition criteria, FIN 48requires the tax position be measured at the largest amount of benefit greaterthan 50 percent likely of being realized upon ultimate settlement. Thisaccounting standard is effective for fiscal years beginning after December 15,2006. deCODE is evaluating the impact of FIN 48 on its financial position,results of operations and cash flows.

In September 2006, the FASB issued SFAS No. 157,*Fair ValueMeasurements* (“SFAS 157”),which establishes a framework for measuring fair value and expands disclosuresabout the use of fair value measurements and liabilities in interim and annualreporting periods subsequent to initial recognition. Prior to the issuance ofSFAS 157, which emphasizes that fair value is a market-based measurement andnot an entity-specific measurement, there were different definitions of fairvalue and limited definitions for applying those definitions under generallyaccepted accounting principles. SFAS 157 is effective for the Company on aprospective basis for the reporting period beginning January 1, 2008.deCODE is evaluating the impact of SFAS 157 on its financial position,  results of operations and cash flows.

In February 2007 the FASB issued Statement No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS No. 159”). SFAS No. 159expands opportunities to use fair value measurement in financial reporting andpermits entities to choose to measure many financial instruments and certainother items at fair value. This Statement is effective for fiscal yearsbeginning after November 15, 2007. deCODE has not decided if it will earlyadopt SFAS 159 or if it will choose to measure any eligible financial assetsand liabilities at fair value.

In September 2006,the Securities and Exchange Commission (“SEC”) issued Staff Accounting BulletinNo. 108,*Considering the Effects of Prior Year MisstatementsWhen Quantifying Misstatements in Current Year Financial Statements* (“SAB108”) which provides guidance on quantifying and evaluating the materiality ofunrecorded misstatements. SAB 108 was effective for fiscal years ending after November 15,2006. SAB 108 did not have an impact on our results of operations or financial position.

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**Item 7A.**                *Quantitative and Qualitative Disclosures About Market Risk*

The primary objectives of our investment activitiesare to preserve principal, maintain a high degree of liquidity to meetoperating needs, and obtain competitive returns subject to prevailing marketconditions. Investments are made primarily in high-grade corporate bonds, asset-backeddebt securities and U.S. government agency debt securities. These investmentsare subject to risk of default, changes in credit rating and changes in marketvalue. These investments are also subject to interest rate risk and willdecrease in value if market interest rates increase. A hypothetical 100 basispoint increase in interest rates would result in an approximate$0.2 million decrease in the fair value of our investments as of December 31,2006. Due to the nature of our investments and relatively short effectivematurities of debt instruments, interest rate risk is mitigated. Changes ininterest rates do not affect interest expense incurred on the Company’sConvertible Notes, because they bear interest at a fixed rate. The market valueof the Senior Convertible Notes was approximately $170.8 million on December 31,2006.

As a consequence of the nature our business andoperations our reported financial results and cash flows are exposed to therisks associated with fluctuations in the exchange rates of the U.S. dollar,the Icelandic krona and other world currencies. We continue to monitor ourexposure to currency risk. A hypothetical 10.0% decrease in value of the USdollar against the Icelandic krona would result in a loss of approximately$0.1 million on our Icelandic krona denominated non-U.S. dollar assets andliabilities. We have historically purchased instruments to hedge these generalrisks through the use of derivative financial instruments; however, we have noderivative instruments outstanding as of December 31, 2006.

As of December 31,2006 we did not have any financing arrangements that were not reflected in ourbalance sheet.

**Item8.**                        *Financial Statements and Supplementary Data*

|                                                                            | ** ** | **Page** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent  Registered Public Accounting Firm                   |       |     | 59         |   |   |
| Consolidated Balance Sheets                                                |       |     | 60         |   |   |
| Consolidated Statements of  Operations                                     |       |     | 61         |   |   |
| Consolidated Statements of  Changes in Stockholders’ Equity (Deficit) |       |     | 62         |   |   |
| Consolidated Statements of  Cash Flows                                     |       |     | 63         |   |   |
| Notes  to Consolidated Financial Statements                                |       |     | 64         |   |   |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders of:deCODE genetics Inc.:

We have audited the accompanying consolidated balancesheets of deCODE genetics Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity (deficit), and cash flows for each of the three years inthe period ended December 31, 2006. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of the Companyas of December 31, 2006 and 2005, and the results of its operations andits cash flows for each of the three years in the period ended December 31,2006, in conformity with accounting principles generally accepted in the UnitedStates of America.

As discussed in Note 2 to the consolidated financialstatements, the Company changed its method of accounting for stock-based compensationon January 1, 2006, as required by Statement of Financial AccountingStandards No. 123R, *Share-Based Payment*.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2006, based on the criteriaestablished in *Internal Control-Integrated Framework* issued by the Committee of Sponsoring Organizations ofthe Treadway Commission and our report dated March 14, 2007expressed an unqualified opinion on management’s assessment of theeffectiveness of the Company’s internal control over financial reporting and anunqualified opinion on the effectiveness of the Company’s internal control overfinancial reporting.

/s/ Deloitte & Touche LLP

Boston, MassachusettsMarch 14, 2007

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**deCODE genetics, Inc.**

**CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                                           | ** ** | **December 31,**                                    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                           | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                                           | ** ** | **(In thousands, except  share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                               |       |                                                     |       |   |   |
| Current assets:                                                                                                                                                                                                                      |       |                                                     |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                            |       | $                                                        | 21,882     |   | $ | 65,943 |   |
| Investments                                                                                                                                                                                                                          |       | 130,134                                                  |       | 89,611 |   |
| Receivables                                                                                                                                                                                                                          |       | 8,464                                                    |       | 7,856 |   |
| Other current assets                                                                                                                                                                                                                 |       | 9,231                                                    |       | 3,541 |   |
| Total current assets                                                                                                                                                                                                                 |       | 169,711                                                  |       | 166,951 |   |
| Property and  equipment, net                                                                                                                                                                                                         |       | 24,382                                                   |       | 24,500 |   |
| Goodwill                                                                                                                                                                                                                             |       | 10,055                                                   |       | 8,863 |   |
| Intangible  assets, net                                                                                                                                                                                                              |       | 4,576                                                    |       | 1,521 |   |
| Other long-term  assets                                                                                                                                                                                                              |       | 6,885                                                    |       | 4,923 |   |
| Total assets                                                                                                                                                                                                                         |       | $                                                        | 215,609    |   | $ | 206,758 |   |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                                                                                          |       |                                                     |       |   |   |
| Current liabilities:                                                                                                                                                                                                                 |       |                                                     |       |   |   |
| Accounts payable                                                                                                                                                                                                                     |       | $                                                        | 2,877      |   | $ | 4,732 |   |
| Accrued expenses and other current liabilities                                                                                                                                                                                       |       | 14,360                                                   |       | 12,823 |   |
| Current portion of capital lease obligations                                                                                                                                                                                         |       | 2,100                                                    |       | 1,313 |   |
| Current portion of long-term debt                                                                                                                                                                                                    |       | 604                                                      |       | 550 |   |
| Deferred revenue                                                                                                                                                                                                                     |       | 3,557                                                    |       | 6,105 |   |
| Total current liabilities                                                                                                                                                                                                            |       | 23,498                                                   |       | 25,523 |   |
| Capital lease  obligations, net of current portion                                                                                                                                                                                   |       | 3,493                                                    |       | 1,046 |   |
| Long-term  debt, net of current portion                                                                                                                                                                                              |       | 212,062                                                  |       | 155,653 |   |
| Deferred gain on  sale-leaseback                                                                                                                                                                                                     |       | 25,716                                                   |       | 27,654 |   |
| Deferred revenue                                                                                                                                                                                                                     |       | 6,219                                                    |       | 6,219 |   |
| Commitments and  contingencies (Note 13)                                                                                                                                                                                             |       |                                                     |       |   |   |
| Stockholders’ deficit:                                                                                                                                                                                                          |       |                                                     |       |   |   |
| Preferred stock, $0.001 par value; Authorized:  6,716,666 shares; Issued and outstanding: none                                                                                                                                  |       | —                                                   |       | — |   |
| Common stock, $0.001 par value; Authorized:  100,000,000 shares; Issued and outstanding: 61,556,985 and 61,555,985,  respectively, at December 31, 2006; and 54,762,095 and 54,742,595  respectively, at December 31, 2005 |       | 62                                                       |       | 55 |   |
| Additional paid-in capital                                                                                                                                                                                                           |       | 483,052                                                  |       | 444,401 |   |
| Notes receivable                                                                                                                                                                                                                     |       | (2,778                                                   | )          | (2,898 | ) |
| Deferred compensation                                                                                                                                                                                                                |       | —                                                   |       | (418 | ) |
| Accumulated deficit                                                                                                                                                                                                                  |       | (535,688                                                 | )          | (450,215 | ) |
| Accumulated other comprehensive income                                                                                                                                                                                               |       | (22                                                      | )          | (139 | ) |
| Treasury stock, 1,000 and 19,500 shares stated at  cost at December 31, 2006 and 2005, respectively                                                                                                                             |       | (5                                                       | )          | (123 | ) |
| Total stockholders’ deficit                                                                                                                                                                                                     |       | (55,379                                                  | )          | (9,337 | ) |
| Total liabilities  and stockholders’ deficit                                                                                                                                                                                    |       | $                                                        | 215,609    |   | $ | 206,758 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

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**deCODE genetics, Inc.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                     | ** ** | **For the Years Ended December 31,**     | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except per  share amounts)** | ** ** |
| Revenue                                                        |       | $                                                                 | 40,510     |   | $ | 43,955 |   | $ | 42,127 |   |
| Operating expenses:                                            |       |                                                              |       |   |   |   |   |
| Cost of revenue                                                |       | 42,660                                                            |       | 37,263 |   | 43,407 |   |
| Research and development                                       |       | 57,108                                                            |       | 43,748 |   | 24,942 |   |
| Selling, general and administrative                            |       | 25,206                                                            |       | 20,118 |   | 20,187 |   |
| Total operating expenses                                       |       | 124,974                                                           |       | 101,129 |   | 88,536 |   |
| Operating loss                                                 |       | (84,464                                                           | )          | (57,174 | ) | (46,409 | ) |
| Interest income                                                |       | 6,685                                                             |       | 6,397 |   | 2,903 |   |
| Interest expense                                               |       | (7,808                                                            | )          | (7,484 | ) | (8,983 | ) |
| Other non-operating  (expense) and income, net                 |       | 114                                                               |       | (4,489 | ) | (4,766 | ) |
| Net loss                                                       |       | $                                                                 | (85,473    | ) | $ | (62,750 | ) | $ | (57,255 | ) |
| Basic and diluted net loss per share                           |       | $                                                                 | (1.49      | ) | $ | (1.17 | ) | $ | (1.07 | ) |
| Shares used in computing  basic and diluted net loss per share |       | 57,465                                                            |       | 53,824 |   | 53,423 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

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**deCODE genetics, Inc.**

**CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’EQUITY (DEFICIT)**

| ** **                                                                            | ** ** | **Common  Stock** | ** ** | **Par  Value** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Notes  Receivable** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Income  (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity (Deficit)** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------|------------|----------------|------------|----------------------------------|------------|-----------------------|------------|----------------------------|------------|--------------------------|------------|-------------------------------------------------------|------------|---------------------|------------|------------------------------------------------------|------------|
| **Balance at January 1, 2004**                                                   |       | 53,735,230        |       |           | $          | 54                               |       |                  |       | $                          | 430,489    |                     |       |                                                  | $          | (4,240              | )          |                                                 |       | $ | (572 | ) |   |   | $ | (330,210 | ) |   |   | $ | 3 |   |   |   | $ | (2,117 | ) |   |   | $ | 93,407 |   |   |
| Issuance of common stock and warrants                                                 |       | 689,703           |       |           | 1          |                             |       |                  | 11,507     |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   | 2,121 |   |   |   | 13,629 |   |   |
| Issuance of common stock upon exercise of stock  options                         |       | 114,657           |       |           |       |                             |       |                  | 519        |                       |       |                     | 3          |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 522 |   |   |
| Compensation arising from stock  options                                              |       |              |       |           |       |                             |       |                  | 484        |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 484 |   |   |
| Cancellation of note receivable and forfeiture of  common stock                       |       | (17,521           | )          |           |       |                             |       |                  |       |                       |       |                     | 124        |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   | (124 | ) |   |   | — |   |   |
| Payment of notes                                                                      |       |              |       |           |       |                             |       |                  |       |                       |       |                     | 1,002      |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 1,002 |   |   |
| Amortization of deferred compensation                                                 |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                | 572        |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 572 |   |   |
| Comprehensive  income (loss):                                                         |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss for the period                                                               |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   | (57,255 | ) |   |   |   |   |   |   |   |   |   |   | (57,255 | ) |   |
| Other  comprehensive income (loss):                                                   |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation                                                          |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   | 10 |   |   |   |   |   |   |   | 10 |   |   |
| Unrealized gain on marketable securities                                              |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   | 25 |   |   |   |   |   |   |   | 25 |   |   |
| Total  comprehensive income (loss):                                                   |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | (57,220 | ) |   |
| **Balance at December 31, 2004**                                                 |       | 54,522,069        |       |           | 55         |                             |       |                  | 442,999    |                       |       |                     | (3,111     | )                                                     |       |                | —     |                                                 |       |   | (387,465 | ) |   |   | 38 |   |   |   | (120 | ) |   |   | 52,396 |   |   |
| Issuance of common stock to consultant                                                |       | 15,000            |       |           |       |                             |       |                  | 104        |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 104 |   |   |
| Issuance of restricted common stock                                                   |       | 57,944            |       |           |       |                             |       |                  | 526        |                       |       |                     |       |                                                  |       |                | (526       | )                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Issuance of common stock upon exercise of warrants                               |       | 47,222            |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Issuance of common stock upon exercise of stock  options                         |       | 102,860           |       |           |       |                             |       |                  | 439        |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 439 |   |   |
| Compensation arising from stock  options                                              |       |              |       |           |       |                             |       |                  | 333        |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 333 |   |   |
| Cancellation of note receivable and forfeiture of  common stock                       |       | (2,500            | )          |           |       |                             |       |                  |       |                       |       |                     | 3          |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   | (3 | ) |   |   | — |   |   |
| Payment of notes                                                                      |       |              |       |           |       |                             |       |                  |       |                       |       |                     | 210        |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 210 |   |   |
| Amortization of restricted stock and deferred  compensation                           |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                | 108        |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 108 |   |   |
| Comprehensive  income (loss):                                                         |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss for the period                                                               |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   | (62,750 | ) |   |   |   |   |   |   |   |   |   |   | (62,750 | ) |   |
| Other  comprehensive income (loss):                                                   |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation                                                          |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   | (3 | ) |   |   |   |   |   |   | (3 | ) |   |
| Unrealized loss on marketable securities                                              |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   | (174 | ) |   |   |   |   |   |   | (174 | ) |   |
| Total  comprehensive income (loss):                                                   |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | (62,927 | ) |   |
| **Balance at December 31, 2005**                                                 |       | 54,742,595        |       |           | 55         |                             |       |                  | 444,401    |                       |       |                     | (2,898     | )                                                     |       |                | (418       | )                                                    |       |   | (450,215 | ) |   |   | (139 | ) |   |   | (123 | ) |   |   | (9,337 | ) |   |
| Issuance of common stock upon public offering, net of  offering expenses of $2,276    |       | 6,000,000         |       |           | 6          |                             |       |                  | 27,594     |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   | 124 |   |   |   | 27,724 |   |   |
| Issuance of common stock for the acquisition of UVS                                   |       | 635,006           |       |           | 1          |                             |       |                  | 6,081      |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 6,082 |   |   |
| Issuance of common stock upon exercise of options                                |       | 171,796           |       |           |       |                             |       |                  | 880        |                       |       |                     | (10        | )                                                     |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 870 |   |   |
| Issuance of restricted common stock                                                   |       | 7,588             |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Elimination of deferred employee stock-based  compensation upon adoption of SFAS 123R |       |              |       |           |       |                             |       |                  | (418       | )                          |       |                     |       |                                                  |       |                | 418        |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Compensation arising from stock  options                                              |       |              |       |           |       |                             |       |                  | 4,301      |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 4,301 |   |   |
| Cancellation of note receivable and forfeiture of  common stock                       |       | (1,000            | )          |           |       |                             |       |                  |       |                       |       |                     | 6          |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   | (6 | ) |   |   | — |   |   |
| Payment of notes                                                                      |       |              |       |           |       |                             |       |                  |       |                       |       |                     | 124        |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 124 |   |   |
| Amortization of restricted common stock                                               |       |              |       |           |       |                             |       |                  | 213        |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 213 |   |   |
| Comprehensive  income (loss):                                                         |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ness loss for the period                                                              |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   | (85,473 | ) |   |   |   |   |   |   |   |   |   |   | (85,473 | ) |   |
| Other  comprehensive income (loss):                                                   |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation                                                          |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   | 10 |   |   |   |   |   |   |   | 10 |   |   |
| Unrealized loss on marketable  securities                                             |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   | 107 |   |   |   |   |   |   |   | 107 |   |   |
| Total  comprehensive income (loss):                                                   |       |              |       |           |       |                             |       |                  |       |                       |       |                     |       |                                                  |       |                |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   | (85,356 | ) |   |
| **Balance  at December 31, 2006**                                                |       | 61,555,985        |       |           | $          | 62                               |       |                  |       | $                          | 483,052    |                     |       |                                                  | $          | (2,778              | )          |                                                 |       | $ | — |   |   |   | $ | (535,688 | ) |   |   | $ | (22 | ) |   |   | $ | (5 | ) |   |   | $ | (55,379 | ) |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

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**deCODE genetics, Inc.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**
|                                                                              | ** ** | **For the Years Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(In thousands)**                                   | ** ** |
| **Cash flows from operating activities:**                                    |       |                                                      |       |   |   |   |   |
| Net loss                                                                     |       | $                                                         | (85,473    | ) | $ | (62,750 | ) | $ | (57,255 | ) |
| Adjustments to reconcile net loss to net cash used in  operating activities: |       |                                                      |       |   |   |   |   |
| Depreciation and  amortization                                               |       | 7,389                                                     |       | 7,611 |   | 14,135 |   |
| Amortization of  deferred gain on sale-leaseback of real estate              |       | (1,938                                                    | )          | (1,394 | ) | — |   |
| Charges for debt  extinguishment                                             |       | —                                                    |       | 1,741 |   | — |   |
| Loss on  investments                                                         |       | —                                                    |       | 1,044 |   | — |   |
| Stock-based  compensation                                                    |       | 4,514                                                     |       | 441 |   | 1,171 |   |
| Gain (loss) on  disposal of equipment, net                                   |       | (685                                                      | )          | 32 |   | 883 |   |
| Charges for write-down  of obsolete and excess materials and supplies        |       | —                                                    |       | 63 |   | 117 |   |
| Loss (gain) on  derivative financial instruments                             |       | —                                                    |       | — |   | 1,465 |   |
| Foreign currency  exchange loss on Icelandic krona denominated debt          |       | (4                                                        | )          | 262 |   | 2,936 |   |
| Amortization of  debt discount                                               |       | 264                                                       |       | — |   | — |   |
| Amortization of  deferred financing costs                                    |       | 913                                                       |       | 949 |   | 872 |   |
| Other                                                                        |       | (33                                                       | )          | (31 | ) | (177 | ) |
| Changes in operating assets and liabilities:                                 |       |                                                      |       |   |   |   |   |
| Receivables                                                                  |       | (379                                                      | )          | (1,456 | ) | 47 |   |
| Other current  assets                                                        |       | (3,643                                                    | )          | 703 |   | 1,174 |   |
| Accounts payable                                                             |       | (1,986                                                    | )          | (1,097 | ) | 476 |   |
| Accrued expenses                                                             |       | 652                                                       |       | 3,399 |   | 2,224 |   |
| Deferred revenue                                                             |       | (4,760                                                    | )          | (3,550 | ) | 1,857 |   |
| Other                                                                        |       | —                                                    |       | — |   | 139 |   |
| Net cash used in  operating activities                                       |       | (85,169                                                   | )          | (54,033 | ) | (29,936 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                                      |       |   |   |   |   |
| Purchase of  investments                                                     |       | (326,070                                                  | )          | (230,678 | ) | (248,040 | ) |
| Sale of  investments                                                         |       | 285,655                                                   |       | 261,920 |   | 125,950 |   |
| Purchase of  property and equipment                                          |       | (6,282                                                    | )          | (3,968 | ) | (2,695 | ) |
| Proceeds from sale  of property and equipment                                |       | 909                                                       |       | 62,452 |   | 39 |   |
| Acquisition of  UVS, net of cash acquired                                    |       | 1,270                                                     |       | — |   | — |   |
| Change in  restricted cash                                                   |       | —                                                    |       | 6,000 |   | — |   |
| Other                                                                        |       | 94                                                        |       | 106 |   | 93 |   |
| Net cash (used in)  provided by investing activities                         |       | (44,424                                                   | )          | 95,832 |   | (124,653 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                                      |       |   |   |   |   |
| Proceeds from  convertible debt offering, net of financing costs             |       | 52,947                                                    |       | — |   | 143,805 |   |
| Proceeds from  issuance of common stock and warrants                         |       | 28,660                                                    |       | 439 |   | 14,153 |   |
| Repayment of notes  receivable for common stock                              |       | 156                                                       |       | 210 |   | 1,002 |   |
| Payments on line  of credit                                                  |       | —                                                    |       | (4,500 | ) | (2,000 | ) |
| Proceeds from  short-term borrowings                                         |       | 600                                                       |       | — |   | 1,119 |   |
| Repayments of  short-term borrowings                                         |       | (268                                                      | )          | (569 | ) | (550 | ) |
| Proceeds from  equipment sale-leaseback financing                            |       | 5,038                                                     |       | 1,200 |   | 436 |   |
| Proceeds from  equipment financing                                           |       | 889                                                       |       | — |   | — |   |
| Proceeds from swap  termination                                              |       | —                                                    |       | — |   | 9,720 |   |
| Debt refinancing  cost                                                       |       | —                                                    |       | (59 | ) | (478 | ) |
| Repayments of debt  and capital lease obligations                            |       | (2,490                                                    | )          | (42,815 | ) | (11,049 | ) |
| Net cash provided  by (used in) financing activities                         |       | 85,532                                                    |       | (46,094 | ) | 156,158 |   |
| Net (decrease) increase  in cash and cash equivalents                        |       | (44,061                                                   | )          | (4,295 | ) | 1,569 |   |
| Cash and cash equivalents  at beginning of period                            |       | 65,943                                                    |       | 70,238 |   | 68,669 |   |
| Cash and cash equivalents  at end of period                                  |       | $                                                         | 21,882     |   | $ | 65,943 |   | $ | 70,238 |   |
| Supplemental cash flow information:                                          |       |                                                      |       |   |   |   |   |
| Cash paid for  interest                                                      |       | $                                                         | 6,017      |   | $ | 6,608 |   | $ | 6,250 |   |
| Supplemental schedule of non-cash transactions                               |       |                                                      |       |   |   |   |   |
| Deferred gain on  sale of property and equipment                             |       | $                                                         | 336        |   | $ | 29,270 |   | $ | — |   |
| Note receivable  for sale of property                                        |       | 222                                                       |       | — |   | — |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (tabular amounts in thousands, except share and per share amounts)**

**1.**   Organization and Business

References in these financial statements to deCODErefer to deCODE genetics, Inc., a Delaware company, and its wholly ownedsubsidiaries, Islensk erfdagreining ehf., an Icelandic company registered inReykjavik, and its subsidiaries and MediChem Life Sciences, Inc., aDelaware corporation, and its subsidiaries.

With its headquarters in Reykjavik, Iceland, deCODE isa biopharmaceutical company developing drugs and DNA-based diagnostics basedupon its discoveries in the inherited causes of common diseases. deCODE’spopulation approach and resources have enabled it to isolate genes and targetsdirectly involved in the development of many of the biggest challenges topublic health. deCODE is focused on turning these findings into a pipeline ofproducts which it believes will be able to combat the cause of disease, notjust the signs and symptoms. deCODE’s customers include major pharmaceuticalcompanies, biotechnology firms, pharmacogenomics companies, governmentinstitutions, universities and other research institutions. deCODE’s businessis global, with its principal markets in the United States and in Europe.

deCODE’s focus is on the discovery andcommercialization of novel therapeutics based on genetic information identifiedin deCODE’s population-based gene discovery work. deCODE has integratedcapabilities for applying genetic findings to the development of drugs, boththrough its proprietary programs and in alliance with corporate partners.deCODE is also applying the links it has identified between genetic factors anddisease to create DNA based tests which can also be used to identify patientswith increased risk of developing a disease or to predict which patients willrespond well to a given drug therapy. deCODE believes that such tests willbecome a standard part of healthcare within the coming decade, making itpossible to gauge individual predisposition to a particular illness and todesign effective preventive strategies; to complement traditional clinicaldiagnoses; and to identify patients who are likely to respond or not respond toparticular drugs.

In addition to conductingwork on targets in deCODE’s collaborative and internal programs, the chemistrygroup provides drug discovery work for fee-for-service customers. deCODE’sother service offerings include protein crystallization products and proteinstructure analysis contract services through its Seattle-based biostructuresgroup; pharmacogenomics and clinical trials services through its Encodesubsidiary; and DNA analysis services through its genotyping laboratory inReykjavik.

**2.**   SignificantAccounting Policies

***Basis of Presentation***

These financial statementsare reported in United States dollars, deCODE’s functional currency, andprepared in accordance with accounting principles generally accepted in theUnited States of America. Tabular amounts are stated in thousands, except pershare amounts.

***Principles of Consolidation***

The consolidated financialstatements include the accounts and operations of deCODE genetics, Inc.and its subsidiaries, all of which are wholly-owned. All significantintercompany accounts and transactions have been eliminated.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

***Use of Estimates and Assumptions***

The preparation offinancial statements in conformity with accounting principles generally acceptedin the United States of America requires management to make certain estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the dates of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. On an ongoing basis deCODE evaluates its estimates, whichinclude, among others, those related to collaborative arrangements, propertyand equipment, income taxes, litigation and other contingencies, materials andsupplies valuation, derivatives, goodwill and intangible assets, and bad debts.deCODE bases its estimates on historical experience and on various otherassumptions that management  believes tobe reasonable under the circumstances, the results of which form its basis formaking judgments about carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results could differ from thoseestimates.

***Uncertainties***

deCODE is subject to riskscommon to companies in the biotechnology industry including, but not limitedto, development by deCODE or its competitors of new technological innovations,ability to market products or services, dependence on key personnel, dependenceon key suppliers and many of deCODE’s materials and supplies, protection ofproprietary technology, ability to obtain additional financing, ability tonegotiate collaborative arrangements, and compliance with governmental andother regulations.

***Concentration of Risk***

At December 31, 2006, deCODE has no significantoff-balance sheet concentrations of credit risk such as foreign exchangecontracts, option contracts or other foreign hedging arrangements. Financialinstruments that potentially subject deCODE to concentrations of credit riskconsist principally of investments made primarily in high-grade commercialpaper, auction rate securities, money market funds, mutual fund investments,government and non-government debt securities and receivables. Theseinstruments are subject to risk of default, changes in credit rating andchanges in market value. Investments are also subject to interest rate risk andwill decrease in value if market interest rates increase.

deCODE’s cash and cash equivalents are deposited withfinancial institutions in Iceland, the United Kingdom and the United Stateshaving a high credit rating (A-/A3 or better). Deposits with banks may exceedthe amount of insurance provided on such deposits. Generally, these depositsmay be redeemed upon demand and, therefore, bear minimal risk.

At December 31, 2005,20% of consolidated receivables were due from Roche. At December 31, 2006and 2005, 37% and 18%, respectively, of consolidated receivables were due fromU.S. Government agencies.

***Fair Value of Financial Instruments***

The fair value of short-term financial instruments,including cash and cash equivalents, investments, receivables, certain othercurrent assets, trade accounts payable, certain accrued liabilities, and othercurrent liabilities approximates their carrying amount in the financialstatements due mainly to the short maturity of such instruments. Based onborrowing rates currently available to deCODE for mortgage loans 

65

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

and capital leaseobligations with similar terms, the carrying value of such of its debtobligations approximates fair value.

The fair values ofequipment notes at December 31, 2006 and 2005 were approximately $792,000and $281,000, respectively, as estimated based on quoted market rates forinstruments with similar terms and remaining maturities. The fair value of the3.5% convertible notes at December 31, 2006 and 2005 was approximately$170,756,000 and $123,375,000, respectively. The fair value of the convertiblenotes was based on the quoted market prices at December 31, 2006 and 2005.

***Cash and Cash Equivalents***

Highly liquid investmentswith a maturity of ninety days or less at the date of purchase are consideredcash equivalents.

***Investments***

deCODE invests its excesscash balances in marketable securities. deCODE classifies all of itsinvestments as available-for-sale. Available-for-sale investments are reportedat fair value as of each balance sheet date and any unrealized gains and lossesare reported in stockholders’ equity in accumulated other comprehensive income.Fair value is generally determined with reference to quotations in activemarkets. Premiums and discounts associated with investments in bonds areamortized using the effective interest rate method. If any adjustment to fairvalue reflects a decline in the value of the investment, is determined to be “otherthan temporary”, the investment is marked to market through a charge to theconsolidated statement of operations.

***Materials and Supplies***

Materials and supplies, included in deCODE’s othercurrent assets, are valued at the lower of cost (first-in, first-out method) ormarket. deCODE evaluates materials and supplies levels and expected usage on aperiodic basis and records write-downs of value for obsolescence as required.At December 31, 2006 and 2005, materials and supplies were valued at$2,290,000 and $1,158,000, respectively.

In 2006, 2005 and 2004,deCODE used materials and supplies for which it had made provisions for inprior years as slow-moving, excess and obsolete, benefiting otherwise reportedresearch and development expenses by $837,000, $816,000 and $1,411,000,respectively.

***Property and Equipment***

Property and equipment arerecorded at cost. Depreciation is computed using the straight-line method overthe estimated useful lives of the related assets of generally fifty years forbuildings, three to four years for laboratory equipment, five years forfurniture and fixtures, and three to five years for other equipment.Maintenance and repairs are expensed as incurred, while major betterments arecapitalized. When assets are retired or otherwise disposed of, the assets andrelated accumulated depreciation or amortization are eliminated from theaccounts and any resulting gain or loss is reflected in the statement ofoperations.

66

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

***Capital Leases***

Assets held under capitallease agreements are initially recorded at the lower of the fair market valueof the related asset or the present value of the future minimum rental paymentsusing interest rates appropriate at the inception of the lease. Property andequipment subject to capital lease agreements are amortized over the shorter ofthe life of the lease or the estimated useful life of the asset unless thelease transfers ownership or contains a bargain purchase option, in which casethe leased asset is amortized over the estimated useful life of such asset.

***Impairment of Long-Lived Assets and Goodwill***

deCODE periodically reviews long-lived assets forpotential impairment whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable. Recoverability ofassets held for use is measured by comparing the carrying amount of an asset tothe undiscounted estimated future cash flows expected to be generated by theasset. In estimating expected future cash flows for determining whether anasset is impaired, assets are grouped at the lowest level for which there areidentifiable cash flows that are largely independent of the cash flows of othergroups of assets. If any such assets are considered to be impaired, theimpairment to be recognized is the amount by which the carrying amount of theassets exceeds its fair value.

deCODE reviews goodwillannually and whenever events or changes in circumstances suggest that thecarrying value of an asset may not be recoverable. For purposes of the goodwillimpairment tests, deCODE identifies its reporting units, identifies the assetsand liabilities of the reporting units and performs impairment tests on thegoodwill associated with them. Goodwill impairment is deemed to exist if thenet book value of a reporting unit exceeds its estimated fair value. Toidentify potential impairments deCODE compares fair value of a reporting unitwith its carrying amount, including goodwill. For this purpose, deCODEestimates fair value of a reporting unit using analyses of comparable companiesand recent comparable transactions.

***Finance Costs Related to Long-Term Debt***

Costs associated withobtaining long-term debt are deferred and amortized as interest expense overthe term of the debt. Remaining unamortized deferred financing costs includedin long-term assets were $6,812,000 and $4,783,000 at December 31, 2006and 2005, respectively.

***Revenue Recognition***

deCODE records revenue provided that there ispersuasive evidence that an arrangement exists, the price is fixed anddeterminable, services were rendered and collectibility is reasonably assured.deCODE has entered into research, development and commercialization alliancesand collaborations with major pharmaceutical and biotechnology companies. Thekey components of the commercial terms of such alliance arrangements typicallyinclude one or more of the following: research funding; up-front, exclusivity,technology access, and technology development fees; milestone payments; licenseor commercialization fees; and royalties or profit sharing from thecommercialization of products.

deCODE’s revenues from research and developmentcollaboration agreements are recorded and recognized in accordance with theapplicable performance requirements and terms of the respective 

67

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

contracts, generallyeither (i) as contract research costs are incurred, usually ratably overthe period of effort, (ii) according to the level of efforts expendedbased on the ratio of contract research costs incurred to expected total costs,or (iii) upon the achievement of substantive milestones. deCODE’saccounting recognition policies with respect to each significant element ofdeCODE’s revenue is summarized as follows:

*Researchfunding and other service fees.**  *Research funding is recognized asearned, typically ratably over the period of effort. Funding payments are notrefundable in the event that the related efforts are not successful. Otherservice revenues from negotiated rate contracts are recognized based upon theterms of the underlying contract generally either (i) on a per diem basisas services are rendered; (ii) on the basis of efforts expended, generallyupon the ratio of costs incurred to total expected costs of providing theservice; or (iii) upon completion of the service rendered. Any losses oncontracts are provided for when they are determinable. Included in revenue arebillings to customers for the cost of materials purchased by deCODE.

*Milestonepayments.**  *Underthe substantive milestone method deCODE records revenue when the milestone hasbeen achieved and payment is due and payable under the terms of the respectiveagreement and deCODE recognizes revenue when acknowledgement of achievement ofapplicable performance requirements is received from the collaborator.Milestone payments without the above characteristics are recognized on aretrospective basis over the contractual term of the underlying agreement.

In arrangements with multiple elements, if the milestoneis substantive in nature and there is uncertainty in the achievement of themilestone and there is no further obligation on the part of deCODE, deCODErecords revenue when the milestone has been achieved and payment is due andpayable under the terms of the respective agreement and deCODE recognizesrevenue when acknowledgement of achievement of applicable performancerequirements is received from the collaborator (“Milestone Payment Method”). Ifthe milestone is earned and there is further obligation under the contract forperformance by deCODE, then deCODE will record revenue when the milestone hasbeen achieved and payment is due and payable under the terms of the respectiveagreement and deCODE retroactively recognizes revenue through the currentperiod based on the total contractual term and amortizes the balance over theremaining contractual term.

*Up-front,exclusivity, technology access, and technology development fees.**  *deCODE recognizes revenue fromnon-refundable fees not specifically tied to a separate earnings processratably over the expected customer relationship period or estimated period ofperformance. Changes in estimates could impact revenue in the period theestimate is changed. If deCODE’s estimate of the period of performance shortensor lengthens, the amount of revenue we recognized from such non-refundable feesnot specifically tied to a separate earnings process could increase or decreasein the period the change in estimate becomes known; future related revenueswould be adjusted accordingly.

*GrantRevenue.*   Researchgrants and contracts that provide for payments to deCODE for work performed arerecognized as revenue when the related expense is incurred and deCODE hasobtained necessary governmental approval to use the grant funds for theseexpenses. Revenues under these contracts will be recognized as deCODE incurscosts related to the contracts.

*Deferred Revenue.*   Ingeneral, prerequisites for billings are established by contractual termsincluding predetermined payment schedules, the achievement of contractmilestones, or submission of appropriate 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

billing detail.Deferred revenue represents amounts billed in accordance with contract termsbut not yet recognized according to deCODE’s accounting policy. Unbilled costsand fees arise when revenue has been recognized but customers have not beenbilled.

***Cost of Revenue***

deCODE’s cost of revenueis comprised of costs of services provided to customers and collaborators,including the entirety of costs incurred in connection with programs that havebeen partnered and on which deCODE receives research funding. At times, deCODEmay dedicate additional resources and incur costs in addition to costs coveredby research funding received in such collaborative programs. Major componentsof deCODE’s cost of revenue include personnel costs, namely salaries, benefitsand stock-based compensation; materials and supplies; services contracted forresearch activities; other third party fees and costs; depreciation of propertyand equipment; amortization of patents and other intangible assets; and itemsof overhead, including allocations of various administrative and facilitiesrelated costs.

***Research and Development Expenses***

All costs associated withinternal research and development and research and development services,including pre-clinical and clinical trial studies, which deCODE has externallycontracted are expensed as incurred.

***Patent Costs***

Patent application costsare charged to legal expense as incurred and classified in selling, general andadministrative expense.

***Stock-Based Compensation***

OnJanuary 1, 2006, deCODE adopted SFAS No. 123R, *Share-B**ased Payment*(“SFAS 123R”), which requires companies to recognize in the statement ofoperations the grant-date fair value of stock awards issued to employees anddirectors. deCODE adopted SFAS 123R using the modified prospective transitionmethod. In accordance with the modified prospective transition method, deCODE’sConsolidated Financial Statements for prior periods have not been restated toreflect the impact of SFAS 123R. deCODE elected to use the short-cut method fordetermining the historical pool of windfall tax benefits in accordance withFASB Staff Position SFAS 123R-3, *Transition Election toAccounting for the Tax Effects of Share-Based Payment Awards* and thetax law ordering approach for purposes of determining whether an excess taxbenefit has been realized.

Prior to the adoption ofSFAS 123R, deCODE applied Accounting Principles Board Opinion No. 25 (“APB25”), *Accounting for Stock Issued to Employees*,and related interpretations to account for stock-based compensation granted toemployees.

***Foreign Currency Translation***

deCODE’s functional currency is the U.S. dollar. Oneof its subsidiaries uses the local currency, the Icelandic krona, as the functionalcurrency. For this entity, the assets and liabilities are translated into U.S. dollarsat exchange rates in effect at the balance sheet date. Income and expense itemsare translated 

69

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

at the average exchangerates prevailing during the period. Gains and losses from translation areincluded in accumulated other comprehensive income.

Foreign currencytransaction gains and losses are reported according to the exchange ratesprevailing on the transaction date and are included in the consolidatedstatements of operations classified as other non-operating income and expense.Net transaction and translation gains (losses) recorded were $114,000,$(124,000) and $(3,294,000) in 2006, 2005 and 2004, respectively.

***Income Taxes***

deCODE accounts for incometaxes using the liability method, which requires the recognition of deferredtax assets or liabilities for the temporary differences between the financialreporting and tax bases of deCODE’s assets and liabilities and for tax losscarryforwards at enacted statutory tax rates in effect for the years in whichthe differences are expected to reverse. A valuation allowance is appliedagainst any deferred tax asset if, based on the weighted available evidence, itis more likely than not that some or all of the deferred tax assets will not berealized.

***Computation of Net Loss per Share***

Basic net loss per share is computed using net lossavailable to common stockholders and the weighted-average number of commonshares outstanding. The weighted-average number of common shares outstandingduring the period is the number of shares determined by relating the portion oftime within a reporting period that common shares have been outstanding to thetotal time in that period.

Diluted net loss per shareis computed using the weighted-average number of common shares outstandingduring the period, plus the dilutive effect of potential common shares. Dilutednet loss per share does not differ from basic net loss per share in all periodspresented as potential common shares are antidilutive for all such periods andare, therefore, excluded from the calculation.

***Recent Accounting Pronouncements***

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48,*Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(“FIN 48”). FIN 48 clarifies the accounting for uncertainties in incometaxes recognized in an enterprise’s financial statements. FIN 48 requirescompanies to determine whether it is more likely than not that a tax positionwill be sustained upon examination by the appropriate taxing authority. If atax position meets the “more likely than not” recognition criteria, FIN 48requires the tax position be measured at the largest amount of benefit greaterthan 50 percent likely of being realized upon ultimate settlement. Thisaccounting standard is effective for fiscal years beginning after December 15,2006. deCODE is evaluating the impact of FIN 48 on its financial position,results of operations and cash flows.

In September 2006, the FASB issued SFAS No. 157,*Fair ValueMeasurements* (“SFAS 157”),which establishes a framework for measuring fair value and expands disclosuresabout the use of fair value measurements and liabilities in interim and annualreporting periods subsequent to initial recognition. Prior to the issuance ofSFAS 157, which emphasizes that fair value is a market-based measurement andnot an entity-specific measurement, there were different definitions of fairvalue and limited definitions for applying those definitions under generallyaccepted accounting principles. SFAS 157 is effective for the 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

Company on a prospectivebasis for the reporting period beginning January 1, 2008. deCODE iscurrently evaluating the impact of SFAS 157 on its financial position,  results of operations and cash flows.

In February 2007 the FASB issued Statement No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS No. 159”). SFAS No. 159expands opportunities to use fair value measurement in financial reporting andpermits entities to choose to measure many financial instruments and certainother items at fair value. This Statement is effective for fiscal yearsbeginning after November 15, 2007. deCODE has not decided if it will earlyadopt SFAS 159 or if it will choose to measure any eligible financial assetsand liabilities at fair value.

In September 2006,the Securities and Exchange Commission (“SEC”) issued Staff Accounting BulletinNo. 108,*Considering the Effects of Prior Year MisstatementsWhen Quantifying Misstatements in Current Year Financial Statements* (“SAB108”) which provides guidance on quantifying and evaluating the materiality ofunrecorded misstatements. SAB 108 was effective for fiscal years ending after November 15,2006. SAB 108 did not have an impact on deCODE’s results of operations orfinancial position.

**3.**   Revenue

Significantelements of deCODE’s revenue are summarized as follows:

| ** **                                                                  | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                  | ** ** | **(In thousands)**                                      | ** ** |
| Research funding  and other service fees                                    |       | $                                                            | 18,907     |   | $ | 29,111 |   | $ | 31,723 |   |
| Milestone  payments                                                         |       | 702                                                          |       | 1,216 |   | 1,835 |   |
| Up-front,  exclusivity, technology access, and technology development  fees |       | 2,000                                                        |       | 4,538 |   | 4,116 |   |
| Grant funding                                                               |       | 16,734                                                       |       | 7,287 |   | 2,032 |   |
| Other                                                                       |       | 2,167                                                        |       | 1,803 |   | 2,421 |   |
|                                                                        |       | $                                                            | 40,510     |   | $ | 43,955 |   | $ | 42,127 |   |

 

Thefollowing table represents revenue derived by geographic area:

| ** **    | ** ** | **For the Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **    | ** ** | **(In thousands)**                                       | ** ** |
| United States |       | $                                                             | 16,816     |   | $ | 15,486 |   | $ | 13,680 |   |
| Iceland       |       | 23,694                                                        |       | 28,469 |   | 28,447 |   |
|          |       | $                                                             | 40,510     |   | $ | 43,955 |   | $ | 42,127 |   |

 

Significant collaborativeagreements, contracts and grants are as follows:

***F. Hoffmann-LaRoche (Roche)***

*Therapeutics.*   In2002, we entered into an agreement with Roche to collaborate on four diseasesthat had been the subject of an earlier collaboration with Roche. During 2004and through January 2005, we collaborated with Roche on two of thosediseases. Under this agreement we discovered genes linked to diabetes and Rochecontinues drug discovery based on one of these discoveries. Under the 2002 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

agreement, which expiredon February 1, 2005, we received $20.0 million in research funding and weare entitled to receive royalties on the sales of any drugs that are developedcoming out of work conducted under this agreement.

In November 2004, we signed a new three-yearagreement with Roche to co-develop inhibitors of PDE4 for the prevention andtreatment of vascular disease, including stroke. This agreement continues workadvanced under the 2002 agreement, and we will focus on optimizing leadcompounds identified under the previous agreement and beginning clinicaldevelopment. Under this agreement, as of December 31, 2006, we havereceived $4.0 million of research funding. We will share drug discovery andclinical trials costs under this new agreement, and we may receive anadditional $2.0 million of research funding over the remaining term of theagreement as well as milestone payments and royalties based on drug sales.

*Diagnostics.*   InJune 2001, we signed a five-year alliance with Roche’s diagnosticsdivision and through June 2006 we collaborated to develop and marketDNA-based diagnostics for major diseases. During the term of the alliance,which has now expired, we received $44,250,000 in research funding, up-frontfees and milestone payments under the agreement and we may receive additionalmilestone payments upon the achievement of research and development milestonesby Roche and royalties on the sales of diagnostic products developed by Roche.

Revenues from these alliances with Roche amounted to$6,722,000, $9,995,000 and $12,613,000 for the years ended December 31,2006, 2005 and 2004, respectively. Costs incurred with these collaborativeprograms with Roche amounted to $6,437,000, $8,257,000 and $19,475,000 for theyears ended December 31, 2006, 2005 and 2004, respectively.

For the years endedDecember 31, 2006, 2005 and 2004, Roche represented 17%, 23% and 30%,respectively, of consolidated revenue.

***Merck & Co, Inc. (Merck)***

*Obesity.**  *In September 2002, deCODEentered into a three year alliance with Merck aimed at developing newtreatments for obesity. Under the alliance, deCODE combined research effortswith Merck in the genetics of obesity to identify, validate and prioritize aseries of drug targets to take into development. During the three-year researchprogram, which has now expired, deCODE has received research funding,technology access fees and milestone payments in the aggregate amount of $26.3million. In addition, deCODE may receive further technology access fees in thetotal aggregate amount of $1.0 million. Subject to Merck’s developing productsbased on collaboration discoveries, deCODE may also receive developmentmilestones and royalties. deCODE has discovered three genes linked to obesityunder this alliance, and Merck has generated a lead series of compounds againstone of the targets deCODE validated through deCODE’s genetics research.

Revenues from this alliance with Merck amounted$1,000,000, $6,325,000 and $7,850,000 for the years ended December 31,2006, 2005 and 2004, respectively. Costs incurred in connection with thisalliance with Merck amounted to $0, $2,933,000 and $4,630,000 for the yearsended December 31, 2006, 2005 and 2004, respectively.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

*Information-RichClinical Trials.**  *InFebruary 2004, deCODE entered into an agreement with Merck which providesthat deCODE will conduct information-rich clinical trials on a range of Merck’sdevelopmental compounds that Merck selects for inclusion in the program. Theterm of the alliance is seven years, subject to termination by Merck after fiveyears. The collaboration involved three agreements: (a) a License andResearch Collaboration Agreement; (b) a Stock and Warrant PurchaseAgreement; and (c) a Warrant Agreement. Under the terms of the License andResearch Collaboration Agreement, deCODE will receive royalties on sales ofdrugs and diagnostics developed as part of the alliance, will receive milestonepayments as compounds or pharmacogenomic tests reach the market, will receiveresearch funding for the clinical development of compounds and pharmacogenomicanalysis, and received a one-time technology access fee of $10,000,000. Acontingency clause on the technology access fee provides that if deCODE rejectsthe first two non-exclusive development compounds that Merck presents to thecollaboration, then Merck has the right to request a refund of $2,500,000 ofthe technology access fee. The remaining amount of the technology access fee isnon-refundable. To date, Merck has not selected any compounds for developmentunder the agreement.

Under the terms of the Stock and Warrant PurchaseAgreement, Merck purchased 689,703 shares of deCODE’s common stock at a priceof $14.50 per share or $10,000,000, which represents a premium of $2,700,000 tothe fair market value of the stock on the effective date of the agreement($10.60 per share). Accordingly, of the $10,000,000 cash received, deCODEascribed $7,300,000 to the common stock and $2,700,000 to deferred revenue. Underthe terms of the Warrant Agreement, deCODE has issued Merck a warrant topurchase up to 1,724,257 of additional shares of deCODE’s common stock at anexercise price of $29.00 per share over the five year term of the warrant. Thewarrant is exercisable at Merck’s option as to 344,851 shares for a period of30 days commencing on the first, second, third, fourth and fifthanniversaries of the Warrant Agreement with the final portion of warrantsexpiring in March 2009. Any portion of this warrant that is not exercisedduring an applicable exercise period shall expire and be of no further force oreffect. The warrant was valued at $6,300,000 using a Black Scholes model withthe following assumptions: lives of one to five years, risk free interest ratesof 1.24% to 3.07%, volatility of 90% and no dividend yield. The one-timetechnology access fee of $10,000,000 and the $2,700,000 premium received on thesale of common stock less the estimated fair value of the warrant of$6,300,000, together netting to $6,400,000, has been recorded as deferredrevenue. This amount less the refundable amount of $2,500,000 ($3,900,000) isbeing recognized as revenue according to level of efforts over the seven-yeardevelopment term. The refundable $2,500,000 technology access fee will berecognized as revenue according to level of efforts retrospectively over theseven-year development term commencing upon satisfaction of the contingency.

Revenues from this alliance with Merck amounted to $0,$190,000 and $825,000 for the years ended December 31, 2006, 2005 and2004, respectively. Costs incurred in connection with this alliance with Merckamounted to $0, $144,000 and $1,313,000 for the years ended December 31,2006, 2005 and 2004, respectively.

For the years ended December 31,2006, 2005 and 2004, total revenues from Merck represented 3%, 15% and 22%,respectively, of consolidated revenue.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

***Grant Funding***

deCODE has receivedvarious research grants from divisions of the United States National Institutesof Health (NIH), the Commission of the European Communities (EC) and privatefoundations. Research grants for multiple years are based on approved budgetswith budgeted amounts subject to approval on an annual basis. NIH grantsgenerally provide for 100% reimbursement of allowable expenditures while thegrant under the EC generally provides for fifty percent reimbursement ofallowable research and development related expenditures. deCODE’s significantresearch grants include:

*NationalInstitutes of Allergy and Infectious Diseases (NIAID).**  *In September 2004, deCODE wasawarded a five-year $23,900,000 contract by the NIAID, a division of NIH. Underthe contract, deCODE will apply its population approach and resources todiscover genetic factors associated with susceptibility to certain infectiousdiseases and with responsiveness to vaccines targeting such diseases. Revenuesfrom this contract with NIAID amounted to $5,566,000, $4,042,000 and $138,000for the years ended December 31, 2006, 2005 and 2004, respectively.

For the years ended December 31,2006, 2005 and 2004, deCODE recognized revenue of $16,734,000, $7,287,000 and$2,032,000, respectively, from research grants. Costs incurred with researchgrants amounted to $19,133,000, $7,724,000 and $2,032,000 for the years ended December 31,2006, 2005 and 2004, respectively. For the year ended December 31, 2006,2005 and 2004, divisions of NIH represented 33%, 13% and 1%, respectively, ofconsolidated revenue.      

**4.  Research and Development**

deCODE’sresearch and development expenses consist of the costs of its own proprietaryprograms and consist of the following:

| ** **                                       | ** ** | **For the Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                                      | ** ** |
| Salaries and  other personnel costs              |       | $                                                            | 20,597     |   | $ | 18,072 |   | $ | 10,233 |   |
| Materials and  supplies                          |       | 7,495                                                        |       | 4,600 |   | 3,671 |   |
| Contractor  services and other third party costs |       | 19,109                                                       |       | 13,285 |   | 3,938 |   |
| Overhead expenses                                |       | 5,107                                                        |       | 4,630 |   | 1,603 |   |
| Depreciation and  amortization                   |       | 3,287                                                        |       | 3,089 |   | 5,123 |   |
| Stock-based  compensation                        |       | 1,513                                                        |       | 72 |   | 374 |   |
|                                             |       | $                                                            | 57,108     |   | $ | 43,748 |   | $ | 24,942 |   |

 

In November 2003, deCODE acquired an exclusiveworldwide license from Bayer HealthCare AG (Bayer) to develop and commercializea small molecule compound (now known as DG031) that is active against a keytarget, located within an inflammatory pathway, made by a gene isolated atdeCODE that predisposes to myocardial infarction, or heart attack. deCODE isobligated to make development milestone payments to Bayer as the compoundadvances towards market approval and will make royalty payments to Bayer basedupon sales of the compound as a marketed drug.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

In May 2006, deCODEentered into a strategic alliance with Illumina, Inc. (“Illumina”) todevelop and commercialize molecular diagnostic products. Under the terms of theagreement, deCODE and Illumina will share development costs equally and splitoperating profits from the sale of diagnostic tests. 

**5.  Net Loss Per Common Share**

Thefollowing potentially dilutive common share equivalents were excluded from thecalculations of diluted net loss per share because their effect wasantidilutive:

| ** **                                                                                            | ** ** | **For the Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                            | ** ** | **(Shares)**                                                  | ** ** |
| Warrants to  purchase shares of common stock                                                          |       | 2,385,022                                                     |       | 2,729,873 |   | 3,124,733 |   |
| Options to  purchase shares of common stock                                                           |       | 4,975,074                                                     |       | 4,702,702 |   | 4,689,942 |   |
| Restricted shares  subject to vesting or with an associated outstanding non-recourse  promissory note |       | 709,497                                                       |       | 774,787 |   | 788,800 |   |
| Convertible  shares issuable upon conversion of 3.5% senior convertible notes                         |       | 16,428,572                                                    |       | 10,714,286 |   | 10,714,286 |   |
|                                                                                                  |       | 24,498,165                                                    |       | 18,921,648 |   | 19,317,761 |   |

 

**6.  Investments**

deCODE’smarketable securities are classified as available for sale. These investmentsare classified in current assets and are summarized as follows:

| ** **                  | ** ** | **Amortized  Cost**     | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------|------------|-------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **(In thousands)** | ** ** |
| **December 31, 2006**  |       |                    |       |                           |       |
| Auction rate  securities    |       | $                       | 105,175    |                           | $          | 105,175 |   |
| Government debt  securities |       | 15,000                  |       | 14,959                         |       |
| Municipal bond              |       | 5,000                   |       | 5,000                          |       |
| Corporate bond              |       | 5,000                   |       | 5,000                          |       |
|                        |       | $                       | 130,175    |                           | $          | 130,134 |   |
| **December 31,  2005** |       |                    |       |                           |       |
| Auction rate  securities    |       | $                       | 69,760     |                           | $          | 69,760 |   |
| Government debt  securities |       | 15,000                  |       | 14,851                         |       |
| Corporate bond              |       | 5,000                   |       | 5,000                          |       |
|                        |       | $                       | 89,760     |                           | $          | 89,611 |   |

 

Gross unrealized gains andlosses were $0 and $41,000 at December 31, 2006, respectively, and $0 and$149,000 at December 31, 2005, respectively.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

**7.  Property and Equipment**

Propertyand equipment consist of the following:

| ** **                                       | ** ** | **December 31,**   | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** |
| Land                                             |       | $                       | 2,303      |   | $ | 2,303 |   |
| Buildings                                        |       | 15,800                  |       | 16,138 |   |
| Laboratory  equipment                            |       | 27,378                  |       | 21,513 |   |
| Furniture and  fixtures                          |       | 5,302                   |       | 3,877 |   |
| Other equipment                                  |       | 2,457                   |       | 4,354 |   |
|                                             |       | 53,240                  |       | 48,185 |   |
| Less: accumulated  depreciation and amortization |       | (28,858                 | )          | (23,686 | ) |
| Total                                            |       | $                       | 24,382     |   | $ | 24,500 |   |

 

The total depreciation and amortization expense ofproperty and equipment for the years ended December 31, 2006, 2005 and2004 was $6,049,000, $7,003,000 and $12,029,000, respectively.

Property and equipment also includes amounts forcertain fixed assets financed under other capital lease obligations. Total costand accumulated amortization relating to all of deCODE’s property and equipmentsubject to capital lease obligations was $11,073,000 and $5,514,000,respectively, as of December 31, 2006 and $1,428,000 and $570,000,respectively, as of December 31, 2005. deCODE’s capital lease obligationsare collateralized by the assets to which the obligations relate.

In light of experience and the current technologicalenvironment, in 2004, deCODE changed certain of its salvage value and usefullife estimates for equipment and furniture and fixtures for purposes ofdepreciation. These changes in estimates had the effect in increasingdepreciation expense and basic and diluted net loss per share by $2,171,000 and$0.04 per share, respectively, for the year end December 31, 2004.

Long-lived assets locatedin the United States and Iceland were $25,356,000 and $20,457,000, respectivelyat December 31, 2006 and $26,231,000 and $13,494,000, respectively at December 31,2005.

**8.  Acquisition of UVS**

On January 17, 2006, deCODE acquired 100% of theoutstanding shares of Urdur Verandi Skuld ehf. (“UVS”), a privately-held cancerresearch firm, from Iceland Genomics Corporation, Inc. (“IGC”), bothcompanies having their principal offices in Reykjavik, Iceland. To acquire UVS,deCODE paid $6,137,000 including 635,006 shares of deCODE common stock valuedat $6,082,000 (based upon the average closing price of deCODE common stock twodays before and after the acquisition date) and approximately $55,000 foracquisition related costs. As part of the transaction, deCODE acquired researchrights for blood and tissue samples and clinical data for various types ofcancers which deCODE has added to its samples for research and developmentpurposes. deCODE has included the results of operations of the acquired entityin deCODE’s consolidated statements of operations from the date of acquisition.Because the activity from the beginning of the period to the acquisition datewas not material, no pro-forma information is presented.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

Thepurchase price was allocated to the estimated fair value of the acquiredtangible and intangible assets and assumed liabilities as follows (amounts inthousands): 

| Cash                            |   | $     | 1,270  |   |
|---------------------------------|--------|-------|--------|--------|
| Net liabilities  acquired       |   | (719  | )      |
| Goodwill                        |   | 1,191 |   |
| Identifiable  intangible assets |   | 4,395 |   |
|                            |   | $     | 6,137  |   |

 

The purchase price was allocated to the net assetsacquired based on their estimated fair values at the date of acquisition. Theexcess of the purchase price over the estimated fair value of the net assetsacquired amounted to $1,191,000, which was allocated to goodwill. UnderIcelandic tax law goodwill is not deductible for tax purposes.

The identifiableintangible assets acquired consist of the exclusive rights to perform researchon blood and tissue samples and related clinical data which were valued at$4,395,000 and will be amortized over a period of 15 years, the estimateduseful life of the assets.

**9.  Goodwill and Other Intangibles**

deCODE’s goodwill resulted from the acquisitions ofMediChem in 2002 and UVS in 2006. Goodwill is tested for impairment annually onSeptember 30 of each year and whenever changes in the circumstancesindicate goodwill could be impaired. No goodwill impairment losses wererecorded in the years ended December 31, 2006, 2005 and 2004.

Otherintangible assets included in other long-term assets and deferred charges onthe consolidated balance sheet as of December 31, 2006 and 2005 consist ofthe following:

| ** **                                | ** ** | **For the Year Ended December 31, 2006** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Gross**                                                              | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **                                | ** ** | **(In thousands)**                                                | ** ** |
| Developed technology,  5 year life   |       | $                                                                      | 4,560      |   |   | $ | 4,370 |   |   | $ | 190 |   |
| Acquired research  rights, 15 year life   |       | 4,395                                                                  |       |   | 293 |   |   | 4,102 |   |
| Patents, 5-7 year  life              |       | 380                                                                    |       |   | 229 |   |   | 151 |   |
| Royalty-free  licenses, 10 year life |       | 230                                                                    |       |   | 110 |   |   | 120 |   |
| Other,  5 year life                  |       | 320                                                                    |       |   | 307 |   |   | 13 |   |
| Total                                     |       | $                                                                      | 9,885      |   |   | $ | 5,309 |   |   | $ | 4,576 |   |

 

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

 

| ** **                                | ** ** | **For the Year Ended December 31, 2005** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Gross**                                                              | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **                                | ** ** | **(In thousands)**                                                | ** ** |
| Developed  technology, 5 year life   |       | $                                                                      | 4,560      |   |   | $ | 3,458 |   |   | $ | 1,102 |   |
| Patents, 5-7 year  life              |       | 380                                                                    |       |   | 181 |   |   | 199 |   |
| Royalty-free  licenses, 10 year life |       | 230                                                                    |       |   | 87 |   |   | 143 |   |
| Other,  5 year life                  |       | 320                                                                    |       |   | 243 |   |   | 77 |   |
| Total                                     |       | $                                                                      | 5,490      |   |   | $ | 3,969 |   |   | $ | 1,521 |   |

 

Aggregateamortization expense was $1,340,000, $1,047,000 and $1,047,000, respectivelyfor the years ended December 31, 2006, 2005 and 2004, respectively. Theseamounts were included in research and development expenses for all periodspresented. As of December 31, 2006 estimated future amortization expenseis as follows:

| 2007       |   | $     | 567    |   |
|------------|--------|-------|--------|--------|
| 2008       |   | 364   |   |
| 2009       |   | 338   |   |
| 2010       |   | 331   |   |
| 2011       |   | 331   |   |
| Thereafter |   | 2,645 |   |
|       |   | $     | 4,576  |   |

 

**10.  Accrued Expenses and Other Current Liabilities**

Accruedexpenses and other current liabilities consist of the following:

| ** **                            | ** ** | **December 31,**   | ** ** |
|---------------------------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(In thousands)** | ** ** |
| Salaries and  other employee benefits |       | $                       | 6,205      |   | $ | 6,814 |   |
| Accrued interest                      |       | 1,716                   |       | 1,107 |   |
| Accrued legal                         |       | 1,862                   |       | 178 |   |
| Other current  liabilities            |       | 4,577                   |       | 4,724 |   |
| Total                                 |       | $                       | 14,360     |   | $ | 12,823 |   |

 

In January 2004, athen executive officer of deCODE acquired an ownership interest in Icelandair,the only regularly-scheduled commercial airline serving Iceland. From January 2004through June 2004 (when the executive officer left the employ of deCODE)deCODE incurred charges to Icelandair of $436,000 for business travel by deCODE’sofficers and employees. deCODE believes that the rates charged by Icelandairare no less favorable than those it charges other customers.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

**11.  Debt**

Long-termdebt consists of the following:

| ** **                                                                                                              | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                              | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                                                                                              | ** ** | **(In thousands)** | ** ** |
| Senior  convertible notes, net of discount of $23,736,000 and $0 at  December 31, 2006 and 2005, respectively |       | $                       | 206,264    |   | $ | 150,000 |   |
| Mortgage loans                                                                                                          |       | 5,611                   |       | 5,921 |   |
| Equipment notes                                                                                                         |       | 791                     |       | 282 |   |
| Total                                                                                                                   |       | 212,666                 |       | 156,203 |   |
| Less current  portion                                                                                                   |       | 604                     |       | 550 |   |
| Long-term portion                                                                                                       |       | $                       | 212,062    |   | $ | 155,653 |   |

 

As of December 31,2006 principal payments on long-term debt are as follows:

| 2007       |   | $       | 604     |   |
|------------|--------|---------|---------|--------|
| 2008       |   | 5,474   |    |
| 2009       |   | 249     |    |
| 2010       |   | 75      |    |
| 2011       |   | 230,000 |    |
| Thereafter |   | —  |    |
|       |   | $       | 236,402 |   |

 

***Senior Convertible Notes***

In April 2004, deCODE completed an offering of$150,000,000 principal amount 3.5% Senior Convertible Notes (the “2004 Notes”)due 2011 to qualified institutional buyers. The 2004 Notes are convertible intoshares of deCODE common stock, at the option of the holder, at a price of$14.00 per share (fair market value of $10.60 on date of issuance), which isequivalent to an initial conversion rate of approximately 71.4286 shares per$1,000 principal amount of the Notes. deCODE may redeem the 2004 Notesbeginning April 20, 2009. Interest is payable semi-annually on April 15and October 15. From this offering, deCODE received net proceeds of$143,805,000. deCODE recorded deferred offering costs of $6,195,000 which arebeing amortized to interest expense over the life of the 2004 Notes (through April 15,2011). During the years ended December 31, 2006, 2005 and 2004, interestexpense of $885,000, $885,000 and $635,000 was recorded to other non-operatingexpenses in the Consolidated Statements of Operations related to the deferredoffering cost amortization. Deferred financing costs related to the 2004 Notesis included in other long-term assets and totals $3,898,000 and $4,783,000 at December 31,2006 and 2005. During the years ended December 31, 2006, 2005 and 2004,interest expense, related to the 3.5% annual interest, of $5,250,000,$5,250,000 and $3,768,000 was recorded to other non-operating expenses in theConsolidated Statements of Operations.

In November 2006deCODE completed the sale of $80,000,000 principal amount of 3.5% SeniorConvertible Notes due 2011 (the “2006 Notes”) at a price of 70% of par pursuantto Rule 144A under the Securities Act of 1933. The 2006 Notes havesubstantially similar terms to the 2004 Notes. The 2006 Notes 

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

areconvertible into shares of deCODE common stock, at the option of the holder, ata price of $14.00 per share, which is equivalent to an initial conversion rateof approximately 71.4286 shares per $1,000 principal amount of the Notes.deCODE may redeem the 2006 Notes beginning April 20, 2009. Interest ispayable semi-annually on April 15 and October 15. From the 2006 Notesoffering, deCODE received gross proceeds of $56,000,000. The 30% ($24,000,000)discount on the 2006 Notes was recorded as a reduction to the debt recorded anddeCODE will accrete this discount, over the life of the 2006 Notes (through April 15,2011), to interest expense up to the full principal amount of $80,000,000.During the year ended December 31, 2006, deCODE recognized interestexpense related to the accretion of the discount of $264,000 in othernon-operating expenses in the Consolidated Statements of Operations, with aremaining discount to be accreted of $23,736,000 at December 31, 2006.deCODE recorded deferred offering costs of $3,053,000 which are being amortizedto interest expense over the life of the 2006 Notes. During the year ended December 31,2006, interest expense of $34,000 was recorded to other non-operating expensesin the Consolidated Statements of Operations with a remaining balance of$3,020,000 at December 31, 2006. During the year ended December 31,2006, interest expense, related to the 3.5% annual interest, of $583,000 wasrecorded to other non-operating expenses in the Consolidated Statements ofOperations.

***Mortgage Loans***

deCODE has a mortgage loan with a financialinstitution for its Woodridge, IL facility. In March 2005, deCODEeliminated restricted cash collateral totaling $6,000,000 and entered into anagreement to refinance its $10,211,000 mortgage with the same financialinstitution by paying down $4,000,000 of the mortgage balance and refinancing$6,211,000. deCODE refinanced the mortgage again in December 2006 and hada balance of $5,611,000 at December 31, 2006. The new mortgage carries aninterest rate of three-month LIBOR + 2.25% (7.62% at December 31, 2006),payable in monthly installments of $26,000 plus interest for two years with afinal payment of $4,990,000 due in December 2008. The mortgage loan iscollateralized by deCODE’s Woodridge, IL facility.

In March 2005, deCODEentered into a sale-leaseback financing for two of its facilities (see Note 12)and in conjunction with that event, certain mortgage loans totaling $21,334,000were repaid. The mortgage loans were collateralized by deCODE’s facilities towhich they underlying loans related to. Prior to the sale-leaseback financingthe mortgage loans that were extinguished in 2005, consisted of (i) a$17,523,000 mortgage loan that bore interest at a rate of three-month LIBORplus 3.00% until March 1, 2009 at which time the lender had the right tounilaterally adjust the interest margin. The loan was payable in twentyquarterly payments starting on march 1, 2009 with a final payment due in 2013, (ii) a$1,907,000 mortgage loan that bore interest at a rate of six-month LIBOR plus1.95% and was payable in semi-annual installments of $73,000 beginning in June 2003with a final payment of $1,835,000 due in 2005, and (iii) a $1,904,000mortgage loan (net of a discount on warrants of $381,000) that bore annualinterest at a rate of three-month LIBOR plus 3.00% with principal and interestpayable quarterly beginning in March 2002. At December 31, 2006 and2005 there were no balances related to these mortgage loans.

***Mortgage Bonds***

During the year ended December 31,2005, deCODE repaid mortgage bonds of $14,236,000 in conjunction with thesale-leaseback financings of Sturlugata and Krokhals (see Note 12). The bonds,had been used to finance the construction of deCODE’s headquarters facility inIceland The mortgage bonds bore annual interest of 8.5% that was payableannually along with principal beginning in December 2002 

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

and witha final payment in December 2008. The mortgage bonds were collateralizedby deCODE’s headquarters facility.

***Short Term Borrowings***

In July 2006, deCODE entered into an agreement tofinance its Directors and Officers insurance premium in the amount of $600,000.The amount is payable monthly with interest at 6.25% with a final payment duein June 2007. At December 31, 2006, $331,000 was due under thisagreement and is included in accrued expenses and other current liabilities inthe accompanying consolidated balance sheet.

During the year ended December 31,2005 and in connection with the sale-leaseback financing of Sturlugatadiscussed in Note 12, deCODE repaid short-term borrowings of $4,500,000. Theseborrowings were due in two amounts of $2,500,000 and $2,000,000 on March 17,2005 and April 28, 2005 and had interest rates of three month LIBOR. Alsoin the year ended December 31, 2005, deCODE repaid the $569,000 balance ofa short term loan, which had been entered into in August 2004 for$1,100,000 at an interest rate of 3.79%, and was due in ten monthly principalinstallments of $114,000. At December 31, 2006 and 2005, none of theseshort term borrowings were outstanding.

***Equipment Notes***

The equipment notesconsist of various loans for equipment and insurance financing, range inprincipal amount from $53,000 to $601,000 and are collateralized by the relatedequipment. The notes are generally payable over a term of 4 years atinterest rates ranging from 8.58% to 10.95%.

**12.  **Sale-Leaseback Financing

***Sturlugata***

In March 2005, deCODE entered into a financingfor the sale and leaseback of its headquarters facility at Sturlugata 8,Reykjavik, Iceland. The sale price for the property was 3.4 billion Icelandickronas ($54,767,000 after taking into account a forward foreign exchangecontact entered in connection with the sale of the property). As a result ofthe sale, the remaining net book value of the property ($29,278,000) has beenremoved from the balance sheet as of December 31, 2005 and the resultinggain has been deferred and is being recognized in earnings over the 15 yearterm of the leaseback.

A portion of the proceeds from the sale of Sturlugata8 were used to prepay approximately $38,639,000 of short and long-term debtthat was secured by mortgages on the property (see Note 11). deCODE recorded aloss on early extinguishment of debt during the year ended December 31,2005 amounting to $3,142,000 which consisted of (i) prepayment fees($1,400,000), (ii) write-off of remaining unamortized finance costs($1,394,000), and (iii) remaining unamortized discount on the prepaidlong-term debt ($347,000). The loss has been recorded in other non-operatingexpense in the accompanying Consolidated Statement of Operations.

deCODE has leased theSturlugata 8 property back under a 15 year non-cancelable lease agreement at arent of 21.4 million Icelandic kronas per month ($298,000 as of December 31,2006), subject to changes based on the Icelandic consumer price index. Thelease is an operating lease and, as a result, Icelandic krona denominated rentwill be included in operating expenses over the 15 year term of the leaseagreement.

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

***Krokhals***

In June 2005, deCODE entered into a financing forthe sale and leaseback of its facility at Krokhals 5D and 5E, Reykjavik,Iceland. The sale price for the property was 502 million Icelandic kronas($7,672,000 after taking into account the sales commission of $117,000). As aresult of the sale, the remaining net book value of the property ($4,029,000)has been removed from the balance sheet as of December 31, 2005, and theresulting gain ($3,559,000) has been deferred and will be recognized toearnings over the 15 year term of the leaseback. A portion of the proceeds fromthe sale of Krokhals were used to prepay approximately $1,836,000 of long-termdebt that was secured by a mortgage on the property.

deCODE has leased theKrokhals 5D and 5E property back under a 15 year non-cancelable lease agreementat a rent of 4.1 million Icelandic krona per month ($57,000 as of December 31,2006), subject to changes based on the Icelandic consumer price index. Thelease is an operating lease and, as a result, Icelandic krona denominated rentwill be included in operating expenses over the 15 year term of the leaseagreement.

***Equipment***

In June 2003, deCODE sold certain laboratoryequipment for $4,750,000 net cash proceeds and leased the equipment back fromthe counter-party (an Icelandic leasing company) for an 18-month term. InJanuary 2004, the lease was extended for another 18-month term withthe final payment due June 2006. As ownership of the equipment wastransferred to deCODE at the end of the extended lease without any furthersignificant payment, the transaction was recorded as a financing and the gain($1,418,000) was deferred and amortized over the remaining useful life of theleased equipment.

In December 2005, deCODE entered into a financingfor the sale and leaseback of equipment. The sale price of the equipment was71.6 million Iceland kronas ($1,200,000) and the resulting gain of $222,000 hasbeen deferred and is being recognized in earnings over the 37 month term of theleaseback.

During 2006, deCODEentered into a financing for the sale and leaseback of laboratory equipmentfrom Illumina for $4,071,000. The net sale price of the equipment was$4,325,000 and the resulting gain of $254,000 has been deferred and is beingrecognized in earnings over the 37 month term of the leaseback. Also, during2006, deCODE sold certain laboratory equipment for $713,000 net cash proceedsand leased the equipment back. The resulting gain of $82,000 has been deferredand is being recognized in earnings over the 37 month term of the leaseback. 

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***deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)***

**13.  Commitments and Contingencies**

***Lease Arrangements***

deCODEleases certain property, equipment and other assets under non-cancelable leasesthat expire at varying dates through 2020. At December 31, 2006, futureminimum lease payments under all non-cancelable leases are as follows:

| ** **                                      | ** ** | **Operating**           | ** ** | **Capital** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-------------|------------|
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| 2007                                            |       |                    | $          | 5,131       |       |   | $ | 2,418 |   |
| 2008                                            |       |                    | 4,921      |        |       | 2,286 |   |
| 2009                                            |       |                    | 4,829      |        |       | 1,399 |   |
| 2010                                            |       |                    | 4,706      |        |       | — |   |
| 2011                                            |       |                    | 4,706      |        |       | — |   |
| Thereafter                                      |       |                    | 38,952     |        |       | — |   |
| Total minimum  lease payments                   |       |                    | $          | 63,245      |       |   | 6,103 |   |
| Less amount  representing interest              |       |                    |       |        |       | 510 |   |
| Present value of  future minimum lease payments |       |                    |       |        |       | 5,593 |   |
| Less: current  portion                          |       |                    |       |        |       | 2,100 |   |
| Long-term portion                               |       |                    |       |        |       | $ | 3,493 |   |

 

Total rent expense foroperating leases was $3,452,000, $2,888,000 and $1,482,000 in the years endedDecember 31, 2006, 2005 and 2004 respectively. For the years endedDecember 31, 2006 and 2005 the amount reflects the amortization of thedeferred gain on sale-leaseback of properties of $1,938,000 and $1,583,000,respectively.

***Other Commitments***

Under the terms of certaintechnology licensing agreements, deCODE is obligated to make payments upon theachievement of established milestones leading to the discovery of definedproducts. These payments could total $5,000,000, with the timing of paymentsnot determinable at the current time.

***Guarantees***

When as part of anacquisition deCODE acquires all of the stock or all of the assets andliabilities of a company, it assumes the liability for certain events oroccurrences that took place prior to the date of acquisition. The maximumpotential amount of future payments it could be required to make for suchobligations is undeterminable at this time. deCODE has no liabilities recordedfor these future payments as of December 31, 2006.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

***Indemnification***

deCODE enters intoindemnification provisions under (i) its agreements with other companiesin its ordinary course of business, typically with business partners,contractors, clinical sites and customers and (ii) its agreements withinvestors. Under these provisions deCODE generally indemnifies and holdsharmless the indemnified party for losses suffered or incurred by theindemnified party as a result of deCODE’s activities or, in some cases, as aresult of the indemnified party’s activities under the agreement. Theseindemnification provisions generally survive termination of the underlyingagreement. In addition, in some cases, deCODE has agreed to reimburse employeesfor certain expenses and to provide salary continuation during short termdisability. The maximum potential amount of future payments deCODE could berequired to make under these indemnification provisions is unlimited. deCODEhas not incurred material costs to defend lawsuits or settle claims related tothese indemnification agreements. As a result, the estimated fair value ofthese agreements is minimal. Accordingly, deCODE has no liabilities recordedfor these agreements as of December 31, 2006.

**14.  Litigation**

Other than claims and legal proceedings that ariseform time to time in the ordinary course of business which are not material,deCODE has no pending legal proceedings except as follows:

On or about April 20, 2002, an amended classaction complaint, captioned *In re deCODE genetics, Inc.Initial Public Offering Securities Litigation* (01 Civ. 11219(SAS)),alleging violations of federal securities laws in connection with deCODE’sinitial public offering was filed in the United States District Court for theSouthern District of New York on behalf of certain purchasers of deCODE commonstock. The complaint names deCODE, two individuals who were executive officersof deCODE at the time of its initial public offering (the “IndividualDefendants”), and the two lead underwriters (the “Underwriter Defendants”) forour initial public offering in July 2000 (the “IPO”) as defendants.

deCODE is aware that similar allegations have beenmade in hundreds of other lawsuits filed (many by some of the same plaintifflaw firms) against numerous underwriter defendants and issuer companies (andcertain of their current and former officers) in connection with various publicofferings conducted in recent years. All of the lawsuits that have been filedin the Southern District of New York have been consolidated for pretrialpurposes before United States District Judge Shira Scheindlin. Pursuant to theunderwriting agreement executed in connection with our IPO, deCODE has demandedindemnification from the Underwriter Defendants. The Underwriter Defendantshave asserted that our request for indemnification is premature.

Pursuant to an agreement the Individual Defendantshave been dismissed from the case without prejudice.

On July 31, 2003, our Board of Directors (otherthan our Chairman and Chief Executive Officer, who recused himself because hewas an Individual Defendant) approved a proposed partial settlement with theplaintiffs in this matter, subject to a number of conditions, including theparticipation of a substantial number of other issuer defendants in theproposed settlement, the consent of deCODE’s insurers to the settlement, andthe completion of acceptable final settlement documentation. Any directfinancial impact of the proposed settlement is expected to be borne by deCODE’sinsurers.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

In conjunction with the plaintiffs, the settling issuerdefendants filed a motion seeking the court’s preliminary approval of the settlement. The court granted preliminaryapproval of the settlement on February 15, 2005, subject to certainmodifications. On August 31, 2005, the court issued a preliminary orderfurther approving the modifications to the settlement and certifying thesettlement classes. The court also appointed the Notice Administrator for thesettlement and ordered that notice of the settlement be distributed to allsettlement class members beginning on November 15, 2005.  The settlement fairness hearing was held on April 24,2006, and the District Court reserved decision. On December 5,2006, the United States Court of Appeals for the Second Circuit (the “SecondCircuit”) issued an opinion vacating the District Court’s certification of alitigation class in that portion of the case between the Plaintiffs and theunderwriter defendants. Because the Second Circuit’s opinion was directed tothe class certified by the District Court for the Plaintiffs’ litigationagainst the underwriter defendants, the opinion’s effect on the class certifiedby the District Court for the Company’s settlement is unclear. On January 5,2007, Plaintiffs filed a petition for rehearing en banc by the Second Circuit. Theproposed settlement is pending final approval by the District Court.

There can be no assurance that this proposedsettlement will be approved and implemented in its current form, if at all. Ifthe settlement of the IPO litigation is not consummated, deCODE expects tocontest the allegations in the action vigorously. Due to the inherentuncertainties of litigation, and the fact that the settlement of the litigationrelating to our IPO remains subject to court approval, the ultimate outcome ofthis matter cannot be predicted. If deCODE were required to pay significantmonetary damages in the event that the IPO settlement is unconsummated or as aresult of an adverse determination in the other actions described above (or anyother lawsuits alleging similar claims filed against deCODE and deCODE’sdirectors and officers in the future), deCODE’s business could be significantlyharmed. Even if such litigations conclude in deCODE’s favor, deCODE may berequired to expend significant funds to defend against the allegations. deCODEis unable to estimate the range of possible loss from the above litigations andno amounts have been provided for such matters in deCODE’s financialstatements.

On August 4, 2006 deCODE commenced an action inthe U.S. District Court for the Eastern District of Pennsylvania against fiveformer employees for misappropriation of deCODE’s trade secrets andintellectual property, related breach of non-competition, non-solicitation, andnon-disclosure provisions of their employment agreements, and violation of thefederal Computer Fraud and Abuse Act. The suit alleges that the defendants,including Hákon Hákonarson, formerly deCODE’s Vice President, BusinessDevelopment, were recruited, and at least four are currently employed, by theCenter for Applied Genomics, a business unit of the Children’s Hospital ofPhiladelphia (CHOP). Also, the suit alleges that while still deCODE employeesand with the knowledge of senior CHOP staff, these defendants copied or sentdirectly to CHOP deCODE proprietary methods, tools, business plans and researchresults. CHOP has intervened as a defendant in the case.

deCODE is seeking preliminary and permanentinjunctions restraining, among other things, the individual defendants fromworking at CHOP in any capacity competitive with deCODE for two years, and theindividual defendants and CHOP from soliciting our employees for a period ofone year and from using or disclosing our confidential information. Inaddition, deCODE is seeking unspecified amounts of compensatory, special andpunitive damages and attorney’s fees.

On August 11, 2006 the court issued a temporaryrestraining order prohibiting the individual defendants from using, altering,destroying or transferring possession of any information taken from 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

deCODE, and fromdestroying, using, altering, copying or transferring possession of one or more250 gigabyte hard drives or any other removable storage devices thatcontained any deCODE information. On August 22, 2006, the court entered anorder extending the temporary restraining order until the court rules ondeCODE’s motion for a preliminary injunction. The hearing on plaintiffs’ motionfor a preliminary injunction concluded on November 22, 2006. Post-hearingbriefs have been submitted. The court has stated that it will schedule a datefor argument on the motion, but no date has been scheduled yet for the argument.Accordingly, the temporary restraining order remains in place.

On September 5, 2006 deCODE filed a motion for anorder to show cause why defendant Robert Skraban should not be held in contemptfor violating the temporary restraining order. On December 1, 2006 deCODEfiled a similar contempt motion as to defendant Hákon Hákonarson. The court hasnot yet ruled on these motions.

On December 13, 2006 CHOP filed counterclaimsagainst deCODE asserting claims for defamation, trade libel, abuse of process,breach of contract, promissory estoppel, intentional interference withprospective contractual relations, and fraud. CHOP’s counterclaims fordefamation, trade libel, intentional interference with prospective contractualrelations, and fraud are asserted against Dr. Kári Stefánsson as well asdeCODE. CHOP’s counterclaims seek unspecified amounts of compensatory, specialand punitive damages, and attorney’s fees.

On December 22, 2006 four individual defendants(Hákon Hákonarson, Struan Grant, Robert Skraban and Jonathan Bradfield) filedcounterclaims against deCODE asserting claims for defamation, trade libel,abuse of process, breach of contract, promissory estoppel, fraud, breach ofimplied contract, breach of covenant of good faith and fair dealing, and falselight. The individual defendants’ counterclaims for defamation, trade libel,abuse of process, fraud, breach of implied contract, and false light areasserted against Dr. Kári Stefánsson as well as deCODE. The individualdefendants’ counterclaims seek unspecified amounts of compensatory, special andpunitive damages, and attorney’s fees.

deCODE and Dr. Stefánsson have filed motions todismiss the counterclaims of CHOP and the individual defendants. The court hasnot yet ruled upon the motions to dismiss.

If deCODE is required to defend the counterclaimsfiled by CHOP and the individual defendants, deCODE believes that it has validdefenses to such counterclaims. If the counterclaims of CHOP or the individualdefendants are resolved against deCODE, it is possible that monetary damagescould be awarded against deCODE that would materially affect the business ofdeCODE.

The fifth individualdefendant, Jesus Sainz, was served with deCODE’s complaint but has not filedany response. The court entered Sainz’s default on September 21, 2006.

**15.  Derivative Financial Instruments**

deCODE recognizes all derivatives as either assets orliabilities in the consolidated balance sheet and measures those instruments atfair value. The fair value of derivative instruments is sensitive to movementsin the underlying market rates and other variables. deCODE monitors the fairvalue of derivative instruments on a periodic basis. Fair values are estimatedfor each derivative using common market valuation methods with reference toavailable market data as of the balance sheet date.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

In March 2004, deCODE refinanced its foreigncurrency debt, with the new instrument being a variable rate U.S dollardenominated debt. Following-on from this refinancing, deCODE reconsidered itstwo cross-currency swaps and decided to liquidate them realizing $9,720,000 in proceeds.deCODE realized a loss on this early termination that, together with unrealizedlosses on the swaps during the year ended December 31,2004, amounted to$1,465,000. Unrealized and realized gains and losses on these twocross-currency swaps are included in other non-operating income and (expense),net in the Consolidated Statements of Operations.

In March 2004, deCODE entered into five forwardforeign exchange contracts with an Icelandic financial institution for purposesof hedging a portion of its Icelandic krona-denominated salaries. On thematurity date of each contract, deCODE sold $1,600,000 and deCODE receivedIcelandic krona at the contracted forward rate. These forward foreign exchangecontracts were designated as economic hedges of the foreign currency salarycash flows and qualified for hedge accounting. The final contract matured in August 2004and no new contracts were entered into. During the year ended December 31,2004, a loss of $11,000 with regard to these forward exchange contracts wasrecorded to operating expenses in the Condensed Consolidated Statements ofOperations.

In March 2005, deCODEpurchased three forward foreign exchange option contracts for $214,000 from anIcelandic financial institution for purposes of hedging a portion of itsIcelandic krona-denominated salaries and other operating expenses. The forwardforeign exchange option contracts provided deCODE the right but not theobligation to sell stated amount of U.S. dollars and receive Icelandic krona atthe contracted forward rates. The forward foreign exchange option contracts tosell $10,000,000, $3,394,000 and $3,394,000, expired unexercised on June 10,June 30 and July 29, 2005, respectively. During the year ended December 31,2005, a loss of $214,000 with regard to these forward exchange contracts wasrecorded to operating expenses in the Condensed Consolidated Statements of Operations.

**16.  Stockholders’ Deficit**

***Common Stock***

The total authorized shares of common stock, par value$0.001, of deCODE is 100,000,000 shares. Holders of shares of common stock areentitled to one vote at all meetings of stockholders for each share held bythem. The common stock has no preemptive rights or other rights to subscribefor additional shares, no conversion right and no right of redemption. Subjectto the rights and preferences of the holders of any preferred stock, theholders of the common stock are entitled to receive such dividends as, when andif declared by the Board of Directors out of funds legally available for thatpurpose.

Notes receivable provided in connection with thepurchase of common stock are collateralized only by the shares to which theyrelate, are payable after a fixed period of generally four years and bear afixed interest rate of generally six percent per annum. Several of the notesthat have become due have been extended a further six years without additionalinterest. The loan becomes payable upon termination of employment and/or whenthe shares are sold.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

In December 2005,deCODE filed a universal shelf registration statement on Form S-3with the Securities and Exchange Commission (“SEC”) for the issuance and salefrom time to time of debt and equity securities either individually or inunits, in one or more offerings, with a total value of up to $100 million. In July 2006deCODE completed the sale of 6,000,000 shares of common stock at a purchaseprice of $5.00 per share, for aggregate net proceeds, after costs of thetransaction, of $27,724,000.

***Preferred Stock***

At December 31,2006, deCODE had 6,716,666 shares of undesignated preferred stock authorizedand no shares issued or outstanding. In respect of the undesignated shares ofpreferred stock, deCODE’s Board of Directors is authorized, except as otherwiselimited by Delaware law, without further action by the stockholders to:

·       issueshares of preferred stock in one or more series;

·       fixor alter the dividend rights, dividend rates, conversion rights, voting rights,terms of redemption (including sinking fund provisions), redemption price orprices, and liquidation preferences of any wholly unissued series of preferredstock;

·       designatethe number of shares constituting, and the designation of, any series ofpreferred stock; and

·       increase or decrease thenumber of shares of a series subsequent to the issue of shares of that series,but not below the number of shares of that series then outstanding.

***Warrants***

Upon the closing of deCODE’s public offering in July 2000,warrants to purchase 1,075,833 shares of Series A preferred stock andwarrants and options to purchase 416,667 shares of Series C preferredstock automatically converted into warrants and options to purchase the samenumber of shares of common stock. Of these warrants, 47,222 were exercised inthe year ended December 31, 2005.

In May 2002, deCODE issued warrants to purchase933,800 shares of common stock at an exercise price of $15.00 per share inconjunction with the issuance of debt.

In February 2004, deCODE issued a warrant topurchase 1,724,257 shares of common stock at $29.00 per share over five yearsto Merck in connection with a Stock and Warrant Purchase Agreement. The warrantis exercisable at Merck’s option as to 344,851 shares for a period of30 days commencing on the first, second, third, fourth and fifthanniversaries of the Warrant Agreement. Any portion of this warrant that is notexercised during an applicable exercise period shall expire and be of nofurther force or effect (see Note 3).

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

Warrantactivity is summarized as follows:

| ** **                        | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Outstanding at  beginning of year |       | 2,729,873                                                     |       | 3,124,724 |   | 1,400,467 |   |
| Issued                            |       | —                                                        |       | — |   | 1,724,257 |   |
| Exercised                         |       | —                                                        |       | (47,222 | ) | — |   |
| Cancelled                         |       | (344,851                                                      | )          | (347,629 | ) | — |   |
| Outstanding at end of  year       |       | 2,385,022                                                     |       | 2,729,873 |   | 3,124,724 |   |

 

Asummary of the exercisable deCODE warrants as of December 31, 2006, is asfollows:

| **Common Shares  Issuable for** | ** ** | **Exercise Price  Per Share** | ** ** | **Warrant Expiration  Date** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------|------------|
| 250,000                                   |       |                                    | $          | 2.00                              |       |   | February 2,  2007 (exercised January 26, 2007) |   |
| 55,555                                    |       |                                    | 3.00       |                              |       | February 5,  2008 |   |
| 55,556                                    |       |                                    | 3.00       |                              |       | May 20,  2009 |   |
| 55,556                                    |       |                                    | 4.00       |                              |       | February 10,  2010 |   |
| 933,800                                   |       |                                    | 15.00      |                              |       | March 1,  2007 (expired, unexercised March 1, 2007) |   |
| 1,350,467                                 |       |                                    |       |                              |       |   |   |

 

***Equity Incentive Plans***

In May 2006, deCODE adopted the deCODE genetics, Inc.2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Plan provides for theissuance of up to 4,000,000 shares of common stock to employees, consultantsand non-employee directors in the form of incentive stock options, nonqualifiedstock options, restricted stock and stock appreciation rights (SARs). deCODEalso maintains the deCODE genetics, Inc. 1996 and 2002 Equity IncentivePlans (together with the 2006 Plan, the “Plans”) that provide for the grant forawards to employees, members of the Board of Directors, consultants and otheradvisors who are not employees. The 1996 Equity Incentive Plan expired in July 2006.A total of 10,000,000 shares were originally reserved for grants of options andrestricted stock under the terms of the 1996 and 2002 Equity Incentive Plans.

The equity incentive Plans are administered by theCompensation Committee of the Board of Directors. The Compensation Committeedetermines the type and term of each award, the award exercise or purchaseprice, if applicable, the number of shares underlying each award granted andthe rate at which each award becomes vested or exercisable. Incentive stockoptions may be granted only to employees of deCODE at an exercise price pershare of not less than the fair market value per share of common stock on theday before the grant and with a term not to exceed ten years from date ofgrant. Nonqualified stock options may be granted to any officer, employee,director, consultant or advisor at a per share exercise price in such amount asthe Compensation Committee may determine. Generally each employee option grantvests twenty-five percent on the first anniversary date of an employee’scommencement of employment and 1/48th of the original grant each monththereafter for the following three years. Upon exercise of options, shares areissued from the pool of registered shares under the Plans.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

The Compensation Committee may also grant restrictedstock and other stock-based awards on such terms and conditions as it maydetermine, which may include deCODE’s right to repurchase the unvestedunderlying stock upon termination of the holder’s employment.

Options granted to date generally vest over a periodof four years, generally have a maximum term of 10 years, and may containearly-exercise provisions allowing for company-provided financing of theexercise price. As of December 31, 2006, 4,201,184 shares were availablefor grant under the Plans.

Thefollowing table summarizes information about stock options outstanding underthe Plans at December 31, 2006:

| ** **                             | ** ** | **Exercise Price  Greater Than Grant  Date  Stock Fair Value** | ** ** | **Exercise Price  Equals Grant Date  Stock Fair Value** | ** ** | **Exercise Price  Less Than Grant  Date  Stock Fair Value** | ** ** | **Total**                              | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **Number  of Shares**                                                              | ** ** | **Weighted  Average  Exercise  Price**                                           | ** ** | **Number  of Shares**                                                           | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  January 1, 2004   |       |                                                                                    | 100,000    |                                                                             |       |                                                                                 | $          | 7.42                                   |       |   |   | 3,516,831 |   |   |   | $ | 7.73 |   |   |   | 491,500 |   |   |   | $ | 9.02 |   |   |   | 4,108,331 |   |   |   | $ | 7.88 |   |   |
| Granted                                |       |                                                                                    | 30,000     |                                                                             |       |                                                                                 | 8.39       |                                   |       |   | 832,734 |   |   |   | 8.35 |   |   |   | — |   |   |   | — |   |   |   | 862,734 |   |   |   | 8.35 |   |   |
| Exercised                              |       |                                                                                    | —     |                                                                             |       |                                                                                 | —     |                                   |       |   | (113,427 | ) |   |   | 4.57 |   |   |   | — |   |   |   | — |   |   |   | (113,427 | ) |   |   | 4.57 |   |   |
| Cancelled                              |       |                                                                                    | —     |                                                                             |       |                                                                                 | —     |                                   |       |   | (164,154 | ) |   |   | 7.68 |   |   |   | (3,542 | ) |   |   | 10.00 |   |   |   | (167,696 | ) |   |   | 7.73 |   |   |
| Outstanding at  December 31, 2004 |       |                                                                                    | 130,000    |                                                                             |       |                                                                                 | 7.64       |                                   |       |   | 4,071,984 |   |   |   | 7.95 |   |   |   | 487,958 |   |   |   | 9.02 |   |   |   | 4,689,942 |   |   |   | 8.05 |   |   |
| Granted                                |       |                                                                                    | —     |                                                                             |       |                                                                                 | —     |                                   |       |   | 592,333 |   |   |   | 8.85 |   |   |   | — |   |   |   | — |   |   |   | 592,333 |   |   |   | 8.85 |   |   |
| Exercised                              |       |                                                                                    | (20,000    | )                                                                                |       |                                                                                 | 7.42       |                                   |       |   | (82,860 | ) |   |   | 3.51 |   |   |   | — |   |   |   | — |   |   |   | (102,860 | ) |   |   | 4.27 |   |   |
| Cancelled                              |       |                                                                                    | (30,000    | )                                                                                |       |                                                                                 | 8.39       |                                   |       |   | (186,713 | ) |   |   | 7.77 |   |   |   | (260,000 | ) |   |   | 5.63 |   |   |   | (476,713 | ) |   |   | 6.64 |   |   |
| Outstanding at  December 31, 2005 |       |                                                                                    | 80,000     |                                                                             |       |                                                                                 | 7.42       |                                   |       |   | 4,394,744 |   |   |   | 8.16 |   |   |   | 227,958 |   |   |   | 12.88 |   |   |   | 4,702,702 |   |   |   | 8.38 |   |   |
| Granted                                |       |                                                                                    | —     |                                                                             |       |                                                                                 | —     |                                   |       |   | 974,194 |   |   |   | 7.24 |   |   |   | — |   |   |   | — |   |   |   | 974,194 |   |   |   | 7.24 |   |   |
| Exercised                              |       |                                                                                    | (80,000    | )                                                                                |       |                                                                                 | 7.42       |                                   |       |   | (96,067 | ) |   |   | 2.97 |   |   |   | — |   |   |   | — |   |   |   | (176,067 | ) |   |   | 4.99 |   |   |
| Cancelled                              |       |                                                                                    | —     |                                                                             |       |                                                                                 | —     |                                   |       |   | (500,755 | ) |   |   | 9.27 |   |   |   | (25,000 | ) |   |   | 18.17 |   |   |   | (525,755 | ) |   |   | 9.68 |   |   |
| Outstanding at  December 31, 2006 |       |                                                                                    | —     |                                                                             |       |                                                                                 | $          | —                                 |       |   |   | 4,772,116 |   |   |   | $ | 7.96 |   |   |   | 202,958 |   |   |   | $ | 12.23 |   |   |   | 4,975,074 |   |   |   | $ | 8.14 |   |   |

 

The aggregate intrinsic value of options exercisedunder the Plans determined as of the date of option exercise was $528,000,$461,000 and $578,000 during the years ended December 31, 2006, 2005, and2004, respectively. The weighted average grant date fair value of optionsgranted during the years ended December 31, 2006, 2005 and 2004 was $4.34,$8.90 and $8.32, per share, respectively. Cash received from option exercisesfor the years ended December 31, 2006 and 2005 and 2004 was $870,000, $439,000and $522,000, respectively.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

Thefollowing table summarizes information about stock options outstanding andexercisable at December 31, 2006:

| ** **              | ** ** | **Options Oustanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------|------------|-----------------------------|------------|------------------------------|------------|
| **Exercise Price** | ** ** | ** **                  | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life  (In years)** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $1.52 to $7.05          |       | 1,055,278                   |       |                         | $          | 4.61 |   |   |   | 7.77 |   |   | 555,063 |   |   | $ | 3.74 |   |   |
| $7.38 to $8.13          |       | 1,104,006                   |       |                         | 7.96       |   |   |   | 6.47 |   |   | 779,939 |   |   | 8.04 |   |   |
| $8.17 to $8.65          |       | 326,236                     |       |                         | 8.41       |   |   |   | 6.94 |   |   | 227,936 |   |   | 8.41 |   |   |
| $8.96 to $8.96          |       | 1,427,501                   |       |                         | 8.96       |   |   |   | 6.88 |   |   | 1,213,444 |   |   | 8.96 |   |   |
| $9.21 to $24.56         |       | 1,062,053                   |       |                         | 10.64      |   |   |   | 7.21 |   |   | 578,634 |   |   | 11.75 |   |   |
| $1.52 to $24.56         |       | 4,975,074                   |       |                         | $          | 8.14 |   |   |   | 7.05 |   |   | 3,355,016 |   |   | $ | 8.33 |   |   |
|                         |            |                             |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue of options outstanding and exercisable at December 29, 2006 was $0and $0, respectively. The aggregate intrinsic value of options outstanding andoptions exercisable represents the total pre-tax intrinsic value, based ondeCODE’s closing stock price of $4.53 as of December 29, 2006 (the lasttrading day for the year ended December 31, 2006), which would have beenreceived by the option holders had all option holders exercised their optionsas of that date. The total number of in-the-money options exercisable as of December 29,2006 was 305,997. The weighted average remaining life of options exercisablewas 6.3 years. The total shares vested and expected to vest at December 31,2006 was approximately 4,751,685.

***Stock-based Compensation***

Effective January 1, 2006 deCODE adopted SFAS123R using the modified prospective transition method, which requires themeasurement and recognition of compensation expense for all stock-based paymentawards made to deCODE’s employees and directors. deCODE’s financial statementsas of and for year ended December 31, 2006 reflect the impact of SFAS123R. In accordance with the modified prospective transition method, deCODE’sfinancial statements for prior periods have not been restated to reflect, anddo not include, the impact of SFAS 123R. Stock-based compensation expenserecognized is based on the value of the portion of stock-based payment awardsthat is ultimately expected to vest. Stock-based compensation expenserecognized in deCODE’s Consolidated Statement of Operations during the yearended December 31, 2006 included compensation expense for stock-basedpayment awards granted prior to, but not yet vested as of December 31,2005, based on the grant date fair value estimated in accordance with the proforma provisions of SFAS 123, and compensation expense for the stock-basedpayment awards granted subsequent to December 31, 2005 based on the grantdate fair value estimated in accordance with the provisions of SFAS 123R. Inconjunction with the adoption of SFAS 123R, deCODE elected to attribute thevalue of stock-based compensation to expense using the straight-line method,which was previously used for its pro forma information required under SFAS123.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

Thefollowing table summarizes stock-based compensation expense related to employeestock options and nonvested share awards under SFAS 123R for the year ended December 31,2006 which was included in the Consolidated Statement of Operations in thefollowing captions:

| ** **                                         | ** ** | **Year Ended  December 31,  2006** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                         | ** ** | **(In thousands)**                      | ** ** |
| Operating Expenses:                                |       |                                         |       |   |   |
| Cost of revenue                                    |       |                                         | $          | 612 |   |   |
| Research and development—proprietary programs |       |                                         | 1,513      |   |   |
| Selling, general and administrative                |       |                                         | 2,176      |   |   |
| Total                                              |       |                                         | $          | 4,301 |   |   |

 

As stock-based compensation expense recognized in theConsolidated Statement of Operations for the year ended December 31, 2006is based on awards ultimately expected to vest, it has been reduced forestimated forfeitures. SFAS 123R requires forfeitures to be estimated at thetime of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates. deCODE has calculated stock-basedcompensation using an estimated forfeiture rate of 5.6%. To the extent theactual forfeiture rate differs materially from this estimate the expense willbe adjusted.

As of December 31, 2006, there was $6,457,000 oftotal unrecognized compensation expense related to non-vested stock options.This unrecognized compensation expense is expected to be recognized over aweighted average period of 1.7 years. The total fair value of options vestedduring the year ended December 31, 2006 was $3,634,000.

Prior to the adoption of SFAS 123R, as permitted bySFAS No. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”) and SFAS No. 148, *Accounting for Stock-Based Compensation—Transition and Disclosure*,deCODE applied the accounting rules under APB 25, which provided that nocompensation expense was charged for options granted at an exercise price equalto the market value of the underlying common stock on the date of grant.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

Thefollowing table illustrates the effect on net loss per share if deCODE hadapplied the fair value recognition provisions of SFAS 123R to awards grantedunder deCODE’s stock-based compensation plans prior to the adoption of thisstandard:

| ** **                                                                                                            | ** ** | **Year Ended December 31,**                       | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2005**                                                         | ** ** | **2004** | ** ** |
| ** **                                                                                                            | ** ** | **(In thousands except  per share amounts)** | ** ** |
| Net loss  attributable to common  stockholders—as reported                                                       |       |                                                             | $          | (62,750 | ) |   |   | $ | (57,255 | ) |   |
| Add: Stock-based  employee compensation expense included in reported net loss                                         |       |                                                             | 441        |   |   |   | 964 |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair  value method for all awards |       |                                                             | (5,347     | ) |   |   | (5,932 | ) |   |
| Net loss  attributable to common stockholders—proforma                                                           |       |                                                             | $          | (67,656 | ) |   |   | $ | (62,223 | ) |   |
| Basic and diluted  net loss per share  as reported—as reported                                                   |       |                                                             | $          | (1.17 | ) |   |   | $ | (1.07 | ) |   |
| Basic and diluted net  loss per share—proforma                                                                   |       |                                                             | (1.26      | ) |   |   | (1.16 | ) |   |

 

Theemployee stock-based compensation recognized under SFAS 123R and presented inthe pro forma disclosures required under SFAS 123 was determined usint theBlack Scholes option valuation model. Option valuation models require the inputof subjective assumptions and these assumptions can vary over time. Theweighted average assumptions used are as follows.

| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected dividend  yield         |       |                                       | —     |   |   |   | — |   |   |   | — |   |   |
| Expected  volatility             |       |                                       | 65.9       | % |   |   | 80.0 | % |   |   | 92.0 | % |   |
| Expected option  life (in years) |       |                                       | 5.1        |   |   |   | 5.0 |   |   |   | 5.0 |   |   |
| Risk-free interest rate          |       |                                       | 4.7        | % |   |   | 4.1 | % |   |   | 3.7 | % |   |

 

deCODE estimates theexpected term of the options based on historical patterns by employees withrespect to exercise and post vesting employment termination behaviors.Beginning on January 1, 2006, expected volatility is based on deCODE’shistorical volatility and is calculated using a weighted average of thevolatility over a period equal to the expected term of the award and the mostrecent one year volatility. deCODE bases the risk-free interest rate used onthe implied yield currently available on the U.S. Treasury zero-coupon issueswith an equivalent term. As deCODE does not pay dividends, the dividend ratevariable in the Black-Sholes model is zero.

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

***Restricted Stock***

deCODE’s Equity Incentive Plans allow for the issuanceof restricted stock awards that may not be sold or otherwise transferred untilcertain restrictions have lapsed. The stock-based compensation expense forthese awards is determined based on the market price of deCODE’s stock at thedate of the grant applied to the total numbers of shares that are anticipatedto fully vest and then amortized over the period the restrictions lapse.

Thefollowing table represents restricted stock activity for the years ended December 31,2006 and 2005:

| ** **                                                   | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | **Number  of  Shares**                      | ** ** | **Weighted  Average  Grant  Date Fair  Value** | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Grant  Date Fair  Value** | ** ** |
| Unvested  restricted shares outstanding, beginning of period |       |                                        | 51,987     |   |   |   | $ | 9.31 |   |   |   | — |   |   |   | $ | — |   |   |
| Restricted shares  issued                                    |       |                                        | 7,588      |   |   |   | 7.38 |   |   |   | 57,944 |   |   |   | 9.08 |   |   |
| Restricted shares  vested                                    |       |                                        | (7,678     | ) |   |   | 7.29 |   |   |   | (5,957 | ) |   |   | 7.05 |   |   |
| Unvested restricted  shares outstanding, end of period       |       |                                        | 51,897     |   |   |   | $ | 9.33 |   |   |   | 51,987 |   |   |   | $ | 9.31 |   |   |

 

At December 31, 2006, there was $261,000 of totalunrecognized compensation cost related to restricted stock to be recognizedover a weighted average remaining period of 1.53 years. The total fair valueof shares vested during the years ended December 31, 2006 and 2005 was$56,000 and $42,000, respectively.

In 2006 and 2005, deCODE granted 7,588 and 7,944shares, respectively to its Audit Committee members. These grants remainsubject to the right of deCODE to repurchase the shares in certaincircumstances through a period of one-year from grant date. During the yearsended December 31, 2006 and 2005, deCODE recognized expense of $56,000 and$36,000 related to these grants, respectively.

In 2005, deCODE granted 50,000 shares to an executiveofficer. This grant remains subject to the right of deCODE to repurchase theshares in certain circumstances until July 2008. During the years ended December 31,2006 and 2005, deCODE recognized expense of $157,000 and $73,000, respectively.

In 2004, deCODE granted astock award to a consultant for 15,000 shares. deCODE recognized expenseof  $104,000 in 2004 related to thisgrant based on the fair market value of common stock on the date of grant.These shares were issued in January 2005. 

**17.**  DefinedContribution Benefits

deCODE contributes to relevant pension organizationsfor personnel in Iceland in accordance with Icelandic law and employmentpractices. Certain other discretionary contributions may be made. Contributionsare based on employee salaries paid and deCODE has no further liability inconnection with 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

these plans. Totalcontributions were $2,231,000, $2,120,000 and $1,648,000 for the years endedDecember 31, 2006, 2005 and 2004, respectively.

deCODE maintains401(k) pension plans available to eligible full-time employees in theUnited States. deCODE made contributions of $319,000, $273,000 and $248,000 forthe years ended December 31, 2006, 2005 and 2004 to these plans. 

**18.**  IncomeTaxes

Deferred income taxes include the net effects oftemporary differences between the carrying amounts for assets and liabilitiesfor financial reporting purposes and the amounts used for income tax purposes.

deCODE’sdeferred tax assets (liabilities) are comprised of the following:

| ** **                                  | ** ** | **December 31,**   | ** ** |
|---------------------------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                  | ** ** | **(In thousands)** | ** ** |
| Loss  carryforwards                         |       | $                       | 73,061     |   | $ | 61,039 |   |
| Capitalized  research and development costs |       | 18,564                  |       | 15,640 |   |
| Deferred revenue                            |       | 1,429                   |       | 2,200 |   |
| Fixed asset  depreciation                   |       | 4,340                   |       | 107 |   |
| Intangible  assets/patents                  |       | (186                    | )          | (597 | ) |
| Other deferred  tax assets                  |       | 750                     |       | 637 |   |
| Total deferred  tax asset, net              |       | 97,958                  |       | 79,026 |   |
| Valuation  allowance                        |       | (97,958                 | )          | (79,026 | ) |
|                                        |       | $                       | —     |   | $ | — |   |

 

Thetable below reconciles the expected U.S. federal income tax rate to therecorded income tax rate:

| ** **                                  | ** ** | **For the Years Ended  December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income taxes at  federal statutory rates    |       | (34.0                                                     | )%         | (34.0 | )% | (34.0 | )% |
| State income  taxes, net of federal benefit |       | (0.9                                                      | )          | (0.2 | ) | (1.6 | ) |
| Non-deductible  equity compensation         |       | 0.5                                                       |       | 0.3 |   | 3.9 |   |
| Foreign rate  differential                  |       | 13.4                                                      |       | 14.8 |   | 12.2 |   |
| Foreign currency  adjustment                |       | (0.8                                                      | )          | 2.6 |   | (12.4 | ) |
| Other                                       |       | (0.3                                                      | )          | 2.1 |   | (0.8 | ) |
| Net change in  valuation allowance          |       | 22.1                                                      |       | 14.4 |   | 32.7 |   |
|                                        |       | 0.0                                                       | %          | 0.0 | % | 0.0 | % |

 

Pre-tax U.S. losses were $13,653,000, $7,986,000 and$13,587,000 and pre-tax Icelandic losses were $71,820,000, $54,764,000 and$43,668,000 in 2006, 2005 and 2004, respectively. As of December 31, 2006,deCODE had U.S. federal net operating loss (“NOL”) carryforwards ofapproximately $49,388,000 that may be available to offset future U.S. federalincome tax liabilities and expire at various dates through 2026. As ofDecember 31, 2006, deCODE’s Icelandic subsidiaries had NOL carryforwardsof approximately $298,535,000 that begin to expire in 2007. Management hasevaluated the positive and 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

negative evidence bearingupon the realizability of its deferred tax assets and has established a fullvaluation allowance for such assets, which are comprised principally of netoperating loss carryforwards and capitalized research and experimentationcosts.

Approximately $655,000 of the net operating losscarryforwards relate to the exercise of non-qualified stock options anddisqualifying dispositions of incentive stock options, the tax benefit fromwhich, if realized, will be credited to additional paid in capital.

Ownership changes, as defined in the Internal RevenueCode, may have limited the amount of net operating loss carryforwards that canbe utilized annually to offset future taxable income. Subsequent ownershipchanges could further affect the limitation in future years.

In the year ended December 31,2004 there was a foreign currency adjustment caused by strengthening of theIcelandic krona against the U.S. dollar, resulting in an increase in deferredtax assets and liabilities that was offset by an increase in the tax valuationallowance of $32,502,000. In the years ended December 31, 2006 and 2005,this strengthening began to reverse resulting in a decrease in deferred taxassets and liabilities that was offset by a decrease in the tax valuationallowance of $26,207,000 and $11,096,000.

**19.**  SubsequentEvent

In February 2007,deCODE entered into an agreement regarding the sale and leaseback of itsproperty (land and facility) in Woodridge, Illinois. Pursuant to theagreement and subject to the satisfaction of contingencies including, withoutlimitation, negotiation of a satisfactory lease, deCODE will sell the Woodridgeproperty for $25,000,000 in cash and lease the property back under a 17 yearlease at an initial rent of $163,000 per month, subject to annual rentincreases of 2.5%. Under the lease contemplated by the agreement, deCODE willhave two 5-year renewal options with rent at the then prevailing marketrate. The lease will be an absolute net lease and deCODE will continue to payall expenses relating to the property, including taxes, utilities, insuranceand maintenance. deCODE’s obligations under the lease are to be secured bya letter of credit in the amount of $5,000,000. The agreement regarding thesale and leaseback of the property is subject to the satisfaction of variouscontingencies, including, without limitation, the negotiation of a satisfactorylease, the buyer’s ability to obtain financing for its purchase of the propertyand the buyer’s satisfaction with its due diligence review of theproperty. The transaction is expected to close in May 2007 if suchcontingencies are satisfied, however, in light of the contingencies, there canbe no assurance that the closing will occur. 

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**deCODE genetics, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (tabular amounts in thousands, except share and per share amounts)**

**20.**  SelectedQuarterly Data (Unaudited)

| ** **                            | ** ** | **For the Three Months Ended**                    | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                            | ** ** | **March 31,**                                                    | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **2006**                              |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                               |       |                                                                  | $          | 10,133 |   |   | $ | 10,360 |   |   | $ | 8,566 |   |   |   | $ | 11,451 |   |   |
| Operating loss                        |       |                                                                  | 20,501     |   |   | 17,698 |   |   | 23,907 |   |   |   | 22,358 |   |   |
| Net loss                              |       |                                                                  | 20,273     |   |   | 18,343 |   |   | 23,632 |   |   |   | 23,225 |   |   |
| Basic and diluted  net loss per share |       |                                                                  | (0.37      | ) |   | (0.34 | ) |   | (0.40 | ) |   |   | (0.38 | ) |   |
| **2005**                              |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                               |       |                                                                  | $          | 9,523 |   |   | $ | 11,437 |   |   | $ | 13,197 |   |   |   | $ | 9,798 |   |   |
| Operating loss                        |       |                                                                  | 12,050     |   |   | 12,855 |   |   | 11,781 |   |   |   | 20,488 |   |   |
| Net loss                              |       |                                                                  | 16,936     |   |   | 13,332 |   |   | 11,370 |   |   |   | 21,112 |   |   |
| Basic and diluted net  loss per share |       |                                                                  | (0.32      | ) |   | (0.25 | ) |   | (0.21 | ) |   |   | (0.39 | ) |   |

 

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**Item 9.**                        *Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure*

Not applicable.

***Item 9A.***          Controlsand Procedures

(a)*     Evaluationof disclosure controls and procedures.* Our Chief Executive Officerand our Chief Financial Officer evaluated the effectiveness of deCODE’sdisclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the fiscal year covered by this Annual Report on Form 10-K.Based upon that evaluation, the Chief Executive Officer and the Chief FinancialOfficer have concluded that as of the end of such fiscal year deCODE’sdisclosure controls and procedures are adequate and effective to ensure thatinformation required to be disclosed in the reports deCODE files under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms. Disclosure controls and procedures include without limitation, controlsand procedures designed to ensure that information required to be disclosed byan issuer in the reports that it files or submits under the Act is accumulatedand communicated to the issuer’s management including its principal executiveand principal financial officers or persons performing similar functions asappropriate to allow timely decisions regarding required disclosures.

In designing and evaluating our disclosure controlsand procedures, our management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurancethat the desired objectives of the control system will be met. In addition, thedesign of any control system is based in part upon certain assumptions about thelikelihood of future events and the application of judgment in evaluating thecost-benefit relationship of possible controls and procedures. Because of theseand other inherent limitations of control systems, there is only reasonableassurance that our controls will succeed in achieving their goals under allpotential future conditions.

(b)*    Changes inInternal Controls.* We are continuously seeking to improve theefficiency and effectiveness of our internal controls. This results in periodicrefinements to internal control processes throughout the Company. However,there was no significant change in our internal control over financialreporting (as defined in Rule 13a-15(f) under the Exchange Act)during the last fiscal quarter of the year ended December 31, 2006 thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

**Management’s Reporton Internal Control Over Financial Reporting**

The management of the Company is responsible forestablishing and maintaining adequate internal control over financial reportingas defined in Rule 13a-15(f) under the Securities Exchange Actof 1934, as amended. The Company’s internal control system was designed toprovide reasonable assurance to the Company’s management and board of directorsregarding the preparation and fair presentation of published financialstatements for external reporting purposes in accordance with accountingprinciples generally accepted in the United States of America.

All internal control systems, no matter how welldesigned, have inherent limitations. Therefore, even those systems determinedto be effective can provide only reasonable assurance with respect to financialstatement preparation and presentation.

The Company’s management assessed the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2006. In making this assessment, it used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control-Integrated Framework*.Based on its assessment management believes that, as of December 31, 2006,the Company’s internal control over financial reporting is effective based onthose criteria.

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The Company’s independent registered public accountingfirm, Deloitte & Touche LLP, which audited the financial statementscontained in this Annual Report on Form 10-K, has issued anattestation report on management’s assessment of the Company’s internal controlover financial reporting as of December 31, 2006. This report, whichexpresses an unqualified opinion on management’s assessment and on theeffectiveness of the Company’s internal control over financial reporting as of December 31,2006, is included below under the heading “Report of Independent RegisteredPublic Accounting Firm.”

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofdeCODE genetics, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over Financial Reporting,that deCODE genetics, Inc. and subsidiaries (the “Company”) maintainedeffective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl-Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion or impropermanagement override of controls, material misstatements due to error or fraudmay not be prevented or detected on a timely basis. Also, projections of anyevaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on the criteriaestablished in *Internal Control-Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.. Also in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31,2006, based on the criteria established in *InternalControl-Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated financialstatements as of and for the year ended December 31, 2006 of the Companyand our report dated March 14, 2007 expressed an unqualified opinion onthose financial statements and includes an explanatory paragraph regarding theCompany’s adoption of Statement of Financial Accounting Standards No. 123R,*Share-Based Payment*, in 2006.

/s/ Deloitte & Touche LLP

Boston, MassachusettsMarch 14, 2007

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**Item 9B.**               *Other Information*

Not applicable

**PART III**

**Item 10.**                 *Directors and Executive Officers of the Registrant*

For information concerningthis item, see the information under “Election of Directors,” “ExecutiveOfficers Who are Not Directors, “ “Code of Ethics” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our Proxy Statement to be filed with respectto our 2007 Annual Meeting of Stockholders, which information is incorporatedherein by reference.

**Item 11.**                 *Executive Compensation*

For information concerningthis item, see the information under “Executive Compensation” in our ProxyStatement to be filed with respect to our 2007 Annual Meeting of Stockholders,which information is incorporated herein by reference.

**Item 12.**                 *Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters*

For information concerningthis item, see the information under “Security Ownership of Certain BeneficialOwners and Management” in our Proxy Statement to be filed with respect to our2007 Annual Meeting of Stockholders, which information is incorporated hereinby reference.

**Item 13.**                 *Certain Relationships and Related Transactions*

For information concerningthis item, see the information under “Certain Relationships and Related Transactions”and “Election of Directors” in our Proxy Statement to be filed with respect toour 2007 Annual Meeting of Stockholders, which information is incorporatedherein by reference.

**Item 14.**                 *Principal Accountant Fees and Services*

For information concerningthis item, see the information under “Principal Accountant Fees and Services”in our Proxy Statement to be filed with respect to our 2007 Annual Meeting ofStockholders, which information is incorporated herein by reference.

**PART IV**

**Item 15.**                 *Exhibits, Financial Statement Schedules, and Reports on Form 8-K*

(a)          The following documents are included as part of this AnnualReport on Form 10-K:

1.    FinancialStatements:

|                                                                            | ** ** | **PAGE** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|
| Reports  of Independent Registered Public Accounting Firm                  |       | 59       |       |
| Consolidated  Balance Sheets                                               |       | 60       |       |
| Consolidated  Statements of Operations                                     |       | 61       |       |
| Consolidated  Statements of Changes in Stockholders’ Equity (Deficit) |       | 62       |       |
| Consolidated  Statements of Cash Flows                                     |       | 63       |       |
| Notes  to Consolidated Financial Statements                                |       | 64       |       |

 

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2.    Allschedules are omitted as the information required is inapplicable or theinformation is presented in the consolidated financial statements or therelated notes.

3.                 Exhibits

The exhibits required to be filed are listed on the “Exhibit Index”attached hereto, which is incorporated herein by reference.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|        |                        | deCODE genetics, Inc. |
|--------|-----------------------------|----------------------------|
|   |                        | By:                        | /s/ Kari Stefansson |
|   |                        |                       | Kari Stefansson, |
|   |                        |                       | Chairman, President and Chief Executive Officer |
|   | Dated: March 14,  2007 |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
| /s/ Kari Stefansson            |   | Chairman, President, Chief Executive Officer and    |   | March 14, 2007 |
|--------------------------------|--------|-----------------------------------------------------|--------|--------------------------|
| Kari Stefansson                |   | Director (principal executive officer)              |   |                     |
| /s/  Lance Thibault            |   | Chief Financial Officer  and Treasurer (principal   |   | March 14, 2007      |
| Lance Thibault                 |   | financial officer and principal accounting officer) |   |                     |
| /s/  J. Neal Armstrong         |   | Director                                            |   | March 14, 2007      |
| J. Neal Armstrong              |   |                                                |   |                     |
| /s/  James Beery               |   | Director                                            |   | March 14, 2007      |
| James Beery                    |   |                                                |   |                     |
| /s/  Terrance McGuire          |   | Director                                            |   | March 14, 2007      |
| Terrance McGuire               |   |                                                |   |                     |
| /s/  Linda Buck                |   | Director                                            |   | March 14, 2007      |
| Linda Buck                     |   |                                                |   |                     |
| /s/  Birgit Stattin Norinder   |   | Director                                            |   | March 14, 2007      |
| Birgit Stattin  Norinder       |   |                                                |   |                     |
| /s/  Earl M. Collier, Jr. |   | Director                                            |   | March 14, 2007      |
| Earl M.  Collier, Jr.     |   |                                                |   |                     |
| /s/  Peter Goodfellow          |   | Director                                            |   | March 14, 2007      |
| Peter Godfellow                |   |                                                |   |                     |

 

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**EXHIBITINDEX**
|       | **Exhibit   Number** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | ** ** | **Description** | ** ** |
|-------|----------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------|------------|
| 3.1   |                 | Amended and Restated  Certificate of Incorporation, as further amended (Incorporated by reference  to Exhibit 3.1 and Exhibit 3.3 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984)  which became effective on July 17, 2000).                                                                                                                                                                          |
| 3.2   |                 | Bylaws, as amended  (Incorporated by reference to Exhibit 3.2 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984)  which became effective on July 17, 2000).                                                                                                                                                                                                                                                   |
| 3.3   |                 | Certificate of Amendment  to Amended and Restated Certificate of Incorporation dated August 30,  2002 (Incorporated by reference to Exhibit 3.2 to the Company’s  Quarterly Report on Form 10-Q filed on November 14, 2002).                                                                                                                                                                                                                 |
| 4.1   |                 | Specimen Common Stock  Certificate (Incorporated by reference to Exhibit 4.1 to the Company’s  Registration Statement on Form S-1 (Registration No. 333-31984)  which became effective on July 17, 2000).                                                                                                                                                                                                                                    |
| 4.2   |                 | Form of Warrant to  Purchase Series C Preferred Stock (Incorporated by reference to  Exhibit 4.3 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on  July 17, 2000).                                                                                                                                                                                                      |
| 4.3   |                 | Warrant, dated  February 25, 2004, issued to Merck & Co., Inc.  (Incorporated by reference to Exhibit 4.7 to the Company’s Annual Report  on Form 10-K filed on March 15, 2004).                                                                                                                                                                                                                                               |
| 4.4   |                 | Indenture dated as of  April 14, 2004 between deCODE genetics, Inc. and The Bank of New  York (including form of 3.5% Senior Convertible Note due 2011)(Incorporated  by reference to Exhibit 4.2 to the Company’s Registration Statement on  Form S-3 (Registration No. 333-116543) which was filed  on June 16, 2004).                                                                                                           |
| 4.5   |                 | Registration Rights  Agreement dated as of April 14, 2004 between deCODE genetics, Inc.,  J.P. Morgan Securities Inc. and Lehman Brothers Inc., as representatives of  the Initial Purchasers (Incorporated by reference to Exhibit 4.9 to the  Company’s Quarterly Report on Form 10-Q filed on May 10,  2004).                                                                                                                        |
| 4.6   |                 | Indenture dated as of  November 17, 2006 between deCODE genetics, Inc. and The Bank of New  York (including form of 3.5% Senior Convertible Note due 2011)(Incorporated  by reference to Exhibit 4.1 to the Company’s Current Report on  Form 8-K filed on November 20, 2006).                                                                                                                                                          |
| 4.7   |                 | Registration Rights  Agreement dated as of November 17, 2006 between deCODE  genetics, Inc. and Lehman Brothers, Inc. as Representative of the  Initial Purchasers (Incorporated by reference to Exhibit 4.2 to the  Company’s Current Report on Form 8-K filed on November 20,  2006).                                                                                                                                            |
| 10.1  |                 | Form of License  from The Icelandic Data Protection Commission (now, The Icelandic Data  Protection Authority) to Islensk erfdagreining ehf. and its Clinical  Collaborators to Use and Access Patient Records and Other Clinical Data  Relating to Individuals (Incorporated by reference to Exhibit 10.1 to  the Company’s Registration Statement on Form S-1 (Registration  No. 333-31984) which became effective on July 17, 2000). |
| 10.2* |                 | 1996 Equity Incentive  Plan, as amended (Incorporated by reference to Exhibit 10.1 to the Company’s  Registration Statement on Form S-8 (Registration No. 333-56996)  filed on March 14, 2001).                                                                                                                                                                                                                                              |
| 10.3* |                 | Form of Non-Statutory  Stock Option Agreement, as executed by employees and officers of deCODE  genetics, Inc. who received non-statutory stock options  (Incorporated by reference to Exhibit 10.3 to the Company’s Annual  Report on Form 10-K filed April 15, 2003).                                                                                                                                                                 |

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| 10.4*  |   | Form of Employee  Proprietary Information and Inventions Agreement (Incorporated by reference  to Exhibit 10.4 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on  July 17, 2000).                                                  |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5   |   | Co-operation  Agreement between Reykjavik Hospital and Islensk erfdagreining ehf., dated  November 4, 1998 (Incorporated by reference to Exhibit 10.22 to the  Company’s Registration Statement on Form S-1 (Registration  No. 333-31984) which became effective on July 17, 2000).          |
| 10.6   |   | Co-operation  Agreement between the Iceland State Hospital and Islensk erfdagreining ehf.,  dated December 15, 1998 (Incorporated by reference to Exhibit 10.24  to the Company’s Registration Statement on Form S-1 (Registration  No. 333-31984) which became effective on July 17, 2000). |
| 10.7*  |   | Form of Employee  Confidentiality, Invention Assignment and Non-Compete Agreement  executed by certain officers (Incorporated by reference to Exhibit 10.44  to the Company’s Registration Statement on Form S-1 (Registration  No. 333-31984) which became effective on July 17, 2000).     |
| 10.8   |   | Purchase Agreement  between Vetrargardurinn ehf. and Festing ehf. dated March 29, 2005  (Incorporated by reference to Exhibit 10.1 to the Company’s Report on  From 10-Q filed on May 10, 2005).                                                                                                       |
| 10.9   |   | Lease Agreement between  Vetrargardurinn ehf. and Festing ehf. dated March 29, 2005 (Incorporated  by reference to Exhibit 10.2 to the Company’s Report on From 10-Q  filed on May 10, 2005).                                                                                                          |
| 10.10* |   | Employment Agreement  between deCODE genetics, Inc. and Daniel L. Hartman, effective as of  July 15, 2005(Incorporated by reference to Exhibit 10.1 to the  Company’s Report on From 10-Q filed on November 9, 2005).                                                                             |
| 10.11* |   | Form of Restricted  Stock Agreement (Incorporated by reference to Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed August 1, 2005).                                                                                                                                                |
| 10.12* |   | 2002 Equity Incentive  Plan (Incorporated by reference to Exhibit 10.40 to the Company’s Annual  Report on Form 10-K filed on April 15, 2003).                                                                                                                                                         |
| 10.13+ |   | License Agreement, dated  as of October 17, 2003, between deCODE genetics, ehf. and Bayer AG  (Incorporated by reference to Exhibit 10.32 to the Company’s Annual  Report on Form 10-K filed on March 15, 2004).                                                                                  |
| 10.14+ |   | License and Research  Collaboration Agreement, dated February 25, 2004, between deCODE  genetics, ehf. and Merck & Co., Inc.                                                                                                                                                                            |
| 10.15* |   | Agreement between deCODE  genetics, Inc. and J. Neal Armstrong dated as of August 18, 2003  and effective as of October 3, 2003 (Incorporated by reference to  Exhibit 10.2 to the Company’s Quarterly Report on From 10-Q filed  on November 13, 2003)                                      |
| 10.16* |   | 2006 Equity Incentive  Plan (Incorporated by reference to Exhibit 99.1 to the Company’s Current  Report on Form 8-K filed on May 11, 2006).                                                                                                                                                            |
| 10.17  |   | Placement Agency  Agreement by and among the Company, Lehman Brothers Inc. and Thomas Weisel  Partners LLC dated as of July 13, 2006 (Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on July 14, 2006).                                            |
| 10.18  |   | Form of Purchase  Agreement between the Company and Certain Purchasers of Common Stock (Incorporated  by reference to Exhibit 10.2 to the Company’s Current Report on  Form 8-K filed on July 14, 2006).                                                                                          |
| 10.19* |   | Employment Agreement  between deCODE genetics, Inc. and Jakob Sigurdsson, dated as of  October 25, 2006                                                                                                                                                                                                          |

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| 10.20 |   | Purchase Agreement dated  November 14, 2006 between deCODE genetics, Inc. and Lehman  Brothers, Inc., as Representative of the Initial Purchasers  (Incorporated by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed on November 15, 2006). |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.21 |   | Agreement of Purchase  and Sale between deCODE Chemistry, Inc and Woodridge Holdings LLC, dated as  of February 5, 2007.                                                                                                                                                                              |
| 21.1  |   | Subsidiaries of deCODE  genetics, Inc.                                                                                                                                                                                                                                                                |
| 23.1  |   | Consent of  Deloitte & Touche LLP, independent registered public accounting  firm.                                                                                                                                                                                                                |
| 31.1  |   | Certifications pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |
| 31.2  |   | Certifications pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |
| 32    |   | Certifications pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |

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+                Confidentialtreatment has been requested for certain portions of this exhibit. The omittedportions have been separately filed with the Commission.

*                    Constitutes amanagement contract or compensatory plan or arrangement.

Note: Unless otherwise noted, the SEC File number ofeach of the above referenced documents is 000-30469.

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