**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-K**

 

| **ý****ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                               |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
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| **For the Fiscal Year Ended December 31, 2003**                                                                                                                                                   |
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| **OR**                                                                                                                                                                                                 |
|                                                                                                                                                                                                   |
| **o****TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                |
|                                                                                                                                                                                                   |
| **For the transition period from                 to               ** |
|                                                                                                                                                                                                   |
| **Commission File Number: 0-27188**                                                                                                                                                                    |

 

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**PHARMACOPEIA,INC.**

(Exact name of Registrant as specified in itsCharter)

 

| **Delaware**                                                             |   | **33-0557266**                                  |
|--------------------------------------------------------------------------|--------|-------------------------------------------------|
| (State or other jurisdiction of  incorporation or organization)     |   | (I.R.S. employer identification number)         |
|                                                                     |   |                                            |
| **PO BOX 5350, Princeton, NJ**                                           |   | **08543-5350**                                  |
| (Address of principal executive offices)                                 |   | (zip code)                                      |
|                                                                     |   |                                            |
| Registrant’s telephone number, including area code **609-452-3600** |
|                                                                     |   |                                            |
| Securities registered pursuant to Section 12(b) of the Act:         |   |                                            |
|                                                                     |   |                                            |
| **Title of  each class**                                                 |   | **Name of  each  exchange on which registered** |
| Common stock, par value $0.0001 per share                                |   | Nasdaq National Market                          |

 

Securities registered pursuant to Section 12(g) of the Act: **None**

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter periods as theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. YES  ý    NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. o

 

Indicate by a check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act). YES  ý    NO o

 

The aggregate market value of voting stock held by non-affiliates ofthe Company as of June 30, 2003 was $138,689,193.

 

Indicate the number of shares outstanding of each of the registrant’sclasses of common stock, as of the latest practicable date.  

 
| **Class**                                 |   | **Outstanding  at January 31, 2004** |
|-------------------------------------------|--------|-------------------------------------------|
| Common stock, par value $0.0001 per share |   | 23,990,353                                |

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Selected portions of the 2004 Proxy Statement are Incorporated byReference in Part III of this Report.

The Exhibit Index (Item No. 15) incorporates several documents byreference as indicated therein.

 

 

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**PHARMACOPEIA,INC.**

 

**2003Form 10-K**

 

**Tableof Contents**

** **
| *PART  I* |                                                                                          |   |
|----------------|-----------------------------------------------------------------------------------------------|--------|
|           |                                                                                          |   |
| *ITEM 1.*      | *BUSINESS*                                                                                    |   |
| *ITEM 2.*      | *PROPERTIES*                                                                                  |   |
| *ITEM 3.*      | *LEGAL PROCEEDINGS*                                                                           |   |
| *ITEM  4.*     | *SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS*                                        |   |
| *ITEM 4A.*     | *EXECUTIVE  OFFICERS OF THE REGISTRANT*                                                       |   |
|           |                                                                                          |   |
| *PART II*      |                                                                                          |   |
|           |                                                                                          |   |
| *ITEM  5.*     | *MARKET  FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS*                 |   |
| *ITEM 6.*      | *SELECTED FINANCIAL  DATA*                                                                    |   |
| *ITEM  7.*     | *MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS* |   |
| *ITEM  7A.*    | *QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.*                                |   |
| *ITEM  8.*     | *FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA.*                                               |   |
| *ITEM  9.*     | *CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.*      |   |
| ITEM 9A.       | CONTROLS AND  PROCEDURES                                                                      |   |
|           |                                                                                          |   |
| *PART III*     |                                                                                          |   |
|           |                                                                                          |   |
| *ITEM  10.*    | *DIRECTORS  AND EXECUTIVE OFFICERS OF THE REGISTRANT.*                                        |   |
| *ITEM 11.*     | *EXECUTIVE COMPENSATION*                                                                      |   |
| *ITEM  12.*    | *SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.*                            |   |
| *ITEM  13.*    | *CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS*                                             |   |
| *ITEM  14.*    | *PRINCIPAL  ACCOUNTANT FEES AND SERVICES*                                                     |   |
|           |                                                                                          |   |
| *PART IV*      |                                                                                          |   |
|           |                                                                                          |   |
| *ITEM 15.*     | *EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND  REPORTS ON FORM 8-K*                            |   |
|           |                                                                                          |   |
|           |                                                                                          |   |
| *SIGNATURES*   |                                                                                          |   |

 

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## **PARTI**

## ** **

**ITEM 1. BUSINESS**

 

Pharmacopeia, Inc. (“Pharmacopeia” or the “Company”) is a leader inenabling science and technology that accelerates and improves the drug discoveryand chemical development processes.  Oursoftware segment is operated through Accelrys Inc. (“Accelrys”), a wholly-ownedsubsidiary of the Company which develops and commercializes molecular modeling,simulation, informatics, and decision support software for the life sciencesand materials research markets.  OurDrug Discovery segment is operated through Pharmacopeia Drug Discovery, Inc.(“PDD”), a wholly-owned subsidiary of the Company which integrates proprietarysmall molecule combinatorial and medicinal chemistry, high-throughputscreening, in-vitro pharmacology, computational methods and informatics todiscover and optimize lead compounds. Pharmacopeia is headquartered inPrinceton, New Jersey and was incorporated in Delaware in 1993.  Our internet address iswww.pharmacopeia.com.  Copies of ourannual reports on Form 10-K, quarterly reports on Form 10-Q, current reports onForm 8-K, and amendments to those reports are available without charge on ourwebsite.

 

When used anywherein this document, the words “expects”, “believes”, “anticipates”, “estimates”and similar expressions are intended to identify forward-looking statements.Forward-looking statements herein may include statements addressing our futurefinancial and operating results. We have based these forward-looking statementson our current expectations about future events. Such statements are subject torisks and uncertainties including, but not limited to, the successfulcompletion of the “spin-off” of PDD described in the next section andexecution upon our strategic plans, the**acceptance of new products, theobsolescence of existing products, the resolution of existing and potentialfuture patent issues, additional competition, changes in economic conditions,and other risks described in documents we have filed with the Securities andExchange Commission, including this report on Form 10-K in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”“Risk Factors,” “Certain Risks Related to the Company as a Whole,” “CertainRisks Related to Intellectual Property,” “Certain Risks Related to Accelrys”and “Certain Risks Related to Pharmacopeia Drug Discovery,” and subsequentreports on Form 10-Q. All forward-looking statements in this document arequalified entirely by the cautionary statements included in this document andsuch filings. These risks and uncertainties could cause actual results todiffer materially from results expressed or implied by forward-lookingstatements contained in this document. These forward-looking statements speakonly as of the date of this document. We disclaim any undertaking to publiclyupdate or revise any forward-looking statements contained herein to reflect anychange in our expectations with regard thereto or any change in events,conditions or circumstances on which any such statement is based.

 

PROPOSED SPIN-OFF OF PHARMACOPEIA DRUGDISCOVERY

 

On December 18, 2003, we announced that our Board of Directors hadapproved in principle a plan to separate our Accelrys and PDD businessesthrough a pro rata distribution to our stockholders of 100% of the outstandingshares of common stock of PDD.  Thedistribution, commonly referred to as a “spin-off,” would result in PDD beingan independent, publicly-traded company with its shares listed on The NasdaqNational Market. The spin-off, which is expected to take place on or aboutMarch 31, 2004, is intended to be tax-free for U.S. federal income taxpurposes (except for cash received in lieu of fractional share interests). Ifcompleted, the distribution would result in PDD owning and operating our DrugDiscovery business on a stand-alone basis, while the Company would continue toown and operate the Accelrys software business.  Immediately following the distribution, our stockholders willcontinue to own their shares of Pharmacopeia stock as well as the shares of PDDstock that will be distributed in the spin-off. Our shares will continue totrade on The Nasdaq National Market under the symbol “ACCL” after thedistribution, and it is our intention to request approval of our stockholdersat

 

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our 2004 Annual Meeting of Stockholders to change the name of theCompany to “Accelrys, Inc.”

 

Our Board of Directors has reserved the right, in its sole discretionand without liability, to provide final approval for the spin-off or to abandonthe spin-off at any time prior to its completion, for any reason or no reasonat all.  In addition, certain conditionsmust be satisfied or waived by us prior to the distribution being effected,including without limitation PDD’s Registration Statement on Form 10 beingdeclared effective under the Securities Exchange Act of 1934, as amended; themailing of the Information Statement contained therein to our stockholders; thereceipt of all required permits, registrations and consents in connection withthe distribution; the approval of the PDD common stock for listing on TheNasdaq National Market; all material government approvals being in full forceand effect; the absence of any order, injunction or decree issued by any courtor agency or other legal restraint or prohibition preventing consummation ofall or a portion of the distribution.

 

We believe that separating PDD from Pharmacopeia will resolvedifficulties we have encountered regarding the effective operation anddevelopment of our drug discovery and software businesses within a singlepublicly-traded corporation.  Thesignificantly different operating and financial models employed by our softwareand drug discovery units pervade the conduct of their respective businesses,affecting both day-to-day decisions and longer-term strategic initiatives. Ourattempts to reconcile these divergent operating models often has required ourmanagement team to compromise in a way that is unsatisfactory for each businesson a stand-alone basis. We believe the spin-off will enhance the performance ofboth Pharmacopeia and PDD by providing both companies with greater managerial,operational and financial focus to better respond to market conditions andopportunities in their respective business environments. The distribution willprovide each company with a publicly-traded equity security in a single line ofbusiness for use in its compensation programs and as a “currency” to facilitatepotential acquisitions, investments and alliances. The separation also shouldenable investors to evaluate better the financial performance of each unit,thereby enhancing the likelihood of appropriate market valuation of thesecurities of each company.

 

Following are moredetailed descriptions of each of our two business segments.  Certain financial information for thesesegments is described in the Notes to the Financial Statements included in thisreport.

 

OUR SOFTWARESEGMENT – ACCELRYS INC.

 

We operate oursoftware business through Accelrys Inc. A wholly owned subsidiary ofPharmacopeia, Inc., Accelrys has over 540 employees and active licenseagreements with most leading chemical, biotechnology and pharmaceuticalorganizations.  Our software covers disciplinesincluding gene sequence analysis, proteomics, rational drug design, leadoptimization, materials research, and formulation design.  Customers are supported by our worldwideorganization headquartered in San Diego, CA.

 

ACCELRYS OVERVIEW

 

For companies inthe pharmaceutical, biotechnology, chemical, petrochemical and materialsindustries, innovation in the discovery and development of new products and therapid, cost-effective commercialization of these products can be crucial tosuccess. Such organizations also strive to increase the efficiency oreffectiveness of products and processes – marginal process improvements canoften have dramatic returns on investment. Companies in these industries invest considerable resources intechnologies that suggest productive new pathways for research projects,increase the efficiency of discovery and development processes, or enable themto

 

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maximize the use of corporate data, information and knowledge.  One such set of technologies is software-basedcomputation, analysis, informatics and knowledge management tools.  These allow users to simulate key chemicaland biological systems, understand and predict fundamental properties, anddesign new or improved products and processes. They also manage and mine scientific data, turning it into usefulinformation and supporting decision processes and R&D workflows.

 

Accelrys designs,develops, markets, and supports software and provides related services thatfacilitate the discovery and development of new and improved products andprocesses in the pharmaceutical, biotechnology, chemical, petrochemical andmaterials industries. Using our software products, researchers may increase thespeed and efficiency of the research and development cycle, thereby reducingproduct development costs and shortening the time to market for new productintroductions and process improvements. Our software customers include leadingcommercial, government and academic organizations. Many of the largestpharmaceutical, biotechnology, chemical, petroleum and semiconductor companiesworldwide use our software. We market our products and services worldwide,principally through our global direct sales force.

 

Following arebrief descriptions of our Accelrys software product lines.

 

*Modeling and Simulation Software*.  Many factors that affect a molecule,including activity, bioavailability, toxicity, shelf life and environmentalimpact, are governed by fundamental properties such as shape, structure andreactivity, that are determined at the sub-atomic, molecular, or near-molecularlevels. A spectrum of simulation technologies – quantum mechanical simulation,molecular simulation, and mesoscale simulation – predict these properties andhelp researchers discover new products, sharpen the focus of experimentalactivities and improve ultimate product performance. We are a leading providerof such modeling and simulation software.

 

We have a broadproduct suite consisting of over 100 application modules based on proprietarytechnologies that employ fundamental scientific principles, advanced computervisualization, molecular modeling techniques and computational chemistry. Theseproducts allow scientists to perform computations of chemical, biological andmaterials properties, to simulate, visualize and analyze chemical andbiological systems, and to communicate the results to other scientists. Ourproducts are based upon advanced software architectures that facilitate thedevelopment, integration and deployment of new software products. We also offeropen access to many of our core software development environments, within whichcustomers and third-party licensees can develop, integrate and distribute theirown software applications for computational chemistry, biology and materialsresearch.

 

We plan tocontinue enhancing our software product and service offerings for specialistcomputational chemists and biologists, who are the principal users of modelingand simulation products. In addition, we are broadening our user base byenabling straightforward access to these methods from personal computers to amuch larger population of experimentalists, laboratory scientists andengineers. This also helps expert modelers to connect and communicate moreeffectively to the wider research organization, and assists these organizationsin capturing, managing, and sharing the critical knowledge developed inmodeling.

 

*Informatics Software.*  We are a leading provider of tools tocapture, store, manage, and mine scientific data and information.  Informatics is a well-established technologyin life sciences, where bioinformatics tools are integral to genetic andbiological research, and cheminformatics applications are widely used to managechemical information.  We are pioneeringthe application

 

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of similar tools in the materials research arena – so-called materialsinformatics or ‘matinformatics’ has found early applications in formulationdesign and materials screening.

 

Our bioinformaticssolutions include a suite of programs enabling molecular biologists to search,edit, compare, map and align sequence data. Researchers use these to enable theanalysis of DNA and protein sequences and structure, predict RNA secondarystructure and annotate protein sequences. Such capabilities help them to usethe genomic data that is being made available by projects such as the HumanGenome Project.  In addition, we provideenterprise-wide data management and analysis tools that assist in themanagement of this data. These are based on the Oracle® architecture.  Data visualization and analysis capabilitiesallow this data to be viewed and understood on standard desktop computers.

 

Our cheminformaticssoftware is based on standard database architectures such as Oracle and Microsoft®Access®. We provide data visualization and analysis software to search,retrieve, and use chemical structures, biological and chemical data,experimental data, and registration information. Many of these tools useindustry standard software components and are compliant with applications suchas Microsoft Excel®, allowing chemists to interact with chemical data withinfamiliar productivity tools. We also use this component technology and ourdatabase architectures to build customized enterprise-wide systems for clientcompanies, and we sell our components, enabling customization and flexibleimplementation of our systems by chemical programmers.

 

ACCELRYS BUSINESSSTRATEGY

 

Our objective isto strengthen Accelrys’ position as a leading provider of software-basedscientific computation, analysis, informatics and knowledge management productsand services worldwide by providing a comprehensive set of integratedproductivity tools that are integral to the enterprise-wide research anddevelopment activities of our customers, and by connecting these tools withinan IT framework that makes it easier for research organizations to manage data,information, knowledge, and collaborative processes.  The key elements of our strategy to achieve this objectiveinclude:

 

*Expand User Base*.  We intend to increase sales to our keysoftware accounts and pursue new software customers within existing markets. Inaddition, software will be targeted not only at a growing number of molecularmodeling, simulation, and gene sequence analysis specialists, but also at themuch larger group of experimentalists (scientists and engineers). We believe wecan leverage our strong relationships with molecular modeling, simulation, andgene sequence analysis specialists to help promote the use of modeling,simulation, and gene sequence analysis methods by other scientists working inthe same organization as the specialists.

 

*Leverage Core ComputationalTechnology and Maintain Technology Leadership*.  We believe that our core modeling and simulationand gene sequence analysis technologies have helped position us at theforefront of computational methods technology providers. We intend to continueto make significant investments in research and development in order to improvethe efficiency and predictive accuracy of this core technology and to maintainour technology leadership.  We willcontinue to ensure that this leading-edge technology is delivered to customersin an environment that best fits emerging market needs – for example, offeringaccess to some of our leading legacy UNIX® workstation products via Linux®clients.

 

*Enhance Technology Position.*  We will strengthen our scientific andtechnical expertise through acquisitions and partnerships, and through jointdevelopment projects with leading academic, governmental and industrialresearchers.  We may continue to pursueacquisitions and strategic relationships with third parties in order to provideus with early access to new

 

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technologies, facilitate market acceptance of new products and reduceinternal research and development investment.

 

*Expand Informatics Market Share.*  Our customers will need more sophisticatedand flexible data and knowledge management tools as the use of modeling andsimulation, gene sequence analysis and other computational methods expands andas the amount of data about drug discovery and chemical development activitiescontinues to grow.  We will continue toimprove and integrate our bioinformatics and cheminformatics offerings, todevelop our components strategy that enables a better fit to customers’individual needs, and to leverage our relationships with customers, in order toachieve this growth.

 

*Create Collaborative Systems andEnvironments.*  Webelieve that the desire among our customer base to increase process efficiencyacross diverse workgroups and disciplines while managing and using enormousquantities of data and information has created a need for workflow and projectmanagement tools that help researchers to better collaborate and manageprojects. We will continue to improve our offerings to include workflow andproject management capabilities. As these product offerings expand, we alsoexpect increased opportunities to tailor and customize work group andenterprise-wide solutions for customers. The integration of informatics capabilities and provision ofcollaborative enterprise environment is being pursued through the developmentof an integrated software platform for discovery research delivered via theDiscovery Studio® product line to the life science market, and through theMaterials Studio® product line to the materials and chemicals processindustries.  We will develop our keymodeling and informatics capabilities such that they are compatible with thisplatform.

 

ACCELRYS SCIENCE ANDTECHNOLOGY

 

Following are moredetailed descriptions of the science and technology supporting each of ourvarious software product lines.

 

*Modeling and Simulation*.Our modeling and simulation technology delivers predictive models of chemical,biological and materials phenomena within an open environment. This technologysimulates subatomic, interatomic and intermolecular interactions, and a widerange of corresponding properties, including molecular structure, activity,diversity, stability, morphology, solubility, adhesion, adsorption, diffusion,color, analytical spectra, and optical, electrical and mechanical properties.There are five primary classes of molecular and materials simulation methods,all of which are found in our products:

 

•                  *QuantumMechanical Methods.* Quantum mechanical (QM) methods, the mostfundamental of our simulation methods, compute interactions at the level ofelectrons and nuclei. These methods are capable of simulating which chemicalentities are stable, how chemical reactions occur, and properties such asreactivity, color and magnetism. These methods are computationally demanding.Historically, they have been applied to small, carefully selected models.  Technological advances, many driven by usand our partners, are now allowing quantum mechanical methodology to be appliedmore generally and to larger materials and systems.  The problems studied using QM methods are those that are typicalin the emerging nanotechnology market.

 

•                  *Molecular Methods.*Molecular methods probe molecular conformations and the interactions betweenmolecules based on simplified analytical expressions. These methods includeautomated procedures for probing how a drug molecule binds to an active site,what conformations a polymer chain may adopt, and what similarities existbetween a new amino acid sequence and protein sequences for which tertiarystructures are known.  They also includetools used to determine structure based on x-ray diffraction or nuclearmagnetic

 

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resonancedata.  Such methods contain moreapproximations than quantum methods but can be applied to much larger and morecomplex systems, providing insight into many chemical processes.

 

•                  *MesoscaleMethods*.  Mesoscale methodsstudy processes above the molecular scale that are critical to materials andchemical engineering properties.  Thesemethods are particularly suited to predicting the properties and mixingbehaviors of polymer mixtures, complex fluids, detergents and soft materials.

•                  *StructureDetermination and Instrument Simulation*.  A range of methods combine the technologies introduced above andintroduce techniques to interpret and simulate data captured from analyticalinstruments in order to determine accurate models of molecular, sub-molecular,and mesoscale structure.  The analyticaltechniques used include powder diffraction, NMR, and infrared spectra.  Such methods are often a vital pre-requisiteto effective modeling and simulation and also act as essential validation ofcomputational work.

 

•                  *CorrelativeMethods.* Correlative methods identify interrelationships betweenstructure and properties that can be used predictively. In many cases, it isknown that macroscopic properties are determined by molecular-level behavior,but the analytical details of these relationships are not known.  The quantitative structure activityrelationship (“QSAR”) methods provide a framework in which to correlatemolecular attributes and macroscopic properties. The framework can predict, toa reasonable degree of confidence, the properties of molecules that arecomparable with a control set for which properties have been measured.

 

*Platform Technologies.*The computational methods outlined above are offered within an informationtechnology framework designed to support the needs of today’s leading researchorganizations:

 

•                  *Desktop andEnterprise-Wide Access.*  TheDiscovery Studio software delivers new platform technology that provides acommon data architecture and project management system forpharmaceutical-focused products.  TheDiscovery Studio software combines updated infrastructure technology and marketleading science acquired and developed by Accelrys.  This platform will allow Accelrys to deliver molecular modelingand simulation desktop products to new classes of users, through the advantagesof client-server computing.  Applicationinstallations range from a single user working on a personal computer (“PC”) toa multi-departmental facility accessing a wide range of heterogeneous computerresources to tackle the biggest simulations problems facing the industry.  The client application is created usingindustry-standard languages and protocols on PC’s, and incorporates powerfulnew technology that enables the display and manipulation of molecularstructures and other data on the PC. Depending on the application, the servers can be UNIX workstations orWindows® NT/2000® servers, or customers can take advantage of the low cost/highperformance offered by Linux servers.

 

The MaterialsStudio software delivers similar benefits via desktop PC’s to users in thematerials sciences. The client software provides a PC-based modeling andvisualization environment from which users can set up, run and analyze resultsof computations on more powerful computer servers on their Intranet. Theservers can be UNIX workstations, Linux servers, or Windows® 2000® servers orworkstations. The client software runs on Windows 98, 2000, XP®, and Me®.

 

•                  *OpenArchitecture.* Accelrys has pioneered an open scientific softwarearchitecture through products such as our Cerius2® and Insight II®software.  Many customers have used ourpublished programming interfaces to incorporate and customize new methods intothese

 

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softwarepackages.  The modular architecture isdesigned to provide streamlined access to the various computational methods,allowing their use in discrete, combined and packaged ways.

 

Within the area ofModeling and Simulations, our graphics and interface subsystems continue to besupported on Silicon Graphics® workstations, which are still the most commonplatform of choice for high-end graphical work according to a recentindependent survey our customers. Accelrys has met the demand for high-end computational capacity bymaking many of the most compute-intensive operations available to run on IBMAIX servers.  Accelrys has also keptpace with changes in computer buying behavior in our customer base by makingselected applications (namely Catalyst® and leading segments of Insight IIavailable for Linux).   Existing andplanned Discovery Studio server software products are planned to run on IBM andLinux systems. Existing and planned Materials Studio server software codes runon Silicon Graphics and HP UNIX workstations and Windows platforms.

 

*Bioinformatics Software.*  Our bioinformatics solutions enable themanagement and analysis of biological data and provide a wide range of genesequence analysis capabilities.

 

•                  *GeneSequence Analysis*.** The core technology serving the bioinformatics and gene sequenceanalysis market is contained within a suite of programs marketed under the nameGCG® Wisconsin Package®. This contains over 130 programs covering the researchneeds of molecular biologists. Based on published algorithms from the fields ofmathematical and computational biology, the GCG Wisconsin Package softwareincludes sequence comparison, database searching and retrieval, DNA/RNAsecondary structure prediction, editing and publication, evolutionary analysis,fragment assembly, gene finding and pattern recognition, importing andexporting, mapping, primer selection, protein analysis, and translation.

 

The computationaland analysis capabilities of the GCG Wisconsin Package software run on UNIXworkstations. They can be accessed through a variety of client user interfaces,enabling broad access to this technology. These now include DS Gene sequenceanalysis software, a PC-based client running within the Discovery Studioproduct line.

 

•                  *RelationalDatabases*.  DS SeqStore®software, our Oracle database technology, allows researchers to collect,organize and maintain genomic data and the results of analyses in in-housecorporate databases. The SeqStore data warehouse makes data from separategroups available across the corporate structure. Dynamic update technologyallows new data to be continually and automatically added to the database.

 

•                  *Data Content*.  We provide our users with a wide range ofpublic databases in convenient formats that can be updated at regular intervalsthrough our data update services.  Theseinclude GenBank® and EMBL for nucleic acid sequences, SP-TREMBL proteintranslations of coding sequences, PIR protein sequences, NRL_3D sequence andthree-dimensional structure, GenPept unannotated translations of GenBanksequences, REBASE restriction enzyme data, including specific restrictionenzymes, SWISS-PROT well-annotated protein sequences, and PROSITE proteinsequence motifs.

 

*Cheminformatics Software*.We provide software to manage chemical information, such as 2D chemicalstructure diagrams and associated property data.  This software ranges from chemical data management and analysistechnology integrated with standard desktop productivity tools toenterprise-wide informatics systems. We also provide a number of softwarepackages focused on particular applications of interest to the chemist, and arange of useful data content.

 

•                  *Enterprisesolutions*.  The *AccordEnterprise Informatics* (AEI) suite unites technology previouslyavailable through the company’s Accord and RS3TM product-lines tocreate a

 

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single, powerful environment for enterprise-wide management of chemicalstructures, biological assay data, and related information.  Based on Oracle databases, which areextended to understand chemistry via the DS *Accord Chemistry Cartridge*, AEI allowscustomers to manage and share this data and access it via a series ofapplications focused on specific tasks, including data analysis, management ofhigh throughput screening workflow, and compound registration.

 

•                  *Desktopsolutions*.  The *DS Accordfor Excel, Accord Chemistry Control, and Accord Grid Control*software allows chemical objects to be stored and manipulated within standardMicrosoft desktop productivity tools. This means that the researcher can viewand analyze chemical data without the need to learn new software systems, andthat the wide range of calculation and data management features available inthese applications can be easily applied to chemical data without the need forus to develop and maintain specialist tools. The DIVA® and the Tsar® softwareprovides desktop decision support capabilities, allowing users to work withchemical structures, assay results and other chemical and biological data.

 

•                  *Data content*.We deliver a range of chemical databases. These include the Failed ReactionsDatabaseTM product, offering data on reactions that afford unexpected results,Solid-Phase Synthesis designed for chemists engaged in the design ofcombinatorial libraries, Metabolism and Biotransformations providing data onthe metabolic fate of organic molecules, Methods in Organic Synthesis (MOS)containing over 3,000 new reactions each year, BioCatalysis covering biomolecule-mediatedorganic synthesis, Protecting Groups providing chemists with ready access toselected information on the full range of protecting group chemistry, BIOSTERthat provides a critical compilation of thousands of bio-analogous moleculepairs, and a series of two organic chemistry databases offered in associationwith J.W. Wiley & Sons, publishers.

 

•                  *Tools andComponents*. We enable IT professionals and scientific applicationdevelopers to construct custom cheminformatics solutions through a wide range oftools and components that includes the DS Accord Chemistry Cartridge, AccordChemistry Control, Accord Grid Control, Accord SDK, and the CombichemEnumeration Components.  These arecentral to our strategy of enabling cheminformatics customers to create systemsand solutions that precisely fit their needs.

 

ACCELRYS PRODUCTS ANDSERVICES

 

We offer a broadsuite of software products and services designed to enable our customers toshorten product lead times, reduce research and development costs, improve productand process performance, manage and analyze chemical and biological data andinformation, and communicate more effectively both inside and outside anorganization. These products and services incorporate the following attributes:

 

*Validated Core Modeling Technology*.The core technology underlying our modeling and simulation products consists ofa number of fundamental, scientifically proven methods for conductingpredictive computer modeling and analyses of chemical, biological and materialsphenomena at the atomic and molecular level. This core technology is validatedby over a decade of industrial use and by the publication of hundreds ofpresentations, papers and articles citing applications of this technology.

 

*Broad Applicability.*The validated core technology underlying our products enables us to offerproducts and services to a wide variety of industries, including thepharmaceutical, biotechnology, chemical, petrochemical, electronics, food,paper, agrochemical, aerospace, plastics, paint and natural gas industries. Ourproducts simulate and analyze both small molecules

 

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that may be candidates for new drugs and more complex molecularstructures such as proteins or the polymers found in advanced materials. Theseproducts are used in research applications as diverse as drug discovery,protein design and structure determination, crystallization and formulation,polymer property prediction, catalysis and development of electronic materials.

 

*Data Management Compliant withIndustry Standards*. Our data management and analysissolutions are based on industry-standard technologies such as Oracle. Thismeans that they are compliant with other corporate systems and retain a highlevel of openness and flexibility. Our technology ensures that these standardsare enabled for chemical and biological data.

 

*Open Architecture*.Many of our products are based upon open architectures that allow customers,collaborators and third parties to develop software applications in the samedevelopment environment we use internally. Core molecular modeling functionsare included in this open environment, which permits developers to focus ontheir particular scientific interests and increase the power and utility oftheir programs by integrating them with our products.

 

*Ease of Use*. Oursoftware products are integrated, modular, focused on specific research areasor techniques, and accessible by intuitive graphical user interfaces (“GUI”).These enable experimentalists to use molecular simulation in a mannerconsistent with established analytical and laboratory techniques, in auser-friendly computational environment.

 

*Increased Access*.We have developed desktop product lines that target a broader group of users,including laboratory scientists and engineers. Scientific researchers increasingly use software products running in theMicrosoft Windows environment on desktop computers to search for, analyze andcommunicate scientific data, particularly within corporate Intranets. Ourdesktop products use familiar technology and are built upon our openarchitecture and validated core technology.

 

Based upon thescience, technology and attributes described above, we provide a broad suite ofsoftware products used throughout the research and development cycle. Webelieve that offering a “single-shop,” integrated drug discovery and chemicaldevelopment solution will be a significant benefit to our customers. Inaddition to these software modules, we also offer the following services:

 

*Customer Support and Training.*  Expert telephone support, an Internet-basedknowledge-base and request-tracking system, on-site training, and scheduledtraining workshops, are all designed to enhance customer success in applicationof our technologies.

 

*Contract Research.*  Accelrys scientists can be contracted towork on specific projects, typically applying our modeling and simulationsolutions to problems such as database construction or structure determination.

 

*Implementation and IntegrationServices*.  Accelryscan assist customers with the implementation of products, where required.  In particular, this is often a requirementfor enterprise informatics products.  Wealso offer an integration service that can customize solutions and integratethem into more complex IT environments or with specialist data.

 

ACCELRYS PRODUCT USES

 

Our softwareproducts are used in a variety of research areas within a number of industries.The principal research and development areas in which our software products areused include the following:

 

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*Sequence to Structure.*  Our bioinformatics, proteomics, andstructural biology software provides tools that enable researchers to tacklethe range of problems inherent in moving from gene sequence data to fullycharacterized targets for drug discovery projects. This range of activitiesrepresents the early stages of the drug discovery process and is an essentialpre-requisite for the structure-based route to drug discovery. Relevant problemsinclude finding interesting sequences within the huge quantities of availablegenetic data, characterizing those sequences and relating them to particularfunctions, determining the secondary structure of DNA and RNA, determining thethree dimensional molecular structure of proteins (often using data fromanalytical techniques such as NMR and X-ray diffraction), and understanding therelationship between this structure and function. The key product for genesequence analysis is the GCG Wisconsin Package software, now augmented andaccessible via DS Gene software. Products used in macromolecular structuredetermination and subsequent protein modeling include the DS ModelingTM, theX-PLOR®, the Insight II® application modules, the QUANTATM, the Discover®, theCHARMm®, and the FelixTM software.

 

*Lead Identification andOptimization.*  Thenext step in drug discovery is the development and optimization of potentialsmall molecule drugs based on these targets. Our rational drug design productsallow the design of small organic therapeutics, based on a protein active sitemodel or on activity data for a set of compounds. Related techniques are usedto design and assess combinatorial molecular libraries that are screened fordesired activity using high throughput experimentation. We thus bring togetherthe worlds of computation and experimentation. The large quantities of datagenerated by such activities can be managed and analyzed using our informaticstools – the results inform more focused testing and design. Rational drugdesign and combinatorial chemistry products include the Catalyst®, Cerius2and Insight II®, and DS MedChem Explorer software.  Cheminformatics tools applied to manage relevant data are basedon the Accord Enterprise Informatics product.

 

*Development and Formulation.* Following the discovery process, a drug mustbe delivered successfully – administered as a crystalline solid in a pill, orthrough some other mechanism such as a patch or spray. Our crystallizationsoftware solves a range of problems that are important to the development andformulation of pharmaceuticals – for example, establishing possible crystallinestructures for the solid material of a pill. Such problems are critical acrossthe chemicals industries, affecting products such as paints, pigments, andpetrochemicals. Our crystallization products are delivered as the Cerius2and the Materials Studio application modules. Development of new and improvedproducts is also achieved through formulation – varying the process andproportions in which known components are combined. Our software can optimizethis process for products including drugs, foods, cosmetics, personal careproducts, detergents, plastics, and specialty chemicals. We serve formulatorsthrough the FAST matinformatics software.

 

*Improving Materials and Processes inthe Chemicals Industry.* Many of our other solutions supportthe design of improved products and processes across the chemicals industry. Inaddition to the crystallization tools introduced above, two key technologyareas in this respect are polymer science and catalysis. Polymer modelingproducts are used by researchers in the chemical, plastics, rubber, adhesives,petrochemical, aerospace and automotive industrial sectors to analyze andpredict polymer properties and establish the link between these properties andthe molecular-level structure of the material. Our polymer software productsallow these researchers to construct and characterize models of polymers andpredict key properties, such as blend compatibility, mechanical behavior,cohesion and adhesion to surfaces. Our polymer products include the Cerius2and the Insight II application modules – the full range of polymer technologyis now extended and available within the Materials Studio product line throughthe Discover, Equilibria, and MesoDyn modules. Our catalysis products are usedby companies in the chemical, petrochemical, natural gas and plasticsindustries and by catalyst manufacturers to characterize

 

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catalysts and sorbent materials, to simulate thermodynamic andreactivity data, and to understand and control chemical reactions. Our productsare used to characterize and design metallocene catalysts, zeolites and othermolecular sieves, and metal oxides. Legacy products include the Cerius2and the Insight II application modules. This range is now available andextended within the Materials Studio product line through the Discover, DMol3,and CASTEP modules.  Through theCombiMat product, informatics methods are now applied to assist materialsscreening – a rapidly emerging technology in the search for new catalysts,polymers, and other materials.

 

*Other Materials-based industries.*  Our products find a broad range ofapplications across industries including electronics, aerospace, structuralmaterials, automotive and energy. In electronics, for example, the trend towardmicrominiaturization of electronic devices has created a need for improvedprocesses and materials. Semiconductor and electronics companies use oursoftware products to understand surface chemistry, defects, thin oxide layers,magnetic properties, and the performance of new packaging materials. Legacyproducts include the Cerius2 and the Insight II applicationmodules.  This range is now availableand extended within the Materials Studio product line through the Discover,Dmol3, and CASTEP modules.

 

ACCELRYS SOFTWARECUSTOMERS

 

Our softwarecustomer base consists of leading commercial, governmental and academicorganizations. No single customer accounted for more than 10% of our softwarerevenues during the fiscal year ended December 31, 2003.

 

*Industrial Customers*.Our industrial customers include many of the largest pharmaceutical,biotechnology, chemical, petroleum and semiconductor companies worldwide. Ineach of the past three fiscal years, a significant portion of our totalsoftware revenue has been derived from pharmaceutical, biotechnology andchemical companies.

 

*Governmental Customers*.Many governmental institutions in the United States, Canada, Europe and theAsia/Pacific region use our software products.

 

*Academic Customers*.Many universities in the United States, Europe and the Asia/Pacific region useour products. This use historically has been for purposes of academic research,but we believe our products increasingly may be used as a part of formaluniversity teaching curricula.

 

ACCELRYS STRATEGIC ANDACADEMIC ALLIANCES

 

We have enteredinto a number of strategic alliances relating to product development, productdistribution and joint marketing. We plan to continue to cultivaterelationships with academic, governmental and commercial research organizationsfor purposes of identifying and licensing new technology to use in productdevelopment. In addition, we plan to maintain and expand our alliances focusingon the compatibility of our products with databases and database managementsystems, other computational chemistry and molecular simulation products, andproducts in related markets such as laboratory instrumentation. We also intendto continue to enter into porting and joint marketing arrangements withhardware vendors on whose systems our products operate.

 

SOFTWARE CONSORTIA

 

Since 1986, wehave formed a number of consortia with outside parties, commonly for purposesof market expansion and product development. We believe the formation andmanagement of these consortia helps us focus on topical industrial needs, andestablishes the

 

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consortia members as an initial customer base for our products. Webelieve our consortia also help us establish valuable working relationshipswith leaders in our target markets.

 

ACCELRYS SALES ANDMARKETING

 

We market oursoftware products and services worldwide. In the United States, Europe andAsia, we have direct sales forces, consisting of field sales, certaindistributor arrangements, and telesales representatives.  Certain of the telesales representativesfocus exclusively on sales to academic researchers.  The direct sales representatives and remaining telesalesrepresentatives work in teams selling to commercial and governmental accountsin assigned geographic territories.  Thedirect sales representatives typically focus on larger accounts andtransactions and work closely with our pre-sales support scientists in order todemonstrate our products and their applicability to various research anddevelopment efforts. Our remaining distributor relationships are focused in theAsia market, and complement the direct sales approach recently implemented.

 

In support of oursales activities, we participate in industry trade shows, publish our ownnewsletters, place advertisements in other industry publications, publisharticles in industrial and scientific publications, conduct direct mail campaigns,sponsor industry conferences and seminars, and maintain a World Wide Web sitethat contains information about us and our product and service offerings.

 

Our softwarecustomers’ buying habits have historically resulted in a higher concentrationof sales in the last quarter of the calendar year.

 

ACCELRYS PRODUCTDEVELOPMENT

 

Development of oursoftware is focused on expanding software product lines, designing enhancementsto our core technology and integrating existing and new products into ourprincipal software architectures. We intend to offer regular updates to ourproducts and to expand our existing product suite. A key component of ourproduct development activities is the extension of our core UNIX-based softwarearchitecture to accommodate access to our products from desktop computers.

 

We licensesoftware products or otherwise have acquired software products from corporate,governmental and academic institutions. These arrangements sometimes involvejoint development efforts and frequently require the payment of royalties byus. The development and royalty obligations, scope of distribution rights,duration and other terms of these arrangements vary depending on the product,the market, resource requirements, the other parties with which we contract andother factors. We intend to continue to license or otherwise acquire technologyor products from third parties.

 

We have alsodeveloped products with funding and direction from customers through ourconsortia activities, see “Business - Software Consortia,” and we may continueto develop products as part of our consortia arrangements with customers.

 

ACCELRYS CUSTOMER SERVICEAND SUPPORT

 

We are committedto providing customers with superior support including telephone, electronicmail, fax and Internet-based technical support services; training; user groupconferences; and targeted contract services involving application of ourtechnology and scientific expertise to particular research needs of customers.We believe that customer service, support and training are key to the adoptionand successful utilization of our products.

 

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Purchases ofmulti-year licenses to use our software products include at least one year ofmaintenance services, consisting of technical support and software upgrades.Thereafter, we offer renewals of maintenance services on an annual basis inreturn for an annual fee. Annual licenses to use our software productsgenerally include all maintenance services. Most of our customers contract formaintenance and support services. These give customers access to new releases,technical notes, documentation addenda and other support which enablescustomers to utilize our products more effectively, including access to ourtechnical and scientific support personnel during extended business hours.Through our distribution channels, we offer training conducted by staffknowledgeable in both the theory and application of our products. Technicalnewsletters and bulletins and advance notification about future softwarereleases are sent to customers to keep them informed and to help them withresource allocation and scheduling. To maintain an ongoing understanding ofcustomer requirements, we sponsor scientific symposia and user group meetings throughoutthe year.

 

ACCELRYS COMPETITORS

 

The market for oursoftware products is intensely competitive, subject to rapid change andsignificantly affected by new product introductions and other market activitiesof industry participants. Our competitors offer a variety of products andservices to address this market. We believe that the principal competitivefactors in this market are product quality, flexibility, ease-of-use,scientific validation and performance, functionality and features, open architecture,quality of support and service, reputation and price. Competition currentlycomes from the following principal sources: other software packages foranalysis of chemical and biological data; desktop software applications,including chemical drawing, molecular modeling and analytical data simulationapplications; consulting and outsourcing services; other types of simulationsoftware provided to engineers; and firms supplying databases, such as chemicalor genomic information databases, database management systems and informationtechnology. In addition, certain of our licenses grant the right to sublicenseour software. As a result, our customers and third-party licensees coulddevelop specific simulation applications using our technology and compete withus by distributing such programs to potential customers. Customers or licenseescould also develop their own modeling, simulation, analyses, bioinformatics orcheminformatics technology and cease using our products and services. Further,they may choose to sublicense such technology.

 

Certain of oursoftware competitors and potential competitors have longer operating historiesthan us and have greater financial, technical, marketing and other resources.Further, many of our competitors offer products and services directed at morespecific markets than those targeted by us, enabling these competitors to focusa greater proportion of their efforts on such markets. Certain offerings thatare competitive with our products and services are developed and made availableby governmental organizations and academic institutions, and these entities maybe able to devote substantial resources to product development and also offertheir products to users for little or no charge. There can be no assurance thatour current or potential competitors will not develop products, services ortechnologies that are comparable to, superior to, or render obsolete, theproducts, services and technologies we offer. There can be no assurance thatour competitors will not adapt more quickly than us to technological advancesand customer demands, thereby increasing such competitors’ market sharerelative to ours. Any material decrease in demand for our technologies orservices may have a material adverse effect on our business, financialcondition and results of operations.

 

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ACCELRYS INTELLECTUALPROPERTY AND OTHER PROPRIETARY RIGHTS

 

We rely primarilyon a combination of copyright, trademark and trade secret laws, confidentialityprocedures and contractual provisions to protect our proprietary rights. Wealso have eleven United States patents. We believe that factors such as thetechnological and creative skills of our personnel, new product development,frequent product enhancements, name recognition and reliable productmaintenance are essential to establishing and maintaining a technologicalleadership position. We seek to protect our software, documentation and otherwritten materials under trade secret and copyright laws, which afford onlylimited protection. Further, there can be no assurance that our patents willoffer any protection or that they will not be challenged, invalidated orcircumvented. Furthermore, there can be no assurance that others will notdevelop technologies that are similar or superior to our technology. Despiteour efforts to protect our proprietary rights, unauthorized parties may attemptto copy aspects of our products or to obtain and use information that we regardas proprietary. In limited instances, we have licensed source codes of certainproducts to customers or collaborators. For these reasons, policingunauthorized use of our products may be difficult. In addition, the laws ofsome foreign countries do not protect proprietary rights as fully as do thelaws of the United States.

 

There can be noassurance that our means of protecting our proprietary rights in the UnitedStates or abroad will be adequate. There can be no assurance that third partieswill not claim infringement by us of their intellectual property rights. Fromtime to time, we receive letters from third parties claiming or suggesting thatour products may infringe patents or other intellectual property rights. Wehave investigated these matters and believe that they are immaterial to our softwareoperations. There can be no assurance, however, that our products do notinfringe upon the patent or other intellectual property rights of thirdparties, that we will not be required to seek licenses for or otherwise acquirerights to technology as a result of claims of infringement or that othercompanies will not bring infringement suits against us. We expect in generalthat software product developers will increasingly be subject to infringementclaims as the number of products and competitors in our industry segments growsand the functionality of products in different industry segments overlaps. Anysuch claims, with or without merit, could be time consuming to defend, resultin costly litigation, divert management’s attention and resources, causeproduct shipment delays or require us to enter into royalty or licensingagreements.

 

Such royalty orlicensing agreements, if required, may not be available on terms acceptable tous, if at all. In the event of a successful claim of product infringementagainst us, our failure or inability to license or design around the infringedtechnology would have a material adverse effect on our business, its financialcondition and its results of operations.

 

From time to time,when we deem it advisable, we challenge potentially conflicting patent rightsasserted by third parties.  For example,in November 2002, we and six other companies filed Notices of Oppositionin the European Patent Office (the “EPO”), seeking to prevent the issuance ofSymyx Technologies, Inc. European Patent Application EP1080435, entitled“Design of Combinatorial Material Libraries.” This EPO matter is progressing, and no decision by the EPO is expecteduntil late 2004.

 

OUR DRUG DISCOVERY SEGMENT – PHARMACOPEIADRUG DISCOVERY, INC.

 

The Company operates its drug discovery business through PharmacopeiaDrug Discovery, Inc. (“PDD”), a wholly owned subsidiary of the Company. PDD isa leading chemistry based collaborative drug discovery company focused on thecreation of new small molecule therapeutics. Using proprietary technologies andprocesses, PDD’s scientists identify and optimize novel drug candidates throughresearch collaborations with major pharmaceutical and biotechnology companiesand through our own internally funded drug discovery programs.

 

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Our collection of approximately 7.5 million proprietary compounds,which we believe is one of the largest in the pharmaceutical industry, isavailable for use in collaborative and internal research programs and forms thebasis of a growing pipeline of potential drug candidates. Three of ourproprietary compounds commenced clinical trials in the second half of 2003, anda fourth commenced clinical trials in the first quarter of 2004.

 

PDD OVERVIEW

 

The pharmaceuticalindustry has seen increased pressure to fill its product pipelines and reducethe time required for drug discovery and development due to the significantnumber of upcoming patent expirations on the horizon and cost containment initiativesfrom government and healthcare providers. In addition, recent advances inbiology, including the sequencing of the human genome, have revealed thousandsof additional potential drug targets. In our view, this proliferation oftargets has shifted the drug discovery bottleneck from the identification ofnew points of disease intervention to the discovery and development of safe andeffective drugs. Further, many traditional biotechnology companies are shiftingsome of their focus downstream from genomics to drug discovery, addressing thechallenge of converting the potential represented by the genomics (i.e., thestudy of genes and their functions) revolution into actual drugs. We believethat our large library of potential therapeutics, proprietary screeningtechnologies, sophisticated chemistry optimization capabilities and extensivemedicinal chemistry expertise can help pharmaceutical organizations increasetheir rates of success, reduce overall drug development time and cost andprovide new potential therapeutic candidates to augment thinning productpipelines.

 

We have drugdiscovery collaborations with leading pharmaceutical companies and emergingbiotechnology companies. We bring drug discovery technologies and expertisethat help our collaborators achieve higher rates of success in their drugdiscovery projects while reducing overall drug development time and cost. Ourcontributions to our partners’ drug discovery programs include:

 

•                  ourprovision of large, diverse libraries of proprietary drug-like chemicalcompounds from which potential therapeutic candidates can be identified;

 

•                  ourhigh throughput screening of these compounds against disease-related targets ofinterest provided by the partner (in which we test a target against tens ofthousands of our potential small molecule therapeutics compounds per week) toidentify “active compounds” (compounds that demonstrate through thesebiological tests the ability to modulate the activity of the target);

 

•                  ourfurther screening and performance of scientific studies of these compounds(known as “hit to lead studies”) to identify active compounds that have thepotential to become “lead” compounds, which are active compounds which meetspecific criteria (such as potency, selectivity, specificity and drug likeness)that warrant their advancement to further stages of the drug discovery process;

 

•                  our“optimization” of the lead compounds identified through the screening processand hit to lead studies, in which we refine the molecular structure of the leadcompounds in an attempt to increase their efficacy, potency andbioavailability, improve their prospects for securing patent protection, andreduce their potential toxicity and address other safety issues;

 

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•                  ourprovision of medicinal chemistry services, through which our scientists design,synthesize (i.e., physically make in our laboratories) and optimize those leadcompounds that we or our collaborators believe are potential drug candidates;and

 

•                  ourdelivery of other services (such as *in vitro*pharmacology) traditionally performed by research divisions withinpharmaceutical and biotechnology companies.

 

Our collaborativeagreements typically require our customers to fund our provision of services,and provide for our receipt of significant milestone payments if and as ourdiscoveries progress through the development process. Thereafter, should any ofthese drug candidates become pharmaceutical products, we are entitled toreceive royalty payments calculated as a percentage of the net sales of theproducts.

 

In addition tocollaborative drug discovery, we conduct proprietary research to discover newdrug-like lead compounds with commercial potential. Unlike our typicalcollaborative partnerships, we provide the required funding for these programs.As we do not receive funding from third party collaborators, we retain allintellectual property and ownership rights in any compounds discovered. At anappropriate point, we may decide to license one or more of the compounds to athird party, converting a proprietary program into a collaborative partnership.

 

Our drug discoveryefforts have produced four clinical candidates so far. Our first candidate, ap38 Kinase Inhibitor developed in collaboration with Bristol-Myers SquibbCompany, commenced clinical trials in August 2003. This potential newdrug, a small molecule from our proprietary compound collection which was theproduct of one of our internal development programs, currently is in Phase I ofclinical testing. A second of our proprietary internal compounds commencedclinical trials in November 2003. This clinical candidate is a product ofour collaboration with Daiichi Pharmaceutical Co. Our third candidate, acompound targeting a respiratory indication developed in collaboration withSchering-Plough Corporation, commenced clinical trials in December 2003.The Schering-Plough relationship produced a second candidate in March ofthis year, when human trials for an inflammatory indication were initiated byour partner with respect to another compound discovered in thecollaboration.  In addition to our fourclinical candidates, we are involved in approximately 43 other drug developmentprograms in the preclinical stage, some with collaborative partners and otherswithin our internal discovery program. In all collaborative programs, we hold afinancial interest in any active compounds we identify through our screeningand drug candidate(s) we help to optimize. In our view, a pipeline of the sizeand quality we have developed holds great potential for the introduction of oneor more drugs into the market.

 

The solutions webring to the challenges of drug discovery include a state-of-the-art technologyplatform and an experienced team of chemists and biologists. Our technologicalcapabilities include advanced medicinal chemistry expertise, proprietarycombinatorial chemistry tools (which enable us to generate large collections,or “libraries,” of compounds by synthesizing all plausible combinations oftheir smaller chemical structures, or “building blocks”), skills in cellengineering and development of assays (biological environments capable ofrevealing the modulating effects of potential therapeutic molecules on diseasetargets), high-throughput and ultra high-throughput (i.e., high throughputscreening that can be executed at the rate of 100,000 compounds per week, ormore) primary screening, secondary screening, *invitro* absorption, distribution, metabolism and excretion (ADME)testing (where our scientists perform screens and other evaluations ofpotential therapeutic compounds to assess how living organisms (andspecifically humans) are likely to absorb, distribute, metabolize and excretethe compound), and modeling, simulation and information management software.Our experienced scientific team, with its track record of success in drugdiscovery, is at the center of our efforts to address these challenges. Throughtheir collaborative work with many of the world’s leading drug discovery

 

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firms, our scientific team brings to our company a diversity ofscientific experience and knowledge of best practices in the pharmaceuticalindustry.

 

TRADITIONAL DRUGDISCOVERY PROCESS

 

Drug discovery anddevelopment is the process of creating and evaluating drugs for the treatmentof human disease. Biological, chemical and informatics expertise are keycomponents of a successful drug discovery effort. The role of biology includesunderstanding disease mechanisms, identifying potential targets for therapeuticintervention and evaluating potential drug candidates. Chemistry’s roleincludes the creation of safe and effective new chemical entities, or drugcandidates, to interact with these targets. Informatics improves decision-makingby identifying and replicating the characteristics of successful drugs,efficiently sharing current knowledge and creating databases to predict futureclinical success. Although many scientific disciplines are required for newdrug discovery and development, chemistry and biology are at the center of thisprocess. Chemists and biologists typically work together to prepare and delivernew chemical substances, develop laboratory models of disease, test compoundsto identify agents that demonstrate the desired activity and finally create amarketable drug. The drug discovery and development process includes thefollowing steps:

 

*Lead identification.*  During the lead identification phase,researchers test libraries of potential lead compounds against disease targetsto evaluate their therapeutic value in a process known as primary screening. Tomaximize the prospects of discovering promising new compounds during primaryscreening, many researchers seek to utilize diverse collections of moleculesthat cover a broad range of possible chemical structures. Scientists mustbalance, however, this desire for diversity in chemical composition against therequirement that the compounds have “drug-like” properties, such that theirchemical structures render them bioavailable and non-toxic. The imperatives ofdiversity and drug-likeness essentially present scientists with something of a“trade-off” in their experimentation. Researchers can address these dual needsby efficiently screening large collections of molecules that are diverse instructure, but drug-like in character. Once active compounds are generated fromprimary screening, medicinal chemists determine which compounds are mostpromising by analyzing the Structure-Activity Relationship (SAR) data. SAR informationeducates scientists with respect to the interaction between the active compoundand the drug target so that compounds of sufficient potency and selectivity canbe identified and tested further.

 

*Lead optimization.*  Lead optimization is the iterative processof refining the chemical structure of a compound to improve its drugcharacteristics with the goal of producing a preclinical drug candidate.Specifically, medicinal chemistry is used to create compounds withcharacteristics that are superior to those of an identified lead candidate.Common among these characteristics are potency, selectivity and/orpharmacokinetics (absorption, solubility, half-life and metabolism). The leadoptimization process involves biological testing, analytical chemistry, pharmacologyand data analysis. Historically, lead optimization has not proven to be nearlyas amenable as lead identification to the efficiencies and economies of scaleof industrialization. Optimization remains largely a manual undertaking, withchemists personally synthesizing numerous compounds for further evaluation.Because most compounds created ultimately will not be utilized in the subjectdrug discovery program, a key to reducing optimization costs is to lower thenumber of molecules that must be synthesized to discover a new drug.

 

*Preclinical development.*  During the lead optimization phase, butprior to clinical testing, potential drug candidates undergo extensive *in vitro*, or laboratory, and *in vivo*, or animal model, studies. Theseefforts are designed to predict drug efficacy and safety. The ultimateobjective of preclinical testing is to obtain results that will allow selectionof a clinical candidate to enter human clinical trials following regulatoryapproval. In parallel, scientists will continue to

 

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synthesize additional compounds that act as analogs for the leadcompound. Researchers will also continue to refine the process formanufacturing larger quantities of the compound, with the goals of reducingproduction costs while ensuring safety. Once a successful process is developed,batches of compounds are synthesized for animal and human testing during thepreclinical (and, later, the clinical) development phase.

 

*Clinical trials.*  Clinical trials, or human tests to determinethe safety and efficacy of potential drug candidates, typically comprise threesequential phases, although the phases may overlap:

 

• Phase I: The drug is initially introduced into healthy human subjects orpatients and tested for safety, dosage tolerance, absorption, metabolism,distribution and excretion.

 

• Phase II: This phase involves studies in a limited patient population toidentify possible adverse effects and safety risks, to determine the efficacyof the product for specific targeted diseases and to determine dosage toleranceand optimal dosage.

 

• Phase III: When Phase II evaluations demonstrate that a dosage range ofthe product is effective and has an acceptable safety profile, Phase III trialsare undertaken to further evaluate dosage and clinical efficacy and to furthertest for safety in an expanded patient population at geographically dispersedclinical study sites.

 

If successful, clinicaltrials in the United States result in the filing of a New Drug Application(NDA) with the FDA. Similarly, separate clinical trials must be conducted andregulatory approvals secured before a drug can be marketed internationally.

 

RECENT DRUG DISCOVERYTRENDS AND OPPORTUNITIES

 

We believe thefollowing trends have led and will continue to lead to increased utilization ofcollaborative drug discovery relationships as well as the component servicesprovided by companies such as PDD:

 

*Patentexpirations, generic competition and pricing pressure spur the need for new pharmaceuticalproducts.*  Loomingpatent expirations and the prospects of generic competition contribute toconcerns surrounding the sustainability of double digit revenue growth ratesfor traditional pharmaceutical companies. Moreover, government legislation andHealth Maintenance Organization (HMO) practices support the substitution ofgeneric therapeutics for branded drugs. In parallel, decreasing willingness onthe part of HMOs and government programs to reimburse for healthcare costs,including prescription and non-prescription drugs, creates margin pressures andemphasizes the need for innovative new products. The need for new drugs tocompete successfully in the prescription drug market should result in strongdemand for collaborative relationships with companies having leadingtechnologies and proven track records of identifying and optimizing preclinicaldrug candidates.

 

*The impact of genomics.*  The research and development process hasexperienced a fundamental change fueled by the revolution in genomics and thesequencing of the human genome. Genomics has resulted in the identification ofmany new potential disease targets, against which chemical compounds must beevaluated. In our view, this breakthrough effectively shifts the drug discoverybottleneck from biology to chemistry, as the need for effective targetidentification and validation has been eclipsed by challenge of discovering anddeveloping viable preclinical and clinical candidates. The proliferation of newpotential drug targets should fuel the demand for collaborative relationshipswith companies having lead generation technology and the medicinal chemistryexpertise to develop promising leads into solid therapeutic candidates.

 

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*The need for faster and cheaperresearch and development.* According to the Tufts Center for the Study of Drug Development (22Journal of Health Economics, 2003), pharmaceutical companies, on average,devote 14 years and spend $800 million for each marketed drug. Despiteescalating R&D expenditures, the number of blockbuster drugs has remainedlow. Notwithstanding the chronicled advances in genomics, biology andchemistry, and significant improvements in information technology andinformatics (where scientists apply this information technology to the drugdiscovery process through tools that enable the capture, visualization andanalysis of data), the pharmaceutical failure rate remains high, and thepercentage of potential new drugs recovering their development costs remainslow. As a result, discovering drugs remains slow, expensive and risky. Webelieve a significant opportunity exists for a drug discovery organization thatcan efficiently create higher quality drug candidates resulting in improvedsuccess in the clinical development process.

 

*Central role of chemistry in drugdiscovery.* The vastmajority of drugs in the global marketplace, as well as potential therapeuticsin preclinical and clinical development, are chemistry derived small moleculecompounds. Small molecule drugs offer manufacturing and delivery advantagesover other protein based drugs, including a greater universe of treatablediseases, lower cost with greater ease of manufacturing, and patient preferencefor an orally available small molecule (e.g., a tablet or capsule) over aninjectible protein or antibody therapeutic. Therefore, we believe smallmolecule drugs will continue to account for the majority of drugs indevelopment and on the market in the future. The chemical make-up or structureof a drug is the key determinant of its potency, specificity, dosing regimenand side effect profile. Minor modifications in chemical structure candifferentiate drugs and determine their success or failure in the marketplace.While targets are used for evaluating the drug characteristics of chemicalcompounds, sophisticated chemistry expertise is required to analyze the rawcompound, understand its chemical composition, engineer it into a therapeuticcandidate, and develop it into a drug. We expect the prevalence of smallmolecule drugs to continue to benefit companies with this (particularlymedicinal chemistry) expertise.

 

PDD BUSINESS STRATEGY

 

Our objective isto expand PDD’s leadership position in collaborative drug discovery andincrease its pipeline of proprietary and partnered drug candidates. Ourstrategies to achieve this objective are as follows:

 

*Enter into new and expanded thirdparty research collaborations, and commence additional internal drug discoveryprograms.*  Throughcollaborative efforts with leading pharmaceutical and biotechnology partnersand internal discovery efforts, we have built a substantial pipeline of drugcandidates. It is our strategy to add to this sizable pipeline of programs.Each new collaboration or other business arrangement into which we enter, andeach new internal program we commence, augments this pipeline. Third partyalliances and proprietary efforts also provide sources of current andprospective revenue for us, effectively funding our product generation efforts.As candidates progress through the development process, the milestone paymentsdue from collaborators increase sharply, providing incentive for us to developas diverse and robust a pipeline as possible.

 

*Become the collaborative drugdiscovery partner of choice for pharmaceutical and biotechnology companies.*We currently have drug discovery collaboration agreements with leadingpharmaceutical and emerging biotechnology companies and have successfullydelivered more than 20 programs to our partners. We believe our strong trackrecord and attractive list of current partners provide validation of ourtechnology and expertise. We further believe that our talented team of chemistsand biologists, equipped with our proprietary combinatorial chemistry technologyand state-of-the-art medicinal chemistry and computational tools, offer aunique

 

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solution to potential collaborative partners and gives us a competitiveadvantage when seeking new partners. Our drug discovery technologies andexpertise allow our partners to reduce their overall drug development time andcost and increase the success of their development efforts.

 

*Maintain our position as a leadingchemistry services provider.* We believe we already are an industry leader in the discovery andchemical optimization of novel drug candidates on an outsourced basis. We viewthe provision of chemistry services as presenting multiple benefits for ourcompany. In addition to the incremental revenue earned from furnishing theseservices, we see our chemistry services offerings as an opportunity topenetrate major pharmaceutical and biotechnology companies which currently arenot prepared to enter into collaborative drug discovery arrangements with us. Aswe demonstrate the value we provide under these service contracts, we hope tobe able to convert the customer relationships into collaborative partnerships.

 

*Expand our business through mergersand acquisitions.* From time to time we have considered, and we will continue to considerin the future, if and when any appropriate opportunities become available,strategic initiatives intended to further the development of our business. Webelieve that there are opportunities to expand our product pipeline through theacquisition or in-licensing of, or investment in, product developmentcandidates, and we intend to continue to explore and evaluate thoseopportunities. In certain cases, we may determine to structure a transaction inwhich we would issue our equity securities in payment of the purchase price.

 

*Continue to develop collection oflibraries and knowledge base.*  We have built sets of libraries that aggregate millions ofcompounds available for future screening programs. This collection of compoundswill increase as new libraries are created and as out-licensed libraries arereturned to us upon the expiration of customers’ exclusivity periods. Webelieve that this growing library collection will provide a valuable source ofleads for future drug discovery programs. We also intend to continue to buildour knowledge base of the relationships between classes of chemical structuresand classes of biological targets. We believe that this database will grow aswe design, synthesize and screen large numbers of compounds against a growingnumber of targets. Further, we believe that this knowledge base will provide afuture competitive advantage by enabling us to more quickly discover activecompounds for newly identified targets.

 

PDD CANDIDATE PIPELINE

 

We have screenedour proprietary collection of drug-like compounds against over 90 moleculardisease targets. As a result of these screening efforts, more than 60 compoundshave shown sufficient activity for lead optimization work to be performed onthe compounds. These optimization programs have yielded a pipeline consistingof four clinical candidates (with respect to which the human testing processhas begun) and 43 other drug development programs in the preclinical stage.Some of these programs are operating with our collaborative partners, whileothers remain within our internal discovery program. In all cases, we have asignificant financial interest in each of the subject compounds. In our view,this pipeline holds great potential for the introduction of one or more drugsinto the market.

 

Our developmentcandidate pipeline is described below:

 

*Our Clinical Candidates. *Four drug candidates in which we have a proprietary interesthave commenced the human clinical testing process. The compound developed inour collaboration with Bristol Myers Squibb, active against p38 (a rheumatoidarthritis target), entered the clinic in August 2003. The p38 programbegan as one of our proprietary programs, and was partnered with Bristol MyersSquibb at the lead identification stage. The candidate emanating from our

 

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collaboration with Daiichi also is from our internal compoundcollection. We partnered this potential therapeutic with Daiichi and beganclinical trials in November 2003. The first compound developed in ourcollaboration with Schering Plough entered the clinic in December 2003 andtargets a respiratory indication. A second candidate emanating from ourSchering-Plough collaboration began human trials this year for an inflammatoryindication.

 

*Development Candidates.*** **There are currently threepreclinical development candidates in our pipeline of potential drugs, each ofwhich is from our proprietary compound library. We have entered intopartnership agreements with major pharmaceutical companies for each of theseprograms, under which we licensed the compounds to the partner for furtherdevelopment. At present, these compounds are at various stages in the GoodLaboratory Practice (GLP) Toxicology evaluation process (in which compounds aretested for safety before their introduction into humans in Phase I of theclinical development process). Two of these programs address asthma/allergyindications and the third is an oncology target.

 

*In Vivo Optimization Candidates.*** **Our pipeline includes eightadvanced lead compounds undergoing *in vivo*optimization and pre-GLP toxicology studies. In this stage of the developmentprocess, testing of the interaction of the compound and the target is conductedin a live animal, such as a rat or mouse. Two of these candidates emanated fromproprietary programs we conducted in the area of obesity and lipidemia, andsubsequently were licensed to pharmaceutical partners for further development.The other six programs involve drug candidates, some of which are ourproprietary compounds, targeting cancer, pain management, depression/anxiety,MS/transplant rejection, sinusitis/rhinitis, inflammation and angiogenesis.

 

*In Vitro OptimizationCandidates. *Sixcandidates in our portfolio are undergoing *invitro* optimization. This portion of the drug discovery processinvolves the testing and analysis of the interaction of the compound and thetarget in a controlled environment, such as our laboratories, outside of anyanimal or other living biological organism, for such properties as metabolicstability, absorption and toxicity. Three of these compounds resulted fromproprietary programs we conducted internally. Therapeutic areas addressed inthese six programs include anxiety/depression, immunological response,neurologic disease, angiogenesis, obesity/sexual dysfunction andallergy/transplant rejection.

 

*Active Compounds.*** **Our pipeline includes sevenactive compounds currently undergoing “hit-to-lead” efforts. In this phase, ourchemists analyze compounds screened against biological targets for desiredtherapeutic activity. “Active” compounds are then evaluated to determinewhether optimization studies should be conducted. Three of these programsoriginated as proprietary projects we conducted internally, and our work iscontinuing to develop the active compounds into lead series for furtherdevelopment. Therapeutic areas covered by these programs include inflammation,the Human Immunodeficiency Virus (HIV), asthma, neurological disease,diabetes/obesity and pain management.

 

*Targets for screening.*** **We are currently screening, orpreparing to screen, another 20 therapeutic targets covering a broad range ofdisease areas. Most of these targets have been provided to us by collaborativepartners. Based on our historical rate of success in identifying leads from ourproprietary collection of drug-like compounds that are active against targetswe accept for screening, we expect to advance a substantial number of theseprograms to the “hit-to-lead” stage. Thereafter, we anticipate that someportion of these active compounds will be selected for chemical optimization,based on their potential for development into solid drug candidates. Thescreening of these new targets is fundamental to the growth of our business, asactive compounds discovered at this early stage replenish and supplement ourcandidate pipeline and lead to additional collaborative work and possible“downstream” milestones and royalties.

 

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PDD PRODUCTS AND SERVICES

 

*Collaborative Drug Discovery. *Central to our strategy isthe pursuit and performance of collaborative drug discovery relationships withmajor pharmaceutical and biotechnology companies. Under these arrangements, ourpartner usually will define one or more therapeutic targets on which theparties will collaborate. We will perform designated services in thecollaboration (such as the screening of our internal compound collectionagainst the target, and the chemical optimization of active compoundsidentified through the screening process) in close consultation with thepartner. The collaboration typically is closely managed, through regularmeetings and detailed reporting requirements, by a Joint Research Committee(JRC), consisting of our representatives and scientists designated by ourpartner. Rather than performing a list of designated services and deliveringthe end product to the customer, we typically employ our technologies andpersonnel pursuant to a joint plan developed and regularly adjusted by the JRC.

 

As compensation,these arrangements typically provide that customers make payments to us in theform of (i) up-front fees for the services requested; (ii) full-time equivalentemployee (FTE) research funding for each scientist we utilize in thecollaboration; (iii) lump-sum milestone payments contingent upon theachievement of scientific endpoints specified in the collaboration agreement;and (iv) royalties from the commercial sale, if any, of a product resultingfrom the parties’ efforts. Milestone payments typically increase as a compoundor lead series progresses through the development process. Early stagemilestones, such as payments for identifying an active compound from ourprimary screening work, usually range in the low six figures. Achievement oflater stage pre-clinical milestones, such as the nomination of a drugdevelopment candidate with respect to a lead compound, trigger payments in themid-to high-six figures. Clinical milestones, such as the filing of anInvestigational New Drug application (an IND), commencement of human clinicaltrials, or the filing of an NDA with the U.S. Food and Drug Administration(FDA), typically lead to payments from one to several million dollars. We willearn royalty payments to the extent that products derived from compoundsdiscovered and/or optimized in the collaboration reach the market. Theseroyalties are calculated as a percentage (on average, 4%-8%) of the dollarsgenerated from any commercial sale of these products.

 

*Proprietary Drug Discovery.*** **We conduct our own internal drugdiscovery research as a key component of our business model. In these programs,our scientific staff (in consultation with our Scientific Advisory Board)selects one or more molecular targets of interest in one of the manytherapeutic areas in which we have experience. We then develop a work plan forthe screening of our internal compound collection against the target(s). Underthe work plan, active compounds discovered during the screening phase typicallyare optimized through the efforts of our medicinal chemists. Our scientistswill continue their work on the internal program until management determines tomarket the program to potential partners (typically, large pharmaceuticalcompanies) for “downstream” development. If such a partnering agreement isreached, the proprietary program is converted into a collaborative drugdiscovery project similar to those discussed in the previous section. Themilestones and royalties payable to us under such a converted program, however,typically are considerably larger than in collaborations in which the partnerprovides the therapeutic target at the initiation of the project. The enhancedcompensation payable to us reflects the higher level of up-front investment wemake in programs of this nature, as well as the increased risk we assume inadvancing the program from its origination to the point at which a developmentpartner is secured.

 

The followingchart sets forth our internal candidate pipeline and the disease area in whichthe program is focused:

 

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| **Proprietary Compound**  |   | **Therapeutic  Area** |
|---------------------------|--------|-----------------------|
| ***Lead Compounds(1)***   |   |                  |
| Avb3 Inhibitors           |   | Angiogenesis          |
| Bradykinin B1             |   | Inflammation          |
| Jak 3 Inhibitors          |   | Immunosuppression     |
|                      |   |                  |
| ***Active Compounds(2)*** |   |                  |
| Tie 2                     |   | Thrombosis, Pain      |
| IKK-B Inhibitors          |   | Inflammation          |
| ORL-1                     |   | Analgesia             |
| HSD-1 Inhibitors          |   | NIDDM                 |
| CXCR3 Agonists            |   | Oncology              |

 

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(1)                                  LeadCompounds are active compounds meeting specific criteria warranting theiradvancement in the drug development process.

 

(2)                                  ActiveCompounds are compounds that demonstrate the ability to modulate a target.

 

*Chemistry Services.*** **We view chemistry services as theprovision of assay development, high throughput screening, compound librarysynthesis and related services under arrangements in which we are compensatedsolely on a fee-for-service basis, without any right to receive milestones,royalties or other “downstream” payments. At present, substantially all of ourrevenue-generating agreements with pharmaceutical and biotechnology companiesare collaborative relationships, in which we have a financial interest in thesubject compounds as they progress through the development process. To date, wehave entered into few fee-for-service based chemistry services contracts.However, it is part of our strategy to selectively enter into additionalagreements of this nature. We see our chemistry services offerings as animportant avenue for penetrating major pharmaceutical and biotechnologycompanies which currently are not prepared to offer their third party serviceproviders a continuing interest in the applicable program. It is our strategyto demonstrate to the customer through these contracts the value we provide,and to convert the relationships to collaborative partnerships.

 

In an effort todevelop a competitive chemistry services offering, we created a strategicpartnership in 2003 with Wu Xi PharmaTech of Shanghai, China to providechemistry and R&D services to pharmaceutical and biotechnology companies.Under this alliance, we offer chemistry support for pre-clinical and R&Dprograms such as the synthesis of combinatorial chemistry templates, compoundlibraries, individual compounds, process research and development and scale up.In addition, we intend to design and market in tandem with Wu Xi PharmaTechtargeted libraries of discrete compounds biased towards particulardisease-related families of targets.

 

PDD SCIENCE ANDTECHNOLOGY

 

Our drug discoveryapproach encompasses our proprietary combinatorial chemistry encodingtechnology, Encoded Combinatorial Libraries on Polymeric Support (“ECLiPS®”),our proprietary collection of chemical compounds, assay technology, productionautomation, information systems and quality assurance programs, as more fullydescribed below.

 

*ECLiPS Technology.*  ECLiPS enables us to generate hundreds ofthousands of small molecule compounds at a fraction of the cost of traditionalchemical synthesis methods. We use “Direct Divide” combinatorial chemistry tobuild collections, or libraries, of 10,000 to 500,000 or more small moleculecompounds by performing only 50 to 200 individual chemical reactions. ECLiPSoffers substantial productivity improvements as compared to the 10,000 to500,000 or more reactions that would be required to prepare similarly sizedchemical libraries by synthesizing each compound individually. The ECLiPStechnology productivity advantage results from the synthesis of compounds ontiny plastic beads in large mixtures, to which we attach

 

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proprietary, easily detectable, stable tag sets to enable the rapididentification from the mixture of any compound that is active in a biologicalscreening assay.

 

We use ECLiPStechnology to build libraries of small compounds, predominantly heterocycles.These low molecular weight compounds are preferred by pharmaceutical companiesbecause they are more likely to be orally active (effective as drugs in tabletor capsule form), tend to have longer duration of action and are less expensiveto manufacture. In contrast, natural peptide and oligonucleotide drugs areusually degraded by human digestive system enzymes and generally must beadministered by injection. In addition, peptide and oligonucleotide drugs areoften quickly eliminated from the body, which limits their duration of action.Further, the ECLiPS technology allows rapid resynthesis of compounds withoutdeconvolution, a process in which an active compound must be “reverseengineered” by resynthesizing and testing various component combinations untilthe structure of the active compound is deduced.

 

Our ECLiPStechnology enables us to build large, densely packed libraries of drug-likecompounds generate rich SAR information from the primary screening process. SARdata, which is detailed information as to the activity produced in a particulardisease target of interest by screening it against various sets of compoundswith related, but differing, molecular structures, greatly facilitates our drugcandidate optimization by providing our medicinal chemists with a type ofstructural “roadmap” to guide their optimization efforts. Lead optimization isfurther accelerated by our expertise in combinatorial chemistry. Our scientistsbuild combinatorial libraries of compounds around molecules and assay themolecules in an effort to determine the most promising course for ongoingsynthesis.

 

Our taggingtechnology has been licensed exclusively from The Trustees of ColumbiaUniversity in the City of New York (“Columbia”) and Cold Spring HarborLaboratories (“Cold Spring”) since 1993. We are obligated to pay a minimumannual license fee of $100,000 to Columbia and Cold Spring. The term of theagreement is the later of (i) 20 years or (ii) the expiration of the lastpatent relating to the technology, at which time we will have a fully paidlicense to the technology. The license granted under this agreement may beterminated by Columbia and Cold Spring (i) upon 30 days written notice to us ifColumbia and Cold Spring elect to terminate if we do not expend certain amountof money developing and commercializing the combinatorial chemical libraries,(ii) upon 30 days written notice to us if we materially breach the agreementand fail to cure the material breach, or (iii) if we commit any act of bankruptcy,become insolvent, file a petition under any bankruptcy or insolvency act orhave a petition filed against us that is not dismissed within 60 days. We arealso obligated to pay royalties to Columbia and Cold Spring based on net salesof pharmaceutical products we develop, as well as a percentage of all otherpayments (such as milestones and royalties) we receive from customers where wehave utilized the technology licensed from Columbia and Cold Spring.

 

*Our Compound Library. *We have employed ECLiPS,together with other technologies, to synthesize approximately 7.5 millionunique and proprietary chemical compounds. Our collection is organized into“libraries,” consisting of both large and diverse “discovery” libraries of20,000-100,000 compounds and smaller “targeted” libraries designed to interactwith particular disease targets or classes of targets. Our collection has hadsuccess producing compounds found to be therapeutically active againstdifficult targets supplied by our partners; in the primary screening process,our libraries often produce hundreds of active compounds of varying potenciesrather than the handful generated by some other collections. In our view, thevalue of significant compound collections has been recognized by a number of leadingpharmaceutical organizations, who recently have decided to build large internalcompound libraries or significantly augment existing small moleculecollections.

 

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*Success Rates.*  Our criteria for determining whether or notwe have been successful in the screening of our compound library against aparticular disease target are both rigorous and relatively simple. We measureour success by evaluating the potency of each screened compound in inducing, orinhibiting, activity in the target at specified concentrations of the compoundper liter. A screen against a given target is deemed to be “successful” if wediscover at least one compound from our collection that is active in thedesired manner against the target at the prescribed concentration.

 

Our compoundcollection and high throughput screening technologies have been proven to beeffective against a wide variety of biological targets. Importantly, we haveachieved success against some of our collaborators’ most difficult targets,often after our partners’ internal drug discovery efforts were unsuccessful.Our libraries have been shown to be particularly effective against some of theindustry’s most important disease targets, such as G-Protein Coupled Receptors(GPCRs) and Kinases.  For example, ofthe 17 Kinases we have screened to date, a potent active compound from ourlibrary was discovered in 15 cases (an 88% success rate). For GPCRs, wediscovered a potent active compound in 17 of 25 cases (a 68% success rate).Overall, we have about a 58% success rate in discovering potent compoundsactive against some of our collaborators’ most challenging targets.

 

Our chemistryoptimization services have also proven highly effective in delivering compoundsto collaborators meeting the criteria specified by our partner. In the GPCRarea, we have produced optimized compounds in 9 of 13 programs we haveconducted (a 69% success rate). Further, in the case of Kinases, we havedelivered optimized compounds in 4 of the 5 programs we have undertaken (an 80%success rate). Overall, we have about a 77% success rate in optimizingcompounds to the criteria specified by our collaborators.

 

*Assay Technology.*  We are an industry leader in the developmentand use of technologies to accurately and rapidly test chemical compoundsagainst biological targets. We employ 384-well and 1,536-well microtiter platescreening assays to identify compounds active against our partners’ targets.These 384-well and 1,536-well formats offer significant throughput improvementsand cost savings as compared to the industry standard 96-well format. In 2003,we completed approximately 40 million tests of our library compounds foractivity against targets. Further, our 1,536-well format allows us to perform,at an extremely low cost, a screen of 5 million compounds against acollaborator’s target in under two weeks. Labor required for screening with a1,536-well assay is reduced tenfold as compared to 96-well plates. We believethat our proprietary assay technology, together with our expertise inminiaturizing assays, makes us one of the industry’s lowest cost producers ofprimary screening results and data, providing us with the strategic capabilityto screen large quantities of compounds at a fraction of the cost incurred bysome of our competitors.

 

*Production Automation.*  Production automation technology is anotherimportant component of our integrated drug discovery approach. We havedeveloped proprietary instruments and methods for quickly and cost effectivelymanipulating large numbers of small plastic beads and the compounds that aredetached from these beads. The technology includes proprietary engineeringmethods and automated systems for placing individual compounds in 96 to1,536-well assays and processing them in preparation for screening.

 

*Information Systems.*** **We have developed proprietarysoftware to support our drug discovery activities. Our information systemsassist our scientists in managing the extensive data generated during library productionand testing. First, our software integrates the tag set decoding results withthe original library design database to quickly provide our scientists with thespecific chemical structure and synthesis steps for the active compound. Ourinformation systems also include molecular modeling, structure analysis andstatistical programs for designing

 

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optimization libraries and software to collect and analyze the resultsof individual assays. We use Accelrys products, thereby significantly enhancingPDD’s ability to use informatics in the drug discovery process.

 

*Quality Assurance.*** **Our drug discovery approachincludes an extensive quality assurance program. As libraries are synthesized,representative compounds are analyzed at each reaction step to assure thatyields are high and compounds are sufficiently pure. During library production,samples are tested at each reaction step to assure that the tag sets have beensatisfactorily attached and can be decoded. Representative compounds are alsotested to identify optimal solvents and detachment conditions for removingcompounds from beads to perform screening assays. Production plates containingcompounds for screening include control samples to further assure that platesto be screened in assays have been prepared appropriately.

 

PDD CUSTOMERS

 

*Schering-Plough Corporation.*** **In September 2003, weentered into new multiyear agreements with Schering-Plough Corporation,extending our largest pharmaceutical collaboration for a minimum of threeyears. Under the terms of the new agreements, we will optimize candidatesselected for clinical development by Schering-Plough and screen our internallibrary to identify compounds active against multiple Schering-Plough targets.If successful, we will license the optimized drug candidates on an exclusivebasis to Schering-Plough for further development. With respect to any target weaccept from Schering-Plough for screening or optimization work, we have agreedthat we will not screen our compound library for other collaborators, or forour own account, against that target for a specified period.  We receive research funding fromSchering-Plough and, in return for our successful drug discovery activities, weare entitled to receive milestone and other payments from Schering-Plough ascompounds progress through development and royalties on sales of any productsresulting from the collaboration. Payments under our Schering-Ploughcollaboration totaled $13.9 million for the year ended December 31, 2003,representing approximately 47% of PDD’s revenue for the year.

 

The initial termof the new agreements is three years. Schering-Plough is obligated to fund aspecified number of our FTEs in the first year, but may reduce its funding inthe second year of the agreements if we do not produce at least one activecompound from the screening of our internal library in such first year. In thatevent, Schering-Plough may “wind down” the collaboration in the third year byreducing its funding obligation by approximately 50% from year one levels. Atthe end of such third year, the collaboration would terminate. If, however, weprovide an active compound by the end of the first year, Schering-Plough isrequired to continue its funding during the second year at the same level asthe first year. Further, if Schering-Plough agrees to optimize at least threeof our internal compounds by the end of the second year, it is required tocontinue to fund us in the third year at the same level as in year one. Ifthree compounds are not selected for optimization, Schering-Plough again mayreduce the number of our FTEs it funds in the third year by 50%, in order to“wind down” the collaboration by the end of that year. If Schering-Plough iscontinuing to fund us at year one levels after three years, the collaborationwill be extended for a fourth year if Schering-Plough agrees in the third yearto optimize another of our compounds screened in the collaboration. Similarly,the agreement will be extended for a fifth year if Schering-Plough agrees inthe fourth year to optimize at least one additional compound. IfSchering-Plough decides not to commence such an optimization program in eitherthe third or fourth year, then the subsequent year (i.e., the fourth or fifthyear, respectively) will be the “wind down” year of the collaboration, in whichSchering-Plough may reduce its funding obligation by 50% and terminate thecollaboration at the end of that year. The third one year extension (i.e., thesixth year of the collaboration) is at Schering-Plough’s sole option.

 

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*N.V. Organon.*** **In February 2002, we enteredinto a five-year drug discovery agreement with N.V. Organon (the pharmaceuticalbusiness unit of Akzo Nobel) to identify and optimize new drug candidates formultiple therapeutic targets provided by Organon. Compounds from ourproprietary collection that are screened and optimized and which meet thepotency, selectivity, efficacy and other criteria determined specified by theparties will be licensed to Organon on an exclusive basis for furtherdevelopment. In addition, with respect to any target we accept from Organon forscreening or optimization work, we have agreed that we will not screen ourcompound library for other collaborators, or for our own account, against thattarget for a specified period. In return for our successful drug discoveryactivities, and meeting certain preclinical and clinical milestones, we areentitled to receive fees and milestone payments from Organon. Thereafter, uponsuccessful commercialization of any product resulting from the relationship, wewill be entitled to receive royalties on sales of that product.

 

The initial termof the agreement is five years. Notwithstanding the stated term, however, Organon has the right toterminate the agreement as soon as 2005, and at future times thereafter, in theevent we are unable to deliver lead compounds meeting the criteria specified inthe agreement.  Payments under ourvarious agreements with Organon totaled almost $5.5 million for the year endedDecember 31, 2003, representing approximately 18.5% of PDD’s revenue forthe year.

 

*Novartis. *In February 2003, we announced the signingof a new collaboration agreement with Novartis AG, the third alliance in thislong-standing drug discovery relationship. In this newest collaboration, thecompanies work together to identify new lead compounds against multiple drugtargets from our partner’s discovery programs. Under the terms of this agreement,we provide assay development and compound screening services on behalf ofNovartis. We expect to complete all of the required services under theagreement by March 31, 2004, when the agreement will expire in accordancewith its terms. Payments under our various agreements with Novartis totaled$3.4 million for the year ended December 31, 2003, representingapproximately 11.4% of PDD’s revenue for the year.

 

*Other Relationships.*** **We have also entered intoresearch collaboration agreements with Berlex Laboratories, Bristol MyersSquibb, Daiichi Pharmaceutical, AstraZeneca, Schering AG, Celgene Corporation,Boehringer Ingelheim, Otsuka Pharmaceutical Factory, Neurocrine Biosciences,Ester Neurosciences, Kowa Company, Altana Pharma, Taiho Pharmaceutical, ProgenicsPharmaceuticals, Locomogene and Mitsubishi Pharma.

 

PDD MARKETING

 

Our seniormanagement and dedicated business development personnel are primarilyresponsible for marketing our collaborative capabilities and related services.Because our customers are typically highly skilled scientists, our use oftechnical experts in marketing has allowed us to establish strong customerrelationships. We market our capabilities and services directly to customers,typically through meetings with senior management of pharmaceutical andbiotechnology companies, and by our participation in trade conferences andshows. We also receive a significant amount of business from customer referralsand through expansion of existing contracts.

 

PDD COMPETITORS

 

We compete with companiesin the United States and abroad that engage generally in the discovery,development and production of drug discovery products and services andparticularly in the effort to identify and optimize compounds for potentialpharmaceutical development. We compete with the research departments ofpharmaceutical companies, biotechnology companies,

 

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combinatorial and medicinal chemistry companies, and research andacademic institutions. Many of these organizations have greater financial andhuman resources and more experience in research and development than us. Wecompete based on a number of factors, including size, relative expertise andsophistication, speed and costs of identifying and optimizing potential leadcompounds and of developing and optimizing chemical processes.

 

Historically,pharmaceutical companies have maintained close control over their researchactivities, including the synthesis, screening and optimization of chemicalcompounds. Many of these companies, which represent the greatest potentialmarket for our services, have developed combinatorial chemistry and othermethodologies to improve productivity, and have made major investments inrobotics technology to permit the automated parallel synthesis of compounds. Inaddition, certain of these companies already have large collections ofcompounds previously synthesized or ordered from chemical supply catalogs orother sources against which they may screen new disease targets. Other sourcesof compounds include those extracted from natural products such as plants andmicroorganisms and compounds created using rational drug design. Academicinstitutions, governmental agencies and other research organizations are alsoconducting research in areas in which we are working, either on their own orthrough collaborative efforts.

 

Competition alsocomes from organizations operating as integrated drug discovery companies orchemistry service providers such as Albany Molecular Research, Inc., ArQule,Inc., Array Biopharma, Inc., Discovery Partners International, Inc., Evotec OAIAG, and Tripos, Inc.

 

PDD PATENTS ANDPROPRIETARY INFORMATION

 

We have appliedfor approximately 161 patents, approximately 77 of which have been issued,relating to various aspects of our technology, including our molecular tagsets, certain screening technologies and our libraries or compounds containedtherein. We either own these patents and patent applications or rights underthem are licensed to us. Of particular note, we are the exclusive licensee ofU.S. patents issued on October 15, 1996, February 24, 1998 andAugust 4, 1998, which provide broad protection to our use of encodedcombinatorial libraries. Our success will depend in large part on our ability,and the ability of our licensees and licensors, to obtain patents for ourtechnologies and the compounds and other products, if any, resulting from theapplication of such technologies, defend patents once obtained, maintain tradesecrets and operate without infringing upon the proprietary rights of others,both in the U.S. and in foreign countries.

 

The patentpositions of pharmaceutical and biotechnology companies, including our company,are uncertain and involve complex legal and factual questions. We do not knowof any patents or patent applications by others that would preclude us frompracticing our ECLiPS technology or obtaining patent protection in the UnitedStates or elsewhere for our ECLiPS technology. However, disputes may arisebetween other patent holders and us as to claims of infringement, which couldinvolve protracted periods of litigation. Some of our competitors have, or areaffiliated with companies having, substantially greater resources than us, andsuch competitors may be able to sustain the costs of complex patent litigationto a greater degree and for longer periods of time than us. Uncertaintiesresulting from the initiation and continuation of any patent or relatedlitigation could have a material adverse effect on our ability to compete inthe marketplace pending resolution of the disputed matters.

 

There can be noassurance that patents will issue as a result of any pending applications orthat, if issued, such patents will be sufficiently broad to afford protectionagainst competitors with similar technology. Moreover, there can be noassurance that we or our customers will be able to obtain patent protection forcompounds or pharmaceutical products based upon our technology. There can be noassurance that any patents issued to us or our collaborative partners, or forwhich

 

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we have license rights, will not be challenged, invalidated orcircumvented, or that the rights granted thereunder will provide competitiveadvantages to us. Litigation, which could result in substantial cost to us, maybe necessary to enforce our patent and license rights or to determine the scopeand validity of others’ proprietary rights.

 

Our commercialsuccess will also depend upon avoiding the infringement of patents issued tocompetitors and upon maintaining the technology licenses upon which certain ofour current products are, or any future products under development might be,based. If our competitors prepare and file patent applications in the UnitedStates that claim technology also claimed by us, we may have to participate ininterference proceedings declared by the US Patent and Trademark Office todetermine the priority of invention, which could result in substantial cost tous, even if the outcome is favorable to us. An adverse outcome could subject usto significant liabilities to third parties and require us to obtain a licenseto disputed rights from third parties or cease using the technology.

 

We currently havecertain licenses from third parties and in the future may require additionallicenses from other parties to develop, manufacture and market commerciallyviable products effectively. In performing Lead Discovery, we or ourcollaborators may need to obtain licenses to enable us to utilize certain assaytechnology and to screen against certain targets. Our commercial success in ourLead Discovery Services may depend on our ability or our collaborators’ abilityto obtain such licenses. There can be no assurance that such licenses will beobtainable on commercially reasonable terms, if at all, that the patentsunderlying such licenses will be valid and enforceable or that the proprietarynature of the patented technology underlying such licenses will remainproprietary.

 

We relysubstantially on certain technologies that are not patentable or proprietaryand are therefore available to our competitors. We also rely on certainproprietary trade secrets and know-how, which are not patentable. Although wehave taken steps to protect our unpatented trade secrets and know-how, in partthrough the use of confidentiality agreements with our employees, consultantsand certain of our contractors, there can be no assurance that these agreementswill not be breached, that we would have adequate remedies for any breach, orthat our trade secrets will not otherwise become known or be independentlydeveloped or discovered by competitors.

 

PDD GOVERNMENT REGULATION

 

Generally, inorder to gain approval of the FDA, a company must conduct preclinical studiesin the laboratory and in animal models to gain preliminary information on acompound’s efficacy and to identify any safety problems. The results of thesestudies are submitted as a part of an IND that the FDA must review prior to thecommencement of clinical trials of an investigational drug. In order tocommercialize any products, we or our customer will be required to sponsor andfile an IND and will be responsible for initiating and overseeing the clinicaltrials to demonstrate the safety and efficacy that are necessary to obtain FDAapproval of any such products. Clinical trials are normally done in threesequential phases (Phase I, Phase II and Phase III) that may overlap andgenerally take two to five years, but may take longer, to complete. Aftercompletion of clinical trials of a new product, FDA and foreign regulatoryauthority marketing approval must be obtained. If the product is classified asa new drug, we, or our customer, will be required to file an NDA and receiveapproval before commercial marketing of the drug. Even if FDA regulatoryclearances are obtained, a marketed product is subject to continual review, andlater discovery of previously unknown problems or failure to comply with theapplicable regulatory requirements may result in restrictions on the marketingof a product or withdrawal of the product from the market as well as possiblecivil or criminal sanctions. For marketing outside the United States, we willalso be subject to foreign regulatory requirements governing human clinicaltrials and marketing approval for pharmaceutical products. The requirementsgoverning the conduct of

 

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clinical trials, product licensing, pricing and reimbursement varywidely from country to country. Further, our research and development processesinvolve the controlled use of hazardous materials. We are subject to federal,state and local laws and regulations governing the use, manufacture, storage,handling and disposal of such materials and certain waste products. Although webelieve that our activities currently comply with the standards prescribed bysuch laws and regulations, the risk of accidental contamination or injury fromthese materials cannot be eliminated.

 

PDD SOURCES OF SUPPLY

 

We currently relyon two suppliers to provide plastic filter bottom microtiter plates that areused in the assay plate preparation process. We have, over the past year,developed a process such that it is not entirely dependent upon thesesuppliers.  Should we be unable, in someinstances, to obtain an adequate supply of these or comparable filter bottomplates at commercially reasonable rates, our ability to continue to prepareassay plates could be adversely affected, which in turn can harm our business.

 

PDD MANUFACTURING

 

We do not expectto directly manufacture or market any pharmaceutical products that may bedeveloped under our collaborative arrangements. However, we may, in the future,consider undertaking such activities if we believe they are appropriate underthe circumstances. We have no experience in developing pharmaceutical productsor in manufacturing or marketing products on a commercial scale. We may nothave the resources to develop or to manufacture or market on our own on acommercial scale any products identified by us. In the event we decide toestablish a manufacturing facility, we will require substantial additionalfunds, and will be required to hire and train significant additional personneland comply with the extensive FDA “good manufacturing practice” regulationsapplicable to such a facility.

 

RESEARCH ANDDEVELOPMENT

 

Pharmacopeia’sexpense for proprietary research and development activities was as follows (inthousands):

 
|                                 |   | **Years  Ended December 31,** |   |
|--------------------------------------|--------|------------------------------------|--------|
|                                 |   | **2003**                           |   | **2002** | ** ** | **2001** | ** ** |
|                                 |   |                               |   |   |   |   |   |
| Proprietary Research and Development |   | $                                  | 22,029 |   | $ | 27,868 |   | $ | 32,529 |   |
|                                      |        |                                    |        |  |  |  |  |  |  |  |

 

The decrease inresearch and development from 2002 to 2003 was due to the restructuring atAccelrys in 2002, and the decrease in research and development from 2001 to2002 resulted from cost efficiencies realized in the software business andplanned reductions in the Drug Discovery business, as more fully described inthe Notes to Consolidated Financial Statements.

 

EMPLOYEES

 

As ofDecember 31, 2003, we had 713 regular employees including 261 chemists,biologists and engineers holding doctorate degrees.  None of our employees is covered by collective bargainingagreements. Substantially all of our employees other than certain of ourexecutive officers with employment agreements are at will employees, which meansthat each of them can

 

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terminate their relationship with us and we can terminate ourrelationship with them at any time. Furthermore, we offer industry competitivewages and benefits and are committed to maintaining a workplace environmentthat promotes employee productivity and satisfaction.  We believe our relations with our employees are good.

 

RISK FACTORS

 

*You should carefully consider the risks described below beforeinvesting in our publicly-traded securities. The risks described below are not the only ones facing us.  Our business is also subject to the risksthat affect many other companies, such as competition, technologicalobsolescence, labor relations, general economic conditions, geopoliticalchanges and international operations. Additional risks not currently known to us or that we currently believeare immaterial also may impair our business operations and our liquidity.*

 

*CERTAIN RISKS RELATED TOTHE PROPOSED SPIN-OFF OF PDD*

* *

*There can be no assurance that the proposed spin-off of PDD will becompleted or, if completed, will be successful.*Our Board of Directors has approvedin principle the plan to separate our Accelrys and PDD businesses through thespin-off to our stockholders of 100% of the outstanding shares of common stockof PDD. The transaction would result in PDD being an independent,publicly-traded company owning and operating our Drug Discovery business; wewould retain ownership of and operate the Accelrys software business. Ourstockholders would continue to own their shares of Pharmacopeia stock, as wellas the shares of PDD stock to be distributed in the spin-off. Under the termsof the distribution, our Board of Directors has reserved the right, in its solediscretion and without liability, to provide final approval for the spin-off orto abandon the spin-off at any time prior to its completion, for any reason orno reason at all.  In addition, certainconditions must be satisfied or waived by us prior to the distribution beingeffected.  As a result, there can be noassurance that we will not abandon the spin-off or that we will be able tocomplete the separation of the businesses. Such abandonment or failure couldhave a material adverse effect on our business, financial condition or resultsof operations.

 

We believe that separating PDD from Pharmacopeia will resolvedifficulties we have encountered regarding the effective operation anddevelopment of our two businesses within a single publicly-tradedcorporation.  We further believe thespin-off will enhance the performance of Pharmacopeia and PDD by providing eachcompany with greater focus on its respective business, with a publicly tradedequity security for use in compensation programs and as “currency” in strategictransactions, and with a clearer story to enable investors to better evaluateeach company and assign each entity an appropriate market valuation. There canbe no assurance that PDD and Pharmacopeia, as stand-alone entities, will beable to benefit from these items.

 

PDD has no current history as an independent company, and will nolonger be able to rely on our financial and other resources and the cash flowsgenerated from our software operations. Currently, we operate our businesses aspart of a broader corporate organization rather than as a stand-alone company.Historically, we have performed certain corporate functions for PDD; after atransition period following the distribution, we will no longer provide suchassistance to PDD. Our estimates concerning the costs for PDD’s own corporateadministrative functions (such as overhead functions, corporate governance,securities compliance, exchange listing and investor relations services) may besubstantially lower than the actual costs PDD will incur.  As a result, it will be difficult for anyoneto accurately forecast PDD’s future operating performance. Further, PDD mayneed to obtain financing on a stand-alone basis after the spin-off, which maybe difficult because its financial and other resources may not be as strong asours prior to the distribution. Any future PDD financing will have to be raisedwithout reference to or reliance on

 

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our financial condition. There can be no assurance that PDD will be ableto obtain financing after the distribution on acceptable terms, or at all.

 

*The combined market value of our shares andthose of PDD after the spin-off may not be equal to or greater than the marketvalue of our shares prior to the distribution.* There isno established public market for PDD’s common stock; after the distribution,the public market will establish trading prices for the common stock of PDD andus. There is no assurance that an active public market for PDD’s or our commonstock will develop or be sustained. In addition, the smaller size of the marketcapitalization of each company after the distribution compared to our marketcapitalization prior to the distribution may result in our loss of, and PDD’sfailure to obtain, stock research analyst coverage, which could adverselyimpact each entity’s stock market following. Consequently, there can be noassurance that the combined market value of our shares and those of PDD afterthe spin-off will be equal to or greater than the market value of our sharesprior to the distribution. Further, the market price of PDD’s and our stock tomay fluctuate substantially, as in recent years the stock market hasexperienced significant price and volume changes and the Company’s stock pricehas been volatile. In addition, following the distribution, our currentstockholders will now own separate securities in PDD and the Company. It ispossible that some stockholders will sell shares of PDD or our common stock forvarious reasons, including the fact that the business profile or marketcapitalization of that entity as a stand-alone company does not fit theirinvestment objectives. Given the large concentration of our stockholdings amongour top seven stockholders, substantial sales of shares by one or more of thesestockholders could depress the market price for PDD’s or our shares. We cannotpredict whether substantial amounts of PDD’s or our stock will be sold in theopen market following the spin-off.

 

*If the distribution is taxable, stockholders could be required to paytax on the fair market value of the shares of PDD common stock you receive, andwe could incur a corporate tax liability.* If thespin-off fails to qualify as a tax-free distribution for U.S. federal incometax purposes, our stockholders who receive PDD shares would be treated as ifthey had received a taxable distribution in an amount equal to the fair marketvalue of the PDD common stock received. In such event, a corporate income taxcould also be payable by us on the excess of the fair market value of the PDDstock over our adjusted tax basis in the stock. Further, even if thedistribution is tax-free to our stockholders, we could be subject to corporateincome tax on any gain inherent in PDD’s stock if one or more persons acquire a50% or greater interest in PDD as part of a plan or series of relatedtransactions that included the spin-off.

 

*We may be required to indemnify PDD, or may not be able to collect onindemnification rights from PDD*. As part of the proposed spin-off, we and PDD have agreed toindemnify one another after the distribution with respect to the indebtedness,liabilities and obligations that will be retained by our respective companies.One such obligation is expected to include a guarantee by us of PDD’sobligations under the existing New Jersey laboratory and headquarters leases,with respect to which PDD will indemnify us should we be required to make anypayment under the guarantee. These indemnification obligations could besignificant. PDD’s ability to satisfy any such indemnification obligations(including, without limitation, PDD’s commitment to indemnify us in the eventof our payment under our guarantee of its leases) will depend upon PDD’s futurefinancial strength. We cannot assure you that, if PDD becomes obligated toindemnify us for any substantial obligations, PDD will have the ability to doso. There also can be no assurance that we will be able to satisfy anyindemnification obligations to PDD. Any required payment by PDD or us couldhave a material adverse effect on its or our business, and any failure by PDDor us to satisfy its obligations could have a material adverse effect on theother company’s business.

 

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*CERTAIN RISKS RELATED TOOUR BUSINESS AS A WHOLE*

 

*Our PDD revenue is highly concentrated in its largest collaborators;the termination of the collaboration with PDD’s largest collaborator would havea material adverse effect on our business, financial condition and results ofoperations.*During the year ended December 31,2003, we earned approximately 47% of PDD’s revenue, and 12% of our consolidatedrevenue, under PDD’s research collaboration agreements with Schering-PloughCorporation. In the third quarter of 2003, PDD entered into new multiyear drugdiscovery collaboration agreements with Schering-Plough, which continue certainexisting programs and implement a number of new activities. The new agreementscontinue PDD’s collaboration with this partner through at leastAugust 2006 and, under their terms, may be extended by the parties for upto three additional years based upon progress made in the programs governed bythe agreements. The agreements may be terminated at the end of the third year,and Schering-Plough’s funding obligations may be reduced significantly beforethat time, under the circumstances summarized previously. There can be noassurance that the results of PDD’s collaboration with Schering-Plough would besufficient to cause Schering-Plough not to exercise its rights to terminate theagreements. In light of the significance to us of the Schering-Ploughrelationship, the termination of PDD’s collaboration agreements would have amaterial adverse effect on PDD and our business as a whole.

 

*Pharmaceutical and biotechnology companies may discontinue or decreasetheir use of our services and products.*****Weare dependent on pharmaceutical and biotechnology companies continuing tocollaborate with outside companies to obtain drug discovery expertise. Ourcapabilities include aspects of the drug discovery process that pharmaceuticalcompanies have traditionally performed internally. Further, these companies(together with diversified chemical and other industrial companies) comprisethe principal market for our Accelrys modeling, simulation, data analysis andrelated software products and services. Although there is a history among pharmaceutical and biotechnologycompanies of outsourcing drug research and development functions, this practicemay not continue. Similarly, these companies have frequently utilized outsidesoftware vendors for key tools used in drug discovery and chemical development,rather than developing needed information and analysis tools internally.  Our revenue depends to a large extent on researchand development expenditures by the pharmaceutical, biotechnology, and chemicalindustries, particularly companies in these industries outsourcing research anddevelopment projects and adding new and improved technologies to acceleratetheir drug discovery and chemical development initiatives.  The willingness of these companies to expandor continue drug discovery collaborations or outsourcing of services to enhancetheir research and development activities is based on certain factors that arebeyond our control. Examples of relevant factors include customers’ andcollaborators’ spending priorities among various types of research activities,their ability to hire and retain qualified scientists, their approach regardingexpenditures during recessionary periods, their policies regarding the balanceof research expenditures versus cost containment and the benefits of newsoftware tools versus their costs of licensure. Since a large proportion of oursoftware customers license our products on an annual basis or buy maintenancecontracts from us annually, if their spending priorities shift, our revenue maybe impacted.  Also, general economicdownturns in our customers’ industries or any decrease in research anddevelopment expenditures could harm our operations, as could increasedpopularity of management theories which counsel against outsourcing of criticalbusiness functions. In addition, the popularity of scientific thinking thatdisfavors expensive products such as large diversity libraries could negativelyimpact our revenue or our sales mix. Any decrease in drug discovery spending bypharmaceutical and biotechnology companies, or in chemical or materialsspending by chemical and industrial companies, could cause our revenue todecline and adversely impact our profitability.

 

*Our ability to increase revenue and grow our business is dependent uponour success in adding new customers and expanding our existing customerrelationships.* In order to generate the additional revenue needed to grow, we must addnew customers and retain, and expand upon, our existing customer relationships.These efforts depend significantly upon, among other factors:

 

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•                  our successfuldevelopment of new products;

•                  the success ofour business development, sales and marketing efforts;

•                  biotechnologyand pharmaceutical company spending for the outsourcing of chemistry and otherdrug discovery services; and

•                  the willingnessof current and potential biotechnology, pharmaceutical and diversified chemicalcustomers to invest in new modeling, simulation and informatics solutions.

 

If we are unable to add revenue from additional or expanded customerrelationships, we may not be able to grow our business.

 

*Our future profitability is uncertain.*Wegenerated losses in 2001, 2002 and 2003. Continuing net losses may limit ourability to fund our operations and we may not generate income from operationsin the future.  Our future profitabilitydepends upon many factors, including several that are beyond our control. Thesefactors include:

 

•                  changes in thedemand for our products and services, or for collaborative relationships withPDD;

•                  the introductionof competitive drug discovery services and software;

•                  our ability tolicense desirable technologies;

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

•                  our ability tosuccessfully, cost effectively and timely develop, introduce and market newcollaborative arrangements, products, services and product enhancements.

 

On a quarterly basis, our future profitability is likely to be highlyvolatile because, among other reasons, it is impacted by our receipt ofmilestone payments from our collaborators. We may not receive milestonepayments on a regular basis, or at all.

 

*We operate in business lines that change rapidly and in unexpectedways.* Rapid technological change and uncertainty dueto new and emerging technologies characterize the software, drug discovery andchemical development industries. We may be unable to develop, integrate andmarket, on a timely basis, the new and enhanced products and services necessaryto keep pace with competitors. Our products and services may be renderedobsolete by the offerings of our competitors. Failure to anticipate or torespond to changing technologies, or significant delays in the development orintroduction of products or services, could cause customers to delay or decideagainst purchases of our products or services.

 

*Failure to attract and retain skilled personnel could have a materialadverse effect on us.* Our success depends in part onthe continued service of key scientific, software, sales, business development,engineering and management personnel and our ability to identify, hire andretain additional personnel. There is intense competition for qualifiedpersonnel. In particular, we believe that there is a shortage of scientistsqualified to work for PDD. The competition among drug discovery and developmentcompanies to hire such scientists is particularly intense. Immigration laws mayfurther restrict our ability to attract or hire qualified personnel. We may notbe able to continue to attract and retain the personnel necessary for thedevelopment of our business. Failure to attract and retain key personnel couldhave a material adverse effect on our business, financial condition and resultsof operations. Further, we are highly dependent on the principal members of ourscientific and management staff, including:

 

•      Joseph A. Mollica, Ph.D.,Chairman of the Board, President and Chief Executive Officer;

•      Mark J. Emkjer, ExecutiveVice President and President, Accelrys; and

 

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•      Stephen A. Spearman, Ph.D.,Executive Vice President and Chief Operating Officer, PDD,

 

and the managers reporting to these senior executives.  One or more of these key employees couldretire or otherwise leave our employ within the foreseeable future, and theloss of any of these people could have a material adverse effect on ourbusiness, financial condition and results of operations. We are currentlyconducting a search to hire a chief executive officer of PDD. Dr. Joseph A.Mollica, Ph.D., the Chairman of the Board, President and Chief ExecutiveOfficer of Pharmacopeia, is expected to serve as PDD’s President and ChiefExecutive Officer until a successor is appointed.  We do not, and do not intend to, maintain key person lifeinsurance on the life of any employee.

 

*We are dependent upon some of our suppliers.*We currently rely on two suppliers to provide plastic filter bottom microtiterplates that are used in the assay plate preparation process. We have, over thepast year, developed a process such that we are not entirely dependent uponthese suppliers.  Should we be unable, insome instances, to obtain an adequate supply of these or comparable filterbottom plates at commercially reasonable rates, our ability to continue toprepare assay plates could be adversely affected, which in turn could harm ourbusiness.

 

*We may be unable to develop strategic relationships with largepharmaceutical, biotechnology, chemical and technology companies.* A component of our business strategy is todevelop strategic relationships with larger pharmaceutical, biotechnology,chemical and technology companies.  Webelieve that through such relationships we can add revenue, expand ourdistribution channels, maximize our research and development resources, improveour competitive position and increase market awareness and acceptance of DrugDiscovery and scientific software products. To date, we have entered intosignificant strategic relationships with such companies as Schering-Plough,N.V. Organon, IBM, Oracle and HP.  Therecan be no assurance that any such relationship will continue, that relationshipswith similar large organizations can be developed, or that any such existing ornew alliances will produce substantial revenue or profit opportunities.

 

*We are subject to risks associated with the operation of aninternational business. *In2003, approximately 53% of the Company’sconsolidated revenue was derived from customers outside the United States,both through international subsidiaries and on an export basis. Approximately36% of our revenue was derived from customers in Europe and approximately 17%was derived from customers in the Asia/Pacific region.  We anticipate that international revenuewill continue to account for a significant percentage of future overallrevenue. Our international operations, particularly at Accelrys, continue to expand,with functions such as software development, sales and customer supportincreasingly being performed outside the United States.  In this connection, we intend to continuethe expansion of our development center in Bangalore, India.

 

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

 

•                  unexpectedchanges in regulatory requirements;

•                  longer paymentcycles;

•                  currencyexchange rate fluctuations;

•                  import andexport license requirements;

•                  tariffs andother barriers;

•                  politicalunrest, terrorism and economic instability;

•                  disruption ofour operations due to local labor conditions;

•                  limitedintellectual property protection;

•                  difficulties incollecting trade receivables;

 

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•                  difficulties inmanaging distributors or representatives;

•                  difficulties inmanaging an organization spread over various countries;

•                  difficulties instaffing foreign subsidiary or joint venture operations; and

•                  potentiallyadverse tax consequences.

 

Our success depends, in part, on our ability to anticipate and addressthese risks. There can be no assurance that these or other factors will notadversely affect our business or operating results.

 

We may not be able to sustain or increase international revenue. Any ofthe foregoing factors may have a material adverse effect on our internationaloperations and, therefore, our business, financial condition and results ofoperations. Our direct international sales generally are denominated in localcurrencies. Fluctuations in the value of currencies in which we conductbusiness relative to the United States dollar result in currency transactiongains and losses, and the impact of future exchange rate fluctuations cannot beaccurately predicted. Future fluctuations in currency exchange rates may have amaterial adverse impact on revenue from international sales, and thus on ourbusiness, financial condition and results of operations. When deemedappropriate, we may engage in currency exchange rate hedging transactions in anattempt to mitigate the impact of adverse exchange rate fluctuations. However,currency hedging policies may not be successful, and they may increase thenegative impact of exchange rate fluctuations.

 

*Investments in Sales and Business Development Efforts.*  Both Accelrys and PDD products and servicesinvolve lengthy sales and business development cycles, often requiring us toexpend considerable financial and personnel resources without any assurancethat revenue will be recognized.  Thesesales and business development cycles typically are long for a number ofreasons.  In drug discovery, factorsinclude the strategic nature of drug discovery partnerships, the size of manysuch transactions, the confidential and proprietary nature of the biologicaltargets against which we screen our chemical compound libraries, and the uniqueterms typically found in each collaborative transaction.  With respect to software sales, sales cyclesare impacted by the time and resources required to educate potential customerorganizations as to the value and comparative advantages of our products. As aresult, we may expend substantial funds and effort to negotiate agreements forcollaborative relationships, services and products in both of our businesssegments, but may ultimately be unable to consummate the related transaction.In these circumstances, our results of operations and ability to achieveprofitability are adversely affected.

 

*Consolidation within the pharmaceutical and biotechnology industriesmay lead to fewer potential customers for our products and services. *A significantportion of our customer base consists of pharmaceutical and biotechnologycompanies. Mergers between large multinational pharmaceutical companies haveaccelerated in recent years. Continued consolidation within the pharmaceuticaland biotechnology industries may result in fewer customers for our products andservices. If one of the parties to a consolidation uses the products orservices of our competitors, we may lose existing customers as a result of suchconsolidation.

 

*Our operations may be interrupted by the occurrence of a naturaldisaster or other catastrophic event at our primary facilities.***  **We depend on our laboratoriesand equipment for the continued operation of our business. Our research anddevelopment operations and administrative functions are primarily conducted atour facilities in the Princeton, New Jersey area, San Diego, California,Cambridge, United Kingdom, and Bangalore, India.  Although we have contingency plans in effect for naturaldisasters or other catastrophic events, catastrophic events could still disruptour operations. Even though we carry business interruption insurance policies,we may suffer losses as a result of business interruptions that exceed thecoverage available under our insurance policies. Any natural disaster orcatastrophic event in our facilities or the areas in which they are locatedcould have a significant negative impact on our operations.

 

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*Because our stock price may be volatile, our stock price couldexperience substantial declines.*** **The market price of our common stock has historicallyexperienced and may continue to experience volatility. Our quarterly operatingresults, changes in general conditions in the economy or the financial marketsand other developments affecting us or our competitors could cause the marketprice of our common stock to fluctuate substantially. In addition, in recentyears, the stock market has experienced significant price and volumefluctuations and, during the past two years, the stock market (and inparticular technology companies) have experienced significant decreases inmarket value. This volatility and the recent market decline has affected themarket prices of securities issued by many companies, often for reasonsunrelated to their operating performance, and may adversely affect the price ofour common stock.

 

*As institutions hold the majority of our Common Stock in large blocks,substantial sales by these stockholders could depress the market price for ourshares.*  As ofJanuary 31, 2004, our company’s seven largest stockholders heldapproximately 61% of our outstanding common stock.  As a result, if one or more of these major stockholders were tosell all or a portion of their holdings, or if the market were to perceive thatsuch sale or sales may occur, the market price of our common stock may fallsignificantly.

 

*Because we do not intend to pay dividends, you will benefit from aninvestment in our common stock only if it appreciates in value.***  **We have never declared or paidany cash dividends on our common stock. We currently intend to retain ourfuture earnings, if any, to finance the expansion of our business and do notexpect to pay any cash dividends in the foreseeable future. As a result, thesuccess of your investment in our common stock will depend entirely upon anyfuture appreciation in its value. There is no guarantee that our common stockwill appreciate in value or even maintain the price at which you purchased yourshares.

 

*Anti-takeover provisions under the Delaware general corporation law,provisions in our certificate of incorporation and bylaws, and our adoption ofa stockholder rights plan may render more difficult the accomplishment ofmergers or the assumption of control by a principal stockholder, making moredifficult the removal of management*. Certainprovisions of the Delaware General Corporation Law may delay or deter attemptsto secure control of our company without the consent of our management. Also,our governing documents provide for a staggered board of directors, which willmake it more difficult for a potential acquirer to gain control of our Board ofDirectors. In 2002, we adopted a stockholder rights plan, which is triggered uponcommencement or announcement of a hostile tender offer or when any one personor group acquires 15% or more of our common stock. The rights plan, oncetriggered, enables stockholders to purchase our common stock, and the stock ofthe entity acquiring us, at reduced prices. These provisions of our governingdocuments and stockholder rights plan, and of Delaware law, could have theeffect of delaying, deferring or preventing a change of control includingwithout limitation a proxy contest, making more difficult the acquisition of asubstantial block of our common stock. The provisions could also limit theprice that investors might be willing to pay in the future for shares of ourcommon stock. Further, the existence of these anti-takeover measures may causepotential bidders to look elsewhere, rather than initiating acquisitiondiscussions with us.

 

*If we consume cash more quickly than expected, we may be unable toraise additional capital and we may be forced to curtail operations.*Weanticipate that our existing capital resources will be adequate to fund ouroperations at least through 2005***.*** However,changes may occur that would consume available capital resources before thattime. Our capital requirements will depend on numerous factors, including:

 

•                  costs associatedwith software sales;

•                  costs associatedwith drug discovery services;

•                  our internalproprietary drug discovery activities;

 

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•                  competingtechnological and market developments;

•                  changes in ourexisting collaborative relationships;

•                  the cost offiling, prosecuting, defending and enforcing patent claims and otherintellectual property rights and the outcome of related litigation;

•                  the purchase ofadditional capital equipment;

•                  acquisitions ofother businesses or technologies; and

•                  the progress ofour milestone and royalty producing activities.

 

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

 

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

 

*CERTAIN RISKS RELATED TOINTELLECTUAL PROPERTY*

* *

*Positions taken by the U.S. patent and trademark office or non-U.S.patent and trademark officials may preclude us from obtaining sufficient ortimely protection for our intellectual property. *The patent positions of pharmaceuticaland biotechnology companies are uncertain and involve complex legal and factualquestions. The coverage claimed in a patent application can be significantlyreduced before the patent is issued. There is a significant risk that the scopeof a patent may not be sufficient to prevent third parties from marketing otherproducts or technologies with the same functionality of our products andtechnologies. Consequently, some or all of our patent applications may notissue into patents, and any issued patents may provide ineffective remedies orbe challenged or circumvented.

 

*Third parties may have filed patent applications of which we may or maynot have knowledge, and which may adversely affect our business. *Patent applicationsin the U.S. are maintained in secrecy for 18 months from filing or until apatent issues. Under certain circumstances, patent applications are neverpublished but remain in secrecy until issuance. As a result, others may havefiled patent applications for products or technology covered by one or morepending patent applications upon which we are relying. There may be third-partypatents, patent applications and other intellectual property or informationrelevant to our software, chemical compositions and other technologies whichare not known to us and that block or compete with our software, chemicalcompositions or other technologies, or limit the scope of patent protectionavailable to us. Moreover, from time to time, patents may issue which block orcompete with our software,

 

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chemical compositions or other technologies, or limit the scope ofpatent protection available to us. Litigation may be necessary to enforcepatents issued to us or to determine the scope and validity of the intellectualproperty rights of third parties.

 

*We may not be able to protect adequately the trade secrets andconfidential information that we disclose to our employees. *We rely upon tradesecrets, technical know-how and continuing technological innovation to developand maintain our competitive position. Competitors through their independentdiscovery (or improper means, such as unauthorized disclosure or industrialespionage) may come to know our proprietary information. We generally requireemployees and consultants to execute confidentiality andassignment-of-inventions agreements. These agreements typically provide thatall materials and confidential information developed by or made known to theemployee or consultant during his, her or its relationship with us are to bekept confidential, and that all inventions arising out of the employee’s orconsultant’s relationship with us are our exclusive property. Our employees andconsultants may breach these agreements, and in some instances we may not havean adequate remedy. Additionally, in some instances, we may have failed torequire that employees and consultants execute confidentiality andassignment-of-inventions agreements.

 

*Foreign laws may not afford us sufficient protections for ourintellectual property, and we may not seek patent protection outside the UnitedStates. *Webelieve that our success depends, in part, upon our ability to obtaininternational protection for our intellectual property. However, the laws ofsome foreign countries may not be as comprehensive as those of the U.S. and maynot be sufficient to protect our proprietary rights abroad. In addition, we maydecide not to pursue patent protection outside the United States, because ofcost and confidentiality concerns. Accordingly, our international competitorscould obtain foreign patent protection for, and market overseas, products andtechnologies for which we are seeking U.S. patent protection.

 

*We may not be able to adequately defend our intellectual property fromthird party infringement, and third party challenges to our intellectualproperty may adversely affect our rights and be costly and time consuming. *Some of ourcompetitors have, or are affiliated with companies having, substantiallygreater resources than we have, and those competitors may be able to sustainthe costs of complex patent litigation to a greater degree and for longerperiods of time than us. Uncertainties resulting from the initiation andcontinuation of any patent or related litigation could have a material adverse effecton our ability to compete in the marketplace pending resolution of the disputedmatters. If our competitors prepare and file patent applications in the UnitedStates that claim technology also claimed by us, we may have to participate ininterference proceedings declared by the U.S. Patent and Trademark Office todetermine the priority of invention, which could result in substantial costs tous, even if the outcome is favorable to us. Similarly, opposition proceedingsmay occur overseas, which may result in the loss or narrowing of the scope ofclaims or legal rights. Such proceedings will at least result in delay in theissuance of enforceable claims. An adverse outcome could subject us tosignificant liabilities to third parties and require us to license disputedrights from third parties or cease using the technology. Despite our efforts toprotect our proprietary rights, unauthorized parties may attempt to copyaspects of our products or to obtain and use information that we regard asproprietary. In limited instances, we have licensed source codes of certainproducts to customers or collaborators. For these reasons, policingunauthorized use of our software products may be difficult.

 

*A patent issued to us may not be sufficiently broad to protect adequatelyour rights in intellectual property to which the patent relates. *Even if patents areissued to us, these patents may not sufficiently protect our interest in oursoftware, chemical compositions or other technologies because the scope ofprotection provided by any patents issued to or licensed by us are subject tothe uncertainty inherent in patent law. Third parties may be able to designaround

 

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these patents or develop unique products providing effects similar toour products. In addition, others may discover uses for our software, chemicalcompositions or technologies other than those uses covered in our patents, andthese other uses may be separately patentable. A number of pharmaceutical andbiotechnology companies, software organizations and research and academicinstitutions, have developed technologies, filed patent applications orreceived patents on various technologies that may be related to our business.Some of these technologies, patent applications or patents may conflict withour technologies, patent applications or patents. These conflicts could alsolimit the scope of patents, if any, that we may be able to obtain, or result inthe denial of our patent applications.

 

*We may be subject to claims of infringement by third parties. *Third parties mayclaim infringement by us of their intellectual property rights. In addition, tothe extent our employees are involved in research areas similar to those areasin which they were involved at their former employers, we may be subject toclaims that one of our employees, or we, have inadvertently or otherwise usedor disclosed the alleged trade secrets or other proprietary information of aformer employer. From time to time, we have received letters claiming orsuggesting that our products or activities may infringe third party patents orother intellectual property rights. Our products may infringe patent or otherintellectual property rights of third parties. A number of patents may have beenissued or may be issued in the future that could cover certain aspects of ourtechnology and that could prevent us from using technology that we use orexpect to use. We may be required to seek licenses for, or otherwise acquirerights to, technology as a result of claims of infringement. We may not possessproper ownership or access rights to the intellectual property we use. Thirdparties or other companies may bring infringement suits against us. We expect,in general, that software product developers will be subject to moreinfringement claims as the number of products and competitors in our industrysegments grows and the functionality of products in different industry segmentsoverlaps. Any claims, with or without merit, could be time consuming to defend,result in costly litigation, divert management’s attention and resources, causeproduct shipment delays or require us to enter into royalty or licensingagreements. Royalty or licensing agreements, if required, may not be availableon terms acceptable to us, if at all. In the event of a successful claim ofproduct infringement against us, our failure or inability to license or designaround the infringed technology could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

*CERTAIN RISKS RELATED TOACCELRYS*

* *

*Our ability to increase Accelrys software revenue may depend uponincreased market acceptance of our products and services*.Accelrys products are currently used primarily by molecular modeling andsimulation and gene sequence analyses specialists. Our strategy is to expandusage of our products and services by marketing and distributing our software,in part through our desktop-based products, client-server solutions, andrelated services to a broader, more diversified group of biologists, chemists,and engineers. If we cannot expand our customer base by selling ourdesktop-based products, client-server solutions, and  related services, we may not be able to increase our softwarerevenue, or such revenue may decline. In general, increased market acceptanceand greater market penetration of our software products depend upon severalfactors, including:

 

•                  overall productperformance;

•                  ease ofimplementation and use;

•                  accuracy ofsimulation;

•                  breadth andintegration of product offerings;

•                  the extent towhich users achieve the intended research and development benefits from theiruse of the products and services; and

•                  willingness ofcustomers to pay for such use.

 

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Our software products and services may not achieve market acceptance orpenetration in their target industries or other industries. Failure to increasemarket acceptance or penetration may restrict substantially the future growthof our software business and may have a material adverse effect on our companyas a whole.

 

*We may be unable to develop and market new Accelrys products that arenecessary to increase revenue*. The success of oursoftware business plan depends heavily upon increases in revenue. Our strategyis to increase software revenue in a number of ways, including:

 

•                  adding morecomputational modeling, simulation, and analyses tools to our current portfolioof tools for chemists and biologists;

•                  offering moreinformatics solutions that capture and manage the data created by customers’drug discovery and chemical development activities, including the data createdby the use of computational modeling, simulation, and analysis software;

•                  creating andmarketing genomic, biological and/or chemical data content for use inconjunction with the software offered to support customers’ drug discoveryactivities; and

•                  developing moreknowledge management workflow software to automate the flow of genomic,biological and chemical data and information and project status between andamong workgroups and the enterprise.

 

We do not have sufficient historical or comparative sales data to relyupon to indicate that our new products or data content services will achievethe desired level of commercial success.

 

*We face strong competition in the scientific software sector*.The market for our software products is intensely competitive, subject to rapidchange and significantly affected by new product introductions, pricingstrategies and other market activities of industry participants. Competitioncurrently comes from the following principal sources:

 

•                  other molecularsimulation software packages and software for analysis of chemical andbiological data;

•                  desktop softwareapplications, including chemical drawing, molecular modeling and analyticaldata simulation applications;

•                  consulting andoutsourcing services;

•                  other types ofsimulation software provided to engineers; and

•                  firms supplyingdatabases, such as chemical or genomic information databases, databasemanagement systems and information technology.

 

In addition, some of our software licenses grant the right tosublicense our software. As a result, our software customers and third-partylicensees could develop specific simulation applications using our softwaredeveloper’s kit and compete with us by distributing these programs to ourpotential customers. Customers or licensees could also develop their ownsimulation technology or informatics software and cease using our softwareproducts and services. Some of our competitors and potential competitors inthis sector have longer operating histories than us and have greater financial,technical, marketing, research and development and other resources. Many of oursoftware competitors offer products and services directed at more specificmarkets than those we target, enabling these competitors to focus a greaterproportion of their efforts on these markets. Some offerings that compete withour software products are developed and made available at lower cost bygovernmental organizations and academic institutions, and these entities may beable to devote substantial resources to product development and also offertheir products to users for little or no charge.

 

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Finally, we also face competition from open source softwareinitiatives, in which developers provide software and intellectual propertyfree over the internet.

 

*If we are unable to license software to, or collect receivables from,our early stage biotechnology customers, it may have a material adverse effecton our operating results.*  We frequently license our modeling, simulation, data analysis andinformatics software to smaller, development stage biotechnology customers.Often these customers have limited or no operating history, and requireconsiderable funding to launch their businesses. As we have experienced inrecent quarters, they often significantly scale back, or altogether cease,operations.  Therefore, there isconsiderable risk in counting on these types of entities for revenuegrowth.  For entities that remain inbusiness, transactions with these customers carry a higher degree of financialrisk. Our customers, particularly our development stage customers, arevulnerable to, and may be impacted by, the current tightening of availablecredit and capital, and general economic slowdown occurring in the UnitedStates and our other key markets. As a result of these conditions, ourcustomers may be unable to license or, if under a license, may be unable to payfor, Accelrys software products. If we are not able to collect such amounts, wemay be required to write-off significant accounts receivable and recognize baddebt expense. We recorded a provision for doubtful accounts of $1.3 million and$0.4 million in 2002 and 2003, respectively. Failure of these businesses, write-offs and difficulties associated withcollection of receivables from these customers, could materially adverselyaffect our operating results.

 

*Defects or malfunctions in our software products, or in the products ofour software technology partners, could hurt our reputation among softwarecustomers and expose us to liability.* Our softwarebusiness and the level of customer acceptance of our products depend upon thecontinuous, effective and reliable operation of our computer software andrelated tools and functions. Defects could occur in current or future Accelrysproducts. To the extent that our software malfunctions and our customers’ useof our products is interrupted, our software reputation and business couldsuffer. We may also be subject to liability for the defects and malfunctions ofthird party technology partners and others with whom our software products andservices are integrated.

 

*Our quarterly operating results in the software business could varysignificantly*. We have historically experiencedstronger financial performance in the third and fourth calendar quarters ofeach year followed by a comparative decline in the first and secondquarters.  Quarterly operating resultsmay continue to fluctuate as a result of a number of factors, including lengthysales cycles, market acceptance of new products and upgrades, timing of newproduct introductions, changes in pricing policies, changes in general economicand competitive conditions, seasonal slowdowns, and the timing and integrationof acquisitions. Additionally, changes in the timing of revenue recognition mayresult if subscription sales increase. We also expect to continue to experience fluctuations in quarterly operatingresults due to general and industry specific economic conditions that mayaffect the research and development expenditures of pharmaceutical andbiotechnology companies. Due to the possibility of fluctuations in our revenueand expenses, we believe that quarter-to-quarter comparisons of our operatingresults are not a good indication of our future performance.

 

CERTAIN RISKS RELATED TOPDD

 

*Our PDD revenue is highly concentrated in its largest collaborators;the termination of the collaborations with certain of PDD’s large collaboratorswould have a material adverse effect on PDD’s business, financial condition andresults of operations. *Duringthe year ended December 31, 2003, we earned approximately $5.5 million, or18.5% of our PDD revenue, and 4.8% of our consolidated revenue, under PDD’sresearch collaboration agreements with N.V. Organon, its second largestcustomer. The principal agreement with Organon, entered into inFebruary 2002,

 

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has a stated term of five years; however, Organon has the right toterminate the agreement in 2005 if PDD is unable to deliver compounds meetingthe criteria specified in the agreement. We have timely delivered the firstcompound required under this agreement for inspection and verification byOrganon. However, there can be no assurance that these compounds will becompliant, or that future compliant compounds will be delivered before theenumerated dates. The termination of this agreement would have a material adverseeffect on PDD, and may have a material adverse effect on our business as awhole.

 

During the year ended December 31, 2003, we earned approximately$3.4 million, or 11.4% of our PDD revenue, and 3.0% of our consolidatedrevenue, under PDD’s research collaboration agreements with Novartis AG.  We entered into our most recentcollaboration agreement with Novartis in February 2003 and expect tocomplete all of the required services under that agreement by March 31,2004, when the agreement will expire in accordance with its terms. If our mostrecent collaboration agreement with Novartis terminates and we are unable toenter into new agreements or extended agreements with Novartis or othercollaborators, there could be a material adverse affect on PDD and on ourbusiness as a whole.

 

*The development of our products is at an early stage and isuncertain. *Drugdevelopment is a highly uncertain process. Our approach and technology maynever result in a commercial drug. None of our compounds are contained inproducts that have received regulatory approval for commercial sale, andcurrently we have only four candidates with respect to which clinical trials(i.e., human testing) have been commenced. All of our therapeutic candidates,including these clinical candidates, are in development, and face thesubstantial risks of failure inherent in the drug development process. Anypotential pharmaceutical product emanating from one of our internal orcollaborative programs must satisfy rigorous standards of safety and efficacybefore the FDA and foreign regulatory authorities will approve them forcommercial use. To satisfy these standards, significant additional research,preclinical studies (i.e, animal testing) and clinical trials will be required.Preclinical and clinical development of drug candidates is a long, expensiveand uncertain process. Failure can occur at any stage of testing. Success inpreclinical testing does not ensure that clinical trials will be successful.Based on results at any stage of product development, we or our developmentcollaborators may decide to discontinue development of our product candidates.

 

Our product candidates and research programs are in the early stages ofdevelopment and require significant, time-consuming and costly research anddevelopment, testing and regulatory approvals. We do not expect that ourproduct candidates will be commercially available for many years, if ever. Inaddition, we pursue the discovery and initial development of product candidatesusing our integrated technology platform in both our internal and collaborativeprograms to implement our strategy of reducing the cost and time incurred bythe pharmaceutical industry in developing drug candidates. To date, we have notidentified a therapeutic candidate that has been developed into a commercialdrug using our platform. It is uncertain whether our technology platform willachieve these goals at all or whether it will be competitive with platformsused by our competitors.

 

*We and our collaborators may not be able to successfully develop ourexisting clinical candidates. *Ourcollaborators, Bristol-Myers Squibb Company, Daiichi Pharmaceutical Co. andSchering-Plough Corporation, currently are performing clinical trials ofprospective pharmaceutical products containing our proprietary compounds. Ineach case, the collaborator is responsible for the development of thesepotential products as well as the decision as to when, or whether, suchdevelopment should cease. Numerous additional studies are necessary to supportthe further development of these product candidates. Results from preclinicalstudies conducted to date on these product candidates are not necessarilyindicative of the results that may be obtained in clinical studies. Resultsfrom additional studies could cause our collaborators to

 

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discontinue or limit development of these product candidates. There canbe no assurance that Bristol-Myers Squibb, Daiichi or Schering-Plough willcontinue to develop these programs. In addition, our collaborators may pursuealternative technologies or drug candidates, either on their own or incollaboration with others, that compete with our clinical candidates. If ourcollaborators do not continue their development efforts, we will not receiveadditional milestone and royalty payments from those efforts.

 

*Disputes may arise between our collaborative partners and us as toroyalties and milestones to which we are entitled.*  The compound basis for drugs developed by acustomer may be a derivative or optimized version of the compound screened oroptimized by us. While our existing collaborative agreements provide that wewill receive milestone payments and royalties with respect to certain productsdeveloped from certain derivative compounds, there can be no assurance thatdisputes will not arise over the application of payment provisions to suchproducts. There can be no assurance that current or future collaborativepartners will not pursue alternative technologies, or develop alternativeproducts either on their own or in collaboration with others, including ourcompetitors, as a means for developing treatments based on the targets whichare the subject of the collaborative arrangements with us.

 

*Our collaborations and internal programs may not result in thediscovery of potential drug candidates that will be safe or effective.*Althoughwe have received license and milestone fees to date, we may never receive anyroyalty payments, or any additional license and milestone fees, under ourcurrent or any future collaborations. Our receipt of any future milestone,royalty or license payments depends on many factors, including whether ourcollaborators desire to or are able to continue to pursue a potential drugcandidate and the ultimate commercial success of the drug. Development andcommercialization of potential drug candidates depend not only on theachievement of research objectives by us and our collaborators, but also oneach collaborator’s financial, competitive, marketing and strategicconsiderations and regulation in the United States and other countries. Ifunforeseen complications arise in the development or commercialization of thepotential drug candidates by our collaborators, we may not realize milestone,royalty or license payments.

 

*The drug research and development industry is highly competitive andsubject to technological change, and we may not have the resources necessary tocompete successfully. *Manyof our competitors have access to greater financial, technical, research,marketing, sales, distribution, service and other resources than we do.Moreover, the pharmaceutical and biotechnology industries are characterized bycontinuous technological innovation. We anticipate that we will face increasedcompetition in the future as new companies enter the market and our competitorsmake advanced technologies available. Technological advances or entirelydifferent approaches that we or one or more of our competitors develop mayrender our products, services and expertise obsolete or uneconomical.Additionally, the existing approaches of our competitors or new approaches ortechnologies that our competitors develop may be more effective than those wedevelop. We may not be able to compete successfully with existing or futurecompetitors.

 

In addition, due to improvements in global communications, combinedwith the supply of lower cost Ph.D. level scientific talent in offshorelocations such as China, India and Eastern Europe, we face the growing threatof competition for our services.

 

*If we cannot manage the multiple relationships and interests involvedin our collaborative arrangements and drug discovery programs, our business,financial condition and results of operations may be materially adverselyaffected. *Wemay need to successfully structure and manage multiple drug discovery programsand collaborative relationships, including maintaining confidentiality of theresearch being performed for multiple customers. We may be unable to managesuccessfully conflicts between competing drug development programs of thirdparties to

 

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which we offer services. Conflicts also may arise between customers asto proprietary rights to particular compounds in our libraries or as to proprietaryrights to biological targets such as receptors or enzymes against which wescreen compounds in our libraries. The occurrence of conflicts could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

*If we use hazardous materials in a manner that causes injury orviolates laws, we may be liable for damages.*  PDD’s activities involve the use ofpotentially harmful hazardous materials, chemicals and various radioactivecompounds. These materials are utilized in the performance of PDD’s assaydevelopment, high throughput screening and chemistry optimization services, andinclude common organic solvents, such as acetone, hexane, methylene chloride,acetonitrile, and isopropyl and methyl alcohol as well as common acids andbases.  The waste from utilization ofthese solvents and other materials is disposed of through licensed third partycontractors.  Further, PDD utilizes anextremely wide variety of chemicals in the performance of its assaydevelopment, screening and optimization services.  These chemicals, such as reagents, buffers and inorganic salts,typically are employed in extremely small amounts in connection with the workperformed in its laboratories.  Wecannot completely eliminate the risk of accidental contamination or injury fromthe use, storage, handling or disposal of these materials. In the event ofcontamination or injury, we could be held liable for damages that result. Wemaintain insurance coverage against environmental hazards arising from thestorage and disposal of the materials utilized in our business. Although ourmanagement believes that such insurance has terms, including coverage limits,which are appropriate for our business, liabilities arising from the use,storage, handling or disposal of these materials could exceed our insurancecoverage as well as our resources. We are subject to federal, state and locallaws and regulations governing the use, storage, handling and disposal of thesematerials and specified waste products. The cost of compliance with these lawsand regulations could be significant. To our knowledge, we have not been, andcurrently are not, the subject of any governmental investigation concerning theviolation of these federal, state and local laws and regulations. There can beno assurance that we will not be the subject of future investigations bygovernmental authorities.

 

*We may not successfully enter into additional collaborations orservices agreements that allow us to participate in the future success of our productcandidates through milestone, royalty and/or license payments, and we may neverreceive any milestone royalty and/or license payments under our current or anyfuture collaborations. *Oneof our business strategies is to expand our proprietary pipeline of drugcandidates and to then enter into collaborations for the development of thesedrug candidates that will allow us to earn milestone, royalty and/or licensepayments. Our proprietary drug discovery program is in its early stage ofdevelopment and is unproven. Although we have expended, and continue to expend,time and money on internal research and development programs, we may beunsuccessful in creating valuable proprietary drug candidates that would enableus to form additional collaborations and receive milestone, royalty and/orlicense payments.

 

*Some of the development and marketing activities of PDD are, or willbe, conducted by third parties. If these third parties fail to perform theirfunctions satisfactorily, our revenue and earnings from PDD could be delayed,reduced or eliminated. *Theultimate success of our business plan for PDD heavily depends upon thesuccessful discovery, development and commercialization of pharmaceuticalproducts. Our drug discovery endeavors will result in commercializedpharmaceutical products, if at all, only after significant preclinical andclinical development, requisite regulatory approvals, establishment ofmanufacturing capabilities and successful marketing. We do not currently havethe technology, facilities, personnel or experience to accomplish all of thesetasks on our own, and we will likely not have all the necessary resources inthe foreseeable future. Therefore, we continue to depend heavily upon theexpertise and dedication of sufficient resources by collaborative partners todevelop and commercialize

 

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products primarily based on lead compounds discovered by us. If acollaborative partner fails to develop or commercialize a compound or productwith respect to which it has rights from us, we may not receive any futuremilestone payments or royalties associated with that compound or product.Similarly, because we rely heavily on our strategic collaborators, our revenuecould be adversely affected if our collaborators:

 

•                  fail to select atarget or product candidate we have identified for subsequent development;

•                  fail to gain therequisite regulatory approvals of product candidates;

•                  do notsuccessfully commercialize products based on the compounds that we originate;

•                  do not conducttheir collaborative activities in a timely manner;

•                  do not devotesufficient time or resources to our partnered programs or potential products;

•                  terminate theiralliances or arrangements with us;

•                  develop, eitheralone or with others, products that may compete with our product candidates;

•                  dispute ourrespective allocations of rights to any products or technology developed duringour collaborations; or

•                  merge with orare acquired by a third party that may wish to terminate our collaboration.

 

*There may be only a limited market for PDD’s drug discovery services.*  The pricing and nature of PDD’s drugdiscovery services are such that there may only be a limited number ofpotential customers for these services. The acceptance by potential customersof our services is important in determining profitability. Historically,pharmaceutical companies have conducted lead compound identification andoptimization within their own research departments due to the highlyproprietary nature of the activities being conducted, the central importance ofthese activities to their drug discovery and development efforts, and thedesire to obtain maximum patent and other proprietary protection on the resultsof their internal programs. In order to achieve our business objectives forPDD, we must convince these companies that our technology and expertise justifythe outsourcing of these programs to us. There can be no assurance that we willbe able to attract customers on acceptable terms for our products and servicesor to develop a sustainable profitable business. Moreover, the pricing andnature of our combinatorial libraries is such that there may only be a limitednumber of pharmaceutical companies that are potential customers for such libraries.There can be no assurance that we will be able to establish additionalcollaborative or licensing arrangements, that any such arrangements or licenseswill be on terms favorable to us, or that current or future collaborative orlicensing arrangements will ultimately be successful.

 

**SHOULDONE OR MORE OF THE ABOVE-DESCRIBED RISKS OR UNCERTAINTIES MATERIALIZE, ORSHOULD THE UNDERLYING ASSUMPTIONS PROVE INCORRECT, OUR ACTUAL RESULTS MAY VARYMATERIALLY FROM THOSE ANTICIPATED.**

 

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### **ITEM 2. PROPERTIES**

 

We currently lease andoccupy approximately 163,000 square feet in three facilities near Princeton,New Jersey.  These leases expire atvarious dates through 2016.  Our principalAccelrys administrative, sales, support, marketing and product developmentfacilities and corporate headquarters are located in San Diego, California,where Accelrys has leased 76,635 square feet through December 2006.  Our European Accelrys headquarters, alongwith administrative, sales, support, marketing and product developmentfunctions, are located in Cambridge, England, where we have leased 38,501square feet through 2022.  Additionallyin Cambridge, we have leased 6,545 square feet through December 31, 2008 whichspace is currently unused.

 

### **ITEM 3.  LEGALPROCEEDINGS**

 

We are not aparty to any legal proceedings the negative outcome of which to us would have amaterial adverse effect on our business, financial condition or results ofoperations.

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

Notapplicable.

 

**ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Our ExecutiveOfficers are as follows:

 
| **Name**                                                     |   | **Age** |   | **Position**                                                                                          |
|--------------------------------------------------------------|--------|---------|--------|-------------------------------------------------------------------------------------------------------|
| Joseph A.  Mollica, Ph.D.                                    |   | 63      |   | Chairman of  the Board, President and Chief Executive Officer of the Company                          |
|                                                         |   |    |   |                                                                                                  |
| Mark J.  Emkjer                                              |   | 48      |   | President,  Accelrys Inc.; Executive Vice President of the Company                                    |
|                                                         |   |    |   |                                                                                                  |
| Stephen A.  Spearman,   

    Ph.D. |   | 54      |   | Chief  Operating Officer, Pharmacopeia Drug Discovery, Inc.; Executive Vice  President of the Company |
| John J.  Hanlon                                              |   | 56      |   | Chief  Financial Officer, Executive Vice President of the Company                                     |
|                                                         |   |    |   |                                                                                                  |
| Michael G.  Lenahan                                          |   | 44      |   | General  Counsel, Executive Vice President and Secretary of the Company                               |
|                                                         |   |    |   |                                                                                                  |
| William J.  DeLorbe, 

    Ph.D.              |   | 55      |   | Executive  Vice President, Human Resources, of the Company                                            |
|                                                         |   |    |   |                                                                                                  |
| Scott D.  Kahn, Ph.D                                         |   | 44      |   | Chief  Science Officer, Senior Vice President, Accelrys Inc.                                          |
|                                                         |   |    |   |                                                                                                  |
| Simon M.  Tomlinson, 

    Ph.D.              |   | 41      |   | Senior Vice  President, Business Development, Phamacopeia Drug Discovery, Inc.                        |
|                                                         |   |    |   |                                                                                                  |
| Mahesh  Krishnamurthy                                        |   | 39      |   | Senior Vice  President, Corporate Development, Accelrys Inc.                                          |
|                                                         |   |    |   |                                                                                                  |
| John S.  Delli Santi                                         |   | 39      |   | Senior Vice  President, Sales, Accelrys Inc.                                                          |
|                                                         |   |    |   |                                                                                                  |
| Nicholas  Austin                                             |   | 40      |   | Vice  President, Research & Development, Accelrys Inc.                                            |
|                                                         |   |    |   |                                                                                                  |
| Arthur E.  Roke, CPA                                         |   | 38      |   | Chief  Accounting Officer, Vice President, Finance of the Company                                     |

 

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Dr. Mollica has served as our Chairman of the Board of Directors andChief Executive Officer since February 1994 and was appointed as our Presidentin August 1996. From 1987 to December 1993, Dr. Mollica was employed initiallyby the DuPont Company and then by The DuPont Merck Pharmaceutical Company, mostrecently as President and Chief Executive Officer.  Dr. Mollica is a director of Genencor International Inc., ImPath,Inc. and Neurocrine BioSciences, Inc. Dr. Mollica received a Ph.D. from the University of Wisconsin, and aDoctor of Science, h.c., from the University of Rhode Island.

 

Mr. Emkjer has served as President of our Accelrys software subsidiary andExecutive Vice President of the Company since December 2002.  From 1999 to 2002, he served as Presidentand Chief Operating Officer of Sunquest Information Systems, Inc., aninformation technology company developing laboratory, radiology and pharmacy systemsand supplying the high-end integrated delivery network market.  Prior to joining Sunquest, Mr. Emkjer wasPresident and Chief Executive Officer of Pace Health Management Systems, Inc.,a provider of clinical decision support software, from 1996 to 1999, and wasPresident and Chief Executive Officer of Hospital Cost Consultants, Inc., aclinical and financial software provider, from 1990 to 1996.  Mr. Emkjer holds a B.S. from FloridaAtlantic University and an M.B.A. from the University of Miami.

 

Dr. Spearman was named Chief Operating Officer and Executive VicePresident of Pharmacopeia Drug Discovery, Inc. in April 2002, and has been anExecutive Vice President of our company since June 1998.  He had served as Chief Operating Officer ofour Drug Discovery division since February 2001.  Previously, he had served as our Executive Vice President,Operations since August 1996 and was appointed our Executive Vice President,Discovery Technology in June 1998.  From1975 to August 1996, Dr. Spearman held several positions at CIBA-GEIGYCorporation, most recently as Project Leader. Dr. Spearman received his Ph.D. and M.S. from Emory University.  Dr. Spearman also holds a M.B.A. in Financefrom Bryant College.

 

Mr. Hanlon has served as our Executive Vice President and ChiefFinancial Officer since May 2002.  From1988 to 1998, Mr. Hanlon was the Chief Financial Officer of MDL InformationSystems, Inc., a provider of integrated scientific information managementsystems, databases and services.  Mostrecently, he was President and Chief Financial Officer of a publicly helde-payment service provider.  Mr. Hanlonalso spent 10 years in public accounting at Coopers and Lybrand.  Mr. Hanlon holds a B.S. from CaliforniaState University, Hayward, and is a Certified Public Accountant.

 

Mr. Lenahan has served as our Executive Vice President and GeneralCounsel since October 2001, and our Secretary since February 2002.  Most recently, Mr. Lenahan served asExecutive Vice President, General Counsel and Secretary of Tricordia Health,LLC, a healthcare venture company, from September 1998 to August 2001. Mr.Lenahan also was Executive Vice President, General Counsel and Secretary ofMerit Behavioral Care Corporation, a provider of behavioral health managed careservices, from October 1993 to February 1998. Previously, Mr. Lenahan spentmore than eight years at Shearman & Sterling, focusing on mergers andacquisitions and corporate finance matters. Mr. Lenahan is a member of the NewYork State Bar, and received his J.D. from New York University School of Law,and his B.A. from the State University of New York at Binghamton.

 

Dr. DeLorbe has served as our Executive Vice President, Human Resourcessince November 2001. Prior to joining us, Dr. DeLorbe served as President ofVenn Works RTP, a company developing and operating life sciences technologycompanies. Previously, Dr. DeLorbe worked for nearly 10 years in a number ofsenior management and human resources positions with The DuPont MerckPharmaceutical Company and The DuPont Pharmaceutical

 

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Company. Healso held various senior level research and management positions at severallife science companies. Dr. DeLorbe holds a Ph.D. from the University of Iowaand a B.A. in Biology from Loras College.

 

Dr. Kahn was named Chief Science Officer of Accelrys in January2004.  He served as Senior VicePresident, Research and Development, of Accelrys from February 2003 to January2004.  Previously, he had served asGeneral Manager and Senior Vice President, Life Science at Accelrys sinceJanuary 2002, and immediately prior to that as Senior Vice President, Modelingand Simulation, at Accelrys since March 2000. He also served as Vice Presidentof Research and Development in 1999, and Director of Marketing from 1995through 1998.  From 1991 until joiningAccelrys, Dr. Kahn was employed by BioCAD, a molecular modeling start-upcompany in Silicon Valley, CA.  Dr. Kahnearned his Ph.D. in Theoretical Organic Chemistry at the University of California,Irvine and performed post-doctoral research at Cambridge University inEngland.  Dr. Kahn also spent four yearsas an Assistant Professor of Chemistry at the University of Illinois atUrbana-Champaign.

 

Dr. Tomlinson has served as Senior Vice President, Business Developmentof Pharmacopeia Drug Discovery, Inc., since April 2003.  Prior to joining Pharmacopeia, Dr. Tomlinsonwas Chief Executive Officer and President of Integrated Discovery SciencesCorporation, a company he co-founded, which developed and marketed a drugdiscovery software platform focused on therapeutic target properties, fromMarch 2002 to April 2003. Previously, he was Vice President and GeneralManager, Europe for DoubleTwist, Inc. from April 2000 through March 2002.During the preceding 10 years, he held a number of senior sales positions withAccelrys and certain of its predecessor companies.  Dr. Tomlinson holds a Ph.D. in Computer Science and a B.Sc. inChemistry from University College London.

 

Mr. Krishnamurthy has served as Senior Vice President, CorporateDevelopment of Accelrys Inc., since January 2004. Prior to joining Accelrys, hewas general partner of KT Venture Group, the venture capital arm of KLA-Tencor.Previously, he was a general partner of Idanta Partners, a private venturecapital firm making investments in the information technology area, includingsemiconductors, telecommunications and software.  He has earlier worked at Honeywell, AT&T and McKinsey.  Mr. Krishnamurthy holds a B.Tech in computerscience from Indian Institute of Technology (Bombay), an MS in computer sciencefrom University of Wisconsin (Madison) and an MBA from Stanford University.

 

Mr. Delli Santi has served as Senior Vice President, Sales of Accelryssince January 2003.  He had served asGeneral Manager and Vice President, Materials Science at Accelrys from January2002 to January 2003, and immediately prior to that as General Manager and VicePresident, Bioinformatics at Accelrys from February 2001 to January 2002.  Previously, he held a series of seniorbusiness development and sales management roles at Accelrys, and prior to thathe spent four years as an industrial medicinal chemist.  Mr. Delli Santi holds both a B.S. inChemistry and an M.B.A. from Fordham University.

 

Mr. Austin has served as Vice President, Research & Development ofAccelrys since July 2003.  From 1990 toJuly 2003, he held a number of positions of increasing managerialresponsibility in the research and development group of Accelrys and certain ofits predecessors, including Molecular Simulations, Inc.  Prior to joining the Accelrys organization,he worked as a scientific consultant for Cambridge Molecular Design Ltd.  He holds a degree in Natural Sciences fromthe University of Cambridge, UK, and did postgraduate research in theoreticalsolid state physics at the University’s Cavendish Laboratories.

 

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Mr. Roke has served asour Vice President, Finance since September 2000 and as our Chief AccountingOfficer since May 2001.  FromApril 1991 through September 2000, Mr. Roke served in various managementpositions; most recently as Chief Financial Officer and Vice President-Finance,at EMD Biosciences, Inc. (formerly CN Biosciences, Inc.), a division of MerckKGaA.  Mr. Roke also spent three yearswith Arthur Andersen & Company.  Mr.Roke holds a B.S. in Business Administration from Georgetown University and isa Certified Public Accountant.

 

## **PART II**

 

**ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY ANDRELATED STOCKHOLDER MATTERS**

 

MARKET FOR COMMON STOCK

 

Our Common Stock tradedon the Nasdaq National Market tier of The Nasdaq Stock Market under the symbolPCOP from the date of our initial public offering (December 5, 1995) untilFebruary 26, 2004.  Since February 27,2004, our Common Stock has traded under the symbol ACCL.  The following table sets forth for theperiods indicated the range of high and low sale prices of the Common Stock.

 
|           |   | **2003** |   | **2002** |   |
|----------------|--------|----------|--------|----------|--------|
|           |   | **High** |   | **Low**  |   | **High** |   | **Low** |   |
| First Quarter  |   | $        | 9.69   |     | $      | 5.94 |   | $ | 15.20 |   | $ | 11.00 |   |
| Second Quarter |   | 11.56    |   | 7.35     |   | 15.45 |   | 7.93 |   |
| Third Quarter  |   | 16.11    |   | 7.50     |   | 9.00 |   | 5.99 |   |
| Fourth Quarter |   | 15.60    |   | 10.45    |   | 11.20 |   | 7.35 |   |
|                |        |          |        |          |        |  |  |  |  |  |  |  |  |

 

### **HOLDERS OF RECORD**

 

As of January 31, 2004there were 436 holders of record of our Common Stock.

 

DIVIDENDS

 

No cash dividendshave been paid on the Common Stock to date.

 

50

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# **ITEM 6.  SELECTED FINANCIAL DATA**

 

The following selectedconsolidated financial data have been derived from our audited ConsolidatedFinancial Statements.  This data shouldbe read in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and the Consolidated Financial Statementsand related notes thereto included elsewhere in this Annual Report.

 
|                                                                 |   | **Years  Ended December 31,**              |    |
|----------------------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                                 |   | **2003**                                   |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                 |   | **(in  thousands, except per share data)** |    |
| **Statement of  Operations Data:**                                   |   |                                       |    |   |   |   |   |   |   |   |   |
|                                                                 |   |                                       |    |   |   |   |   |   |   |   |   |
| Total revenue (1)                                                    |   | $                                          | 115,064 |   | $ | 124,408 |   | $ | 122,303 |   | $ | 114,436 |   | $ | 95,524 |   |
| Operating loss from continuing operations  (1)                       |   | (5,716                                     | )       | (14,878 | ) | (19,950 | ) | (7,262 | ) | (672 | ) |
| Income (loss) from continuing operations  (1)                        |   | (3,497                                     | )       | (11,627 | ) | (14,741 | ) | 677 |   | 2,950 |   |
| Net income (loss) (2)                                                |   | $                                          | (3,497  | ) | (11,627 | ) | (14,320 | ) | 1,175 |   | 3,771 |   |
| Basic and diluted net income (loss) per  common share                |   | (0.15                                      | )       | (0.49 | ) | (0.60 | ) | 0.05 |   | 0.19 |   |
| Shares used in computing basic net income  (loss) per common share   |   | 23,752                                     |    | 23,512 |   | 23,729 |   | 22,659 |   | 19,684 |   |
| Shares used in computing diluted net income  (loss) per common share |   | 23,752                                     |    | 23,512 |   | 23,729 |   | 24,453 |   | 20,294 |   |
| Cash dividends declared per common share                             |   | —                                     |    | — |   | — |   | — |   | — |   |
|                                                                      |        |                                            |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                                              |   | **As of  December 31,** |    |
|-------------------------------------------------------------------|--------|-------------------------|---------|
|                                                              |   | **2003**                |    | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |
|                                                              |   | **(in  thousands)**     |    |
| **Balance Sheet Data:**                                           |   |                    |    |   |   |   |   |   |   |   |   |
|                                                              |   |                    |    |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and marketable  securities                 |   | $                       | 134,055 |   | $ | 141,071 |   | $ | 155,828 |   | $ | 165,178 |   | $ | 69,032 |   |
| Total assets                                                      |   | 239,667                 |    | 240,105 |   | 270,398 |   | 284,766 |   | 126,259 |   |
| Notes payable, deferred revenue, and other  long-term liabilities |   | 5,249                   |    | 4,766 |   | 4,555 |   | 4,553 |   | 5,121 |   |
| Accumulated deficit                                               |   | (97,318                 | )       | (93,821 | ) | (82,194 | ) | (67,874 | ) | (69,049 | ) |
| Total stockholders’ equity                                   |   | 182,734                 |    | 183,337 |   | 197,989 |   | 209,867 |   | 78,746 |   |
|                                                                   |        |                         |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

*(1)  Revenue, Operating loss fromcontinuing operations, and Income(loss) from continuing operations excludehardware revenue and related costs. Accelrys discontinued hardware re-sale operations effective December 31,2001.*

 

*(2)  Net income (loss) includes$0.7 million of costs related to the spin-off of PDD, and $2.9 million ofacquisition related intangible asset amortization in 2003; $4.3 million ofrestructuring, and $5.8 million of acquisition related intangible assetamortization in 2002;  $3.0 million ofdiscontinued acquisition costs, $7.6 million of acquisition related goodwillamortization and $6.8 million of acquisition related intangible assetamortization in 2001; $8.7 million of acquisition related write-offs ofin-process R&D, $3.8 million of acquisition related goodwill amortization,and $3.3 million of acquisition related intangible asset amortization in 2000;$0.4 million of acquisition related goodwill amortization in 1999.*

 

**ITEM 7. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussionand analysis of the financial condition and results of operations should beread in conjunction with “Selected Consolidated Financial Data” and theConsolidated Financial Statements and related disclosures included elsewhere inthis Report.

 

This Report, including,without limitation, this section regarding Management’s Discussion and Analysisof Financial Condition and Results of Operations, contains forward-lookingstatements regarding the Company and its business, financial condition, resultsof operations, and prospects.  Wordssuch as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,”“estimates,” and similar expressions are intended to identify forward-lookingstatements, but are not the exclusive means of identifying forward-lookingstatements in this Report. Additionally, statements concerning future matters such as thedevelopment of new products, enhancements or technologies, possible changes inlegislation, and other statements regarding matters that are not

 

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historical are forward-lookingstatements.

 

Although forward-looking statements in thisReport reflect the good faith judgment of our management, such statements canonly be based on facts and factors currently known to us.  Consequently, forward-looking statements areinherently subject to risks and uncertainties and actual results and outcomesmay differ materially from the results and outcomes discussed in or anticipatedby the forward-looking statements. Factors that could cause or contribute to such differences in resultsand outcomes include, without limitation, those discussed in “SignificantRisks, Trends, and Uncertainties” below, and in “Business — Risk Factors”above, such as uncertain revenue levels, rapidly changing technologies,acquisition-related uncertainties, stock price volatility, and other factors asdiscussed elsewhere in this Report. Readers are urged not to place undue reliance on these forward-lookingstatements, which speak only as of the date of this Report.  We undertake no obligation to revise or updateany forward-looking statements in order to reflect any event or circumstancethat may arise after the date of this Report. Readers are urged to carefully review and consider the variousdisclosures made in this Report, which attempt to advise interested parties ofthe risks and factors that may affect the our business, financial condition,results of operations, and prospects.

 

BUSINESS OVERVIEW

 

We design, develop, market, and supportscience- and technology-based products and services intended to improve andaccelerate the processes of drug discovery and chemical development.  Our Software Segment, Accelrys, providesmolecular modeling, simulation, informatics and decision support software forthe life sciences and materials research markets.  Our Drug Discovery Segment, PDD, provides drug discovery servicesto pharmaceutical and biotechnology companies based on proprietarycombinatorial chemistry, high throughput screening and Accelrystechnologies.  Segment and geographicaldata are included in the Notes to Consolidated Financial Statements.

 

RESULTS OF OPERATIONS

 

**2003Compared to 2002**

 

Total revenue decreased 8% to $115.1 million for the year endedDecember 31, 2003 compared to $124.4 million for the year ended December 31,2002.

 
|                                |   | **For the  Years Ended December 31,** |   |
|-------------------------------------|--------|---------------------------------------|--------|
|                                |   | **2003**                              |   | **2002** |   | **% Change** |   |
| Revenues:                           |   |                                  |   |   |   |   |   |
| Software license, service and other |   | $                                     | 85.6   |   | $ | 95.1 |   | -10 | % |
| Drug discovery                      |   | 29.5                                  |   | 29.3 |   | 1 | % |
| Total revenues                      |   | $                                     | 115.1  |   | $ | 124.4 |   | -8 | % |

 

**Software license,service and other revenue** for the years ended December 31, 2003 and 2002 was $85.6 million and$95.1 million, respectively.  Revenue inEurope and the United States declined 14% in the year ended December 31, 2003as compared to the year ended December 31, 2002.   Revenue in Asia increased 9% in the year ended December 31, 2003as compared to the year ended December 31, 2002.  Revenue decreased 8% in modeling and simulation in the year endedDecember 31, 2003 as compared to the year ended December 31, 2002, whileinformatics revenue declined by 15% in the year ended December 31, 2003 ascompared to the year ended December 31, 2002. The overall decrease in revenue was due primarily to closed consortia,pricing pressure across all customer types and, particularly in thebioinformatics and materials science sectors, delays and deferrals incustomers’ purchasing

 

52

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decisionsand fewer renewals of annual licenses, attributable to changes in customers’business focus from research activities toward development efforts.

 

**PDD revenue** increased 1% to $29.5 million for the year endedDecember 31, 2003 compared to $29.3 million for the year ended December 31,2002.  The increase was attributable to anincrease of $3.6 million in milestone and license revenue offset almostentirely by a $3.4 million decrease in service revenue.  In 2002, we recorded a $1.2million increase in revenue resulting from a change in our estimate of costsrequired to complete a contract. Excluding the revenue from milestones and license fees and theadjustment, service revenue decreased 8% in the year ended December 31, 2003 ascompared to the year ended December 31, 2002. The decrease resulted from decreased lead optimization revenue due tothe expiration of a collaboration agreement. In 2003 and 2002, one Drug Discovery customer accounted for 12% ofconsolidated revenue.

 

Gross margin decreased 13% to $73.1 million (63% of related revenues)for the year ended December 31, 2003 compared to $83.8 million (67% of relatedrevenues) for the year ended December 31, 2002.

 
|                                |   | **For the  Years Ended December 31,** |   |
|-------------------------------------|--------|---------------------------------------|--------|
|                                |   | **2003**                              |   | **2002** |   | **% Change** |   |
|                                |   | **$**                                 |   | **% of  Revenue** |   | **$** |   | **% of  Revenue** |   |   |   |
| Gross margin:                       |   |                                  |   |   |   |   |   |   |   |   |   |
| Software license, service and other |   | $                                     | 65.8   |   | 77 | % | $ | 73.6 |   | 77 | % | -11 | % |
| Drug discovery                      |   | 7.3                                   |   | 25 | % | 10.2 |   | 35 | % | -28 | % |
| Total gross margin                  |   | $                                     | 73.1   |   | 63 | % | $ | 83.8 |   | 67 | % | -13 | % |

 

**Software license,service and other gross margin** decreased 11% to $65.8 million (77% of related revenue) in the yearended December 31, 2003 compared to $73.6 million (77% of related revenue) inthe year ended December 31, 2002.  Thedecrease in gross margin is primarily due to decreased revenue, enhanced bydecreased amortization of purchased intangibles, a portion of which becamefully amortized in Q1, and the remainder of which became fully amortized in Q3.

 

**PDD gross margindecreased** 28% to$7.3 million (25% of related revenue) in the year ended December 31, 2003compared to $10.2 million (35% of related revenue) in the year ended December31, 2002.  The decrease resulted fromincreased resources allocated to collaborations from research and developmentactivities, which resulted in increased direct and allocated fixed costs beingassociated with 2003 revenue.

 

Research and development expense decreased by 21% to $22.0 million inthe year ended December 31, 2003 compared to $27.9 million in the year endedDecember 31, 2002.

 

**Software research anddevelopment expense**consists primarily of the employment-related costs of personnel associated withdeveloping new products, enhancing existing products, testing software productsand developing product documentation. **PDDresearch and development expense** includes the employment-relatedcosts of scientific staff working on unfunded internal drug discovery projectsfocused on the creation of new small molecule therapeutics.

 

Software research and development expense is capitalized in accordancewith Statement of Financial Accounting Standards No. 86, “Accounting for theCost of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS86).  Capitalized software developmentcosts consist primarily of the employment-related costs and consulting feespaid to consultants in relation to the development of Accelrys’ products thathave not yet been released.

 

53

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The following table shows the breakout of research and developmentcosts by division and the amount of capitalized software development for theperiods indicated:

 
|                                   |   | **For the  Years Ended December 31,** |   |
|----------------------------------------|--------|---------------------------------------|--------|
|                                   |   | **2003**                              |   | **2002** |   | **% Change** |   |
| Research and development:              |   |                                  |   |   |   |   |   |
| Gross software development costs       |   | $                                     | 22.3   |   | $ | 23.5 |   | -5 | % |
| Capitalized software development costs |   | (4.3                                  | )      | (2.5 | ) | 72 | % |
| Internal drug discovery                |   | 4.0                                   |   | 6.9 |   | -42 | % |
| Total research and development costs   |   | $                                     | 22.0   |   | $ | 27.9 |   | -21 | % |

 

The decrease in research and development expenses was attributable to,among other things, cost efficiencies realized at Accelrys due to theconsolidation of research efforts, cost reductions implemented in 2002,increased capitalization of software development activities due to increasedproducts in development, and increased resources allocated to PDDcollaborations which expense is included in the determination of gross marginas described above.

 

Sales, general and administrative expense decreased by 14% to $57.1million in the year ended December 31, 2003 compared to $66.4 million in theyear ended December 31, 2002.  Thedecrease in sales, general, and administrative expenses was attributable to therestructuring undertaken in the third quarter of 2002, and additional costreduction initiatives implemented by management in the year ended December 31,2003.

 

During 2003, the Company terminated a facility lease, the expectedremaining obligation under which had been included in the restructuringprovision taken in the year ended December 31, 2002, and finalized certainremaining severance obligations.  Assuch, the Company reversed an excess portion of the restructuring liability inthe amount of $0.4.

 

The Company incurred $0.7 million for transaction costs associated withthe spin-off of PDD during the year ended December 31, 2003.  The Company expects to incur additionalcosts during the first calendar quarter of 2004 when the spin-off of PDD is expectedto be completed.

 

Interest and other income, net, increased 7% to $4.2 million in theyear ended December 31, 2003 compared to $3.9 million in the year endedDecember 31, 2002.  The increase wasattributable to foreign exchange gains in the year ended December 31, 2003.

 

The Company recorded an income tax provision of $1.3 million in theyear ended December 31, 2003 compared to $0.7 million in the year endedDecember 31, 2002.  The 2003 and 2002tax provisions are primarily due to foreign taxable income generated byAccelrys’ foreign subsidiaries.  Theseprovisions differ from the Federal tax rate primarily because of the effect ofpermanent book-tax differences, net operating loss carryforwards, and netoperating loss carrybacks.

 

As a result of the lower revenue and lower costs described above, theCompany generated a net loss of ($3.5) million (($0.15) per diluted share) inthe year ended December 31, 2003, compared to a net loss of ($11.6) million(($0.49) per diluted share) in the year ended December 31, 2002.

 

**2002Compared to 2001**

 

Total revenue increased 2% to $124.4 million for the year endedDecember 31, 2002 compared to $122.3 million for the year ended December 31,2001.

 

54

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|                                |   | **For the  Years Ended December 31,** |   |
|-------------------------------------|--------|---------------------------------------|--------|
|                                |   | **2002**                              |   | **2001** |   | **% Change** |   |
| Revenues:                           |   |                                  |   |   |   |   |   |
| Software license, service and other |   | $                                     | 95.1   |   | $ | 95.1 |   | 0 | % |
| Drug discovery                      |   | 29.3                                  |   | 27.2 |   | 8 | % |
| Total revenues                      |   | $                                     | 124.4  |   | $ | 122.3 |   | 2 | % |

 

**Software license,service and other revenue** for the years ended December 31, 2002 and 2001 was $95.1 million eachyear.  Combined revenue (includingrevenue from a strategic alliance) in our largest geographic regions, Europeand the United States was also consistent from year to year.  Excluding the revenue from a strategicalliance, revenue in the combined European and US regions decreased by 4% dueto market conditions under which customers, particularly in the Biotech sector,discontinued research, shifted their focus downstream to development, or wentout of business.  Revenue in Asiaincreased 1%, attributable to our direct sales in Japan in 2002 compared todiscounted distributor sales in 2001. Revenue growth was 2% in modeling and simulation (including the revenuefrom the strategic alliance), while informatics revenue decreased by 1%.  The decrease in informatics revenue wasattributable primarily to the market conditions described above.

 

**PDD revenue** increased 8% to $29.3 million for the year endedDecember 31, 2002 compared to $27.2 million for the year ended December 31,2001.  The increase was due primarily toadditional revenue earned under collaborative drug discovery agreements,increased milestone revenue, and $1.2 million from a revenue adjustmentrecorded in the third quarter of 2002 resulting from a positive change in ourestimate of costs required to complete a contract.  Milestone revenue recorded in the year ended December 31, 2002and 2001 was $2.1 million, and $1.6 million, respectively.  Excluding the revenue from milestones andthe $1.2 million adjustment, service revenue increased 2% from year toyear.  In 2002 and 2001, one DrugDiscovery customer accounted for 12% and 11% of consolidated revenue,respectively.

 

Gross Margin increased 1% to $83.8 million (67% of related revenues)for the year ended December 31, 2002 compared to $82.8 million (68% of relatedrevenues) for the year ended December 31, 2001.

 
|                                |   | **For the  Years Ended December 31,** |   |
|-------------------------------------|--------|---------------------------------------|--------|
|                                |   | **2002**                              |   | **2001** |   | **% Change** |   |
|                                |   | **$**                                 |   | **% of  Revenue** |   | **$** |   | **% of  Revenue** |   |   |   |
| Gross margin:                       |   |                                  |   |   |   |   |   |   |   |   |   |
| Software license, service and other |   | $                                     | 73.6   |   | 77 | % | $ | 76.0 |   | 80 | % | -3 | % |
| Drug discovery                      |   | 10.2                                  |   | 35 | % | 6.8 |   | 25 | % | 51 | % |
| Total gross margin                  |   | $                                     | 83.8   |   | 67 | % | $ | 82.8 |   | 68 | % | 1 | % |

 

**Software license,service and other gross margin** decreased 3% to $73.6 million (77% of related revenue) in the year endedDecember 31, 2002 compared to $76.0 million (80% of related revenue) in theyear ended December 31, 2001.  Thedecrease in gross margin is primarily due to additional costs incurred relatedto enhancements of the post sales support function, and additional direct costsassociated with revenue from a strategic alliance.

 

**PDD gross margin** increased 51% to $10.2 million (35% of relatedrevenue) in the year ended December 31, 2002 compared to $6.8 million (25% ofrelated revenue) in the year ended December 31, 2001.  The increase in gross margin resulted fromthe higher revenue level, including milestone revenue and the revenueadjustment, which carried only minor costs of revenue.  Excluding the effect of the milestonerevenue and the revenue adjustment on gross margin, total gross marginincreased by 35%, which is attributable primarily to planned cost

 

55

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reductionsrelated to existing contracts and the effect of fixed costs spread over alarger revenue base.  Cost efficiencieshave been achieved on existing contracts and cannot be assured on futurecontracts.

 

Research and development expense decreased by 14% to $27.9 million inthe year ended December 31, 2002 compared to $32.5 million in the year endedDecember 31, 2001.

 

**Software research anddevelopment expense**consists primarily of the employment-related costs of personnel associated withdeveloping new products, enhancing existing products, testing software productsand writing product documentation. **PDDresearch and development expense** includes the employment-relatedcosts of scientific staff working on unfunded internal drug discovery projectsfocused on the creation of new small molecule therapeutics.

 

Software research and development expense is capitalized in accordancewith Statement of Financial Accounting Standards No. 86, “Accounting for theCost of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS86).  Capitalized software developmentcosts consist primarily of the employment-related costs and consulting feespaid to consultants in relation to the development of Accelrys’ products thathave not yet been released.

 

The following table shows the breakout of research and developmentcosts by division and the amount of capitalized software development for theperiods indicated:

 
|                                   |   | **For the  Years Ended December 31,** |   |
|----------------------------------------|--------|---------------------------------------|--------|
|                                   |   | **2002**                              |   | **2001** |   | **% Change** |   |
| Research and development:              |   |                                  |   |   |   |   |   |
| Gross software development costs       |   | $                                     | 23.5   |   | $ | 28.8 |   | -18 | % |
| Capitalized software development costs |   | (2.5                                  | )      | (3.5 | ) | -29 | % |
| Internal drug discovery                |   | 6.9                                   |   | 7.2 |   | -5 | % |
| Total research and development costs   |   | $                                     | 27.9   |   | $ | 32.5 |   | -14 | % |

 

The decrease in research and development expense is attributable tocost efficiencies realized in the software business due to the consolidation ofresearch efforts on Accelrys’ expanded product line and due to efficienciesrealized from standardization of products on a common platform.  Also, decreased capitalization of softwaredevelopment activities resulted from these efficiencies.  Additionally, cost decreases at PDD relatedto the reduction of non-chemistry and biology research activities, were plannedin 2001 and fully realized in 2002.

 

Sales, general and administrative expense increased by 8% to $66.4million in the year ended December 31, 2002 compared to $61.6 million in theyear ended December 31, 2001.  Theincrease in sales, general and administrative expense is attributable largelyto increases in sales staff and management infrastructure, particularly inJapan where direct sales were undertaken in 2002 as compared to the formerdistributor sales model.  Additionally,expense associated with a new facility and facility consolidation, severance,and excess consulting capacity in the current year totaled approximately $0.7million with no corresponding expense in the prior year.  Finally, approximately $1.0 million of thefull year increase was attributable to the sales, general and administrativeexpense of Synomics Limited, acquired in June 2001.  Excluding the foregoing items, sales, general and administrativeexpense increased by 5%.

 

A restructuring charge of $4.3 million was recorded in the thirdquarter of 2002 related to actions taken to improve our financial performance.

 

56

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No goodwill amortization was recorded in the year ended December 31,2002 compared to $8.6 million in the year ended December 31, 2001.  The decrease is attributable to changes inaccounting rules.

 

No discontinued acquisition costs were recorded in the year ended December31, 2002 compared to $3.0 million in the year ended December 31, 2001.

 

Interest and other income, net, decreased 57% to $3.9 million in theyear ended December 31, 2002 compared to $9.1 million in the year endedDecember 31, 2001.  Interest and otherincome, net, in the comparable prior year period included a $0.7 millioncapital gain related to the sale of an investment.  Approximately $3.5 million of the decrease is due to decreases inaverage investment balances and decreases in market interest rates, and theremaining difference relates to translation of certain current assetsdenominated in foreign currencies and other non-operating expenses.

 

The Company recorded an income tax provision of $0.7 million in theyear ended December 31, 2002 compared to $0.9 million in the year endedDecember 31, 2001.  The 2002 and 2001tax provisions are primarily due to foreign taxable income generated byAccelrys’ foreign subsidiaries.  Theseprovisions differ from the Federal tax rate primarily because of the effect ofpermanent book-tax differences, net operating loss carryforwards, and netoperating loss carrybacks.

 

Hardware re-sale operations were discontinued in 2001.  As such, there was no net income fromdiscontinued hardware operations for the year ended December 31, 2002 comparedto $0.4 million in the year ended December 31, 2001.

 

As a result of the factors described above, the Company generated a netloss of $11.6 million ($0.49 per diluted share) in the year ended December 31,2002, compared to a net loss of $14.3 million ($0.60 per diluted share) in theyear ended December 31, 2001.  Net lossin the prior year period was made up of a net loss from continuing operationsof $14.7 million ($0.62 per diluted share) partially offset by income fromdiscontinued operations of $0.4 million ($0.02 per diluted share).

 

**Liquidity and Capital Resources**

 

We have funded our activities to date primarily through the sales ofequity securities, and sales of software licenses, software maintenanceservices, and drug discovery services. We had cash, cash equivalents, and marketable securities of $134.1million as of December 31, 2003 compared to $141.1 million as of December 31,2002, a decrease of $7.0 million.

 

Cash provided by operations increased by $1.5 million to $2.5 millionin the year ended December 31, 2003 compared to $1.0 million the year endedDecember 31, 2002.  The increase was dueto the decreased operating loss, offset by increased receivables due to thetiming of increased sales closer to the end of the year ended December 31, 2003as compared to the end of the year ended December 31, 2002.  Cash used in investing activities decreasedby $31.0 million to $5.6 million in the year ended December 31, 2003 compared to$36.6 million in the year ended December 31, 2002.  The decrease resulted from decreased expenditures for informationtechnology infrastructure offset by the timing of investments in marketablesecurities.  Cash provided by financingactivities, excluding purchases of treasury stock of $7.0 million in 2002,decreased by $0.2 million to $1.7 million in the year ended December 31, 2003compared to $1.9 million used in the year ended December 31, 2002.  These amounts primarily represented cashproceeds to the Company from stock option exercises.

 

57

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The following summarizes our long-term contractual obligations as ofDecember 31, 2003 (in thousands):

 
|                        |   | **Payments  Due by Period** |   |
|-----------------------------|--------|-----------------------------|--------|
| **Contractual Obligations** |   | **Total**                   |   | **Less than  1 Year** |   | **1 to 3  Years** |   | **4 to 5 Years** |   | **After 5  Years** |   |
|                        |   |                        |   |   |   |   |   |   |   |   |   |
| Operating leases            |   | $                           | 63,140 |   | $ | 7,812 |   | $ | 14,463 |   | $ | 7,213 |   | $ | 33,652 |   |
|                        |   |                        |   |   |   |   |   |   |   |   |   |
| Total                       |   | $                           | 63,140 |   | $ | 7,812 |   | $ | 14,463 |   | $ | 7,213 |   | $ | 33,652 |   |

 

The Company pays royalties to approximately thirty-six partners forworldwide licenses to enhance and market certain software developed atuniversities, corporations, and other institutions.  A majority of the royalty agreements are long term or perpetualin nature and the royalty obligations are generally based on a percentage ofrevenues derived from certain software license sales including associated salesof post-contract support and maintenance. The royalty agreements require quarterly payments and generally do notlimit the maximum royalty amount under the agreement.  Certain agreements contain provisions for quarterly and annualminimum royalty payments that total approximately $0.5 million on an annualbasis.  In 2003, 2002, and 2001, theCompany incurred related royalty expense of $2.8 million, $3.2 million, and$3.0 million, respectively.  Based onexisting royalty agreements, the Company expects to continue to incur aboutthese levels of annual future royalty obligations.

 

We anticipate that our capital requirements may increase in futureperiods as a result of seasonal sales trends, additional research anddevelopment activities, and the acquisition of additional equipment.  Our capital requirements may also increasein future periods as we seek to expand our technology platform throughinvestments, licensing arrangements, technology alliances, or acquisitions.

 

We anticipate that our existing capital resources will be adequate tofund our operations at least through 2004. However, there can be no assurance that changes will not occur thatwould consume available capital resources before then.  Our capital requirements depend on numerousfactors, including our ability to continue to generate software sales, ourability to extend existing drug discovery agreements and to enter intoadditional arrangements, competing technological and market developments,changes in our existing collaborative relationships, the cost of filing,prosecuting, defending, and enforcing patent claims and other intellectualproperty rights and the outcome of related litigation, the purchase ofadditional capital equipment, acquisitions of other businesses or technologies,and the progress of our customers’ milestone and royalty producingactivities.  There can be no assurancethat additional funding, if necessary, will be available to us on favorableterms, if at all.  Our forecast for theperiod of time through which our financial resources will be adequate tosupport our operations is forward looking information, and actual results couldvary.

 

# **Off-Balance SheetArrangements**

 

As of December 31, 2002 and 2003, we did not have any otherrelationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in such relationships.

 

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**Critical Accounting Policies**

 

Thepreparation of our consolidated financial statements and disclosures involvethe use of judgments and estimates.  Webelieve the following critical accounting policies involve the more significantjudgments and estimates used.

 

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

 

We recognizeAccelrys software license revenue upon delivery if no significant obligationsremain deliverable to the customer, the sales contract fee is fixed ordeterminable, amounts are due within one year and collection is probable, andwhen no material uncertainties regarding customer acceptance exist.  Customer payments received in connectionwith license sales are recorded as deferred revenue until such time as all ofthe above criteria are met.  Prepaidpost-contract support and maintenance (“PCS”) revenue bundled with softwarelicense agreements is unbundled and deferred based on objective, vendorspecific evidence.  PCS revenue isrecognized pro-rata over the related service period, which is generally oneyear.  Consulting and training fees arerecognized upon rendering of service. Support revenues are recognized ratably over the applicable contractperiods or as services are performed. Amounts billed but not yet recognized as revenue, and other paymentsreceived prior to recognition of revenue, are recorded as deferred revenue.

 

We alsorecognize a limited amount or software license revenue on an annualsubscription basis.  However, we areplanning to offer more software licenses on terms which would requiresubscription accounting.  Annual licenserevenue under an annual subscription model will be recognized ratably over thelicense term.  This contrasts sharplywith our typical annual license offering, in which we recognize 64% of thelicense revenue in the quarter in which the license is executed and amortizethe other 36% of the revenue over the remaining term of the contract to reflectthe costs of post-sales support.  Therevenue recognition for the new license is even more dramatic when compared toour traditional perpetual license offering, in which we recognize 85% of thelicense revenue in the quarter in which the contract is executed and amortizethe remaining 15% of the revenue over the term of a one-year maintenance agreement.  For example, under our existing annuallicense structure, if we were to enter into a one-year license generating$100,000 in revenue, we would have recognized $64,000 of the revenue when thesoftware was shipped and recognized the remaining $36,000 of the revenueratably over the contract term. Similarly, in the case of our existing perpetual license offering,completed on similar terms, we would have recognized $85,000 of the revenuewhen the product was shipped and the remaining $15,000 of the revenue ratablyover the term of the one-year maintenance agreement.  In contrast to both our annual and perpetual license offerings,on similar terms, under the new license offering we would recognize onlyone-twelfth of the revenue, or $8,333, in the month following shipment, and$8,333 in each of the remaining months during the term of the contract.  To further illustrate the point, if over thenext twelve months we were to book the same amount of orders as in calendar2003, in the same mix of annual and perpetual licenses and at the same timeduring the quarter as in 2003, total revenue recognized for those 12 monthswould be about $10 million lower than in 2003.   The unrecognized revenue, amortized over the remaining term ofthe agreement, will be accounted for as “deferred revenue” on the balancesheet.  We expect that, at the end ofabout five quarters from now, the significant impact of the subscriptionaccounting for this new license offering on Accelrys’ recognized revenue anddeferred revenue will be largely ameliorated.

 

Finally, wealso earn software revenue under consortia agreements wherein several unrelatedparties enter into a joint software development agreement with us.  These agreements are

 

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generally one to three years inlength, require an annual membership fee, and contain best efforts developmentmilestones.  Customers receive aconsortium membership, a software library, and related software and maintenancesupport.  The portion of consortium feesassociated with the initial software library is recognized upon delivery, whileconsortium fees associated with consortium membership and software maintenanceare recognized ratably over the term of the agreement.  We are not required to deliver specifiedproducts under the agreements and the consortium fees are generallynon-refundable.  If we are successful indeveloping software under a consortia agreement as described above, anon-transferable license is typically awarded to the consortium members.

 

As describedabove, recognition of software licence, service and other revenue is dependent,in part, on management judgment.  Sincemanagement’s judgment is involved, changes in our estimates or assumptionscould impact revenue recognition in the future.

 

Drug Discoverycontract revenue is recognized either (i) ratably over the term of theagreement, which approximates the performance of services, for contractsspecifying payment for services over a given period, or (ii) as services areperformed under the agreement for contracts specifying payment on a perfull-time employee basis.

 

Drug Discoveryrevenue earned related to up-front product and technology license fees isrecognized in accordance with SAB No. 101 issued by the SEC, and EITF 00-21,“Revenue Recognition for Multiple Element Arrangements.”  Accordingly, amounts received undermultiple-element arrangements requiring ongoing services or performance by usare recognized over the period of such services or performance.

 

Drug Discoveryrevenue from milestones are recognized when earned, as evidenced by writtenacknowledgement from the collaborator, provided that (i) the milestone event issubstantive and its achievability was not reasonably assured at the inceptionof the agreement, and (ii) our performance obligations after the milestoneachievement will continue to be funded by the collaborator at a comparablelevel to before the milestone achievement. If both of these criteria are notmet, the milestone payment would be recognized over the remaining minimumperiod of our performance obligations under the arrangement. Royalties, arerecognized as earned in accordance with the terms of various research andcollaboration agreements.

 

As describedabove, Drug Discovery revenue recognition is based, in part, on estimates andassumptions by management that are subject to change depending on thecontract.  As such, any change in ourestimates could impact revenue recognition in the future.

 

*Software DevelopmentCosts* – We capitalize software development costs inaccordance with Statement of Financial Accounting Standards No. 86, “Accountingfor the Cost of Computer Software to be Sold, Leased or Otherwise Marketed”(SFAS 86).  Such costs are stated at thelower of cost or net realizable value. Capitalized software costs are comprised of costs incurred in thedevelopment of new software products and enhancements to existing softwareproducts after technological feasibility has been established.  We amortize capitalized costs over theestimated product life, not to exceed three years from the date on which theproduct is available for general release. The estimated product life may be reduced based on obsolescence or otherfactors, which could affect the carrying value of capitalized software andresult in charges to operating results. These estimates are based on management’s judgment.  Since management’s judgment is involved, anychange in our estimates could impact operating results in the future.

 

*Goodwill*– The Company’s Goodwill resulted from acquisitions made by Accelrys in 2000and 2001.  We assess goodwill forimpairment in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets” (SFAS 142).  Under SFAS 142,goodwill and intangible assets with

 

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indefinite lives are no longeramortized but are assessed annually (or more frequently if impairmentindicators arise) for impairment by comparing fair market value of the netassets of our software segment to the carrying value.  In making this annual assessment, which we do in the fourthcalendar quarter, we rely on a number of factors including operating results,business plans, economic projections, anticipated future cash flows, and marketplace data.  There are inherentuncertainties related to these factors and management’s judgment in applyingthem to the analysis of goodwill impairment. We completed our annual intangibleasset impairment test during the quarter ended December 31, 2003, and concludedthat the carrying value of our goodwill was not impaired.  Continued economic weakness, unexpectedsignificant declines in operating results of reporting units, and additionalnon-temporary market capitalization declines may be indicative of goodwill impairmentand cause us to perform additional valuation analyses for our reporting unitsprior to the next required annual assessment. These types of events and the resulting analyses could result in chargesfor goodwill expense in the future.

 

*Impairment ofLong-Lived Assets*– We review long-lived assets,including leasehold improvements, property and equipment, and capitalizedsoftware development costs for impairment whenever events or changes inbusiness circumstances indicate that the carrying amount of the assets may notbe fully recoverable. This requires us to estimate future cash flows related tothese assets. Actual results could differ from these estimates, which mayaffect the carrying amount of assets and the actual amortization expense.  TheCompany has identified no such impairment losses as of December 31, 2003.

 

### **New AccountingStandards**

 

In May 2003,the Financial Accounting Standards Board (FASB) issued SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity” (SFAS 150). This statement clarifies the definition of a liability, as currentlydefined under FASB Concepts Statement No. 6 “Elements of Financial Statements”,as well as other items.  The statementrequires that financial instruments that embody an obligation of an issuer beclassified as a liability.  Furthermore,the standard provides guidance for the initial and subsequent measurement aswell as disclosure requirements of these financial instruments.  This statement is effective for financialinstruments entered into after May 31, 2003. The adoption of this statement has not had a material impact on ourresults of operations or financial condition.

 

In April 2003,the FASB issued SFAS No. 149, “Amendment of Statement 133 on DerivativeInstruments and Hedging Activities.” This statement amends and clarifies the financial accounting andreporting requirements, as were originally established in FASB Statement No.133, for derivative instruments and hedging activities.  FASB Statement No. 149 provides greaterclarification of the characteristics of a derivative instrument so thatcontracts with similar characteristics will be accounted for consistently.  This statement is effective for contractsentered into or modified after June 30, 2003, as well as for hedging relationshipsdesignated after June 30, 2003, excluding certain implementation issues thathave been effective prior to this date under FASB Statement No. 133.  The adoption of this statement has not had amaterial impact on our results of operations or financial condition.

 

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**ITEM 7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

We are exposedto various market risks consisting primarily of changes in foreign currencyexchange rates.  Our international salesgenerally are denominated in local currencies. In 2003, 53% of our consolidated revenue was derived from customersoutside the United States (including 36% from customers in Europe and 17% fromcustomers in the Asia/Pacific region). Our exchange rate risk is greatest for Dollar/Sterling, Dollar/Euro andDollar/Yen fluctuations.  When deemedappropriate, we engage in exchange rate-hedging transactions in an attempt tomitigate the impact of adverse exchange rate fluctuations.  At December 31, 2003, we had no hedgingtransactions in effect.

 

We do not use derivativefinancial instruments for trading or speculative purposes.  However, we regularly invest excess cash inovernight repurchase agreements that are subject to changes in short-terminterest rates.  We believe that themarket risk arising from holding these financial instruments is minimal.

 

Our exposureto market risks associated with changes in interest rates relates primarily tothe increase or decrease in the amount of interest income earned on ourinvestment portfolio, since we have minimal debt.  We ensure the safety and preservation of invested funds bylimiting default risks, market risk, and reinvestment risk.  We mitigate default risk by investing ininvestment grade securities.  A hypothetical100 basis point adverse move in interest rates along the entire interest rateyield curve would not materially affect the fair value of our interestsensitive financial instruments at December 31, 2003.

 

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# **ITEM 8. FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

**REPORTOF ERNST & YOUNG LLP, INDEPENDENT AUDITORS**

 

The Board of Directors andStockholders

Pharmacopeia, Inc.

 

We have audited theaccompanying consolidated balance sheets of Pharmacopeia, Inc. as ofDecember 31, 2003 and 2002, and the related consolidated statements ofoperations, stockholders’ equity and cash flows for each of the three years inthe period ended December 31, 2003.  Ouraudits also included the financial statement schedule listed in the index atItem 15(a)(2).  These financialstatements and schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andschedule based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free from material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of Pharmacopeia, Inc. at December 31, 2003 and2002, and the consolidated results of its operations and its cash flows foreach of the three years in the period ended December 31, 2003, in conformitywith accounting principles generally accepted in the United States.  Also, in our opinion, the related financialstatement schedule, when considered in relation to the basic financialstatements taken as a whole, presents fairly in all material respects theinformation set forth therein.

 

 
|                   | /s/ERNST  & YOUNG LLP |   |
|------------------------|--------------------------------|--------|
|                   |                           |
|                   |                           |
| San Diego,  California |                           |
| January 30,  2004      |                           |

 

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**Pharmacopeia, Inc.**

**Consolidated Balance Sheets**

 (in thousands, except per sharedata)

 
|                                                                                                                      |   | **As of  December 31,** |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|
|                                                                                                                      |   | **2003**                |    | **2002** |   |
| **ASSETS**                                                                                                                |   |                    |    |   |   |
| Current assets:                                                                                                           |   |                    |    |   |   |
| Cash and cash equivalents                                                                                                 |   | $                       | 27,509  |   | $ | 28,236 |   |
| Marketable securities                                                                                                     |   | 106,546                 |    | 112,835 |   |
| Trade receivables, net of allowance for  doubtful accounts of $505 and $1,634, respectively                               |   | 42,082                  |    | 35,571 |   |
| Prepaid expenses and other current assets                                                                                 |   | 5,365                   |    | 5,505 |   |
| Total current assets                                                                                                      |   | 181,502                 |    | 182,147 |   |
|                                                                                                                      |   |                    |    |   |   |
| Property and equipment, net                                                                                               |   | 15,398                  |    | 14,157 |   |
| Goodwill, net of accumulated amortization  of $13,201                                                                     |   | 34,072                  |    | 34,404 |   |
| Software development costs, net of  accumulated amortization of $26,555 and $21,118, respectively                         |   | 7,634                   |    | 8,656 |   |
| Other intangible asset, net of accumulated  amortization of $2,720 and $2,604, respectively                               |   | —                  |    | 116 |   |
| Other assets                                                                                                              |   | 1,061                   |    | 625 |   |
| Total assets                                                                                                              |   | $                       | 239,667 |   | $ | 240,105 |   |
|                                                                                                                      |   |                    |    |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                             |   |                    |    |   |   |
| Current liabilities:                                                                                                      |   |                    |    |   |   |
| Accounts payable                                                                                                          |   | $                       | 4,659   |   | $ | 2,497 |   |
| Accrued liabilities                                                                                                       |   | 19,762                  |    | 20,417 |   |
| Deferred revenue, current portion                                                                                         |   | 27,255                  |    | 29,076 |   |
| Leases payable, current portion                                                                                           |   | 8                       |    | 12 |   |
| Total current liabilities                                                                                                 |   | 51,684                  |    | 52,002 |   |
|                                                                                                                      |   |                    |    |   |   |
| Leases payable, long-term                                                                                                 |   | —                  |    | 8 |   |
| Deferred revenue, long-term                                                                                               |   | 5,249                   |    | 4,758 |   |
|                                                                                                                      |   |                    |    |   |   |
| Stockholders’ equity:                                                                                                |   |                    |    |   |   |
| Preferred stock, $.0001 par value, 2,000  shares authorized, none issued and outstanding                                  |   | —                  |    | — |   |
| Common stock, $.0001 par value, 40,000  shares authorized, 24,568 and 24,241 shares issued and outstanding,  respectively |   | 2                       |    | 2 |   |
| Additional paid-in capital                                                                                                |   | 287,592                 |    | 284,733 |   |
| Unearned compensation                                                                                                     |   | (536                    | )       | — |   |
| Treasury stock                                                                                                            |   | (8,340                  | )       | (8,340 | ) |
| Accumulated deficit                                                                                                       |   | (97,318                 | )       | (93,821 | ) |
| Accumulated comprehensive income                                                                                          |   | 1,334                   |    | 763 |   |
| Total stockholders’ equity                                                                                           |   | 182,734                 |    | 183,337 |   |
| Total liabilities and stockholders’ equity                                                                           |   | $                       | 239,667 |   | $ | 240,105 |   |

 

See accompanying notes to these consolidated financial statements.

 

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## **Pharmacopeia, Inc.**

## **ConsolidatedStatements of Operations**

## **(inthousands, except per share data)**

 
|                                                  |   | **For the  Years Ended December 31,** |   |
|-------------------------------------------------------|--------|---------------------------------------|--------|
|                                                  |   | **2003**                              |   | **2002** |   | **2001** |   |
| Revenues:                                             |   |                                  |   |   |   |   |   |
| Software license, service and other                   |   | $                                     | 85,561 |   | $ | 95,104 |   | $ | 95,107 |   |
| Drug discovery                                        |   | 29,503                                |   | 29,304 |   | 27,196 |   |
| Total revenues                                        |   | 115,064                               |   | 124,408 |   | 122,303 |   |
|                                                  |   |                                  |   |   |   |   |   |
| Cost of revenues:                                     |   |                                  |   |   |   |   |   |
| Software license, service  and other             |   | 19,845                                |   | 21,575 |   | 19,046 |   |
| Drug discovery                                        |   | 22,157                                |   | 19,080 |   | 20,411 |   |
| Total cost of revenues                                |   | 42,002                                |   | 40,655 |   | 39,457 |   |
|                                                  |   |                                  |   |   |   |   |   |
| Gross margin                                          |   | 73,062                                |   | 83,753 |   | 82,846 |   |
|                                                  |   |                                  |   |   |   |   |   |
| Operating costs and expenses:                         |   |                                  |   |   |   |   |   |
| Research and development                              |   | 22,029                                |   | 27,868 |   | 32,529 |   |
| Sales, general and administrative                     |   | 57,133                                |   | 66,423 |   | 61,647 |   |
| Restructuring                                         |   | (384                                  | )      | 4,340 |   | — |   |
| Amortization of goodwill                              |   | —                                |   | — |   | 8,620 |   |
| Total operating costs and expenses                    |   | 78,778                                |   | 98,631 |   | 102,796 |   |
| Operating loss from continuing operations             |   | (5,716                                | )      | (14,878 | ) | (19,950 | ) |
| Spin-off transaction costs                            |   | (700                                  | )      | — |   | — |   |
| Discontinued acquisition costs                        |   | —                                |   | — |   | (2,985 | ) |
| Interest and other income, net                        |   | 4,179                                 |   | 3,915 |   | 9,082 |   |
| Loss from continuing operations before tax  provision |   | (2,237                                | )      | (10,963 | ) | (13,853 | ) |
| Provision for income taxes                            |   | 1,260                                 |   | 664 |   | 888 |   |
| Loss from continuing operations                       |   | (3,497                                | )      | (11,627 | ) | (14,741 | ) |
| Discontinued operations:                              |   |                                  |   |   |   |   |   |
| Income from discontinued operations                   |   | —                                |   | — |   | 421 |   |
| Net loss                                              |   | $                                     | (3,497 | ) | $ | (11,627 | ) | $ | (14,320 | ) |
|                                                  |   |                                  |   |   |   |   |   |
| Loss per share from continuing operations:            |   |                                  |   |   |   |   |   |
| - Basic and diluted                                   |   | $                                     | (0.15  | ) | $ | (0.49 | ) | $ | (0.62 | ) |
|                                                  |   |                                  |   |   |   |   |   |
| Income per share from discontinued  operations:       |   |                                  |   |   |   |   |   |
| - Basic and diluted                                   |   | $                                     | — |   | $ | — |   | $ | 0.02 |   |
|                                                  |   |                                  |   |   |   |   |   |
| Net loss per share:                                   |   |                                  |   |   |   |   |   |
| - Basic and diluted                                   |   | $                                     | (0.15  | ) | $ | (0.49 | ) | $ | (0.60 | ) |
|                                                  |   |                                  |   |   |   |   |   |
| Weighted average number of common stock  outstanding: |   |                                  |   |   |   |   |   |
| - Basic and diluted                                   |   | 23,752                                |   | 23,512 |   | 23,729 |   |

 

See accompanying notes to these consolidated financial statements.

 

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##  

## **Pharmacopeia, Inc.**

## **ConsolidatedStatements of Stockholders’ Equity**

## **(inthousands)**

 
|                                                      |   | **Common Stock**      |       | **Additional  Paid-in Capital** |       |       |                       | **Treasury Stock** |                  |       |       | **Unrealized  Gain (Loss)  on Marketable Securities** |                     | **Cumulative  Translation  Adjustment** |       | **Total**  |                           |
|-----------------------------------------------------------|--------|-----------------------|------------|---------------------------------|------------|------------|----------------------------|--------------------|-----------------------|------------|------------|-------------------------------------------------------|--------------------------|-----------------------------------------|------------|------------|--------------------------------|
|                                                      |   | **Number of  Shares** | ** ** | **Amount**                      | ** ** | ** ** | **Unearned  Compensation** | ** **         | **Number of  Shares** | ** ** | **Amount** | ** **                                            | **Accumulated  Deficit** | ** **                              | ** ** | ** ** | **Stockholders’  Equity** | ** ** |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Balance at December 31, 2000                              |   | 23,411                |       | $                               | 2          |       | $                          | 276,144            |                  | $          | —     |                                                  | —                   |                                    | $          | —     |                           | $ | (67,874 | ) | $ | 1,995 |   | $ | (400 | ) | $ | 209,867 |   |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Comprehensive loss:                                       |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Net loss                                                  |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     | (14,320                                 | )          |       |                           |   |   | (14,320 | ) |
| Translation adjustment                                    |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           | (514 | ) | (514 | ) |
| Unrealized gain on marketable securities                  |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       | (1,137     | )                              |   |   | (1,137 | ) |
| Comprehensive loss                                        |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | (15,971 | ) |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Acquisition of treasury stock                             |   |                  |       |                            |       |       |                       |               |                  | 113        |       | (1,316                                                | )                        |                                    |       |       |                           |   |   | (1,316 | ) |
| Issuance of common stock for exercise of stock options    |   | 380                   |       | —                          |       | 2,739      |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 2,739 |   |
| Issuance of common stock in employee stock purchase plan  |   | 91                    |       | —                          |       | 1,308      |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 1,308 |   |
| Issuance of common stock for 401(k) matching              |   | 74                    |       | —                          |       | 1,362      |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 1,362 |   |
| Balance at December 31, 2001                              |   | 23,956                |       | 2                               |       | 281,553    |                       | —             |                  | 113        |       | (1,316                                                | )                        | (82,194                                 | )          | 858        |                           | (914 | ) | 197,989 |   |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Comprehensive loss:                                       |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Net loss                                                  |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     | (11,627                                 | )          |       |                           |   |   | (11,627 | ) |
| Translation adjustment                                    |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           | 487 |   | 487 |   |
| Unrealized gain on marketable securities                  |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       | 332        |                           |   |   | 332 |   |
| Comprehensive loss                                        |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | (10,808 | ) |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Acquisition of treasury stock                             |   |                  |       |                            |       |       |                       |               |                  | 531        |       | (7,024                                                | )                        |                                    |       |       |                           |   |   | (7,024 | ) |
| Exercise of warrant, net value exercise                   |   | (51                   | )          |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | — |   |
| Retirement of restriced stock                             |   | (2                    | )          |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | — |   |
| Non-cash stock option compensation expense                |   |                  |       |                            |       | 103        |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 103 |   |
| Issuance of common stock for exercise of restricted stock |   |                  |       |                            |       | 20         |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 20 |   |
| Issuance of common stock for exercise of stock options    |   | 98                    |       | —                          |       | 785        |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 785 |   |
| Issuance of common stock in employee stock purchase plan  |   | 126                   |       | —                          |       | 1,139      |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 1,139 |   |
| Issuance of common stock for 401(k) matching              |   | 114                   |       | —                          |       | 1,133      |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 1,133 |   |
| Balance at December 31, 2002                              |   | 24,241                |       | 2                               |       | 284,733    |                       | —             |                  | 644        |       | (8,340                                                | )                        | (93,821                                 | )          | 1,190      |                           | (427 | ) | 183,337 |   |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Comprehensive loss:                                       |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Net loss                                                  |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     | (3,497                                  | )          |       |                           |   |   | (3,497 | ) |
| Translation adjustment                                    |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           | 1,147 |   | 1,147 |   |
| Unrealized gain on marketable securities                  |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       | (576       | )                              |   |   | (576 | ) |
| Comprehensive loss                                        |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | (2,926 | ) |
|                                                      |   |                  |       |                            |       |       |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   |   |   |
| Unearned compensation                                     |   |                  |       |                            |       |       |                       | (536               | )                     |       |       |                                                  |                     |                                    |       |       |                           |   |   | (536 | ) |
| Non-cash stock option compensation expense                |   |                  |       |                            |       | 93         |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 93 |   |
| Issuance of common stock for exercise of stock options    |   | 107                   |       | —                          |       | 781        |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 781 |   |
| Issuance of common stock in employee stock purchase plan  |   | 112                   |       | —                          |       | 942        |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 942 |   |
| Issuance of common stock for 401(k) matching              |   | 108                   |       | —                          |       | 1,043      |                       |               |                  |       |       |                                                  |                     |                                    |       |       |                           |   |   | 1,043 |   |
| Balance at December 31, 2003                              |   | 24,568                |       | $                               | 2          |       | $                          | 287,592            |                  | $          | (536       | )                                                     | 644                      |                                    | $          | (8,340     | )                              | $ | (97,318 | ) | $ | 614 |   | $ | 720 |   | $ | 182,734 |   |

 

See accompanying notes to these consolidated financial statements.

 

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##  

## **Pharmacopeia, Inc.**

## **ConsolidatedStatements of Cash Flows**

(in thousands)

 
|                                                                            |   | **Years  Ended December 31,** |   |
|---------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                            |   | **2003**                      |   | **2002** |   | **2001** |   |
| OPERATING ACTIVITIES:                                                           |   |                          |   |   |   |   |   |
| Net loss                                                                        |   | $                             | (3,497 | ) | $ | (11,627 | ) | $ | (14,320 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities |   |                          |   |   |   |   |   |
| Depreciation                                                                    |   | 6,211                         |   | 6,173 |   | 5,645 |   |
| Amortization                                                                    |   | 5,542                         |   | 7,884 |   | 16,151 |   |
| Contribution of stock to 401(k) members                                         |   | 1,043                         |   | 1,133 |   | 1,362 |   |
| Non-cash compensation                                                           |   | 93                            |   | 103 |   | — |   |
| Changes in assets and liabilities:                                              |   |                          |   |   |   |   |   |
| Trade receivables                                                               |   | (4,073                        | )      | 7,576 |   | (4,018 | ) |
| Prepaid expenses and other current assets                                       |   | 361                           |   | 1,758 |   | (294 | ) |
| Other assets                                                                    |   | (439                          | )      | 860 |   | 372 |   |
| Accounts payable                                                                |   | 2,051                         |   | (1,865 | ) | 1,369 |   |
| Accrued liabilities                                                             |   | (1,847                        | )      | (5,755 | ) | (5,312 | ) |
| Deferred revenue                                                                |   | (2,973                        | )      | (5,252 | ) | 958 |   |
| Net cash provided by operating activities                                       |   | 2,472                         |   | 988 |   | 1,913 |   |
| INVESTING ACTIVITIES:                                                           |   |                          |   |   |   |   |   |
| Capital expenditures, net                                                       |   | (7,013                        | )      | (8,498 | ) | (4,864 | ) |
| Increase in capitalized software  development costs                             |   | (4,253                        | )      | (2,529 | ) | (3,537 | ) |
| Purchases of marketable securities                                              |   | (93,861                       | )      | (135,505 | ) | (164,051 | ) |
| Proceeds from sales of marketable  securities                                   |   | 99,574                        |   | 109,938 |   | 171,796 |   |
| Acquisition of business, net of cash  acquired                                  |   | —                        |   | — |   | (3,855 | ) |
| Net cash used in investing activities                                           |   | (5,553                        | )      | (36,594 | ) | (4,511 | ) |
| FINANCING ACTIVITIES:                                                           |   |                          |   |   |   |   |   |
| Proceeds from issuance of common stock                                          |   | 1,723                         |   | 1,944 |   | 4,048 |   |
| Purchases of treasury stock                                                     |   | —                        |   | (7,024 | ) | (1,316 | ) |
| Principal payments on notes and leases  payable                                 |   | (12                           | )      | (58 | ) | (95 | ) |
| Net cash provided by (used in) financing  activities                            |   | 1,711                         |   | (5,138 | ) | 2,637 |   |
| Exchange rate effect on cash and  equivalents                                   |   | 643                           |   | 89 |   | (498 | ) |
| Net decrease in cash and equivalents                                            |   | (727                          | )      | (40,655 | ) | (459 | ) |
| Cash and equivalents, beginning of period                                       |   | 28,236                        |   | 68,891 |   | 69,350 |   |
| Cash and equivalents, end of period                                             |   | $                             | 27,509 |   | $ | 28,236 |   | $ | 68,891 |   |
|                                                                            |   |                          |   |   |   |   |   |
| SUPPLEMENTAL INFORMATION:                                                       |   |                          |   |   |   |   |   |
| Cash paid during the period for:                                                |   |                          |   |   |   |   |   |
| Interest expense                                                                |   | $                             | 5      |   | $ | 20 |   | $ | 30 |   |
| Income tax expense                                                              |   | $                             | 296    |   | $ | 436 |   | $ | 1,007 |   |

 

## **See accompanying notes to these consolidated financialstatements.**

 

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##  

## **Pharmacopeia, Inc.**

## **Notesto Consolidated Financial Statements**

 

# **1.  Organization and Description of Business**

 

Pharmacopeia designs, develops, markets, and supports science- andtechnology-based products and services intended to improve and accelerate theprocesses of drug discovery and chemical development.  The Company’s software segment, Accelrys Inc. (“Accelrys”),provides molecular modeling, simulation, informatics and decision support forthe life sciences and materials research markets.  The Company’s drug discovery segment, Pharmacopeia DrugDiscovery, Inc. (“PDD”), provides collaborative drug discovery services topharmaceutical and biotechnology companies based on proprietary combinatorialchemistry, high-throughput screening and Accelrys technologies.

 

In December 2003, the Company announced its intention to spin-off PDDto its shareholders.  The Companyexpects to complete the spin-off during the first calendar quarter of 2004.

 

# **2.  Significant Accounting Policies**

 

# **Principles ofConsolidation**

 

Theseconsolidated financial statements include the accounts of Pharmacopeia and itssubsidiaries.   All materialintercompany balances and transactions have been eliminated in consolidation.

 

# **Cash and Cash Equivalents**

 

The Companyconsiders all highly liquid investments with an original maturity of threemonths or less to be cash equivalents. The Company invests its cash with major financial institutions in moneymarket funds, US Treasury securities and other investment grade securities suchas prime-rated commercial paper.

 

# **Marketable Securities**

 

Marketablesecurities consist of fixed-income investments with an original maturity ofgreater than three months such as US Treasury securities, obligations of USGovernment agencies and other investment grade securities such as prime-ratedcommercial paper and corporate bonds. The Company applies Statement of Financial Accounting Standards No. 115“Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115)in accordance with its investments in marketable securities.  The Company’s marketable securities areclassified as available-for-sale and are recorded at estimated fair value withunrealized gains or losses reported in accumulated comprehensive income instockholders’ equity.

 

Included inaccumulated comprehensive income as of December 31, 2003 and 2002 are $0.3 millionand $0.2 million, respectively, of unrealized gain on an investment in thecommon stock of two unrelated, publicly-traded corporations.  The Company included these investments inother current assets.

 

Marketable securitiesconsisted of the following (in thousands):

 

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|                                                                  |   | **December  31, 2003** |    | **December  31, 2002** |   |
|-----------------------------------------------------------------------|--------|------------------------|---------|------------------------|--------|
|                                                                  |   | **Amortized  Cost**    |    | **Market  Value**      |   | **Unrealized  Gain** |   | **Amortized  Cost** |   | **Market  Value** |   | **Unrealized  Gain** |   |
| U.S. Treasury securities and obligations of  U.S. Government agencies |   | $                      | 69,863  |                   | $      | 70,029 |   | $ | 166 |   | $ | 69,563 |   | $ | 70,054 |   | $ | 491 |   |
|                                                                  |   |                   |    |                   |   |   |   |   |   |   |   |   |   |
| U.S. corporate debt securities                                        |   | 36,335                 |    | 36,517                 |   | 182 |   | 42,251 |   | 42,781 |   | 530 |   |
|                                                                  |   | $                      | 106,198 |                   | $      | 106,546 |   | $ | 348 |   | $ | 111,814 |   | $ | 112,835 |   | $ | 1,021 |   |

 

Available-for-salemarketable securities by contractual maturity at December 31, 2003 are asfollows (in thousands):

 
| Due within one year                     |   | $      | 57,167  |   |
|-----------------------------------------|--------|--------|---------|--------|
| Due after one year through eleven years |   | 49,379 |    |
|                                    |   | $      | 106,546 |   |

 

# **Property and Equipment**

 

Property and equipmentis stated at cost.  Depreciation isprovided on the straight-line method over the estimated useful lives of therelated assets, which range from two to ten years.  Assets under capital leases are amortized over their estimateduseful life or the applicable lease period, whichever period is shorter.  The Company amortizes leasehold improvementsover the shorter of their estimated useful lives or the remaining term of therelated lease.  Repair and maintenancecosts are charged to expense as incurred.

 

# **Advertising Costs**

 

The cost of advertisingis expensed as incurred.  The Companyincurred $0.3 million, $0.3 million, and $1.1 million in advertising costsduring 2003, 2002, and 2001, respectively.

 

# **Research and DevelopmentCosts**

 

All research anddevelopment costs not subject to capitalization under SFAS 86 are charged tooperations as incurred.

 

# **Foreign CurrencyTranslation**

 

The Companytranslates certain of its accounts and the financial statements of its foreignoperations in accordance with SFAS No. 52, “Foreign Currency Translation” (SFAS52).  The financial statements of theCompany’s international operations are translated into US dollars usingperiod-end exchange rates for assets and liabilities and average exchange ratesduring the period for revenues and expenses. Cumulative translation gains andlosses are excluded from results of operations and recorded as a separatecomponent of comprehensive income (loss) within stockholders’ equity.  Gains and losses resulting from foreigncurrency transactions are included in the consolidated statement of operations.

 

# **Concentrations of Risk**

 

In 2003, 2002 and2001, one of PDD’s customers accounted for 12%, 12% and 11%, respectively, ofconsolidated revenue.  The agreementwith this customer had been scheduled to expire in March 2004.  In the third quarter of 2003, however, PDDentered into new drug discovery collaboration agreements with thiscustomer.  The new agreements continue PDD’s

 

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collaboration with thiscustomer through at least August 2006, and under their terms, may be extendedby the parties for up to three additional years based upon progress made in theprograms governed by the agreements. The termination of these new agreements would have a material adverseeffect on PDD, and our business as a whole.

 

The Company’sinternational sales are generally denominated in foreign currencies.  Conversion of foreign-denominatedreceivables into US dollars could have a material adverse effect on the Company’sresults of operations.  The Companyconducts business in Europe and in the Asia/Pacific region, primarily inJapan.  Any significant decline in theeconomies or the value of the currencies in these regions could have a materialadverse impact on the Company.

 

# **Use of Estimates**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, revenues and expenses,and the disclosure of contingent assets and liabilities.  Actual future results could differ fromthose estimates.

 

# ***RevenueRecognition***

 

The Companyrecognizes software license revenue upon delivery if no significant obligationsremain deliverable to the customer, the sales contract fee is fixed ordeterminable, amounts are due within one year and collection is probable, andwhen no material uncertainties regarding customer acceptance exist.  Customer payments received in connectionwith license sales are recorded as deferred revenue until such time as all ofthe above criteria are met.  Prepaidpost-contract support and maintenance (“PCS”) revenue bundled with softwarelicense agreements is unbundled and deferred based on objective, vendorspecific evidence.  PCS revenue isrecognized pro-rata over the related service period, which is generally oneyear.  Consulting and training fees arerecognized upon rendering of service. Support revenues are recognized ratably over the applicable contractperiods or as services are performed. Amounts billed but not yet recognized as revenue, and other paymentsreceived prior to recognition of revenue, are recorded as deferred revenue.

 

      The Company also earns software revenueunder consortia agreements wherein several unrelated parties enter into a jointsoftware development agreement.  Theseagreements are generally one to three years in length, require an annualmembership fee, and contain best efforts development milestones.  Customers receive a consortium membership, asoftware library, and related software and maintenance support.  The portion of consortium fees associatedwith the initial software library is recognized upon delivery, while consortiumfees associated with consortium membership and software maintenance arerecognized on a straight-line basis over the term of the agreement.  The Company is not required to deliverspecified products under the agreements and the consortium fees are generallynon-refundable.  If the Company issuccessful in developing software under a consortia agreement as describedabove, a non-transferable license is typically awarded to the consortiummembers.

 

ThroughDecember 31, 2001, the Company sold computer hardware to a licensee of theCompany’s software products.  In theseinstances, the Company typically ordered the hardware from an unrelated vendorand recognized revenue upon shipment of the hardware to the licensee by thevendor.  During 2001, the Companydiscontinued selling computer hardware to licensees.  Accordingly, all revenues and expenses related to this operationhave been included in income from discontinued hardware operations in thestatement of operations for all years presented.

 

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The Companyrecognizes Drug Discovery contract revenue either (i) ratably over the term ofthe agreement, which approximates the performance of services, for contractsspecifying payment for services over a given period, or (ii) as services areperformed under the agreement for contracts specifying payment on a perfull-time employee basis.

 

The Companyalso recognizes Drug Discovery revenue related to up-front product andtechnology license fees in accordance with Staff Accounting Bulletin No. 101issued by the Securities and Exchange Commission. Accordingly, amounts receivedunder multiple-element arrangements requiring ongoing services or performanceby us are recognized over the period of such services or performance.

 

Finally, theCompany recognizes Drug Discovery revenue from milestones when earned, asevidenced by written acknowledgement from the collaborator, provided that (i)the milestone event is substantive and its achievability was not reasonablyassured at the inception of the agreement, and (ii) our performance obligationsafter the milestone achievement will continue to be funded by the collaboratorat a comparable level to before the milestone achievement. If both of thesecriteria are not met, the milestone payment would be recognized over theremaining minimum period of our performance obligations under the arrangement.Royalties are also recognized as earned in accordance with the terms of variousresearch and collaboration agreements.

 

*Allowance forDoubtful Accounts*

 

The Companymaintains an allowance for doubtful accounts for estimated losses resultingfrom the inability of our customers to make required payments.  This estimate is based on a specificcustomer analysis, and an additional amount may be provided when and if anaccount becomes uncollectible at a later date. If the financial condition of a customer were to deteriorate, resultingin an impairment of its ability to make payments, an additional allowance wouldbe required.

 

# ***SoftwareDevelopment Costs***

 

The Companycapitalizes software development costs in accordance with SFAS No. 86,“Accounting for the Cost of Computer Software to be Sold, Leased or OtherwiseMarketed” (SFAS 86).  Such costs arestated at the lower of cost or net realizable value. Capitalized software costsare comprised of costs incurred in the development of new software products andenhancements to existing software products after technological feasibility hasbeen established.  The Company amortizescapitalized costs over the estimated product life, not to exceed three yearsfrom the date on which the product is available for general release.  The estimated product life may be reducedbased on obsolescence or other factors, which could affect the carrying valueof capitalized software and result in changes to operating results.

 

*Goodwill*

 

The Company assessesgoodwill and intangible assets for impairment in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets” (SFAS 142).  Under SFAS 142, goodwill and intangible assets with indefinite livesare no longer amortized but are assessed annually (or more frequently ifimpairment indicators arise) for impairment. In making this annual assessment, the Company relies on a number offactors including operating results, business plans, economic projections,anticipated future cash flows, and market place data.  We completed

 

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our annual intangible asset impairment test during the quarter endedDecember 31, 2003, and concluded that the carrying value of our goodwill wasnot impaired.

 

# ***Impairment ofLong-Lived Assets***

 

The Companyreviews long-lived assets, including leasehold improvements, property andequipment, and capitalized software development costs for impairment wheneverevents or changes in business circumstances indicate that the carrying amountof the assets may not be fully recoverable. The Company has identified no such impairment losses as of December 31,2003, 2002, or 2001.

 

*Income Taxes*

 

The Company estimates full year taxable income of the various legalentities and jurisdictions used in the tax rate calculation, which changethroughout the year in accordance with SFAS No. 109 “Accounting for IncomeTaxes”.

 

# **Net Income (Loss) PerShare**

 

The Company computes netincome (loss) per share pursuant to SFAS No. 128, “Earnings Per Share” (SFAS128).  Under the provisions of SFAS 128,basic net loss per share is computed by dividing the net income (loss)available to common stockholders for the period by the weighted average numberof common shares outstanding during the period.  Diluted net income (loss) per share is computed by dividing thenet income (loss) for the period by the weighted average number of common andcommon equivalent shares outstanding during the period.  Common equivalent shares, composed ofunvested restricted common shares and incremental common shares issuable uponthe exercise of stock options, are included in diluted net income (loss) pershare to the extent these shares are dilutive.

 

The followingtable sets forth the computation of basic and diluted net loss per share asfollows (in thousands, except per share amounts):

 
|                                                                              |   | **Years  Ended December 31,** |   |
|-----------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                              |   | **2003**                      |   | **2002** | ** ** | **2001** | ** ** |
| Numerator:                                                                        |   |                          |   |   |   |   |   |
| Net loss                                                                          |   | $                             | (3,497 | ) | $ | (11,627 | ) | $ | (14,320 | ) |
|                                                                              |   |                          |   |   |   |   |   |
| Denominator:                                                                      |   |                          |   |   |   |   |   |
| Weighted average shares outstanding and  denominator for basic earnings per share |   | 23,752                        |   | 23,512 |   | 23,729 |   |
|                                                                              |   |                          |   |   |   |   |   |
| Effect of dilutive securitites:                                                   |   |                          |   |   |   |   |   |
| Employee stock options                                                            |   | —                        |   | — |   | — |   |
|                                                                              |   |                          |   |   |   |   |   |
| Denominator for diluted earnings per share                                        |   | 23,752                        |   | 23,512 |   | 23,729 |   |
|                                                                              |   |                          |   |   |   |   |   |
| Net loss per share:                                                               |   |                          |   |   |   |   |   |
| Basic and diluted                                                                 |   | $                             | (0.15  | ) | $ | (0.49 | ) | $ | (0.60 | ) |

 

Dilutive common stockequivalents would include the dilutive effects of common stock options,warrants for common stock equivalents, and restricted stock that has not yetfully vested.

 

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Potentially dilutive commonstock equivalents totaled approximately 3,530,000, 3,818,000, and 2,843,000shares for the years ended December 31, 2003, 2002, and 2001 respectively.  Potentially dilutive common stockequivalents were excluded from the 2003, 2002 and 2001 diluted earnings pershare denominator because of their anti-dilutive effect.

 

# **Comprehensive Income(Loss)**

 

# **The Company has adopted theprovisions of SFAS No. 130, “Reporting Comprehensive Income” (SFAS 130).  SFAS 130 establishes standards for reportingcomprehensive income (loss) and its components in financial statements.  Comprehensive income (loss), as defined,includes all changes in equity (net assets) during a period from non-ownersources. Net income (loss) and other comprehensive income (loss), includingforeign currency translation adjustments, and unrealized gains and losses oninvestments shall be reported, net of their related tax effect, to arrive at comprehensiveloss.  The Company’s net income (loss)and its total comprehensive income (loss) are included in the statement ofstockholders’ equity.**

 

# **Stock Based Compensation**

 

As permittedby SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), theCompany elected to follow Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (APB 25) and related interpretationsin accounting for its employee stock option plans.  Under APB 25, no compensation expense is recognized at the timeof option grant if the exercise price of the Company’s employee stock optionequals the fair market value of the underlying common stock on the date ofgrant.

 

SFAS 123 requires proforma information regarding net income and earnings per share as if the Companyhad accounted for its employee stock options and warrants granted subsequent toDecember 31, 1994 and shares of common stock purchased by employees inconnection with the ESPP (“equity awards”) under the fair value method.  The fair value of these equity awards wasestimated at the date of grant using a Black-Scholes option pricing model withthe following weighted average assumptions for 2003, 2002, and 2001,respectively: risk-free interest rates of 3.8%, 3.3%, and 4.8%; expected volatilityof 86%, 91%, and 94%; expected option life of 6.3, 6.5, and 6.8 years fromvesting; and an expected dividend yield of 0.0%.

 

For purposesof pro forma disclosures, the estimated fair value of the equity awards wouldbe amortized to expense over the options’ vesting period.  The Company’s pro forma net loss and netloss per share information would be as follows (in thousands, except per shareamounts):

 
|                                          |   | **Years  Ended December 31,** |
|-----------------------------------------------|--------|-------------------------------|
|                                          |   | **2003**                      |   | **2002** |   | **2001** |   |
| Net loss:                                     |   |                          |   |   |   |   |   |
| As reported                                   |   | $                             | (3,497 | ) | $ | (11,627 | ) | $ | (14,320 | ) |
| Pro forma                                     |   | (15,168                       | ) | (24,487 | ) | (31,899 | ) |
| Basic and diluted net loss per common  share: |   |                          |   |   |   |   |   |
| As reported                                   |   | $                             | (0.15 | ) | $ | (0.49 | ) | $ | (0.60 | ) |
| Pro forma                                     |   | (0.64                         | ) | (1.04 | ) | (1.34 | ) |

 

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# **Effectof New Accounting Standards**

 

In May 2003, theFinancial Accounting Standards Board (FASB) issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity” (SFAS 150).  This statementclarifies the definition of a liability, as currently defined under FASBConcepts Statement No. 6 “Elements of Financial Statements”, as well as otheritems.  The statement requires thatfinancial instruments that embody an obligation of an issuer be classified as aliability.  Furthermore, the standardprovides guidance for the initial and subsequent measurement as well asdisclosure requirements of these financial instruments.  This statement is effective for financialinstruments entered into after May 31, 2003. The adoption of this statement has not had a material impact on ourresults of operations or financial condition.

 

InApril 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities.”  This statement amends and clarifies the financial accounting andreporting requirements, as were originally established in FASB Statement No.133, for derivative instruments and hedging activities.  FASB Statement No. 149 provides greaterclarification of the characteristics of a derivative instrument so thatcontracts with similar characteristics will be accounted for consistently.  This statement is effective for contractsentered into or modified after June 30, 2003, as well as for hedgingrelationships designated after June 30, 2003, excluding certainimplementation issues that have been effective prior to this date under FASBStatement No. 133.  The adoption of thisstatement has not had a material impact on our results of operations orfinancial condition.

 

**3.Business Combinations and Divestitures**

 

**Acquisitionof Software Businesses**

 

On June 29, 2001, the Company acquired Synomics Limited(“Synomics”), a UK-based company providing middleware technology and consultingexpertise.  The Company paid $4.0million for Synomics, consisting of $3.5 million cash and $0.5 million intransaction costs.  The purchase pricewas allocated as follows: $0.3 million to net tangible assets (including cashacquired of $0.1 million) and $3.7 million to goodwill and other intangibles.

 

The operatingresults of Synomics have been included in the Company’s results of operationssince the acquisition date.  Assumingthat the acquisition had occurred on January 1, 2001, the pro formaconsolidated results of operations in 2001 would have been as follows (inthousands, except per share amounts):

 

| Total revenue       |   | $      | 122,682 |   |
|---------------------|--------|--------|---------|--------|
| Net loss            |   | $      | (18,614 | )      |
|                |   |   |    |
| Net loss per share: |   |   |    |
| Basic and diluted   |   | $      | (0.78   | )      |

 

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**DiscontinuedAcquisitions**

 

In March 2001 and January 2002, the Companydecided to discontinue pursuits of two separate potential acquisitions.  Accumulated costs related to these potentialacquisitions were expensed during the first and fourth quarters of 2001,respectively, in the total amount of $3.0 million.

 

**Proposed Spin-off ofDrug Discovery Business**

 

InDecember 2003, the Company announced its intention to spin-off its whollyowned drug discovery segment, Pharmacopeia Drug Discovery, Inc., to itsshareholders.  Costs related to this divestiturewere expensed as incurred.  The Companyexpects to complete the spin-off during the first calendar quarter of 2004.

 

**4.**  Composition of Certain Financial Statement Captions

 

Property andequipment consist of the following (in thousands):

 
|                                      |   | **December 31,** |   |
|-------------------------------------------|--------|-----------------------|--------|
|                                      |   | **2003**              |   | **2002** |   |
| Laboratory equipment                      |   | $                     | 12,830 |   | $ | 12,149 |   |
| Furniture, fixtures and equipment         |   | 5,907                 |   | 5,639 |   |
| Computers and software                    |   | 21,088                |   | 18,151 |   |
| Leasehold improvements                    |   | 8,607                 |   | 8,117 |   |
| Other                                     |   | 3,947                 |   | 979 |   |
|                                      |   | 52,379                |   | 45,035 |   |
| Accumulated depreciation and amortization |   | (36,981               | )      | (30,878 | ) |
| Property and equipment, net               |   | $                     | 15,398 |   | $ | 14,157 |   |

 

Accruedliabilities consist of the following (in thousands):

 
|                                   |   | **December 31,** |   |
|----------------------------------------|--------|-----------------------|--------|
|                                   |   | **2003**              |   | **2002** |   |
| Payroll and other compensation         |   | $                     | 9,606  |   | $ | 8,144 |   |
| Royalties                              |   | 1,640                 |   | 1,489 |   |
| Merger related and restructuring costs |   | 1,312                 |   | 2,626 |   |
| Taxes                                  |   | 4,992                 |   | 4,994 |   |
| Other                                  |   | 2,212                 |   | 3,164 |   |
|                                   |   | $                     | 19,762 |   | $ | 20,417 |   |

 

**5.  IncomeTaxes**

 

The Company accounts for income taxes using the liability method.  Under the liability method, deferred incometaxes are recognized for the tax consequences of “temporary differences” byapplying enacted statutory tax rates applicable to future years to differencesbetween the financial carrying amounts and the tax basis of existing assets andliabilities.

 

75

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Significantcomponents of the Company’s deferred tax assets and liabilities are as follows(in thousands):

 
|                                 |   | **December 31,** |   |
|--------------------------------------|--------|-----------------------|--------|
|                                 |   | **2003**              |   | **2002** |   |
| Deferred tax assets:                 |   |                  |   |   |   |
| Net operating loss carryforwards     |   | $                     | 37,004 |   | $ | 32,117 |   |
| Unused tax credits                   |   | 914                   |   | 914 |   |
| Fixed assets                         |   | —                |   | 840 |   |
| Accruals and reserves                |   | 11,464                |   | 13,067 |   |
| Gross deferred tax asset             |   | 49,382                |   | 46,938 |   |
|                                 |   |                  |   |   |   |
| Deferred tax liabilities:            |   |                  |   |   |   |
| Fixed assets                         |   | 280                   |   | — |   |
| Intangibles                          |   | 6,713                 |   | 5,010 |   |
|                                 |   |                  |   |   |   |
| Net asset before valuation allowance |   | 42,389                |   | 41,928 |   |
| Valuation allowance                  |   | (42,389               | )      | (41,928 | ) |
|                                 |   |                  |   |   |   |
| Net deferred tax asset               |   | $                     | — |   | $ | — |   |

 

As ofDecember 31, 2003, approximately $2.6 million of the valuation allowancefor deferred tax assets relates to pre-acquisition tax deductions, which to theextent recognized, will result in a reduction of goodwill.  As of December 31, 2003 and 2002, $0.3million and $1.0 million of pre-acquisition tax deductions had been used, andaccordingly, a corresponding amount of valuation allowance reduced goodwill.

 

Pretax (loss) from the Company’s domestic operations totaledapproximately ($2.9) million, $(15.3) million, and $(12.8) million in 2003,2002, and 2001, respectively.  Pretaxincome (loss) from the Company’s foreign operations totaled approximately $0.7million, ($4.3) million, and ($0.7) million in 2003, 2002, and 2001,respectively.

 

The provision for income taxes consists of the following (inthousands):

 
|     |   | **Years Ended  December 31,** |   |
|----------|--------|------------------------------------|--------|
|     |   | **2003**                           |   | **2002** |   | **2001** |   |
| Current: |   |                               |   |   |   |   |   |
| Federal  |   | $                                  | — |   | $ | — |   | $ | — |   |
| State    |   | 139                                |   | 53 |   | 183 |   |
| Foreign  |   | 1,121                              |   | 611 |   | 705 |   |
| Total    |   | $                                  | 1,260  |   | $ | 664 |   | $ | 888 |   |

 

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The followingreconciles income taxes computed at the US statutory federal tax rate to theprovision for income taxes from continuing operations (in thousands):

 
|                                                   |   | **Years  Ended December 31,** |   |
|--------------------------------------------------------|--------|------------------------------------|--------|
|                                                   |   | **2003**                           |   | **2002** |   | **2001** |   |
| Tax expense (benefit) at U.S. statutory  rate          |   | $                                  | (761   | ) | $ | (3,727 | ) | $ | (4,710 | ) |
| State income taxes, net of Federal income  tax benefit |   | (175                               | )      | (670 | ) | (766 | ) |
| Nondeductible merger costs                             |   | —                             |   | — |   | 3,056 |   |
| Foreign taxes                                          |   | 600                                |   | 391 |   | 1,852 |   |
| Change in valuation allowance and other                |   | 1,596                              |   | 4,670 |   | 1,456 |   |
| Provision for income taxes                             |   | $                                  | 1,260  |   | $ | 664 |   | $ | 888 |   |

 

As of December 31, 2003, the Company has US federal net operatingloss carryforwards of approximately $92.5 million, and credit carryforwards ofapproximately $1.0 million.  The USfederal net operating losses and credits begin to expire in 2008 through 2023,if not fully utilized.  Realization isdependent on generating sufficient taxable income prior to expiration of theloss and credit carryforwards. Approximately $43.4 million of the net operating losses relate to stockoption deductions which will result in an increase to paid-in capital and adecrease in income taxes payable at such time that the tax benefit is realized.

 

A portion of theCompany’s US federal net operating loss carryforwards that relate to the acquiredcompanies may be subject to annual usage limitations under Section 382 ofthe Internal Revenue Code.

 

**6.  Stock Plans**

 

The Company has four Stock Plans; the 1994 Incentive Stock Plan, the 1995 Employee Stock Purchase Plan,the 1995 Director’s Option Plan, and the 2000 Stock Option Plan.

 

In accordance with the 1994 Incentive Stock Plan (the “Plan”), theCompany may grant both incentive or non-qualified stock options or stockpurchase rights to purchase up to 5,700,000 shares of common stock to officers,directors, employees, sales representatives, and consultants of theCompany.  The term of each incentive andnon-qualified stock option and stock purchase right is generally ten years.  Vesting generally occurs over a period ofnot greater than five years.  AtDecember 31, 2003, there were 191,778 shares available for future grants under the 1994 Incentive Stock Plan.

 

In 1995, the Company adopted the 1995 Employee Stock Purchase Plan(“ESPP”) under Section 423 of the Internal Revenue Code.  The Company reserved 750,000 shares ofcommon stock for offering under the ESPP. In 2003, 112,439 shares of common stock were purchased at prices rangingfrom $8.33 to $8.42 per share.  AtDecember 31, 2003, there were 200,879 shares available for future purchaseunder the ESPP.

 

In accordance with the 1995 Director’s Option Plan, the Company maygrant options to purchase up to 300,000 shares of common stock to non-employeemembers of the Board.  The exerciseprice of the stock options shall be equal to the fair market value per share ofcommon stock on the option grant date. Each option has a term of ten years from the option grant date and shallbecome exercisable in a series of three equal and successive annualinstallments.  In 2003,

 

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35,000 options were granted at an exercise price of $9.21.  At December 31, 2003, there were 58,333shares available for future grants under the Director’s Option Plan.

 

In accordance with the 2000 Stock Option Plan, the Company may grantnon-qualified stock options or stock purchase rights to purchase up to1,500,000 shares of common stock to employees and consultants of theCompany.  The term of each non-qualifiedstock option and stock purchase right is ten years.  In 2003, 175,750 options were granted at exercise prices rangingfrom $6.12 to $14.79.  Vesting generallyoccurs over a period of not greater than five years.  At December 31, 2003, there were 319,627 shares availablefor future grants under the 2000 Stock Option Plan.

 

A summary of the Company’s stock option activity and weighted averageexercise prices follows (in thousands, except per share amounts):

 
|                                                            |   | **2003**                   |   | **2002**                              |   | **2001**                    |   |
|-----------------------------------------------------------------|--------|----------------------------|--------|---------------------------------------|--------|-----------------------------|--------|
|                                                            |   | **Common  Stock  Options** |   | **Weighted  Average  Exercise Price** |   | **Common  Stock   Options** |   | **Weighted  Average  Exercise Price** |   | **Common  Stock   Options** |   | **Weighted  Average  Exercise Price** |   |
| Outstanding at beginning of year:                               |   | 4,940                      |   | $                                     | 17.49  |                        | 4,878  |   | $ | 21.46 |   | 3,383 |   | $ | 23.33 |   |
| Granted                                                         |   | 1,053                      |   | 7.07                                  |   | 1,348                       |   | 9.99 |   | 2,282 |   | 15.48 |   |
| Exercised                                                       |   | (107                       | )      | 7.27                                  |   | (98                         | )      | 8.02 |   | (384 | ) | 7.03 |   |
| Expired                                                         |   | (408                       | )      | 19.69                                 |   | (1,188                      | )      | 26.09 |   | (403 | ) | 23.02 |   |
| Outstanding at end of year:                                     |   | 5,478                      |   | 15.53                                 |   | 4,940                       |   | 17.49 |   | 4,878 |   | 21.46 |   |
|                                                            |   |                       |   |                                  |   |                        |   |   |   |   |   |   |   |
| Exercisable at end of year                                      |   | 2,988                      |   |                                  |   | 2,299                       |   |   |   | 1,679 |   |   |   |
|                                                            |   |                       |   |                                  |   |                        |   |   |   |   |   |   |   |
| Weighted average fair value of options  granted during the year |   |                       |   | $                                     | 5.30   |                        |   |   | $ | 7.80 |   |   |   | $ | 18.75 |   |

 

A summary of stock options outstanding and exercisable as ofDecember 31, 2003, follows (in thousands, except per share amounts):

 
|                         |   |                     |   | **Options  Outstanding**                        |   | **Options  Exercisable**              |   |
|------------------------------|--------|--------------------------|--------|-------------------------------------------------|--------|---------------------------------------|--------|
| **Range of Exercise Prices** |   | **Options  Outstanding** |   | **Weighted  Average  Remaining Life   (years)** |   | **Weighted  Average  Exercise Price** |   | **Number  Excercisable** |   | **Weighted  Average   Exercise Price** |   |
| $ 0.38 - $10.00              |   | 2,226                    |   | 7.6                                             |   | $                                     | 7.88   |   | 704 |   | $ | 8.41 |   |
| $ 10.01 - $15.00             |   | 1,664                    |   | 6.8                                             |   | 11.79                                 |   | 968 |   | 11.78 |   |
| $ 15.01 - $20.00             |   | 623                      |   | 5.3                                             |   | 17.89                                 |   | 490 |   | 17.83 |   |
| $ 20.01 - $40.00             |   | 319                      |   | 5.7                                             |   | 25.81                                 |   | 263 |   | 25.87 |   |
| $ 40.01 - $85.00             |   | 645                      |   | 6.0                                             |   | 44.19                                 |   | 563 |   | 44.26 |   |
| $ 0.38 - $85.00              |   | 5,478                    |   | 6.8                                             |   | $                                     | 15.53  |   | 2,988 |   | $ | 19.34 |   |

 

**7.  Deferred Compensation and Retirement SavingsPlans**

 

The Company has an employee savings and retirement plan (the “401(k)Plan”) and a deferred compensation plan for certain senior employees.

 

The 401(k) Plan is intended to be a tax-qualified plan coveringsubstantially all employees.  Under theterms of the 401(k) Plan, employees may elect to contribute up to 20% of theircompensation, or the statutory prescribed limit, if less.  As part of this plan employees may elect toinvest in the stock of the Company.  TheCompany may, at its discretion, match employee contributions up to a maximum of3% of the employee’s compensation. Employer contributions, made up entirely of Company common stock,totaled $1.0 million, $1.1 million, and $1.4 million for the years endedDecember 31, 2003, 2002, and 2001.

 

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The Deferred Compensation plan was established in 2000 and permitsselected employees to defer up to 100% of their compensation.  The Company may also be required to makecontributions based on stock price and these contributions vest over threeyears from the date of payment into the plan. Contributions to this plan are held in a trust account and are investedat the participant’s discretion in marketable debt and equity securities.  These investments are reflected in otherassets on the balance sheet and total $1.3 million and $0.7 million as ofDecember 31, 2003 and 2002, respectively. In accordance with the terms of the plan, the Company incurred aliability as of December 31, 2003 in the amount of $0.5 million.  Since the contribution is subject tovesting, this amount has been recorded as unearned compensation and will berecognized as expense over the vesting term.

 

**8.  Segment Information**

 

The Company operates in two industry segments.  The Company’s Software Segment, AccelrysInc. (“Accelrys”), provides molecular modeling, simulation, informatics anddecision support for the life sciences and materials research markets.  The Company’s Drug Discovery Segment,Pharmacopeia Drug Discovery, Inc. (“PDD”), provides drug discovery services topharmaceutical and biotechnology companies based on proprietary combinatorialchemistry, high-throughput screening and Accelrys technologies.

 

Summarized financial information concerning the industry segments andgeographic revenues follows (in thousands):

 
|                                      |   | **Years  Ended December 31,** |    |
|-------------------------------------------|--------|------------------------------------|---------|
|                                      |   | **2003**                           |    | **2002** |   | **2001** |   |
|                                      |   | **Accelrys**                       |    | **PDD** |   | **Total** |   | **Accelrys** |   | **PDD** |   | **Total** |   | **Accelrys** |   | **PDD** |   | **Total** |   |
| Revenues:                                 |   |                               |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Software licenses services and other      |   | $                                  | 85,561  |   | $ | — |   | $ | 85,561 |   | $ | 95,104 |   | $ | — |   | $ | 95,104 |   | $ | 95,107 |   | $ | — |   | $ | 95,107 |   |
| Drug discovery services                   |   | —                             |    | 29,503 |   | 29,503 |   | — |   | 29,304 |   | 29,304 |   | — |   | 27,196 |   | 27,196 |   |
| Total revenues                            |   | $                                  | 85,561  |   | $ | 29,503 |   | $ | 115,064 |   | $ | 95,104 |   | $ | 29,304 |   | $ | 124,408 |   | $ | 95,107 |   | $ | 27,196 |   | $ | 122,303 |   |
|                                      |   |                               |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization             |   | $                                  | 9,859   |   | $ | 1,894 |   | $ | 11,753 |   | $ | 11,844 |   | $ | 2,213 |   | $ | 14,057 |   | $ | 18,899 |   | $ | 2,897 |   | $ | 21,796 |   |
| Operating loss from continuing operations |   | $                                  | (3,108  | ) | $ | (2,608 | ) | $ | (5,716 | ) | $ | (12,750 | ) | $ | (2,128 | ) | $ | (14,878 | ) | $ | (13,351 | ) | $ | (6,599 | ) | $ | (19,950 | ) |
| Capital expenditures                      |   | $                                  | 2,831   |   | $ | 4,182 |   | $ | 7,013 |   | $ | 7,629 |   | $ | 869 |   | $ | 8,498 |   | $ | 3,561 |   | $ | 1,303 |   | $ | 4,864 |   |
| Total assets (1)                          |   | $                                  | 114,010 |   | $ | 125,657 |   | $ | 239,667 |   | $ | 104,143 |   | $ | 135,962 |   | $ | 240,105 |   | $ | 119,538 |   | $ | 150,860 |   | $ | 270,398 |   |
|                                      |   |                               |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues (2)                              |   |                               |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.                                      |   |                               |    |   |   | $ | 73,638 |   |   |   |   |   | $ | 80,473 |   |   |   |   |   | $ | 76,513 |   |
| Europe                                    |   |                               |    |   |   | 24,348 |   |   |   |   |   | 28,314 |   |   |   |   |   | 30,310 |   |
| Asia-Pacific                              |   |                               |    |   |   | 17,078 |   |   |   |   |   | 15,621 |   |   |   |   |   | 15,480 |   |
| Total                                     |   |                               |    |   |   | $ | 115,064 |   |   |   |   |   | $ | 124,408 |   |   |   |   |   | $ | 122,303 |   |

 

----

*(1)**       Includes cash and cash equivalents of $20,252 and $7,257 at Software andDrug Discovery, respectively, in 2003; cash and cash equivalents of $13,058 and$15,178 at Software and Drug Discovery, respectively, in 2002; and $14,614 and$54,277 at Software and Drug Discovery, respectively, in 2001.*

*(2)**       Revenue in the US category includes export revenue from Drug Discoveryand Software.  Export revenues from theUS to Europe totaled $17,717, $16,336 and, $15,081 in 2003, 2002, and 2001,respectively; and export revenues to Asia-Pacific totaled $2,362, $5,207,and  $2,371 in 2003, 2002, and 2001,respectively.*

 

**9.  Commitments and Contingencies**

 

### **OperatingLeases**

 

The Company has several operating leases or sub-leases for office andlaboratory space, which expire at various dates through 2022.  The leases for the Company’s primaryfacilities in Cambridge, UK, CA and NJ, USA, provide generally for scheduledrent increases, options to extend the leases with certain changes to the termsof the lease agreement, and refurbishment

 

79

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allowances.  Rent expense underoperating leases for 2003, 2002, and 2001 was approximately $7.4 million, $8.1million, and $6.6 million, respectively.

 

Future minimum lease commitments at December 31, 2003 are asfollows (in thousands):

 
|       |   | **Total** |   |
|------------|--------|-----------|--------|
| 2004       |   | $         | 7,812  |   |
| 2005       |   | 7,897     |   |
| 2006       |   | 6,566     |   |
| 2007       |   | 3,554     |   |
| 2008       |   | 3,659     |   |
| Thereafter |   | 33,652    |   |
|       |   | $         | 63,140 |   |

 

**Royalties**

 

The Company pays royalties to approximately thirty-six partners forworldwide licenses to enhance and market certain software developed atuniversities, corporations, and other institutions.  A majority of the royalty agreements are long term or perpetualin nature and the royalty obligations thereunder are generally based on apercentage of revenues derived from certain software licenses plus associatedrevenues from post-contract support and maintenance.  The royalty agreements require quarterly payments and generallydo not limit the maximum royalty amount under the agreement.  Certain agreements contain provisions forquarterly and annual minimum royalty payments that total approximately $0.5million on an annual basis.  In 2003,2002, and 2001, the Company incurred related royalty expense of $2.8 million,$3.2 million, and $3.0 million, respectively.

 

Additionally, the Company has a license agreement that grants anexclusive, worldwide license to certain technology for making and usingcombinatorial chemical libraries.  Thisagreement requires PDD to pay annual license fees and certain royalties. In2003, 2002, and 2001 the Company paid related royalties and license fees of$0.6 million, $0.3 million, and $0.2 million, respectively.

 

**Litigation**

 

In the ordinary course of business, the Company is subject to claimsand, from time to time, is named in various legal proceedings. In the opinionof management, the amount of ultimate liability, if any, with respect to anypending actions will not materially affect the financial position or results ofoperations of the Company.

 

 

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**10.  Selected Quarterly Financial Information(unaudited)**

 

The following is a summary of the quarterly results of operations forthe years ended December 31, 2003 and 2002 (in thousands, except per shareamounts):

 
|              |   | **2003**          |   |
|-------------------|--------|-------------------|--------|
|              |   | **March 31** |   | **June 30** |   | **Sept. 30** |   | **Dec. 31** |   |
|              |   |              |   |   |   |   |   |   |   |
| Revenues          |   | $                 | 24,740 |   | $ | 26,104 |   | $ | 25,097 |   | $ | 39,123 |   |
| Cost of revenues  |   | $                 | 10,945 |   | $ | 10,410 |   | $ | 10,691 |   | $ | 9,956 |   |
| Net loss          |   | $                 | (5,453 | ) | $ | (3,764 | ) | $ | (2,134 | ) | $ | 7,854 |   |
|              |   |              |   |   |   |   |   |   |   |
| Per Common Share: |   |              |   |   |   |   |   |   |   |
| Net loss          |   |              |   |   |   |   |   |   |   |
| - Basic           |   | $                 | (0.23  | ) | $ | (0.16 | ) | $ | (0.09 | ) | $ | 0.33 |   |
| - Diluted         |   | $                 | (0.23  | ) | $ | (0.16 | ) | $ | (0.09 | ) | $ | 0.32 |   |

 
|              |   | **2002**          |   |
|-------------------|--------|-------------------|--------|
|              |   | **March 31** |   | **June 30** |   | **Sept. 30** |   | **Dec. 31** |   |
|              |   |              |   |   |   |   |   |   |   |
| Revenues          |   | $                 | 26,840 |   | $ | 29,300 |   | $ | 30,908 |   | $ | 37,360 |   |
| Cost of revenues  |   | $                 | 9,617  |   | $ | 10,624 |   | $ | 10,296 |   | $ | 10,118 |   |
| Net loss          |   | $                 | (6,003 | ) | $ | (5,080 | ) | $ | (6,330 | ) | $ | 5,786 |   |
|              |   |              |   |   |   |   |   |   |   |
| Per Common Share: |   |              |   |   |   |   |   |   |   |
| Net loss          |   |              |   |   |   |   |   |   |   |
| - Basic           |   | $                 | (0.25  | ) | $ | (0.22 | ) | $ | (0.27 | ) | $ | 0.25 |   |
| - Diluted         |   | $                 | (0.25  | ) | $ | (0.22 | ) | $ | (0.27 | ) | $ | 0.24 |   |

 

**11.  Goodwill and Other Intangible Assets –Adoption of Statements 141 and 142**

 

As required by SFAS No. 141, “Business Combinations” (SFAS 141), duringthe quarter ended March 31, 2002, the Company reclassified $1.8 million ofintangible assets with indefinite lives to goodwill.  The related amortization expense in the prior period, which hadbeen previously classified as sales, general and administrative expense, hasbeen reclassified to amortization of goodwill. All such reclassified intangibles and related amortization areassociated with Accelrys.

 

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”(SFAS 142), goodwill and intangible assets with indefinite lives are no longeramortized but are reviewed annually (or more frequently if impairmentindicators arise) for impairment.  TheCompany adopted SFAS 142 during the quarter ended March 31, 2002,completed its annual intangible asset impairment test during the quarter endedDecember 31, 2003, and concluded that the carrying value of goodwill wasnot impaired.  Goodwill was reduced by$0.3 million in 2003, and $1.0 million in 2002 since certain pre-acquisitionnet operating loss carryforwards were utilized.

 

The Company’s other intangibles are amortized on a straight-linebasis.  Intangible asset amortization inthe three years ended December 31, 2003 was $0.1 million, $0.9 million,and $0.9 million.  These intangibleswere fully amortized as of December 31, 2003.

 

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**12.  Restructuring**

 

During the third quarter of 2002, the Company announced that it wasundertaking various actions to restructure its operations to improve itsoverall financial performance.  Therestructuring effort included a reduction in force of 71 employees, of whichall had been terminated as of December 31, 2003, and the closure ofcertain facilities. As a result of this plan, restructuring related charges ofapproximately $4.3 million were recognized as operating expense in the thirdquarter of 2002.

 

The following table summarizes the balance of the accrued restructuringreserve, which relates entirely to a lease obligation and is adequate to covercosts through the expiration of the lease, and has been included in accruedliabilities at December 31, 2003 (in thousands):

 
|                              |   | **Severance  Cost for  Involuntary Employee  Terminations** |   | **Costs to  Exit  Lease  Obligations** |   | **Total** |   |
|-----------------------------------|--------|-------------------------------------------------------------|--------|----------------------------------------|--------|-----------|--------|
| Balance at August 6, 2002    |   | $                                                           | 2,367  |                                   | $      | 1,973     |   | $ | 4,340 |   |
| Ultization of Reserves:           |   |                                                        |   |                                   |   |      |   |
| Cash                              |   | (2,272                                                      | )      | (523                                   | )      | (2,795    | )      |
| Reserve reductions                |   | (95                                                         | )      | (289                                   | )      | (384      | )      |
| Balance at December 31, 2003 |   | $                                                           | — |                                   | $      | 1,161     |   | 1,161 |   |
|                                   |        |                                                             |        |                                        |        |           |        |  |  |  |

 

**13.****       RelatedParty Transactions**

 

A stockholder and member of the Company’s Board of Directors is also apartner in the principal outside law firm that provides legal services to theCompany.  For the years ended December 31,2003, 2002, and 2001 the Company expended a total of $0.5 million, $0.8million, and $2.2 million in fees related to services provided by such firm.

 

The Company’s Chairman, President, and CEO, who is a stockholder of theCompany, is also the Chairman of the Board of Directors of a customer.  For the years ended December 31, 2003,2002, and 2001, the Company received $0.7 million, $0.2 million, and $0.2million in payment for services and products provided to the customer.

 

**14.  Commitments and Guarantees**

 

*Guaranteesof Indebtedness of Others. *FASBInterpretation No. 45 (FIN 45) elaborateson previously existing disclosure requirements for most guarantees, includingloan guarantees such as standby letters of credit. It also clarifies that atthe time a company issues a guarantee, the company must recognize an initialliability for the fair value, or market value, of the obligations it assumesunder the guarantee and must disclose that information in its interim andannual financial statements. The provisions related to recognizing a liabilityat inception of the guarantee for the fair value of the guarantor’s obligationsdo not apply to product warranties, indemnifications or to guarantees accountedfor as derivatives. The initial recognition and initial measurement provisionsapply on a prospective basis to guarantees issued or modified afterDecember 31, 2002.

 

Weprovide indemnifications of varying scope and size to certain customers againstclaims of intellectual property infringement made by third parties arising fromthe use of our products. We evaluate estimated losses for such indemnificationsunder SFAS 5, Accounting for Contingencies,

 

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as interpreted by FIN 45. We consider such factors as the degree ofprobability of an unfavorable outcome and the ability to make a reasonableestimate of the amount of loss. To date, we have not encountered material costsas a result of such obligations and have not accrued any liabilities related tosuch indemnifications in our financial statements.

 

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**ITEM 9. CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

 

# **ITEM 9A.  CONTROLS AND PROCEDURES**

 

The Company’s management, with the participation of the Company’s ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof the Company’s disclosure controls and procedures as of December 31,2003.  Based on that evaluation, theCompany’s Chief Executive Officer and Chief Financial Officer concluded thatthe Company’s disclosure controls and procedures were effective as ofDecember 31, 2003.  There were nomaterial changes in the Company’s internal control over financial reportingduring the fourth quarter of 2003.

 

**PART III**

** **

**ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

The information required by this Item concerning the Company’sdirectors and executive officers, other than as set forth in Item 4A, isincorporated by reference from the Company’s Proxy Statement (the “ProxyStatement”) related to the Annual Stockholders Meeting to be held on May 5,2004.

 

**ITEM 11. EXECUTIVE COMPENSATION**

 

The information required by this Item is incorporated by reference fromthe section entitled “Executive Compensation” in the Proxy Statement.

 

**ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The information required by this Item is incorporated by reference fromthe section entitled “Stock Ownership of Principal Stockholders andManagement” in the Proxy Statement.

 

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information required by this item is incorporated by reference fromthe section entitled “Certain Relationships and Related Transactions” inthe Proxy Statement.

 

**ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

The information required by this item is incorporated by reference fromthe section entitled “Audit Committee Report and Payment of Fees toAuditors—Auditor Fees” in the Proxy Statement.

 

84

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**PART IV**

 

**ITEM 15****.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES ANDREPORTS ON FORM****8-K**

 

(a)(1)  Financial Statements

 

The following Consolidated Financial Statements are included:

 
| Report  of Ernst & Young LLP, Independent Auditors                                                                 |
|------------------------------------------------------------------------------------------------------------------------|
| Consolidated Balance Sheets as of December 31, 2003 and 2002                                                      |
| Consolidated Statements of Operations for  the years ended December 31, 2003, 2002 and 2001                       |
| Consolidated Statements of Stockholders’  Equity for the years ended   December 31, 2003, 2002 and 2001 |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001                       |
| Notes to Consolidated Financial Statements                                                                             |

 

(a)(2)  Financial StatementSchedules

 

Schedule II – Valuation and Qualifying Accounts (in thousands)

 
|                              |   |                                 |   | **Additions**                       |   |                            |   |           |   |
|-----------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|---------------------------------|--------|----------------|--------|
| **DESCRIPTION**                   |   | **Balance at  Beginning of  Period** |   | **Charged to  Costs and  Expenses** |   | **Charged to  Other  Accounts** |   | **Deductions** |   | **Balance at  the  End of  Period** |   |
|                              |   |                                 |   |                                |   |                            |   |           |   |   |   |
| Allowances for doubtful accounts: |   |                                 |   |                                |   |                            |   |           |   |   |   |
| Year ended December 31, 2001 |   | $                                    | 2,305  |                                | $      | 315                             |   | $              | — |   | $ | 1,706 | (1) | $ | 914 |   |
| Year ended December 31, 2002 |   | $                                    | 914    |                                | $      | 1,270                           |   | $              | — |   | $ | 550 | (1) | $ | 1,634 |   |
| Year ended December 31, 2003 |   | $                                    | 1,634  |                                | $      | 425                             |   | $              | — |   | $ | 1,554 | (1) | $ | 505 |   |

 

----

(1)          represents writeoffs, net of recoveries

 

All other schedules are omitted because they are not applicable, or notrequired, or because the required information is included in the financialstatements or notes thereto.

 

(a)(3)  Exhibits:

 
| 3.1    |   | Restated Certificate of Incorporation of the Registrant (incorporated  by Reference to Exhibit 3.1 to the Company’s Report on Form 10-K for the year  ended December 31, 1996).               |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.3    |   | Bylaws of the Registrant, as amended (incorporated by Reference to  Exhibit 3.3 to the Company’s Report on Form 10-K for the year ended  December 31, 1996).                                  |
| 3.3(a) |   | Amendment to Bylaws of the Registrant dated July 31, 1997 (incorporated  by Reference to Exhibit 3.3(a) to the Company’s Report on Form 10-Q for the  quarter ended September 30, 1997). |
| 3.3(b) |   | Amendment to Bylaws of the Registrant dated January 17, 2002  (incorporated by Reference to Exhibit 3.3(b) to the Company’s Report on Form  10-K for the year ended December 31, 2001).  |

 

85

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| 4.1      |   | Rights Agreement, dated as of September 6, 2002, between  Pharmacopeia, Inc. and American Stock Transfer & Trust Company,  as Rights Agent, which includes as Exhibit A thereto the Certificate of  Designations, Preferences and Rights of Series A Junior Participating  Preferred Stock and Exhibit B thereto the Form of Right Certificate  (incorporated by Reference to Exhibit 4.1 to the Company’s Report on Form 8-K  dated September 4, 2002). |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1#    |   | Amended 1994 Incentive Stock Plan (incorporated by Reference to  Exhibit 10.5 to the Company’s Report on Form 10-K for the year ended  December 31, 1995 (File Number 000-27188)).                                                                                                                                                                                                                                                                                                         |
| 10.1(a)# |   | Amendment No. 1 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(a) to the Company’s Report on Form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.1(b)# |   | Amendment No. 2 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(b) to the Company’s Report on Form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.1(c)# |   | Amendment No. 3 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.5(a) to the Company’s Report on Form 10-Q for the  quarter ended June 30, 1997).                                                                                                                                                                                                                                                                                                                |
| 10.1(d)# |   | Amendment No. 4 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(d) to the Company’s Report on Form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.1(e)# |   | Amendment No. 5 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(e) to the Company’s Report on Form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.1(f)# |   | Amendment No. 6 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(f) to the Company’s Report on Form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.1(g)# |   | Amendment No. 7 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(g) to the Company’s Report on Form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                               |
| 10.1(h)# |   | Amendment No. 8 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.54 to the Company’s Report on Form 10-Q for the  quarter ended June 30, 2000).                                                                                                                                                                                                                                                                                                                  |
| 10.1(i)# |   | Amendment No. 9 to the 1994 Incentive Stock Plan (incorporated by  reference to Exhibit 10.1(i) to the Company’s Report on Form 10-Q for the  quarter ended March 31, 2002).                                                                                                                                                                                                                                                                                                               |
| 10.2#    |   | 1995 Employee Stock Purchase Plan (incorporated by Reference to  Exhibit 10.6 to the Company’s Registration Statement on Form S-1 (Reg. No.  33-98246)).                                                                                                                                                                                                                                                                                                                                        |
| 10.2(a)# |   | Amendment No. 1 to the Employee Stock Purchase Plan (incorporated by  reference to Exhibit 10.2(a) to the Company’s Report on Form 10-Q for the  quarter ended March 31, 2001).                                                                                                                                                                                                                                                                                                            |
| 10.3#    |   | 1995 Director Option Plan (incorporated by reference to Exhibit 10.7  to the Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).                                                                                                                                                                                                                                                                                                                                                 |
| 10.3(a)# |   | Amendment No. 1 to 1995 Director Option Plan (incorporated by  reference to Exhibit 10.3(a) to the Company’s report on form 10-K for the  year ended December 31, 2000).                                                                                                                                                                                                                                                                                                                   |
| 10.3(b)# |   | Amendment No. 2 to the 1995 Director Option Plan (incorporated by  reference to Exhibit 10.3(b) to the Company’s report on Form 10-Q for the  quarter ended March 31, 2001).                                                                                                                                                                                                                                                                                                               |
| 10.4+    |   | Research, License, and Royalty Agreement, dated as of  February 15, 1995, between Pharmacopeia and Berlex Laboratories, Inc.  (incorporated by Reference to Exhibit 10.9 to the Company’s Registration  Statement on Form S-1 (Reg. No. 33-98246)).                                                                                                                                                                                                                                        |
| 10.4(a)+ |   | Amendment No. 1 to Research, License and Royalty Agreement between  the                                                                                                                                                                                                                                                                                                                                                                                                                              |

 

86

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|     |   | Company and Berlex Laboratories, Inc. dated November 27, 1996  (incorporated by Reference to Exhibit 10.9(a) to the Company’s Report on Form  10-Q for the quarter ended June 30, 1997).                                                                                                                |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4(b)+ |   | Amendment No. 2 to Research, License and Royalty Agreement between  the Company and Berlex Laboratories, Inc. dated June 30, 1997  (incorporated by Reference to Exhibit 10.9(b) to the Company’s Report on Form  10-Q for the quarter ended June 30, 1997).                                            |
| 10.4(c)+ |   | Amendment No.3 to Research, License and Royalty Agreement between the  Company and Berlex Laboratories, Inc. dated November 21, 1997  (incorporated by Reference to Exhibit 10.9(c) to the Company’s Report on Form  10-K for the year ended December 31, 1997).                                        |
| 10.4(d)+ |   | Amendment No. 4 to Research, License and Royalty Agreement between  the Company and Berlex Laboratories, Inc. dated July 22, 1998  (incorporated by reference to Exhibit 10.4(d) to the Company’s Report on Form  10-K for the year ended December 31, 2003).                                           |
| 10.4(e)+ |   | Amendment No. 5 to Research, License and Royalty Agreement between  the Company and Berlex Laboratories, Inc. dated January 24, 2003  (incorporated by reference to Exhibit  10.4(e) to the Company’s Report on Form 10-K for the year ended  December 31, 2003).                                  |
| 10.5+    |   | License Agreement, dated as of October 6, 1995, among  Pharmacopeia, the Trustees of Columbia University in the City of New York and  Cold Spring Harbor Laboratory (incorporated by Reference to Exhibit 10.10 to  the Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).                   |
| 10.6+    |   | Collaboration Agreement, dated as of December 22, 1994, between  Pharmacopeia and Schering Corporation and Schering-Plough, Ltd.  (incorporated by Reference to Exhibit  10.11 to the Company’s Registration Statement on Form S-1 (Reg. No.  33-98246)).                                               |
| 10.6(a)+ |   | Amendment No. 2 to Collaboration Agreement and Random Library  Agreement between the Company and Schering Corporation and Schering-Plough,  Ltd. dated as of April 22, 1996 (incorporated by Reference to Exhibit  10.11(b) to the Company’s Report on Form 10-Q for the quarter ended  June 30, 1997). |
| 10.6(b)+ |   | Amendment No. 3 to Collaboration Agreement and Random Library  Agreement between the Company and Schering Corporation and Schering-Plough,  Ltd. dated as of April 21, 1997 (incorporated by Reference to Exhibit  10.11(c) to the Company’s Report on Form 10-Q for the quarter ended  June 30, 1997). |
| 10.7+    |   | Random Library Agreement, dated as of December 22, 1994, between  Pharmacopeia and Schering Corporation and Schering-Plough, Ltd. (incorporated  by Reference to Exhibit 10.12 to the Company’s Registration Statement on Form  S-1 (Reg. No. 33-98246)).                                                    |
| 10.8     |   | Lease Agreement between Pharmacopeia and Eastpark at 8A (incorporated  by Reference to Exhibit 10.13 to the Company’s Registration Statement on Form  S-1 (Reg. No. 33-98246)).                                                                                                                                   |
| 10.8(a)  |   | Amendment dated as of January 22, 1996 to Lease Agreement  between Pharmacopeia and Eastpark at 8A (incorporated by reference to Exhibit  10.13(a) to the Company’s Report on Form 10-K for the year ended  December 31, 1995 (File Number 000-27188)).                                                 |
| 10.8(b)  |   | Third Amendment to Lease Agreement dated March 31, 1996 between  Pharmacopeia and Eastpark at 8A (incorporated by reference to Exhibit  10.13(b) to the Company’s Report on Form 10-Q for the quarter ended  June 30, 1996).                                                                            |
| 10.9#    |   | Employment Agreement dated as of February 26, 2001 between the  Company and Joseph A. Mollica, Ph.D. (incorporated by reference to the  Company’s Report on form 10-K for the year ended December 31, 2000).                                                                                            |
| 10.9(a)# |   | Amendment, effective as of May 1, 2003, to employment agreement  between                                                                                                                                                                                                                                               |

 

87

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|   |   | the Company and Joseph A. Mollica, Ph.D. (incorporated by reference  to exhibit 10.9(a) to the Company’s report on Form 10-Q for the quarter ended  March 31, 2003.)                                                                                                                                                               |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10# |   | Employment Agreement, dated June 3, 1993, between the Company  and John J. Baldwin, Ph.D. (incorporated by Reference to Exhibit 10.20 to the  Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).                                                                                                                   |
| 10.11# |   | Employment Agreement, dated June 20, 1996, between the Company  and Stephen A. Spearman, Ph.D. (incorporated by reference to Exhibit 10.32 to  the Company’s Report on Form 10-Q for the quarter ended September 30,  1996).                                                                                                  |
| 10.12+ |   | Collaboration and License Agreement between Pharmacopeia, Inc. and  Bristol-Myers Squibb Company dated November 26, 1997 (incorporated by  reference to Exhibit 10.34 to the Company’s Report on Form 10-K/A-2 for the  year ended December 31, 1997).                                                                        |
| 10.13+ |   | Collaboration and License Agreement, dated as of October 29,  1998, between Pharmacopeia, Inc. and Schering-Plough Ltd. (incorporated by  reference to Exhibit 10.43 to the Company’s Report on Form 10-K for the year  ended December 31, 1998).                                                                             |
| 10.14+ |   | Collaboration and License Agreement, dated as of October 29, 1998,  between Pharmacopeia, Inc. and Schering Corporation (incorporated by  reference to Exhibit 10.44 to the Company’s Report on Form 10-K for the year  ended December 31, 1998).                                                                             |
| 10.15  |   | Guarantee, dated as of October 29, 1998, between Pharmacopeia,  Inc. and Schering-Plough Corporation (incorporated by reference to Exhibit  10.45 to the Company’s Report on Form 10-K for the year ended  December 31, 1998).                                                                                                |
| 10.16  |   | Lease dated November 12, 1998 between Molecular Simulations Inc.  and San Diego Tech Center, LLC (incorporated by reference to Exhibit 10.47 to  the Company’s Report on Form 10-K for the year ended December 31, 1998).                                                                                                     |
| 10.17# |   | Form of Indemnity Agreement for Directors and Executive Officers  (incorporated by reference to Exhibit 10.48 to the Company’s Report on Form  10-K for the year ended December 31, 1998).                                                                                                                                         |
| 10.18  |   | Lease Agreement, dated May 1, 1999, between Pharmacopeia and South  Brunswick Rental I, LTD (incorporated by reference to Exhibit 10.49 to the  Company’s Report on Form 10-Q for the quarter ended June 30, 1999).                                                                                                                |
| 10.19  |   | Amendment No. 1, effective April 15, 1999, to Collaboration and  License Agreements, dated as of October 29, 1998, between Pharmacopeia,  Inc., Schering-Plough Ltd. And Schering Corporation (incorporated by  reference to Exhibit 10.50 to the Company’s Report on Form 10-K for the year  ended December 31, 1999).  |
| 10.20+ |   | Amendment No. 2, effective October 1, 1999, to Collaboration and  License Agreements, dated as of October 29, 1998, between Pharmacopeia,  Inc., Schering-Plough Ltd. and Schering Corporation (incorporated by  reference to Exhibit 10.51 to the Company’s Report on Form 10-K for the year  ended December 31, 1999). |
| 10.21# |   | Pharmacopeia, Inc. 2000 Stock Option Plan (incorporated by reference  to the Company’s Report on form 10-K for the year ended December 31,  2000).                                                                                                                                                                                 |
| 10.22# |   | Pharmacopeia, Inc. Executive Non-Qualified Deferred Compensation Plan  (incorporated by reference to Exhibit 10.52 to the Company’s Report on Form  10-Q for the quarter ended March 31, 2000).                                                                                                                                    |
| 10.23  |   | Form of Stock Purchase Agreement, dated as of March 8, 2000,  among the company and the investors set forth therein (incorporated by  reference to Exhibit 10.53 to the Company’s Report on Form 10-Q for the  quarter ended March 31, 2000.)                                                                                 |
| 10.24# |   | Consulting Agreement for Founding Members of the Pharmacopeia, Inc.  Scientific Advisory Board, between Pharmacopeia, Inc. and Paul A. Bartlett  (incorporated by reference to the Company’s Report on form 10-K for the year  ended December 31, 2000).                                                                           |

 

88

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| 10.25#    |   | Employment Agreement dated May 1, 2001 between the Company and  Michael R. Stapleton. (incorporated by reference to the Company’s Report on  form 10-Q for the quarter ended September 30, 2001).                                                                                                                                                              |
|-----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25(a)# |   | Separation Agreement and Release of Claims dated September 30,  2002, by and between Pharmacopeia, Inc. and Michael R. Stapleton  (incorporated by reference to Exhibit 10.28 to the Company’s Report on Form  10-K for the year ended December 31, 2003).                                                                                                |
| 10.26     |   | Lease Agreement dated July 29, 2001 among the Masters, Fellows  and Scholars of Trinity College, Cambridge, Accelrys Limited, and Accelrys  Inc. and Trinity College (CJP) Limited (incorporated by reference to the  Company’s Report on form 10-Q for the quarter ended September 30, 2001).                                                            |
| 10.27+    |   | Collaboration and License Agreement dated February 25, 2002  between the Company and N.V. Organon (incorporated by reference to the  Company’s Report on form 10-K for the year ended December 31, 2001).                                                                                                                                                 |
| 10.28#    |   | Employment Agreement dated December 3, 2002 by and between  Pharmacopeia, Inc. and Mark J. Emkjer (incorporated by reference to Exhibit  10.28 to the Company’s Report on Form 10-K for the year ended  December 31, 2003).                                                                                                                               |
| 10.29     |   | Amendment No. 3, effective as of April 17, 2003, to the Collaboration  and License Agreements, dated as of October 29, 1998, by and between  Pharmacopeia, Inc., Schering Corporation and Schering-Plough, Ltd.  (incorporated by reference to Exhibit 10.13(a) to the Company’s Report on  Form 10-Q for the quarterly period ended March 31, 2003) |
| 10.30++   |   | Amendment No. 4, effective as of May 29, 2003, to the Collaboration  and License Agreements, dated as of October 29, 1998, by and between  Pharmacopeia, Inc., Schering Corporation, and Schering-Plough, Ltd.  (incorporated by reference to Exhibit 10.30 to the Company’s Report on Form  10-Q for the quarterly period ended June 30, 2003)           |
| 10.31++   |   | Amendment No. 5, effective as of July 9, 2003, to the  Collaboration and License Agreements, dated as of October 29, 1998, by  and between Pharmacopeia, Inc., Schering Corporation, and Schering-Plough,  Ltd. (incorporated by reference to Exhibit 10.31 to the Company’s Report on  Form 10-Q for the quarterly period ended June 30, 2003)      |
| 10.32++   |   | Collaboration and License Agreement, dated as of July 9, 2003  and effective August 8, 2003, between Pharmacopeia, Inc. and  Schering-Plough Ltd. (incorporated by reference to the Company’s report on  form 10-Q for the quarter ended September 30, 2003)                                                                                         |
| 10.33++   |   | Collaboration and License Agreement, dated as of July 9, 2003  and effective August 8, 2003, between Pharmacopeia, Inc. and Schering  Corporation. (incorporated by reference to the Company’s report on form 10-Q  for the quarter ended September 30, 2003)                                                                                        |
| 10.34     |   | Guarantee, dated July 9, 2003, between Pharmacopeia, Inc. and  Schering-Plough Corporation. (incorporated by reference to the Company’s  report on form 10-Q for the quarter ended September 30, 2003)                                                                                                                                                    |
| 10.35     |   | Lease, dated August 20, 2003, between Pharmacopeia, Inc. and  Eastpark at 8A (Building 1000) (incorporated by reference to the Company’s  report on form 10-Q for the quarter ended September 30, 2003)                                                                                                                                                   |
| 10.36     |   | Lease, dated August 20, 2003, between Pharmacopeia, Inc. and  Eastpark at 8A (Building 3000) (incorporated by reference to the Company’s  report on form 10-Q for the quarter ended September 30, 2003)                                                                                                                                                   |
| 21.1*     |   | Subsidiaries of Pharmacopeia, Inc.                                                                                                                                                                                                                                                                                                                                       |
| 23.1*     |   | Consent of Ernst & Young LLP, Independent Auditors.                                                                                                                                                                                                                                                                                                                  |
| 24.1*     |   | Powers of Attorney (See signature page)                                                                                                                                                                                                                                                                                                                                  |
| 31.1*     |   | Section 302 Certification of the Principal Executive Officer                                                                                                                                                                                                                                                                                                        |
| 31.2*     |   | Section 302 Certification of the Principal Financial Officer                                                                                                                                                                                                                                                                                                        |

 

89

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| 32.1* |   | Section 906 Certification of the Chief Executive Officer |
|-------|--------|---------------------------------------------------------------|
| 32.2* |   | Section 906 Certification of the Chief Financial Officer |

 

----

+                             Confidential treatmentgranted.

++                      Confidential treatment requested.

#                             Represents a managementcontract or compensatory plan or arrangement.

*                             Filed herewith

 

(b) Reports on Form 8-K –

 

(i)                                     On November 6, 2003, the Companyfiled a current report on Form 8-K relating to a press release that was issuedand a conference call that was held regarding the Company’s financial resultsfor the third quarter of 2003.

 

(ii)                                  On December 22, 2003, the Companyfiled a current report on Form 8-K regarding an press release that was issuedannouncing that the Company’s Board of Directors had approved a plan toseparate its drug discovery and software businesses into two independent,publicly traded companies through the spin-off to its shareholders of the drug discoveryunit.

 

(c) Exhibits

 

See Item 15 (a)(3) above.

 

90

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this Report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
|   | PHARMACOPEIA, INC.             |
|--------|--------------------------------|
|   |                           |
|   |                           |
|   | By:                            | /s/ Joseph A. Mollica, Ph.D. |   |
|   |                           | Joseph A. Mollica, Ph.D. |
|   |                           | Chairman of the Board, President and Chief |
|   |                           | Executive Officer |
|   |                           | (Principal Executive Officer and Authorized Signatory) |
|   |                           |
|   | Date:  March 8, 2004 |

 

91

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**POWEROF ATTORNEY**

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signatureappears below constitutes and appoints John J. Hanlon and Joseph A. Mollica,Ph.D., jointly and severally, as his or her attorney-in-fact, each with fullpower of substitution, for him or her, in any and all capacities, to sign eachamendment to this Report on Form 10-K, and to file the same, with exhibitsthereto and other documents in connection therewith, with the Securities andExchange Commission, hereby ratifying and confirming all that each of saidattorneys-in-fact or his or her substitute or substitutes may lawfully do orcause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this Report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated:

 
| **Signatures**                |   | **Title**                                                           |                         | **Date** |
|-------------------------------|--------|---------------------------------------------------------------------|------------------------------|----------|
|                          |   |                                                                |                         |     |
| /s/ Joseph A. Mollica, Ph.D.  |   |                                                                | Chairman of the Board,       |     | March 9, 2004 |
| Joseph A. Mollica, Ph.D.      |   | President and Chief Executive Officer (Principal Executive Officer) |                         |     |
| /s/ John J. Hanlon            |   |                                                                | Executive Vice President and |     | March 9, 2004 |
| John J. Hanlon                |   | Chief Financial Officer  (Principal Financial Officer)              |                         |     |
| /s/ Arthur E. Roke, CPA       |   |                                                                | Vice President, Finance and  |     | March 9, 2004 |
| Arthur E. Roke, CPA           |   | Chief Accounting Officer  (Principal Accounting Officer)            |                         |     |
| /s/ Frank Baldino, Jr., Ph.D. |   |                                                                | Director                     |     | March 9, 2004 |
| Frank Baldino, Jr., Ph. D.    |   |                                                                |                         |     |
|                          |   |                                                                |                         |     |
| /s/ Paul A. Bartlett, Ph.D.   |   |                                                                | Director                     |     | March 9, 2004 |
| Paul A. Bartlett, Ph.D.       |   |                                                                |                         |     |
|                          |   |                                                                |                         |     |
| /s/ Gary E. Costley, Ph.D.    |   |                                                                | Director                     |     | March 9, 2004 |
| Gary E. Costley, Ph.D.        |   |                                                                |                         |     |
|                          |   |                                                                |                         |     |
| /s/ Ricardo B. Levy, Ph.D.    |   |                                                                | Director                     |     | March 9, 2004 |
| Ricardo B. Levy, Ph.D.        |   |                                                                |                         |     |
|                          |   |                                                                |                         |     |
| /s/ James J. Marino, Esq.     |   |                                                                | Director                     |     | March 9, 2004 |
| James J. Marino, Esq.         |   |                                                                |                         |     |
|                          |   |                                                                |                         |     |
| /s/ Kenneth L. Coleman        |   |                                                                | Director                     |     | March 9, 2004 |
| Kenneth L. Coleman            |   |                                                                |                         |     |

 

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