**UNITED STATESSECURITIES 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**     |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                           |
| **For  the Fiscal Year Ended December 31, 2002**                                                                                                                               |
|                                                                                                                                                                           |
| **OR**                                                                                                                                                                         |
|                                                                                                                                                                           |
| **o**                                                                                                                                                                          |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                           |
| **For  the transition period from              to             ** |

 

**CommissionFile Number:  0-27188**

 

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| **PHARMACOPEIA,  INC.**                                               |
|-----------------------------------------------------------------------|
| (Exact name of  Registrant as specified in its Charter)               |
|                                                                  |   |   |
| **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 January 31, 2003 was $110,186,518.

 

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, 2003** |
|-------------------------------------------|--------|--------------------------------------|
| Common stock, par value $0.0001 per share |   | 23,612,423                           |

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Selected portions of the 2003 Proxy Statement are Incorporated byReference in Part III of this Report.

The Exhibit Index (Item No. 15) located on pages 66 to 70incorporates several documents by reference as indicated therein.

 

 

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**PHARMACOPEIA, INC.**

 

**2002 Form 10-K**

 

**Table of 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       |
|       |      |                                                                                        |
| 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.  | CONTROLS AND  PROCEDURES                                                                    |
|       |      |                                                                                        |
| PART  IV   |      |                                                                                        |
|       |      |                                                                                        |
|       | ITEM  15. | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                            |
|       |      |                                                                                        |
| SIGNATURES |      |

 

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**PART I**

 

**ITEM 1.  BUSINESS**

 

Pharmacopeia, Inc. (“Pharmacopeia” or the “Company”)is a leader in enabling science and technology that accelerates and improvesthe drug discovery and chemical development processes.  Our software segment, Accelrys Inc.(“Accelrys”), develops and commercializes molecular modeling, simulation,informatics, and decision support software for the life sciences and materialsresearch markets.  Our Drug Discoverysegment, Pharmacopeia Drug Discovery, Inc. (“PDD”), 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 anywhere in this document, the words“expects”, “believes”, “anticipates”, “estimates” and similar expressions areintended to identify forward-looking statements. Forward-looking statementsherein may include statements addressing our future financial and operatingresults. We have based these forward-looking statements on our currentexpectations about future events. Such statements are subject to risks anduncertainties including, but not limited to, the successful implementation ofour strategic plans, the**acceptanceof new products, the obsolescence of existing products, the resolution ofexisting and potential future patent issues, additional competition, changes ineconomic conditions, and other risks described in documents we have filed withthe Securities and Exchange Commission, including this report on Form 10-K in“Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” “Risk Factors,” “Certain Risks Related to the Company as a Whole,”“Certain Risks Related to Intellectual Property,” “Certain Risks Related toAccelrys” and “Certain Risks Related to Pharmacopeia Drug Discovery,” andsubsequent reports on Form 10-Q. All forward-looking statements in thisdocument are qualified entirely by the cautionary statements included in thisdocument and such filings. These risks and uncertainties could cause actualresults to differ materially from results expressed or implied byforward-looking statements contained in this document. These forward-lookingstatements speak only as of the date of this document. We disclaim anyundertaking to publicly update or revise any forward-looking statementscontained herein to reflect any change in our expectations with regard theretoor any change in events, conditions or circumstances on which any suchstatement is based.

 

Following are more detailed descriptions of each ofour two business segments.  Certainfinancial information for these segments is described in the Notes to theFinancial Statements included in this report.

 

OUR SOFTWARE SEGMENT –ACCELRYS INC.

 

We operate our software business through Accelrys, asubsidiary established by bringing together five leading specialist softwarecompanies: Molecular Simulations Inc. (MSI) - simulation and modeling for lifescience and materials research; Synopsys Scientific Systems - chemicalinformation management and data content; Oxford Molecular - cheminformatics,high throughput screening, and decision support solutions; Genetics ComputerGroup (GCG) - bioinformatics and gene sequence analysis software; and Synomics - middleware technology andconsulting services for life sciences research.  A wholly owned subsidiary of Pharmacopeia, Inc., Accelryshas over 500 employees and active license agreements with most leadingchemical, biotechnology and pharmaceutical organizations.  Our software covers disciplines includinggene sequence analysis, proteomics, inorganic chemistry, and formulationdesign, to meet the needs of most research organizations.  Customers are supported by our worldwideorganization headquartered in San Diego, CA.

 

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ACCELRYS OVERVIEW

 

For companies in the pharmaceutical, biotechnology,chemical, petrochemical and materials industries, innovation in the discoveryand development of new products and the rapid, cost-effective commercializationof these products is crucial to success. Companies in these industries investconsiderable resources in technologies that suggest productive new pathways forresearch projects, increase the efficiency of discovery and developmentprocesses, or enable them to maximize the use of corporate data, informationand knowledge.  One such technology issoftware-based computation, analysis, informatics and knowledge managementtools.  These tools allow users tosimulate processes, predict the outcome of product designs, manage data andturn it into useful information, support decisions, and manage workflows.

 

Accelrys designs, develops, markets, and supportssoftware and provides related services that facilitate the discovery anddevelopment of new products and processes in the pharmaceutical, biotechnology,chemical, petrochemical and materials industries. Using our software products,researchers may increase the speed and efficiency of the research anddevelopment cycle, thereby reducing product development costs and shorteningthe time to market for new product introductions and process improvements. Oursoftware customers include leading commercial, governmental and academicorganizations. Many of the largest pharmaceutical, biotechnology, chemical,petroleum and semiconductor companies worldwide use our software. We market ourproducts and services worldwide, principally through our global direct salesforce.

 

Following are brief descriptions of our Accelryssoftware product lines.

 

*Modelingand Simulation Software*. Many factors that affect a molecule, including activity,bioavailability, toxicity, shelf life and environmental impact, are governed byfundamental, properties such as shape, structure and reactivity, that aredetermined at the sub-atomic, molecular, or near-molecular levels. A spectrumof simulation technologies – quantum mechanical simulation, molecularsimulation, and mesoscale simulation – predict these properties and helpresearchers discover new products, sharpen the focus of experimental activitiesand improve ultimate product performance. We are a leading provider of suchmodeling and simulation software.

 

We have a broad product suite consisting of over 100application modules based on proprietary technologies that employ fundamentalscientific principles, advanced computer visualization, molecular modelingtechniques and computational chemistry. These products allow scientists toperform computations of chemical, biological and materials properties, tosimulate, visualize and analyze chemical and biological systems, and tocommunicate the results to other scientists. Our products are based uponadvanced software architectures that facilitate the development, integrationand deployment of new software products. We also offer open access to our coresoftware development environment, within which customers and third-partylicensees can develop, integrate and distribute their own software applicationsfor computational chemistry, biology and materials research.

 

We plan to continue enhancing our software product andservice offerings for specialist computational chemists and biologists, who arethe principal users of modeling and simulation products. In addition, we arebroadening our user base by enabling straightforward access to these methodsfrom personal computers to a much larger population of experimentalists,laboratory scientists and engineers.

 

*InformaticsSoftware.*  We are aleading provider of tools to capture, store, manage, and mine scientific dataand information.  Informatics is awell-established technology in the life sciences, where bioinformatics toolsare integral to genetic and biological research, and cheminformaticsapplications are widely used to manage chemical information.  We are pioneering the application of similartools in the materials research arena – so-called materials informatics hasfound early applications in formulation design and combinatorial materialsscience. Our bioinformatics solutions include a suite of programs enablingmolecular biologists to search, edit, compare, map and align sequence data.Researchers use these to enable the analysis of DNA and protein sequences andstructure, predict RNA secondary structure and annotate protein sequences. Suchcapabilities help them to use the genomic data that is being made available byprojects such as the Human Genome Project. In addition, we provide 

 

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enterprise-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 cheminformatics software is based onstandard database architectures such as Oracle and Microsoft® Access®. Weprovide data visualization and analysis software to search, retrieve, and usechemical structures, biological and chemical data, experimental data, andregistration information. Many of these tools use industry standard softwarecomponents and are compliant with applications such as Microsoft Excel®,allowing chemists to interact with chemical data within familiar productivitytools. We also use this component technology and our database architectures tobuild customized enterprise-wide systems for client companies.

 

ACCELRYS BUSINESS STRATEGY

 

Our objective is to strengthen Accelrys’ position as aleading provider of software-based computation, analysis, informatics andknowledge management products and services worldwide by providing acomprehensive set of integrated productivity tools that are integral to theenterprise-wide research and development activities of our customers, and byconnecting these tools within an IT framework that makes it easier for researchorganizations to manage data, information, knowledge, and collaborativeprocesses.  The key elements of ourstrategy to achieve this objective include:

 

*ExpandUser Base*.  We plan toincrease sales to our key software accounts and pursue new software customerswithin existing markets. In addition, software will be targeted not only at agrowing number of molecular modeling and simulation and gene sequence analysesspecialists, but also at the much larger group of experimentalists (scientistsand engineers). We believe we can leverage our strong relationships withmodeling, simulation and analysis specialists to help promote the use ofmodeling, simulation and analyses methods by other scientists working in thesame organization as the specialists.

 

*LeverageCore Computational Technology and Maintain Technology Leadership*.  We believe that our core modeling andsimulation and gene sequence analysis technologies have helped position us atthe forefront of computational methods technology providers. We intend tocontinue to make significant investments in research and development in orderto improve the efficiency and predictive accuracy of this core technology andto maintain our technology leadership.

 

*EnhanceTechnology Position.* We will strengthen our scientific and technical expertise throughacquisitions and consortia, and through joint development projects with leadingacademic, governmental and industrial researchers.  We may continue to pursue acquisitions and strategicrelationships with third parties in order to provide us with early access tonew technologies, facilitate market acceptance of new products and reduceinternal research and development investment.

 

*ExpandInformatics Market Share.* Our customers will need more sophisticated data and knowledge managementtools as the use of modeling and simulation, gene sequence analysis and othercomputational methods expand, especially to the experimentalists, and as theamount of data about drug discovery and chemical development activities alsocontinues to grow.  We will continue toimprove and integrate our bioinformatics and cheminformatics offerings, and toleverage our relationships with customers, in order to achieve this growth.

 

*CreateCollaborative Systems and Environments.*  We believe that the desire among ourcustomer base to increase process efficiency across diverse workgroups anddisciplines while managing and using enormous quantities of data andinformation has created a need for enterprise workflow and project managementtools that help researchers to better collaborate and manage projects. We willcontinue to improve our offerings to include workflow and project managementcapabilities. As these product offerings expand, we also expect increasedopportunities to tailor and customize work group and enterprise-wide solutionsfor customers.  The integration ofinformatics capabilities and provision of collaborative enterprise environmentis being pursued through the development of an integrated software platform fordiscovery research delivered via the Discovery StudioTM product line to the lifescience market, and through the Materials Studio® product line to the materialsand chemicals 

 

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process industries.  We willdevelop our key modeling and informatics capabilities such that they arecompatible with this platform.

 

ACCELRYS SCIENCE AND TECHNOLOGY

 

Following are more detailed descriptions of thescience and technology supporting each of our various software product lines.

 

*Modelingand Simulation*. Our modeling and simulation technologydelivers predictive models of chemical, biological and materials phenomenawithin an open environment. This technology simulates subatomic, interatomic andintermolecular interactions, and a wide range of corresponding properties,including molecular structure, activity, diversity, stability, morphology,solubility, adhesion, adsorption, diffusion, color, analytical spectra, andoptical, electrical and mechanical properties. There are five primary classesof molecular and materials simulation methods, all of which are found in ourproducts:

 

•                  *QuantumMethods.* Quantum methods, the most fundamental of our simulationmethods, compute interactions at the level of electrons and nuclei. Thesemethods are capable of simulating which chemical entities are stable, howchemical reactions occur, and properties such as reactivity, color andmagnetism. These methods are computationally demanding. Historically, they havebeen applied to small, carefully selected models.  Technological advances, many driven by us and our partners, arenow allowing quantum mechanical methodology to be applied more generally and tolarger materials and systems.

 

•                  *MolecularMethods.* Molecular methods probe molecular conformations and theinteractions between molecules based on simplified analytical expressions.These methods include automated procedures for probing how a drug moleculebinds to an active site, what conformations a polymer chain may adopt, and whatsimilarities exist between a new amino acid sequence and protein sequences forwhich tertiary structures are known. They also include tools used to determine structure based on x-raydiffraction or nuclear magnetic resonance data.  Such methods contain more approximations than quantum methods butcan be applied to much larger and more complex systems, supporting insight intomany 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.

 

•                  *CorrelativeMethods.* Correlative methods identify interrelationships betweenstructure and properties that can be used predictively. In many cases, it isknown that macroscopic properties determine by molecular-level behavior, butthe 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.

 

*PlatformTechnologies*. The computational methods outlined above areoffered within an information technology framework designed to support theneeds of today’s leading research organizations:

 

•                  *Open Architecture.* We pioneered an openscientific software architecture through our Cerius2® software, which includesan efficient data model; libraries of mathematical, chemical and graphicalutilities; and a client/server data and communications management layer. TheCerius2 software, a modular, object-oriented system, is written principally inC++ and uses industry-standard protocols such as MOTIF and TCP/IP. This modulararchitecture is designed to provide streamlined access to the various methodsdescribed above, allowing their use in discrete, combined and packagedways.  Our internal developers use theCerius2 application programming interfaces (“APIs”) to create products. Thesame APIs are made available through the Cerius2 Software Developer’s Kit(“SDK”) to customers and third-party licensees.

 

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•                  *Desktop and Enterprise-Wide Access. *The Discovery Studio softwaredelivers new platform technology that will provide a common data architectureand project management system for pharmaceutical-focused products.  The Discovery Studio software combines newtechnology, components from our architecture, and technology and expertiseacquired along with Synomics in June 2001. It is also the medium by which we can deliver molecular modeling andsimulation desktop products for life sciences experimentalists, throughclient-server computing.  The serverwill be a workstation accessed through a corporate Intranet. The clientapplication is created using industry-standard languages and protocols on apersonal computer (“PC”), and incorporates powerful new technology that enablesthe display and manipulation of molecular structures and other data on the PC.

 

The Materials Studiosoftware delivers similar benefits via desktop PC’s to users in the materialssciences. The client software provides a PC-based modeling and visualizationenvironment from which users can set up, run and analyze computations on morepowerful computer servers on their Intranet. The servers can beUNIX®workstations, Linux® servers or Windows® NT/2000® servers or workstations.The client software runs on Windows 95, 98, 2000, NT®, XP®, and Me®.

 

Our Cerius2 architecture,graphics and interface subsystems continue to be supported on Silicon Graphics®and IBM® UNIX workstations. Certain of the methods are also supported on vectorsupercomputers and on shared and distributed memory parallel architectures.Existing and planned Discovery Studio server software products will run on IBM andSilicon Graphics UNIX workstations. Existing and planned Materials Studioserver software codes run on Silicon Graphics and HP UNIX workstations andWindows platforms.

 

*BioinformaticsSoftware.*  Ourbioinformatics solutions enable the management and analysis of biological dataand provide a wide range of gene sequence 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 computational andanalysis 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 include DS Gene sequenceanalysis software, a PC-based client running within the Discovery Studioproduct line; SeqWeb® software, a web browser-based interface that allowsresearchers to access the technology across corporate Intranets; SeqLab®software, enabling X-Windows-based access; and OMIGATM software, which providesaccess to users of Windows operating systems. MacVector® sequence analysissoftware provides gene sequence analysis capabilities to users of Macintoshcomputers.

 

•                  *RelationalDatabases*.  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.

 

In-house developers canaccess the Oracle data from popular development tools across multiple platformsand multiple networks, including Microsoft’s VisualToolsTM, Open DatabaseConnectivity (ODBC), Java®, Java Database Connectivity (JDBC), and OracleObjects for OLE.

 

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GCG Wisconsin Packagesoftware analyses can be applied to SeqStore databases – a process that can beautomated as the data is updated, creating an automated sequence analysispipeline that alerts the researcher to potentially valuable information as itis created.

 

•                  *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.

* *

*CheminformaticsSoftware*. We provide software to manage chemical information,such as 2D chemical structure diagrams and associated property data.  This software ranges from chemical datamanagement and analysis technology integrated with standard desktop productivitytools to enterprise-wide informatics systems. We also provide a number ofsoftware packages focused on particular applications of interest to thechemist, and a range of useful data content.

 

•                  *Desktoptools*.  The *Accord*for Excel, and *Accord* for Access software packages allow chemical objectsto be stored and manipulated within standard Microsoft desktop productivitytools. This means that the researcher can view and analyze chemical datawithout the need to learn new software systems, and that the wide range ofcalculation and data management features available in these applications can beeasily applied to chemical data without the need for us to develop and maintainspecialist tools. The DIVA® and the Tsar® software technologies provide desktopdecision support capabilities, allowing users to work with chemical 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 coveringbiomolecule-mediated organic synthesis, Protecting Groups providing chemistswith ready access to selected information on the full range of protecting groupchemistry, and BIOSTER that provides a critical compilation of thousands ofbio-analogous molecule pairs.

 

•                  *Tools andComponents*. We enable IT professionals and scientific applicationdevelopers to construct custom cheminformatics solutions through the AccordChemistry ControlTM, Accord Grid ControlTM, Accord Developer StudioTM, and AccordSDK products.

 

ACCELRYS PRODUCTS AND SERVICES

 

We offer a broad suite of software products andservices designed to enable our customers to shorten product lead times, reduceresearch and development costs, improve product and process performance, manageand analyze chemical and biological data and information, and communicate moreeffectively both inside and outside an organization. These products andservices incorporate the following attributes:

 

*ValidatedCore Modeling Technology*. The core technology underlying ourmodeling and simulation products consists of a number of fundamental,scientifically proven methods for conducting predictive computer modeling andanalyses of chemical, biological and materials phenomena at the atomic andmolecular level. This core technology is validated by over a decade ofindustrial use and by the publication of hundreds of presentations, papers andarticles citing applications of this technology.

 

*BroadApplicability.* The validated core technology underlying ourproducts enables us to offer products and services to a wide variety ofindustries, including the pharmaceutical, biotechnology, chemical,petrochemical, 

 

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electronics, food, paper, agrochemical, aerospace, plastics, paint andnatural gas industries. Our products simulate and analyze both small moleculesthat may be candidates for new drugs and more complex molecular structures suchas proteins or the polymers found in advanced materials. These products areused in research applications as diverse as drug discovery, protein design andstructure determination, crystallization and formulation, polymer propertyprediction, catalysis and development of electronic materials.

 

*DataManagement Compliant with Industry Standards*. Our datamanagement and analysis solutions are based on industry-standard technologiessuch as Oracle. This means that they are compliant with other corporate systemsand retain the maximum openness and flexibility. Our technology ensures thatthese standards are enabled for chemical and biological data.

 

*OpenArchitecture*. Many of our products are based upon openarchitectures that allow customers, collaborators and third parties to developsoftware applications in the same development environment we use internally.Core molecular modeling functions are included in this open environment, whichpermits developers to focus on their particular scientific interests andincrease the power and utility of their programs by integrating them with ourproducts.

 

*Easeof Use*. Our software products are integrated, modular,focused on specific research areas or techniques, and accessible by intuitivegraphical user interfaces (“GUI”). These enable experimentalists to usemolecular simulation in a manner consistent with established analytical andlaboratory techniques, in a user-friendly computational environment.

 

*IncreasedAccess*. We have developed desktop product lines that target abroader group of users, including laboratory scientists and engineers.  Scientific researchers increasingly usesoftware products running in the Microsoft Windows environment on desktopcomputers to search for, analyze and communicate scientific data, particularlywithin corporate Intranets. Our desktop products use familiar technology andare built upon our open architecture and validated core technology.

 

Based upon the science, technology and attributesdescribed above, we provide a broad suite of software products used throughoutthe research and development cycle. We believe that offering a “single-shop,”integrated drug discovery and chemical development solution will be asignificant benefit to our customers. In addition to these software modules, wealso offer the following:

 

*IntegrationProducts and Services*. With most software modules, we offer customers and third-party licenseesa standard environment in which to develop and integrate their ownapplications. These integration products provide an external developer withaccess to APIs used by our own internal development staff.  As a result, a developer can employ most ofthe functions, subsystems or methods embodied in or accessible through ourproducts to integrate an external program or to create additional applicationfunctionality, with a corresponding GUI.

 

*Databases*.  Databases are a close adjunct to oursoftware products. We create, maintain and sell a database of chemicalreactions in connection with our cheminformatics product line. We also resell anumber of scientific databases created by third parties.

 

ACCELRYS PRODUCT USES

 

Our software products are used in a variety ofresearch areas within a number of industries. The principal research anddevelopment areas in which our software products are used include thefollowing:

 

*Sequenceto Structure.*  Ourbioinformatics, proteomics, and structural biology software provides tools thatenable researchers to tackle the range of problems inherent in moving from genesequence data to fully characterized targets for drug discovery projects. Thisrange of activities represents the early stages of the drug discovery processand is an essential pre-requisite for the structure-based route to drugdiscovery. Relevant 

 

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problems include finding interesting sequences within the hugequantities of available genetic data, characterizing those sequences andrelating them to particular functions, determining the secondary structure ofDNA and RNA, determining the three dimensional molecular structure of proteins(often using data from analytical techniques such as NMR and X-raydiffraction), and understanding the relationship between this structure andfunction. The key product for gene sequence analysis is the GCG WisconsinPackage software, now augmented and accessible via DS Gene software. Productsused in macromolecular structure determination and subsequent protein modelinginclude the DS ModelingTM, the X-PLOR®, the Insight II® application modules, theQUANTATM, the Discover®, the CHARMm®, and the FelixTM software.

 

*LeadIdentification and Optimization.*  The next step in drug discovery is the development and optimizationof potential small molecule drugs based on these targets. Our rational drugdesign products allow the design of small organic therapeutics, based on aprotein active site model or on activity data for a set of compounds. Relatedtechniques are used to design and assess combinatorial molecular libraries thatare screened for desired activity using high throughput experimentation. Wethus bring together the worlds of computation and experimentation. The largequantities of data generated by such activities can be managed and analyzedusing our informatics tools – the results inform more focused testing anddesign. Rational drug design and combinatorial chemistry products include theCatalyst®, the Cerius2 and the Insight II application modules, and the QSARTM,the Discover, and the DS MedChem ExplorerTM software.  Cheminformatics tools applied to manage relevant data are basedon the Accord Enterprise Informatics product.

 

*Developmentand Formulation.* Following the discovery process, a drug must be deliveredsuccessfully – administered as a crystalline solid in a pill, or through someother mechanism such as a patch or spray. Our crystallization software solves arange of problems that are important to the development and formulation ofpharmaceuticals – for example, establishing possible crystalline structures forthe solid material of a pill. Such problems are critical across the chemicalsindustries, affecting products such as paints, pigments, and petrochemicals.Our crystallization products are delivered as the Cerius2 and the MaterialsStudio application modules. Development of new and improved products is alsoachieved through formulation – varying the process and proportions in whichknown components are combined. Our software can optimize this process forproducts including drugs, foods, cosmetics, personal care products, detergents,plastics, and specialty chemicals. We serve formulators through the MS FASTTMinformatics software.

 

*ImprovingMaterials and Processes in the Chemicals Industry.* Many ofour other solutions support the design of improved products and processesacross the chemicals industry. Two key technology areas in this respect arepolymer science and catalysis. Polymer modeling products are used byresearchers in the chemical, plastics, rubber, adhesives, petrochemical,aerospace and automotive industrial sectors to analyze and predict polymer propertiesand establish the link between these properties and the molecular-levelstructure of the material. Our polymer software products allow theseresearchers to construct and characterize models of polymers and predict keyproperties, such as blend compatibility, mechanical behavior, cohesion andadhesion to surfaces. Our polymer products include the Cerius2 and the InsightII application modules – the full range of polymer technology is now extendedand available within the Materials Studio product line through the Discover,the EquilibriaTM, and the MesoDynTM modules. Our catalysis products are used bycompanies in the chemical, petrochemical, natural gas and plastics industriesand by catalyst manufacturers to characterize catalysts and sorbent materials,to simulate thermodynamic and reactivity data, and to understand and controlchemical reactions. Our products are used to characterize and designmetallocene catalysts, zeolites and other molecular sieves, and metal oxides.Legacy products include the Cerius2 and the Insight II application modules.This range is now available and extended within the Materials Studio productline through the Discover, the DMol3TM, and the CASTEPTM modules.  Through the MS CombiMatTM product,informatics methods are now applied to assist combinatorial materials science –a rapidly emerging technology in the search for new catalysts, polymers, andother materials.

 

*OtherMaterials-based industries.* Our products find a broad range of applications across industriesincluding electronics, aerospace, structural materials, automotive and energy.In electronics, for example, the trend toward microminiaturization ofelectronic devices has created a need for improved processes and materials.Semiconductor 

 

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and electronics companies use our software products to understandsurface chemistry, defects, thin oxide layers, magnetic properties, and theperformance of new packaging materials. Legacy products include the Cerius2 andthe Insight II application modules. This range is now available and extended within the Materials Studioproduct line through the Discover, the Dmol3, and the CASTEP modules.

 

ACCELRYS SOFTWARE CUSTOMERS

 

Our software customer base consists of leadingcommercial, governmental and academic organizations. No single customeraccounted for more than 10% of our software revenues during the fiscal yearended December 31, 2002.

 

*IndustrialCustomers*. Our industrial customers include many of thelargest pharmaceutical, biotechnology, chemical, petroleum and semiconductorcompanies worldwide. In each of the past three fiscal years, a significantportion of our total software revenue has been derived from pharmaceutical,biotechnology and chemical companies.

 

*GovernmentalCustomers*. Many governmental institutions in the UnitedStates, Canada, Europe and the Asia/Pacific region use our software products.

 

*AcademicCustomers*. Many universities in the United States, Europe andthe Asia/Pacific region use our products. This use historically has been forpurposes of academic research, but we believe our products increasingly may beused as a part of formal university teaching curricula.

 

ACCELRYS STRATEGIC AND ACADEMIC ALLIANCES

 

We have entered into a number of strategic alliancesrelating to product development, product distribution and joint marketing. Weplan to continue to cultivate relationships with academic, governmental andcommercial research organizations for purposes of identifying and licensing newtechnology to use in product development. In addition, we plan to maintain andexpand our alliances focusing on the compatibility of our products withdatabases and database management systems, other computational chemistry andmolecular simulation products, and products in related markets such aslaboratory instrumentation. We also intend to continue to enter into portingand joint marketing arrangements with hardware vendors on whose systems ourproducts operate.

 

SOFTWARE CONSORTIA

 

Since 1986, we have formed a number of consortia withoutside parties, commonly for purposes of market expansion and productdevelopment. We believe the formation and management of these consortia helpsus focus on topical industrial needs, and establishes the consortia members asan initial customer base for our products. We believe our consortia also helpus establish valuable working relationships with leaders in our target markets.

 

ACCELRYS SALES AND MARKETING

 

We market our software products and servicesworldwide. In the United States, Europe and Asia, we have direct sales forces,consisting of field sales, certain distributor arrangements, and telesalesrepresentatives.  Certain of the telesalesrepresentatives focus exclusively on sales to academic researchers.  The direct sales representatives andremaining telesales representatives work in teams selling to commercial andgovernmental accounts in assigned geographic territories.  The direct sales representatives typicallyfocus on larger accounts and transactions and work closely with our pre-salessupport scientists in order to demonstrate our products and their applicabilityto various research and development efforts. Our remaining distributor relationships are focused in the Asian market,and complement the direct sales approach recently implemented.

 

In support of our sales activities, we participate inindustry trade shows, publish our own newsletters, place advertisements inother industry publications, publish articles in industrial and scientificpublications, conduct direct 

 

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mail campaigns, sponsor industry conferences and seminars, and maintaina World Wide Web home page that contains information about us and our productand service offerings.

 

Our software customers’ buying habits havehistorically resulted in a higher concentration of sales in the last quarter ofthe calendar year.

 

ACCELRYS PRODUCT DEVELOPMENT

 

Development of our software is focused on expandingsoftware product lines, designing enhancements to our core technology andintegrating existing and new products into our principal softwarearchitectures. We intend to offer regular updates to our products and to expandour existing product suite. A key component of our product developmentactivities is the extension of our core UNIX-based software architecture toaccommodate access to our products from desktop computers.

 

We license software products or otherwise have acquiredsoftware products from corporate, governmental and academic institutions. Thesearrangements sometimes involve joint development efforts and frequently requirethe payment of royalties by us. The development and royalty obligations, scopeof distribution rights, duration and other terms of these arrangements varydepending on the product, the market, resource requirements, the other partieswith which we contract and other factors. We intend to continue to license orotherwise acquire technology or products from third parties.

 

We have also developed products with funding anddirection from customers through our consortia activities, see “Business -Software Consortia,” and we may continue to develop products as part of ourconsortia arrangements with customers.

 

ACCELRYS CUSTOMER SERVICE AND SUPPORT

 

We are committed to providing customers with superiorsupport including telephone, electronic mail, fax and Internet-based technicalsupport services; training; user group conferences; and targeted contractservices involving application of our technology and scientific expertise toparticular research needs of customers. We believe that customer service,support and training are key to the adoption and successful utilization of ourproducts.

 

Purchases of multi-year licenses to use our softwareproducts include one year of maintenance services, consisting of technicalsupport and software upgrades. Thereafter, we offer renewals of maintenanceservices on an annual basis for an annual fee. Annual licenses to use oursoftware products generally include all maintenance services. Most of ourcustomers contract for maintenance and support services. These give customersaccess to new releases, technical notes, documentation addenda and othersupport which enables customers to utilize our products more effectively,including access to our technical and scientific support personnel duringextended business hours. Through our distribution channels, we offer trainingconducted by staff knowledgeable in both the theory and application of ourproducts. Technical newsletters and bulletins and advance notification aboutfuture software releases are sent to customers to keep them informed and tohelp them with resource allocation and scheduling. To maintain an ongoing understandingof customer requirements, we sponsor scientific symposia and user groupmeetings throughout the year.

 

ACCELRYS COMPETITORS

 

The market for our software products is intenselycompetitive, subject to rapid change and significantly affected by new productintroductions and other market activities of industry participants. Ourcompetitors offer a variety of products and services to address this market. Webelieve that the principal competitive factors in this market are productquality, flexibility, ease-of-use, scientific validation and performance,functionality and features, open architecture, quality of support and service,reputation and price. Competition currently comes from the following principalsources: other software packages for analysis of chemical and biological data;desktop software

 

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applications, including chemical drawing, molecular modeling andanalytical data simulation applications; consulting and outsourcing services;other types of simulation software provided to engineers; and firms supplyingdatabases, such as chemical or genomic information databases, databasemanagement systems and information technology. In addition, certain of ourlicenses grant the right to sublicense our software. As a result, our customersand third-party licensees could develop specific simulation applications usingour technology and compete with us by distributing such programs to potentialcustomers. Customers or licensees could also develop their own modeling,simulation, analyses, bioinformatics or cheminformatics technology and ceaseusing our products and services. Further, they may choose to sublicense suchtechnology.

 

Certain of our software competitors and potentialcompetitors have longer operating histories than us and have greater financial,technical, marketing and other resources. Further, many of our competitorsoffer products and services directed at more specific markets than thosetargeted by us, enabling these competitors to focus a greater proportion oftheir efforts on such markets. Certain offerings that are competitive with ourproducts and services are developed and made available by governmentalorganizations and academic institutions, and these entities may be able todevote substantial resources to product development and also offer theirproducts to users for little or no charge. There can be no assurance that ourcurrent 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.

 

ACCELRYS INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

 

We rely primarily on a combination of copyright,trademark and trade secret laws, confidentiality procedures and contractualprovisions to protect our proprietary rights. We also have eleven United Statespatents. We believe that factors such as the technological and creative skillsof our personnel, new product development, frequent product enhancements, namerecognition and reliable product maintenance are essential to establishing andmaintaining a technological leadership position. We seek to protect our software,documentation and other written materials under trade secret and copyrightlaws, which afford only limited protection. Further, there can be no assurancethat our patents will offer any protection or that they will not be challenged,invalidated or circumvented. Furthermore, there can be no assurance that otherswill not develop technologies that are similar or superior to our technology.Despite our efforts to protect our proprietary rights, unauthorized parties mayattempt to copy aspects of our products or to obtain and use information thatwe regard as proprietary. In limited instances, we have licensed source codesof certain products 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 no assurance that our means of protectingour proprietary rights in the United States or abroad will be adequate. There canbe no assurance that third parties will not claim infringement by us of theirintellectual property rights. From time to time, we receive letters from thirdparties claiming or suggesting that our products may infringe patents or otherintellectual property rights. We have investigated these matters and believethat they are immaterial to our software operations. There can be no assurance,however, that our products do not infringe upon the patent or otherintellectual property rights of third parties, that we will not be required toseek licenses for or otherwise acquire rights to technology as a result ofclaims of infringement or that other companies will not bring infringementsuits against us. We expect in general that software product developers willincreasingly be subject to infringement claims as the number of products andcompetitors in our industry segments grows and the functionality of products indifferent industry segments overlaps. Any such claims, with or without merit,could be time consuming to defend, result in costly litigation, divertmanagement’s attention and resources, cause product shipment delays or requireus to enter into royalty or licensing agreements.

 

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Such royalty or licensing agreements, if required, maynot be available on terms acceptable to us, if at all. In the event of asuccessful claim of product infringement against us, our failure or inabilityto license or design around the infringed technology would have a materialadverse effect on our business, its financial condition and its results ofoperations.

 

From time to time, when we deem it advisable, wechallenge potentially conflicting patent rights asserted by third parties.  For example, in November 2002, we and sixother companies filed Notices of Opposition in the European Patent Office (the“EPO”), seeking to prevent the issuance of Symyx Technologies, Inc. EuropeanPatent Application EP1080435, entitled “Design of Combinatorial MaterialLibraries.”  This EPO matter is at anearly stage, and no decision by the EPO is expected until at least 2004.

 

OUR DRUG DISCOVERYSEGMENT – PHARMACOPEIA DRUG DISCOVERY, INC.

 

In May 2002, we transferred substantially all of theassets, operations and business of our Drug Discovery segment (which had beenoperated as a division since its inception in 1993) into a new, wholly ownedsubsidiary of the Company, Pharmacopeia Drug Discovery, Inc. (“PDD”). As aresult of this transaction, we operate both our Software and Drug Discovery businessesthrough wholly owned subsidiaries of the Company (Accelrys and PDD,respectively). In determining to reorganize our business in this manner, ourBoard of Directors concluded that such an organization would benefit theCompany and our stockholders by, among other things, enabling our management tobetter focus on designing and implementing strategies intended to enhance theoperating performance of each discrete business segment, thereby enhancing ourability to optimize our consolidated financial results and equity value;creating a stronger marketplace identity for our business segments throughutilization of a corporate entity structure for each unit; establishingparallel corporate structures across our two operating units; and promoting ourcorporate objective of managing risks and limiting liabilities arising from theoperation of each of our businesses.

 

Our PDD business applies our proprietary combinatorialchemistry technology, Encoded Combinatorial Libraries on Polymeric Support(“ECLiPS®”), computational modeling, discovery biology, medicinal chemistry,ultra high-throughput screening and applied engineering to identify, enhanceand optimize potential drugs. To date, our scientists have synthesized morethan seven million diverse small molecules with drug-like characteristics. Thisunique collection, integrated with various other platform capabilities supportsthe following programs:

 

•                  *Lead Discovery*.  We utilize our multi-million compound sample collection of novelsmall molecules and expertise in assay development, high-throughput and ultrahigh-throughput screening to identify compounds active against drug targets

 

•                  *Lead Optimization*.  We utilize our broad chemistry expertise,including combinatorial chemistry, medicinal chemistry, and parallel synthesis,together with advanced biological screening and ADME, to enhance and optimizepotency, selectivity and other criteria of lead compounds and evolve them intopotential clinical candidates.

 

•                  *Collaborative Drug Discovery*.  Our Lead Discovery and Lead Optimizationcapabilities are combined to create a total collaborative research effort.These collaborations are customized, utilizing the full scope of our technologyplatforms, to deliver results that are consistent with desired goals and timelines.

 

A major challenge in the drug discovery process is thegeneration and evaluation of large numbers of diverse and readily identifiablesmall molecule compounds to find new, orally active drugs. Our encodingtechnology, ECLiPS, enables us to generate hundreds of thousands of smallmolecule compounds at a fraction of the cost of traditional chemical synthesismethods. We use “Direct Divide” combinatorial chemistry to build collections,or libraries, of 10,000 to 500,000 or more small molecule compounds byperforming only 50 to 200 individual chemical reactions. Our ECLiPS technologyoffers substantial productivity improvements as compared to the 10,000 to500,000 or more reactions that would be required to prepare similarly sizedchemical libraries by 

 

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synthesizing each compound individually. The ECLiPS technologyproductivity advantage results from the synthesis of compounds on tiny plasticbeads in large mixtures. After each solid phase synthesis step, proprietary tagsets are attached to the beads to indicate the chemical building block andreaction conditions used in that step. These stable, easily detectable tag setsenable the rapid identification from the mixture of any compound that is activein a biological screening assay. This tagging technology is licensedexclusively from Columbia University (“Columbia”) and Cold Spring HarborLaboratory (“Cold Spring”).

 

Another challenge addressed by our drug discoveryscience and technologies is the ability to accurately and rapidly test chemicalcompounds against biological targets. We use 96-well, 384-well, and 1,536-wellscreening formats to identify compounds active against our partners’ drugdiscovery targets. Our 384-well and 1,536-well formats offer significantthroughput improvements and cost reductions compared to the industry-standard96-well format.

 

To assist in the modeling of potential drugs, thesimulation of interactions between chemicals and biological targets and thecollection, storage and use of the data generated from our drug discoveryactivities, our PDD segment makes extensive use of Accelrys’ products, softwaredesigned in-house and software purchased from other vendors.

 

Our Drug Discovery technology supports ourpharmaceutical and biotechnology customers in improving their drug discoveryproductivity. Our objective is to be among the industry leaders in thediscovery and optimization of novel drug candidates on behalf of our customers.Our commercialization strategy is to pursue collaborations with pharmaceuticaland biotechnology companies. Pursuant to collaborative agreements, we leverageour multi-million compound sample collection and abilities in high-throughputscreening to perform Lead Discovery and Lead Optimization Services forcustomers. Our Drug Discovery technology strategy is to enhance productivitythrough cost reductions and increased throughput, to increase the size andquality of our library compound collection and our high throughput screeningcapabilities, and to build our knowledge base of the relationships betweenchemical structures and biological targets for use in future drug discoveryprograms.

 

Focusing on Lead Discovery and Lead OptimizationServices for drug discovery, we seek customers to develop, manufacture, marketand sell resulting drugs. In 2002, we initiated and continued Lead Discoveryand Lead Optimization Service contracts with several pharmaceutical andbiotechnology customers for collaborations using our large collection of novel,small molecules and high-throughput screening. These customers include Schering Plough, N.V. Organon, Novartis,Boehringer Ingelheim, Takeda, Antigenics, Ester Neurosciences, Locomogene,AstraZeneca, Schering AG, Kowa Company, Progenics, Otsuka PharmaceuticalFactory (“Otsuka”), and Mitsubishi-Tokyo Pharmaceuticals (“Mitsubishi”).

 

In 2003, PDD created a strategic partnership with WuXi Pharma Tech to provide chemistry services and research development topharmaceutical and biotechnology companies. PDD will offer chemistry supportfor pre-clinical and research and development programs such as the synthesis ofcombinatorial chemistry templates, compound libraries, individual compounds,process research and development and scale up. In addition, PDD will design andmarket targeted libraries of discrete compounds biased towards particulardisease related families of targets.

 

DRUG DISCOVERY BUSINESS STRATEGY

 

Our objective is to be an industry leader in thediscovery and optimization of novel drug candidates on an outsourced basis. Weseek to minimize our financing requirements and accelerate profitability bypursuing drug discovery collaborations with multiple pharmaceutical andbiotechnology companies. We do not currently plan to develop, manufacture andsell our own pharmaceutical products. Our business strategy exploits theemerging trend in the pharmaceutical industry to outsource certain products andservices that can be more efficiently provided by third parties. Ourcommercialization and technology strategy has several components.

 

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•                  *CommercializationStrategy.*Ourcommercialization strategy is to provide lead compounds and optimized leadcompounds to multiple pharmaceutical and biotechnology customers. Under these arrangements,PDD customers are responsible for the clinical development and eventualmanufacture and sale of any resulting drugs. Generally, customers compensate usthrough (i) funding or fees during or upon completion of our services and (ii)milestone payments and royalties on any drugs based on our technology anddeveloped by our customers. Each collaboration is tailored to the individualcustomer’s needs, but is developed within the frameworks of Lead Discovery andLead Optimization Services.

 

•                  *TechnologyStrategy*. Our Drug Discovery technology strategy is to enhanceproductivity through cost reductions and increased throughput and to build ourlibrary collection and our knowledge base of the relationships between chemicalstructures and biological targets for use in future drug discovery programs.

 

•                  *EnhanceProductivity*. We seek to leverage our existing technology byincreasing productivity through cost reductions and significant increases inthroughput. Our internal research and development efforts focus on: (i)advances in our automated systems; (ii) the development of enhanced software;(iii) the development of new materials and reactions for solid phase synthesis;and (iv) new high throughput screening formats.

 

•                  *DevelopCollection of Libraries and Knowledge Base*. We have built sets oflibraries that aggregate millions of compounds available for future screeningprograms. This collection of compounds will increase as new libraries arecreated and as outlicensed libraries are returned to PDD upon the expiration ofcustomers’ exclusivity periods. We believe that this growing library collectionwill provide a valuable source of leads for future drug discovery programs. Wealso intend to build a knowledge base of the relationships between classes ofchemical structures and classes of biological targets. This knowledge base willgrow as our designs, synthesizes and screens large numbers of compounds againsta growing number of targets. We believe that this knowledge base will provide afuture competitive advantage by enabling us to more quickly identify activecompounds for newly identified targets.

 

DRUG DISCOVERY PROGRAMS

 

We have several active Lead Discovery and LeadOptimization programs for drug discovery underway with our customers.Previously, we funded the identification and optimization of lead compounds fortargets that we had chosen in various therapeutic areas. In 1999, a strategicdecision was made to substantially reduce work on self-funded drug discoveryprograms. Rather, we are now primarily pursuing only those projects that arefunded by our customers.

 

DRUG DISCOVERY CUSTOMERS

 

In 2002, we performed drug discovery for a number ofpharmaceutical and biopharmaceutical customers, including Schering-Plough, N.V.Organon, Novartis, Antigenics, AstraZeneca, Schering AG, Boehringer Ingelheim,Ester Neurosciences, Kowa, Locomogene, Takeda, Progenics, Otsuka, andMitsubishi. Drug discovery revenue from one such customer representedapproximately 50% of PDD’s revenue and 12% of our consolidated revenue in2002.  Further, as noted under “RisksRelated to Pharmacopeia Drug Discovery,” our contract with this key customerexpires in accordance with its terms in October 2003. We are currently indiscussions with the customer concerning the renewal of this agreement. Therecan be no assurance that such a renewal will be entered into or that the terms(if any) of such a renewal will be as favorable to us as the currentagreement.  The loss of this customerwould have a material adverse effect on our PDD business and on our companytaken as a whole.

 

DRUG DISCOVERY TECHNOLOGIES

 

A major bottleneck in the drug discovery process isthe limited number and limited diversity of available chemical compounds. Usingtraditional manual chemical synthesis techniques, a chemist is usually able tosynthesize only 25 to 50 compounds per year. The low productivity of manualsynthesis severely constrains the 

 

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number of compounds available for screening in order to identify activecompounds and provide the basis for initial structure-activity relationships(“SAR”) analysis. Manual synthesis also slows the optimization process bylimiting the number of analogs synthesized and tested.

 

Numerous technologies have been developed toaccelerate the synthesis of chemical compounds. Several early methods werebased on either automated or combinatorial chemical synthesis ofoligonucleotides and peptides, which are not generally useful as oral drugs.Combinatorial chemistry involves the synthesis of large numbers of differentchemical compounds by creating all possible combinations of a set of chemicalcomponents, or building blocks. More recent methods include robotic synthesisand various combinatorial chemistry approaches to synthesizing libraries ofsmall molecules, which are generally preferred by pharmaceutical companies asdrug development candidates.

 

We believe that our drug discovery technology offers aunique solution to the bottleneck that constrains the drug discovery process.Our combinatorial chemistry technology generates large, diverse libraries ofthe small molecules favored by pharmaceutical companies for development. Mostimportantly, our technology uses solid phase synthesis and an encoding systemto permit rapid identification of compounds synthesized in combinatorialmixtures.

 

The ECLiPS technology uses a patented “Direct Divide”approach to combinatorial chemistry to build collections, or libraries, of10,000 to 500,000 or more small molecule compounds by performing only 50 to 200individual chemical reactions.  This“Direct Divide” approach yields a more controlled distribution of finalcompounds than does the “pool and split” method currently used by certain othercompanies in drug discovery and previously practiced by us. We are able tosynthesize a large number of widely diverse libraries of small moleculecompounds because our chemists can combine a nearly unlimited set of chemicalbuilding blocks using a wide variety of reactions.  Although large libraries of peptides, oligonucleotides and otheroligomers can be generated, their diversity is constrained by the limitednumber of building blocks and the fewer reactions available to combine them.

 

We use ECLiPS technology to build libraries of small,low molecular weight compounds, predominantly heterocycles. These low molecularweight compounds are preferred by pharmaceutical companies because they aremore likely to be orally active (effective as drugs in tablet or capsule form),tend to have longer duration of action and are less expensive to manufacture.In contrast, natural peptide and oligonucleotide drugs are usually degraded byhuman digestive system enzymes and generally must be administered by injection.In addition, peptide and oligonucleotide drugs are often quickly eliminatedfrom the body, which limits their duration of action.

 

The ECLiPS technology allows us to quickly identifythe chemical structure of individual small compounds synthesized incombinatorial mixtures. This identification is made possible through the use ofour encoded solid phase synthesis technology. Solid phase synthesis generallyrefers to the synthesis of compounds on tiny plastic beads. Encoding refers tothe tag sets that we attach to each bead as a compound is synthesized. These tagsets allow us to rapidly identify the chemical structure of each compound.

 

Our drug discovery approach encompasses the ECLiPStechnology, assay technology, production automation, information systems andquality assurance programs, as more fully described below.

 

*ECLiPSTechnology. *TheECLiPS technology is a central component of our Drug Discovery business. TheECLiPS technology includes solid phase synthesis, combinatorial chemistry, andsets of encoding molecules.

 

•                  *Solid PhaseSynthesis*.  We have developedproprietary methods and procedures for performing a variety of small moleculechemical reactions on tiny plastic beads. In this approach to chemicalsynthesis, known as solid phase synthesis, compounds are bound to these tinyplastic beads using special linkers. This approach offers several advantagesover solution phase synthesis. Solid phase synthesis can often result in higheryields because the beads can be repeatedly re-exposed to reactants until thedesired reaction product has reached a satisfactorily high yield. Solid phasesynthesis also facilitates the isolation of individual 

 

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compounds. Beads can bewashed with solvents to remove byproducts, and an individual compound can thenbe isolated from a mixture by removing a single bead and breaking the linkageto detach the compound from the bead.

 

We believe that ourexperience in solid phase synthesis of diverse, heterocyclic, small compoundsis a key competitive advantage. Large, diverse libraries of these smallmolecules are more difficult to synthesize than libraries of oligonucleotidesor peptides. The great diversity of chemical building blocks and the variety ofchemical reactions that must be used in synthesizing these small moleculesrequire a wide range of reaction conditions, including temperature, pH,solvents, catalysts and other variables. Each chemical reaction must beoptimized to achieve high yields of the desired compound.

 

•                  *CombinatorialChemistry*.  Our ECLiPStechnology employs “Direct Divide” combinatorial chemistry. For example, achemist using a five-step reaction sequence and ten building blocks per stepcan synthesize a mixture of 100,000 different chemicals by performing only 50chemical reactions. Using larger numbers of building blocks or steps can createlarger libraries. This technology offers substantial productivity improvementin comparison to parallel synthesis and other techniques currently employed togenerate chemical libraries. Parallel synthesis is the performance of a seriesof individual chemical reactions, usually several dozen simultaneously,typically using robotics. In parallel synthesis, 111,110 individual chemicalreactions would be required to synthesize the same 100,000 compounds that ourtechnology can accomplish in 50 reactions. Parallel synthesis requiresextensive labor and time and a significant capital investment in robotics. Thelabor and time disadvantage increases exponentially with library size.

 

•                  *Sets ofencoding molecules.*  Weovercame the challenge of identifying active compounds from combinatorialmixtures through our use of a proprietary collection of chemically stable smallmolecules, or tag sets, to encode each bead used in solid phase synthesis. Thisenables us to quickly identify the structure of an active compound preparedusing the “Direct Divide” technique without resorting to deconvolution, aprocess in which an active compound must be “reverse engineered” byresynthesizing and testing various component combinations until the structureof the active compound is deduced. During each step of our solid phasesynthesis process, specific tag sets are attached to the beads to indicate thechemical reagent and reaction conditions used in that step. By the end of thesynthesis process, each bead has collected tag sets that represent all of thebuilding blocks used to create the compound on that bead. When an activecompound is found in an assay, the bead from which the active compound wasextracted is analyzed. The tag sets are detached from the bead using specificchemical reactions that break the linkage between the tag sets and the bead.The detached tag sets are read using conventional gas chromatographytechniques. The results, which resemble a bar code, are captured in a database thatidentifies and stores data regarding the active compound.

 

Our proprietary tag sets have the following importantcharacteristics:

 

•                  *Stability*.  Our proprietary tag sets are relativelyunreactive. For this reason, the tag sets do not break or decompose as a resultof heat, vigorous shaking or other harsh reaction conditions. Thus, the tagsets rarely interfere with or limit the solid phase chemical reactions used tocreate potential new drug compounds. By contrast, the oligonucleotides andpeptides used as tags by some companies are more fragile because they are morereactive. These large molecule tags may therefore interfere with chemicalreactions or may be decomposed or altered chemically during compound synthesis.These factors constrain the range of chemicals that can be synthesized in solidphase when oligonucleotide or peptide tags are used.

 

•                  *Size andDetectability*.  In contrastto the relatively large size of oligonucleotide and peptide tags, our tag setsare small and easy to attach to and detach from the beads. The highly sensitivedetection methods available for these tag sets allow PDDS to use them inextremely small quantities. Our tag sets do not occupy a significant portion ofthe beads’ capacity and do not interfere with the extraction or testing ofdetached compounds.

 

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Thus, using our proprietary ECLiPS technology, we cansynthesize a large combinatorial mixture of compounds and rapidly identify thespecific structure of individual active compounds found in the library. As ofDecember 31, 2002, we had used our ECLiPS technology to synthesize librariescontaining an aggregate of more than 7.4 million unique chemical compounds.Many of these libraries have initially been licensed to customers for theirexclusive use for varying periods of time.

 

*AssayTechnology. *Thesecond component of our drug discovery approach is our proprietary assaytechnology. We employ 96-well, 384-well and 1,536-well microtiter platesolution phase assays to evaluate the biological activity of compounds in ourlibraries.

 

Each screening well in our 1,536-well ultrahigh-throughput screening (“UHTS”) system accommodates a 1-microlitervolume for conducting the assay. This compares with a 100-microliter volumerequired in each well of a 96-well plate. Thus, compound and reagentconsumption is reduced by 99%. In addition, each plate represents over 1,500tests rather than 96.  We have beendeveloping this 1,536-well system internally and through contractors, vendors andcollaborators since 1996.

 

We have improved the 96-well, the 384-well and the1,536-well microtiter plate assays we perform for our collaborators. Theseimprovements include increasing the sensitivity of detection, increasing thenumber of assays that can be run daily, reducing labor and materials requiredto execute assays and allowing simultaneous collection of information on theactivity of a single compound against multiple targets.

 

In 2002, we completed several million tests of ourlibrary compounds for activity against biological targets such as receptors orenzymes.  For primary screening, weoften include 10-20 compounds per well to perform a quick survey of a library’sactivity.  If assay results suggest thatsome compounds in that library are active, then compounds from that library aretested individually.

 

*ProductionAutomation. *Productionautomation technology is another important component of our integrated drugdiscovery approach. We have developed proprietary instruments and methods for quicklyand cost effectively manipulating large numbers of small plastic beads and thecompounds that are detached from these beads. Our proprietary technologyincludes bead washing and synthesis vessels that support the synthesis process.The production automation technology also includes proprietary engineeringmethods and automated systems for placing individual compounds in 96 to1,536-well microtiter plates and processing these plates in preparation forscreening. Screening a single 50,000 compound library against 20 or moretargets can require the loading, processing and testing of thousands of 96-wellmicrotiter plates.

 

*InformationSystems*.  We have developed proprietarysoftware to support our drug discovery activities. Our information systemsassist our scientists in managing the extensive data generated during libraryproduction and testing. First, the software tracks the chemical buildingblocks, reaction steps and tag sets used to create each library. Our systemsthen track the thousands of bar-coded microtiter plates filled and processed aslibraries are screened. As active compounds are identified and decoded, oursoftware integrates the tag set decoding results with the original librarydesign database to quickly provide our scientists with the specific chemicalstructure and synthesis steps for the active compound.

 

Our information systems also include analytical anddatabase tools. Databases of available chemical building blocks and reactionsare used as reference sources in the library design process. Molecularmodeling, structure analysis and statistical programs are available fordesigning optimization libraries. In addition, analytical and database softwareis used to collect and analyze the results of individual assays.  PDD uses Accelrys products, therebysignificantly enhancing our ability to use informatics in the drug discoveryprocess.  See “Pharmacopeia’s SoftwareSegment – Accelrys Inc.”

 

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As we continue to build our chemical libraries andaccelerate our high-throughput screening activities a sizable amount of SARinformation is emerging from these activities, which is being stored in ourinformation systems. We have the ability to access this SAR information for ourown internal use or to assist existing and new customers in the search ofcandidate molecules that interact with specific targets.

 

*QualityAssurance. *Our drug discovery approach includesan 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.

 

DRUG DISCOVERY COMPETITORS

 

Many organizations are actively attempting to identifyand optimize compounds for potential pharmaceutical development. We competewith the research departments of pharmaceutical companies, biotechnologycompanies, other combinatorial chemistry companies and research and academicinstitutions.

 

Many of these competitors have greater financial andhuman resources, and more experience in research and development, than we.  Historically, pharmaceutical companies havemaintained close control over their research activities, including thesynthesis, screening and optimization of chemical compounds. Many of these companies,which represent the greatest potential market for our products and services,are developing combinatorial chemistry and other methodologies to improveproductivity, including major investments in robotics technology to permit theautomated parallel synthesis of compounds. In addition, these companies mayalready have large collections of compounds previously synthesized or orderedfrom chemical supply catalogs or other sources against which they may screennew targets. Other sources of compounds include compounds extracted fromnatural products such as plants and microorganisms and compounds created usingrational drug design. Academic institutions, governmental agencies and otherresearch organizations are also conducting research in areas in which we areworking, either on their own or through collaborative efforts.

 

We compete with several alternative technologies inthe design and synthesis of new chemical libraries for drug discovery programs.Combinatorial chemistry libraries of oligonucleotides and peptides can besynthesized in extremely large numbers. These molecules are also sequenceable,making it easy to identify the structure of an individual oligonucleotide orpeptide found to be active in an assay. However, oligonucleotides and peptidesare not usually effective as oral drugs because they are usually notbioavailable. These molecules are also usually quickly metabolized in the humanbloodstream. Other, unnatural oligomer libraries have also been prepared, butthese are less easily sequenceable than peptides and oligonucleotides. Inaddition, unnatural oligomer libraries lack the diversity of structures of thesmall molecule libraries we prepare.

 

Libraries of small molecule compounds, which arepreferred as drug candidates due to their increased potential for oralbioavailability and long duration of action, are being developed usingcompetitive techniques. Three such techniques are based on “pool and split”solid phase combinatorial chemistry. The first uses oligonucleotide or peptidetags on each bead to identify each synthesis step. These large molecule tagsare relatively fragile, which limits the nature of reaction conditions(temperature, pressure, etc.) and reagents (acids, bases, etc.) that can beused to build compounds. In addition, these large molecule tags complicate thesynthesis of compounds or beads. Our proprietary tag sets, in comparison, aredurable, simple to attach and detach, and allow us to make larger and morediverse libraries of small compounds. The second “pool and split” combinatorialchemistry technique uses deconvolution to identify the chemical structure ofcompounds found active in assays. Deconvolution is a slow, labor-intensiveprocess, and may require several weeks of scientists’ time to determine thestructure of a single active compound. Our tag sets permit hundreds ofstructures to be determined each day. The third “pool and split” 

 

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combinatorial chemistry technique uses what are referred to as “hardtags” and is proprietary to a specific large pharmaceutical company.

 

A fourth competitive approach is to perform a seriesof individual chemical reactions, typically using a robotic system. The resultof robotic synthesis is compounds in individually labeled vessels. Roboticsynthesis also yields larger quantities of each compound than are usuallyachieved in combinatorial mixtures such as ours.  Using robotic synthesis, however, requires extensive labor andtime when compared with Direct Divide combinatorial chemistry. This labor andtime disadvantage increases exponentially with library size.

 

DRUG DISCOVERY BUSINESS - EXCLUSIVE LICENSE WITH COLUMBIA UNIVERSITYAND COLD SPRING HARBOR LABORATORY

 

In 1993, we entered into an exclusive licenseagreement with Columbia and Cold Spring (jointly, the “Licensors”) coveringtechnology related to tagged combinatorial chemical libraries and methods ofpreparing and utilizing such libraries. The licensed technology includespatents and patent applications filed by Columbia and Cold Spring covering theuse of encoding tag sets to implement the drug discovery process usingcombinatorial chemistry libraries. We are obligated to pay a minimum annuallicense fee of $100,000 to the Licensors. The term of the agreement is thelater of (i) 20 years or (ii) the expiration of the last patent relating to thetechnology, at which time we will have a fully paid license to the technology.We are also obligated to pay royalties to the Licensors based on net sales ofpharmaceutical products we developed, as well as a percentage of all otherpayments and royalties we receive from customers where we have utilized thetechnology licensed from the Licensors.

 

DRUG DISCOVERY - PATENTS AND PROPRIETARY INFORMATION

 

We have applied for 161 patents in the PDD business,69 of which have been issued relating to various aspects of our PDD technology,including our molecular tag sets, certain screening technologies and ourlibraries or compounds contained therein. We either own these patents and patent applications or rights under themare licensed to us.  Of particular note,we are the exclusive licensee of US patents issued on October 15, 1996,February 24, 1998 and August 4, 1998, which provide broad protection to our useof encoded combinatorial libraries. Our success will depend in large part onour ability, and the ability of our licensees and licensors, to obtain patentsfor our technologies and the compounds and other products, if any, resultingfrom the application of such technologies, defend patents once obtained,maintain trade secrets and operate without infringing upon the proprietaryrights of others, both in the United States and in foreign countries.

 

The patent positions of pharmaceutical andbiotechnology companies, including our Company, are uncertain and involvecomplex legal and factual questions for which important legal questions are notcompletely resolved. We do not know of any patents or patent applications byothers that would preclude us from practicing our ECLiPS technology orobtaining patent protection in the United States or elsewhere for our ECLiPStechnology. However, disputes may arise between other patent holders and us asto claims of infringement, which could involve protracted periods oflitigation. Some of our competitors have, or are affiliated with companieshaving, substantially greater resources than us, and such competitors may beable to sustain the costs of complex patent litigation to a greater degree andfor longer periods of time than us. Uncertainties resulting from the initiationand continuation of any patent or related litigation could have a materialadverse effect on our ability to compete in the marketplace pending resolutionof the disputed matters.

 

There can be no assurance that patents will issue as aresult of any pending applications or that, if issued, such patents will besufficiently broad to afford protection against competitors with similartechnology. Moreover, there can be no assurance that we or our customers willbe able to obtain patent protection for compounds or pharmaceutical productsbased upon our technology. There can be no assurance that any patents issued tous or our collaborative partners, or for which we have license rights, will notbe challenged, invalidated or circumvented, or that the rights grantedthereunder will provide competitive advantages to us. Litigation, which couldresult in

 

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substantial cost to us, may be necessary to enforce our patent andlicense rights or to determine the scope and validity of others’ proprietaryrights.

 

Our commercial success will also depend upon avoidingthe infringement of patents issued to competitors and upon maintaining thetechnology licenses upon which certain of our current products are, or anyfuture products under development might be, based. If our competitors prepareand file patent applications in the United States that claim technology alsoclaimed by us, we may have to participate in interference proceedings declaredby the US Patent and Trademark Office to determine the priority of invention,which could result in substantial cost to us, even if the outcome is favorableto us. An adverse outcome could subject us to significant liabilities to thirdparties and require us to obtain a license to disputed rights from thirdparties or cease using the technology.

 

We currently have certain licenses from third partiesand in the future may require additional licenses from other parties todevelop, manufacture and market commercially viable products effectively. Inperforming Lead Discovery, we or our collaborators may need to obtain licensesto enable us to utilize certain assay technology and to screen against certaintargets. Our commercial success in our Lead Discovery Services may depend onour ability or our collaborators’ ability to obtain such licenses. There can beno assurance that such licenses will be obtainable on commercially reasonableterms, if at all, that the patents underlying such licenses will be valid andenforceable or that the proprietary nature of the patented technologyunderlying such licenses will remain proprietary.

 

We rely substantially on certain technologies that arenot patentable or proprietary and are therefore available to our competitors.We also rely on certain proprietary trade secrets and know-how, which are notpatentable. Although we have taken steps to protect our unpatented tradesecrets and know-how, in part through the use of confidentiality agreementswith our employees, consultants and certain of our contractors, there can be noassurance that these agreements will not be breached, that we would haveadequate remedies for any breach, or that our trade secrets will not otherwisebecome known or be independently developed or discovered by competitors.

 

DRUG DISCOVERY - GOVERNMENT REGULATION

 

Regulation by governmental entities in the UnitedStates and other countries will be a significant factor in the production andmarketing of any pharmaceutical products that may be developed by a customer ofours or, in the event we decide to develop a drug beyond the preclinical phase,by us. The nature and the extent to which such regulation may apply to ourcustomers will vary depending on the nature of any such pharmaceuticalproducts. Virtually all pharmaceutical products developed by our customers willrequire regulatory approval by governmental agencies prior tocommercialization. In particular, human pharmaceutical therapeutic products aresubject to rigorous preclinical and clinical testing and other approvalprocedures by the US Food and Drug Administration (“FDA”) and by foreignregulatory authorities. Various federal and, in some cases, state statutes andregulations also govern or influence the manufacturing, safety, labeling,storage, record keeping and marketing of such pharmaceutical products. Theprocess of obtaining these approvals and the subsequent compliance withappropriate federal and foreign statutes and regulations are time consuming andrequire the expenditure of substantial resources.

 

Generally, in order to gain FDA approval, a companymust conduct preclinical studies in the laboratory and in animal models to gainpreliminary information on a compound’s efficacy and to identify any safetyproblems. The results of these studies are submitted as a part of anInvestigational New Drug application (“IND”) that the FDA must review beforehuman clinical trials of an investigational drug can start. 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 clinicalstudies to demonstrate the safety and efficacy that are necessary to obtain FDAapproval of any such products. Clinical trials are normally done in threephases and generally take two to five years, but may take longer, to complete.After completion of clinical trials of a new product, FDA and foreignregulatory authority marketing approval must be obtained. If the product isclassified as a new drug, we, or our customer, will be required to file a NewDrug Application and receive approval before commercial marketing of the drug.The testing and approval processes require substantial time and effort andthere can be no assurance that any approval will be granted on a timely basis,if at all. Even if FDA regulatory clearances are obtained, a marketed productis subject to 

 

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continual review, and later discovery of previously unknown problems orfailure to comply with the applicable regulatory requirements may result inrestrictions on the marketing of a product or withdrawal of the product fromthe market as well as possible civil or criminal sanctions. For marketingoutside the United States, we will also be subject to foreign regulatoryrequirements governing human clinical trials and marketing approval forpharmaceutical products. The requirements governing the conduct of clinicaltrials, product licensing, pricing and reimbursement vary widely from countryto country. Our research and development processes involve the controlled useof hazardous materials. We are subject to federal, state and local laws andregulations governing the use, manufacture, storage, handling and disposal ofsuch materials and certain waste products. Although we believe that ouractivities currently comply with the standards prescribed by such laws andregulations, the risk of accidental contamination or injury from thesematerials cannot be eliminated. In the event of such an accident, we could beheld liable for any damages that result and any liability could exceed ourresources. In addition, there can be no assurance that we will not be requiredto incur significant costs to comply with environmental laws and regulations inthe future.

 

DRUG DISCOVERY - SOURCES OF SUPPLY

 

We currently rely on two suppliers to provide plasticfilter bottom microtiter plates that are used in the assay plate preparationprocess. We have, over the past year, developed a process such that it is notentirely dependent upon these suppliers. Should we be unable, in some instances, to obtain an adequate supply ofthese or comparable filter bottom plates at commercially reasonable rates, ourability to continue to prepare assay plates could be adversely affected, whichin turn can harm our business.

 

DRUG DISCOVERY - PHARMACEUTICAL MANUFACTURING AND MARKETING

 

We do not expect to directly manufacture or market anypharmaceutical products that may be developed under our collaborativearrangements. However, we may, in the future, consider undertaking suchactivities if we believe they are appropriate under the circumstances. We haveno experience in developing pharmaceutical products or in manufacturing ormarketing products on a commercial scale. We may not have the resources todevelop or to manufacture or market on our own on a commercial scale anyproducts identified by us. In the event we decide to establish a manufacturingfacility, we will require substantial additional funds, and will be required tohire and train significant additional personnel and comply with the extensiveFDA “good manufacturing practice” regulations applicable to such a facility.

 

RESEARCH AND DEVELOPMENT

 

Pharmacopeia’s expense for proprietary research anddevelopment activities was as follows (in thousands):

 

| **Years Ended December 31,** |   |
|------------------------------|--------|
| **2002**                     |   | **2001** |   | **2000** |   |
| $                            | 27,868 |   | $ | 32,529 |   | $ | 25,205 |   |
|                              |        |  |  |  |  |  |  |  |

 

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.  The increase from 2000 to 2001 resulted primarily fromacquisitions.  The 2000 amount excludesan $8,740 charge for in-process research and development identified in theacquisitions of Oxford and Synopsys, collectively, as described in the Notes toConsolidated Financial Statements.

 

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EMPLOYEES

 

As of December 31, 2002, we had 687 regular employees,including 263 chemists, biologists and engineers holding doctoratedegrees.  None of our employees iscovered by collective bargaining agreements. We believe our relations with our employees are good.

 

RISKFACTORS

 

*Youshould carefully consider the risks described below before investing in ourpublicly-traded securities.  The risksdescribed below are not the only ones facing us.  Our business is also subject to the risks that affect many othercompanies, such as competition, technological obsolescence, labor relations,general economic conditions, geopolitical changes and internationaloperations.  Additional risks notcurrently known to us or that we currently believe are immaterial also mayimpair our business operations and our liquidity.*

 

CERTAIN RISKS RELATED TO OUR BUSINESS AS AWHOLE

 

*Our success depends in part upon the successfulimplementation of our management’s strategic plan.* Ourmanagement has been, and continues to be, engaged in the consideration andexploration of strategic alternatives for our businesses, including thepossible separation by various means of our Drug Discovery business from ourAccelrys software operation.  There canbe no assurance that any such strategic alternative will be implemented or, ifcompleted, that it will enhance the value of either or both of ourbusinesses.  Such alternatives also mayinclude the acquisition of businesses and technologies which complement orsupplement our existing businesses and technologies. However, management may beunable to identify suitable strategic opportunities, choose the wrongtechnologies or businesses to pursue or be unable to negotiate suitable pricesor favorable terms with respect to strategic opportunities.  The occurrence of any of the foregoing mayhave a material adverse effect on our business.

 

*The agreement with our major Drug Discovery customer expiresthis year.*** **Duringthe year ended December 31, 2002, we earned approximately 12% of ourconsolidated revenue from one major customer in our Drug DiscoverySegment.  The agreement with this keycustomer expires by its terms in October 2003. We have initiated negotiations with the customer concerning renewal ofthis agreement; however, renewal of the agreement, on the same, similar orother favorable terms, or at all, is uncertain.  The termination of this agreement, without renewal on acceptableterms, will have a material adverse effect on PDD, and our business as awhole.  There can be no assurance wewill be able to renew the agreement with this significant customer on the same,similar or other favorable terms, or at all.

 

*Pharmaceutical and biotechnology companies may discontinueor decrease their use of our services and products.*** **We depend on pharmaceutical andbiotechnology companies that use our services for a large portion of our drugdiscovery revenue. Further, these companies (together with diversified chemicaland other industrial companies) comprise the principal market for our Accelrysmodeling, simulation, data analysis and related software products andservices.  Although there is a historyamong pharmaceutical and biotechnology companies of outsourcing drug researchand development functions, this practice may not continue. Similarly, thesecompanies have frequently utilized outside software vendors for key tools usedin drug discovery and chemical development, rather than developing neededinformation and analysis tools internally. Our revenue depends to a large extent on research and developmentexpenditures by the pharmaceutical, biotechnology, chemical and agriculturalindustries, particularly companies in these industries outsourcing research anddevelopment projects and adding new and improved technologies to acceleratetheir drug discovery and chemical development initiatives.  These expenditures are based on a widevariety of factors, including the resources available for purchasing researchequipment, the spending priorities among various types of research, policiesregarding expenditures during recessionary periods and the benefits of newsoftware tools versus their costs of licensure.  General economic downturns in our customers’ industries or any decreasein research and development expenditures could harm our operations, as couldincreased popularity of management theories which counsel against outsourcingof critical business functions. In addition, the popularity of scientificthinking that disfavors expensive products such as large diversity libraries

 

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could negatively impact our revenue or our sales mix. Any decrease indrug discovery spending by pharmaceutical and biotechnology companies, or inchemical or materials spending by chemical and agricultural companies, couldcause our revenues to decline and adversely impact our profitability.

 

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

 

•                  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 revenues from additional orexpanded customer relationships, we may not be able to grow our business.

 

*Our future profitability is uncertain.*We generated a small profit in 2000, andwe’ve generated losses in 2001 and 2002. Our future profitability depends upon many factors, includingseveral that are beyond our control. These factors include:

 

•                  changes in thedemand for our products and services;

•                  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 and timely develop, introduce and market new products, servicesand product enhancements cost effectively.

 

*We operate in business lines that change rapidly and inunexpected ways.* Rapid technological change and uncertaintydue to new and emerging technologies characterize the software, drug discoveryand chemical 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 amaterial adverse effect on us.* Our success depends in part onthe continued service of key scientific, software, sales, engineering andmanagement personnel and our ability to identify, hire and retain additionalpersonnel. There is intense competition for qualified personnel. In particular,we believe that there is a shortage of scientists qualified to work in the DrugDiscovery segment. 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 the Drug Discovery segment. Failure to attract and retain keypersonnel could have a material adverse effect on our business, financialcondition and results of operations. Further, we are highly dependent on theprincipal members of our scientific and management staff, including:

 

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

•                  Mark J. Emkjer,Executive Vice President and President, Accelrys; and

 

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•                  Stephen A.Spearman, Ph.D., Executive Vice President and Chief Operating Officer,Pharmacopeia Drug Discovery, Inc.,

 

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 do not, and do notintend to, maintain key person life insurance on the life of any employee.

 

* We are dependentupon some of our suppliers.* We currently rely on twosuppliers to provide plastic filter bottom microtiter plates that are used inthe assay plate preparation process. We have, over the past year, developed aprocess such that we are not entirely dependent upon these suppliers.  Should we be unable, in some instances, toobtain an adequate supply of these or comparable filter bottom plates atcommercially reasonable rates, our ability to continue to prepare assay platescould be adversely affected, which in turn could harm our business.

 

*We may be unable to develop strategic relationships withlarge pharmaceutical, 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 AG, IBM,Oracle and HP.  There can be noassurance that any such relationship will continue, that relationships withsimilar large organizations can be developed, or that any such existing or newalliances will produce substantial revenue opportunities.

 

*We are subject to risks associated with the operation of aninternational business.* In 2002, approximately 53% of our consolidated revenue was derived fromcustomers outside the United States, both through international subsidiariesand on an export basis. Approximately 36% of our revenue was derived fromcustomers in Europe and approximately 17% was derived from customers in theAsia/Pacific region. We anticipate that international revenue will continue toaccount for a significant percentage of overall revenue. Our internationaloperations are subject to risks inherent in the conduct of internationalbusiness, including:

 

•      unexpected changes inregulatory requirements;

•      longer payment cycles;

•      currency exchange ratefluctuations;

•      import and export licenserequirements;

•      tariffs and other barriers;

•      political and economicinstability;

•      limited intellectualproperty protection;

•      difficulties in collectingtrade receivables;

•      difficulties in managingdistributors or representatives;

•      difficulties in staffing andmanaging foreign subsidiary or joint venture operations; and

•      potentially adverse tax consequences.

 

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We may not be able to sustain or increaseinternational revenue. Any of the foregoing factors may have a material adverseeffect on our international operations and, therefore, our business, financialcondition and results of operations. Our direct international sales generallyare denominated in local currencies. Fluctuations in the value of currencies inwhich we conduct business relative to the United States dollar result incurrency transaction gains and losses, and the impact of future exchange ratefluctuations cannot be accurately predicted. Future fluctuations in currencyexchange rates may have a material adverse impact on revenue from internationalsales, and thus on our business, financial condition and results of operations.When deemed appropriate, we may engage in currency exchange rate hedgingtransactions in an attempt to mitigate the impact of adverse exchange ratefluctuations. However, currency hedging policies may not be successful, andthey may increase the negative impact of exchange rate fluctuations.

 

*Investments in Sales Efforts.*  Both our Drug Discovery and softwareproducts and services involve lengthy sales cycles, often requiring us toexpend considerable financial and personnel resources without any assurancethat revenue will be recognized.  Thesesales cycles typically are long for a number of reasons.  In Drug Discovery, factors include thestrategic nature of Drug Discovery partnerships, the size of many suchtransactions, the confidential and proprietary nature of the biological targetsagainst which we screen our chemical compound libraries, and the unique termstypically found in each services transaction. With respect to software sales, sales cycles are impacted by the timeand resources required to educate potential customer organizations as to thevalue and comparative advantages of our products. As a result, we may expendsubstantial funds and effort to negotiate agreements for services and productsin both of our business segments, but may ultimately be unable to consummate asale. In these circumstances, our results of operations and ability to achieveprofitability are adversely affected.

 

*Consolidation within the pharmaceutical and biotechnologyindustries may lead to fewer potential customers for our products andservices. *Asignificant portion of our customer base consists of pharmaceutical andbiotechnology companies. Mergers between large multinational pharmaceuticalcompanies have accelerated in recent years. Continued consolidation within thepharmaceutical and biotechnology industries may result in fewer customers forour products and services. If one of the parties to a consolidation uses theproducts or services of our competitors, we may lose existing customers as aresult of such consolidation.

 

*Our operations may be interrupted by the occurrence of anatural disaster or other catastrophic event at our primary facilities. *We depend on our laboratories and equipment for the continued operationof our business. Our research and development operations and administrativefunctions are primarily conducted at our facilities in the Princeton, NewJersey area, San Diego, California and Cambridge, United Kingdom.  Although we have contingency plans in effectfor natural disasters or other catastrophic events, catastrophic events couldstill disrupt our operations. Even though we carry business interruptioninsurance policies, we may suffer losses as a result of business interruptionsthat exceed the coverage available under our insurance policies. Any naturaldisaster or catastrophic event in our facilities or the areas in which they arelocated could have a significant negative impact on our operations.

 

*Terrorist attacks or acts of war may seriously harm ourbusiness.*** **Terroristattacks or acts of war may cause damage or disruption to our company, ouremployees, our facilities and our customers, which could significantly impactour revenues, costs and expenses and financial condition. The terrorist attacksthat took place in the United States on September 11, 2001 were unprecedentedevents that have created many economic and political uncertainties, some ofwhich may materially adversely affect our business, results of operations andfinancial condition. The long-term effects on our company of the September 11,2001 attacks are unknown. The potential for future terrorist attacks, the nationaland international responses to terrorist attacks, and other acts of war orhostility have created many economic and political uncertainties, which couldmaterially adversely affect our business, results of operations, and financialcondition in ways that we currently cannot predict.

 

*Because our stock price may be volatile, our stock pricecould experience 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. In addition, 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.

 

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*As institutions hold the majority of our Common Stock inlarge blocks, substantial sales by these stockholders could depress the marketprice for our shares.* As of January 31, 2003, our company’s six largest stockholders heldapproximately 53% 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 benefitfrom an investment in our common stock only if it appreciates in value.*  Wehave never declared or paid any cash dividends on our common stock. Wecurrently intend to retain our future earnings, if any, to finance theexpansion of our business and do not expect to pay any cash dividends in theforeseeable future. As a result, the success of your investment in our commonstock will depend entirely upon any future appreciation in its value. There isno guarantee that our common stock will appreciate in value or even maintainthe price at which you purchased your shares.

 

*Anti-takeover provisions under the Delaware generalcorporation law, provisions in our certificate of incorporation and bylaws, andour adoption of a stockholder rights plan may render more difficult theaccomplishment of mergers or the assumption of control by a principalstockholder, making more difficult the removal of management*.Certain provisions of the Delaware General Corporation Law may delay or deterattempts to secure control of our company without the consent of ourmanagement. Also, our governing documents provide for a staggered board ofdirectors, which will make it more difficult for a potential acquiror to gain controlof our Board of Directors. In 2002, we adopted a stockholder rights plan, whichis triggered upon commencement or announcement of a hostile tender offer orwhen any one person or group acquires 15% or more of our common stock. Therights plan, once triggered, enables stockholders to purchase our common stock,and the stock of the entity acquiring us, at reduced prices. These provisionsof our governing documents, stockholder rights plan and Delaware law could havethe effect 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 beunable to raise 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 2003***.*** 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;

•                  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,the capital could be raised through public or private financings involving debtor equity. However, additional capital may not be available on favorable terms,or at all. If adequate funds are not available, we may be required to curtailoperations significantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

 

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CERTAIN RISKS RELATED TO INTELLECTUALPROPERTY

 

*Positions taken by the U.S. patent and trademark office ornon-U.S. patent and trademark officials may preclude us from obtainingsufficient or timely protection for our intellectual property.*Thepatent positions of pharmaceutical, biotechnology and software companies areuncertain and involve complex legal and factual questions. The coverage claimedin a patent application can be significantly reduced before the patent isissued. There is a significant risk that the scope of a patent may not besufficient to prevent third parties from marketing other products ortechnologies with the same functionality of our products and technologies.Consequently, some or all of our patent applications may not issue intopatents, and any issued patents may provide ineffective remedies or bechallenged or circumvented.

 

*Third parties may have filed patent applications of which wemay or may not have knowledge, and which may adversely affect our business*.Patent applications in the U.S. are maintained in secrecy for 18 months fromfiling or until a patent issues. Under certain circumstances, patentapplications are never published but remain in secrecy until issuance. As aresult, others may have filed patent applications for products or technologycovered by one or more pending patent applications upon which we are relying.There may be third-party patents, patent applications and other intellectualproperty or information relevant to our software, chemical compositions andother technologies which are not known to us and that block or compete with oursoftware, chemical compositions or other technologies, or limit the scope ofpatent protection available to us. Moreover, from time to time, patents mayissue which block or compete with our software, chemical compositions or othertechnologies, or limit the scope of patent protection available to us.** **Litigation may be necessary toenforce patents issued to us or to determine the scope and validity of theintellectual property rights of third parties. See, e.g., “Business – Accelrys Intellectual Property and OtherProprietary Rights.”

 

*We may not be able to protect adequately the trade secretsand confidential information that we disclose to our employees*.We rely upon trade secrets, technical know-how and continuing technologicalinnovation to develop and maintain our competitive position. Competitorsthrough their independent discovery (or improper means, such as unauthorizeddisclosure or industrial espionage) may come to know proprietary information.We generally require employees 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 during the employee’s relationship with us are to be keptconfidential, and that all inventions arising out of the employee’srelationship with us are our exclusive property. Our employees and consultantsmay breach these agreements, and in some instances we may not have an adequateremedy. Additionally, in some instances, we may have failed to require thatemployees and consultants execute confidentiality and assignment-of-inventionsagreements.

 

*Foreign laws may not afford us sufficient protections forour intellectual property, and we may not seek patent protection outside theUnited States*. We believe that our success depends, in part,upon our ability to obtain international protection for our intellectualproperty. However, the laws of some foreign countries may not be ascomprehensive as those of the U.S. and may not be sufficient to protect ourproprietary rights abroad. In addition, we may decide not to pursue patentprotection outside the United States, because of cost and confidentialityconcerns. Accordingly, our international competitors could obtain foreignpatent protection for, and market overseas, products and technologies for whichwe are seeking U.S. patent protection.

 

*We may not be able to adequately defend our intellectualproperty from third party infringement, and third party challenges to ourintellectual property may adversely affect our rights and be costly and timeconsuming*. Some of our competitors have, or are affiliatedwith companies having, substantially greater resources than we have, and thosecompetitors may be able to sustain the costs of complex patent litigation to agreater degree and for longer periods of time than us. Uncertainties resultingfrom the initiation and continuation of any patent or related litigation couldhave a material adverse effect on our ability to compete in the marketplacepending resolution of the disputed matters. If our competitors prepare and filepatent applications in the United States that claim technology also 

 

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claimed by us, we may have to participate in interference proceedingsdeclared by the U.S. Patent and Trademark Office to determine the priority ofinvention, which could result in substantial costs to us, even if the outcomeis favorable to us. Similarly, opposition proceedings may occur overseas, whichmay result in the loss or narrowing of the scope of claims or legal rights.Such proceedings will at least result in delay in the issuance of enforceableclaims. An adverse outcome could subject us to significant liabilities to thirdparties and require us to license disputed rights from third parties or ceaseusing the technology. Despite our efforts to protect our proprietary rights,unauthorized parties may attempt to copy aspects of our products or to obtainand use information that we regard as proprietary. In limited instances, wehave licensed source codes of certain products to customers or collaborators.For these reasons, policing unauthorized use of our software products may be difficult.

 

*A patent issued to us may not be sufficiently broad toprotect adequately our rights in intellectual property to which the patentrelates*. Even if patents are issued to us, these patents maynot sufficiently protect our interest in our software, chemical compositions orother technologies because the scope of protection provided by any patentsissued to or licensed by us are subject to the uncertainty inherent to patentlaw. Third parties may be able to design around these patents or develop uniqueproducts providing effects similar to our products. In addition, others maydiscover uses for our software, chemical compositions or technologies otherthan those uses covered in our patents, and these other uses may be separatelypatentable. A number of pharmaceutical and biotechnology companies, andresearch and academic institutions, have developed technologies, filed patentapplications or received patents on various technologies that may be related toour business. Some of these technologies, patent applications or patents mayconflict with our technologies, patent applications or patents. These conflictscould also limit the scope of patents, if any, that we may be able to obtain,or result in the denial of our patent applications.

 

*We may be subject to claims of infringement by third parties*.Third parties may claim infringement by us of their intellectual propertyrights. In addition, to the extent our employees are involved in research areassimilar to those areas in which they were involved at their former employers,we may be subject to claims that our employee or we have inadvertently orotherwise used or disclosed the alleged trade secrets or other proprietaryinformation of a former employer. From time to time, we have received lettersclaiming or suggesting that our products or activities may infringe third partypatents or other intellectual property rights. Our products may infringe patentor other intellectual property rights of third parties. A number of patents mayhave been issued or may be issued in the future that could cover certainaspects of our technology and that could prevent us from using technology thatwe use or expect to use. We may be required to seek licenses for or otherwiseacquire rights to technology as a result of claims of infringement. We may notpossess proper ownership or access rights to the intellectual property we use.Third parties or other companies may bring infringement suits against us.  We expect, in general, that simulationsoftware product developers will be subject to more infringement claims as thenumber of products and competitors in our industry segments grows and thefunctionality of products in different industry segments overlaps. Any claims,with or without merit, could be time consuming to defend, result in costlylitigation, divert management’s attention and resources, cause product shipmentdelays or require us to enter into royalty or licensing agreements. 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 could have a material adverse effect on our business, financialcondition and results of operations.

 

CERTAIN RISKS RELATED TO ACCELRYS

 

*Our ability to increase Accelrys software revenues maydepend upon increased 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, to experimentalists, such asscientists and engineers. If we cannot expand our customer base to includeexperimentalists, or if we otherwise cannot successfully market and sell ourdesktop-based products and related services, we may not be able to increase oursoftware revenue, or such revenue may decline. In general, increased marketacceptance and greater market penetration of our software products depend uponseveral factors, including:

 

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•                  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.

 

Our software products and services may not achievemarket acceptance or penetration in their target industries or otherindustries. Failure to increase market acceptance or penetration may restrictsubstantially the future growth of our software business and may have a materialadverse effect on our company as a whole.

 

*We may be unable to develop and market new Accelrys productsthat are necessary to increase revenue*. The success of oursoftware business plan depends heavily upon successful increases in revenue.Our strategy is 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 morebioinformatics and cheminformatics database software that captures and managesthe data created by customers’ drug discovery and chemical developmentactivities, including the data created by the use of computational modeling,simulation, and analyses 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 comparativesales data to rely upon to indicate that our products or data content serviceswill achieve the 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 and other marketactivities of industry participants. Competition currently comes from thefollowing 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, database managementsystems and information technology.

 

In addition, some of our software licenses grant theright to sublicense our software. As a result, our software customers andthird-party licensees could develop specific simulation applications using oursoftware developer’s kit and compete with us by distributing these programs toour potential 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 

 

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these competitors to focus a greater proportion of their efforts onthese markets. Some offerings that compete with our software products aredeveloped and made available at lower cost by governmental organizations andacademic institutions, and these entities may be able to devote substantialresources to product development and also offer their products to users forlittle or no charge.

 

*If we are unable to license software to, or collectreceivables from, our early stage biotechnology customers, it may have amaterial adverse effect on our operating results.*  We frequently license our modeling,simulation, data analysis and informatics software to smaller, developmentstage biotechnology customers. Often these customers have limited or nooperating history, and require considerable funding to launch their businesses.They often significantly scale back, or altogether cease, operations.  Therefore, there is considerable risk incounting on these types of entities for revenue growth.  For entities that remain in business,transactions with these customers carry a higher degree of financial risk. Ourcustomers, particularly our development stage customers, are vulnerable to, andmay be impacted by, the current tightening of available credit and capital, andgeneral economic slowdown occurring in the United States and our other keymarkets. As a result of these conditions, our customers may be unable tolicense or, if under a license, may be unable to pay for, Accelrys softwareproducts. If we are not able to collect such amounts, we may be required towrite-off significant accounts receivable and recognize bad debt expense. Werecorded a provision for doubtful accounts of $1.3 million in fiscal 2002compared to $0.3 million in fiscal 2001. Failure of these businesses, and write-offs and difficulties associatedwith collection of receivables from these customers, could materially adverselyaffect our operating results.

 

*Defects or malfunctions in our software products, or in theproducts of our software technology partners, could hurt our reputation amongsoftware customers 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 businesscould vary significantly***.** We have historically experienced strongerfinancial performance in the third and fourth calendar quarters of each yearfollowed by a comparative decline in the first and second quarters. Quarterlyoperating results may continue to fluctuate as a result of a number of factors,including lengthy sales cycles, market acceptance of new products and upgrades,timing of new product introductions, changes in pricing policies, changes ingeneral economic and competitive conditions, seasonal slowdowns, and the timingand integration of acquisitions. We also expect to continue to experiencefluctuations in quarterly operating results due to general and industry specificeconomic conditions that may affect the research and development expendituresof pharmaceutical and biotechnology companies. Due to the possibility offluctuations in our revenues and expenses, we believe that quarter-to-quartercomparisons of our operating results are not a good indication of our futureperformance.

 

CERTAIN RISKS RELATED TO PHARMACOPEIA DRUGDISCOVERY, INC.

 

*The agreement with a second Drug Discovery customer isterminable under certain circumstances.*** **During the year ended December 31, 2002, we earnedapproximately 10% of our PDD revenue, and 2% of our consolidated revenue, froma second customer in our Drug Discovery business.  The agreement with this significant customer has a stated term offive years; however, the customer has the right to terminate the agreement asearly as the first quarter of 2004 in the event we are unable to deliver to thecustomer a lead compound meeting criteria specified in the agreement.  Thereafter, the customer again has the rightto terminate the agreement prior to the expiration of its stated term if wecannot deliver additional lead compounds meeting these criteria prior to datesset forth in the agreement.  Thetermination of this agreement will have a material adverse effect on PDD, andmay have a material adverse effect on our company’s business as a whole. Therecan be no assurance that we will be able to deliver compliant compounds to thecustomer before the enumerated dates.

 

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*Some of the development and marketing activities of our DrugDiscovery segment are, or will be, conducted by third parties. If these thirdparties fail to perform their functions satisfactorily, our revenue andearnings from the Drug Discovery segment could be delayed, reduced oreliminated.* Theultimate success of the business plan for our Drug Discovery subsidiary heavilydepends upon the successful discovery, development and commercialization ofpharmaceutical products. Our drug discovery endeavors will result in commercializedpharmaceutical products, if at all, only after significant pre-clinical 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 partnersand/or by third parties under service contracts to develop and commercializeproducts primarily based on therapeutic antibodies and lead compoundsdiscovered by us. If a third party working for us under a service contract failsto perform the contracted services adequately, our efforts with respect to thedrug candidate under contract could be delayed or terminated. Further, 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 and serviceproviders, our revenue could be adversely affected if our collaborators and/orservice providers:

 

•                  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 that we originate;

•                  do not conducttheir service or 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 athird party that may wish to terminate our collaboration or service contract.

* *

*Disputes may arise between our collaborative partners and usas to royalties 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 provided tothe customer 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.

 

*There may be only a limited market for our drug discoveryservices.*  The pricingand nature of our drug discovery services are such that there may only be alimited number of potential customers for these services. Continuedconsolidation in the pharmaceutical and biotechnology industries may furtherdecrease the number of potential customers. The acceptance by potentialcustomers of our services is important in determining profitability.Historically, pharmaceutical companies have conducted lead compoundidentification and optimization within their own research departments due tothe highly proprietary nature of the activities being conducted, the centralimportance of these activities to their drug discovery and development efforts,and the desire to obtain maximum patent and other proprietary protection on theresults of their internal programs. In order to achieve our business objectivesfor Pharmacopeia Drug Discovery, Inc., we must convince these companies thatour technology and expertise justify the outsourcing of these programs to us.There can be no assurance that we will be able to attract customers onacceptable terms for our products and services or to develop a sustainableprofitable business. Moreover, the pricing and nature of our combinatoriallibraries is such that there may only be a limited number of

 

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pharmaceutical companies that are potential customers for suchlibraries. There can be no assurance that we will be able to establishadditional collaborative or licensing arrangements, that any such arrangementsor licenses will be on terms favorable to us, or that current or futurecollaborative or licensing arrangements will ultimately be successful.

 

*We may be unable to manage the multiple relationships andinterests involved in our collaborative arrangements and drug discoveryprograms.*  We may needto successfully structure and manage multiple drug discovery programs andcollaborative 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 which we offer services. Conflicts also may arise between customersas to proprietary rights to particular compounds in our libraries or as toproprietary rights to biological targets such as receptors or enzymes againstwhich we screen compounds in our libraries. The occurrence of conflicts couldhave a material adverse effect on our business, financial condition or resultsof operations.

 

*Our current and potential customers are primarily from, andare subject to risks faced by, the pharmaceutical, biotechnology and chemicalindustries*.  For theforeseeable future, we will derive a substantial portion of our revenue fromfees paid by pharmaceutical companies, chemical companies and largerbiotechnology companies for our products and services. As a result, we aresubject to risks and uncertainties that affect the pharmaceutical, chemical andbiotechnology industries and to possible reduction and delays in research anddevelopment expenditures by companies in these industries. Our revenue may alsobe adversely affected by mergers and consolidation in the pharmaceutical,biotechnology and chemical industries, which will reduce the number ofpotential customers.

 

*We may be unsuccessful in producing and licensingproprietary technology developed from our internal research and developmentefforts or acquired from a third party.*** **We have expended and continue to expend time and money oninternal research and development with the intention of producing proprietarytechnologies in order to patent and then license them to other companies.However, we may not be successful in producing any valuable technology orsuccessful in licensing it to a third party. To the extent we are unable toproduce technology that we can license, we may not receive any revenue relatedto our internal research and development efforts.

 

*If we use biological and hazardous materials in a mannerthat causes injury or violates laws, we may be liable for damages.*Our Drug Discovery activities may involve the use of potentially harmfulbiological materials as well as hazardous materials, chemicals and variousradioactive compounds. We cannot completely eliminate the risk of accidentalcontamination or injury from the use, storage, handling or disposal of thesematerials. In the event of contamination or injury, we could be held liable fordamages that result, and any liability could exceed our resources. We aresubject to federal, state and local laws and regulations governing the use,storage, handling and disposal of these materials and specified waste products.The cost of compliance with these laws and regulations could be significant.

 

**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 and occupy approximately 144,000 squarefeet in two facilities near Princeton, New Jersey.  These leases expire at various dates through 2006.  Our principal Accelrys administrative,sales, support, marketing and product development facilities and corporateheadquarters are located in San Diego, California, where Accelrys has leased76,635 square feet through December 2006. Our European Accelrys headquarters, along with administrative, sales,support, marketing and product development functions, are located in Cambridge,England, where we have leased 38,501 square feet through 2022.  Additionally in Cambridge, we have leased6,545 square feet through December 31, 2008 which space is currently unused.

 

### **ITEM 3.  LEGAL PROCEEDINGS**

 

We are not a party to any material legal proceedings.

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Not applicable.

 

**ITEM4A.  EXECUTIVE OFFICERS OF THEREGISTRANT**

 

Our Executive Officers are as follows:

 
| **Name**                    |   | **Age** |   | **Position**                                                                                         |   |
|-----------------------------|--------|---------|--------|------------------------------------------------------------------------------------------------------|--------|
| Joseph A.  Mollica, Ph.D.   |   | 62      |   | Chairman of the Board, President and Chief Executive  Officer of the Company                         |   |
|                        |   |    |   |                                                                                                 |   |
| Mark J. Emkjer              |   | 47      |   | President, Accelrys Inc.; Executive Vice President  of the Company                                   |   |
|                        |   |    |   |                                                                                                 |   |
| Stephen A.  Spearman, Ph.D. |   | 53      |   | Chief Operating Officer, Pharmacopeia Drug  Discovery, Inc.; Executive Vice President of the Company |   |
|                        |   |    |   |                                                                                                 |   |
| John J. Hanlon              |   | 55      |   | Chief Financial Officer, Executive Vice President of  the Company                                    |   |
|                        |   |    |   |                                                                                                 |   |
| Michael G.  Lenahan         |   | 43      |   | General Counsel, Executive Vice President and  Secretary of the Company                              |   |
|                        |   |    |   |                                                                                                 |   |
| William J.  DeLorbe         |   | 54      |   | Executive Vice President, Human Resources, of the  Company                                           |   |
|                        |   |    |   |                                                                                                 |   |
| Scott D. Kahn,  Ph.D        |   | 43      |   | Chief Science Officer, Senior Vice President,  Research and Development, Accelrys Inc.               |   |
|                        |   |    |   |                                                                                                 |   |
| John Delli Santi            |   | 38      |   | Senior Vice President, Sales, Accelrys Inc.                                                          |   |
|                        |   |    |   |                                                                                                 |   |
| Dennis A. Rossi             |   | 52      |   | Vice President, Marketing, Accelrys Inc.                                                             |   |
|                        |   |    |   |                                                                                                 |   |
| Arthur E. Roke,  CPA        |   | 37      |   | Chief Accounting Officer, Vice President, Finance of  the Company                                    |   |

 

Dr. Mollica has served as our Chairman of the Board ofDirectors and Chief Executive Officer since February 1994 and was appointed asour President in August 1996. From 1987 to December 1993, Dr. Mollica wasemployed initially by the DuPont Company and then by The DuPont MerckPharmaceutical Company, most recently as President and Chief ExecutiveOfficer.  Dr. Mollica is a director ofGenencor International Inc., ImPath, Inc. and Neurocrine BioSciences, Inc.  Dr. Mollica received a Ph.D. from theUniversity of Wisconsin, and a Doctor of Science, h.c., from the University ofRhode Island.

 

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Mr. Emkjer has served as President of our Accelryssoftware subsidiary and Executive Vice President of the Company since December2002.  From 1999 to 2002, he served asPresident and Chief Operating Officer of Sunquest Information Systems, Inc., aninformation technology company developing laboratory, radiology and pharmacysystems and 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 1992 to 1996.  Mr. Emkjer holds an M.B.A. from FloridaAtlantic University and a B.S. from the University of Miami.

 

Dr. Spearman was named Chief Operating Officer andExecutive Vice President of Pharmacopeia Drug Discovery, Inc. in April 2002,and has been an Executive 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 Presidentand Chief Financial Officer since June 2002. From 1988 to 1998, Mr. Hanlon was the Chief Financial Officer of MDLInformation Systems, Inc., a provider of integrated scientific informationmanagement systems, databases and services. Most recently, he was President and Chief Financial Officer of apublicly held e-payment service provider. Mr. Hanlon also spent 10 years in public accounting at Coopers andLybrand.  Mr. Hanlon holds a B.S. fromCalifornia State University, Hayward, and is a Certified Public Accountant.

 

Mr. Lenahan has served as our Executive Vice Presidentand General Counsel since October 2001, and our Secretary since February2002.  Most recently, Mr. Lenahan servedas Executive Vice President, General Counsel and Secretary of Tricordia Health,LLC, a healthcare venture company, from September 1998 to August 2001. Mr. Lenahanalso was Executive Vice President, General Counsel and Secretary of MeritBehavioral 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 VicePresident, Human Resources since November 2001. Prior to joining us, Dr.DeLorbe served as President of Venn Works RTP, a company developing andoperating life sciences technology companies. Previously, Dr. DeLorbe workedfor nearly 10 years in a number of senior management and human resourcespositions with The DuPont Merck Pharmaceutical Company and The DuPontPharmaceutical Company. He also held various senior level research andmanagement positions at several life science companies. Dr. DeLorbe holds aPh.D. from the University of Iowa and a B.A. in Biology from Loras College.

 

Dr. Kahn was named Chief Science Officer and SeniorVice President, Research and Development, of Accelrys in February 2003.  Previously, he had served as General Managerand Senior Vice President, Life Science at Accelrys since January 2002, andimmediately prior to that as Senior Vice President, Modeling and Simulation, atAccelrys since March 2000. He also served as Vice President of Research andDevelopment in 1999, and Director of Marketing from 1995 through 1998.  From 1991 until joining Accelrys, Dr. Kahnwas employed by BioCAD, a molecular modeling start-up company in SiliconValley, CA.  Dr. Kahn earned his Ph.D.in Theoretical Organic Chemistry at the University of California, Irvine andperformed post-doctoral research at Cambridge University in England.  Dr. Kahn also spent four years as anAssistant Professor of Chemistry at the University of Illinois at Urbana-Champaign.

 

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Mr. Delli Santi was named Senior Vice President, Salesof Accelrys in February 2003.  He hadserved as General Manager and Vice President, Materials Science at Accelryssince January 2002, and immediately prior to that as General Manager and VicePresident, Bioinformatics at Accelrys since March 2001.  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. Rossi has served as VicePresident, Marketing of Accelrys since February 2002. Prior to joiningAccelrys, he was a Partner of Harvard Strategy Group, a technology and lifesciences management consulting firm since April 2000.  Mr. Rossi also served as Senior Vice President, Sales andMarketing, for NetGenics Inc., a bioinformatics software, consulting andservice company, from 1999 to March 2000. Before joining NetGenics, Mr. Rossiheld a number of senior management positions during an 18-year tenure withDigital Equipment Corporation, most recently serving as Director, InternetBusiness Services, from 1996 to 1999. Mr. Rossi holds a B.S. from the School ofBiology of the Medical Technology University of Rhode Island, an M.P.H. fromthe University of Hawaii School of Public Health, and an M.B.A. from the BostonUniversity School of Management Executive Program.

 

Mr. Roke has served as our Vice President, Financesince September 2000 and as our Chief Accounting Officer since May 2001.  From April 1991 through September 2000, Mr.Roke served in various management positions, most recently as Chief FinancialOfficer and Vice President-Finance, at EM Biosciences, Inc. (formerly CN Biosciences,Inc.); a division of Merck KGaA.  Mr.Roke also spent three years with Arthur Andersen & Company.  Mr. Roke holds a B.S. in BusinessAdministration from Georgetown University and is a Certified Public Accountant.

 

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## **PART II**

 

**ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERMATTERS**

 

MARKET FOR COMMON STOCK

 

Our Common Stock has traded on the Nasdaq NationalMarket tier of The Nasdaq Stock Market under the symbol PCOP since our initialpublic offering on December 5, 1995. The following table sets forth for the periods indicated the range ofhigh and low sale prices of the Common Stock.

 
|           |   | **2002** |   | **2001** |       |
|----------------|--------|----------|--------|----------|------------|
|           |   | **High** |   | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |   | $        | 15.20  |     | $          | 11.00 |   | $ | 30.00 |   | $ | 13.00 |   |
| Second Quarter |   | 15.45    |   | 7.93     |       | 25.25 |   | 16.75 |   |
| Third Quarter  |   | 9.00     |   | 5.99     |       | 20.94 |   | 10.95 |   |
| Fourth Quarter |   | 11.20    |   | 7.35     |       | 16.99 |   | 12.60 |   |
|                |        |          |        |          |            |  |  |  |  |  |  |  |  |

 

HOLDERS OF RECORD

 

As of January 31, 2003 there were 447 holders ofrecord of our Common Stock.

 

DIVIDENDS

 

No cash dividends have been paid on the Common Stockto date.

 

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# **ITEM6.  SELECTED FINANCIAL DATA**

 

The following selected consolidated financial datahave been derived from our audited Consolidated Financial Statements.  This data should be read in conjunction with“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and the Consolidated Financial Statements and related notes theretoincluded elsewhere in this Report.

 
|                                                                 |   | **Years  Ended December 31,**                  |    |
|----------------------------------------------------------------------|--------|------------------------------------------------|---------|
|                                                                 |   | **2002**                                       |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                 |   | **(in  thousands, except per share data****)** |    |
| **Statement  of Operations Data:**                                   |   |                                           |    |   |   |   |   |   |   |   |   |
| Total revenue(1)                                                     |   | $                                              | 124,408 |   | $ | 122,303 |   | $ | 114,436 |   | $ | 95,524 |   | $ | 84,097 |   |
| Operating loss  from continuing operations(1)                        |   | (14,878                                        | )       | (19,950 | ) | (7,262 | ) | (672 | ) | (14,393 | ) |
| Income (loss)  from continuing operations(2)                         |   | (11,627                                        | )       | (14,741 | ) | 677 |   | 2,950 |   | (11,100 | ) |
| Net income  (loss)(3)                                                |   | (11,627                                        | )       | (14,320 | ) | 1,175 |   | 3,771 |   | (10,163 | ) |
| Basic and  diluted net income (loss) per common share                |   | (0.49                                          | )       | (0.60 | ) | 0.05 |   | 0.19 |   | (0.54 | ) |
| Shares used in  computing basic net income (loss) per common share   |   | 23,512                                         |    | 23,729 |   | 22,659 |   | 19,684 |   | 18,916 |   |
| Shares used in  computing diluted net income (loss) per common share |   | 23,512                                         |    | 23,729 |   | 24,453 |   | 20,294 |   | 18,916 |   |
| Cash dividends  declared per common share                            |   | —                                         |    | — |   | — |   | — |   | — |   |
|                                                                      |        |                                                |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                                             |   | **As of December 31,** |    |
|------------------------------------------------------------------|--------|------------------------|---------|
|                                                             |   | **2002**               |    | **2001** |   | **2000** |   | **1999** |   | **1998** | ** ** |
|                                                             |   | **(in thousands****)** |    |
| **Balance Sheet Data:**                                          |   |                   |    |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and marketable securities                |   | $                      | 141,071 |   | $ | 155,828 |   | $ | 165,178 |   | $ | 69,032 |   | $ | 81,098 |   |
| Total assets                                                     |   | 240,105                |    | 270,398 |   | 284,766 |   | 126,259 |   | 127,865 |   |
| Notes payable, deferred revenue, and other long-term liabilities |   | 4,766                  |    | 4,555 |   | 4,553 |   | 5,121 |   | 3,332 |   |
| Accumulated deficit                                              |   | (93,821                | )       | (82,194 | ) | (67,874 | ) | (69,049 | ) | (72,820 | ) |
| Total stockholders’ equity                                  |   | 183,337                |    | 197,989 |   | 209,867 |   | 78,746 |   | 72,217 |   |
|                                                                  |        |                        |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*(1)**       Revenueand Operating loss from continuing operations exclude hardware revenue andrelated costs.  Accelrys discontinued hardwarere-sale operations effective December 31, 2001.*

*(2)**       Netincome (loss) from continuing operations is derived from net income (loss)excluding net hardware revenue and related costs.*

*(3)**       Netincome (loss) includes $3.0 million of discontinued acquisition costs, $7.6million of acquisition related goodwill amortization and $6.8 million ofacquisition related intangible asset amortization in 2001; $8.7 million ofacquisition related write-offs of in-process R&D, $3.8 million ofacquisition related goodwill amortization, and $3.3 million of acquisitionrelated intangible asset amortization in 2000; $0.4 million of acquisitionrelated goodwill amortization in 1999; and $8.0 million of merger relatedexpenses in 1998.*

 

**ITEM7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

The following discussion and analysis of the financialcondition and results of operations should be read in conjunction with“Selected Consolidated Financial Data” and the Consolidated Financial Statementsand related disclosures included elsewhere in this Report.

 

This Report, including, without limitation, thissection regarding Management’s Discussion and Analysis of Financial Conditionand Results of Operations, contains forward-looking statements regarding theCompany and its business, financial condition, results of operations, andprospects.  Words such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” andsimilar expressions are intended to identify forward-looking statements, butare not the exclusive means of identifying forward-looking statements in thisReport.  Additionally, statementsconcerning future matters such as the development of new products, enhancementsor technologies, possible changes in legislation, and other statementsregarding matters that are not historical are forward-looking statements.

 

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Although forward-looking statements in this Reportreflect the good faith judgment of our management, such statements can only bebased on facts and factors currently known to us.  Consequently, forward-looking statements are inherently subjectto risks and uncertainties and actual results and outcomes may differmaterially from the results and outcomes discussed in or anticipated by theforward-looking statements.  Factorsthat could cause or contribute to such differences in results and outcomesinclude, without limitation, those discussed in “Significant Risks, Trends, andUncertainties” below, and in “Business — Risk Factors” above, such as uncertainrevenue levels, rapidly changing technologies, acquisition-relateduncertainties, stock price volatility, and other factors as discussed elsewherein this Report.  Readers are urged notto place undue reliance on these forward-looking statements, which speak onlyas of the date of this Report.  Weundertake no obligation to revise or update any forward-looking statements inorder to reflect any event or circumstance that may arise after the date ofthis Report.  Readers are urged tocarefully review and consider the various disclosures made in this Report,which attempt to advise interested parties of the risks and factors that mayaffect the our business, financial condition, results of operations, and prospects.

 

BUSINESS OVERVIEW

 

We design, develop, market, and support science- andtechnology-based products and services intended to improve and accelerate theprocesses of drug discovery and chemical development.  Our Software Segment, Accelrys Inc. (“Accelrys”), providesmolecular modeling, simulation, informatics and decision support software forthe life sciences and materials research markets.  Our Drug Discovery Segment, Pharmacopeia Drug Discovery, Inc.(“PDD”), provides drug discovery services to pharmaceutical and biotechnologycompanies based on proprietary combinatorial chemistry, high throughputscreening and Accelrys technologies. Segment and geographical data are included in the Notes to ConsolidatedFinancial Statements.

 

# **RESULTS OF OPERATIONS**

 

###### **2002 Compared to 2001**

 

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

 

Software license, service andother revenue for the years ended December 31, 2002 and 2001 was $95.1 millioneach year.  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 the 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 the current yearcompared to discounted distributor sales in the prior year.  Revenue growth was 2% in modeling andsimulation (including the revenue from the strategic alliance), while informaticsrevenue decreased by 1%.  The decreasein informatics revenue was attributable primarily to the market conditionsdescribed above.

 

Drug Discovery revenue increased8% to $29.3 million for the year ended December 31, 2002 compared to $27.2million for the year ended December 31, 2001. The increase was due primarily to additional revenue earned undercollaborative drug discovery agreements, increased milestone revenue, and $1.2million from a revenue adjustment recorded in the third quarter of 2002 resultingfrom a positive change in our estimate of costs required to complete acontract.  Milestone revenue recorded inthe year ended December 31, 2002 and 2001 was $2.1 million, and $1.6 million,respectively.  Excluding the revenuefrom milestones and the adjustment, revenue increased 2% from year toyear.  In 2002 and 2001, one DrugDiscovery customer accounted for 12% and 11% of consolidated revenue,respectively.

 

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Software license, service and othergross margin decreased 3% to $73.5 million (77% of related revenue) in the yearended December 31, 2002 compared to $76.1 million (80% of related revenue) inthe year 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 the revenue from a strategic alliance.

 

Drug Discovery gross marginincreased 51% to $10.2 million (35% of related revenue) in the year endedDecember 31, 2002 compared to $6.8 million (25% of related revenue) in the yearended December 31, 2001.  The increasein gross margin resulted from the higher revenue level, including milestonerevenue and the revenue adjustment, which carry no associated cost ofrevenue.  Excluding the effect of themilestone revenue and the revenue adjustment on gross margin, total grossmargin increased by 35%, which is attributable primarily to planned costreductions related to existing contracts and the effect of fixed costs spreadover a larger revenue base.  Costefficiencies have been achieved on existing contracts and cannot be assured onfuture contracts.

 

Research and development expensedecreased by 14% to $27.9 million in the year ended December 31, 2002 comparedto $32.5 million in the year ended December 31, 2001. Research and developmentcosts include software development costs and costs associated with internaldrug discovery programs.  The decreasein research and development expense is attributable to cost efficienciesrealized in the software business due to the consolidation of research effortson Accelrys’ expanded product line and due to efficiencies realized fromstandardization of products on a common platform.  Additionally, cost decreases in the Drug Discovery business,related to the reduction of non-chemistry and biology research activities, wereplanned in 2001 and fully realized in 2002. Research and development expense in the Drug Discovery business,however, may increase if efforts on internally funded programs expand.

 

Sales, general andadministrative expense increased by 8% to $66.4 million in the year endedDecember 31, 2002 compared to $61.6 million in the year ended December 31,2001.  The increase in sales, generaland administrative expense is attributable largely to increases in sales staffand management infrastructure, particularly in Japan.  Additionally, expense associated with a new facility and facilityconsolidation, severance, and excess consulting capacity in the current yeartotaled approximately $0.7 million with no corresponding expense in the prioryear.  Finally, approximately $1.0million of the full year increase was attributable to the sales, general andadministrative expense of Synomics Limited, acquired in June 2001.  Excluding the foregoing items, sales,general and administrative expense increased by 5%.

 

A restructuring charge of $4.3million was recorded in the third quarter of 2002 related to actions taken toimprove our financial performance.  SeeNote 13 to Consolidated Financial Statements.

 

No goodwill amortization wasrecorded in the year ended December 31, 2002 compared to $8.6 million in theyear ended December 31, 2001.  Thedecrease is attributable to changes in accounting rules.  See Note 11 to Consolidated FinancialStatements.

 

No discontinued acquisitioncosts were recorded in the year ended December 31, 2002 compared to $3.0million in the year ended December 31, 2001. Prior period amounts were reclassified from sales, general and administrativeexpense.

 

Interest and other income, net,decreased 57% to $3.9 million in the year ended December 31, 2002 compared to$9.1 million in the year ended December 31, 2001.  Interest and other income, net, in the comparable prior yearperiod included a $0.7 million capital gain related to the sale of aninvestment.  Approximately $3.5 millionof the decrease is due to decreases in average investment balances anddecreases in market interest rates, and the remaining difference relates totranslation of certain current assets denominated in foreign currencies andother non-operating expenses.

 

The Company recorded an incometax provision of $0.7 million in the year ended December 31, 2002 compared to$0.9 million in the year ended December 31, 2001.  The 2002 and 2001 tax provisions are primarily due to

 

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foreign taxable income generated by the softwarebusiness.  These provisions differ fromthe Federal tax rate primarily because of the effect of permanent book-taxdifferences, net operating loss carryforwards, and net operating losscarrybacks.

 

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.  Hardware re-sale operations were discontinued in 2001.  See Note 2 to Consolidated FinancialStatements.

 

As a result of the factorsdescribed above, the Company generated a net loss of $11.6 million ($0.49 perdiluted share) in the year ended December 31, 2002, compared to a net loss of$14.3 million ($0.60 per diluted share) in the year ended December 31,2001.  Net loss in the prior year periodwas made up of a net loss from continuing operations of $14.7 million ($0.62per diluted share) partially offset by income from discontinued operations of$0.4 million ($0.02 per diluted share).

 

###### **2001 Compared to 2000**

 

Total revenue grew 7% to $122.3 million in 2001compared to $114.4 million in 2000, excluding hardware re-sale revenue.  Hardware re-sale operations werediscontinued in 2001.

 

Accelrys software license,service and other revenue increased 26% to $95.1 million in 2001 compared to$75.4 million in 2000.  This increaseincludes revenues generated from sales of products and services added throughthe acquisitions of Synopsys Scientific Systems Limited and the softwaresubsidiaries of Oxford Molecular Group Plc in 2000 and the acquisition ofSynomics Limited in 2001 (hereinafter collectively “the Acquisitions”; see Note3 of the Notes to Consolidated Financial Statements).  Excluding the effect of theAcquisitions, software license, service, and other revenue increased 10% in2001 compared to 2000.

 

Accelrys software license, service, and other revenueincreased 32% to $79.1 million in 2001 in the European and US region combined,including the effect of the Acquisitions. Excluding the effect of the Acquisitions, organic European and US regionsoftware license, service, and other revenue increased 13%.  Accelrys software license, service, andother revenue decreased 4% to $16.0 million in the Asia region.  The decrease was due to a renegotiatedminimum volume commitment with Accelrys’ distribution partner, under which 2001modeling and simulation software revenues in Japan were not expected toincrease beyond the level achieved in 2000. This minimum volume commitment and related distribution agreementterminated December 31, 2001.

 

Drug Discovery revenue decreased 30% to $27.2 millionin 2001 compared to $39.0 million in 2000. The 2000 results included an aggregate$5.5 million from a non-recurring technology out-license fee, and a contracttermination fee.  The 2001 and 2000results also included milestone revenue of $1.6 million and $2.3 million,respectively.  In addition, the 2000results included $3.6 million of revenue from a drug discovery collaborationthat terminated in June 2000.  Excludingthe non-recurring technology out-license fee, the revenue and fees from theterminated collaboration, and the milestone revenues, drug discovery revenuedeclined by 7% primarily due to declines in general economic conditions andcompetitive pressures.  In 2001 and2000, one Drug Discovery customer accounted for 11% of consolidated revenue.

 

Accelrys gross margin increased 18% to $76.1 million(80% of related revenues) in 2001 compared to $64.5 million (86% of relatedrevenues) in 2000.  The increase in theamount of gross margin dollars resulted from the increase in software license,service, and other revenue as described above. The decrease in gross margin as a percentage of related revenues isprimarily due to the amortization of the developed technology intangible assetidentified in the Acquisitions. Excluding this amortization, gross margin as a percentage of relatedrevenues for 2001 would have been approximately equal to gross margin as apercentage of related revenues in 2000.

 

Drug Discovery gross margin decreased 57% to $6.8million (25% of related revenues) in 2001 compared to $15.9 million (41% ofrelated revenues) in 2000.  The decreasein gross margin dollars resulted primarily from the

 

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decrease in revenue described above. The decrease in Drug Discovery gross margin as a percentage of relatedrevenue is due to the non-recurring technology out-license revenue, thecontract termination revenue, and the milestone revenues which carried noassociated cost of revenue, and to the decreased volume of work which causedfixed costs to be spread over the lower revenue level.

 

Research and development expenses increased 29% to$32.5 million in 2001 compared to $25.2 million in 2000 including the effect ofthe Acquisitions.  Research anddevelopment costs include costs associated with internal drug discoveryprograms and software development.  Allof the increase in research and development costs occurred at Accelrys, andresulted both from the Acquisitions and from increased costs associated withthe further development of modeling, simulation, analysis, informatics, andworkflow software.  Accelrys increasedits software and informatics research and development staff in response to theanticipated product integration needs of its expanded software product line.

 

Selling, general, and administrative expensesincreased 25% to $61.6 million in 2001 compared to $49.5 million in 2000.  The increase in sales, general, andadministrative expenses is primarily attributable to the Acquisitions,including amortization of certain acquired intangible assets identified in theAcquisitions, and increases in the depth and breath of skills in the salesforce required in order to sell the combined product line.

 

Goodwill amortization increased to $8.6 million for2001 compared to $4.2 million for 2000. The increase is attributable to the timing of the Acquisitions.  Goodwill will not be amortized in the futuredue to Recently Issued Accounting Standards described below.

 

A write-off of $8.7 million of in-process research anddevelopment was recorded for 2000 and was related to the Acquisitions.  No comparable write-offs were made in 2001.

 

Discontinued acquisition costs of $3.0 million werewritten off in 2001.  No comparablewrite-offs were made in 2000.

 

Net interest income decreased 1% to $9.1 million in2001 compared to $9.2 million in 2000. The decrease is due to increases in average investment balances offsetby decreases in market interest rates.

 

The provision for income taxes decreased 29% to $0.9million in 2001 compared to $1.3 million in 2000.  The tax provisions are primarily due to foreign taxable incomegenerated at Accelrys.  These provisionsdiffer from the expected tax rate primarily because of the effect of netoperating loss carryforwards and carrybacks.

 

As a result of the increased revenue and gross margin,increased operating expenses and one-time charges, and the other mattersdescribed above, we incurred a loss from continuing operations of $14.7million, or $0.62 per basic and diluted share in 2001, as compared to incomefrom continuing operations of $0.7 million, or $0.03 per basic and dilutedshare in 2000.

 

Income from the re-sale ofcomputer hardware decreased by 15% to $0.4 million, or $0.02 per basic anddiluted share in 2001, as compared to $0.5 million, or $0.02 per basic anddiluted share in 2000.  These hardwarere-sale operations were discontinued in 2001.

 

Net loss was $14.3 million, or $0.60 per basic anddiluted share in 2001, as compared to net income of $1.2 million, or $0.05 perbasic and diluted share in 2000.

 

**Liquidityand Capital Resources**

 

We have funded our activities todate primarily through the sales of equity securities, and sales of softwarelicenses, software maintenance services, and drug discovery services.  We had cash, cash equivalents, andmarketable securities of

 

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$141.1 million as of December 31, 2002 comparedto $155.8 million as of December 31, 2001, a decrease of $14.7 million.

 

Cash provided by operationsdecreased by $0.9 million in the year ended December 31, 2002 compared to theyear ended December 31, 2001 due to the decrease in operating earningsexcluding the effect of goodwill amortization (which was discontinued in 2002),partially offset by improvements in the collection of trade receivables.  Cash used in investing activities increasedby $32.0 million in the year ended December 31, 2002 compared to the year endedDecember 31, 2001, due primarily to increased expenditures for informationtechnology infrastructure, leasehold improvements at the new Accelrys facilityin Cambridge, United Kingdom, and the timing of investments in marketablesecurities.  Cash used in financingactivities increased by $7.8 million in the year ended December 31, 2002compared to the year ended December 31, 2001, due to purchases of treasurystock and lower proceeds from the issuance of common stock.

 

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

 

We anticipate that our existingcapital resources will be adequate to fund our operations at least through2003.  However, there can be noassurance that changes will not occur that would consume available capitalresources before then.  Our capitalrequirements depend on numerous factors, including our ability to continue togenerate software sales, our ability to extend existing drug discoveryagreements and to enter into additional arrangements, competing technologicaland market developments, changes in our existing collaborative relationships,the cost of filing, prosecuting, defending, and enforcing patent claims andother intellectual property rights and the outcome of related litigation, thepurchase of additional capital equipment, acquisitions of other businesses ortechnologies, and the progress of our customers’ milestone and royaltyproducing activities.  There can be noassurance that additional funding, if necessary, will be available to us onfavorable terms, if at all.  Ourforecast for the period of time through which our financial resources will beadequate to support our operations is forward looking information, and actualresults could vary.

 

**CriticalAccounting Policies**

 

The preparation of our consolidated financialstatements and disclosures involve the use of judgments and estimates.  We believe the following critical accountingpolicies involve the more significant judgments and estimates used.

 

*RevenueRecognition* – Revenues are recognized in accordance with theAmerican Institute of Certified Public Accountants (“AICPA”) Statement ofPosition (“SOP”) 97-2, as amended by SOP 98-4 and SOP 98-9 and SEC StaffAccounting Bulletin (“SAB”) No. 101.

 

We recognize Accelrys software license revenue upondelivery if no significant obligations remain deliverable to the customer, thesales contract fee is fixed or determinable, amounts are due within one yearand collection is probable, and when no material uncertainties regardingcustomer acceptance exist.  Customerpayments received in connection with license sales are recorded as deferredrevenue until such time as all of the above criteria are met.  Prepaid post-contract support andmaintenance (“PCS”) revenue bundled with software license agreements isunbundled and deferred based on objective, vendor specific evidence.  PCS revenue is recognized pro-rata over therelated service period, which is generally one year.  Consulting and training fees are recognized upon rendering ofservice.  Support revenues arerecognized ratably over the applicable contract periods or as services areperformed.  Amounts billed but not yetrecognized as revenue, and other payments received prior to recognition ofrevenue, are recorded as deferred revenue.

 

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We also earn software revenue under consortiaagreements wherein several unrelated parties enter into a joint softwaredevelopment agreement with us.  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.  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.

 

Accordingly, recognitionof software licence, service and other revenue is dependent, in part, onmanagement judgment.  Since management’sjudgment is involved, changes in our estimates or assumptions could impactrevenue recognition in the future.

 

We recognize revenue from Drug Discovery primarilyusing the percentage-of-completion method. Accordingly, revenue is recognizedas service deliverables are expended against a total research and developmentplan.  Payments received prior to thecompletion of the related work are recorded as deferred revenue.  Non-refundable payments are recognized asrevenue only when they are not subject to future performance obligations.  Otherwise, such payments are deferred andamortized into revenue over the term of the agreement.  Our revenue recognition policies, inparticular as they relate to percentage-of-completion arrangements, are basedon estimates and assumptions by management that are subject to change dependingon the contract.  As such, any change inour estimates could impact revenue recognition in the future.

 

*Allowancefor Doubtful Accounts* – We maintain an allowance for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments.  This estimateis based on a specific customer analysis, and an additional amount may beprovided when and if an account becomes uncollectible at a later date.  If the financial condition of a customer wasto deteriorate, resulting in an impairment of its ability to make payments, anadditional allowance would be required. Our allowance for doubtful accounts, therefore, is based on estimatesmade by management.  Since management’sjudgment is involved, there is a risk that the estimate may be overstated orunderstated which could impact operating results in the future.

 

*Software Development Costs* – We capitalize software development costsin accordance with Statement of Financial Accounting Standards 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 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* – We adopted Statement of Financial Accounting Standards No. 142,“Goodwill and Other Intangible Assets” (“SFAS 142”) during the quarterended March 31, 2002.  Under SFAS 142,goodwill and intangible assets with indefinite lives are no longer amortizedbut are assessed annually (or more frequently if impairment indicators arise)for impairment.  In making this annual assessment,we rely on a number of factors including operating results, business plans,economic projections, anticipated future cash flows, and market placedata.  There are inherent uncertaintiesrelated to these factors and management’s judgment in applying them to theanalysis of goodwill impairment.  Sincemanagement’s judgment is involved in performing goodwill valuation analyses,there is risk that the carrying value of our goodwill may be overstated.  We completed our annual intangible assetimpairment test during the quarter ended December 31, 2002, and concluded thatthe carrying value of our goodwill was not impaired.  Continued economic weakness, unexpected significant declines inoperating results of reporting units,

 

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and additional non-temporary market capitalization declines may beindicative of goodwill impairment and cause us to perform additional valuationanalyses for our reporting units prior to the next required annual assessment.  These types of events and the resultinganalyses could result in charges for goodwill expense in the future.

 

*IncomeTaxes* – Estimates of full year taxable income of the variouslegal entities and jurisdictions are used in the tax rate calculation, whichchange throughout the year.  Managementuses judgment in estimating what the income will be for the year.  Since judgment is involved, there is riskthat the tax rate may significantly increase or decrease in any period, andthat operating results could be impacted in the future.

 

### **New Accounting Standards**

 

In June 2002, the Financial Accounting Standards Board("FASB") issued Statement No. 146, “Accounting for Costs Associatedwith Exit or Disposal” (“SFAS No. 146”). SFAS No. 146 addresses financial accounting and reporting for costsassociated with exit or disposal activities and nullifies Emerging Issues TaskForce ("EITF") Issue No. 94-3, “Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (includingCertain Costs Incurred in a Restructuring)” (“EITF 94-3”).  The principal difference between SFAS No.146 and EITF 94-3 relates to SFAS No. 146’s requirements for recognition of aliability for a cost associated with an exit or disposal activity.  SFAS No. 146 requires that a liability for acost associated with an exit or disposal activity be recognized when theliability is incurred.  Under EITF 94-3,a liability for an exit cost as generally defined in EITF 94-3 was recognizedat the date of an entity’s commitment to an exit plan.  The provisions of SFAS No. 146 are effectivefor exit or disposal activities that are initiated after December 31, 2002,with early application encouraged.  Wedo not expect that the adoption of SFAS No. 146 will have a material impact onthe consolidated financial statements.

 

In November 2002, the EITFreached consensus on EITF Issue 00-21, “Accounting for Revenue Arrangementswith Multiple Deliverables” (“EITF 00-21”), which addresses how to account forarrangements that may involve the delivery or performance of multiple products,services, and/or rights to use assets. The final consensus of EITF 00-21 willbe applicable to agreements entered into in fiscal periods beginning after June15, 2003, with early adoption permitted. Additionally, companies will bepermitted to apply the consensus guidance to all existing arrangements as thecumulative effect of a change in accounting principle in accordance with APBOpinion No. 20, Accounting Changes. Management is currently evaluating the effectthat the adoption of EITF 00-21 will have on its results of operations andfinancial position.

 

In December 2002, the FASBissued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure” (“SFAS No. 148”).  SFAS No.148 is an amendment to SFAS No. 123 providing alternative methods of transitionfor a voluntary change to the fair value based method of accounting forstock-based employee compensation and also provides additional disclosuresabout the method of accounting for stock-based employee compensation.Amendments are effective for financial statements for the Company ending afterDecember 15, 2002. The Company has currently chosen to not adopt the voluntarychange to the fair value based method of accounting for stock-based employeecompensation. If the Company should choose to adopt such a method, itsimplementation pursuant to SFAS No. 148 could have a material effect on theCompany’s consolidated financial position and results of operations.

 

**ITEM7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are exposed to various market risks consistingprimarily of changes in foreign currency exchange rates.  Our international sales generally aredenominated in local currencies.  In2002, 36% of our consolidated revenue was derived from customers outside theUnited States (including 23% from customers in Europe and 13% from customers inthe Asia/Pacific region).  Our exchangerate risk is greatest for Dollar/Euro and Dollar/Yen fluctuations.  When deemed appropriate, we engage inexchange rate-hedging transactions in an attempt to mitigate the impact ofadverse exchange rate fluctuations.  AtDecember 31, 2002, we had no hedging transactions in effect.

 

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The introduction and use of the Euro, which began in1999, has not had a material effect on our foreign exchange or hedgingactivities.  We will continue toevaluate the impact of the Euro, however, based on currently available information.We do not believe that the introduction of the Euro currency will have amaterial adverse impact on our consolidated financial condition, cash flows, orresults of operations.

 

We do not use derivative financial instruments fortrading or speculative purposes. However, we regularly invest excess cash in overnight repurchaseagreements that are subject to changes in short-term interest rates.  We believe that the market risk arising fromholding these financial instruments is minimal.

 

Our exposure to market risks associated with changesin interest rates relates primarily to the increase or decrease in the amountof interest income earned on our investment portfolio, since we have minimaldebt.  We ensure the safety andpreservation of invested funds by limiting default risks, market risk, andreinvestment risk.  We mitigate defaultrisk by investing in investment grade securities.  A hypothetical 100 basis point adverse move in interest ratesalong the entire interest rate yield curve would not materially affect the fairvalue of our interest sensitive financial instruments at December 31,2002.  However, declines in interestrates that occurred in 2002 may result in some level of decrease to ourinterest income in 2003 as compared to the amount earned in 2002.  Additional declines in interest rates overtime would further reduce our interest income.

 

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# **ITEM 8. FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

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

 

The Board of Directors and StockholdersPharmacopeia, Inc.

 

We have audited the accompanying consolidated balance sheets ofPharmacopeia, Inc. as of December 31, 2002 and 2001, and the relatedconsolidated statements of operations, stockholders’ equity and cash flows foreach of the three years in the period ended December 31, 2002.  Our audits also included the financialstatement schedule listed in the index at Item 15(a)(2).  These financial statements and schedule arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements and schedule based on ouraudits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free from materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofPharmacopeia, Inc. at December 31, 2002 and 2001, and the consolidated resultsof its operations and its cash flows for each of the three years in the periodended December 31, 2002, in conformity with accounting principles generallyaccepted in the United States.  Also, inour opinion, the related financial statement schedule, when considered inrelation to the basic financial statements taken as a whole, presents fairly inall material respects the information set forth therein.

 

As discussed in Note 2 to the consolidated financial statements,Pharmacopeia, Inc. changed its method of accounting for purchased goodwill andother intangible assets in accordance with Statement of Financial AccountingStandards No. 142 during 2002.

 
| /s/   ERNST  & YOUNG LLP |   |
|----------------------------------------|--------|

 

 

San Diego, California

January 28, 2003

 

46

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**Pharmacopeia,Inc.Consolidated Balance Sheets** (in thousands, except per share data)

 
|                                                                                                                      |   | **As of December 31,** |       |
|---------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|
|                                                                                                                      |   | **2002**               |       | **2001** |   |
| **ASSETS**                                                                                                                |   |                   | ** ** |   | ** ** |
| **Current  assets:**                                                                                                      |   |                   | ** ** |   | ** ** |
| Cash and cash  equivalents                                                                                                |   | $                      | 28,236     |   | $ | 68,891 |   |
| Marketable  securities                                                                                                    |   | 112,835                |       | 86,937 |   |
| Trade  receivables, net of allowance for doubtful accounts of $1,634 and $914,  respectively                              |   | 35,571                 |       | 43,147 |   |
| Prepaid expenses  and other current assets                                                                                |   | 5,505                  |       | 7,263 |   |
| Total current  assets                                                                                                     |   | 182,147                |       | 206,238 |   |
|                                                                                                                      |   |                   |       |   |   |
| Property and  equipment, net                                                                                              |   | 14,157                 |       | 11,726 |   |
| Goodwill, net of  accumulated amortization of $13,201                                                                     |   | 34,404                 |       | 36,823 |   |
| Software  development costs, net of accumulated amortization of $21,118 and $15,076,  respectively                        |   | 8,656                  |       | 13,104 |   |
| Other intangible  asset, net of accumulated amortization of $2,604 and $1,698, respectively                               |   | 116                    |       | 1,022 |   |
| Other assets                                                                                                              |   | 625                    |       | 1,485 |   |
| Total assets                                                                                                              |   | $                      | 240,105    |   | $ | 270,398 |   |
|                                                                                                                      |   |                   |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                            |   |                   |       |   |   |
| **Current  liabilities:**                                                                                                 |   |                   |       |   |   |
| Accounts payable                                                                                                          |   | $                      | 2,497      |   | $ | 4,361 |   |
| Accrued  liabilities                                                                                                      |   | 20,417                 |       | 28,884 |   |
| Deferred  revenue, current portion                                                                                        |   | 29,076                 |       | 34,565 |   |
| Notes payable,  current portion                                                                                           |   | 12                     |       | 44 |   |
| Total current  liabilities                                                                                                |   | 52,002                 |       | 67,854 |   |
|                                                                                                                      |   |                   |       |   |   |
| Notes payable  and long-term liabilities                                                                                  |   | 8                      |       | 34 |   |
| Deferred  revenue, long-term                                                                                              |   | 4,758                  |       | 4,521 |   |
|                                                                                                                      |   |                   |       |   |   |
| **Stockholders’  equity:**                                                                                           |   |                   |       |   |   |
| Preferred stock,  $.0001 par value, 2,000 shares authorized, none issued and outstanding                                  |   | —                 |       | — |   |
| Common stock,  $.0001 par value, 40,000 shares authorized, 24,241 and 23,956 shares issued  and outstanding, respectively |   | 2                      |       | 2 |   |
| Additional  paid-in capital                                                                                               |   | 284,733                |       | 281,553 |   |
| Treasury stock                                                                                                            |   | (8,340                 | )          | (1,316 | ) |
| Accumulated  deficit                                                                                                      |   | (93,821                | )          | (82,194 | ) |
| Accumulated  comprehensive income (loss)                                                                                  |   | 763                    |       | (56 | ) |
| Total  stockholders’ equity                                                                                          |   | 183,337                |       | 197,989 |   |
| Total  liabilities and stockholders’ equity                                                                          |   | $                      | 240,105    |   | $ | 270,398 |   |

 

See accompanying notes tothese consolidated financial statements.

 

47

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## **Pharmacopeia, Inc.Consolidated Statements ofOperations**(inthousands, except per share data)

 
|                                                           |   | **For the Years Ended December 31,** |       |
|----------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                           |   | **2002**                             |       | **2001** |   | **2000** |   |
| Revenues:                                                      |   |                                 | ** ** |   | ** ** |   | ** ** |
| Software  license, service and other                           |   | $                                    | 95,104     |   | $ | 95,107 |   | $ | 75,401 |   |
| Drug discovery                                                 |   | 29,304                               |       | 27,196 |   | 39,035 |   |
| Total revenues                                                 |   | 124,408                              |       | 122,303 |   | 114,436 |   |
|                                                           |   |                                 |       |   |   |   |   |
| Cost of  revenues:                                             |   |                                 |       |   |   |   |   |
| Software  license, service and other                           |   | 21,575                               |       | 19,046 |   | 10,901 |   |
| Drug discovery                                                 |   | 19,080                               |       | 20,411 |   | 23,100 |   |
| Total cost of  revenues                                        |   | 40,655                               |       | 39,457 |   | 34,001 |   |
|                                                           |   |                                 |       |   |   |   |   |
| Gross margin                                                   |   | 83,753                               |       | 82,846 |   | 80,435 |   |
|                                                           |   |                                 |       |   |   |   |   |
| Operating costs  and expenses:                                 |   |                                 |       |   |   |   |   |
| Research and  development                                      |   | 27,868                               |       | 32,529 |   | 25,205 |   |
| Sales, general  and administrative                             |   | 66,423                               |       | 61,647 |   | 49,505 |   |
| Restructuring                                                  |   | 4,340                                |       | — |   | — |   |
| Amortization of  goodwill                                      |   | —                               |       | 8,620 |   | 4,247 |   |
| Write-off of  in-process research and development              |   | —                               |       | — |   | 8,740 |   |
| Total operating  costs and expenses                            |   | 98,631                               |       | 102,796 |   | 87,697 |   |
| Operating loss  from continuing operations                     |   | (14,878                              | )          | (19,950 | ) | (7,262 | ) |
| Discontinued  acquisition costs                                |   | —                               |       | (2,985 | ) | — |   |
| Interest and other  income, net                                |   | 3,915                                |       | 9,082 |   | 9,194 |   |
| Income (loss)  from continuing operations before tax provision |   | (10,963                              | )          | (13,853 | ) | 1,932 |   |
| Provision for income  taxes                                    |   | 664                                  |       | 888 |   | 1,255 |   |
| Income (loss)  from continuing operations                      |   | (11,627                              | )          | (14,741 | ) | 677 |   |
| Discontinued  operations:                                      |   |                                 |       |   |   |   |   |
| Income from  discontinued operations                           |   | —                               |       | 421 |   | 498 |   |
| Net income  (loss)                                             |   | $                                    | (11,627    | ) | $ | (14,320 | ) | $ | 1,175 |   |
|                                                           |   |                                 | ** ** |   | ** ** |   | ** ** |
| Income (loss)  per share from continuing operations:           |   |                                 |       |   |   |   |   |
| - Basic                                                        |   | $                                    | (0.49      | ) | $ | (0.62 | ) | $ | 0.03 |   |
| - Diluted                                                      |   | $                                    | (0.49      | ) | $ | (0.62 | ) | $ | 0.03 |   |
|                                                           |   |                                 | ** ** |   | ** ** |   | ** ** |
| Income (loss)  per share from discontinued operations:         |   |                                 |       |   |   |   |   |
| - Basic                                                        |   | $                                    | —     |   | $ | 0.02 |   | $ | 0.02 |   |
| - Diluted                                                      |   | $                                    | —     |   | $ | 0.02 |   | $ | 0.02 |   |
|                                                           |   |                                 | ** ** |   | ** ** |   | ** ** |
| Net income  (loss) per share:                                  |   |                                 |       |   |   |   |   |
| - Basic                                                        |   | $                                    | (0.49      | ) | $ | (0.60 | ) | $ | 0.05 |   |
| - Diluted                                                      |   | $                                    | (0.49      | ) | $ | (0.60 | ) | $ | 0.05 |   |
|                                                           |   |                                 |       |   |   |   |   |
| Weighted average  number of common stock outstanding:          |   |                                 |       |   |   |   |   |
| - Basic                                                        |   | 23,512                               |       | 23,729 |   | 22,659 |   |
| - Diluted                                                      |   | 23,512                               |       | 23,729 |   | 24,453 |   |

 

See accompanying notes tothese consolidated financial statements.

 

48

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## **Pharmacopeia, Inc.Consolidated Statements ofStockholders’ Equity**(inthousands)

 
|                                                                |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    | **Unrealized****Gain (Loss)****on****Marketable  Securities** |    |    |   |    |   |
|---------------------------------------------------------------------|--------|-----------------------|--------|------------------------------------|--------|--------------------|-----------------------|---------|------------|--------|-------------------------------------------|---------|-----------------------------------------|---------------------------------------------------------------|---------|---------|--------|---------|--------|
|                                                                |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |
|                                                                |   | **Common Stock**      |   | **Additional****Paid-in  Capital** |   | **Treasury Stock** |                  |    |       |   | **Cumulative****Translation  Adjustment** |    | **Total****Stockholders’  Equity** |                                                          |
|                                                                |   | **Number of  Shares** |   | **Amount**                         |   |               | **Number of  Shares** |    | **Amount** |   | **Accumulated  Deficit**                  |    |                                    |                                                          |    |
| **Balance at December 31, 1999**                                    |   | 20,183                |   | $                                  | 1      |               | $                     | 148,862 |       | — |                                      | $       | —                                  |                                                          | (69,049 | )       | (127   | )       | (941   | ) | 78,746 |   |
|                                                                |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |   |
| Comprehensive income (loss):                                        |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |   |
| Net income                                                          |   |                  |   |                               |   |               |                  |    |       |   |                                      | 1,175   |                                    |                                                          |    |    |   | 1,175   |   |
| Change in translation adjustment                                    |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    | 541     |   | 541     |   |
| Change in unrealized gain (loss) on marketable securities           |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    | 2,122                                                         |    |    |   | 2,122   |   |
| Comprehensive income                                                |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   | 3,838   |   |
|                                                                |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |   |
| Issuance of common stock in private placement, net                  |   | 1,860                 |   | 1                                  |   | 110,149            |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   | 110,150 |   |
| Issuance of common stock in connection with business acquistion     |   | 19                    |   | —                             |   | 1,199              |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   | 1,199   |   |
| Issuance of common stock for exercise of stock options and warrants |   | 1,259                 |   | —                             |   | 14,017             |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   | 14,017  |   |
| Issuance of common stock in employee stock purchase plan            |   | 62                    |   | —                             |   | 1,044              |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   | 1,044   |   |
| Issuance of common stock for 401(k) matching                        |   | 28                    |   | —                             |   | 873                |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   | 873     |   |
| **Balance at December 31, 2000**                                    |   | 23,411                |   | 2                                  |   | 276,144            |                  | —  |       | — |                                      | (67,874 | )                                       | 1,995                                                         |    | (400    | )      | 209,867 |   |
|                                                                |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |   |
| Comprehensive income (loss):                                        |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |   |
| Net loss                                                            |   |                  |   |                               |   |               |                  |    |       |   |                                      | (14,320 | )                                       |                                                          |    |    |   | (14,320 | )      |
| Change in translation adjustment                                    |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    | (514    | )      | (514    | )      |
| Change in unrealized gain (loss) 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 income (loss):                                        |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    |    |   |    |   |
| Net loss                                                            |   |                  |   |                               |   |               |                  |    |       |   |                                      | (11,627 | )                                       |                                                          |    |    |   | (11,627 | )      |
| Change in translation adjustment                                    |   |                  |   |                               |   |               |                  |    |       |   |                                      |    |                                    |                                                          |    | 487     |   | 487     |   |
| Change in unrealized gain (loss) 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 |   |
|                                                                     |        |                       |        |                                    |        |                    |                       |         |            |        |                                           |         |                                         |                                                               |         |         |        |         |        |  |  |  |  |  |  |  |

 

See accompanying notes tothese consolidated financial statements.

 

49

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## **Pharmacopeia, Inc.Consolidated Statements of Cash Flows**(in thousands)

 
|                                                                                       |   | **Years Ended December 31,** |    |
|--------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                       |   | **2002**                     |    | **2001** |   | **2000** |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                     |   |                         |    |   |   |   |   |
| Net income (loss)                                                                          |   | $                            | (11,627 | ) | $ | (14,320 | ) | $ | 1,175 |   |
| Adjustments to  reconcile net income (loss) to net cash provided from operating activities |   |                         |    |   |   |   |   |
| Depreciation                                                                               |   | 6,173                        |    | 5,645 |   | 5,314 |   |
| Amortization                                                                               |   | 7,884                        |    | 16,151 |   | 8,860 |   |
| Contribution of  stock to 401(k) members                                                   |   | 1,133                        |    | 1,362 |   | 873 |   |
| Non-cash  compensation                                                                     |   | 103                          |    | — |   | — |   |
| Write-off of  in-process research and development                                          |   | —                       |    | — |   | 8,740 |   |
| Changes in  assets and liabilities:                                                        |   |                         |    |   |   |   |   |
| Trade  receivables                                                                         |   | 7,576                        |    | (4,018 | ) | (8,923 | ) |
| Prepaid expenses  and other current assets                                                 |   | 1,758                        |    | (294 | ) | (748 | ) |
| Other assets                                                                               |   | 860                          |    | 372 |   | 173 |   |
| Accounts payable                                                                           |   | (1,865                       | )       | 1,369 |   | (1,218 | ) |
| Accrued  liabilities                                                                       |   | (5,755                       | )       | (5,312 | ) | (311 | ) |
| Deferred revenue                                                                           |   | (5,252                       | )       | 958 |   | 6,403 |   |
| Other                                                                                      |   | —                       |    | — |   | 1,203 |   |
| Net cash  provided by operating activities                                                 |   | 988                          |    | 1,913 |   | 21,541 |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                     |   |                         |    |   |   |   |   |
| Capital  expenditures, net                                                                 |   | (8,498                       | )       | (4,864 | ) | (4,176 | ) |
| Increase in  capitalized software development costs                                        |   | (2,529                       | )       | (3,537 | ) | (1,956 | ) |
| Purchases of  marketable securities                                                        |   | (135,505                     | )       | (164,051 | ) | (133,241 | ) |
| Proceeds from  sales of marketable securities                                              |   | 109,938                      |    | 171,796 |   | 89,536 |   |
| Acquisition of  business, net of cash acquired                                             |   | —                       |    | (3,855 | ) | (45,084 | ) |
| Net cash used in  investing activities                                                     |   | (36,594                      | )       | (4,511 | ) | (94,921 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                     |   |                         |    |   |   |   |   |
| Proceeds from  issuance of common stock                                                    |   | 1,944                        |    | 4,048 |   | 125,210 |   |
| Purchases of  treasury stock                                                               |   | (7,024                       | )       | (1,316 | ) | — |   |
| Principal  payments on notes payable                                                       |   | (58                          | )       | (95 | ) | (320 | ) |
| Net cash  provided by (used in) financing activities                                       |   | (5,138                       | )       | 2,637 |   | 124,890 |   |
| Exchange rate  effect on cash and equivalents                                              |   | 89                           |    | (498 | ) | 683 |   |
| Net increase  (decrease) in cash and equivalents                                           |   | (40,655                      | )       | (459 | ) | 52,193 |   |
| Cash and  equivalents, beginning of period                                                 |   | 68,891                       |    | 69,350 |   | 17,157 |   |
| Cash and  equivalents, end of period                                                       |   | $                            | 28,236  |   | $ | 68,891 |   | $ | 69,350 |   |
|                                                                                       |   |                         |    |   |   |   |   |
| SUPPLEMENTAL  SCHEDULE OF CASH FLOW INFORMATION:                                           |   |                         |    |   |   |   |   |
| Cash paid during  the period for:                                                          |   |                         |    |   |   |   |   |
| Interest                                                                                   |   | $                            | 20      |   | $ | 30 |   | $ | 21 |   |
| Income tax                                                                                 |   | $                            | 436     |   | $ | 1,007 |   | $ | 503 |   |

 

## **Seeaccompanying notes to these consolidated financial statements.**

## ** **

## **50**

## ****

## ** **

## **Pharmacopeia, Inc.Notes to Consolidated FinancialStatements**

 

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

 

Pharmacopeia designs, develops, markets, and supportsscience- and technology-based products and services intended to improve andaccelerate the processes of drug discovery and chemical development.  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.

 

# **2.  Significant Accounting Policies**

# ** **

# **Principles ofConsolidation**

 

These consolidated financial statements include theaccounts of Pharmacopeia and its subsidiaries. All material intercompany balances and transactions have been eliminatedin consolidation.

 

# **Use of Estimates**

 

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses, and the disclosure of contingent assets andliabilities.  Actual future resultscould differ from those estimates.

 

# **Cash and CashEquivalents**

 

The Company considers all highly liquid investmentswith an original maturity of three months or less to be cash equivalents.  The Company invests its cash with majorfinancial institutions in money market funds, US Treasury securities and otherinvestment grade securities such as prime-rated commercial paper.

 

# **Marketable Securities**

 

Marketable securities consist of fixed-incomeinvestments with an original maturity of greater than three months such as USTreasury securities, obligations of US Government agencies and other investmentgrade securities such as prime-rated commercial paper and corporate bonds.  The Company applies Statement of FinancialAccounting Standards No. 115 “Accounting for Certain Investments in Debt andEquity Securities” (SFAS 115) to 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 in accumulated comprehensive income as ofDecember 31, 2002 and 2001 is $0.2 and $0.4 million, respectively, ofunrealized gain on an investment in the common stock of two unrelated,publicly-traded corporations.  TheCompany included these investments in other current assets.

 

51

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At December 31, 2002 and 2001, marketable securitiesconsisted of the following (in thousands):

 
|                                                                  |   | **2002**            |    | **2001**          |   |
|-----------------------------------------------------------------------|--------|---------------------|---------|-------------------|--------|
|                                                                  |   | **Amortized  Cost** |    | **Market  Value** |   | **Unrealized  Gain** |   | **Amortized  Cost** |   | **Market  Value** |   | **Unrealized  Gain** |   |
| U.S. Treasury  securities and obligations of U.S. Government agencies |   | $                   | 69,563  |              | $      | 70,054 |   | $ | 491 |   | $ | 45,020 |   | $ | 45,315 |   | $ | 295 |   |
|                                                                  |   |                |    |              |   |   |   |   |   |   |   |   |   |
| U.S. corporate  debt securities                                       |   | 42,251              |    | 42,781            |   | 530 |   | 41,421 |   | 41,622 |   | 201 |   |
|                                                                  |   | $                   | 111,814 |              | $      | 112,835 |   | $ | 1,021 |   | $ | 86,441 |   | $ | 86,937 |   | $ | 496 |   |

 

Available-for-sale marketable securities bycontractual maturity at December 31, 2002 are as follows (in thousands):

 
| Due within one  year                     |   | $      | 40,395  |   |
|------------------------------------------|--------|--------|---------|--------|
| Due after one  year through eleven years |   | 72,440 |    |
|                                     |   | $      | 112,835 |   |

 

# **Property and Equipment**

 

Property and equipment is stated at cost.  Depreciation is provided on thestraight-line method over the estimated useful lives of the related assets,which range from two to ten years. Assets under capital leases are amortized over their estimated usefullife 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.

 

# **Software DevelopmentCosts**

 

The Company capitalizes software development costs inaccordance with SFAS No. 86, “Accounting for the Cost of Computer Software tobe Sold, Leased or Otherwise Marketed” (“SFAS 86”).  Such costs are stated at the lower of cost or net realizablevalue. Capitalized software costs are comprised of costs incurred in thedevelopment of new software products and enhancements to existing software productsafter technological feasibility has been established.  The Company amortizes capitalized costs over the estimatedproduct life, not to exceed three years from the date on which the product isavailable for general release.

 

# **Research and DevelopmentCosts**

 

All research and development costs not subject tocapitalization under SFAS 86 are charged to operations as incurred.

 

# **Impairment of Long-LivedAssets**

 

The Company reviews the recoverability of the carryingvalue of long-lived assets, primarily property, plant and equipment, intangibleassets, and software development costs, for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe fully recoverable.  Should indicatorsof impairment exist, the carrying values of the assets are evaluated inrelation to the operating performance and future undiscounted cash flows of theunderlying business.  The net book valueof an asset is adjusted to fair value if its expected future undiscounted cashflow is less than its book value.  TheCompany has identified no such impairment losses as of December 31, 2002 and2001.

 

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**Goodwill**

 

The Company has adoptedSFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).  Under SFAS 142, goodwill and intangibleassets with indefinite lives are no longer amortized but are assessed annually(or more frequently if impairment indicators arise) for impairment.  The Company elected to perform this annualintangible asset impairment test during the quarter ended December 31 2002, andconcluded that the carrying value of goodwill was not impaired.  See Note 11.

 

# **Foreign CurrencyTranslation**

 

The Company translates certain of its accounts and thefinancial statements of its foreign operations in accordance with SFAS No. 52,“Foreign Currency Translation” (“SFAS 52”). The financial statements of the Company’s international operations aretranslated into US dollars using period-end exchange rates for assets andliabilities and average exchange rates during the period for revenues andexpenses. Cumulative translation gains and losses are excluded from results ofoperations and recorded as a separate component of comprehensive income (loss)within stockholders’ equity.  Gains andlosses resulting from foreign currency transactions are included in theconsolidated statement of operations.

 

# **Concentrations of Risk**

 

In 2002, 2001 and 2000, one of the Company’s DrugDiscovery customers accounted for 12%, 11% and 11%, respectively, ofconsolidated revenue.  The Company’sagreement with this customer expires by its terms in October 2003.  The Company has initiated negotiations withthe customer concerning renewal of this agreement; however, renewal of theagreement, on the same or similar terms or at all, is beyond the Company’scontrol.  The termination of thisagreement, without renewal on acceptable terms, will have a material adverseeffect on PDD and the Company’s business as a whole.

 

The Company’s international sales are generallydenominated in foreign currencies. Conversion of foreign-denominated receivables into US dollars could havea material adverse effect on the Company’s results of operations.  The Company conducts business in Europe andin the Asia/Pacific region, primarily in Japan.  Any significant decline in the economies or the value of thecurrencies in these regions could have a material adverse impact on theCompany.

 

# **Revenue Recognition**

 

The Company recognizes revenue from licenses ofcomputer software provided that the customer has signed a non-cancelablelicense agreement, the software and related documentation has been shipped, nomaterial uncertainties regarding customer acceptance exist, and collection ofthe resulting receivable is deemed probable. Prepaid post-contract support and maintenance (“PCS”) revenue bundledwith software license agreements is unbundled using objective, vendor specificevidence.  PCS revenue is recognizedpro-rata over the related service period, which is generally one year.  Revenue generated from consulting, training,and software customization sold separately from license agreements isrecognized as the services are performed.

 

The Company earns revenue under consortium agreementswherein several unrelated parties enter into a joint software developmentagreement with the Company.  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

 

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are generally non-refundable. If the Company is successful in developing software under a consortiumagreement described above, a non-transferable license is typically awarded tothat consortium’s members.

 

Through December 31, 2001, the Company sold computerhardware to a licensee of the Company’s software products.  In these instances, the Company typicallyordered the hardware from an unrelated vendor and recognized revenue uponshipment of the hardware to the licensee by the vendor.  During 2001, the Company discontinuedselling computer hardware to licensees. Accordingly, all revenues and expenses related to this operation havebeen included in income from discontinued hardware operations in the statementof operations for all years presented.

 

Revenue from Drug Discovery is recognized primarilyusing the percentage-of-completion method. Accordingly, revenue is recognizedas service deliverables are expended against a total research and developmentplan.  Payments received prior to thecompletion of the related work are recorded as deferred revenue.  Non-refundable payments are recognized asrevenue only when they are not subject to future performance obligations.  Otherwise, such payments are deferred andamortized into revenue over the term of the agreement.

 

# **Advertising Expense**

 

The cost of advertising is expensed as incurred.  The Company incurred $0.3 million, $1.1million, and $0.4 million in advertising costs during 2002, 2001, and 2000,respectively.

 

# **Stock Based Compensation**

 

As permitted by SFAS No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”), the Company elected to followAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees” (“APB 25”) and related interpretations in accounting for itsemployee stock option plans.  Under APB25, no compensation expense is recognized at the time of option grant becausethe exercise price of the Company’s employee stock option equals the fairmarket value of the underlying common stock on the date of grant.

 

SFAS 123 requires pro forma information regarding netincome and earnings per share as if the Company had accounted for its employeestock options and warrants granted subsequent to December 31, 1994 and sharesof common stock purchased by employees in connection with the ESPP (“equityawards”) under the fair value method. The fair value of these equity awards was estimated at the date of grantusing a Black-Scholes option pricing model with the following weighted averageassumptions for 2002, 2001, and 2000, respectively: risk-free interest rates of3.3%, 4.8%, and 5.2%; expected volatility of 91%, 94%, and 108%; expectedoption life of 6.5, 6.8, and 5.9 years from vesting; and an expected dividendyield of 0.0%.

 

For purposes of pro forma disclosures, the estimatedfair value of the equity awards is amortized to expense over the options’vesting period.  The Company’s pro formanet loss and net loss per share information is as follows (in thousands, exceptper share amounts):

** **
|                                                   |   | **Years Ended December 31,** |    |
|--------------------------------------------------------|--------|------------------------------|---------|
|                                                   |   | **2002**                     |    | **2001** |   | **2000** |   |
| Net income  (loss):                                    |   |                         |    |   |   |   |   |
| As reported                                            |   | $                            | (11,627 | ) | $ | (14,320 | ) | $ | 1,175 |   |
| Pro forma                                              |   | (24,487                      | )       | (31,899 | ) | (16,823 | ) |
| Basic and  diluted net income (loss) per common share: |   |                         |    |   |   |   |   |
| As reported                                            |   | $                            | (0.49   | ) | $ | (0.60 | ) | $ | 0.05 |   |
| Pro forma                                              |   | (1.04                        | )       | (1.34 | ) | (0.74 | ) |

 

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# **Net Income (Loss) PerShare**

 

The Company computes net income (loss) per sharepursuant to SFAS No. 128, “Earnings Per Share” (“SFAS 128”).  Under the provisions of SFAS No. 128, basicnet loss per share is computed by dividing the net income (loss) available tocommon stockholders for the period by the weighted average number of commonshares outstanding during the period. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted average number of common andcommon equivalent shares outstanding during the period.  Common 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 following table sets forth the computation ofbasic and diluted net income (loss) per share as follows (in thousands, exceptper share amounts):

 
|                                                                              |   | **Years Ended December 31,** |    |
|-----------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                              |   | **2002**                     |    | **2001** |   | **2000** |   |
| Numerator:                                                                        |   |                         |    |   |   |   |   |
| Net income  (loss)                                                                |   | $                            | (11,627 | ) | $ | (14,320 | ) | $ | 1,175 |   |
|                                                                              |   |                         |    |   |   |   |   |
| Denominator:                                                                      |   |                         |    |   |   |   |   |
|                                                                              |   |                         |    |   |   |   |   |
| Weighted average  shares outstanding and Denominator for basic earnings per share |   | 23,512                       |    | 23,729 |   | 22,659 |   |
|                                                                              |   |                         |    |   |   |   |   |
| Effect of  dilutive securities:                                                   |   |                         |    |   |   |   |   |
| Employee stock  options                                                           |   | —                       |    | — |   | 1,794 |   |
|                                                                              |   |                         |    |   |   |   |   |
| Denominator for  diluted earnings per share                                       |   | 23,512                       |    | 23,729 |   | 24,453 |   |
|                                                                              |   |                         |    |   |   |   |   |
| Net income  (loss) per share:                                                     |   |                         |    |   |   |   |   |
| Basic and  Diluted                                                                |   | $                            | (0.49   | ) | $ | (0.60 | ) | $ | 0.05 |   |

 

Dilutive common stock equivalents would include thedilutive effects of common stock options, warrants for common stockequivalents, and restricted stock that has not yet fully vested.  Potentially dilutive common stock equivalentstotaled approximately 3,818,000, 2,843,000, and 626,000 shares for the yearsended December 31, 2002, 2001, and 2000 respectively.  Potentially dilutive common stock equivalents were excluded fromthe 2002 and 2001 diluted earnings per share denominator because of theiranti-dilutive effect.

# ** **

# **Comprehensive Income(Loss)**

### ** **

The Company has adopted the provisions of SFAS No.130, “Reporting Comprehensive Income” (“SFAS 130”).  SFAS 130 establishes standards for reporting comprehensive income(loss) and its components in financial statements.  Comprehensive income (loss), as defined, includes all changes inequity (net assets) during a period from non-owner sources. Net income (loss)and other comprehensive income (loss), including foreign currency translationadjustments, and unrealized gains and losses on investments shall be reported,net of their related tax effect, to arrive at comprehensive loss.  The Company’s net income (loss) and itstotal comprehensive income (loss) are included in the statement of stockholders’equity.

 

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# **Effect of New AccountingStandards**

 

In June 2002, the Financial Accounting Standards Board("FASB") issued Statement No. 146, “Accounting for Costs Associatedwith Exit or Disposal” (“SFAS No. 146”). SFAS No. 146 addresses financial accounting and reporting for costsassociated with exit or disposal activities and nullifies Emerging Issues TaskForce ("EITF") Issue No. 94-3, “Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (includingCertain Costs Incurred in a Restructuring)” (“EITF 94-3”).  The principal difference between SFAS No.146 and EITF 94-3 relates to SFAS No. 146’s requirements for recognition of aliability for a cost associated with an exit or disposal activity.  SFAS No. 146 requires that a liability for acost associated with an exit or disposal activity be recognized when theliability is incurred.  Under EITF 94-3,a liability for an exit cost as generally defined in EITF 94-3 was recognizedat the date of an entity’s commitment to an exit plan.  The provisions of SFAS No. 146 are effectivefor exit or disposal activities that are initiated after December 31, 2002,with early application encouraged.  TheCompany does not expect that the adoption of SFAS No. 146 will have a materialimpact on the consolidated financial statements.

 

In November 2002, the EITF reached consensus on EITFIssue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables”(“EITF 00-21”), which addresses how to account for arrangements that mayinvolve the delivery or performance of multiple products, services, and/orrights to use assets. The final consensus of EITF 00-21 will be applicable toagreements entered into in fiscal periods beginning after June 15, 2003, withearly adoption permitted. Additionally, companies will be permitted to applythe consensus guidance to all existing arrangements as the cumulative effect ofa change in accounting principle in accordance with APB Opinion No. 20,Accounting Changes. Management is currently evaluating the effect that theadoption of EITF Issue 00-21 will have on its results of operations andfinancial position.

 

In December 2002, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFASNo. 148”).  SFAS No. 148 is an amendmentto SFAS No. 123 providing alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation and also provides additional disclosures about the method ofaccounting for stock-based employee compensation.  Amendments are effective for financial statements for the Companyending after December 15, 2002.  TheCompany has currently chosen to not adopt the voluntary change to the fairvalue based method of accounting for stock-based employee compensation.  If the Company should choose to adopt such amethod, its implementation pursuant to SFAS No. 148 could have a materialeffect on the Company’s consolidated financial position and results ofoperations.

 

# **Reclassifications**

### ** **

Certain amounts in prior periods have beenreclassified to conform with current period presentation.

 

**3. Business Combinations**

 

**Acquisition of Software Businesses**

 

On June 29, 2001, the Company acquired SynomicsLimited (“Synomics”), a UK-based company providing middleware technology andconsulting expertise.  The Company paid$4.0 million 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.

 

On February 29, 2000, the Company acquired SynopsysScientific Systems Limited (“Synopsys”), a UK-based company providing chemicaldatabase software, chemical data content, and system integration services tothe pharmaceutical, biotechnology, and chemical industries.  The Company paid $25.6 million for Synopsys,consisting of $23.7 million in cash, $0.7 million in transaction costs, and19,142 shares of the Company’s common stock valued at $1.2 million.  The purchase price was allocated as follows:$6.4 million to in-process research and development,

 

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$0.3 million to net tangible assets (including cash acquired of $0.5million), $3.0 million to developed software, $3.4 million to customer listsand other identified intangible assets, and $12.5 million to goodwill.

 

On September 6, 2000, the Company acquired thesoftware subsidiaries of Oxford Molecular Group Plc (“Oxford”), a group of UKand US based companies providing informatics technologies.  The Company paid $32.1 million for Oxford,consisting of $18.7 million in cash, $11.9 million in assumed liabilities and$1.5 million in transaction costs.  Thepurchase price was allocated as follows: $2.3 million to in-process researchand development, $5.3 million to net liabilities (net of cash acquired of $0.2million), $11.7 million to developed software, $2.1 million to customer listsand other identified intangible assets, and $21.3 million to goodwill.

 

The Company has included $0.1 million and $8.4 millionin accrued liabilities for closure of identified facilities, termination andrelocation of employees, and contractual holdbacks as of December 31, 2002 and2001, respectively, resulting from these acquisitions.  Such accruals were recorded at the time ofacquisition based on plans established at that time.  During 2002, the Company charged $4.0 million against the 2001accrual for exit, involuntary employee termination, and relocation costs, $3.1million was paid to Oxford, and $1.2 million was used to reduce the balance ofgoodwill.

 

**Pro Forma Consolidated Results of Operations**

 

The operating results of Synomics, Synopsys, andOxford have been included in the Company’s results of operations since theirrespective acquisition dates.  Assumingthat the acquisitions had occurred on January 1 of the respective years, thepro forma consolidated results of operations would be as follows (in thousands,except per share amounts):

 
|                 |   | **Years Ended December 31,** |    |
|----------------------|--------|------------------------------|---------|
|                 |   | **2001**                     |    | **2000** |   |
| Total revenue        |   | $                            | 122,682 |   | $ | 131,494 |   |
| Net loss             |   | $                            | (18,614 | ) | $ | (23,911 | ) |
|                 |   |                         |    |   |   |
| Net loss per  share: |   |                         |    |   |   |
| Basic and  diluted   |   | $                            | (0.78   | ) | $ | (1.06 | ) |

 

The 2000 pro forma results of operations exclude thewrite-off of allocated in-process research and development of $8.7 million.

 

**DiscontinuedAcquisitions**

 

In March 2001 and January 2002, the Company decided todiscontinue 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.

 

57

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**4.  Composition of CertainFinancial Statement Captions**

 

Property and equipment consist of the following (inthousands):

 
|                                       |   | **December 31,** |   |
|--------------------------------------------|--------|------------------|--------|
|                                       |   | **2002**         |   | **2001** |   |
| Laboratory  equipment                      |   | $                | 12,149 |   | $ | 11,501 |   |
| Furniture,  fixtures and equipment         |   | 5,639            |   | 5,977 |   |
| Computers and  software                    |   | 18,151           |   | 16,409 |   |
| Leasehold  improvements                    |   | 8,117            |   | 6,955 |   |
| Other                                      |   | 979              |   | 610 |   |
|                                       |   | 45,035           |   | 41,452 |   |
| Accumulated  depreciation and amortization |   | (30,878          | )      | (29,726 | ) |
| Property and  equipment, net               |   | $                | 14,157 |   | $ | 11,726 |   |

 

Accrued liabilities consist of the following (inthousands):

 
|                                    |   | **December 31,** |   |
|-----------------------------------------|--------|------------------|--------|
|                                    |   | **2002**         |   | **2001** |   |
| Payroll and  other compensation         |   | $                | 8,144  |   | $ | 10,508 |   |
| Royalties                               |   | 1,489            |   | 1,731 |   |
| Merger related  and restructuring costs |   | 2,275            |   | 8,158 |   |
| Income and other  taxes                 |   | 4,994            |   | 4,843 |   |
| Other                                   |   | 3,515            |   | 3,644 |   |
|                                    |   | $                | 20,417 |   | $ | 28,884 |   |

 

**5. Income Taxes**

 

The Company accounts for income taxes using theliability method.  Under the liabilitymethod, deferred income taxes are recognized for the tax consequences of“temporary differences” by applying enacted statutory tax rates applicable tofuture years to differences between the financial carrying amounts and the taxbasis of existing assets and liabilities.

 

Significant components of the Company’s deferred taxassets and liabilities are as follows (in thousands):

** **
|                                  |   | **December 31,** |   |
|---------------------------------------|--------|------------------|--------|
|                                  |   | **2002**         |   | **2001** |   |
| Deferred tax  assets:                 |   |             |   |   |   |
| Net operating  loss carryforwards     |   | $                | 32,117 |   | $ | 30,224 |   |
| Unused tax  credits                   |   | 914              |   | 914 |   |
| Fixed assets                          |   | 840              |   | 698 |   |
| Accruals and  reserves                |   | 13,067           |   | 12,037 |   |
| Gross deferred  tax asset             |   | 46,938           |   | 43,873 |   |
|                                  |   |             |   |   |   |
| Deferred tax  liabilities:            |   |             |   |   |   |
| Intangibles                           |   | 5,010            |   | 6,137 |   |
|                                  |   |             |   |   |   |
| Net asset before  valuation allowance |   | 41,928           |   | 37,736 |   |
| Valuation  allowance                  |   | (41,928          | )      | (37,736 | ) |
|                                  |   |             |   |   |   |
| Net deferred tax  asset               |   | $                | — |   | $ | — |   |

 

58

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As of December 31, 2002, approximately $1.9 million ofthe valuation allowance for deferred tax assets relates to pre-acquisition taxdeductions, which to the extent recognized, will result in a reduction ofgoodwill.

 

Pretax income (loss) from the Company’s domesticoperations totaled approximately $(15.3 million), $(12.8 million), and $0.6million in 2002, 2001, and 2000, respectively. Pretax income (loss) from the Company’s foreign operations totaledapproximately $4.3 million, $(0.7 million), and $1.9 million in 2002, 2001, and2000, respectively.

 

The provision for income taxes consists of thefollowing (in thousands):

 
|     |   | **Years Ended December 31,** |   |
|----------|--------|------------------------------|--------|
|     |   | **2002**                     |   | **2001** |   | **2000** |   |
| Current: |   |                         |   |   |   |   |   |
| Federal  |   | $                            | — |   | $ | — |   | $ | — |   |
| State    |   | 53                           |   | 183 |   | 329 |   |
| Foreign  |   | 611                          |   | 705 |   | 926 |   |
| Total    |   | $                            | 664    |   | $ | 888 |   | $ | 1,255 |   |

 

The following reconciles income taxes computed at theUS statutory federal tax rate to the provision for income taxes from continuingoperations (in thousands):

 
|                                                   |   | **Years Ended December 31,** |   |
|--------------------------------------------------------|--------|------------------------------|--------|
|                                                   |   | **2002**                     |   | **2001** |   | **2000** |   |
| Tax expense  (benefit) at U.S. statutory rate          |   | $                            | (3,727 | ) | $ | (4,710 | ) | $ | 826 |   |
| State income  taxes, net of Federal income tax benefit |   | (670                         | )      | (766 | ) | 329 |   |
| Nondeductible  merger costs                            |   | —                       |   | 3,056 |   | 5,031 |   |
| Foreign taxes                                          |   | 391                          |   | 1,852 |   | 183 |   |
| Change in  valuation allowance and other               |   | 4,670                        |   | 1,456 |   | (5,114 | ) |
| Provision for  income taxes                            |   | $                            | 664    |   | $ | 888 |   | $ | 1,255 |   |

 

As of December 31, 2002, the Company has US federalnet operating loss carryforwards of approximately $76.0 million, and creditcarryforwards of approximately $1.0 million. The US federal net operating losses and credits begin to expire in 2008through 2022, if not fully utilized. Realization is dependent on generating sufficient taxable income priorto expiration of the loss and credit carryforwards.  A portion of the net operating losses relate to stock optiondeductions which will result in an increase to paid-in capital and a decreasein income taxes payable at such time that the tax benefit is realized.

 

A portion of the Company’s US federal net operatingloss carryforwards that relate to the acquired companies may be subject toannual usage limitations under Section 382 of the Internal Revenue Code.

 

**6.  Stock Plans**

 

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

 

In accordance with the 1994 Incentive Stock Plan (the“Plan”), the Company may grant both incentive or non-qualified stock options orstock purchase rights to purchase up to 5,700,000 shares of common stock toofficers, directors, employees, sales representatives, and consultants of theCompany.  The term of each incentive andnon-qualified stock option and stock purchase right is generally tenyears.  Vesting generally occurs over aperiod of not

 

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greater than five years.  AtDecember 31, 2002, there were 794,000 shares available for future grants underthe 1994 Incentive Stock Plan.

 

In 1995, the Company adopted the 1995 Employee StockPurchase Plan (“ESPP”) under Section 423 of the Internal Revenue Code.  A total of 750,000 shares of common stockare reserved for offering under the ESPP. In 2002, 126,000 shares of common stock were purchased at prices rangingfrom $8.52 to $9.48 per share.  AtDecember 31, 2002, there were 313,000 shares available for future purchaseunder the ESPP.

 

In accordance with the 1995 Director’s Option Plan, theCompany may grant options to purchase up to 300,000 shares of common stock tonon-employee members of the Board.  Theexercise price of the stock options shall be equal to the fair market value pershare of common stock on the option grant date.  Each option has a term of ten years from the option grant dateand shall become exercisable in a series of three equal and successive annualinstallments.  In 2002, 30,000 optionswere granted at an exercise price of $11.10. At December 31, 2002, there were 92,000 shares available for futuregrants under the Director’s Option Plan.

 

In accordance with the 2000 Stock Option Plan, theCompany may grant non-qualified stock options or stock purchase rights topurchase up to 1,500,000 shares of common stock to employees and consultants ofthe Company.  The term of eachnon-qualified stock option and stock purchase right is ten years.  In 2002, 146,000 options were granted atexercise prices ranging from $6.00 to $14.09. Vesting generally occurs over a period of not greater than fiveyears.  At December 31, 2002, there were334,000 shares available for future grants under the 2000 Stock Option Plan.

 

A summary of the Company’s stock option activity andweighted average exercise prices follows (in thousands, except per shareamounts):

 
|                                                            |   | **2002**                   |   | **2001**                               |   | **2000**                   |   |
|-----------------------------------------------------------------|--------|----------------------------|--------|----------------------------------------|--------|----------------------------|--------|
|                                                            |   | **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:                              |   | 4,878                      |   | $                                      | 21.46  |                       | 3,383  |   | $ | 23.33 |   | 3,664 |   | $ | 10.73 |   |
| Granted                                                         |   | 1,348                      |   | $                                      | 9.99   |                       | 2,282  |   | $ | 15.48 |   | 1,460 |   | $ | 42.53 |   |
| Exercised                                                       |   | (98                        | )      | $                                      | 8.02   |                       | (384   | ) | $ | 7.03 |   | (1,259 | ) | $ | 10.93 |   |
| Expired                                                         |   | (1,188                     | )      | $                                      | 26.09  |                       | (403   | ) | $ | 23.02 |   | (482 | ) | $ | 19.04 |   |
| Outstanding at  end of year:                                    |   | 4,940                      |   | $                                      | 17.49  |                       | 4,878  |   | $ | 21.46 |   | 3,383 |   | $ | 23.33 |   |
|                                                            |   |                       |   |                                   |   |                       |   |   |   |   |   |   |   |
| Exercisable at  end of year                                     |   | 2,299                      |   |                                   |   | 1,679                      |   |   |   | 1,223 |   |   |   |
|                                                            |   |                       |   |                                   |   |                       |   |   |   |   |   |   |   |
| Weighted average  fair value of options granted during the year |   |                       |   | $                                      | 7.80   |                       |   |   | $ | 18.75 |   |   |   | $ | 35.83 |   |

 

A summary of stock options outstanding and exercisableas of December 31, 2002, 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                                          |   |                                   | 1,442  |   | 7.9 |   | $ | 8.67 |   | 534 |   | $ | 7.81 |   |
| $                             | 10.01  | -                        | $      | 15.00                                          |   |                                   | 1,690  |   | 8.2 |   | 11.81 |   | 609 |   | 11.78 |   |
| $                             | 15.01  | -                        | $      | 20.00                                          |   |                                   | 733    |   | 6.4 |   | 17.90 |   | 471 |   | 17.78 |   |
| $                             | 20.01  | -                        | $      | 40.00                                          |   |                                   | 366    |   | 7.0 |   | 25.79 |   | 226 |   | 25.63 |   |
| $                             | 40.01  | -                        | $      | 85.00                                          |   |                                   | 709    |   | 7.3 |   | 44.24 |   | 459 |   | 44.31 |   |
| $                             | 0.38   | -                        | $      | 85.00                                          |   |                                   | 4,940  |   | 7.6 |   | $ | 17.49 |   | 2,299 |   | $ | 19.94 |   |

 

60

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**7. Deferred Compensation and Retirement Savings Plans**

 

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

 

The 401(k) Plan is intended to be a tax-qualified plancovering substantially all employees. Under the terms of the 401(k) Plan, employees may elect to contribute upto 20% of their compensation, 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 $1.1 million, $1.4 million, and $0.9 million for the years endedDecember 31, 2002, 2001, and 2000.

 

The Deferred Compensation plan was established in 2000and permits selected employees to defer up to 100% of their compensation.  Contributions to this plan are held in atrust account and are invested at the participant’s discretion in marketabledebt and equity securities.  Theseinvestments are reflected in other assets on the balance sheet and total $0.7million and $0.5 million as of December 31, 2002 and 2001, respectively.

 

**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”), Inc. provides drug discoveryservices to pharmaceutical and biotechnology companies based on proprietarycombinatorial chemistry, high-throughput screening and Accelrys technologies.

 

Summarized financial information concerning theindustry segments and geographic revenues follows (in thousands):

 
|                                                  |   | **Years  Ended December 31,** |    |
|-------------------------------------------------------|--------|-------------------------------|---------|
|                                                  |   | **2002**                      |    | **2001** |   | **2000** |   |
|                                                  |   | **Accelrys**                  |    | **PDD** |   | **Total** |   | **Accelrys** |   | **PDD** |   | **Total** |   | **Accelrys** |   | **PDD** |   | **Total** |   |
| Revenues:                                             |   |                          |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Software licenses services and other                  |   | $                             | 95,104  |   | $ | — |   | $ | 95,104 |   | $ | 95,107 |   | $ | — |   | $ | 95,107 |   | $ | 75,401 |   | $ | — |   | $ | 75,401 |   |
| Drug discovery                                        |   | —                        |    | 29,304 |   | 29,304 |   | — |   | 27,196 |   | 27,196 |   | — |   | 39,035 |   | 39,035 |   |
| Total revenues                                        |   | $                             | 95,104  |   | $ | 29,304 |   | $ | 124,408 |   | $ | 95,107 |   | $ | 27,196 |   | $ | 122,303 |   | $ | 75,401 |   | $ | 39,035 |   | $ | 114,436 |   |
|                                                  |   |                          |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization                         |   | $                             | 11,844  |   | $ | 2,213 |   | $ | 14,057 |   | $ | 18,899 |   | $ | 2,897 |   | $ | 21,796 |   | $ | 10,764 |   | $ | 3,410 |   | $ | 14,174 |   |
| Operating income (loss) from continuing operations(1) |   | $                             | (12,750 | ) | $ | (2,128 | ) | $ | (14,878 | ) | $ | (13,351 | ) | $ | (6,599 | ) | $ | (19,950 | ) | $ | (7,962 | ) | $ | 700 |   | $ | (7,262 | ) |
| Capital expenditures                                  |   | $                             | 7,629   |   | $ | 869 |   | $ | 8,498 |   | $ | 3,561 |   | $ | 1,303 |   | $ | 4,864 |   | $ | 2,365 |   | $ | 1,811 |   | $ | 4,176 |   |
| Total assets(2)                                       |   | $                             | 104,143 |   | $ | 135,962 |   | $ | 240,105 |   | $ | 119,538 |   | $ | 150,860 |   | $ | 270,398 |   | $ | 119,386 |   | $ | 165,380 |   | $ | 284,766 |   |
|                                                  |   |                          |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues(3)                                           |   |                          |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.                                                  |   |                          |    |   |   | $ | 80,473 |   |   |   |   |   | $ | 76,513 |   |   |   |   |   | $ | 75,673 |   |
| Europe                                                |   |                          |    |   |   | 28,314 |   |   |   |   |   | 30,310 |   |   |   |   |   | 23,366 |   |
| Asia-Pacific                                          |   |                          |    |   |   | 15,621 |   |   |   |   |   | 15,480 |   |   |   |   |   | 15,397 |   |
| Total                                                 |   |                          |    |   |   | $ | 124,408 |   |   |   |   |   | $ | 122,303 |   |   |   |   |   | $ | 114,436 |   |

 

----

*(1)**       Includes  $8.7 million ofwrite-offs of in-process research and development in 2000.*

*(2)**       Includes cash and cash equivalents of $13,058 and $15,178 at Software andDrug Discovery, respectively in 2002; $14,614 and $142,042 at Software and DrugDiscovery, respectively, in 2001;and $18,242 and $146,721 at Software and Drug Discovery, respectively, in2000.*

*(3)**       Revenue in the US category includes export revenue from Drug Discoveryand Software.  Export revenues from theUS to Europe totaled $16,336, $15,081 and, $15,953 in 2002, 2001, and 2000,respectively; and export revenues to Asia-Pacific totaled $5,207,$2,371,and  $1,170 in 2002, 2001, and2000, respectively.*

 

61

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**9.  Commitments and Contingencies**

 

### **Operating Leases**

 

The Company has several operating leases or sub-leasesfor office and laboratory space, which expire at various dates through2022.  The leases for the Company’sprimary facilities in Cambridge, UK, CA and NJ, USA, provide generally forscheduled rent increases, options to extend the leases with certain changes tothe terms of the lease agreement, and refurbishment allowances.  Rent expense under operating leases for2002, 2001, and 2000 was approximately $8.1 million, $6.6 million, and $5.7million, respectively.

 

Future minimum lease commitments at December 31,2002 are as follows (in thousands):

 
|       |   | **Total** |   |
|------------|--------|-----------|--------|
| 2003       |   | $         | 6,393  |   |
| 2004       |   | 6,237     |   |
| 2005       |   | 6,006     |   |
| 2006       |   | 3,633     |   |
| 2007       |   | 1,580     |   |
| Thereafter |   | 18,839    |   |
|       |   | $         | 42,688 |   |

 

# **Royalties**

 

The Company pays royalties to approximately thirtypartners for worldwide licenses to enhance and market certain softwaredeveloped at universities, corporations, and other institutions.  A majority of the royalty agreements arelong term or perpetual in nature and the royalty obligations thereunder aregenerally based on a percentage of revenues derived from certain softwarelicenses plus associated revenues from post-contract support andmaintenance.  The royalty agreementsrequire quarterly payments and generally do not limit the maximum royaltyamount under the agreement.  Certainagreements contain provisions for quarterly and annual minimum royalty paymentsthat total approximately $0.5 million on an annual basis.  In 2002, 2001, and 2000 the Company incurredrelated royalty expense of $3.2 million, $3.0 million, and $2.2 million,respectively.  Based on existing royaltyagreements, the Company expects to continue to incur about these levels ofannual future royalty obligations.

 

Additionally, the Company has a license agreement thatgrants to the Company an exclusive, worldwide license to certain technology formaking and using combinatorial chemical libraries.  This agreement requires the Company to pay annual license feesand certain royalties. In 2002, 2001, and 2000 the Company paid relatedroyalties and license fees of $0.3 million, $0.2 million, and $0.2 million,respectively.

 

**Litigation**

 

In the ordinary course of business, the Company issubject to claims and, from time to time, is named in various legalproceedings. In the opinion of management, the amount of ultimate liability, ifany, with respect to any pending actions will not materially affect thefinancial position or results of operations of the Company.

 

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

 

The following is a summary of the quarterly results ofoperations for the years ended December 31, 2002 and 2001 (in thousands, exceptper share amounts):

 

62

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|                                         |   | **2002**     |   | **2001**    |   |
|----------------------------------------------|--------|--------------|--------|-------------|--------|
|                                         |   | **March 31** |   | **June 30** |   | **Sept. 30** |   | **Dec. 31** |   | **March 31** |   | **June 30** |   | **Sept. 30** |   | **Dec. 31** |   |
|                                         |   |         |   |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues                                     |   | $            | 26,840 |        | $      | 29,300 |   | $ | 30,908 |   | $ | 37,360 |   | $ | 25,563 |   | $ | 27,218 |   | $ | 28,500 |   | $ | 41,022 |   |
| Cost of revenues                             |   | $            | 9,617  |        | $      | 10,624 |   | $ | 10,296 |   | $ | 10,118 |   | $ | 9,790 |   | $ | 9,536 |   | $ | 9,906 |   | $ | 10,224 |   |
| Net income (loss) from continuing operations |   | $            | (6,003 | )           | $      | (5,080 | ) | $ | (6,330 | ) | $ | 5,786 |   | $ | (5,875 | ) | $ | (5,632 | ) | $ | (5,930 | ) | $ | 2,697 |   |
| Net income (loss)                            |   | $            | (6,003 | )           | $      | (5,080 | ) | $ | (6,330 | ) | $ | 5,786 |   | $ | (5,780 | ) | $ | (5,408 | ) | $ | (5,953 | ) | $ | 2,821 |   |
|                                         |   |         |   |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Per Common Share:                            |   |         |   |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss) from continuing operations |   |         |   |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| - Basic                                      |   | $            | (0.25  | )           | $      | (0.22 | ) | $ | (0.27 | ) | $ | 0.25 |   | $ | (0.25 | ) | $ | (0.24 | ) | $ | (0.25 | ) | $ | 0.11 |   |
| - Diluted                                    |   | $            | (0.25  | )           | $      | (0.22 | ) | $ | (0.27 | ) | $ | 0.24 |   | $ | (0.25 | ) | $ | (0.24 | ) | $ | (0.25 | ) | $ | 0.11 |   |
|                                         |   |         |   |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss):                           |   |         |   |        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| - Basic                                      |   | $            | (0.25  | )           | $      | (0.22 | ) | $ | (0.27 | ) | $ | 0.25 |   | $ | (0.25 | ) | $ | (0.23 | ) | $ | (0.25 | ) | $ | 0.12 |   |
| - Diluted                                    |   | $            | (0.25  | )           | $      | (0.22 | ) | $ | (0.27 | ) | $ | 0.24 |   | $ | (0.25 | ) | $ | (0.23 | ) | $ | (0.25 | ) | $ | 0.12 |   |

 

**11. Goodwill and Other Intangible Assets – Adoption of Statements 141 and142**

 

In July 2001, the Financial Accounting Standards Boardissued SFAS No. 141, “Business Combinations” (“SFAS 141”).  As required by SFAS 141, during the quarterended March 31, 2002, the Company reclassified $1.8 million of intangibleassets with indefinite lives to goodwill. The related amortization expense in the prior period, which had beenpreviously classified as sales, general and administrative expense, has beenreclassified to amortization of goodwill. All such reclassified intangibles and related amortization areassociated with Accelrys.

 

The Financial Accounting Standards Board also issuedSFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) in July2001.  Under SFAS 142, goodwill andintangible assets with indefinite lives are no longer amortized but arereviewed annually (or more frequently if impairment indicators arise) forimpairment.  The Company adopted SFAS142 during the quarter ended March 31, 2002, completed its annual intangibleasset impairment test during the quarter ended December 31, 2002, and concludedthat the carrying value of goodwill was not impaired.

 

The Company’s other intangibles are amortized on astraight-line basis.  Intangible assetamortization in the three years ended December 31, 2002 was $0.9 million, $0.9million, and $0.8 million.  The balanceof $0.1 million as of December 31, 2002 will be expensed in the first calendarquarter of 2003.

 

The effect of excluding amortization of goodwill fromthe Company’s net loss and net loss per share, based on the implementation ofSFAS 142, is as follows (in thousands, except per share amounts):

 
|                                  |   | **Years Ended December 31,** |    |
|---------------------------------------|--------|------------------------------|---------|
|                                  |   | **2002**                     |    | **2001** |   |
| Reported net  loss                    |   | $                            | (11,627 | ) | $ | (14,320 | ) |
| Addback:  Goodwill amortization       |   | —                       |    | 8,620 |   |
| Adjusted net  loss                    |   | $                            | (11,627 | ) | $ | (5,700 | ) |
|                                  |   |                         |    |   |   |
| Basic and  Diluted net loss per share |   |                         |    |   |   |
| Reported net  loss per share          |   | $                            | (0.49   | ) | $ | (0.60 | ) |
| Addback:  Goodwill amortization       |   | —                       |    | 0.36 |   |
| Adjusted net  loss per share          |   | $                            | (0.49   | ) | $ | (0.24 | ) |

 

**12. Treasury Stock**

 

During the third quarter of 2001, the Company’s Boardof Directors authorized a stock repurchase program under which up to 1,000,000shares of Pharmacopeia common stock with a market value up to $16 million maybe acquired

 

63

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in the open market.  As ofDecember 31, 2002, the Company had repurchased a total of 643,900 shares for$8.3 million.

 

**13. Restructuring**

 

During the third quarter of 2002, the Companyannounced that it was undertaking various actions to restructure its operationsto improve its overall financial performance. The restructuring effort included a reduction in force of 71 employees,of which 68 had been terminated as of December 31, 2002, and the closure of certainfacilities. 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 theaccrued restructuring reserve, which has been included in accrued liabilitiesat December 31, 2002 (in thousands):

 
|                          |   | **Severance  Costs for  Involuntary  Employee  Terminations** |   | **Costs to  Exit  Certain  Lease  Obligations** |   | **Total** |   |
|-------------------------------|--------|---------------------------------------------------------------|--------|-------------------------------------------------|--------|-----------|--------|
| Balance at  August 6, 2002    |   | $                                                             | 2,367  |                                            | $      | 1,973     |   | $ | 4,340 |   |
| Utilization of  Reserves:     |   |                                                          |   |                                            |   |      |   |
| Cash                          |   | (1,823                                                        | )      | (242                                            | )      | (2,065    | )      |
| Balance at  December 31, 2002 |   | $                                                             | 544    |                                            | $      | 1,731     |   | $ | 2,275 |   |

 

**14. Related Party Transactions**

 

A stockholder and member of the Company’s Board ofDirectors is also a partner in the principal outside law firm that provideslegal services to the Company.  For theyears ended December 31, 2002, 2001, and 2000 the Company expended a total of$0.8 million, $2.2 million, and $1.0 million in fees related to services providedby such firm.

 

64

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**ITEM9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

 

None

 

## **PART III**

 

**ITEM10.  DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

The information required by this Item concerning theCompany’s directors and executive officers, other than as set forth in Item 4A,is incorporated by reference from the Company’s Proxy Statement (the “ProxyStatement”) related to the Annual Stockholders Meeting to be held on May 1,2003.

 

**ITEM11.  EXECUTIVE COMPENSATION**

 

The information required by this Item is incorporatedby reference from the section entitled “Executive Compensation” in the ProxyStatement.

 

**ITEM12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The information required by this Item is incorporatedby reference from the section entitled “Stock Ownership of PrincipalStockholders and Management” in the Proxy Statement.

 

**ITEM13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required by this item is incorporatedby reference from the section entitled “Certain Relationships and RelatedTransactions” in the Proxy Statement.

 

# **ITEM 14.  CONTROLS AND PROCEDURES**

 

Under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, we conducted an evaluation of the effectiveness of thedesign and operation of our disclosure controls and procedures, as such term isdefined under Rule 13a-14(c) promulgated under the Securities  Exchange Act of 1934, as amended, within the90 days prior to the filing date of this report. Based on their evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures are effective as of the evaluation date.

 

There have been no significant changes (includingcorrective actions with regard to significant deficiencies or materialweaknesses) in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of the evaluationdescribed above.

 

65

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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, 2002 and 2001                                               |
| Consolidated  Statements of Operations for the years ended December 31, 2002, 2001 and 2000                 |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 2002,  2001 and 2000 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000                 |
| Notes to  Consolidated Financial Statements                                                                 |

 

(a)(2) Financial Statement Schedules

 

Schedule II – Valuation and Qualifying Accounts (inthousands)

 
|                               |   |                                 |   | **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, 2000      |   | $                                    | 624    |                                | $      | 564                             |   | $              | 1,673  | (1) | $ | 556 | (2)  | $ | 2,305 |   |
| Year ended  December 31, 2001      |   | $                                    | 2,305  |                                | $      | 315                             |   | $              | — |   | $ | 1,706 | (2) | $ | 914 |   |
| Year ended  December 31, 2002      |   | $                                    | 914    |                                | $      | 1,270                           |   | $              | — |   | $ | 550 | (2) | $ | 1,634 |   |

 

----

(1)          $1,664 represents amountfrom acquisitions, $9 represents amounts charged to foreign currency translationadjustment.

(2)          Represents write-offs,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.                                                                                                                                               |

 

66

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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                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

67

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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                                                                                                                                                                           |
| 10.4(e)*++ |   | Amendment No. 5 to Research, License and Royalty  Agreement between the Company and Berlex Laboratories, Inc. dated January 24,  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).                                                                                      |
| 10.10#     |   | 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                                                                                                                                                           |

 

68

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|       |   | 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).                                                                 |
| 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.                                                                                                                                                                                            |
| 10.26      |   | Lease Agreement dated July 29, 2001 among the  Masters, Fellows and Scholars of Trinity College, Cambridge, Accelrys  Limited, and Accelrys Inc.                                                                                                                                                                              |

 

69

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|    |   | 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.                                                                                                              |
| 21.1*   |   | Subsidiaries of Pharmacopeia, Inc.                                                                                                                                                                                   |
| 23.1*   |   | Consent of Ernst & Young LLP, Independent  Auditors.                                                                                                                                                             |
| 24.1*   |   | Powers of Attorney (See signature page)                                                                                                                                                                              |

 

----

+                             Confidentialtreatment granted.

++                      Confidentialtreatment requested.

#                             Representsa management contract or compensatory plan or arrangement.

*                             Filedherewith

 

(b) Reports on Form 8-K

 

(i)                                     Currentreport on Form 8-K filed October 9, 2002 reported under Item 7 relating to apresentation to investors on October 9, 2002.

 

(c) Exhibits

 

See Item 15 (a)(3) above.

 

70

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**SIGNATURES**

 

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

 
|   | 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  25, 2003 |                                                    |
|        |                             |                                                         |  |  |

 

71

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**POWER OF ATTORNEY**

 

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints John J. Hanlon andJoseph A. Mollica, Ph.D., jointly and severally, as his or herattorney-in-fact, each with full power of substitution, for him or her, in anyand all capacities, to sign each amendment to this Report on Form 10-K, and tofile the same, with exhibits thereto and other documents in connectiontherewith, with the Securities and Exchange Commission, hereby ratifying andconfirming all that each of said attorneys-in-fact or his or her substitute orsubstitutes may lawfully do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this Report has been signed below by the followingpersons on behalf of the Registrant and in the capacities and on the datesindicated:

 
| **Signatures**                    |   | **Title**                                                                                     |   | **Date**       |
|-----------------------------------|--------|-----------------------------------------------------------------------------------------------|--------|----------------|
|                              |   |                                                                                          |   |           |
| /s/ Joseph A. Mollica, Ph.D.      |   | Chairman of the Board,  President and Chief Executive  Officer (Principal Executive  Officer) |   | March 25, 2003 |
| Joseph A. Mollica, Ph.D.          |   |                                                                                          |   |
|                              |   |                                                                                          |   |           |
| /s/ John J. Hanlon                |   | Executive Vice President and  Chief Financial Officer  (Principal Financial Officer)          |   | March 25, 2003 |
| John J. Hanlon                    |   |                                                                                          |   |
|                              |   |                                                                                          |   |           |
| /s/ Arthur E. Roke, CPA           |   | Vice President, Finance and  Chief Accounting Officer  (Principal Accounting Officer)         |   | March 25, 2003 |
| Arthur E. Roke, CPA               |   |                                                                                          |   |
|                              |   |                                                                                          |   |           |
| /s/ Frank Baldino, Jr., Ph.D.     |   | Director                                                                                      |   | March 25, 2003 |
|  Frank  Baldino, Jr., Ph. D. |   |                                                                                          |   |           |
|                              |   |                                                                                          |   |           |
| /s/ Paul A. Bartlett, Ph.D.       |   | Director                                                                                      |   | March 25, 2003 |
| Paul A. Bartlett, Ph.D.           |   |                                                                                          |   |           |
|                              |   |                                                                                          |   |           |
| /s/ Gary E. Costley, Ph.D.        |   | Director                                                                                      |   | March 25, 2003 |
| Gary E. Costley, Ph.D.            |   |                                                                                          |   |           |
|                              |   |                                                                                          |   |           |
| /s/ Ricardo B. Levy, Ph.D.        |   | Director                                                                                      |   | March 25, 2003 |
| Ricardo B. Levy, Ph.D.            |   |                                                                                          |   |           |
|                              |   |                                                                                          |   |           |
| /s/ James J. Marino, Esq.         |   | Director                                                                                      |   | March 25, 2003 |
| James J. Marino, Esq.             |   |                                                                                          |   |           |
|                              |   |                                                                                          |   |           |
| /s/ Charles A. Sanders, M.D.      |   | Director                                                                                      |   | March 25, 2003 |
| Charles A. Sanders, M.D.          |   |                                                                                          |   |           |

 

 

[Rest of Pageintentionally left blank]

 

72

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**CERTIFICATIONOF CHIEF EXECUTIVE OFFICER**

 

I, Joseph A. Mollica, certify that:

 

1.                                       Ihave reviewed this annual report on Form 10-K of Pharmacopeia, Inc.;

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)                                      presentedin this annual report our conclusions about the effectiveness of thesedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this annualreport whether there were significant changes in internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

Date:  March 25, 2003

 
|   |   | /s/Joseph A. Mollica                                          |   |   |   |
|--------|--------|---------------------------------------------------------------|--------|--------|--------|
|   |   | Joseph A. Mollica, Ph.D.                                      |
|   |   | Chairman of the Board, President  and Chief Executive Officer |
|   |   |

 

73

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**CERTIFICATIONOF CHIEF FINANCIAL OFFICER**

 

I, John J. Hanlon, certify that:

 

1.                                       Ihave reviewed this annual report on Form 10-K of Pharmacopeia, Inc.;

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)                                      presentedin this annual report our conclusions about the effectiveness of thesedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this annualreport whether there were significant changes in internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

Date:  March 25, 2003

 
|   |   | /s/ John J. Hanlon                                    |   |   |   |
|--------|--------|-------------------------------------------------------|--------|--------|--------|
|   |   | John J. Hanlon                                        |
|   |   | Executive Vice President  and Chief Financial Officer |

 

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PHARMACOPEIA, INC.

 

CERTIFICATIONPURSUANT TO 18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

 

In connection with the Annual Report of Pharmacopeia, Inc. (the“Company”) on Form 10-K for the period ended December 31, 2002, as filed withthe Securities and Exchange Commission on the date hereof (the “Report”), I,Joseph A. Mollica, Ph.D., Chairman of the Board, President and ChiefExecutive Officer of the Company, hereby certify pursuant to 18 U.S.C. ss.1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that:

 

(1)  The Report fully complieswith the requirements of Section 13(a) or 15(d) of the Securities Exchange Actof 1934; and

 

(2)  The information containedin the Report fairly presents, in all material respects, the financial conditionand results of operations of the Company.

 

 
| /s/ Joseph A. Mollica, Ph.D.                                  |   |   |
|---------------------------------------------------------------|--------|--------|
| Joseph A. Mollica, Ph.D.                                      |   |
| Chairman of the Board, President  and Chief Executive Officer |   |
|                                                          |   |
| March 25, 2003                                                |   |

 

The foregoing Certification is being furnished solely pursuant toSection 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) ofSection 1350, Chapter 63 of the Title 18, United States Code).  It is not being filed as part of, or as anexhibit to, any disclosure document, and is not being filed as a separatedisclosure document.

 

75

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PHARMACOPEIA, INC.

 

CERTIFICATIONPURSUANT TO 18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

 

In connection with the Annual Report of Pharmacopeia, Inc. (the“Company”) on Form 10-K for the period ended December 31, 2002, as filed withthe Securities and Exchange Commission on the date hereof (the “Report”), I,John J. Hanlon, Executive Vice President and Chief Financial Officerof the Company, hereby certify pursuant to 18 U.S.C. ss. 1350, as adoptedpursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that:

 

(1)  The Report fully complieswith the requirements of Section 13(a) or 15(d) of the Securities Exchange Actof 1934; and

 

(2)  The information containedin the Report fairly presents, in all material respects, the financialcondition and results of operations of the Company.

 

 
| /s/ John J. Hanlon                                    |   |   |
|-------------------------------------------------------|--------|--------|
| John J. Hanlon                                        |   |
| Executive Vice President  and Chief Financial Officer |   |
|                                                  |   |
| March 25, 2003                                        |   |

 

The foregoing Certification is being furnished solely pursuant toSection 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) ofSection 1350, Chapter 63 of the Title 18, United States Code).  It is not being filed as part of, or as anexhibit to, any disclosure document, and is not being filed as a separatedisclosure document.

 

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