**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **
| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**For the Quarterly PeriodEnded September 30, 2006**

** **
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|-------|------------|----------------------------------------------------------------------------------------------------------|

** **

**For thetransition period from              to               **

**Commissionfile number:  0-25323**

**ALBANY MOLECULAR RESEARCH, INC.**

(Exact name of registrant as specified in its charter)

 
| **DELAWARE**                     | ** ** | **14-1742717**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer     |
| incorporation or  organization)  |       | Identification  No.) |

**21Corporate CirclePO Box 15098Albany, New York  12212-5098**

(Address of principal executive offices)

**(518) 464-0279**

(Registrant’s telephone number, includingarea code)

**N/A**

(Former name, former address and formerfiscal year, if changed since last report)

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

| Yes |   | x |   | No |   | o |
|-----|--------|---|--------|----|--------|---|

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

| Large accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|---------------------------|--------|----------------------|--------|--------------------------|

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

| Yes |   | o |   | No |   | x |
|-----|--------|---|--------|----|--------|---|

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

| **Class**                     |   | **Outstanding at October  31, 2006** |
|-------------------------------|--------|-----------------------------------------------------|
| Common Stock, $.01  par value |   | 34,696,271                                          |

 

 

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ALBANY MOLECULAR RESEARCH, INC.

INDEX
| Part I.       | Financial Information |                                                                                        |
|--------------------|-----------------------|---------------------------------------------------------------------------------------------|
|               |                  |                                                                                        |   |
|               | Item 1.               | Condensed Consolidated  Financial Statements (Unaudited)                                    |   |
|               |                  |                                                                                        |   |
|               |                  | Condensed Consolidated Statements of Operations                                             |   |
|               |                  | Condensed Consolidated Balance Sheets                                                       |   |
|               |                  | Condensed Consolidated Statements of Cash Flows                                             |   |
|               |                  | Notes to Condensed Consolidated Financial Statements                                        |   |
|               |                  |                                                                                        |   |
|               | Item 2.               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|               |                  |                                                                                        |   |
|               | Item 3.               | Quantitative and Qualitative Disclosures About  Market Risk                                 |   |
|               |                  |                                                                                        |   |
|               | Item 4.               | Controls and  Procedures                                                                    |   |
|               |                  |                                                                                        |   |
| Part II.      | Other Information     |                                                                                        |
|               |                  |                                                                                        |   |
|               | Item 1.               | Legal Proceedings                                                                           |   |
|               |                  |                                                                                        |   |
|               | Item  1A.             | Risk  Factors                                                                               |   |
|               |                  |                                                                                        |   |
|               | Item 3.               | Quantitative  & Qualitative Disclosures about Market Risk                               |   |
|               |                  |                                                                                        |   |
|               | Item  6.              | Exhibits                                                                                    |   |
|               |                  |                                                                                        |   |
| Signatures         |                  |                                                                                        |
|               |                  |                                                                                        |   |
| Exhibit Index |                  |                                                                                        |

 

2

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**PART I— FINANCIAL INFORMATION**

**Item 1.**    Condensed Consolidated Financial Statements

**AlbanyMolecular Research, Inc.**

**Condensed Consolidated Statements of Operations**

**(unaudited)**

 
| ** **                                                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands, except for per share data)** | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Contract revenue                                                                         |       | $                                | 37,907     |                             | $          | 31,550 |   | $ | 112,478 |   | $ | 104,124 |   |
| Recurring royalties                                                                      |       | 6,333                            |       | 12,779                           |       | 20,711 |   | 40,679 |   |
| Total revenue                                                                            |       | 44,240                           |       | 44,329                           |       | 133,189 |   | 144,803 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Cost of contract  revenue                                                                |       | 32,132                           |       | 26,137                           |       | 95,764 |   | 84,600 |   |
| Technology incentive  award                                                              |       | 633                              |       | 1,277                            |       | 2,151 |   | 4,072 |   |
| Research and  development                                                                |       | 2,583                            |       | 4,070                            |       | 7,925 |   | 11,039 |   |
| Selling, general and  administrative                                                     |       | 8,112                            |       | 6,331                            |       | 22,659 |   | 19,177 |   |
| Property and equipment  impairment                                                       |       | —                           |       | —                           |       | 3,084 |   | — |   |
| Total costs and  expenses                                                                |       | 43,460                           |       | 37,815                           |       | 131,583 |   | 118,888 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Income from operations                                                                   |       | 780                              |       | 6,514                            |       | 1,606 |   | 25,915 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Interest income, net                                                                     |       | 759                              |       | 561                              |       | 2,146 |   | 1,081 |   |
| Other income (expense),  net                                                             |       | 89                               |       | (137                             | )          | 1 |   | (67 | ) |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Income before income  tax expense                                                        |       | 1,628                            |       | 6,938                            |       | 3,753 |   | 26,929 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Income tax expense                                                                       |       | 222                              |       | 2,565                            |       | 806 |   | 9,666 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Net income                                                                               |       | $                                | 1,406      |                             | $          | 4,373 |   | $ | 2,947 |   | $ | 17,263 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Basic earnings per share                                                                 |       | $                                | 0.04       |                             | $          | 0.14 |   | $ | 0.09 |   | $ | 0.54 |   |
|                                                                                     |       |                             |       |                             |       |   |   |   |   |
| Diluted earnings per share                                                               |       | $                                | 0.04       |                             | $          | 0.13 |   | $ | 0.09 |   | $ | 0.53 |   |

 

*See notes to unaudited condensed consolidatedfinancial statements.*

3

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**Albany MolecularResearch, Inc.**

**Condensed Consolidated Balance Sheets**

**(unaudited)**
| **(Dollars and share amounts in thousands)**                                                                                           | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                                                                                                                                                            |       |                             |       |                            |       |
| **Assets**                                                                                                                                                      | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Current assets:                                                                                                                                                 |       |                             |       |                            |       |
| Cash and cash equivalents                                                                                                                                       |       | $                                | 23,828     |                            | $          | 27,606 |   |
| Investment securities, available-for-sale                                                                                                                       |       | 79,169                           |       | 100,304                         |       |
| Accounts receivable, net                                                                                                                                        |       | 32,866                           |       | 22,238                          |       |
| Royalty income receivable                                                                                                                                       |       | 6,038                            |       | 6,247                           |       |
| Inventories                                                                                                                                                     |       | 23,412                           |       | 30,603                          |       |
| Prepaid expenses and other current assets                                                                                                                       |       | 7,044                            |       | 6,391                           |       |
| Property and equipment held for sale                                                                                                                            |       | 2,000                            |       | 5,376                           |       |
| Total current assets                                                                                                                                            |       | 174,357                          |       | 198,765                         |       |
|                                                                                                                                                            |       |                             |       |                            |       |
| Property, plant  and equipment, net                                                                                                                             |       | 154,041                          |       | 151,078                         |       |
|                                                                                                                                                            |       |                             |       |                            |       |
| Other assets:                                                                                                                                                   |       |                             |       |                            |       |
| Goodwill                                                                                                                                                        |       | 36,312                           |       | 25,747                          |       |
| Intangible assets and patents, net                                                                                                                              |       | 1,854                            |       | 1,434                           |       |
| Equity investments in unconsolidated affiliates                                                                                                                 |       | 956                              |       | 956                             |       |
| Other assets                                                                                                                                                    |       | 1,221                            |       | 1,202                           |       |
|                                                                                                                                                            |       |                             |       |                            |       |
| Total assets                                                                                                                                                    |       | $                                | 368,741    |                            | $          | 379,182 |   |
|                                                                                                                                                            |       |                             |       |                            |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                   | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Current  liabilities:                                                                                                                                           |       |                             |       |                            |       |
| Accounts payable and accrued expenses                                                                                                                           |       | $                                | 15,019     |                            | $          | 14,375 |   |
| Deferred revenue                                                                                                                                                |       | 7,193                            |       | 12,537                          |       |
| Accrued pension benefits                                                                                                                                        |       | 1,014                            |       | 1,014                           |       |
| Income taxes payable                                                                                                                                            |       | 2,526                            |       | 7,466                           |       |
| Current installments of long-term debt                                                                                                                          |       | 4,541                            |       | 4,536                           |       |
| Total current liabilities                                                                                                                                       |       | 30,293                           |       | 39,928                          |       |
|                                                                                                                                                            |       |                             |       |                            |       |
| Long-term  liabilities:                                                                                                                                         |       |                             |       |                            |       |
| Long-term debt, excluding current installments                                                                                                                  |       | 15,061                           |       | 18,521                          |       |
| Deferred income taxes                                                                                                                                           |       | 4,452                            |       | 5,080                           |       |
| Pension and postretirement benefits                                                                                                                             |       | 1,319                            |       | 2,356                           |       |
| Other long term liabilities                                                                                                                                     |       | 236                              |       | 236                             |       |
| Total liabilities                                                                                                                                               |       | 51,361                           |       | 66,121                          |       |
|                                                                                                                                                            |       |                             |       |                            |       |
| Commitments and  contingencies                                                                                                                                  |       |                             |       |                            |       |
|                                                                                                                                                            |       |                             |       |                            |       |
| Stockholders’  equity:                                                                                                                                     |       |                             |       |                            |       |
| Common stock, $0.01 par value, 100,000 shares  authorized, 34,685 shares issued at September 30, 2006, and 34,471  shares issued at December 31, 2005 |       | 347                              |       | 345                             |       |
| Additional paid-in capital                                                                                                                                      |       | 195,624                          |       | 193,066                         |       |
| Unearned compensation — restricted stock                                                                                                                   |       | (3,094                           | )          | (1,921                          | )          |
| Accumulated other comprehensive loss                                                                                                                            |       | (410                             | )          | (395                            | )          |
| Retained earnings                                                                                                                                               |       | 162,084                          |       | 159,137                         |       |
| Less, treasury  shares at cost, 2,077 shares                                                                                                                    |       | (37,171                          | )          | (37,171                         | )          |
| Total stockholders’ equity                                                                                                                                 |       | 317,380                          |       | 313,061                         |       |
| Total liabilities and  stockholders’ equity                                                                                                                |       | $                                | 368,741    |                            | $          | 379,182 |   |

*See notesto unaudited condensed consolidated financial statements.*

4

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**AlbanyMolecular Research, Inc.**

**Condensed Consolidated Statements of Cash Flows**

**(unaudited)**
| ** **                                                                         | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands)**                                               | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|                                                                               |       |                             |       |   |   |
| **Operating  activities**                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                | 2,947      |   | $ | 17,263 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                      |       | 11,319                           |       | 11,536 |   |
| Foreign exchange loss                                                              |       | 4                                |       | 9 |   |
| Provision for (recovery of) bad debts                                              |       | 94                               |       | (72 | ) |
| Deferred income tax (benefit) expense                                              |       | (689                             | )          | 1,921 |   |
| Loss on disposal of property, plant and equipment                                  |       | 12                               |       | 169 |   |
| Stock-based compensation expense                                                   |       | 874                              |       | 256 |   |
| Impairment of property, plant and equipment                                        |       | 3,084                            |       | — |   |
| Provision for obsolete inventories                                                 |       | 1,046                            |       | — |   |
| (Increase) decrease in:                                                            |       |                             |       |   |   |
| Accounts receivable                                                                |       | (9,721                           | )          | (6,316 | ) |
| Royalty income receivable                                                          |       | 209                              |       | (605 | ) |
| Unbilled services                                                                  |       | 190                              |       | (217 | ) |
| Inventory, prepaid expenses and other assets                                       |       | 6,396                            |       | (3,793 | ) |
| (Decrease) increase in:                                                            |       |                             |       |   |   |
| Accounts payable and accrued expenses                                              |       | (609                             | )          | (1,234 | ) |
| Income tax payable                                                                 |       | (5,056                           | )          | 3,049 |   |
| Deferred revenue                                                                   |       | (6,463                           | )          | 2,772 |   |
| Pension and postretirement benefits                                                |       | (1,037                           | )          | (618 | ) |
| Other long-term liabilities                                                        |       | —                           |       | (54 | ) |
| Net cash  provided by operating activities                                         |       | 2,600                            |       | 24,066 |   |
|                                                                               |       |                             |       |   |   |
| **Investing  activities**                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net purchases of investment securities                                             |       | (117,341                         | )          | (95,083 | ) |
| Proceeds from sale of investment securities                                        |       | 138,498                          |       | 87,114 |   |
| Purchase of business, net of cash acquired                                         |       | (11,607                          | )          | — |   |
| Purchase of property, plant and equipment                                          |       | (12,430                          | )          | (11,958 | ) |
| Proceeds from disposal of property, plant and  equipment                           |       | 44                               |       | 27 |   |
| Payments for patent applications and other costs                                   |       | (389                             | )          | (219 | ) |
| Net cash used in  investing activities                                             |       | (3,225                           | )          | (20,119 | ) |
|                                                                               |       |                             |       |   |   |
| **Financing  activities**                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Principal payments on long-term debt                                               |       | (3,517                           | )          | (28,998 | ) |
| Proceeds from sale of common stock                                                 |       | 477                              |       | 1,225 |   |
| Tax benefit from exercise of stock options                                         |       | —                           |       | 356 |   |
| Net cash used in  financing activities                                             |       | (3,040                           | )          | (27,417 | ) |
|                                                                               |       |                             |       |   |   |
| Effect of exchange  rate changes on cash flows                                     |       | (113                             | )          | (67 | ) |
|                                                                               |       |                             |       |   |   |
| Decrease in cash  and cash equivalents                                             |       | (3,778                           | )          | (23,537 | ) |
|                                                                               |       |                             |       |   |   |
| Cash and cash  equivalents at beginning of period                                  |       | 27,606                           |       | 41,171 |   |
|                                                                               |       |                             |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | $                                | 23,828     |   | $ | 17,634 |   |

 

*See notesto unaudited condensed consolidated financial statements.*

5

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**Note 1 — Summary of Operations and Significant AccountingPolicies**(All amounts in thousands, except per share amounts, unless otherwise noted)

**Nature of Business and Operations**

Albany MolecularResearch, Inc. (the “Company”) is a global chemistry-based drug discoveryand development company focused on identifying and developing novelbiologically active small molecules with applications in the drug market. TheCompany engages in new drug research services and manufacturing, from leaddiscovery, optimization and development to commercial manufacturing and hasoperations in the United States, India, Singapore and Hungary. The Companyconducts research and development projects and collaborates with many leadingpharmaceutical and biotechnology companies, and is developing proprietary newchemistry technology for potential pharmaceutical products.

**Basis ofPresentation**

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with U.S. generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q and Rule10-01 of Regulation S-X. In accordance with Rule 10-01, the unaudited condensedconsolidated financial statements do not include all of the information andfootnotes required by U.S. generally accepted accounting principles forcomplete consolidated financial statements. The year-end condensed consolidatedbalance sheet data was derived from audited financial statements but does notinclude all disclosures required by U.S. generally accepted accountingprinciples. In the opinion of management, all adjustments (consisting of normalrecurring accruals and adjustments) considered necessary for a fair statementof the results for the interim period have been included. Operating results forthe three and nine months ended September 30, 2006 are not necessarilyindicative of the results that may be expected for the year endingDecember 31, 2006. The accompanying unaudited condensed consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the year ended December 31, 2005.

Theaccompanying unaudited condensed consolidated financial statements include theaccounts of Albany Molecular Research, Inc. and its wholly-owned subsidiaries.All intercompany balances and transactions have been eliminated duringconsolidation. Assets and liabilities of non-U.S. operations are translated atperiod-end rates of exchange, and the statements of operations are translatedat the average rates of exchange for the period. Gains or losses resulting fromtranslating non-U.S. currency financial statements are recorded in accumulatedother comprehensive (loss) income in the accompanying unaudited condensedconsolidated balance sheets.

**Use ofManagement Estimates**

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affect thereported amounts of assets and liabilities, and disclosures of contingentassets and liabilities, at the date of the financial statements, and thereported amounts of revenues and expenses during the reporting period. Actualresults can vary from these estimates.

**ContractRevenue Recognition**

TheCompany’s contract revenue consists primarily of fees earned under contractswith third-party customers and reimbursed expenses under such contracts. TheCompany also seeks to include provisions in certain contracts which contain acombination of up-front licensing fees, milestone and royalty payments shouldthe Company’s proprietary technology and expertise lead to the discovery of newproducts that reach the market. Reimbursed expenses consist of chemicals and otherproject specific costs. Generally, the Company’s contracts may be terminated bythe customer upon 30 days’ to one year’s prior notice, depending on thesize of the contract. The Company analyzes its agreements to determine whetherthe elements can be separated and accounted for individually or as a singleunit of accounting in accordance with EITF No. 00-21, “Revenue Arrangements with MultipleDeliverables” and SAB 104, “RevenueRecognition”. Allocation of revenue to individual elements which qualifyfor separate accounting is based on the estimated fair value of the respectiveelements.

TheCompany generates contract revenue on the following basis:

*Full-time Equivalent (FTE).*An FTE agreementestablishes the number of Company employees contracted for a project or aseries of projects, the duration of the contract period, the price per FTE,plus an allowance for chemicals and other project specific costs, which may ormay not be incorporated in the FTE rate. FTE contracts can run in one monthincrements, but typically have terms of six months or longer. FTE contractstypically provide for annual adjustments in billing rates for the scientistsassigned to the contract. 

6

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Thesecontracts involve the Company’s scientists providing services on a “bestefforts” basis in a project which may involve a research component with atimeframe or outcome that has some level of unpredictability. There are nofixed deliverables that must be met for payment as part of these services. Assuch, the Company recognizes revenue under FTE contracts on a monthly basis asservices are performed according to the terms of the contract.

*Time and Materials*. Under a time and materials contract the Company chargescustomers an hourly rate plus reimbursement for chemicals and other projectspecific costs. The Company recognizes revenue for time and material contractsbased on the number of hours devoted to the project multiplied by the customer’sbilling rate plus other project specific costs incurred.

*Fixed-Fee*. Undera fixed-fee contract the Company charges a fixed agreed upon amount for adeliverable. Fixed-fee contracts have fixed deliverables upon completion of theproject. Typically, the Company recognizes revenue for fixed-fee contractsafter projects are completed, delivery is made and title transfers to thecustomer and collection is reasonably assured. In certain instances, theCompany’s customers request that the Company retain materials produced uponcompletion of the project due to the fact that the customer does not have aqualified facility to store those materials. In these instances, the revenuerecognition process is considered complete when project documents (batchrecords, Certificates of Analysis, etc.) have been delivered to the customerand payment has been collected.

*Up-Front License Fees, Milestone and Royalty Revenue***.**The Company recognizes revenue fromup-front non-refundable licensing fees on a straight-line basis over the periodof the underlying project. The Company will recognize revenue arising from asubstantive milestone payment upon the successful achievement of the event, andthe resolution of any uncertainties or contingencies regarding potentialcollection of the related payment, or if appropriate over the remaining term ofthe agreement.

*Recurring Royalty Revenue Recognition***.** Recurring royalties consist of royalties under a license agreement withSanofi-Aventis based on the worldwide sales of fexofenadine HCl, marketed asAllegra in the Americas and Telfast elsewhere, as well as on sales ofSanofi-Aventis’ authorized generics. The Company records royalty revenue in theperiod in which the sales of Allegra/Telfast occur, because we can reasonablyestimate such royalties. Royalty payments from Sanofi-Aventis are due within45 days after each calendar quarter and are determined based on sales ofAllegra/Telfast in that quarter.

**Long-livedAssets**

In accordance with the provisions of SFAS No. 144**, “**Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), the Company assesses the impairment of long-lived assets whenever events or changes in circumstances indicate that their carrying value may not be recoverable. Factors the Company considers important which could trigger an impairment review include, among others, the following:

·                  a significant change in the extent or manner in which a long-lived asset is being used;

·                  a significant change in the business climate that could affect the value of a long-lived asset; and

·                  a significant decrease in the market value of assets.

If theCompany determines that the carrying value of long-lived assets may not berecoverable, based upon the existence of one or more of the above indicators ofimpairment, the Company compares the carrying value of the asset group to theundiscounted cash flows expected to be generated by the asset group. If thecarrying value exceeds the undiscounted cash flows an impairment charge isrecorded. An impairment charge is recognized to the extent that the carryingamount of the asset group exceeds their fair value and will reduce only thecarrying amounts of the long-lived assets. The Company utilizes the assistanceof an independent valuation firm in determining the fair values.

**Goodwill**

In accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), the Company performs an annual****assessment of the carrying value of goodwill for potential impairment (or on an interim basis if certain triggering events occur). A determination of impairment is made based upon the estimated discounted future cash flows of the operations associated with the related reporting unit. If goodwill is determined to be impaired in the future the Company would be required to record a charge to its results of operations. Factors the Company considers important which could result in an impairment include the following:

7

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·              significant underperformance relative to historical or projected future operating results;

·              significant changes in the mannerof our use of the acquired assets or the strategy for overall business;

·              significant negative industry oreconomic trends; and

·              market capitalization relative tonet book value.

TheCompany performed the annual goodwill assessment for its reporting units duringthe third quarter of 2006. Based on the results of these assessments, nogoodwill impairment was identified.  Ifmanagement’s expectations of future operating results change, or if there arechanges to other assumptions, the estimate of the fair value of the Company’sreporting units could change significantly. Such a change could result ingoodwill impairment charges in future periods, which could have a significantimpact on the Company’s consolidated financial statements. Total goodwillrecorded on the Company’s unaudited condensed consolidated balance sheet atSeptember 30, 2006 was $36,312 including $23,060 of goodwill associated withthe Company’s acquisition of Organichem, Inc. and $10,565 of goodwillassociated with the Company’s acquisition of ComGenex Kutato-Fejleszto Rt.

**Stock Compensation**

Effective January 1, 2006, the Company adopted SFASNo. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123 (R)”), whichamends SFAS No. 123 and supersedes APB No. 25**inestablishing standards for the accounting for transactions in which an entityexchanges its equity instruments for goods or services, as well as transactionsin which an entity incurs liabilities in exchange for goods or services thatare based on the fair value of the entity’s equity instruments or that may besettled by the issuance of those equity instruments. This Statement requiresthat the cost resulting from all share-based payment transactions be recognizedin the financial statements based on the fair value of the share-based payment.This Statement establishes fair value as the measurement objective inaccounting for share-based payment transactions with employees, except forequity instruments held by employee share ownership plans. As allowed underSFAS No. 123 (R), the Company elected the modified prospective method ofadoption, under which compensation cost is recognized in the financial statementsbeginning with the effective date of SFAS No. 123(R) for all share-basedpayments granted after that date, and for all unvested awards granted prior tothe effective date of SFAS No. 123 (R). Accordingly, prior period amounts havenot been restated.

**Note 2 —Business Combination**

On February 28, 2006, theCompany, through a wholly-owned subsidiary, acquired all of the outstandingshares of ComGenex Kutato-Fejleszto Rt. (“ComGenex”), a privately held drugdiscovery service company located in Budapest, Hungary.

The aggregatepurchase price of $11,930 included cash payments totaling $11,160 andcapitalized costs related to the acquisition, primarily professional fees, of$770. The purchase price may be adjusted based upon the final release ofpurchase funds currently held in escrow in accordance with the provisions ofthe purchase agreement. The results of ComGenex’s operations have been includedin the unaudited condensed consolidated statement of income for the three andnine months ended September 30, 2006 from the date of acquisition.

The followingtable summarizes the preliminary allocation of the purchase price to theestimated fair value of the net assets acquired.  The allocation will befinalized upon final determination of the purchase price and the completion ofthe Company’s valuation of the acquired assets and liabilities of ComGenex.

8

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| ** **                                 | ** ** | **February 28,  2006** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| **Assets Acquired**                        | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                 |       | $                           | 323        |   |
| Accounts  receivable, net                  |       | 1,002                       |       |
| Inventory                                  |       | 121                         |       |
| Prepaid expenses  and other current assets |       | 1,141                       |       |
| Property and  equipment, net               |       | 1,270                       |       |
| Goodwill                                   |       | 10,564                      |       |
| Intangible  assets and patents, net        |       | 292                         |       |
| Other assets                               |       | 21                          |       |
| Total assets acquired                      |       | $                           | 14,734     |   |
|                                       |       |                        |       |
| **Liabilities Assumed**                    | ** ** | ** **                  | ** ** |
| Accounts payable  and accrued expenses     |       | $                           | 1,545      |   |
| Deferred revenue                           |       | 1,119                       |       |
| Deferred income  taxes                     |       | 78                          |       |
| Other long term  liabilities               |       | 62                          |       |
| Total liabilities assumed                  |       | $                           | 2,804      |   |
|                                       |       |                        |       |
| Net assets  acquired                       |       | $                           | 11,930     |   |

 

Pro forma financialinformation for the three and nine month periods ended September 30, 2006 and2005 as if the ComGenex acquisition had been completed as of January 1, 2005has been excluded due to the immateriality of the operating results of ComGenexin relation to the Company’s consolidated operating results as a whole.

**Note 3 — Earnings Per Share**

Theshares used in the computation of the Company’s basic and diluted earnings pershare are as follows:
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands)**                     | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average  common shares outstanding |       | 32,185                                               |       | 32,097                                              |       | 32,160 |   | 32,018 |   |
| Dilutive effect  of stock options           |       | 157                                                  |       | 258                                                 |       | 172 |   | 247 |   |
| Dilutive effect  of restricted stock        |       | 79                                                   |       | 79                                                  |       | 74 |   | 43 |   |
| Weighted average common  shares outstanding |       | 32,421                                               |       | 32,434                                              |       | 32,406 |   | 32,308 |   |

 

The Company has excludedcertain outstanding stock options and warrants from the calculation of dilutedearnings per share for the three months ended September 30, 2006 and 2005, andthe nine months ended September 30, 2006 and 2005 because the exercise pricewas greater than the average market price of the Company’s common shares duringthat period, and as such, these options and warrants would be anti-dilutive.The weighted average number of anti-dilutive options, restricted shares, andwarrants outstanding (before the effects of the treasury stock method) was2,050 and 2,408 for the three months ended September 30, 2006 and 2005,respectively.  The weighted averagenumber of anti-dilutive options and warrants outstanding (before the effects ofthe treasury stock method) was 1,964 and 2,555 for the nine months endedSeptember 30, 2006 and 2005, respectively. These amounts are not included in the calculation of weighted averagecommon shares outstanding.

**Note4 — Inventory**

Inventoryconsisted of the following at September 30, 2006 and December 31,2005:

9

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|                                             | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials                               |       | $                            | 9,379      |                        | $          | 13,039 |   |
| Work in process                             |       | 1,427                        |       | 2,188                       |       |
| Finished goods                              |       | 12,259                       |       | 15,029                      |       |
| Libraries, net  of accumulated amortization |       | 347                          |       | 347                         |       |
| Total                                       |       | $                            | 23,412     |                        | $          | 30,603 |   |

 

**Note 5 — Restructuring of Mt. Prospect**

In 2004 the Companyconsolidated operations by relocating its Mt. Prospect facility operations toits facilities in New York. All activities of Mt. Prospect were relocated toNew York and continue to be fully integrated with the Company’s drug discoveryand development technologies. The restructuring resulted in the closure of theMt. Prospect Research Center in the fourth quarter of 2004.

We are currently marketing the Mt. Prospect Research Center facilityfor sale. The facility qualified for held for sale treatment in accordance withSFAS No. 144 during the fourth quarter of 2004. The long-lived assetsassociated with Mt. Prospect have been segregated to a separate line item inthe unaudited condensed consolidated balance sheet until they are sold anddepreciation expense has ceased with respect to those assets. At the time thatthe facility qualified for held for sale treatment in accordance with SFAS No.144, we anticipated the completion of the sale of the facility byJune 2006.  The Company previouslydisclosed that if a definitive agreement to sell the facility was not in placeas of June 30, 2006, it would reassess the classification of the facility asheld for sale in accordance with SFAS No. 144 at that time.  The Company was not able to secure adefinitive agreement to sell the facility as of June 30, 2006.  Accordingly, and in connection with thepreparation of its second quarter unaudited condensed consolidated financialstatements, the Company reassessed Mt. Prospect as a held for sale facility.

 As a result of this assessment, the Companyreaffirmed its intention to sell the Mt. Prospect facility, and determined thata $3,376 write-down of the carrying value of the facility was required.  Management has estimated the fair value basedupon its intention to sell the facility within twelve months and comparablereal estate transactions in the facility’s market area.

At September 30, 2006,the Company had recorded restructuring liabilities totaling $220 related toasset disposal costs, including brokerage commissions, legal fees, andmarketing expenses associated with the planned sale of the Mt. ProspectResearch Center facility. These restructuring liabilities are included inaccounts payable and accrued expenses in the Company’s unaudited condensedconsolidated balance sheet. The Company’s restructuring liabilities decreasedby $292 during the nine months ended September 30, 2006, representing areduction of estimated brokerage commissions as a result of the reduction incarrying value and estimated sales price of the Mt. Prospect facility asdescribed above.

**Note 6 —Goodwill and Intangible Assets**

The carrying amounts of goodwill, by the Company’sDiscovery/Development/Small Scale Manufacturing (“DDS”) and Large ScaleManufacturing (“LSM”) operating segments, as of September 30, 2006 andDecember 31, 2005 are as follows:
| ** **                 | ** ** | **DDS**    | ** ** | **LSM**    | ** ** | **Total**  | ** ** |
|----------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **September  30, 2006**    | ** ** |       | $          | 13,252     |       | $          | 23,060     |   | $ | 36,312 |   |
|                       |       |       |       |       |       |       |       |
| **December 31, 2005** | ** ** |       | $          | 2,687      |       | $          | 23,060     |   | $ | 25,747 |   |

 

The increase ingoodwill within the DDS segment from December 31, 2005 to September 30, 2006 isrelated to the Company’s acquisition of ComGenex described in Note 2.

The components ofintangible assets are as follows:

10

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| ** **                    | ** ** | **Cost**   | ** ** | **Accumulated  Amortization** | ** ** | **Net**    | ** ** | **Amortization  Period** | ** ** |
|-------------------------------|------------|------------|------------|-------------------------------|------------|------------|------------|--------------------------|------------|
| **September  30, 2006**       | ** ** | ** ** | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** |
| Patents and  Licensing Rights |       | $          | 2,362      |                          | $          | (619       | )          | $                        | 1,743      |   | 2-16 years |   |
| Non-Compete  Agreements       |       | 129        |       | (18                           | )          | 111        |       | 18-24 months             |       |
| Total                         |       | $          | 2,491      |                          | $          | (637       | )          | $                        | 1,854      |   |   |   |
|                          |       |       |       |                          |       |       |       |                     |       |
| **December 31,  2005**   | ** ** |       |       |                          |       |       |       |                     |       |   |
| Patents and Licensing  Rights |       | $          | 1,811      |                          | $          | (377       | )          | $                        | 1,434      |   | 16 years |   |

 

Amortizationexpense related to intangible assets was $96 and $24 for the three months endedSeptember 30, 2006 and 2005, respectively and $260 and $73, for the nine monthsended September 30, 2006 and 2005 respectively. Estimated future annual amortization expense related to intangibleassets is approximately $97 for the remainder of 2006, $336 for 2007, $164 for2008, $131 for 2009 and $131 for 2010.

**Note7 -****Defined Benefit and PostretirementWelfare Plan**

OrganichemCorporation previously provided retirement benefits under two non-contributorydefined benefit plans and a non-contributory, unfunded post-retirement welfareplan. Future benefits under the defined benefit plans and for salariedparticipants in the post-retirement welfare plan have been frozen.

***Componentsof Net Periodic Benefit Cost***
| ** **                          | ** ** | **Pension   Benefits**                                | ** ** | **Postretirement   Benefits**                         | ** ** | **Pension   Benefits**                               | ** ** | **Postretirement   Benefits**                        | ** ** |
|-------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                          | ** ** | **Three Months   Ended September 30,** | ** ** | **Three Months   Ended September 30,** | ** ** | **Nine Months   Ended September 30,** | ** ** | **Nine Months   Ended September 30,** | ** ** |
| ** **                          | ** ** | **2006**                                                   | ** ** | **2005**                                                   | ** ** | **2006**                                                  | ** ** | **2005**                                                  | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                |       |                                                       |       |                                                       |       |                                                      |       |                                                      |       |   |   |   |   |   |   |   |   |
| Service cost                        |       | $                                                          | —     |                                                       | $          | —                                                    |       | $                                                         | 18         |   | $ | 25 |   | $ | — |   | $ | — |   | $ | 54 |   | $ | 47 |   |
| Interest cost                       |       | 298                                                        |       | 290                                                        |       | 8                                                         |       | 11                                                        |       | 895 |   | 871 |   | 23 |   | 19 |   |
| Expected return  on plan assets     |       | (337                                                       | )          | (308                                                       | )          | —                                                    |       | —                                                    |       | (1,012 | ) | (923 | ) | — |   | — |   |
| Recognized net  loss                |       | 14                                                         |       | 6                                                          |       | 2                                                         |       | 6                                                         |       | 40 |   | 16 |   | 7 |   | 6 |   |
| Net periodic benefit  (income) cost |       | $                                                          | (25        | )                                                          | $          | (12                                                       | )          | $                                                         | 28         |   | $ | 42 |   | $ | (77 | ) | $ | (36 | ) | $ | 84 |   | $ | 72 |   |

 

***EmployerContributions***

TheCompany previously disclosed in its consolidated financial statements for theyear ended December 31, 2005 that it expected to contribute $1,014 to itspension plan in 2006.  As of September 30, 2006, $1,007 incontributions have been made.  The Company does not plan on making anyadditional contributions during 2006.

**Note8 — Share-Based Payments**

During the three and ninemonths ended September 30, 2006, the Company recognized total share basedcompensation cost, net of tax, of $268 and $665, and $61 and $166 for the sameperiods in 2005 in its unaudited condensed consolidated statements ofoperations. During the three and nine months ended September 30, 2005, theCompany applied the intrinsic value-based method of accounting prescribed byAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations, in accounting for itsshare-based payments.

Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123to its share-based payments during 2005:

11

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|                                                                                                                                               | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Net income, as  reported                                                                                                                      |       | $                                                      | 4,373      |                                                  | $          | 17,263 |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                  |       | 61                                                     |       | 166                                                   |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (579                                                   | )          | (1,878                                                | )          |
| Pro forma net  income                                                                                                                         |       | $                                                      | 3,855      |                                                  | $          | 15,551 |   |
|                                                                                                                                          |       |                                                   |       |                                                  |       |
| Earnings per  share:                                                                                                                          |       |                                                   |       |                                                  |       |
| Basic as reported                                                                                                                             |       | $                                                      | 0.14       |                                                  | $          | 0.54 |   |
| Basic pro-forma                                                                                                                               |       | $                                                      | 0.12       |                                                  | $          | 0.49 |   |
|                                                                                                                                          |       |                                                   |       |                                                  |       |
| Diluted as reported                                                                                                                           |       | $                                                      | 0.13       |                                                  | $          | 0.53 |   |
| Diluted  pro-forma                                                                                                                            |       | $                                                      | 0.12       |                                                  | $          | 0.48 |   |

The Company grants share-based payments, includingrestricted shares, under its 1998 Stock Option and Incentive Plan, as well asits 1998 Employee Stock Purchase Plan. Information regarding the Company’sshare-based payment arrangements follows:

***1998 Stock Option and IncentivePlan***

**Restricted Stock**

The Company also issues restricted shares of commonstock to employees of the Company under the 1998 Stock Option and IncentivePlan. The shares are issued as restricted stock and are held in the custody ofthe Company until all vesting restrictions are satisfied. Shares vest underthis grant over a period of five years, with 60% vesting after three years ofcontinuous employment from the grant date and an additional 20% vesting aftereach of four and five years of continuous employment from the grant date. Ifthe vesting terms under which the award was granted are not satisfied, theshares are forfeited. Unearned compensation is recorded based on the marketvalue of the shares on the grant date, and is amortized on a straight-linebasis over the applicable vesting period. The Company reduces the straight-linecompensation expense by an estimated forfeiture rate to account for theestimated impact of shares of restricted stock that are expected to beforfeited before becoming fully vested. This estimate is based on ourhistorical forfeiture experience and is currently estimated at 6%.

A summary of unvested restricted stock activity as ofSeptember 30, 2006 and changes during the nine months then ended is presentedbelow:

|                                  | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant Date  Fair Value** | ** ** |
|----------------------------------|------------|----------------------------|------------|-------------------------------------------------------------|------------|
| Outstanding,  December 31, 2005  |       | 257                        |       | $                                                           | 8.75       |   |
| Granted                          |       | 169                        |       | $                                                           | 10.15      |   |
| Vested                           |       | —                     |       | $                                                           | —     |   |
| Forfeited                        |       | (9                         | )          | $                                                           | 8.59       |   |
| Outstanding, September  30, 2006 |       | 417                        |       | $                                                           | 9.32       |   |

The weighted average fair value of restricted sharesgranted during the nine months ended September 30, 2006 and 2005 were $10.15and $8.46, respectively. As of September 30, 2006, there was $3,094 of totalunrecognized compensation cost related to non-vested restricted shares. Thatcost is expected to be recognized over a weighted-average period of 3.93 years.No restricted shares vested during the nine months ended September 30, 2006 and2005.

12

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**Stock Options**

The Company has a stock option plan, through whichincentive stock options or non-qualified stock options may be issued. Incentivestock options granted to employees may not be granted at prices less than 100%of the fair market value of the Company’s common stock at the date of optiongrant. Non-qualified stock options may be granted to employees, directors,advisors, consultants and other key persons of the Company at pricesestablished at the date of grant, and may be less than the fair market value atthe date of grant. All incentive stock options may be exercised at any time,after vesting, over a ten-year period subsequent to the date of grant.Incentive stock options generally vest over five years, with a 60% vestingoccurring at the end of the third anniversary of the grant date, 20% at the endof the fourth anniversary of the grant date and 20% at the end of the fifthanniversary of the grant date. Non-qualified stock option vesting terms areestablished at the date of grant, but have a duration of not more than ten years.

The fair value of each stock option award is estimatedat the date of grant using the Black-Scholes valuation model based on theassumptions noted below. The application of this valuation model involves theuse of assumptions that are judgmental in nature. The following is a summary ofthe methodology applied to develop each assumption:

Expected Price Volatility

Expected price volatility is a measure of the amountby which the price of a security has fluctuated or is expected to fluctuate.The Company uses actual historical changes in the market value of its stock tocalculate the volatility assumption. The Company calculates daily market valuechanges from the date of grant over a past period representative of the expectedlife of the options to determine volatility. An increase in the expectedvolatility will increase compensation expense.

Risk-Free Interest Rate

For the risk-free interest rate, the Company uses theU.S. Treasury rate for the week of the grant having a term approximating theexpected life of the option. An increase in the risk-free interest rate willincrease compensation expense.

Expected Lives

This is the period of time over which the optionsgranted are expected to remain outstanding, and is based on our historicalstock option exercise and forfeiture experience. Options granted have a maximumterm of ten years. An increase in the expected life will increase compensationexpense.

Dividend Yield

The Company has not made any dividend payments nordoes it have plans to pay dividends in the foreseeable future. An increase inthe dividend yield will decrease compensation expense.

The fair value of each option is amortized intocompensation expense on a straight-line basis over the vesting period. TheCompany reduces the straight-line compensation expense by an estimatedforfeiture rate to account for the estimated impact of options that areexpected to be forfeited before becoming fully vested. This estimate is basedon our historical forfeiture experience and is currently estimated at 8%. Anincrease in the forfeiture rate will decrease compensation expense.

The following weighted-average assumptions were usedto determine the per share weighted-average fair value of stock options grantedduring the nine months ended September 30, 2006 and 2005:

|                        | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------|------------|---------------------------------------------------|------------|
| ** **             | ** ** | **September 30,  2006**                      | ** ** | **September 30,  2005** | ** ** |
| Expected life in years |       | 5                                                 |       | 5 |   |
| Interest rate          |       | 4.99                                              | %          | 4.06 | % |
| Volatility             |       | 42                                                | %          | 48 | % |
| Dividend yield         |       | —                                            |       | — |   |

 

13

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A summary of stockoption activity under the Company’s stock option plan as of September 30, 2006and changes during the nine month period then ended is presented below:
| ** **                               | ** ** | **Number of  Shares** | ** ** | **Weighted  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual Term  (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding,  January 1, 2006            |       | 2,246                      |       | $                             | 19.97      |                                                                 |       |                            |       |   |
| Granted                                  |       | 85                         |       | $                             | 10.15      |                                                                 |       |                            |       |   |
| Exercised                                |       | (11                        | )          | $                             | 1.58       |                                                                 |       |                            |       |   |
| Forfeited                                |       | (55                        | )          | $                             | 23.85      |                                                                 |       |                            |       |   |
| Expired                                  |       | (12                        | )          | $                             | 1.10       |                                                                 |       |                            |       |   |
| Outstanding, September 30, 2006          |       | 2,253                      |       | $                             | 19.70      |                                                                 | 5.3        |                            | $          | 1,534 |   |
| Options  exercisable, September 30, 2006 |       | 2,041                      |       | $                             | 20.58      |                                                                 | 5.0        |                            | $          | 1,534 |   |

 

The weighted average fair value per share of stockoptions granted during the nine months ended September 30, 2006 and 2005 was $4.45and $5.91, respectively. The total intrinsic value of stock options exercisedduring the nine months ended September 30, 2006 and 2005 was $90 and $1,580,respectively.

As of September 30, 2006, there was $982 of totalunrecognized compensation cost related to non-vested stock options. That costis expected to be recognized over a weighted-average period of 2.47 years. Thetotal fair value of shares vested during the nine months ended September 30,2006 and 2005 was $265 and $5,504, respectively.

Effective December 30, 2005, pursuant to and inaccordance with the recommendation of the Compensation Committee (the“Committee”) of the Board of Directors, the Board of Directors of the Companyapproved full acceleration of the vesting of each otherwise unvested stockoption that had an exercise price of $15.00 or greater granted under theCompany’s 1998 Stock Option and Incentive Plan that was held by employees,officers, and non-employee directors. These options had exercise prices inexcess of the current market value of the Company’s common stock, based on theclosing price of $12.15 per share, on December 30, 2005 (*i.e*., such options were “underwater”). Options to purchaseapproximately 1.3 million shares of the Company’s common stock, includingapproximately 101,000 options held by executive officers, were subject to thisacceleration.

The Committee also required that, as a condition tothe acceleration of vesting, each executive officer and each non-employeedirector agree to refrain from selling shares of the Company’s common stock acquiredupon the exercise of accelerated options (other than shares needed to cover theexercise price and satisfy withholding taxes) until the date on which theexercise of such options would have been permitted under the option’spre-acceleration vesting terms or, if earlier, the officer’s or director’s lastday of employment or upon a “change in control” as defined in the Company’sstock option plan.

The decision to accelerate the vesting of theseunderwater options was made primarily to minimize certain future compensationexpenses that the Company would otherwise recognize in its consolidatedstatements of income with respect to these options pursuant to SFASNo. 123 (R). The Company also believes that the acceleration may have apositive effect on employee morale, retention and the perception of optionvalue.

***Employee Stock Purchase Plan***

The Company’s 1998 Employee Stock Purchase Plan (the“Purchase Plan”) was adopted during August 1998. Up to 600 shares ofcommon stock may be issued under the Purchase Plan, which is administered bythe Compensation Committee of the Board of Directors. The Purchase Planestablishes two stock offering periods per calendar year, the first beginningon January 1 and ending on June 30, and the second beginning onJuly 1 and ending December 31. All employees who work more than20 hours per week are eligible for participation in the Purchase Plan.Employees who are deemed to own greater than 5% of the combined voting power ofall classes of stock of the Company are not eligible for participation in thePurchase Plan.

During each offering, anemployee may purchase shares under the Purchase Plan by authorizing payrolldeductions up to 10% of their cash compensation during the offering period. Themaximum number of shares to be issued to any single employee during an offeringperiod is limited to one thousand. At the end of the offering period, theaccumulated payroll deductions will be used to purchase common stock on thelast business day of the offering period at a price equal to 85% of the closingprice of the common stock on the first or last day of the offering period,whichever is lower.

14

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Under SFAS No. 123 (R),the 15% discount and the look-back feature are considered compensatory itemsfor which expense must be recognized. The Company values Purchase Plan sharesas a combination position consisting of 15% of a share of nonvested stock and85% of a six-month stock option. The value of the nonvested stock is estimatedbased on the fair market value of the Company’s common stock at the beginningof the offering period. The value of the stock option is calculated using theBlack-Scholes valuation model using historical expected volatility percentages,a risk free interest rate equal to the six-month U.S. Treasury rate at the beginningof the offering period, and an expected life of six months. The resultingper-share value is multiplied by the shares estimated to be purchased duringthe offering period based on historical experience to arrive at a totalestimated compensation cost for the offering period. The estimated compensationcost is recognized on a straight-line basis over the offering period.

During the nine months ended September 30, 2006 and2005, 40 and 41 shares, respectively, were issued under the Purchase Plan.  During the nine months ended September 30,2006 and 2005, cash received from stock option exercises and employee stockpurchase plan purchases was $477 and $1,225, respectively. The actual taxbenefit realized for the tax deductions from stock option exercises was $0 and$356 during the nine months ended September 30, 2006 and 2005.

**Note 9 —Operating Segment Data**

The Company has organized its sales, marketing and productionactivities into the Discovery/Development/Small Scale Manufacturing (DDS) andLarge Scale Manufacturing (LSM) segments based on the criteria set forth inSFAS No. 131, “Disclosures about Segments of an Enterprise and RelatedInformation”. The Company’s management relies on an internal managementaccounting system to report results of the segments. The system includesrevenue and cost information by segment. The Company’s management makesfinancial decisions and allocates resources based on the information itreceives from this internal system.

DDS includes activities such as drug lead discovery, optimization, drugdevelopment and small scale commercial manufacturing. LSM includes pilot tocommercial scale manufacturing of active pharmaceutical ingredients andintermediates and high potency and controlled substance manufacturing all ofwhich are in compliance with the Food and Drug Administration’s (FDA) currentGood Manufacturing Practices. Corporate activities include business developmentand administrative functions, as well as research and development costs thathave not been allocated to the operating segments.

The followingtable contains earnings data by operating segment, reconciled to totalsincluded in the unaudited condensed consolidated financial statements:
| ** **                                              | ** ** | **Contract  Revenue** | ** ** | **Recurring  Royalty  Revenue** | ** ** | **Operating  (loss) income** | ** ** | **Depreciation  and  Amortization** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|---------------------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| **For the  three months ended September 30, 2006** | ** ** | ** **            | ** ** | ** **                      | ** ** | ** **                        | ** ** | ** **                          | ** ** |
| DDS                                                     |       | $                     | 19,683     |                            | $          | 6,333                             |       | $                                   | 11,493     |   | $ | 2,310 |   |
| LSM                                                     |       | 18,224                |       | —                          |       | (18                               | )          | 1,509                               |       |
| Corporate                                               |       | —                |       | —                          |       | (10,695                           | )          | —                              |       |
| Total                                                   |       | $                     | 37,907     |                            | $          | 6,333                             |       | $                                   | 780        |   | $ | 3,819 |   |
|                                                    |       |                  |       |                            |       |                              |       |                                |       |
| **For the  three months ended September 30, 2005** | ** ** | ** **            | ** ** | ** **                      | ** ** | ** **                        | ** ** | ** **                          | ** ** |
| DDS                                                     |       | $                     | 12,902     |                            | $          | 12,779                            |       | $                                   | 14,114     |   | $ | 2,338 |   |
| LSM                                                     |       | 18,648                |       | —                          |       | 2,802                             |       | 1,434                               |       |
| Corporate                                               |       | —                |       | —                          |       | (10,402                           | )          | —                              |       |
| Total                                                   |       | $                     | 31,550     |                            | $          | 12,779                            |       | $                                   | 6,514      |   | $ | 3,772 |   |
|                                                    |       |                  |       |                            |       |                              |       |                                |       |
| **For the  nine months ended September 30, 2006**  | ** ** | ** **            | ** ** | ** **                      | ** ** | ** **                        | ** ** | ** **                          | ** ** |
| DDS                                                     |       | $                     | 54,240     |                            | $          | 20,711                            |       | $                                   | 30,238     |   | $ | 6,792 |   |
| LSM                                                     |       | 58,238                |       | —                          |       | 1,952                             |       | 4,527                               |       |
| Corporate                                               |       | —                |       | —                          |       | (30,584                           | )          | —                              |       |
| Total                                                   |       | $                     | 112,478    |                            | $          | 20,711                            |       | $                                   | 1,606      |   | $ | 11,319 |   |
|                                                    |       |                  |       |                            |       |                              |       |                                |       |
| **For the  nine months ended September 30, 2005**  | ** ** | ** **            | ** ** | ** **                      | ** ** | ** **                        | ** ** | ** **                          | ** ** |
| DDS                                                     |       | $                     | 39,855     |                            | $          | 40,679                            |       | $                                   | 44,598     |   | $ | 7,256 |   |
| LSM                                                     |       | 64,269                |       | —                          |       | 11,532                            |       | 4,280                               |       |
| Corporate                                               |       | —                |       | —                          |       | (30,215                           | )          | —                              |       |
| Total                                                   |       | $                     | 104,124    |                            | $          | 40,679                            |       | $                                   | 25,915     |   | $ | 11,536 |   |

 

15

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The following table summarizes other information bysegment as of September 30, 2006:
| ** **                                | ** ** | **As of September 30, 2006** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| **(in thousands)**                   | ** ** | **DDS**                                          | ** ** | **LSM** | ** ** | **Total** | ** ** |
|                                      |       |                                             |       |   |   |   |   |
| Total assets                              |       | $                                                | 236,780    |   | $ | 131,961 |   | $ | 368,741 |   |
| Goodwill  included in total assets        |       | 13,252                                           |       | 23,060 |   | 36,312 |   |
| Investments in  unconsolidated affiliates |       | 956                                              |       | — |   | 956 |   |
| Capital  expenditures                     |       | 8,231                                            |       | 4,199 |   | 12,430 |   |
|                                           |            |                                                  |            |  |  |  |  |  |  |  |

The following table summarizes other information bysegment as of September 30, 2005:
| ** **                                | ** ** | **As of September 30, 2005** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| **(in thousands)**                   | ** ** | **DDS**                                          | ** ** | **LSM** | ** ** | **Total** | ** ** |
|                                      |       |                                             |       |   |   |   |   |
| Total assets                              |       | $                                                | 233,961    |   | $ | 138,848 |   | $ | 372,809 |   |
| Goodwill  included in total assets        |       | 2,687                                            |       | 23,060 |   | 25,747 |   |
| Investments in  unconsolidated affiliates |       | 956                                              |       | — |   | 956 |   |
| Capital  expenditures                     |       | 5,103                                            |       | 6,855 |   | 11,958 |   |
|                                           |            |                                                  |            |  |  |  |  |  |  |  |

 

**Note10 — Financial Information by Customer Concentration and Geographic Area**

Totalcontract revenue from DDS’ three largest customers represented approximately 11%,7% and 6% of AMR’s total contract revenue for the three months endedSeptember 30, 2006, and 16%, 7% and 6% of total contract revenue for thethree months ended September 30, 2005. Total contract revenue from DDS’three largest customers represented approximately 12%, 8% and 6% of AMR’s totalcontract revenue for the nine months ended September 30, 2006, and 15%, 9%and 5% of total contract revenue for the nine months ended September 30,2005.  Total contract revenue from LSM’slargest customer, GE Healthcare (GE), represented 40% and 54% of LSM’s totalcontract revenue for the three months ended September 30, 2006 and 2005,respectively.  Total contract revenuefrom GE represented 48% and 70% of LSM’s total contract revenue for the ninemonths ended September 30, 2006 and 2005, respectively.  GE accounted for approximately 25% and 43% ofthe Company’s total contract revenue for the nine months endedSeptember 30, 2006 and 2005, respectively. In 2005, GE discontinued its purchases of one of the products itreceived from the Company, and made all of its 2005 purchases in the first halfof the year.  Sales of this producttotaled $16,962 in 2005.

The Company’s total contract revenue for the three and nine monthsended September 30, 2006 and 2005 was recognized from customers in thefollowing geographic regions:

|               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States |       | 66                                                   | %          | 62                                                  | %          | 65 | % | 53 | % |
| Europe        |       | 30                                                   |       | 33                                                  |       | 33 |   | 44 |   |
| Other         |       | 4                                                    |       | 5                                                   |       | 2 |   | 3 |   |
|          |       |                                                 |       |                                                |       |   |   |   |   |
| Total         |       | 100                                                  | %          | 100                                                 | %          | 100 | % | 100 | % |
|          |       |                                                 |       |                                                |       |   |   |   |   |

 

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**Note 11— Comprehensive Income**

Thefollowing table presents the components of the Company’s comprehensive incomefor the three and nine months ended September 30, 2006 and 2005:
| ** **                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands)**                                                          | ** ** | **2006**                                                       | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income                                                                       |       | $                                                              | 1,406      |                                                    | $          | 4,373 |   | $ | 2,947 |   | $ | 17,263 |   |
|                                                                             |       |                                                           |       |                                                    |       |   |   |   |   |
| Other  comprehensive income (loss):                                              |       |                                                           |       |                                                    |       |   |   |   |   |
| Change in unrealized gain (loss) on  available-for-sale securities, net of taxes |       | 104                                                            |       | (52                                                     | )          | 138 |   | (95 | ) |
| Change in unrealized (loss) gain on interest rate  swap, net of taxes            |       | (57                                                            | )          | 62                                                      |       | (40 | ) | 122 |   |
| Foreign currency translation gain (loss)                                         |       | 18                                                             |       | (17                                                     | )          | (113 | ) | (67 | ) |
| Total  comprehensive income                                                      |       | $                                                              | 1,471      |                                                    | $          | 4,366 |   | $ | 2,932 |   | $ | 17,223 |   |

 

**Note 12— Legal Proceedings**

The Company, from time to time, may be involved invarious claims and legal proceedings arising in the ordinary course ofbusiness. Except as noted below in regards to litigation relating to Allegra,the Company is not currently a party to any such claims or proceedings which,if decided adversely to the Company, would either individually or in theaggregate have a material adverse effect on the Company’s business, financialcondition, results of operations or cash flows.

AMR Technology, a subsidiary of the Company, alongwith Aventis Pharmaceuticals Inc., the U.S. pharmaceutical business ofSanofi-Aventis S.A., are involved in legal proceedings with several companiesseeking to market generic versions of Allegra. Beginning in 2001, BarrLaboratories, Inc., Impax Laboratories, Inc., Mylan Pharmaceuticals, Inc., TevaPharmaceuticals USA, Dr. Reddy’s Laboratories, Ltd./Dr. Reddy’s Laboratories,Inc., Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., and Sandoz Inc.filed Abbreviated New Drug Applications (ANDAs) with the U.S. Food and DrugAdministration, or FDA, to produce and market generic versions of Allegraproducts.

In response to the filings described above, beginningin 2001, Aventis Pharmaceuticals filed patent infringement lawsuits againstBarr Laboratories, Impax Laboratories, Mylan Pharmaceuticals, TevaPharmaceuticals, Dr. Reddy’s Laboratories, Ranbaxy Laboratories Ltd./RanbaxyPharmaceuticals Inc., and Sandoz. Each of the lawsuits was filed in the U.S.District Court in New Jersey and alleges infringement of one or more patentsowned by Aventis Pharmaceuticals. Further, beginning in March 5, 2004, AMRTechnology, along with Aventis Pharmaceuticals, filed suit in the U.S. DistrictCourt in New Jersey against Barr Laboratories, Impax Laboratories, MylanPharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories, AminoChemicals, Ltd., Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc.,DiPharma S.P.A., DiPharma Francis s.r.l., and Sandoz, Inc., assertinginfringement of two of our U.S. patents that are exclusively licensed toAventis Pharmaceuticals relating to Allegra and Allegra-D products.

In the pending litigations, Aventis Pharmaceuticalsand AMR Technology have entered into covenants not to sue the defendants otherthan  DiPharma S.P.A. and DiPharmaFrancis s.r.l., under U.S. Patent No. 5,578,610, which patent has not beenasserted in the litigation but which Aventis Pharmaceuticals exclusivelylicenses from us. However, we and Aventis Pharmaceuticals have agreed thatAventis Pharmaceuticals will continue to pay royalties to us based on thatpatent under our original license agreement with Aventis Pharmaceuticals. Underour arrangements with Aventis Pharmaceuticals, we will receive royalties untilexpiration of the underlying patents (2013 for U.S. Patent No. 5,578,610 and2015 for U.S. Patent No. 5,750,703) unless the patents are earlier determinedto be invalid.

Under applicable federal law, marketing of an FDA-approvedgeneric version of Allegra may not commence until the earlier of a decisionfavorable to the generic challenger in the patent litigation or 30 months afterthe date the patent infringement lawsuit was filed. In general, the firstgeneric filer is entitled to a 180-day marketing exclusivity period upon FDAapproval.

On September 6, 2005, Barr Pharmaceuticals, Inc. andTeva Pharmaceuticals Industries Ltd. announced that they have entered into anagreement for the launch of Fexofenadine Hydrochloride 30 mg, 60 mg and 180 mgtablets, the generic version of Allegra tablets in the United States. Thelaunch of the generic product is considered an “at-risk” launch due to theon-going litigation. This generic launch has had a material adverse impact on U.S.sales of Allegra by Sanofi-Aventis since the fourth quarter of 2005 and inturn, the royalties earned by the Company on those sales. The launch has nothad a material impact on non-U.S. sales of Allegra to date. 

On September 20, 2005, AMR Technology, along withAventis Pharmaceuticals, filed a Motion for Preliminary Injunction in the U.S.District Court in New Jersey seeking to enjoin Barr Pharmaceuticals, Inc., TevaPharmaceuticals Ltd., Ranbaxy Laboratories, Ltd. and Amino Chemicals, Ltd. fromthe sale of generic versions of Allegra in the United States. On January 30,2006, the U.S. District Court denied the request by AMR Technology and AventisPharmaceuticals for a preliminary injunction. An appeal of that decision

17

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was taken to the U.S. Court of Appeals for the FederalCircuit and, on November 8, 2006, the appellate court affirmed the DistrictCourt’s denial of a preliminary injunction. The court’s decisions on thepreliminary injunction application are not dispositive of the merits of theclaims being asserted as described above.

Subsequent to the preliminary injunction proceeding,Dr. Reddy’s Laboratories has engaged in an at-risk launch of genericfexofenadine products.

Should the Company be unsuccessful in defending thesepatents, the Company would continue to experience a material decrease inoperating cash flows and a material adverse effect on our results of operationsand financial condition.

**Note 13 — Recently Issued AccountingPronouncements**

In July 2006, the Financial Accounting Standards Board (FASB) issuedFASB Interpretation No. 48,**“Accounting for Uncertainty in Income Taxes”(“FIN 48”).  Among other things, FIN 48requires the application of a “more likely than not” threshold to the de-recognitionof tax positions, and provides for enhanced quantitative and qualitative disclosuresregarding unrecognized tax benefits resulting from tax positions taken by anentity.  This Interpretation applies tothe Company effective January 1, 2007.  TheCompany is currently assessing the impact of applying this Interpretation.

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements”.  This Statement defines fair value,establishes a framework for measuring fair value, and expands disclosures aboutfair value measurements; however, it does not require any new fair value measurements.  The Statement applies to fair-valuemeasurements that are already required or permitted by existing standardsexcept for measurements of share-based payments and measurements that aresimilar to, but not intended to be, fair value.  Its applicability is also limited by thepracticability exceptions to applying fair value currently found in somestandards. The Statement

imposes no requirements for additional fair-value measures in financialstatements.  The provisions of SFAS No.157 will be applied to fair value measurements and disclosures in the Company’scondensed consolidated financial statements beginning in the first quarter of2008.  The Company is currently assessingthe impact of applying this Statement.

 

In September 2006, theFASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans,” requiring an employer to recognize theoverfunded or underfunded status of its postretirement plans in the statementof financial position and to recognize changes in that funded status in theyear in which the changes occur. Additionally, an employer is required to measure the funded status of aplan as of the end of the employer’s fiscal year. The Company is required toadopt SFAS No. 158, as it relates to recognizing the overfunded or underfundedstatus of its defined benefit postretirement plans and the related disclosurerequirements, at December 31, 2006 and the requirement to measure the fundedstatus as of the date of the year-end statement of financial position isrequired by December 31, 2008. The Company does not expect this Statement tohave a material effect on the Company’s consolidated financial statements.

 

**Note 14 – Subsequent Event**

On November 9, 2006, theCompany announced plans to initiate a restructuring of the Company’s LSMbusiness segment.  Consistent with the Company’scontinued strategy of realigning its LSM segment toward a greater focus onmanufacturing clinical trial materials with strong commercial potential, thegoals of the restructuring plan are to strengthen the Company’s competitivenessin this area and reduce operating costs by eliminating overlap in businessprocesses, organization and project process flow, as well as leveragingexisting resources and assets.  Therestructuring plan calls for the Company to reduce its workforce in thissegment by approximately 40 employees or approximately 15%, as well asreduce non-essential operating expenses, raw material costs and future capitalexpenditure activities.  The Company hasestimated that total large scale costs will be reduced by $5 million annuallyas a result of this restructuring.  TheCompany has also estimated that it will record a restructuring charge ofapproximately $3 - $4 million in the fourth quarter of 2006, including anon-cash asset disposal charge of approximately $2 million, and cashcharges of approximately $1 - $2 million consisting oftermination benefits of approximately $1 - $1.3 million andasset disposal and other related costs of up to approximately $0.7 million.

 

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Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations

**Forward-LookingStatements**

The following discussion of our results of operations andfinancial condition should be read in conjunction with the accompanyingCondensed Consolidated Financial Statements and the Notes thereto includedwithin this report. This quarterly report on Form 10-Q contains“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. These statements may be identified byforward-looking words such as “may,” “could,” “should,” “would,” “will,” “intend,”“expect,” “anticipate,” “believe,” and “continue” or similar words and include,but are not limited to, statements concerning the Mount Prospect ResearchCenter, pension and postretirement benefit costs, GE Healthcare and the salesof products to GE Healthcare in 2006, demand for our products, contractrevenues, costs and margins and the Company’s restructuring of its Large ScaleManufacturing segment and the associated cost savings and anticipatedprofitability, operating cash flow cycles, patent protection and the ongoingAllegra patent infringement litigation, Allegra royalty revenue, customerspending and business trends, foreign operations (including Singapore, Indiaand Hungary), access to foreign markets, clinical supply and commercial productmanufacturing, management’s strategic plans, drug discovery, productcommercialization, license arrangements, research and development projects andexpenses, selling, general and administrative expenses and tax rates. TheCompany’s actual results may differ materially from such forward-lookingstatements as a result of numerous factors, some of which the Company may notbe able to predict and may not be within the Company’s control. Factors thatcould cause such differences include, but are not limited to, those discussedin Part I, Item 1A, “Risk Factors”, of the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005 as filed with the Securities andExchange Commission on March 16, 2006, and as amended by Amendment No. 1on Form 10-K/A filed with the Securities and Exchange Commission on May 9,2006, and in Part II Item 1A,“Risk Factors,” in this Form 10-Q. All forward-looking statements aremade as of the date of this report, and we do not undertake to update any suchforward-looking statements in the future. References to “we,” “us,” and “our,”refer to Albany Molecular Research, Inc. and its subsidiaries, taken as awhole.

**Overview**

We are a globalchemistry-based drug discovery and development company, focused on identifyingand developing novel biologically active small molecules with applicationsprimarily in the prescription drug market. We engage in comprehensive chemistryresearch from lead discovery, optimization and development to commercialmanufacturing and conduct cell and non-cell based high throughput screening ona variety of biological targets. We perform research for many of the leadingpharmaceutical and biotechnology companies and for our own internal researchand development.

In addition to ourcontract services, we also conduct proprietary research and development todiscover new therapeutically active lead compounds with commercial potential.We anticipate that we would then license these compounds to third parties inreturn for up-front service fees and milestone payments as well as recurringroyalty payments if these compounds are developed into new commercial drugs. InOctober 2005, we licensed the worldwide rights to develop andcommercialize potential products from our amine neurotransmitter reuptakeinhibitors identified in one of our proprietary research programs toBristol-Myers Squibb Company (BMS). Our proprietary research and developmentactivities previously led to the development, patenting and 1995 licensing of asubstantially pure form of, and a manufacturing process for, the activeingredient in the non-sedating antihistamine fexofenadine HCl marketed bySanofi-Aventis S.A. as Allegra in the Americas and as Telfast elsewhere.

Our total revenue for the quarter ended September 30,2006 was $44.2 million, as compared to $44.3 million for the quarter ended September30, 2005. Recurring royalty revenues decreased $6.4 million from the quarterended September 30, 2005 due to the impact of the at-risk launch of genericfexofenadine by Barr Pharmaceuticals, Inc. and Teva PharmaceuticalsIndustries Ltd. on U.S. sales of Allegra by Sanofi-Aventis.

Contract chemistry services revenue for the thirdquarter of 2006 was $37.9 million, compared to $31.6 million in the thirdquarter of 2005. Discovery, development, and small scale manufacturing (DDS)revenues increased $6.8 million from the quarter ended September 30, 2005 dueto increased worldwide demand for these services, the recognition of licensefees resulting from our licensing and research agreement with BMS, andincremental revenues resulting from the February 28, 2006 acquisition ofComGenex (now known as AMRI Hungary), a drug discovery service company inBudapest, Hungary. These increases were offset by a decrease in large scalemanufacturing revenue of $0.4 million, due to the timing of demand for the keyproduct sold to our large scale manufacturing (LSM) facility’s largestcustomer, GE Healthcare (GE). Sales of this product in the third quarter of2006 decreased $2.6 million from the third quarter of 2005.  Total sales of this product for the ninemonths ended September 30, 2006 are consistent with the nine months endedSeptember 30, 2005, and we expect total sales of this product for the remainderof 2006 to be relatively consistent with 2005. Partially offsetting this decrease was an increase in revenue from theproduction of clinical supply materials for use in advance stage human trials of$0.8 million. The decrease was further offset by a $1.3 million increase insales of commercial 

19

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products to customers other than GE due to the timingof customer requirements. We expect the trend of increased demand for theseproducts to continue in the fourth quarter of 2006.

Consolidated gross margin was 15.2% for the quarterended September 30, 2006 compared to 17.2% for the quarter ended September30, 2005. Gross margin at the DDS operating segment increased to 29.4% in thethird quarter of 2006 compared to 20.1% for the same period in 2005, primarilyresulting from increased contract revenues in relation to the fixed costcomponents of the DDS segment, and from strong margin contributions on servicesperformed at AMRI Hungary. Gross margin at the LSM operating segment was (0.1%)in the third quarter of 2006, compared with a gross margin of 15.0% in the thirdquarter of 2005. The decrease in gross margin from the third quarter of 2005 isdue to the impact of the transition of our large-scale manufacturing facilityfrom specializing in the repetitive manufacturing of commercial products forone customer to the non-repetitive manufacturing of clinical supply compoundsand commercial products for numerous customers. On November 9, 2006 we announced a restructuring plan to realign thefacility’s operations and cost structure with this business model.  The goal of the restructuring plan is toimprove the efficiency and profitability of the LSM operating segment byeliminating overlap in business processes, organization and project processflow, as well as leveraging existing resources and assets. We expect to realizeannual savings of approximately $5 million from the restructuring planbeginning in 2007.  The savings areexpected to occur through workforce reductions as well as non-workforce-relatedactions such as the disposal of underutilized assets, elimination ofnon-essential operating expenses, and reductions in raw material costs.  Most of these initiatives will be implementedby the end of 2006.

Duringthe quarter ended September 30, 2006, cash flow from operations was $0.06million..  The decrease in cash flow fromoperations from the quarter ended June 30, 2006 resulted from a temporarylengthening of our  cash collectioncycle, which was partially offset by a similar lengthening of our cashdisbursement cycle due to the implementation of our enterprise resourceplanning system.  The lengthening ofthese cycles resulted in a $6.0 million decrease in operating cash flows duringthe quarter.  We expect the timing ofthese cycles to normalize in the fourth quarter.  We spent $2.7 million in capital on ourfacilities and equipment, primarily related to the development of ourenterprise resource planning (“ERP”) system, the outfitting of our laboratoryfacilities in Singapore, the initiation of construction on a new researchcentre in India, and the modernization of our large-scale manufacturing suites.  In addition, we spent $1.1 million inprincipal payments on our outstanding debt balances.  As of September 30, 2006, we had $103.0million in cash, cash equivalents and investments and $19.6 million in bankand other related debt.

The trends that began to emerge in chemistryoutsourcing during 2005 continued through the third quarter of 2006. Wecontinued to experience strong demand for our developmental and small-scalecGMP manufacturing services, further extending a growth trend that began in thesecond half of 2004 that is reflective of a reduction in budgetary constraintsand increased efforts to bring identified compounds into clinical trials on thepart of our pharmaceutical and biotechnology customers. Pricing for ourservices remained extremely competitive, and the trend of sourcing contractedchemistry services to lower-cost providers continued. Our ability to providediscovery services under a variety of business models and cost structures by incorporatingour lower cost international facilities that were established in India andSingapore in 2005 continued to be well-received by our customers. The resultingincrease in worldwide demand for our discovery services, which began in thelatter portion of 2005 and ended a two-year period of declining demand forthese services, continued through the third quarter of 2006. In addition, theacquisition of AMRI Hungary on February 28, 2006 provided incremental discoveryservices revenues in the third quarter. We expect the acquisition of AMRIHungary to provide significantly increased access to European markets, as wellas another lower-cost environment that will allow us to further diversify thebusiness models and cost structures that are available to our customers.

We also continued to transition and expand ourclinical supply manufacturing revenue stream at our large-scale manufacturingfacility, enabling us to seamlessly transfer our customers’ clinical supplymanufacturing projects through the drug discovery and development process fromthe development of these materials at our smaller scale chemistry laboratoriesto large-scale production for use in advanced stage human trials. Clinicalsupply manufacturing supplements our large-scale facility’s legacy services,which include cGMP commercial production, as well as high potency andcontrolled drug substance manufacturing, and is expected to assist us inrecovering lost revenues resulting from the 2005 discontinuation of purchasesof one of the products that we sold to GE Healthcare. Sales of this producttotaled $17.0 million in 2005, which represented 21% of large scalemanufacturing revenue for the year ended December 31, 2005. In addition,clinical supply manufacturing presents additional commercial productionopportunities, as we seek to enter into comprehensive agreements with ourcustomers that also provide for commercial supply of these materials uponmeeting regulatory approval.   We entered into two of these types ofagreements during the second quarter. The materials to be produced under these agreements received positiveregulatory announcements in October 2006, and we currently expect thecommercial manufacturing of a product under one of these contracts to begin inthe fourth quarter of 2006.  Clinicalsupply manufacturing represented 37% of our LSM revenue in the third quarter of2006, compared to 31% in the third quarter of 2005. As noted above, weannounced a restructuring plan that we expect will enable us to improve theefficiency and profitability of our LSM segment under this revised businessmodel. We are also evaluating opportunities to leverage our large-scale cGMPproduction facilities, including identifying niche products to manufacture suchas active pharmaceutical ingredients (“API”) for use in generic

20

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versions of compounds whose patents have expired orwill be expiring, as well as assessing complementary lines of business thatsupport cGMP production.

**Resultsof Operations – Three Months and Nine Months ended September 30, 2006 Comparedto Three Months and Nine Months ended September 30, 2005**

***Revenues***

*Totalcontract revenue*

Contract revenueconsists primarily of fees earned under contracts with our third partycustomers.  Our contract revenues foreach of our DDS and LSM segments were as follows:

|                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine months Ended September 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands)** | ** ** | **2006**                                                       | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|                    |       |                                                           |       |                                                    |       |   |   |   |   |
| DDS                     |       | $                                                              | 19,683     |                                                    | $          | 12,902 |   | $ | 54,240 |   | $ | 39,855 |   |
| LSM                     |       | 18,224                                                         |       | 18,648                                                  |       | $ | 58,238 |   | $ | 64,269 |   |
| Total                   |       | $                                                              | 37,907     |                                                    | $          | 31,550 |   | $ | 112,478 |   | $ | 104,124 |   |

DDS contract revenues forthe quarter ended September 30, 2006, increased $6.8 million to $19.7million as compared to $12.9 million for the same quarter in the prior year.  The increase is due to an increase incontract revenue from chemical development, small-scale GMP manufacturing andanalytical services of $3.0 million as customers continue to focus ondevelopment-stage projects. In addition, discovery services revenue increased$3.8 million due to the recognition of license fee and FTE service revenuesresulting from our License and Research Agreement with BMS, strong demand fordiscovery services provided through our international facilities, and theaddition of $2.2 million in revenue from AMRI Hungary. We currently expect theoverall growth trends in DDS contract revenues noted above to continue throughthe remainder of 2006.

LSM contract revenues for the third quarter of 2006were $18.2 million, a decrease of $0.4 million compared to contract revenue of$18.6 million during the third quarter of 2005, primarily due to the timing ofdemand for the key product sold to our large scale manufacturing (LSM)facility’s largest customer, GE Healthcare (GE). Sales of this product in thethird quarter of 2006 decreased $2.6 million from the third quarter of2005.  Total sales of this product forthe nine months ended September 30, 2006 are consistent with the nine monthsended September 30, 2005,  and we expecttotal sales of this product for the remainder of 2006 to be relativelyconsistent with 2005.  Partiallyoffsetting this decrease was an increase in revenue from the production ofclinical supply materials for use in advanced stage human trials of $0.8 million.The decrease was further offset by a $1.3 million increase in sales ofcommercial products to customers other than GE due to the timing of customerrequirements. We expect the trend of increased demand for these non-GE productsto continue in the fourth quarter of 2006.

For the nine months endedSeptember 30, 2006, DDS contract revenue has increased 36.1% from the ninemonths ended September 30, 2005, due to increased worldwide demand for discovery,development, small-scale GMP manufacturing and analytical services as notedabove, and the addition of $4.5 million in revenues from AMRI Hungary.  LSM contract revenues for the nine monthsended September 30, 2006 decreased 9.4% from the nine months endedSeptember 30, 2005 due to the discontinuation of purchases of one of LSM’sproducts by GE in the second quarter of 2005. Sales of this product totaled $17.0 million for the nine months endedSeptember 30, 2005.  This decreaseis largely offset by sales of clinical supply products for advanced stage humanclinical trials as described above, as well as increases in other commercialproducts due to the timing of customer delivery requirements.

* *

*Recurringroyalty revenue*

We earn royalties under our licensing agreement with Sanofi-AventisS.A. for the active ingredient in Allegra. Royalties were as follows:

| Three Months Ended September 30, | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|
| **2006**                                             | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **(in thousands)**                              | ** ** |
|                                                 |       |                                          |       |   |   |   |   |
| $                                                    | 6,333      |                                          | $          | 12,779 |   | $ | 20,711 |   | $ | 40,679 |   |
|                                                      |            |                                               |            |  |  |  |  |  |  |  |  |

 

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Recurring royaltiesdecreased 50.4% to $6.3 million for the quarter ended September 30, 2006 from$12.8 million for the quarter ended September 30, 2005. The decrease isprimarily attributable to the at-risk launch of generic fexofenadine by BarrPharmaceuticals, Inc. and Teva Pharmaceuticals Industries Ltd. inSeptember 2005, which has had a material adverse impact on U.S. sales ofAllegra.

The recurring royaltieswe receive on the sales of Allegra/Telfast have historically provided amaterial portion of our revenues, earnings, and operating cash flows. Wecurrently expect that the at risk-launch of generic fexofenadine will have asimilar impact on our royalty revenues in future periods. We expect toexperience a decrease in revenues, earnings, and operating cash flows in theshort term as we continue to develop our business in an effort to supplementthe revenues, earnings and operating cash flows that have historically beenprovided by Allegra/Telfast royalties.

On September 20,2005, we and Aventis Pharmaceuticals filed a Motion for Preliminary Injunctionin the U.S. District Court in New Jersey seeking to enjoin BarrPharmaceuticals, Inc., Teva Pharmaceuticals Ltd., Ranbaxy Laboratories, Ltd.and Amino Chemicals, Ltd. from the sale of generic versions of Allegra in theUnited States. Our motion was denied on January 30, 2006. We continue toforcefully and vigorously defend our intellectual property related to Allegra.We have filed an appeal of the ruling on the preliminary injunction matter, andwe continue to pursue our intellectual property rights as the patentinfringement litigation progresses. However, should we or Aventis beunsuccessful in defending these patents we would continue to experience amaterial decrease in royalty revenues. Furthermore, an at-risk launch of ageneric version of Allegra-D by a generic competitor could result in furtherdecreases in royalty revenues.

***Costs and Expenses***

*Costof contract revenue*

Ourcost of contract revenue consists primarily of compensation and associatedfringe benefits for employees, chemicals, depreciation and other indirectproject related costs.  Cost of contractrevenue for our DDS and LSM segments were as follows:
| **Segment**             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine months Ended  September 30,** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands)** | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                    |       |                                                 |       |                                                |       |   |   |   |   |
| DDS                     |       | $                                                    | 13,890     |                                                | $          | 10,291 |   | $ | 39,478 |   | $ | 31,863 |   |
| LSM                     |       | 18,242                                               |       | 15,846                                              |       | 56,286 |   | 52,737 |   |
| Total                   |       | $                                                    | 32,132     |                                                | $          | 26,137 |   | $ | 95,764 |   | $ | 84,600 |   |
|                    |       |                                                 |       |                                                |       |   |   |   |   |
| DDS Gross Margin        |       | 29.4                                                 | %          | 20.2                                                | %          | 27.2 | % | 20.1 | % |
| LSM Gross Margin        |       | (0.1                                                 | )%         | 15.0                                                | %          | 3.4 | % | 17.9 | % |
| Total Gross Margin      |       | 15.2                                                 | %          | 17.2                                                | %          | 14.9 | % | 18.8 | % |

DDShad a contract revenue gross margin of 29.4% and 27.2% for the three and ninemonths ended September 30, 2006, respectively, compared to contractrevenue gross margin of 20.2% and 20.1% for the same periods in 2005.  The increase in gross margin largely resultedfrom the increase in contract revenues in relation to the fixed cost componentsof  the DDS contract business, including the addition of license feerevenues associated with our Licensing and Research Agreement with BMS.  The recognition of license fees contributedapproximately $0.7 million and $2.1 million to DDS contract revenue for thethree and nine months ended September 30, 2006, respectively, with nocorresponding incremental costs.  We alsorealized strong margin contributions on services performed at AMRI Hungary.  DDS contract gross margin was also favorablyimpacted by a $0.3 million and $0.9 million decrease in the amortization of theCompany’s chemical compound and natural product library inventories for thethree and nine months ended September 30, 2006, respectively, due to theimpairment of these libraries in the fourth quarter of 2005. This item wasoffset by increased salary and benefit expenses due to annual merit increasesand the recognition of additional share-based compensation expense under SFASNo. 123(R). We currently expect DDS contract margins over the balance of theyear to remain consistent with the margins earned for the first nine months of2006.

LSM’s contract revenue gross margin decreased to(0.1%) and 3.4% for the three and nine months ended September 30, 2006compared to 15.0% and 17.9% for the same periods in 2005.  The decrease is due to the impact of the transitionof our large-scale manufacturing facility from specializing in the repetitivemanufacturing of commercial products to the non-repetitive manufacturing ofclinical supply compounds for numerous customers for use in clinical trials.   OnNovember 9, 2006 we announced a restructuring plan to realign the facility’soperations and cost structure with this business model.  The goal of the restructuring plan is toimprove the efficiency and profitability of the LSM operating segment byeliminating overlap in business processes, organization and project

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processflow, as well as leveraging existing resources and assets. We expect to realizeannual savings of approximately $5 million from the restructuring planbeginning in 2007.  The savings areexpected to occur through workforce reductions as well as non-workforce-relatedactions such as the disposal of underutilized assets, elimination ofnon-essential operating expenses, and reductions in raw material costs.  Most of these initiatives will be implementedby the end of 2006.  We currently expectcontinued downward pressure on LSM margins in the 4th quarter of 2006 as we implement ourrestructuring plan.

*Technology incentive award*

Wemaintain a Technology Development Incentive Plan, the purpose of which is tostimulate and encourage novel innovative technology development by ouremployees.  This plan allows eligible participantsto share in a percentage of the net revenue earned by us relating to patentedtechnology with respect to which the eligible participant is named as aninventor.  The award is currently payableprimarily to Dr. Thomas D’Ambra, the Chief Executive Officer and Presidentof the Company.  The incentive award wasas follows:

| **Three Months Ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|
| **2006**                                                 | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **(in thousands)**                                  | ** ** |
| ** **                                               | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                                        | 633        |                                          | $          | 1,277 |   | $ | 2,151 |   | $ | 4,072 |   |
|                                                          |            |                                               |            |  |  |  |  |  |  |  |  |

 

The decrease for the threeand nine months ended September 30, 2006 was attributed to decreased Allegraroyalties for 2006 as compared to 2005, partially offset by technologyincentive awards paid to employees involved in the development of ourproprietary amine neurotransmitter reuptake inhibitors as a result of thesuccessful licensing of this technology to BMS.

*Researchand development*

Research and development expense consists of compensation and benefits forscientific personnel for work performed on proprietary technology development,research projects, costs of chemicals and other out of pocket costs, andoverhead costs. We utilize our expertise in small molecule chemistry,biocatalysis and natural products to perform our internal research anddevelopment projects. The goal of these programs is to discover new compoundswith commercial potential. We would then seek to license these compounds to athird party in return for a combination of up-front license fees, milestonepayments and recurring royalty payments if these compounds are successfullydeveloped into new drugs and reach the market. In addition, research anddevelopment is performed at our large-scale manufacturing facility related tothe potential manufacture of new products and the development of alternativemanufacturing processes.

Researchand development expenses were as follows:

| **Three Months Ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|
| **2006**                                                 | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **(in thousands)**                                  | ** ** |
| ** **                                               | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                                        | 2,583      |                                          | $          | 4,070 |   | $ | 7,925 |   | $ | 11,039 |   |
|                                                          |            |                                               |            |  |  |  |  |  |  |  |  |

The decrease inR&D expense during the three months and nine months ended September 30,2006 is due primarily to the out-licensing of our CNS programs, whichrepresented our most significant investment in R&D in 2005, to BMS inOctober 2005. As a result, after signing the agreement in October 2005,we did not incur significant R&D expenditures that would have beennecessary to further advance these programs. In addition, certain costsassociated with these programs, primarily consisting of compensation, employeebenefit, and overhead costs related to the AMRI scientific personnel working onthese programs have been allocated to cost of contract revenue related to thecontract research we are performing for BMS in conjunction with the Licensingand Research Agreement.  On October 30,2006, the Company announced the selection of a compound from its proprietaryoncology research program for advanced preclinical testing, with the goal ofsubmitting an Investigational New Drug Application (IND) with the U.S. Food andDrug Administration (FDA) in 2007.  Wecurrently expect research and development expenses in the fourth quarter of2006 to remain consistent with those incurred in the third quarter, withexpected increases in these expenses in 2007 as we advance our oncologycompound towards an IND submission with the FDA.

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R&D spending related to individualprojects may fluctuate based on the results of those projects.  Projecting expected project completion datesand anticipated revenue from our internal research programs is not practical atthis time due to the early stages of the projects and the inherent risksrelated to the development of new drugs. Our internal central nervous systemprogram, our most advanced project to date, was licensed to BMS in exchange forup-front license fees, contracted research services, and the rights to futuremilestone and royalty payments.   We also continue to utilize our proprietarytechnologies to further advance other early to middle-stage internal researchprograms in the fields of oncology, immunosuppresion, bacterial infection andother diseases, with a view to seeking a licensing partner for these programsat an appropriate research or developmental stage.

*Selling,general and administrative*

                Selling, general andadministrative expenses consist of compensation and related fringe benefits formarketing and administrative employees, professional service fees, marketingcosts and all costs related to facilities and information services.  Selling, general and administrative expenseswere as follows:

| **Three Months Ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| **(in thousands)**                                  | ** ** |
|                                                     |       |                                                    |       |   |   |   |   |
| $                                                        | 8,112      |                                                    | $          | 6,331 |   | $ | 22,659 |   | $ | 19,177 |   |
|                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

                The increase in selling, general, and administrativeexpenses for the three months ended September 30, 2006 is primarilyattributable  to $0.8 million inincremental administrative costs incurred at AMRI Hungary, which was acquiredin February 2006.  In addition,compensation and benefit costs increased approximately $0.7 million fromthe third quarter of 2005 due to the addition of administrative and businessdevelopment personnel throughout 2005 and the recognition of additionalshare-based compensation expense for unvested stock options and restrictedstock grants under SFAS No. 123 (R).  We alsoincurred $0.4 million in  additional dataprocessing costs associated with the implementation and maintenance of our ERPsystem.   These increases were partiallyoffset by a decrease in administrative costs from our India operations of $0.2million due to the elimination of administrative costs incurred to set up thefacility in 2005.

                The increase in selling,general, and administrative expenses for the nine months endedSeptember 30, 2006 is primarily due to the addition of $2.1 million inincremental administrative costs incurred at AMRI Hungary, an increase insalary and benefit expenses of $1.4 million due to the addition ofadministrative and business development personnel and the recognition ofadditional share-based compensation expense under SFAS No. 123 (R) and anincrease in costs of $0.8 million due to the implementation and maintenance of ourERP system. These increases are partially offset by a decrease of $0.4 millionfrom a refund of property taxes at our Mt. Prospect facility.  We currently expect selling, general andadministrative costs in future periods to remain consistent with amountsincurred in the third quarter of 2006.

*Impairmentand restructuring charges*

We are currently marketing the Mt. Prospect Research Center facilityfor sale. The facility qualified for held for sale treatment in accordance withSFAS No. 144 during the fourth quarter of 2004. At the time that thefacility qualified for held for sale treatment in accordance with SFAS No. 144,we anticipated the completion of the sale of the facility byJune 2006.  The Company previouslydisclosed that if a definitive agreement to sell the facility was not in placeas of June 30, 2006, it would reassess the classification of the facility as heldfor sale in accordance with SFAS No. 144 at that time.  The Company was not able to secure adefinitive agreement to sell the facility as of June 30, 2006.  Accordingly, and in connection with thepreparation of its second quarter results, the Company reassessed Mt. Prospectas a held for sale facility.

As aresult of this assessment, the Company reaffirmed its intention to sell the Mt.Prospect facility, and determined that a further write-down of the carryingvalue of the facility was required. Management has estimated the fair valuebased upon its intention to sell the facility within twelve months andcomparable real estate transactions in the facility’s market area.  As a result of the reduction in the carryingvalue of Mt. Prospect facility, the Company also adjusted its accruedrestructuring costs to reflect a reduction in the estimated sales commissionsto be paid upon completion of the sale of the facility.  The Company recorded the following non-cashpre-tax items related to the Mt. Prospect facility:

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|                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands)**            | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|                               |       |                                                     |       |                                                    |       |   |   |   |   |
| Property and  equipment impairment |       | $                                                        | —     |                                                    | $          | — |   | $ | 3,376 |   | $ | — |   |
| Restructuring charge               |       | —                                                   |       | —                                                  |       | $ | (292 | ) | $ | — |   |
|                                    |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

*Interest income (expense), net*

|                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(in thousands)**         | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest expense                |       | $                                                        | (278       | )                                                       | $          | (468 | ) | $ | (805 | ) | $ | (1,509 | ) |
| Interest income                 |       | 1,037                                                    |       | 1,029                                                   |       | $ | 2,951 |   | $ | 2,590 |   |
| Interest income  (expense), net |       | $                                                        | 759        |                                                    | $          | 561 |   | $ | 2,146 |   | $ | 1,081 |   |

Thedecrease in interest expense for the three and nine months ended September 30,2006 was primarily due to the paydown of the $25.5 million outstanding balanceon the Company’s line of credit in the third quarter of 2005.

The increase in interest income was due to increasesin the rates earned on investment securities, interest bearing cash accountsand other short-term cash equivalents, partially offset by decreases in theunderlying interest-earning balances held by the Company.

*Incometax expense*

| **Three Months Ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| **(in thousands)**                                  | ** ** |
| ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                                        | 222        |                                                    | $          | 2,565 |   | $ | 806 |   | $ | 9,666 |   |
|                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

The decrease in tax expense for the three months endedSeptember 30, 2006 is due primarily to a decrease in pre-tax income from thethree months ended September 30, 2005. In addition, the Company’s effective tax rate decreased from 37.0% ofpre-tax income for the three months ended September 30, 2005 to 13.6% ofpre-tax income for the three months ended September 30, 2006. The change in theeffective rate in the quarter resulted primarily from a decrease in theestimated full year effective tax rate from 27.5% to 21.5% of pre-tax income.The decrease in the 2006 effective tax rate from 35.1% for the year endedDecember 31, 2005 is due to the consistency of the Company’s deductible itemsand non-taxable earnings and a decrease in pre-tax income, as well as thebenefit recognized from tax holidays that the Company has been granted onearnings from certain of its foreign operations.

The decrease in tax expense for the nine months endedSeptember 30, 2006 is due primarily to a decrease in pre-tax income from thenine months ended September 30, 2005. In addition, the Company’s effective taxrate decreased from 35.9% of pre-tax income for the nine months ended September30, 2005 to 21.5% of pre-tax income for the nine months ended September 30,2006. The decrease is due to the consistency of the Company’s deductible itemsand non-taxable earnings and a decrease in pre-tax income, as well as thebenefit recognized from tax holidays that the Company has been granted onearnings from certain of its foreign operations.

Liquidityand Capital Resources

We have historically funded our business throughoperating cash flows, proceeds from borrowings and the issuance of equitysecurities. During the first nine months of 2006, we generated cash of $2.6million from operating activities. Cash provided by operations during the firstnine months of 2006 decreased from the first nine months of 2005 due primarilyto a decrease in Allegra royalty receipts of $19.2 million.  The primary sources of operating cash flowsare payments received for the performance of contracted chemistry services androyalty payments received from Sanofi-Aventis based upon a percentage of salesof Allegra. The primary uses of operating cash flows are the payment ofcompensation and benefits to both scientific and administrative personnel,purchases of inventory and supplies, and payment of occupancy costs. Asubstantial majority of the uses of operating cash flows pertain to theCompany’s research and development and contract service business activities.

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During the first nine months of 2006, we used $3.2million in investing activities, resulting from the use of $11.6 millionrelated to the acquisition of AMRI Hungary and $12.4 million for theacquisition of property and equipment, partially offset by net proceeds frominvestment securities transactions of $21.2 million. During the first ninemonths of 2006, we used $3.0 million for financing activities, consisting of$3.5 million in long-term debt repayments, offset by $0.5 million of proceedsfrom our stock purchase plan and stock option exercises.

Working capital was $144.0 million at September 30,2006 as compared to $158.8 million as of December 31, 2005. The primarysources of the decrease were the use of cash and investments to fund capitalexpenditures and the acquisition of AMRI Hungary, and a decrease in thecarrying value of our held-for-sale Mt. Prospect facility. These decreases werepartially offset by a decrease in deferred revenue due primarily to therecognition of deferred up-front licensing fees received in conjunction withour Licensing and Research Agreement with BMS as well as the completion of therevenue recognition process on several fixed fee contracts, and an increase inaccounts receivable resulting  from atemporary lengthening of our cash collection cycle due to the implementation ofour enterprise resource planning system in the third quarter. We expect thetiming of this cycle to normalize in the fourth quarter.  We currently anticipate making $1.0 millionin defined benefit pension plan contributions, all of which were paid in thefirst nine months of the year. There have been no significant changes in futurematurities on our long-term debt since December 31, 2005.

Weentered into a credit facility consisting of a $30.0 million term loan and a$35.0 million line of credit during 2003. The term loan matures in February,2008. As of September 30, 2006, the interest rate on $10.7 million of theoutstanding term loan balance was 4.31% and the interest rate on the remaining$5.4 million was 6.45%. The line of credit matures in June, 2010. The lineof credit bears interest at a variable rate based on the Company’s leverageratio. As of September 30, 2006, the outstanding balance of the line of creditwas $0. The credit facility contains certain financial covenants, including amaximum leverage ratio, a minimum required operating cash flow coverage ratio,a minimum earnings before interest and taxes to interest ratio and a minimumcurrent ratio. Other covenants include limits on asset disposals and thepayment of dividends. As of September 30, 2006 we were in compliance with allcovenants under the credit facility.

The disclosure of payments we have committed to makeunder our contractual obligations is set forth under the heading “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Liquidity and Capital Resources” under Item 7 of our 2005Form 10-K. Excluding the repayment of $3.5 million of outstanding debt,and $1.0 million in defined benefit pension plan contributions, as describedabove, there have been no material changes to our contractual obligations sinceDecember 31, 2005.

We are pursuingthe expansion of our operations through internal growth and strategicacquisitions. We expect that such activities will be funded from existing cashand cash equivalents, cash flow from operations, the issuance of debt or equitysecurities and borrowings. Future acquisitions, if any, could be funded withcash on hand, cash from operations, borrowings under our credit facility and/orthe issuance of equity or debt securities. There can be no assurance thatattractive acquisition opportunities will be available to us or will beavailable at prices and upon such other terms that are attractive to us. Weregularly evaluate potential acquisitions of other businesses, products andproduct lines and may hold discussions regarding such potential acquisitions.As a general rule, we will publicly announce such acquisitions only after adefinitive agreement has been signed. In addition, in order to meet ourlong-term liquidity needs or consummate future acquisitions, we may incuradditional indebtedness or issue additional equity or debt securities, subjectto market and other conditions. There can be no assurance that such additionalfinancing will be available on terms acceptable to us or at all. The failure toraise the funds necessary to finance our future cash requirements or consummatefuture acquisitions could adversely affect our ability to pursue our strategyand could negatively affect our operations in future periods. Furthermore, acontinued significant decrease in royalties from Allegra would negativelyaffect our cash flow from operations and financial condition in future periods.

The recurring royalties we receive on the sales ofAllegra/Telfast have historically provided a material portion of our operatingcash flows. As discussed in Part II, Item 1 of this Form 10-Q, severalgeneric manufacturers have filed ANDA applications with the FDA seekingauthorization to produce and market a generic version of Allegra. We and AventisPharmaceuticals have filed several patent infringement suits against thesegeneric companies alleging infringement of certain U.S. patents. OnSeptember 6, 2005, Barr Pharmaceuticals, Inc. and TevaPharmaceuticals Industries Ltd. announced that they had entered into anagreement for the launch of Fexofenadine Hydrochloride 30 mg, 60 mg and 180 mgtablets, the generic version of Allegra tablets in the United States. Thelaunch of the generic product is considered an “at-risk” launch due to theon-going litigation. The at-risk launch of generic fexofenadine has had amaterial adverse impact on U.S. sales of Allegra by Sanofi-Aventis and in turn,the royalties earned by us on those sales. On September 20, 2005, we andAventis Pharmaceuticals filed a Motion for Preliminary Injunction in the U.S.District Court in New Jersey seeking to enjoin Barr Pharmaceuticals,  Inc., Teva Pharmaceuticals Ltd., RanbaxyLaboratories, Ltd. and Amino Chemicals, Ltd. from the sale of generic versionsof Allegra in the United States. Our motion was denied on January 30,2006. We continue to forcefully and vigorously defend our intellectual propertyrelated to Allegra. We have filed an appeal of the ruling on the preliminary 

26

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injunction matter, and we continue to pursue our intellectualproperty rights as the patent infringement litigation progresses. However,should we or Aventis be unsuccessful in defending these patents we wouldcontinue to experience a material decrease in royalty revenues and operatingcash flows.

**Critical Accounting Policies and Estimates**

Our discussion and analysis of our financial conditionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with U.S. generally accepted accountingprinciples. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to bad debts, inventories, intangible assets, equity investments,unbilled revenue, income taxes and contingencies. We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

We refer to the policies and estimates set forth inthe section “Management’s Discussion and Analysis of Financial Condition andResults of Operations — Critical Accounting Estimates” of our Annual Report onForm 10-K for the fiscal year ended December 31, 2005. There have been nomaterial changes or modifications to the policies since December 31, 2005,except as follows:

Effective January 1,2006, the Company adopted SFAS No. 123 (Revised 2004), “Share-Based Payment”(SFAS No. 123 (R)), which amends SFAS No. 123 and supersedes APBNo. 25**in establishing standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services, as well as transactions in which an entity incursliabilities in exchange for goods or services that are based on the fair valueof the entity’s equity instruments or that may be settled by the issuance ofthose equity instruments. This Statement requires that the cost resulting fromall share-based payment transactions be recognized in the financial statementsbased on the fair value of the share-based payment. This Statement establishesfair value as the measurement objective in accounting for share-based paymenttransactions with employees, except for equity instruments held by employeeshare ownership plans.

As allowed under SFAS No. 123 (R), the Company electedthe modified prospective method of adoption, under which compensation cost isrecognized in the financial statements beginning with the effective date ofSFAS No. 123 (R) for all share-based payments granted after that date, andfor all unvested awards granted prior to the effective date of SFAS No. 123(R). Accordingly, prior period amounts have not been restated. The Company recognizedincremental compensation expense, net of taxes, of approximately $212 and $397in the unaudited condensed consolidated statements of income for the three and ninemonths ended September 30, 2006, respectively, as a result of the adoption ofSFAS No. 123 (R).

Effective December 30, 2005, pursuant to and in accordance withthe recommendation of the Compensation Committee (the “Committee”) of the Boardof Directors, the Board of Directors of the Company approved full accelerationof the vesting of each otherwise unvested stock option that had an exerciseprice of $15.00 or greater granted under the Company’s 1998 Stock Option andIncentive Plan that was held by employees, officers, and non-employeedirectors. These options had exercise prices in excess of the current marketvalue of the Company’s common stock, based on the closing price of $12.15 pershare, on December 30, 2005 (*i.e*., suchoptions were “underwater”). Options to purchase approximately 1.3 millionshares of the Company’s common stock, including approximately 101,000 optionsheld by executive officers, were subject to this acceleration.

 

The Committee also required that, as a condition tothe acceleration of vesting, each executive officer and each non-employeedirector agree to refrain from selling shares of the Company’s common stockacquired upon the exercise of accelerated options (other than shares needed tocover the exercise price and satisfy withholding taxes) until the date on whichthe exercise of such options would have been permitted under the option’spre-acceleration vesting terms or, if earlier, the officer’s or director’s lastday of employment or upon a “change in control” as defined in the Company’sstock option plan.

The decision to accelerate the vesting of theseunderwater options was made primarily to minimize certain future compensationexpenses that the Company would otherwise recognize in its consolidatedstatements of income with respect to these options pursuant to SFASNo. 123 (R). The Company also believes that the acceleration may have apositive effect on employee morale, retention and the perception of optionvalue.

 

Please see Note 8 to the unaudited condensedconsolidated financial statements for additional information regarding theCompany’s 

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share-based payment plans and the implementation ofSFAS No. 123 (R).

Item 4. Controls and Procedures

*Disclosure Controls andProcedures*

As required byrule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”), as of the end of the period covered by this Quarterly Reportour management conducted an evaluation with the participation of our ChiefExecutive Officer and Chief Financial Officer, regarding the effectiveness ofour disclosure controls and procedures. In designing and evaluating our disclosurecontrols and procedures, we recognize that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and our management necessarily wasrequired to apply its judgment in evaluating and implementing possible controlsand procedures. Based upon that evaluation, our Chief Executive Officer andChief Financial Officer have concluded that, as of the end of the periodcovered by this Quarterly Report, our disclosure controls and procedures wereeffective in that they provide reasonable assurance that information requiredto be disclosed by us in the reports we file or submit under the Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the Securities and Exchange Commission’s rules and forms,including ensuring that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow timely decisions regarding required disclosure. Weintend to review and document our disclosure controls and procedures, includingour internal controls and procedures for financial reporting, on an ongoingbasis, and may from time to time make changes aimed at enhancing theireffectiveness and to ensure that our systems evolve with our business.

*Internal Control Over FinancialReporting*

During the quarter endedSeptember 30, 2006, management completed its implementation of enterpriseresource planning (“ERP”) software at its domestic locations.  This conversion involved various changes tointernal processes and control procedures over financial reporting; however,the basic internal controls over financial reporting have not materiallychanged as a result of the ERP implementation. There were no changes in the Company’s internal control over financialreporting identified in connection with the evaluation of such internal controlthat occurred during the Company’s last fiscal quarter that have materially affected,or are reasonably likely to materially affect, the Company’s internal controlover financial reporting.

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PART II -OTHER INFORMATION

Item 1.    LegalProceedings

The Company, from time to time, may be involved invarious claims and legal proceedings arising in the ordinary course ofbusiness. Except as noted below in regards to litigation relating to Allegra,the Company is not currently a party to any such claims or proceedings which,if decided adversely to the Company, would either individually or in theaggregate have a material adverse effect on the Company’s business, financialcondition, results of operations or cash flows.

AMR Technology, a subsidiary of the Company, alongwith Aventis Pharmaceuticals Inc., the U.S. pharmaceutical business ofSanofi-Aventis S.A., are involved in legal proceedings with several companiesseeking to market generic versions of Allegra. Beginning in 2001, BarrLaboratories, Inc., Impax Laboratories, Inc., Mylan Pharmaceuticals, Inc., TevaPharmaceuticals USA, Dr. Reddy’s Laboratories, Ltd./Dr. Reddy’s Laboratories,Inc., Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., and Sandoz Inc.filed Abbreviated New Drug Applications (ANDAs) with the U.S. Food and DrugAdministration, or FDA, to produce and market generic versions of Allegraproducts.

In response to the filings described above, beginningin 2001, Aventis Pharmaceuticals filed patent infringement lawsuits againstBarr Laboratories, Impax Laboratories, Mylan Pharmaceuticals, TevaPharmaceuticals, Dr. Reddy’s Laboratories, Ranbaxy Laboratories Ltd./RanbaxyPharmaceuticals Inc., and Sandoz. Each of the lawsuits was filed in the U.S.District Court in New Jersey and alleges infringement of one or more patentsowned by Aventis Pharmaceuticals. Further, beginning in March 5, 2004, AMRTechnology, along with Aventis Pharmaceuticals, filed suit in the U.S. DistrictCourt in New Jersey against Barr Laboratories, Impax Laboratories, MylanPharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories, AminoChemicals, Ltd., Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc.,DiPharma S.P.A., DiPharma Francis s.r.l., and Sandoz, Inc., assertinginfringement of two of our U.S. patents that are exclusively licensed toAventis Pharmaceuticals relating to Allegra and Allegra-D products.

In the pending litigations, Aventis Pharmaceuticalsand AMR Technology have entered into covenants not to sue the defendants otherthan  DiPharma S.P.A. and DiPharmaFrancis s.r.l., under U.S. Patent No. 5,578,610, which patent has not beenasserted in the litigation but which Aventis Pharmaceuticals exclusivelylicenses from us. However, we and Aventis Pharmaceuticals have agreed thatAventis Pharmaceuticals will continue to pay royalties to us based on thatpatent under our original license agreement with Aventis Pharmaceuticals. Underour arrangements with Aventis Pharmaceuticals, we will receive royalties untilexpiration of the underlying patents (2013 for U.S. Patent No. 5,578,610 and2015 for U.S. Patent No. 5,750,703) unless the patents are earlier determinedto be invalid.

Under applicable federal law, marketing of anFDA-approved generic version of Allegra may not commence until the earlier of adecision favorable to the generic challenger in the patent litigation or 30months after the date the patent infringement lawsuit was filed. In general,the first generic filer is entitled to a 180-day marketing exclusivity periodupon FDA approval.

On September 6, 2005, Barr Pharmaceuticals, Inc. andTeva Pharmaceuticals Industries Ltd. announced that they have entered into anagreement for the launch of Fexofenadine Hydrochloride 30 mg, 60 mg and 180 mgtablets, the generic version of Allegra tablets in the United States. Thelaunch of the generic product is considered an “at-risk” launch due to theon-going litigation. This generic launch has had a material adverse impact onU.S. sales of Allegra by Sanofi-Aventis since the fourth quarter of 2005 and inturn, the royalties earned by the Company on those sales. The launch has nothad a material impact on non-U.S. sales of Allegra to date.

On September 20, 2005, AMR Technology, along withAventis Pharmaceuticals, filed a Motion for Preliminary Injunction in the U.S.District Court in New Jersey seeking to enjoin Barr Pharmaceuticals, Inc., TevaPharmaceuticals Ltd., Ranbaxy Laboratories, Ltd. and Amino Chemicals, Ltd. fromthe sale of generic versions of Allegra in the United States. On January 30,2006, the U.S. District Court denied the request by AMR Technology and AventisPharmaceuticals for a preliminary injunction. An appeal of that decision wastaken to the U.S. Court of Appeals for the Federal Circuit and, onNovember 8, 2006, the appellate court affirmed the District Court’s denialof a preliminary injunction. The court’s decisions on the preliminaryinjunction application are not dispositive of the merits of the claims beingasserted as described above.

Subsequent to the preliminary injunction proceeding,Dr. Reddy’s Laboratories has engaged in an at-risk launch of genericfexofenadine products.

Should the Company be unsuccessful in defending thesepatents, the Company would continue to experience a material decrease inoperating cash flows and a material adverse effect on our results of operationsand financial condition.

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Item 1A. RiskFactors

Inaddition to the other information set forth in this report, you shouldcarefully consider the factors discussed in Part I, Item 1A. Risk Factors inour Annual Report on Form 10-K for the year ended December 31, 2005, whichcould materially affect our business, financial condition or future results.The risks described in our Annual Report on Form 10-K are not the only risksfacing our Company. In addition to the risk described below, additional risksand uncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition and/or operating results.

***Our business may be adversely affected ifwe encounter complications in connection with our implementation of informationmanagement software.***

In July 2006, wecompleted the first of several phases of the implementation of a newcomprehensive enterprise resource planning (“ERP”) system to enhance operating efficiencies and provide moreeffective management of our business operations. Continuing and uninterruptedperformance of our****ERP system is critical to the successof our business strategy. Any material failure of our ERP system that interruptsor delays our operations could  adverselyimpact our ability to do the following in a timely manner and have a materialadverse effect on our operations:

·                  reportfinancial results;

·                  accuratelyreflect inventory costs;

·                  acceptand process customer orders;

·                  receiveinventory and ship products;

·                  invoiceand collect receivables;

·                  placepurchase orders and pay invoices; and

·                  accuratelyreflect all other business transactions related to the finance, order entry,purchasing, supply chain and human resource processes within the new****ERPinformation system.

***Therestructuring of our Large Scale Manufacturing segment may not have the desiredimpact on the results of our operations.***

OnNovember 9, 2006 we announced a restructuring plan designed to improve theefficiency and profitability of our LSM operating segment by eliminatingoverlap in business processes, organization and project process flow, as wellas leveraging existing resources and assets.  The key elements of the restructuring plan include workforce reductionsas well as non-workforce-related actions such as disposal of underutilized assets,elimination of non-essential operating expenses, and reductions in raw materialcosts.  Most of these initiatives will beimplemented by the end of 2006.  Weexpect to realize annual savings of approximately $5 million from therestructuring plan beginning in 2007. The plan as currently constituted,however, may not be sufficient to achieve the desired level of cost savingsduring the time period indicated. Additional restructuring activities may be required to attain theintended reduction in operating costs and the expected impact on operatingmargins within our Large Scale Manufacturing segment.  Furthermore, the implementation of therestructuring plan could cause disruptions to Large Scale Manufacturingoperations that could have an adverse impact on the results of our operations.

 

Item 3.Quantitative and Qualitative Disclosures about Market Risk

There have been nomaterial changes with respect to the information on Quantitative andQualitative Disclosures about Market Risk appearing in Part II,Item 7A to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005.

Item 6.    Exhibits

(a)                      Exhibits.

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31.1                           Certificationof the Chief Executive Officer pursuant toRule 13a-14(a)/15d-14(a) of the Security Exchange Act of 1934.

31.2                           Certificationof the Chief Financial Officer pursuant toRule 13a-14(a)/15d-14(a) of the Security Exchange Act of 1934.

32.1                           Certificationof the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2                           Certificationof the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                              | ALBANY MOLECULAR RESEARCH, INC. |
|------------------------------|---------------------------------|
|                         |                            |   |
|                         |                            |   |
| Date: November 9,  2006 | By:                             | /s/ Mark T. Frost |   |
|                         | ** **                      | Mark T. Frost | ** ** |
|                         |                            | Chief Financial Officer and Treasurer  (Authorized Officer and Principal Financial Officer) |

 

 

 

 

 

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