**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **ý**                                                                                                                                                              | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                              | ** ** | ** **                                                                                         | ** ** |
| **For the Quarterly Period Ended June 30, 2004**                                                                                                                   |
| ** **                                                                                                                                                              | ** ** | ** **                                                                                         | ** ** |
| **o**                                                                                                                                                                   | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** | ** ** |
| ** **                                                                                                                                                              | ** ** | ** **                                                                                         |
| **For the transition period from             to             ** |

 

**Commission file number:  0-25323**

 

**ALBANY MOLECULAR RESEARCH, INC.**

(Exact name of registrant as specified inits charter)

 

| **DELAWARE**                                                                              | ** ** | **14-1742717**                        |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction  of  incorporation or organization)                          |       | (I.R.S. Employer  Identification No.) |
|                                                                                      |       |                                  |
| **21  Corporate Circle  PO Box 15098  Albany, New York  12212-5098**                 |
| (Address of principal  executive offices)                                                 |
|                                                                                      |       |                                  |
| **(518)  464-0279**                                                                       |
| (Registrant’s telephone  number, including area code)                                |
|                                                                                      |       |                                  |
| **N/A**                                                                                   |
| (Former  name, former address and former fiscal  year, if changed since last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes                            ý                                    No                                o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).

 

Yes                            ý                                    No                                o

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 
| **Class**                    | ** ** | **Outstanding at August 2, 2004** |
|------------------------------|------------|----------------------------------------|
| Common Stock, $.01 par value |       | 31,725,359                             |

 

 

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ALBANY MOLECULAR RESEARCH, INC.

INDEX

 
| Part I.       | Financial  Information | 3                                                                                           |
|---------------|------------------------|---------------------------------------------------------------------------------------------|
|          |                   |                                                                                        |   |
|          | Item 1.                | Condensed  Consolidated Financial Statements (Unaudited)                                    | 3 |
|          |                   |                                                                                        |   |
|          |                   | Condensed  Consolidated Statements of Operations                                            | 3 |
|          |                   | Condensed  Consolidated Balance Sheets                                                      | 4 |
|          |                   | Condensed  Consolidated Statements of Cash Flows                                            | 5 |
|          |                   | Notes  to Condensed Consolidated Financial Statements                                       | 6 |
|          |                   |                                                                                        |   |
|          | Item 2.                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 17 |
|          |                   |                                                                                        |   |
|          | Item 3.                | Quantitative  and Qualitative Disclosures About Market Risk                                 | 29 |
|          |                   |                                                                                        |   |
|          | Item 4.                | Controls  and Procedures                                                                    | 29 |
|          |                   |                                                                                        |   |
| Part II.      | Other  Information     | 30                                                                                          |
|          |                   |                                                                                        |   |
|          | Item 1.                | Legal  Proceedings                                                                          | 30 |
|          |                   |                                                                                        |   |
|          | Item 4.                | Submission  of Matters to a Vote of Security Holders                                        | 31 |
|          |                   |                                                                                        |   |
|          | Item 6.                | Exhibits  and Reports on Form 8-K                                                           | 31 |
|          |                   |                                                                                        |   |
| Signatures    | 32                     |
|          |                   |                                                                                        |   |
| Exhibit Index |                   |

 

2

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PART I —FINANCIAL INFORMATION

 

Item 1.    CondensedConsolidated Financial Statements

 

**Albany Molecular Research, Inc.**

**Condensed Consolidated Statements ofOperations**

**(unaudited)**

 

*(Dollars inthousands, except for per share data)*

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                               | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Contract revenue                                         |       | $                      | 28,118     |                   | $          | 38,777 |   | $ | 58,932 |   | $ | 72,616 |   |
| Recurring royalties                                      |       | 13,878                 |       | 15,200                 |       | 23,870 |   | 26,300 |   |
| Total revenue                                            |       | 41,996                 |       | 53,977                 |       | 82,802 |   | 98,916 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Cost of contract revenue                                 |       | 22,853                 |       | 29,158                 |       | 46,715 |   | 55,170 |   |
| Write-down of library inventories                        |       | 5,974                  |       | —                 |       | 5,974 |   | — |   |
| Total cost of contract revenue                           |       | 28,827                 |       | 29,158                 |       | 52,689 |   | 55,170 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Technology incentive award                               |       | 1,387                  |       | 1,520                  |       | 2,385 |   | 2,630 |   |
| Research and development                                 |       | 5,368                  |       | 5,552                  |       | 13,248 |   | 11,117 |   |
| Selling, general and administrative                      |       | 5,811                  |       | 5,304                  |       | 9,732 |   | 11,433 |   |
| Property and equipment impairment                        |       | 4,728                  |       | —                 |       | 4,728 |   | — |   |
| Goodwill impairment                                      |       | 14,494                 |       | —                 |       | 14,494 |   | — |   |
| Intangible asset impairment                              |       | 3,541                  |       | —                 |       | 3,541 |   | — |   |
| Restructuring charge                                     |       | 426                    |       | —                 |       | 426 |   | — |   |
| Total costs and expenses                                 |       | 64,582                 |       | 41,534                 |       | 101,243 |   | 80,350 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| (Loss) income from operations                            |       | (22,586                | )          | 12,443                 |       | (18,441 | ) | 18,566 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Equity in (loss) of income of  unconsolidated affiliates |       | —                 |       | (87                    | )          | (65 | ) | (21 | ) |
| Interest income, net                                     |       | 142                    |       | 354                    |       | 302 |   | 560 |   |
| Other income, net                                        |       | 1                      |       | 110                    |       | 9 |   | 122 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| (Loss) income before income tax expense                  |       | (22,443                | )          | 12,820                 |       | (18,195 | ) | 19,227 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Income tax (benefit) expense                             |       | (1,670                 | )          | 4,551                  |       | (183 | ) | 6,826 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Net (loss) income                                        |       | $                      | (20,773    | )                      | $          | 8,269 |   | $ | (18,012 | ) | $ | 12,401 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Basic (loss) earnings per share                          |       | $                      | (0.65      | )                      | $          | 0.26 |   | $ | (0.57 | ) | $ | 0.39 |   |
|                                                     |       |                   |       |                   |       |   |   |   |   |
| Diluted (loss) earnings per share                        |       | $                      | (0.65      | )                      | $          | 0.26 |   | $ | (0.57 | ) | $ | 0.38 |   |

 

*See notes to unaudited condensed consolidated financial statements.*

 

3

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**Albany Molecular Research, Inc.**

**Condensed Consolidated Balance Sheets**

**(unaudited)**

 

*(Dollars and shareamounts in thousands)*

 
| ** **                                                                                                                                                 | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                                       |       |                    |       |                        |       |
| **Assets**                                                                                                                                                 |       |                    |       |                        |       |
| Current assets:                                                                                                                                            |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                  |       | $                       | 57,087     |                        | $          | 47,437 |   |
| Investment securities, available-for-sale                                                                                                                  |       | 64,633                  |       | 77,191                      |       |
| Accounts receivable, net                                                                                                                                   |       | 16,335                  |       | 18,261                      |       |
| Royalty income receivable                                                                                                                                  |       | 13,875                  |       | 12,970                      |       |
| Inventories                                                                                                                                                |       | 32,010                  |       | 34,292                      |       |
| Unbilled services                                                                                                                                          |       | 300                     |       | 248                         |       |
| Prepaid income taxes                                                                                                                                       |       | 112                     |       | —                      |       |
| Prepaid expenses and other current assets                                                                                                                  |       | 3,725                   |       | 5,125                       |       |
| Total current assets                                                                                                                                       |       | 188,077                 |       | 195,524                     |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Property, plant and equipment, net                                                                                                                         |       | 147,775                 |       | 146,639                     |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Other assets:                                                                                                                                              |       |                    |       |                        |       |
| Goodwill                                                                                                                                                   |       | 26,817                  |       | 42,056                      |       |
| Intangible assets and patents, net                                                                                                                         |       | 1,123                   |       | 4,864                       |       |
| Equity investments in unconsolidated affiliates                                                                                                            |       | 2,230                   |       | 2,191                       |       |
| Other assets                                                                                                                                               |       | 858                     |       | 1,357                       |       |
| Total other assets                                                                                                                                         |       | 31,028                  |       | 50,468                      |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Total assets                                                                                                                                               |       | $                       | 366,880    |                        | $          | 392,631 |   |
|                                                                                                                                                       |       |                    |       |                        |       |
| **Liabilities and Stockholders’ Equity**                                                                                                              |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                       |       |                    |       |                        |       |
| Accounts payable and accrued expenses                                                                                                                      |       | $                       | 10,330     |                        | $          | 12,844 |   |
| Deferred revenue                                                                                                                                           |       | 1,261                   |       | 1,179                       |       |
| Accrued pension benefits                                                                                                                                   |       | 2,819                   |       | 2,500                       |       |
| Income taxes payable                                                                                                                                       |       | —                  |       | 884                         |       |
| Current installments of long-term debt and  capital leases                                                                                                 |       | 4,529                   |       | 4,521                       |       |
| Total current liabilities                                                                                                                                  |       | 18,939                  |       | 21,928                      |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Long-term liabilities:                                                                                                                                     |       |                    |       |                        |       |
| Long-term debt and capital leases,  excluding current installments                                                                                         |       | 50,752                  |       | 53,129                      |       |
| Deferred income taxes                                                                                                                                      |       | 6,861                   |       | 11,860                      |       |
| Pension and postretirement benefits                                                                                                                        |       | 1,931                   |       | 2,844                       |       |
| Other long term  liabilities                                                                                                                          |       | 326                     |       | 586                         |       |
| Total liabilities                                                                                                                                          |       | 78,809                  |       | 90,347                      |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Commitments and contingencies                                                                                                                              |       |                    |       |                        |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                 |       |                    |       |                        |       |
| Common stock, $0.01 par value, 100,000  shares authorized, 33,802 shares issued at June 30, 2004, and 33,694  shares issued at December 31, 2003 |       | 338                     |       | 337                         |       |
| Additional paid-in capital                                                                                                                                 |       | 188,228                 |       | 184,365                     |       |
| Retained earnings                                                                                                                                          |       | 137,426                 |       | 155,438                     |       |
| Accumulated other comprehensive loss                                                                                                                       |       | (750                    | )          | (685                        | )          |
|                                                                                                                                                       |       | 325,242                 |       | 339,455                     |       |
|                                                                                                                                                       |       |                    |       |                        |       |
| Less, treasury shares at cost, 2,077 shares                                                                                                                |       | (37,171                 | )          | (37,171                     | )          |
| Total stockholders’ equity                                                                                                                            |       | 288,071                 |       | 302,284                     |       |
| Total liabilities and stockholders’ equity                                                                                                            |       | $                       | 366,880    |                        | $          | 392,631 |   |

 

*See notes to unaudited condensed consolidated financial statements.*

 

4

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**Albany Molecular Research, Inc.**

**Condensed Consolidated Statements of CashFlows**

**(unaudited)**

 

*(Dollars inthousands)*
| ** **                                                                                | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
|                                                                                      |       |                   |       |   |   |
| **Operating  activities**                                                                 |       |                   |       |   |   |
| Net (loss) income                                                                         |       | $                      | (18,012    | ) | $ | 12,401 |   |
| Adjustments to reconcile net income (loss) to net cash provided by  operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                                             |       | 7,194                  |       | 6,252 |   |
| Abandonment loss                                                                          |       | —                 |       | 1,400 |   |
| Write-down of library inventories                                                         |       | 5,974                  |       | — |   |
| Property and equipment impairment                                                         |       | 4,728                  |       | — |   |
| Goodwill impairment                                                                       |       | 14,494                 |       | — |   |
| Intangible asset impairment                                                               |       | 3,541                  |       | — |   |
| Warrant issuance expense                                                                  |       | 3,053                  |       | — |   |
| Allowance for bad debts                                                                   |       | —                 |       | 210 |   |
| Tax benefit of stock options                                                              |       | —                 |       | 66 |   |
| Amortization of deferred financing fees                                                   |       | 12                     |       | 12 |   |
| Equity in income (loss) of unconsolidated  affiliates                                     |       | 65                     |       | 154 |   |
| Minority interest in consolidated  subsidiary                                             |       | —                 |       | (133 | ) |
| Deferred income tax expense                                                               |       | (4,098                 | )          | 1,036 |   |
| Amortization of discount on note payable                                                  |       | —                 |       | (13 | ) |
| Change in fair value of interest rate swap                                                |       | —                 |       | (166 | ) |
|                                                                                      |       |                   |       |   |   |
| (Increase) decrease in operating assets,  net of business acquisition in 2003:            |       |                   |       |   |   |
| Accounts receivable                                                                       |       | 1,926                  |       | (5,351 | ) |
| Royalty income receivable                                                                 |       | (905                   | )          | (1,838 | ) |
| Unbilled services                                                                         |       | (52                    | )          | 48 |   |
| Inventory, prepaid expenses and other  assets                                             |       | (2,754                 | )          | 2,897 |   |
| (Decrease) increase in:                                                                   |       |                   |       |   |   |
| Accounts payable and accrued expenses                                                     |       | (1,609                 | )          | (3,120 | ) |
| Income tax payable                                                                        |       | (996                   | )          | 1,313 |   |
| Deferred revenue                                                                          |       | 82                     |       | 423 |   |
| Pension and postretirement benefits                                                       |       | (594                   | )          | (393 | ) |
| Environmental liability                                                                   |       | (17                    | )          | (35 | ) |
| Other liabilities                                                                         |       | —                 |       | (13 | ) |
| Net cash provided by operating activities                                                 |       | 12,032                 |       | 15,150 |   |
|                                                                                      |       |                   |       |   |   |
| **Investing  activities**                                                                 |       |                   |       |   |   |
| Proceeds from maturity of investment  securities                                          |       | 12,037                 |       | 19,655 |   |
| Purchase of business, net of cash acquired                                                |       | —                 |       | (28,305 | ) |
| Purchases of property, plant and equipment                                                |       | (12,771                | )          | (14,539 | ) |
| Payments for patent applications and other  costs                                         |       | (89                    | )          | (163 | ) |
| Net cash used in investing activities                                                     |       | (823                   | )          | (23,352 | ) |
|                                                                                      |       |                   |       |   |   |
| **Financing  activities**                                                                 |       |                   |       |   |   |
| Borrowings on long-term debt                                                              |       | —                 |       | 30,010 |   |
| Principal payments on capital leases                                                      |       | —                 |       | (238 | ) |
| Principal payments on long-term debt                                                      |       | (2,369                 | )          | (1,299 | ) |
| Purchase of treasury stock                                                                |       | —                 |       | (7,623 | ) |
| Proceeds from sale of common stock                                                        |       | 810                    |       | 316 |   |
| Net cash (used in) provided by financing  activities                                      |       | (1,559                 | )          | 21,166 |   |
|                                                                                      |       |                   |       |   |   |
| Increase in cash and cash equivalents                                                     |       | 9,650                  |       | 12,964 |   |
|                                                                                      |       |                   |       |   |   |
| Cash and cash equivalents at beginning of  period                                         |       | 47,437                 |       | 34,838 |   |
|                                                                                      |       |                   |       |   |   |
| Cash and cash equivalents at end of period                                                |       | $                      | 57,087     |   | $ | 47,802 |   |

 

*See notes to unaudited condensed consolidated financial statements.*

 

5

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**Note 1 – Summary of Operations andSignificant Accounting Policies**

(All amounts in thousands,except per share amounts, unless otherwise noted)

 

** Nature of Business and Operations.**

 

Albany Molecular Research, Inc. (the “Company”) is a leadingchemistry-based drug discovery and development company focused on applicationsfor new small molecule prescription drugs. The Company conducts research anddevelopment projects and collaborates with many leading pharmaceutical andbiotechnology companies, and is developing new chemistry technology forpotential pharmaceutical products. The Company engages in chemistry research,from lead discovery, optimization and development to commercial manufacturing.As part of its drug discovery strategy, the Company is also producing novelcompound collections and chemical screening collections. In addition to itschemistry research services, the Company also conducts proprietary research anddevelopment to develop new technologies and to discover new lead compounds withcommercial potential. The Company seeks to license these compounds to thirdparties in return for up-front service fees and milestone payments as well asrecurring royalty payments if these compounds are developed into new drugssuccessfully reaching the market.

 

**Significant Q2 Accounting Transactions:**

 

As previouslydisclosed by the Company, the Company made certain investments in 2003 whichthe Company believed would enhance its ability to market and sell its naturalproduct libraries and achieve certain revenue targets. The Company alsodisclosed that if it was not able to successfully execute against its businessplan within certain time constraints, including the achievement of revenuetargets, or if market conditions were less favorable than those projected bymanagement, the Company might be required to write-down the value of certainlibrary assets and related goodwill and intangible assets. After investing inexpanded marketing and sales efforts, the Company was not able to achieve anysales or signed purchase commitments for its natural product libraries duringthe six months ended June 30, 2004, or through the date of the filing ofthis Form 10-Q. Accordingly, and in connection with the preparation of itssecond quarter results, the Company recently completed an in-depth review ofthe carrying value of all of its library inventories. As a result of thisreview, which was based on expected future revenues, it was determined that asignificant write-down in the carrying value of library inventories wasrequired. The reduction in the carrying value of its library inventoriesreflects less favorable market conditions than previously projected bymanagement and an excess quantity and carrying value of inventory on handcompared to projected future sales revenue.

 

The write-downof library inventories triggered an assessment of the recoverability of certainother related long-lived assets and goodwill within its Bothell reporting unit,including the goodwill and intangibles which resulted from the 2001 acquisitionof New Chemical Entities (NCE). The Company completed its assessments inaccordance with the provisions of SFAS 144, “Accounting for the Impairment orDisposal of Long-Lived Assets” (SFAS 144) and SFAS 142, “Goodwill and OtherIntangible Assets” (SFAS 142). Based on its review, the Company determined thatan impairment of certain related goodwill and long-lived assets had occurredand accordingly the following pre-tax charges were recorded in the quarterended June 30, 2004 together with the write-down of inventories discussedabove:

 
| Write-down in carrying value of library  inventories |   | $      | 5,974  |   |
|------------------------------------------------------|--------|--------|--------|--------|
| Impairment of library-related intangibles            |   | 3,541  |   |
| Impairment of property and equipment                 |   | 3,113  |   |
| Impairment of goodwill                               |   | 13,251 |   |
|                                                 |   | $      | 25,879 |   |

 

Additionally,as discussed in the Company’s Form 10-Q for the quarter ended March 31,2004, during the quarter ended June 30, 2004, the Company also initiated arestructuring which will result in the closure of its Mt. Prospect ResearchCenter and the consolidation of the Mt. Prospect operations into the Company’sNew York facilities.  As a result of therestructuring, the Company recorded $426 in restructuring charges in thequarter ended June 30, 2004, which relate to severance benefits providedto terminated employees.  Therestructuring triggered an assessment of the carrying value of the Mt. ProspectResearch Center long-lived assets and related goodwill. Based on its review,and in accordance with the****provisions ofSFAS 144 and SFAS 142, the Company determined that an impairment of certainrelated goodwill and long-lived assets had occurred.  Accordingly, the Company recorded thefollowing pre-tax charges relating to Mt. Prospect in the quarter endedJune 30, 2004:

 
| Impairment of property and equipment |   | $     | 1,615  |   |
|--------------------------------------|--------|-------|--------|--------|
| Impairment of goodwill               |   | 1,243 |   |
|                                 |   | $     | 2,858  |   |

 

See Notes 3, 4, 5 and 6 forfurther details on these reserves, impairments and restructurings.

 

6

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**Basis of Presentation:**

 

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America for interim financial information and with theinstructions to Form 10-Q and Rule 10-01 of Regulation S-X.  In accordance with Rule 10-01, the unauditedcondensed consolidated financial statements do not include all of the informationand footnotes required by accounting principles generally accepted in theUnited States of America for complete consolidated financial statements.  The year-end condensed consolidated balancesheet data was derived from audited financial statements but does not includeall disclosures required by accounting principles generally accepted in theUnited States of America.  In the opinionof management, all adjustments (consisting of normal recurring accruals andadjustments) considered necessary for a fair statement of the results for theinterim period have been included. Operating results for the quarter and six months ended June 30,2004 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2004.

 

The accompanying condensed consolidated financial statements should beread in conjunction with the consolidated financial statements and notesthereto included in our Annual Report on Form10-K for the year endedDecember 31, 2003.

 

The accompanying unaudited condensed consolidated financial statementsinclude the accounts of Albany Molecular Research, Inc. and its wholly ownedsubsidiaries.  All intercompany balancesand transactions have been eliminated during consolidation.

 

**Use of Management Estimates.**

 

The preparation of consolidated financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, and disclosures of contingent assets andliabilities, at the date of the financial statements, and the reported amountsof revenues and expenses during the reporting period. Actual results can varyfrom these estimates.

 

**Contract Revenue Recognition.**

 

The Company’s contract revenue consists primarily of fees earned undercontracts with third-party customers and reimbursed expenses under suchcontracts. The Company also seeks to include provisions in certain contractswhich contain a combination of up-front licensing fees, milestone and royaltypayments should the Company’s proprietary technology and expertise lead to thediscovery of new products that reach the market. Reimbursed expenses consist ofchemicals and other project specific costs. Generally, the Company’s contractsmay be terminated by the customer upon 30 days’ to one year’s priornotice, depending on the size of the contract.

 

The Company generates contract revenue on the following basis:

 

*Full-time Equivalent (FTE).*  An FTE agreement establishes the number ofour employees contracted for a project or a series of projects, the duration ofthe contract period, the price per FTE, plus an allowance for chemicals andother project specific costs, which may or may not be incorporated in the FTErate. Typically, FTE contracts have terms of six months or longer. FTEcontracts typically provide for annual adjustments in billing rates for thescientists assigned to the contract. These contracts involve the Company’sscientists providing services on a “best efforts” basis in the development ofnovel chemistry for customers. There are no fixed deliverables as part of theseservices. As such, the Company recognizes revenue under FTE contracts on amonthly basis as services are performed according to the terms of the contract.

 

*Time and Materials***.** Under a time and materials contract the Company charges customers anhourly rate plus an allowance for chemicals and other project specific costs.The Company recognizes revenue for time and material contracts based on thenumber of hours devoted to the project multiplied by the customer’s billingrate plus other project specific costs incurred.

 

7

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*Fixed Fee***.** Under a fixed-fee contract the Company charges a fixed agreed uponamount for a deliverable. Fixed-fee contracts have fixed deliverables uponcompletion of the project. The Company recognizes revenue for fixed feecontracts after projects are completed, delivery is made and title transfers tothe customer and collection is reasonably assured.

 

*Up-Front License Fees, Milestone and RoyaltyRevenue***.**  The Company analyzes its agreements todetermine whether the elements can be separated and accounted for individuallyor as a single unit of accounting in accordance with EITF No. 00-21, *Revenue Arrangements with Multiple Deliverables*and SAB 104, *Revenue Recognition*.Allocation of revenue to individual elements which qualify for separateaccounting is based on the estimated fair value of the respective elements. TheCompany recognizes revenue from up-front non-refundable licensing fees on astraight line basis over the period of the underlying project. The Company willrecognize revenue arising from a milestone payment upon the successfulachievement of the event, and the resolution of any uncertainties orcontingencies regarding potential collection of the related payment, or ifappropriate over the remaining term of the agreement.

 

*Recurring Royalty Revenue Recognition***.**

 

Recurring royalties consist of royalties under a license agreement withAventis based on the worldwide sales of fexofenadine HCl, marketed as Allegrain the Americas and Telfast elsewhere. The Company records royalty revenue inthe period in which the sales of Allegra occur. Royalty payments from Aventis aredue within 45 days after each calendar quarter and are determined based onsales of Allegra/Telfast in that quarter.

 

**Natural Product and Lead Finding SampleCollections.**

 

As part of the Company’s strategy to provide a comprehensive offeringof natural product and chemical lead finding discovery services andtechnologies to its customers, it has acquired natural product samplecollections and related assets and is producing novel compound libraries andchemical screening collections. The natural product sample collections wereacquired in connection with the 2001 acquisition of NCE. For internallydeveloped libraries, the Company is capitalizing the cost of internallyproducing novel compound and screening collections in inventory.  Initial costs to develop novel compoundlibraries are categorized as research and development expense until such timeit becomes probable that a saleable library can be successfully produced. As aresult, costs for the design, research, and testing of libraries underdevelopment are expensed as incurred. Our research chemists review the resultsof analytical procedures to determine if the chemical reactions were completedas expected and the product purity and product yields are within requiredspecifications. This “validation” process determines whether the chemistry issuccessful and if a saleable product will result. We capitalize costs ofproduction to inventory once the validation process is completed and successfulproduction is reasonably assured. If a core reaction is unsuccessful, thelibrary template is abandoned and no further development takes place.

 

As noted above, during****the quarterended June 30, 2004, the Company recorded a $5,974 write-down to reducethe carrying value of its natural product and chemical lead finding libraryinventories. The Company monitors the carrying value of its remaining naturalproduct and lead finding sample collections for impairment on a quarterlybasis.  If the Company is unable to meetforecasted revenues related to those assets, or if actual market conditions areless favorable than those projected, the Company may be required to write-downall or a portion of the remaining value of certain compound library assets(totaling $4,232 at June 30, 2004), resulting in a future****charge to operations. See Note 3 for further information on the inventory reserves recordedduring the quarter ended June 30, 2004.

 

**Long-lived Assets**

 

In accordance with the provisions of SFAS 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 the Company determines that the carrying value of long-lived assets may not be recoverable, based upon the existence of one or more of the above indicators of impairment, the Company compares the carrying value of the asset group to the

 

8

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undiscounted cash flows expected to be generated by the asset group. Ifthe carrying 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 assistance of an independent valuation firm indetermining the fair values.

 

As noted above, during the quarter ended June 30, 2004, the Company recorded impairment charges to intangibles, property and equipment of $6,654 and $1,615, respectively, related to Bothell and the Mount Prospect Research Center. See Note 5 for further information.

 

**Goodwill**

 

In accordance with the provisions of SFAS 142, the Company performs anannual****assessment of the carrying value ofgoodwill for potential impairment (or on an interim basis if certain triggeringevents occur).  A determination ofimpairment is made based upon the estimated discounted future cash flows of theoperations associated with the related reporting unit.**** If goodwill is determined to be impaired inthe future the Company would be required to record a charge to its results ofoperations. Factors the Company considers important which could result in animpairment include the following:

 

•                                       significantunderperformance relative to historical or projected future operating results;

 

•                                       significantchanges in the manner of our use of the acquired assets or the strategy foroverall business;

 

•                                       significantnegative industry or economic trends; and

 

•                                       marketcapitalization relative to net book value.

 

As noted above, during the quarter ended June 30, 2004, theCompany recorded goodwill impairment charges of $13,251 and $1,243,respectively, relating to its Bothell reporting unit and its Mt. Prospectreporting unit.  See Note 6 for furtherinformation.

 

The Companywill perform the annual goodwill assessment for the other remaining reportingunits during the third quarter of 2004.

**Stock Compensation**

 

The Company applies the intrinsic value-basedmethod of accounting prescribed by Accounting Principles Board (APB) OpinionNo. 25, ‘‘Accounting for Stock Issued to Employees,’’ and relatedinterpretations, in accounting for its fixed plan stock options. As such,compensation expense would be recorded only if, on the date of grant, thecurrent market price of the underlying stock exceeded the exercise price. Anycompensation expense would be recognized over the vesting period.  The following table illustrates the effect onnet income and earnings per share if the Company had applied the fair valuerecognition provisions of FASB Statement No. 123, *Accountingfor Stock-Based Compensation,*to stock-based employee compensation.

 
| ** **                                                                                                                                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands, except per share data)**                                                                                                            | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net (loss) income, as reported                                                                                                                       |       | $                                    | (20,773    | )                                  | $          | 8,269 |   | $ | (18,012 | ) | $ | 12,401 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards, net of related tax effects. |       | 661                                  |       | 625                                |       | 1,326 |   | 1,222 |   |
| Pro Forma net (loss) income                                                                                                                          |       | $                                    | (21,434    | )                                  | $          | 7,644 |   | $ | (19,338 | ) | $ | 11,179 |   |
|                                                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| (Loss) earnings per share:                                                                                                                           |       |                                 |       |                               |       |   |   |   |   |
| Basic as reported                                                                                                                                    |       | $                                    | (0.65      | )                                  | $          | 0.26 |   | $ | (0.57 | ) | $ | 0.39 |   |
| Basic pro-forma                                                                                                                                      |       | $                                    | (0.68      | )                                  | $          | 0.24 |   | $ | (0.61 | ) | $ | 0.35 |   |
|                                                                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| Diluted as reported                                                                                                                                  |       | $                                    | (0.65      | )                                  | $          | 0.26 |   | $ | (0.57 | ) | $ | 0.38 |   |
| Diluted pro-forma                                                                                                                                    |       | $                                    | (0.68      | )                                  | $          | 0.24 |   | $ | (0.61 | ) | $ | 0.34 |   |

 

9

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**Note 2 –(Loss) Earnings Per Share**

 

The shares used in the computation of the Company’s basic and diluted(loss) earnings per share are as follows:

 

*(in thousands)*

 
| ** **                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                 | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted average common shares outstanding |       | 31,719                               |       | 31,885                             |       | 31,627 |   | 32,056 |   |
| Dilutive effect of stock options           |       | —                               |       | 499                                |       | — |   | 515 |   |
| Weighted average common shares outstanding |       | 31,719                               |       | 32,384                             |       | 31,627 |   | 32,571 |   |

 

The Companyhas excluded the effects of outstanding stock options from the calculation ofdiluted net loss per share for the three and six months ended June 30,2004 because such securities would be anti-dilutive.  The number of anti-dilutive options andwarrants outstanding, prior to consideration of the treasury stock method,****were 3,126 and 2,152 for the three month periods endedJune 30, 2004 and 2003, respectively, and are not included in thecalculation of weighted average common shares outstanding.  The number of anti-dilutive options andwarrants outstanding were 3,079 and 1,981 for the six month periods endedJune 30, 2004 and 2003, respectively.

 

**Note3 – Inventory**

 

Inventory consisted of the following at June 30, 2004 andDecember 31, 2003:

 
| ** **                 | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials              |       | $                       | 6,586      |                        | $          | 12,250 |   |
| Work in process            |       | 16,213                  |       | 3,622                       |       |
| Finished goods             |       | 7,049                   |       | 10,846                      |       |
| Libraries                  |       | 10,206                  |       | 9,114                       |       |
| Total inventories, at cost |       | 40,054                  |       | 35,832                      |       |
| Less reserves              |       | (8,044                  | )          | (1,540                      | )          |
| Total inventory, net       |       | $                       | 32,010     |                        | $          | 34,292 |   |

 

As noted in Note 1 above,during the quarter ended June 30, 2004, the Company determined that thecarrying value of its natural product and chemical lead finding librariesexceeded its latest forecasted revenues. The Company’s forecasted revenues from natural product and chemical leadfinding libraries have been lowered to reflect less favorable market conditionsthan previously projected.  As a result,the Company recorded a $5,974 non-cash charge to reduce the carrying value ofits library inventories.  Additionally,the Company determined that its inventory of raw materials used in discoveryand chemical services exceeded anticipated usage and accordingly increased itsreserves for excess raw materials inventories by $888, which has been recordedas a component of cost of contract revenue in the accompanying condensedconsolidated statement of operations.

 

**Note 4 – Restructuring of Mt. Prospect**

 

On May 4, 2004, the Company announced plans toconsolidate operations by relocating its Mt. Prospect, IL operations to theCompany’s facilities in New York.  TheCompany’s proprietary biocatalysis technology platform, drug metabolismscreening, research fermentation and chemical development technologies in Mt.Prospect will be relocated to New York and continue to be fully integrated withthe Company’s drug discovery and development technologies.  The restructuring will result in the closureof the Mt. Prospect Research Center, which is expected to be completed in thefourth quarter of 2004.   Theconsolidation was initiated as a result of a lack of anticipated growth in theCompany’s chemical development services at the facility. As a result of therestructuring, 33 employees were terminated and 25 employees will be relocatingto facilities in New York.

 

10

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The Company has accounted for the restructuring costsas required by SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities” (SFAS No. 146). SFAS No. 146 requires that a liability for a cost associated withan exit or disposal activity be recognized and measured initially at its fairvalue in the period in which the liability is incurred, except for one-timetermination benefits that meet certain requirements. These actions resulted inthe recognition of $426 of restructuring charges in the second quarter of 2004.During 2004, the Company expects to continue to recognize additionalrestructuring charges primarily related to additional termination benefits of$100 and asset disposal related costs of $600.

 

The employee termination costs are included under thecaption restructuring charge in the statements of operations and therestructuring liabilities are included in accounts payable and accrued expenseson the balance sheet at June 30, 2004. The following table displays therestructuring activity and liability balances:

 

| ** **             | ** ** | **Balance At  March 31, 2004** | ** ** | **Charges** | ** ** | **Payments** | ** ** | **Balance At  June 30, 2004** | ** ** |
|------------------------|------------|-------------------------------------|------------|-------------|------------|--------------|------------|------------------------------------|------------|
|                   |       |                                |       |        |       |         |       |                               |       |
| Termination Benefits   |       | $                                   | —     |        | $          | 400          |       | $                                  | (9         | ) | $ | 391 |   |
|                   |       |                                |       |        |       |         |       |                               |       |
| Other associated costs |       | —                              |       | 26          |       | (26          | )          | —                             |       |
|                   |       |                                |       |        |       |         |       |                               |       |
| Total                  |       | $                                   | —     |        | $          | 426          |       | $                                  | (35        | ) | $ | 391 |   |

 

Costs of termination benefits relate to severancepackages, outplacement services and career counseling for employees affected bythe restructuring.

 

The Company also incurred $258 in employee andequipment relocation costs during the second quarter of 2004.  The Company expects to recognize anadditional $1,300 in employee and equipment relocation costs during theremainder of 2004.  These relocationcosts are included under the caption “selling, general and administrative” inthe statement of operations.

 

Although the Company made the determination to sell the Mt. Prospectfacility in the second quarter of 2004, it did not meet all of the criteria inSFAS No. 144 to classify these assets as held for sale during the secondquarter of 2004.  The Company expects tomeet the held for sale criteria in the second half of 2004.  Upon qualifying for held for sale treatment,the long-lived assets associated with Mt. Prospect will be segregated to aseparate line item on the consolidated balance sheet until sold anddepreciation expense will cease respective to those assets.

 

The above restructuring activity was recorded exclusively in the AMRoperating segment.  The net cash outflowrelated to the restructuring for the quarter ended June 30, 2004 was$35.  Anticipated cash outflows relatedto the restructuring for the third and fourth quarters of 2004 are $1,091,which primarily consists of additional termination benefits and asset disposalcosts.

 

**Note 5 - Impairment of Long-Lived and Intangible Assets**

 

During the quarter ended June 30, 2004, due to the triggeringevents discussed in Note 1, the Company performed SFAS 144 analyses of itsproperty and equipment for potential impairment at its Mt. Prospect ResearchCenter and its Bothell facility. The Company’s analyses concluded that thecarrying value of the respective asset groups exceeded their fair value.  The impairment will be allocated to thelong-lived assets of the groups on a pro-rata basis.  Accordingly, our Mt. Prospect Research Centerand Bothell Research Center recorded impairment losses on its long-lived assetsof $1,615 and $3,113, respectively.  TheCompany utilized the assistance of an independent valuation firm in determiningfair values.

 

Due to the write-down of the Company’s natural product libraries, theCompany also performed an assessment of the carrying value of its microbialcultures and related technologies. The microbial cultures and relatedtechnologies are the starting materials and technology used in the developmentof the natural product libraries and therefore would be used to makeincremental copies of the natural product libraries.  Based on its assessment, the Companyconcluded that the carrying value of the microbial cultures and relatedtechnologies was not recoverable, and accordingly recorded a $3,541 impairmentcharge representing the entire remaining carrying value of microbial culturesand related technologies.

 

 

11

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The components ofintangible assets are as follows:

 
| ** **                   | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** | **Amortization  Period** | ** ** |
|------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|--------------------------|------------|
| **June 30,  2004**      |       |     |       |                          |       |    |       |                     |       |
| Microbial Cultures           |       | $        | —     |                          | $          | —  |       | $                        | —     |   | 15 years |   |
| Patents and Licensing Rights |       | 1,321    |       | 198                           |       | 1,123   |       | 16 years                 |       |
|                         |       | $        | 1,321      |                          | $          | 198     |       | $                        | 1,123      |   |   |   |
|                         |       |     |       |                          |       |    |       |                     |       |
| **December 31,  2003**  |       |     |       |                          |       |    |       |                     |       |
| Microbial Cultures           |       | $        | 4,511      |                          | $          | 751     |       | $                        | 3,760      |   | 15 years |   |
| Patents and Licensing Rights |       | 1,231    |       | 127                           |       | 1,104   |       | 16 years                 |       |
|                         |       | $        | 5,742      |                          | $          | 878     |       | $                        | 4,864      |   |   |   |

 

Amortization expense relatedto intangible assets for the three months ended June 30, 2004 was $155.

 

Estimated future annual amortization expense related to intangibleassets is approximately $86 per year through the year ended December 31,2017.

 

**Note 6 – Goodwill**

 

During the quarter ended June 30, 2004, due to the triggeringevents discussed in Notes 1 and 5, the Company determined that the carryingvalue of its goodwill at its Bothell reporting unit may be impaired.  Accordingly, the Company conducted a goodwillimpairment review as required under SFAS 142, and concluded that an impairmenthad occurred and therefore recorded a $13,251 goodwill impairment charge, whichreflects a full impairment of the Bothell goodwill.  In calculating the goodwill impairmentcharge, the fair value of the Bothell reporting unit was determined with theassistance of an independent valuation advisor using a discounted cash flowvaluation approach.  Significantassumptions used in this analysis include (i) expected future revenue growthrates, reporting unit profit margins, and working capital levels, (ii) adiscount rate, and (iii) a terminal value multiple. The revenue growth rates,working capital levels and reporting unit profit margins were based onmanagement’s best estimate of future results.

 

As further noted in Notes 1, 4 and 5, during the quarter endedJune 30, 2004, the Company announced its decision to close its Mt.Prospect facility and consolidate operations in New York. This restructuringand related impairment of property and equipment were considered triggeringevents under SFAS 142.  Accordingly, theCompany conducted a goodwill impairment review as required under SFAS 142. TheCompany completed its assessment and concluded that an impairment had occurredand recorded a $1,243 goodwill impairment charge based upon a valuation of thereporting unit.  The valuation wasprepared with the assistance of an independent valuation advisor using adiscounted cash flow approach. Significant assumptions used were similar to those used for the Bothellreporting unit valuation.

 

The changes inthe carrying amount of goodwill, by segment, for the six months endedJune 30, 2004 and the year ended December 31, 2003 is as follows: 

 
| ** **                         | ** ** | **AMR** | ** ** | **Organichem** | ** ** | **Total** | ** ** |
|------------------------------------|------------|---------|------------|----------------|------------|-----------|------------|
| Balance as of January 1, 2004 |       | $       | 17,180     |           | $          | 24,876    |       | $ | 42,056 |   |
| Goodwill acquired (1)              |       | —  |       | (745           | )          | (745      | )          |
| Impairment losses                  |       | (14,494 | )          | —         |       | (14,494   | )          |
| Balance as of June 30, 2004   |       | $       | 2,686      |           | $          | 24,131    |       | $ | 26,817 |   |

 

----

(1) adjustment resultingfrom the reversal of a tax valuation allowance

 

12

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| ** **                           | ** ** | **AMR** | ** ** | **Organichem** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|---------|------------|----------------|------------|-----------|------------|
| Balance as of January 1, 2003   |       | $       | 17,180     |           | $          | —    |       | $ | 17,180 |   |
| Goodwill acquired                    |       | —  |       | 24,876         |       | 24,876    |       |
| Impairment losses                    |       | —  |       | —         |       | —    |       |
| Balance as of December 31, 2003 |       | $       | 17,180     |           | $          | 24,876    |       | $ | 42,056 |   |

 

**Note 7 -****Defined Benefit and Postretirement Welfare Plan**

 

Organichem previously provided retirement benefits under twonon-contributory defined benefit plans and a non-contributory, unfundedpost-retirement welfare plan. Future benefits under all three plans have beenfrozen.

 

***Components of Net Periodic Benefit Cost***

 
| ** **                               | ** ** | **Pension  Benefits**                 | ** ** | **Postretirement  Benefits**          | ** ** | **Pension  Benefits**               | ** ** | **Postretirement  Benefits**        | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                               | ** ** | **Three Months  Ended June 30,** | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
| ** **                               | ** ** | **2004**                              | ** ** | **2003**                              | ** ** | **2004**                            | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                                  |       |                                  |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| Service Cost                             |       | $                                     | —     |                                  | $          | 141                                 |       | $                                   | 10         |   | $ | 15 |   | $ | 44 |   | $ | 283 |   | $ | 19 |   | $ | 30 |   |
| Interest Cost                            |       | 301                                   |       | 307                                   |       | 4                                   |       | 7                                   |       | 600 |   | 615 |   | 8 |   | 15 |   |
| Expected return on plan assets           |       | (283                                  | )          | (239                                  | )          | —                              |       | —                              |       | (565 | ) | (478 | ) | — |   |   |   |
| Amortization of prior service  cost |       | —                                |       | —                                |       | —                              |       | —                              |       | — |   | — |   | — |   | — |   |
| Recognized net (gain) loss               |       | 2                                     |       | —                                |       | —                              |       | —                              |       | 3 |   | — |   | — |   | 1 |   |
| Net Periodic benefit cost                |       | $                                     | 20         |                                  | $          | 209                                 |       | $                                   | 14         |   | $ | 22 |   | $ | 82 |   | $ | 420 |   | $ | 27 |   | $ | 46 |   |

 

***Employer Contributions***

 

The Company previously disclosed in its financial statement for theyear ended December 31, 2003 that it expected to contribute $2,500 to itspension plan in 2004.  As of June 30, 2004, $1,013 in contributionshave been made.  The Company continues to anticipate contributing theadditional $1,487 to fund its pension plan in 2004.

 

**Note 8 -Stock Purchase Warrants**

 

In March 2004, the Company issued warrants to purchase up to 516shares of the Company’s common stock, with exercise prices ranging from $30.24to $35.24, to Bristol-Myers Squibb Company (BMS).  The warrants expire inSeptember, 2009.  The issuance of thesewarrants results from a 2002 agreement whereby BMS transferred intellectualproperty to the Company, providing the Company with ownership of one of BMS’spreclinical drug candidates, along with patent applications covering attentiondeficit hyperactivity disorder (ADHD) and central nervous system indications.In connection with the agreement, in March 2004, the Company elected toretain ownership of the technology and all improvements made to date, resultingin the issuance of the warrants to BMS.  The issuance of these warrantssatisfies all equity-related obligations to BMS and results in the Company’sfull ownership of these preclinical drug candidates and related intellectualproperty.  Such warrants, which had a value of $3,053 on the date ofissuance, were charged to research and development costs, with a correspondingcredit to stockholders’ equity, during the three months ended March 31,2004. The value of warrants issued was determined using the Black-Scholesoption-pricing model with the following assumptions.

 
| Expected Life (years) |   | 5.5    |   |
|-----------------------|--------|--------|--------|
| Interest rate         |   | 2.73   | %      |
| Volatility            |   | 62.00  | %      |
| Dividend yield        |   | — |   |

 

13

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**Note 9 - Income Taxes**

 

The Company’s 2004 effective tax rate is impacted by the impairment ofcertain nondeductible items related to the goodwill impairment charges itrecorded in the second quarter of 2004. Non-deductible impairment charges totaling $17.1 million were treated asinfrequent discrete items in the preparation of the Company’s income taxprovision for the three months ended June 30, 2004.  The differences between income tax expenseand income taxes computed using a federal statutory rate of 35% for the threeand six months ended June 30, 2004 and 2003, were as follows:

 
| ** **                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                              | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                    |       |                                 |       |                               |       |   |   |   |   |
| Statutory tax rate                                      |       | -35.0                                | %          | 35.0                               | %          | -35.0 | % | 35.0 | % |
|                                                    |       |                                 |       |                               |       |   |   |   |   |
| Increase (reduction) in tax rate resulting  from:       |       |                                 |       |                               |       |   |   |   |   |
| Tax-free interest income                                |       | 1.14                                 | %          | -0.7                               | %          | 0.29 | % | -0.9 | % |
| Goodwill and intangible asset impairment                |       | 26.61                                | %          | 0.0                                | %          | 32.82 | % | 0.0 | % |
| State taxes, net of federal benefit                     |       | -0.88                                | %          | 1.3                                | %          | 0.23 | % | 1.8 | % |
| Non-deductable Organichem purchase  Accounting expenses |       | 0.0                                  | %          | 0.7                                | %          | 0.0 | % | 0.9 | % |
| Extraterritorial income credit                          |       | 0.97                                 | %          | -1.1                               | %          | 0.25 | % | -1.5 | % |
| Other, net                                              |       | -0.51                                | %          | 0.2                                | %          | 0.40 | % | 0.1 | % |
|                                                    |       |                                 |       |                               |       |   |   |   |   |
|                                                    |       | -7.67                                | %          | 35.4                               | %          | -1.01 | % | 35.4 | % |

 

**Note 10 – Operating Segment Data**

 

The Company has organizedits sales, marketing and production activities into the Albany MolecularResearch (AMR) and Organichem segments based on the criteria set forth in SFASNo. 131, “Disclosures about Segments of an Enterprise and RelatedInformation”.  The Company’s managementrelies on an internal management accounting system to report results of thesegments.  The system includes revenueand cost information by segment.  TheCompany’s management makes financial decisions and allocates resources based onthe information it receives from this internal system.

 

Albany Molecular Researchincludes activities such as drug lead discovery, optimization, drug developmentand small scale commercial manufacturing. Organichem 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.

 

The following tablecontains earnings data by operating segment, reconciled to consolidated totalsincluded in the financial statements:

 
| ** **                                         | ** ** | **Contract  Revenue** | ** ** | **Recurring  Royalty  Revenue** | ** ** | **Operating  (loss) income** | ** ** | **Depreciation  and  Amortization** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|---------------------------------|------------|------------------------------|------------|-------------------------------------|------------|
| **For the three  months ended June 30, 2004** |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                |       | $                     | 12,383     |                            | $          | 13,878                       |       | $                                   | (15,505    | ) | $ | 2,225 |   |
| Organichem                                         |       | 15,735                |       | —                          |       | 4,098                        |       | 1,441                               |       |
| Corporate                                          |       | —                |       | —                          |       | (11,179                      | )          | —                              |       |
| Total                                              |       | $                     | 28,118     |                            | $          | 13,878                       |       | $                                   | (22,586    | ) | $ | 3,666 |   |
|                                               |       |                  |       |                            |       |                         |       |                                |       |
| **For the three  months ended June 30, 2003** |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                |       | $                     | 16,238     |                            | $          | 15,200                       |       | $                                   | 19,275     |   | $ | 1,877 |   |
| Organichem                                         |       | 22,539                |       | —                          |       | 4,024                        |       | 1,340                               |       |
| Corporate                                          |       | —                |       | —                          |       | (10,856                      | )          | —                              |       |
| Total                                              |       | $                     | 38,777     |                            | $          | 15,200                       |       | $                                   | 12,443     |   | $ | 3,217 |   |
|                                               |       |                  |       |                            |       |                         |       |                                |       |
| **For the six months  ended June 30, 2004**   |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                |       | $                     | 26,449     |                            | $          | 23,870                       |       | $                                   | (2,801     | ) | $ | 4,317 |   |
| Organichem                                         |       | 32,483                |       | —                          |       | 7,340                        |       | 2,877                               |       |
| Corporate                                          |       | —                |       | —                          |       | (22,980                      | )          | —                              |       |
| Total                                              |       | $                     | 58,932     |                            | $          | 23,870                       |       | $                                   | (18,441    | ) | $ | 7,194 |   |
|                                               |       |                  |       |                            |       |                         |       |                                |       |
| **For the six months  ended June 30, 2003**   |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                |       | $                     | 31,951     |                            | $          | 26,300                       |       | $                                   | 34,854     |   | $ | 3,622 |   |
| Organichem                                         |       | 40,665                |       |                            |       | 6,262                        |       | 2,630                               |       |
| Corporate                                          |       | —                |       | —                          |       | (22,550                      | )          | —                              |       |
| Total                                              |       | $                     | 72,616     |                            | $          | 26,300                       |       | $                                   | 18,566     |   | $ | 6,252 |   |

 

14

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The following tablesummarizes other information by segment as of June 30, 2004:

 
| ** **                               | ** ** | **As of June 30, 2004** | ** ** |
|------------------------------------------|------------|------------------------------|------------|
| **(in thousands)**                       | ** ** | **AMR**                      | ** ** | **Organichem** | ** ** | **Total** | ** ** |
|                                     |       |                         |       |   |   |   |   |
| Total assets                             |       | 249,015                      |       | 117,865 |   | 366,880 |   |
| Goodwill included in total assets        |       | 2,686                        |       | 24,131 |   | 26,817 |   |
| Investments in unconsolidated affiliates |       | 2,230                        |       | — |   | 2,230 |   |
| Capital expenditures                     |       | 7,126                        |       | 5,645 |   | 12,771 |   |

 

**Note 11 – Financial Information by CustomerConcentration and Geographic Area**

 

Total contract revenue from AMR’s three largest customers representedapproximately 16%, 12% and 6% of AMR’s total contract revenue for the threemonths ended June 30, 2004, and 19%, 13% and 7% of total contract revenuefor the three months ended June 30, 2003. Total contract revenue fromAMR’s three largest customers represented approximately 14%, 12% and 6% ofAMR’s total contract revenue for the six months ended June 30, 2004, and13%, 9% and 8% of total contract revenue for the six months ended June 30,2003.  Total contract revenue fromOrganichem’s largest customer, Amersham Health PLC, represented 59% and 79% ofOrganichem’s total contract revenue for the three months ended June 30,2004 and 2003, respectively.  Totalcontract revenue from Organichem’s largest customer represented 69% and 74% ofOrganichem’s total contract revenue for the six months ended June 30, 2004and 2003, respectively.  Amersham HealthPLC accounted for approximately 38% and 42% of the Company’s total contract revenuefor the six months ended June 30, 2004 and 2003, respectively.

 

The Company’s total contract revenue for the three and six months endedJune 30, 2004 and 2003 was recognized from customers in the followinggeographic regions:

 
| ** **    | ** ** | **Three Months Ended June 30,** | *** *** | **Six Months Ended June 30,** | *** *** |
|---------------|------------|--------------------------------------|--------------|------------------------------------|--------------|
| ** **    | ** ** | **2004**                             | ** **   | **2003**                           | ** **   | **2004** | ** ** | **2003** | ** ** |
|          |       |                                 |         |                               |         |   |   |   |   |
| United States |       | 66                                   | %            | 47                                 | %            | 61 | % | 49 | % |
| Europe        |       | 32                                   | %            | 50                                 | %            | 36 | % | 48 | % |
| Other         |       | 2                                    | %            | 3                                  | %            | 3 | % | 3 | % |
|          |       |                                 |         |                               |         |   |   |   |   |
| Total         |       | 100                                  | %            | 100                                | %            | 100 | % | 100 | % |

 

**Note12 – Comprehensive (Loss) Income**

 

The Company is required to report comprehensive income and itscomponents in accordance with the provisions of the Financial AccountingStandards Board Statement No. 130, “Reporting Comprehensive Income.”

 

The following table presents the components of the Company’scomprehensive (loss) income for the three and six months ended June 30,2004 and 2003:

 

15

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*(in thousands)*

 
| ** **                                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                       | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net (loss) income                                                |       | $                                    | (20,773    | )                                  | $          | 8,269 |   | $ | (18,012 | ) | $ | 12,401 |   |
|                                                             |       |                                 |       |                               |       |   |   |   |   |
| Other comprehensive loss:                                        |       |                                 |       |                               |       |   |   |   |   |
| Unrealized loss on available-for-sale  securities, next of taxes |       | (324                                 | )          | (85                                | )          | (367 | ) | (214 | ) |
| Unrealized gain (loss) on Interest Rate  Swap, net of taxes      |       | 486                                  |       | (656                               | )          | 304 |   | (656 | ) |
| Total comprehensive (loss) income                                |       | $                                    | (20,611    | )                                  | $          | 7,528 |   | $ | (18,075 | ) | $ | 11,531 |   |

 

**Note 13– Legal Proceedings**

 

The Company, from time to time, may be involved in various claims andlegal proceedings arising in the ordinary course of business. Except as notedbelow in regards to litigation relating to Allegra, the Company is notcurrently a party to any such claims or proceedings which, if decided adverselyto the Company, would either individually or in the aggregate have a materialadverse effect on the Company’s business, financial condition, results ofoperations or cash flows.

 

AMR Technology, a subsidiary of the Company, along with Aventis Pharmaceuticals Inc., the U.S.pharmaceutical business of Aventis S.A., are involved in legal proceedings withseveral companies seeking to market generic versions of Allegra.  Beginning in 2001, Barr Laboratories, Inc.,Impax Laboratories, Inc., Mylan Pharmaceuticals, Inc., Teva PharmaceuticalsUSA, Dr. Reddy’s Laboratories, Ltd./Dr. Reddy’s Laboratories, Inc., Ranbaxy LaboratoriesLtd./Ranbaxy Pharmaceuticals Inc., and Sandoz Inc. filed Abbreviated NewDrug Applications (ANDAs) with the U.S. Food and Drug Administration, or FDA,to produce and market generic versions of Allegra products.

 

In response to the filings described above, beginning in 2001, AventisPharmaceuticals filed patent infringement lawsuits against Barr Laboratories,Impax Laboratories, Mylan Pharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’sLaboratories, Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., andSandoz.  Each of the lawsuits was filedin the U.S. District Court in New Jersey and alleges infringement of one ormore patents owned by Aventis Pharmaceuticals. Further, beginning in March 5, 2004, AMR Technology, along withAventis Pharmaceuticals, filed suit in the U.S. District Court in New Jerseyagainst Barr Laboratories, Impax Laboratories, Mylan Pharmaceuticals, TevaPharmaceuticals, Dr. Reddy’s Laboratories, Amino Chemicals, Ltd., andRanbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., asserting infringementof two of our U.S. patents that are exclusively licensed to AventisPharmaceuticals relating to Allegra and Allegra-D products.

 

In the pending litigations, Aventis Pharmaceuticals and AMR Technologyhave entered into covenants not to sue the defendants under U.S. Patent No.5,578,610, which patent has not been asserted in the litigation but whichAventis Pharmaceuticals exclusively licenses from us.  However, we and Aventis Pharmaceuticals haveagreed that Aventis Pharmaceuticals will continue to pay royalties to us basedon that patent under our original license agreement with AventisPharmaceuticals.  Under our arrangementswith Aventis Pharmaceuticals, we will receive royalties until expiration of theunderlying patents (2013 for U.S. Patent No. 5,578,610 and 2015 for U.S. PatentNo. 5,750,703) unless the patents are earlier determined to be invalid.

 

Under applicable federal law, marketing of an FDA-approved genericversion of Allegra may not commence until the earlier of a decision favorableto the generic challenger in the patent litigation or 30 months after the datethe patent infringement lawsuit was filed. In general, the first generic fileris entitled to a 180-day marketing exclusivity period upon FDA approval.

 

Should the Company beunsuccesful in defending these patents we would experience a material decreasein operating cash flows.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations

 

**Forward-LookingStatements**

 

The following discussion of our results of operations and financialcondition should be read in conjunction with the accompanying CondensedConsolidated Financial Statements and the Notes thereto included within thisreport. This quarterly report on Form 10-Q contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended (the “Securities Act”), and Section 21E of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”).  These statements may be identified byforward-looking words such as “may,” “could,” “should,” “would,” “will,”“intend,” “expect,” “anticipate,” “believe,” and “continue” or similar words.  The Company’s actual results may differmaterially from such forward-looking statements as a result of numerousfactors, some of which the Company may not be able to predict and may not bewithin the Company’s control.  Factorsthat could cause such differences include, but are not limited to, the Company’sability to successfully relocate and consolidate its Mt. Prospect operationswith its New York facility, the risk that the Company will not achieve the costsavings expected to result from the closure and relocation of its Mt. Prospectoperations, the Company’s ability to recruit and retain experienced scientists,trends in pharmaceutical and biotechnology companies outsourcing chemicalresearch and development, the loss of a significant customer, sales of Allegra(including any deviations in estimates provided by Aventis) and the Company’sreceipt of significant royalties from the Allegra license agreement, the riskthat Allegra may be approved for over-the-counter use, the over-the-countersales of Claritan, the over-the-counter sale of generic alternatives for thetreatment of allergies and the risk of new product introductions for thetreatment of allergies, the Company’s and Aventis’ ability to successfullyenforce their respective intellectual property, patent rights and technology,including with respect to the generic companies’ Abbreviated New DrugApplication filings, the integration and operating risks associated with theCompany’s acquisition of Organichem, the Company’s ability to successfullydevelop novel compounds and lead candidates in its collaborative arrangements,the Company’s ability to take advantage of proprietary technology and expandthe scientific tools available to it, the ability of the Company’s strategicinvestments and acquisitions to perform as expected and goodwill impairmentrelated to such investments and acquisitions, the Company’s ability tosuccessfully complete its ongoing expansion projects on schedule, the Company’sability to execute its business plan for compound and chemical screeninglibraries, and the Company’s ability to effectively manage its growth, as wellas those discussed in the Company’s Annual Report on Form 10-K for the yearended December 31, 2003 as filed with the Securities and ExchangeCommission on March 15, 2004.  Allforward-looking statements are made as of the date of this report, and we donot undertake to update any such forward-looking statements in the future.  References to “we,” “us,” and “our,” refersto Albany Molecular Research, Inc. and its subsidiaries, taken as a whole.

 

**Overview**

 

We are a leading chemistry-based drug discovery and developmentcompany, focused on identifying and developing novel biologically active smallmolecules with applications in the prescription drug market. We engage incomprehensive chemistry research from lead discovery, optimization anddevelopment to commercial manufacturing and conduct cell and non-cell basedhigh throughput screening on a variety of biological targets. We performcontract research services for many of the leading pharmaceutical and biotechnologycompanies and also conduct our own internal proprietary research anddevelopment to discover new therapeutically-active lead compounds withcommercial potential. We anticipate that we would then license these compoundsto third parties in return for up-front service fees and milestone payments aswell as recurring royalty payments if these compounds are developed into newcommercial drugs. In 1995, our proprietary research and development activitiesled to the development, patenting and licensing of a substantially pure formof, and a manufacturing process for, the active ingredient in the non-sedatingantihistamine fexofenadine HCl marketed by Aventis S.A. as Allegra in theAmericas and as Telfast elsewhere. In addition, certain of our discovery technologycontracts provide for us to receive milestone and royalty payments fordiscoveries that lead to commercial products.

 

Our total revenue for the quarter ended June 30, 2004 was$42.0 million, including $28.1 million from our chemistry contractbusiness, as compared to $54.0 million for the quarter ended June 30,2003.  Contract revenue for the secondquarter of 2004 decreased $10.7 million from $38.8 million in the secondquarter of 2003.  The decline in contractrevenue is primarily due to a shift in the annual delivery schedule forOrganichem’s largest customer, continued off-shore competition, pricingpressures and reductions in chemistry spending by pharmaceutical andbiotechnology companies.  Consolidatedgross margin was (2.5%) for the quarter ended June 30, 2004 compared to24.8% for the quarter ended June 30, 2003. Gross profit margin for Organichem in the second quarter of 2004 was26.0%, compared to 17.9% in the second quarter of 2003.  The improvementin Organichem’s gross margin is primarily attributable to cost reductionefforts implemented subsequent to AMRI’s acquisition of Organichem.  Gross margin at the AMR operating segmentdecreased to (38.8%) in the second quarter of 2004 compared to 34.5% for thesame period in 2003, primarily due to the write-down in the carrying value ofthe Company’s natural product and chemical library inventories of $6.0 million,the fixed cost components of AMRI’s contract business on lower revenues,competitive pricing pressures and the $0.9 million increase in reserves forexcess raw materials.

 

 

17

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During the quarter ended June 30, 2004, we generated$2.3 million****in cash from operations and spent$7.0 million in capital on our facilities and equipment, primarily relatedto the expansion of our manufacturing suites at Organichem.  As of June 30, 2004, we had $121.7million in cash, cash equivalents and investments and $55.3 million inbank and other related debt.

 

The business environment for chemistry outsourcing continued to bechallenging in the second quarter of 2004. Our customers remain under budgetarypressures and are currently spending a greater portion of their research anddevelopment dollars on later stage development projects. While overall pharmaceuticalspending is projected to increase in 2004, in certain areas of our businessthere has been a significant increase in foreign competition that hassubstantially lower cost structures. The lower cost structures result fromparts of the world where salaries are a fraction of what they are inindustrialized countries. This trend has resulted in lost business and hasbrought pricing pressures in the U.S., impacting our ability to increase ormaintain pricing on our customer contracts. We expect the increase incompetition from lower cost locations, such as Asia and India, to continue.

 

We are currently assessing several strategies to establish operationsin a lower-cost, off-shore environment. We believe the ability to offer customers a choice of business modelsand cost structures to meet their drug discovery needs would be a competitiveadvantage.  We anticipate completing ourassessment in the next several months.

 

Total contract revenue from Organichem’s largest customer, AmershamHealth PLC, represented 59% and 79% of Organichem’s total contract revenue forthe three months ended June 30, 2004 and 2003, respectively.  Total contract revenue from Organichem’slargest customer, Amersham Health PLC, represented 69% and 74% of Organichem’stotal contract revenue for the six months ended June 30, 2004 and 2003,respectively.  Amersham Health PLCaccounted for approximately 38% and 42% of our consolidated contract revenuefor the six months ended June 30, 2004 and 2003, respectively.

 

Included in total revenue for the quarter ended June 30, 2004 was$13.9 million in Allegra royalties compared to $15.2 million for the quarterended June 30, 2003.  The marketingof Claritin as an over-the-counter (OTC) drug, the subsequent marketing ofgeneric alternatives to Claritin, and health maintenance organization (HMO)programs attempting to direct consumers towards OTC antihistamines, contributedto the 9% decline in royalties compared to the second quarter of 2003.

 

**Mt. Prospect Restructuring and Impairments**

 

We continue to control our costs and seek opportunities to improveoverall operating margins.  As part ofthis process, on May 4, 2004 we announced our restructuring plan to consolidateoperations by relocating our Mt. Prospect operations to our facilities in NewYork.  AMR’s proprietary biocatalysistechnology platform, drug metabolism screening, research fermentation andchemical development technologies in Mt. Prospect will be relocated to New Yorkand continue to be fully integrated with AMRI’s drug discovery and developmenttechnologies.  The consolidation of thesetechnologies will result in the closure of the Mt. Prospect Research Center,which is anticipated to occur during the fourth quarter of 2004.  The consolidation was initiated as a resultof a lack of anticipated growth in the Company’s chemical development servicesat the facility.  As a result of therestructuring, 33 employees were terminated and 25 employees will be relocatingto facilities in New York.

 

During the second quarter of 2004 we incurred restructuring costsrelated to the Mt. Prospect Research Center restructuring totaling $0.4million, primarily related to termination benefits. We expect to incuradditional restructuring costs in the third and fourth quarter of 2004 of up to$0.7 million, comprised of $0.1 million of additional termination benefits and$0.6 million of asset disposal related costs. During the second quarter of 2004 we also incurred $0.2 million in costsrelated to the relocation of employees from Mt. Prospect to Albany.  We expect to incur an additional $1.3 millionin employee and equipment relocation costs in the third and fourth quarters of2004.  We also recorded a $1.6 millionimpairment charge in the second quarter of 2004, in accordance with theprovision of SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets” (SFAS 144).  Thisimpairment charge was required to write-down the carrying value of the Mt.Prospect facility and related machinery and equipment to its estimated fairvalue.

 

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Our decision to close the Mt. Prospect facility and consolidateoperations in New York, along with the impairment charges recognized inconnection with our assessment of the impairment of the Mt. Prospect propertyand equipment, were considered triggering events under SFAS 142, “Goodwill andOther Intangible Assets” (SFAS 142). Accordingly, we conducted a goodwill impairment review as required underSFAS 142 as of June 30, 2004 and concluded that an impairment of thegoodwill at the Mt. Prospect reporting unit had occurred as of that date. We****recorded a $1.2 million goodwill impairment charge basedupon a valuation of the reporting unit prepared by an independent valuationadvisor using a discounted cash flow approach.

 

We are currently marketing the Mt. Prospect Research Center facilityfor sale.  Upon qualifying for held forsale treatment, the long-lived assets associated with Mt. Prospect will besegregated to a separate line item on the consolidated balance sheet until soldand depreciation expense will cease respective to those assets. We anticipatethat as a result of this restructuring, we will experience annual expensesavings up to $5.0 million starting in 2005 resulting from a reduction infacility and labor costs.

 

**Bothell Library Inventory Write-Off and Asset Impairment**

 

In connection with the preparation of our results of operations for thequarter ended June 30, 2004, we completed an in-depth review of thecarrying value of our library inventories. As previously disclosed, we made certain investments in 2003 which webelieved would enhance our ability to market and sell our natural productlibraries and achieve certain revenue targets. We also disclosed that if wewere not able to successfully execute against our business plan within certaintime constraints, including the achievement of revenue targets, or if marketconditions were less favorable than those projected by management, we might berequired to write-down the value of certain library assets and related goodwilland intangible assets. After investing in expanded marketing and sales efforts,we have not been able to achieve any sales or signed purchase commitments forour natural product libraries during the six months ended June 30, 2004,or through the date of the filing of this Form 10-Q.  As a result of our recent review, we recordeda reserve of $6.0 million to reduce the carrying value of our inventories.  The reduction in the carrying value of ourlibrary inventories reflects the less favorable market conditions thanpreviously projected by management and an excess quantity and carrying value ofinventory on hand compared to projected future sales revenue. We****continue to monitor the carrying value of our remainingnatural product and lead finding sample collections for impairment.  If we are unable to meet forecasted revenuesrelated to those assets or if actual market conditions are less favorable thanthose projected, we may be required to write-down all or a portion of theremaining value of certain compound library assets (totaling $4.2 million atJune 30, 2004), resulting in a charge to operations.

 

In connectionwith our reduction in carrying value of natural product inventories, we alsoperformed an assessment of the carrying value of our microbial cultures andrelated technologies. The microbial cultures and related technologies are thestarting materials and technology used in the development of the naturalproduct libraries and therefore would be used to make incremental copies of thenatural product libraries.  Based on our****assessment, we concluded that the carrying value of themicrobial cultures and related technologies was not recoverable, andaccordingly recorded an impairment charge of $3.5 million representing theentire remaining carrying value of microbial cultures and related technologies.

 

We determined that the reduction in the carrying value of the Bothelllibrary inventories was a triggering event under SFAS 144.  Based on the results of our SFAS 144analysis,  we also recorded a $3.1million reduction in the fair value of our property and equipment at Bothellbased upon a valuation of these assets utilizing the assistance of anindependent valuation advisor.

 

We determined that the write-down of the inventory, microbial cultures,and property and equipment at Bothell were triggering events under SFAS 142 andthat the carrying value of our goodwill at the Bothell reporting unit may beimpaired.  Accordingly, we****conducted a goodwill impairment review as required underSFAS 142 as of June 30, 2004 and concluded that an impairment had occurredwhich resulted in a $13.3 million goodwill impairment charge.  In calculating the goodwill impairmentcharge, the fair value of the Bothell reporting unit was determined with theassistance of an independent valuation advisor using a discounted cash flowvaluation approach.  Significantassumptions used in this analysis include (i) expected future revenue growthrates, reporting unit profit margins, and working capital levels, (ii) a discountrate, and (iii) a terminal value multiple. The revenue growth rates, workingcapital levels and reporting unit profit margins were based on management’sbest estimate of future results.

 

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**Warrant Issuance**

 

In March 2004, we issued warrants to purchase up to 516,232 sharesof our common stock, with exercise prices ranging from $30.24 to $35.24 toBristol-Myers Squibb Company (BMS).  The exercise period for thesewarrants is 5.5 years.  The issuance ofthese warrants results from a 2002 agreement whereby BMS transferredintellectual property to us, providing us with ownership of one of BMS’spreclinical drug candidates, along with patent applications covering attentiondeficit hyperactivity disorder (ADHD) and central nervous system indications.In connection with the agreement, in March 2004, we elected to retainownership of the technology and all improvements made to date by us, resultingin the issuance of the warrants to BMS.  The issuance of these warrantssatisfies all equity-related obligations to BMS and results in our fullownership of these preclinical drug candidates and related intellectualproperty.  Such warrants, which had a value of $3.1 million on the date ofissuance, were charged to research and development costs with a correspondingcredit to stockholders’ equity during the period ended March 31, 2004. Thevalue of warrants issued was determined using the Black-Scholes option-pricingmodel.

 

**Strategy**

 

We continue to execute a long-term strategy to grow our platformchemistry services business while leveraging our proprietary technologies andcapabilities to provide greater value to our customers and further growth forthe company.  We have enhanced ourchemistry service offerings with the addition of our high throughput screeningexpertise and technologies, the addition of Eli Lilly and Co.’s natural productcollection, ongoing production of our semi-exclusive synthetic chemical libraryand the development of our diverse chemical sample collection. We believe thatthe pharmaceutical industry is placing more emphasis on the quality and contentof compound libraries and their related screening versus the quantity of thecompounds. We have also enhanced our service offerings with the addition ofcertain physical chemistry services to evaluate polymorphic forms and crystalhabits and to evaluate salt selection for potential new drug candidates.

 

In early 2003 we completed the full acquisition of Organichem.Organichem strategically positions us to offer high quality clinical trial andlarge scale cGMP production capabilities for our customers, as well asexpertise in high potency and controlled drug substance manufacturing whichprovide higher profit margins. We have realized strategic benefits fromOrganichem by successfully transitioning several of our customer’s clinicalsupply manufacturing projects from our smaller scale chemistry laboratoriesinto the facilities of Organichem. We will continue to seek opportunities toadd services and technologies that add value to our customers. We are alsoevaluating opportunities to leverage our large-scale cGMP production facilitiesat Organichem, including identifying niche products to manufacture and sell aswell as assessing complementary lines of business that support cGMP production.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to bad debts, inventories, intangibleassets, equity investments, unbilled revenue, income taxes and contingencies.We base our estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Actualresults may differ from these estimates under different assumptions orconditions.

 

We incorporate by reference the section “Management’s Discussionand Analysis of Financial Condition and Results of Operation — CriticalAccounting Estimates” of our Annual Report on Form 10-K for the fiscal yearended December 31, 2003. Changes or modifications to the policies sinceDecember 31, 2003 are included below.

 

**Inventory**

 

**Natural Product and Lead Finding SampleCollections**

 

As part of our strategy to provide a comprehensive offering of naturalproduct and chemical lead finding discovery services and technologies to ourcustomers, we have acquired natural product sample collections and relatedassets and are producing novel compound libraries and chemical screeningcollections. The natural product sample collections were

 

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acquired in connection with the 2001 acquisition of New ChemicalEntities.  We are capitalizing the costof internally producing our novel compound and screening collections in ourinventory. Initial costs to develop our novel compound libraries arecategorized as research and development expense until such time it becomesprobable that a saleable library can be successfully produced. As a result,costs for the design, research, and testing of libraries under development areexpensed as incurred. Our research chemists review the results of analyticalprocedures to determine if the chemical reactions were completed as expectedand the product purity and product yields are within required specifications.This “validation” process determines whether the chemistry is successful and ifa saleable product will result. We capitalize costs of production to inventoryonce the validation process is completed and successful production isreasonably assured. If a core reaction is unsuccessful, the library template isabandoned and no further development takes place.

 

We launched our novel semi-exclusive compound library of approximately30,000 compounds in 2002 on a semi-exclusive basis. We sold nine copies of thisnovel compound library in 2003 and 2004 and realized revenue of$2.1 million. We are currently preparing our second and thirdsemi-exclusive library offering which we expect to market in late 2004. AtJune 30, 2004 the inventory value of our semi-exclusive libraries on ourconsolidated balance sheet was $1.9 million.

 

In February 2003, we acquired Eli Lilly and Co.’s collection ofnatural product libraries including source materials, purified screeninglibrary samples, chemical analytical data and chemistry database tools. As partof our collaboration with Eli Lilly, we also significantly enhanced ourbiological screening capabilities. Our investment in biological screeningcapabilities became operational in January 2004.

 

We anticipate completing our chemical screening library ofapproximately 125,000 diverse compounds in the fourth quarter of 2004.  We anticipate marketing this library as astand-alone drug discovery service offering and as part of a larger discoverycollaboration including target screening and other of our  service offerings. We also plan to utilizethis library for internal research and development projects.  At June 30, 2004 the inventory value ofour chemical screening library on our balance sheet was $2.0 million.

 

On a quarterly basis we evaluate the net realizable value of ourinventories.  We write down inventoriesif the carrying value of the inventory is greater than its estimated netrealizable value based upon assumptions about future demand and marketconditions.

 

During the quarter ended June 30, 2004, we completed an in-depthreview of the carrying value of our library inventories and recorded a reserveto write-down the carrying value of those inventories.  See Overview section for a discussion ofthe results of these analyses.

 

**Valuation of Long-Lived Assets**

 

We periodically review for continued appropriateness the carrying value of our long-lived assets.  This review is based on our projections of anticipated undiscounted future cash flows. If indicators of impairment are present, we would evaluate the undiscounted cash flows estimated to be generated by those assets compared to the carrying amount of those items. The net carrying value of assets not recoverable would be reduced to fair value. While we believe that our estimates of undiscounted future cash flows are reasonable, different assumptions regarding such cash flows and comparable sales values could materially affect our evaluations.  Indicators we consider 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.

 

As a result of our decision to close our Mt. Prospect Research Center and write-down our library inventories in Bothell (both of which were considered triggering events), we reviewed the carrying amount of the respective long-lived assets compared to their fair value.  We recorded pre-tax noncash charges of $1.6 million and $3.1 million, respectively, related to the impairment of these long-lived assets. Fair value was established with the assistance of an independent valuation advisor.  See Overview section for a discussion of the results of these analyses.

 

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**Goodwill**

 

We perform an annual assessment of the carrying value of our goodwillfor potential impairment or on an interim basis if certain triggering eventsoccur. A determination of impairment is made based upon the estimated futurecash flows of the operations associated with goodwill. If goodwill isdetermined to be impaired in the future we would be required to record a chargeto our results of operations. Factors we consider important which could resultin an impairment include the following:

 

•                                          significantunderperformance relative to historical or projected future operating results;

 

•                                          significantchanges in the manner of our use of the acquired assets or the strategy for ouroverall business;

 

•                                          significantnegative industry or economic trends; and

 

•                                          ourmarket capitalization relative to net book value.

 

As a result of our decision to close our Mt. Prospect Research Centerand the write-down of our library inventories (both of which were consideredtriggering events) and related long-lived assets, we performed a goodwillimpairment analysis on the effected reporting units.  See Overview section for a discussion ofthe results of these analyses.  Ourannual goodwill assessment is performed in the third quarter of each year andgoodwill at our other reporting units will be assessed at that time.

 

We have $26.8 million of goodwill on our consolidated balancesheet as of June 30, 2004. Approximately $24.1 million of this goodwill balance relates to theacquisition of Organichem.   Thisgoodwill will be assessed during the third quarter for impairment.

 

Ifmanagement’s expectations of future operating results change, or if there arechanges to other assumptions, the estimate of the fair value of our reportingunits could change significantly. Such a change could result in additionalgoodwill impairment charges in future periods, which could have a significantimpact on our consolidated financial statements.

 

**Intangible Assets**

 

Our intangible assets are amortized on a straight-line basis overfifteen to sixteen years. We review our intangible assets for impairmentwhenever events or changes in circumstances indicate that the carrying value ofthe assets may not be recoverable. A determination of impairment is made basedon estimates of future cash flows. If such assets are considered to be impairedthe amount of the impairment would be based on the excess of the carrying valueover the fair value of the assets. Factors that could result in impairment include those listed under“Valuation of Long-Lived Assets” above.

 

During the quarter ended June 30, 2004, we wrote off the entirevalue of our microbial culture and related technology intangible assets as aresult of the write-down of our natural products library inventory, which arecreated from our microbial cultures.  SeeOverview section for a discussion of the results of these analyses.

 

**Results of Operations – Three Months and Six Months Ended June 30,2004 Compared to Three Months and Six Months Ended June 30, 2003**

 

***Revenues***

 

*Total contract revenue*

 

Contract revenue consists primarily of fees earned under contracts withour third party customers.  Our contractrevenues for each of our AMR and Organichem segments were as follows:

 

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| ** **          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in  thousands)** | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                |       |                                 |       |                               |       |   |   |   |   |
| AMR                 |       | $                                    | 12,383     |                               | $          | 16,238 |   | $ | 26,449 |   | $ | 31,951 |   |
| Organichem          |       | 15,735                               |       | 22,539                             |       | $ | 32,483 |   | $ | 40,665 |   |
| Total               |       | $                                    | 28,118     |                               | $          | 38,777 |   | $ | 58,932 |   | $ | 72,616 |   |

 

AMR contract revenues for the quarter ended June 30, 2004,decreased $3.8 million to $12.4 million as compared to $16.2 million for thesame quarter in the prior year.  Thedecrease is primarily due to continued offshore competition, pricing pressuresand reductions in chemistry spending by pharmaceutical and biotechnologycompanies.  We see this negative trendcontinuing, at least for the short term. Organichem contract revenues for the second quarter of 2004 were $15.7million, a decrease of $6.8 million compared to contract revenue of $22.5million during the second quarter of 2003. Organichem’s contract revenue decreased primarily due to a shift in theannual delivery schedule for their largest customer.  During the second quarter of 2004, sales toOrganichem’s largest customer were $9.2 million, compared to $18.1 million forthe comparable period in 2003, a 49% decrease. For the six months endedJune 30, 2004, AMR contract revenue has decreased 17%, primarilyattributable to continued offshore competition, pricing pressures andreductions in chemistry spending by pharmaceutical and biotechnologycompanies.  Organichem contract revenuesfor the six months ended June 30, 2004 decreased 20% due to a shift in theannual delivery schedule for their largest customer.  We anticipate Organichem contract revenuefrom its largest customer for the full year 2004 to decline by approximately$4.0 million or 8% from the full year 2003 

 

*Recurring royalty revenue*

 

We earn royalties under our licensing agreement with Aventis S.A. forthe active ingredient in Allegra/Telfast. Royalties were as follows:

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(in thousands)**                   | ** ** |
| $                                    | 13,878     |                               | $          | 15,200 |   | $ | 23,870 |   | $ | 26,300 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The 9% decrease in royalty revenue for the three and six months endedJune 30, 2004, respectively, was attributable to decreased sales ofAllegra by Aventis due to the sale of Claritin and other generic alternativesto Claritin as OTC drugs.

 

***Costs and Expenses***

 

*Cost of contract revenue*

 

Our cost of contract revenue, from which we derive gross profit fromcontract revenue, consists primarily of compensation and associated fringebenefits for employees, chemicals, depreciation and other indirect projectrelated costs.  Cost of contract revenuefor our AMR and Organichem segments were as follows;

 

| **Segment**             | ** **   | **Three Months Ended June 30,** | ** **   | **Six Months Ended June 30,** | ** **   |
|-------------------------|--------------|--------------------------------------|--------------|------------------------------------|--------------|
| **(in  thousands)**     | ** **   | **2004**                             | ** **   | **2003**                           | ** **   | **2004** | ** ** | **2003** | ** ** |
| *** ***            | *** *** | *** ***                         | *** *** | *** ***                       | *** *** | *** *** | *** *** | *** *** | *** *** |
| AMR                     |         | $                                    | 17,190       |                               | $            | 10,643 |   | $ | 27,546 |   | $ | 20,767 |   |
| Organichem              |         | 11,637                               |         | 18,515                             |         | 25,143 |   | 34,403 |   |
| Total                   |         | $                                    | 28,827       |                               | $            | 29,158 |   | $ | 52,689 |   | $ | 55,170 |   |
|                    |         |                                 |         |                               |         |   |   |   |   |
| AMR Gross Margin        |         | (39                                  | )%           | 35                                 | %            | (4 | )% | 35 | % |
| Organichem Gross Margin |         | 26                                   | %            | 18                                 | %            | 23 | % | 15 | % |
| Total Gross Margin      |         | (3                                   | )%           | 25                                 | %            | 11 | % | 24 | % |

 

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AMR had a negative contract revenue gross margin of (39%) and (4%) forthe three and six months ended June 30, 2004, respectively, compared topositive gross margin of 35% for the same periods in 2003.  The decline in gross margin largely resultedfrom the reduction in carrying value of our natural product and chemicallibrary inventories by $6.0 million during the quarter ended June 30,2004, as well as the decline in contract revenues, and the fixed costcomponents of AMR’s contract business. In addition, we recorded $0.9 million in additional raw materialinventory reserves in the second quarter of 2004.  Organichem’s contract revenue gross marginincreased to 26% and 23% for the three and six months ended June 30, 2004compared to 18% and 15% for the same periods in 2003.  The increase was due to product mix as wellas cost reduction efforts implemented subsequent to our acquisition ofOrganichem in 2003.

 

*Technology incentive award*

 

We maintain a Technology Development Incentive Plan, the purpose ofwhich is to stimulate and encourage novel innovative technology development byour employees.  This plan allows eligibleparticipants to share in a percentage of the net revenue earned by us relatingto patented technology with respect to which the eligible participant is namedas an inventor.  The award is payableprimarily to Dr. Thomas D’Ambra, the Chief Executive Officer and President ofthe Company.  The incentive award was asfollows:

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(in thousands)**                   | ** ** |
|                                 |       |                               |       |   |   |   |   |
| $                                    | 1,387      |                               | $          | 1,520 |   | $ | 2,385 |   | $ | 2,630 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The decrease was attributed to decreased Allegra royalties for 2004 ascompared to 2003.

 

*Research and development*

 

Research and development expense consists of compensation and benefitsfor scientific personnel for work performed on proprietary technologydevelopment, research projects, costs of chemicals and other out of pocketcosts and overhead costs. In addition, research and development is performed atOrganichem related to the improvement of production processes as well asresearch related to the potential manufacture of new products.  Research and development expenses were asfollows:

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(in thousands)**                   | ** ** |
|                                 |       |                               |       |   |   |   |   |
| $                                    | 5,368      |                               | $          | 5,552 |   | $ | 13,248 |   | $ | 11,117 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The slight decrease in R&D spending during the three months endedJune 30, 2004 is attributable to lower costs incurred on our internalresearch programs.  We continue tofurther develop the technologies we own in the central nervous system,bioscience and natural product drug discovery areas.   We expect our research and development coststo remain at these levels for the remainder of 2004.  R&D expenses for the six months endedJune 30, 2004 includes $3.1 million in expenses recorded for the issuanceof warrants to BMS relating to intellectual property transferred to us,partially offset by reduced expenditures on internal research programs.

 

*Selling, general and administrative*

 

Selling, general and administrative expenses consists of compensationand related fringe benefits for marketing and administrative employees,professional service fees, marketing costs and all costs related to facilitiesand information services.  Selling,general and administrative expenses were as follows:

 

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| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(in thousands)**                   | ** ** |
|                                 |       |                               |       |   |   |   |   |
| $                                    | 5,811      |                               | $          | 5,304 |   | $ | 9,732 |   | $ | 11,433 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The increase in selling, general and administrative expenses for thesecond quarter of 2004 is attributable to approximately $0.8 million inprofessional fees related to our Sarbanes Oxley compliance initiatives andother accounting and valuation services, and $0.3 million of employee relocationcosts related to the closure of our Mt. Prospect facility.  We expect to incur up to $1.3 million inadditional relocation costs in the third and fourth quarter of 2004 related tothe Mt. Prospect restructuring – see Overview. We also expect to continue to incur increased consulting costs relatedto our Sarbanes Oxley compliance initiatives over the next severalquarters.  The decrease in selling,general and administrative expenses for the six months ended June 30, 2004is primarily attributable to decrease in bad debt expense of $0.4 million,decreased recruiting costs of $0.5 million and cost saving synergies from theacquisition of Organichem.

 

*Impairment and Restructuring Charges*

 

As ofJune 30, 2004 we completed an in-depth review of the carrying value of allof our natural product and chemical compound library inventories. As a resultof this review, which was based on expected future revenues, it was determinedthat a significant write-down in the carrying value of library inventories wasrequired. The reduction in the carrying value of the library inventoriesreflects the less favorable market conditions than previously projected.

 

The write-down of library inventories triggered an assessment of therecoverability of certain other related long-lived assets and goodwill withinthe Bothell reporting unit, including the goodwill and intangibles whichresulted from the 2001 acquisition of New Chemical Entities (NCE), inaccordance with the provisions of SFAS 144 and SFAS 142. Based on our review, wedetermined that an impairment of certain related goodwill and long-lived assetshad occurred.

 

In addition, we initiated a restructuring which will result in theclosure of our Mt. Prospect Research Center and the consolidation of Mt.Prospect’s operations in our New York facilities. The restructuring triggeredan assessment of the carrying value of the Mt. Prospect Research Centerproperty and equipment and related goodwill. Based on its review, and inaccordance with the provisions of SFAS 144 and SFAS 142, we determined that animpairment of certain related goodwill and property and equipment hadoccurred.  Further, during the secondquarter we incurred restructuring costs related to the Mt. Prospectrestructuring.

 

Based on the foregoing, during the quarter ended June 30, 2004,the Company recorded non-cash pre-tax charges and incurred restructuring costsrelated to its Bothell and Mt. Prospect businesses as follows:

 

| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in  thousands)**               | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                              |       |                                 |       |                               |       |   |   |   |   |
| Property and equipment impairment |       | $                                    | 4,728      |                               | $          | — |   | $ | 4,728 |   | $ | — |   |
| Goodwill impairment               |       | 14,494                               |       | —                             |       | 14,494 |   | — |   |
| Intangible asset impairment       |       | 3,541                                |       | —                             |       | 3,541 |   | — |   |
| Restructuring charge              |       | 426                                  |       | —                             |       | 426 |   | — |   |
|                                   |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

See Overview section for a more detailed discussion.

 

Property & Equipment Impairment

 

The $4.7 million property and equipment impairment charge recorded inthe second quarter of 2004 relates to two impairment analyses performed as aresult of certain triggering events.  A$1.6 million property and equipment impairment charge was recorded due toour Mt. Prospect Research Center facility closure.  During the quarter ended June 30, 2004,we announced the closure of the Mt. Prospect facility.  It was determined that the carrying value ofthe assets was in excess of the fair value of the asset group and we recorded awrite-down of $1.6 million. Additionally, a $3.1 million property andequipment impairment charge was recorded due to an impairment analysis that wasperformed as a result of the reduction in

 

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the carrying value of the library inventories at our Bothell ResearchCenter.  As a result of the impairmentanalysis, it was determined that the carrying value of the assets was in excessof the fair value of the asset group and we recorded a write-down of$3.1 million. The revised carrying value of the assets is beingdepreciated over the average remaining life of the primary assets of the group.

 

Goodwill Impairment

 

As a result of the reduction in carrying value of our natural productlibraries and related long-lived assets at our Bothell reporting unit and theannounced closure of our Mt. Prospect reporting unit, we performed goodwillimpairment analyses on each of these reporting units as of June 30,2004.  As a result of these analyses, werecorded a $13.3 million goodwill impairment charge related to our Bothellreporting unit and a $1.2 million impairment charge related to our Mt. Prospectreporting unit. In calculating the goodwill impairment charges, the fair valueof the reporting units was determined with assistance from an independentvaluation advisor.  The valuations werebased upon a discounted cash flow approach. Significant assumptions used in the analysis include (i) expected futurerevenue growth rates, reporting unit profit margins, and working capitallevels, (ii) a discount rate, and (iii) a terminal value multiple. The revenuegrowth rates, working capital levels and reporting unit profit margins werebased on management’s best estimate of future results.

 

Intangible Asset Impairment

 

As a result of our reduction in the quarter ending June 30, 2004of the carrying value of our natural product libraries, we also performed anassessment of the carrying value of our microbial cultures and relatedtechnologies, which are the starting materials and technology used in thedevelopment of the natural product libraries. Based on our assessment, we concluded that the carrying value of themicrobial cultures and related technologies was not recoverable, andaccordingly recorded an impairment charge of $3.5 million representing theentire remaining carrying value of microbial cultures and related technologies.

 

See Overview section for a more detailed discussion.

 

Restructuring

 

On May 4, 2004 we announced our plan to consolidate operations byrelocating our Mt. Prospect facility operations to our facilities in NewYork.  During the second quarter of 2004we incurred restructuring costs totaling $0.4 million, consisting primarily oftermination benefits.  We expect to incuradditional restructuring costs, including termination benefits and assetdisposal costs, in the third and fourth quarter of 2004 totaling up to $0.7million.

 

*Interest income (expense), net*

 

| ** **           | ** **   | **Three Months Ended June 30,** | ** **   | **Six Months Ended June 30,** | ** ** |
|----------------------|--------------|--------------------------------------|--------------|------------------------------------|------------|
| ** **           | ** **   | **2004**                             | ** **   | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| *** ***         | *** *** | **(in thousands)**                   | *** *** |
| Interest Expense     |         | $                                    | (385         | )                                  | $          | (353 | ) | $ | (724 | ) | $ | (823 | ) |
| Interest Income      |         | 527                                  |         | 707                                |       | 1,026 |   | 1,383 |   |
| Interest income, net |         | $                                    | 142          |                               | $          | 354 |   | $ | 302 |   | $ | 560 |   |

 

Interest expense for the second quarter and first half of 2004 wasconsistent with interest expense for the same periods in 2003.

 

The decrease in interest income was primarily due to a 50 basis pointdecrease in our average return rate in the second quarter of 2004 compared to2003 due to the maturity of higher rate bonds within our portfolio.

 

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*Income tax expense (benefit)*.

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(in thousands)**                   | ** ** |
|                                 |       |                               |       |   |   |   |   |
| $                                    | (1,670     | )                                  | $          | 4,551 |   | $ | (183 | ) | $ | 6,826 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

Our income tax expense (benefit) for the quarter ended June 30,2004, reflects the goodwill and intangible asset impairment charges asnon-deductible tax items.  Excludingthese items from income before income taxes, results in an effective tax rateof 31.03% for the quarter ended June 30, 2004 as compared to 35.5% for thesame period in 2003.  The reduction inthe effective rate resulted primarily from the impact the revised projected annualresults have in relationship to the projected annual permanentdifferences.  We expect our effective taxrate, excluding these non-deductible items, to be approximately 25% for thefull year.

                                                                       

**Liquidity and Capital Resources**

 

We have historically funded our business through operating cash flows,proceeds from borrowings and the issuance of equity securities.  During the first six months of 2004, wegenerated cash of $12.0 million from operating activities.

 

During the first six months of 2004, we used $0.8 million for investingactivities, resulting from $12.0 million from the maturity of investmentsecurities and the use of $12.8 million for the acquisition of property andequipment.  During the first six monthsof 2004, we used $1.6 million for financing activities, consisting of $2.4million in long-term debt repayments, offset by $0.8 million provided by stockoption and stock purchase plan exercises.

 

Working capital was $169.1 million at June 30, 2004 as compared to$173.6 million as of December 31, 2003. The primary source of the increase was reduction in vendor payables dueto timing of payments.  During 2004, weanticipate making $2.5 million in defined benefit pension plan contributions,$1.0 million of which was paid in the first two quarters of 2004.  There have been no significant changes infuture maturities on our long term debt since December 31, 2003.

 

We entered into a credit facility consisting of $30.0 million term loanand $35.0 million line of credit to fund the acquisition of Organichem during2003.  The term loan matures in February,2008.  As of June 30, 2004, theinterest rate on $16.4 million of the outstanding term loan balance was 4.37%and the interest rate on the remaining $8.2 million was 2.11%.  The line of credit expires inFebruary 2006 and bears interest at a variable rate based on the Company’sleverage ratio.  As of June 30,2004, the outstanding balance of the line of credit was $25.5 million and theinterest rate was 2.09%.  The creditfacility contains certain financial covenants, including a maximum leverageratio, a minimum required operating cash flow coverage ratio, a minimumearnings before interest and taxes to interest ratio and a minimum currentratio.  Other covenants include limits onasset disposals and the payment of dividends. As of June 30, 2004 we were in compliance with all covenants underthe credit facility.

 

The disclosure of payments we have committed to make under ourcontractual obligations is set forth under the heading “Management’s Discussionand Analysis of Financial Condition and Results of Operations—Liquidity andCapital Resources” under Item 7 of our 2003 Form 10-K. Excluding therepayment of $2.4 million outstanding under our credit facility, as describedabove, there have been no material changes to our contractual obligations sinceDecember 31, 2003.

 

We are pursuing the expansion of our operations through internal growthand strategic acquisitions. We expect that such activities will be funded fromexisting cash and cash equivalents, cash flow from operations, the issuance ofdebt or equity securities and borrowings. Future acquisitions, if any, could befunded with cash on hand, cash from operations, borrowings under our creditfacility and/or the issuance of equity or debt securities. There can be noassurance that attractive acquisition opportunities will be available to us orwill be available at prices and upon such other terms that are attractive tous. We regularly evaluate potential acquisitions of other businesses, productsand product lines and may hold discussions regarding such potentialacquisitions. As a general rule, we will publicly announce such acquisitionsonly after a definitive agreement has been signed. In addition, in order tomeet our long-term liquidity needs or consummate future acquisitions, we mayincur additional indebtedness or issue additional equity or debt securities,subject to market and other conditions. There can be no assurance that suchadditional financing will be available on terms acceptable to us or at all. Thefailure to raise the funds necessary to finance our future cash requirements orconsummate future acquisitions could adversely affect our ability to pursue ourstrategy and could negatively affect our operations in future periods.

 

The recurring royalties we receive on the sales of Allegra/Telfast havehistorically provided a material portion of our operating cash flows.  As discussed in Part II, Item I of this Form10-Q, several generic manufacturers have filed ANDA applications with

 

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the FDA seeking authorization to produce and market a generic versionof Allegra.  We and AventisPharmaceuticals have filed several patent infringement suits against thesegeneric companies alleging infringement of certain U.S. patents.  Should we or Aventis be unsuccessful indefending these patents we would experience a material decrease in operatingcash flows.

 

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Item 3.  Quantitative and Qualitative Disclosuresabout Market Risk

 

There are nomaterial changes in market risks since our annual report on Form 10-K for theyear ended December 31, 2003.

 

Item 4.  Controls and Procedures

 

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 disclosure controls and procedures, werecognize that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desired controlobjectives, and our management necessarily was required to apply its judgmentin evaluating and implementing possible controls and procedures. Based uponthat evaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that they believe that, as of the end of the period covered by thisQuarterly Report, our disclosure controls and procedures were effective , inthat they provide reasonable assurance that information required to bedisclosed by us in the reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.  We intend to review and document ourdisclosure controls and procedures, including our internal controls andprocedures for financial reporting, on an ongoing basis, and may from time totime make changes aimed at enhancing their effectiveness and to ensure that oursystems evolve with our business.  Therewas no change in our internal control over financial reporting that occurredduring the period covered by this Quarterly Report on Form 10-Q that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

As a result ofSection 404 of the Sarbanes-Oxley Act of 2002 and the related rulesadopted by the Securities and Exchange Commission (collectively, the“Section 404 requirements”), the Company will be required to include inits Annual Report on Form 10-K for the year ending December 31, 2004, areport on management’s assessment of the effectiveness of the Company’sinternal controls over financial reporting. The Company’s independent auditor will also be required to attest to andreport on management’s assessment.  Whilethe Company has been and continues to prepare for the Section 404requirements, a significant amount of work remains and there can be noassurance that the Company will be able to complete management’s assessment bythe December 31, 2004 deadline or that the Company’s independent auditorwill be able to complete the testing necessary to attest to management’sassessment.  Further, there can be noassurance that, if completed, management’s assessment and the auditor’sattestation will not report any material weaknesses in the Company’s internalcontrols over financial reporting.

 

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PART II -OTHER INFORMATION

 

Item 1.             Legal Proceedings

 

The Company, from time to time, may be involved in various claims andlegal proceedings arising in the ordinary course of business. Except as notedbelow in regards to litigation relating to Allegra, the Company is notcurrently a party to any such claims or proceedings which, if decided adverselyto the Company, would either individually or in the aggregate have a materialadverse effect on the Company’s business, financial condition, results ofoperations or cash flows.

 

AMR Technology, a subsidiary of the Company, along with Aventis Pharmaceuticals Inc., the U.S.pharmaceutical business of Aventis S.A., are involved in legal proceedings withseveral companies seeking to market generic versions of Allegra.  Beginning in 2001, Barr Laboratories, Inc.,Impax Laboratories, Inc., Mylan Pharmaceuticals, Inc., Teva PharmaceuticalsUSA, Dr. Reddy’s Laboratories, Ltd./Dr. Reddy’s Laboratories, Inc., RanbaxyLaboratories Ltd./Ranbaxy Pharmaceuticals Inc., and Sandoz Inc. filedAbbreviated 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, beginning in 2001, AventisPharmaceuticals filed patent infringement lawsuits against Barr Laboratories,Impax Laboratories, Mylan Pharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’sLaboratories, Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., andSandoz.  Each of the lawsuits was filedin the U.S. District Court in New Jersey and alleges infringement of one ormore patents owned by Aventis Pharmaceuticals. Further, beginning in March 5, 2004, AMR Technology, along withAventis Pharmaceuticals, filed suit in the U.S. District Court in New Jerseyagainst Barr Laboratories, Impax Laboratories, Mylan Pharmaceuticals, TevaPharmaceuticals, Dr. Reddy’s Laboratories, Amino Chemicals, Ltd., andRanbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., asserting infringementof two of our U.S. patents that are exclusively licensed to AventisPharmaceuticals relating to Allegra and Allegra-D products.

 

In the pending litigations, Aventis Pharmaceuticals and AMR Technologyhave entered into covenants not to sue the defendants under U.S. Patent No.5,578,610, which patent has not been asserted in the litigation but whichAventis Pharmaceuticals exclusively licenses from us.  However, we and Aventis Pharmaceuticals haveagreed that Aventis Pharmaceuticals will continue to pay royalties to us basedon that patent under our original license agreement with AventisPharmaceuticals.  Under our arrangements withAventis Pharmaceuticals, we will receive royalties until expiration of theunderlying patents (2013 for U.S. Patent No. 5,578,610 and 2015 for U.S. PatentNo. 5,750,703) unless the patents are earlier determined to be invalid.

 

Under applicable federal law, marketing of an FDA-approved genericversion of Allegra may not commence until the earlier of a decision favorableto the generic challenger in the patent litigation or 30 months after the datethe patent infringement lawsuit was filed. In general, the first generic fileris entitled to a 180-day marketing exclusivity period upon FDA approval.

 

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Item 4.                         Submissionof Matters to a Vote of Security Holders

 

The Company held its annual meeting of stockholders (the “AnnualMeeting”) on May 19, 2004.  At the AnnualMeeting, stockholders of the Company voted to elect Thomas E. D’Ambra, andAnthony P. Tartaglia, to serve as Class II Directors of the Company forthree-year terms, such terms to continue until the annual meeting ofstockholders in 2007 and until their respective successors are duly elected andqualified.  The votes cast for, andwithheld from, the election of the aforementioned Directors are listed below:

 

| ** **             | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|------------------------|------------|------------|------------|--------------|------------|
|                   |       |       |       |         |       |
| Thomas E. D’Ambra |       | 28,858,613 |       | 865,044      |       |
|                   |       |       |       |         |       |
| Anthony P. Tartaglia   |       | 29,073,822 |       | 649,835      |       |

 

The following individuals continued as directors following the meeting:Paul S. Anderson, Frank W. Haydu III, Donald E. Kuhla, Kevin O’Connor andArthur J. Roth.

 

Item 6.             Exhibits and Reports Filed on Form 8-K

 

(a)                      Exhibits.

 

31.1                           Certification of the ChiefExecutive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Security ExchangeAct of 1934.

 

31.2                           Certification of the ChiefFinancial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Security ExchangeAct of 1934.

 

32.1                           Certification of the ChiefExecutive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002.

 

32.2                           Certification of the ChiefFinancial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b)                     Reports onForm 8-K.

 

On May 4, 2004, Albany Molecular Research, Inc. furnished a currentreport of Form 8-K reporting under Item 12 that the Company issued a pressrelease announcing its financial results for the quarter ended March 31,2004 and furnished the press release as an exhibit.

 

On August 6, 2004, Albany Molecular Research, Inc. furnished acurrent report of Form 8-K reporting under Item 12 that the Company issued apress release announcing a delay in the release of its financial results forthe second quarter of 2004 and furnished the press release as an exhibit.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                             |       | ALBANY MOLECULAR RESEARCH, INC. |
|----------------------------------|------------|---------------------------------|
|                             |       |                            |
|                             |       |                            |   |
| Date:  August 13, 2004 |       | By:                             | /s/ Thomas E. D’Ambra, Ph.D. |   |
|                             |       |                            | Thomas E. D’Ambra, Ph.D. |
|                             |       |                            | Chairman of the Board, President and Chief Executive |
|                             |       |                            | Officer |
|                             |       |                            |   |
|                             |       |                            |   |
| Date:  August 13, 2004 |       | By:                             | /s/ David P. Waldek |   |
| ** **                       | ** ** | ** **                      | **David  P. Waldek** |
|                             |       |                            | Chief Financial Officer, Treasurer and Secretary |

 

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