**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**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, 2005**                                                                                                                   |
| ** **                                                                                                                                                              | ** ** | ** **                                                                                               | ** ** |
| **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 tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes         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, 2005** |
|-------------------------------|------------|----------------------------------------|
| Common Stock,  $.01 par value |       | 32,348,511                             |

 

 

----

 

ALBANYMOLECULAR RESEARCH, INC.

INDEX

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

 

2

----

 

PART I — FINANCIAL INFORMATION

 

Item 1.    CondensedConsolidated Financial Statements

 

**Albany Molecular Research, Inc.**

**CondensedConsolidated Statements of Operations**

**(unaudited)**

 

*(Dollars in thousands, except for per share data)*

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|----------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                         | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Contract  revenue                                  |       | $                      | 35,948     |                   | $          | 28,118 |   | $ | 72,574 |   | $ | 58,932 |   |
| Recurring  royalties                               |       | 15,892                 |       | 13,878                 |       | 27,900 |   | 23,870 |   |
| Total  revenue                                     |       | 51,840                 |       | 41,996                 |       | 100,474 |   | 82,802 |   |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Cost  of contract revenue                          |       | 29,327                 |       | 22,853                 |       | 58,463 |   | 46,715 |   |
| Write-down  of library inventories                 |       | —                 |       | 5,974                  |       | — |   | 5,974 |   |
| Total  cost of contract revenue                    |       | 29,327                 |       | 28,827                 |       | 58,463 |   | 52,689 |   |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Technology  incentive award                        |       | 1,594                  |       | 1,387                  |       | 2,795 |   | 2,385 |   |
| Research  and development                          |       | 3,480                  |       | 5,368                  |       | 6,969 |   | 13,248 |   |
| Selling,  general and administrative               |       | 6,394                  |       | 5,811                  |       | 12,846 |   | 9,732 |   |
| 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                          |       | 40,795                 |       | 64,582                 |       | 81,073 |   | 101,243 |   |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Income  (loss)  from operations               |       | 11,045                 |       | (22,586                | )          | 19,401 |   | (18,441 | ) |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Equity  in loss of unconsolidated affiliates       |       | —                 |       | —                 |       | — |   | (65 | ) |
| Interest  income, net                              |       | 320                    |       | 142                    |       | 520 |   | 302 |   |
| Other  income, net                                 |       | 67                     |       | 1                      |       | 70 |   | 9 |   |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Income  (loss) before income tax expense (benefit) |       | 11,432                 |       | (22,443                | )          | 19,991 |   | (18,195 | ) |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Income  tax expense (benefit)                      |       | 4,138                  |       | (1,670                 | )          | 7,101 |   | (183 | ) |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Net  income (loss)                                 |       | $                      | 7,294      |                   | $          | (20,773 | ) | $ | 12,890 |   | $ | (18,012 | ) |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Basic  earnings (loss) per share                   |       | $                      | 0.23       |                   | $          | (0.65 | ) | $ | 0.40 |   | $ | (0.57 | ) |
|                                               |       |                   |       |                   |       |   |   |   |   |
| Diluted  earnings (loss) per share                 |       | $                      | 0.23       |                   | $          | (0.65 | ) | $ | 0.40 |   | $ | (0.57 | ) |

 

*See notes to unaudited condensedconsolidated financial statements.*

 

3

----

 

**Albany Molecular Research, Inc.**

**CondensedConsolidated Balance Sheets**

**(unaudited)**

 

*(Dollars and share amounts in thousands)*

 
| ** **                                                                                                                                                | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                                      |       |                    |       |                        |       |
| **Assets**                                                                                                                                                |       |                    |       |                        |       |
| Current assets:                                                                                                                                           |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                 |       | $                       | 46,065     |                        | $          | 41,171 |   |
| Investment securities, available-for-sale                                                                                                                 |       | 97,276                  |       | 92,578                      |       |
| Accounts receivable, net                                                                                                                                  |       | 20,503                  |       | 14,263                      |       |
| Royalty income receivable                                                                                                                                 |       | 15,873                  |       | 12,178                      |       |
| Inventories                                                                                                                                               |       | 30,660                  |       | 32,415                      |       |
| Prepaid expenses and other current assets                                                                                                                 |       | 3,370                   |       | 3,914                       |       |
| Property and equipment held for sale                                                                                                                      |       | 5,627                   |       | 5,627                       |       |
| Total current assets                                                                                                                                      |       | 219,374                 |       | 202,146                     |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Property, plant and equipment, net                                                                                                                        |       | 145,389                 |       | 145,753                     |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Other assets:                                                                                                                                             |       |                    |       |                        |       |
| Goodwill                                                                                                                                                  |       | 25,747                  |       | 25,747                      |       |
| Intangible assets and patents, net                                                                                                                        |       | 1,250                   |       | 1,201                       |       |
| Equity investments in unconsolidated affiliates                                                                                                           |       | 956                     |       | 956                         |       |
| Other assets                                                                                                                                              |       | 1,588                   |       | 1,089                       |       |
| Total other assets                                                                                                                                        |       | 29,541                  |       | 28,993                      |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Total assets                                                                                                                                              |       | $                       | 394,304    |                        | $          | 376,892 |   |
|                                                                                                                                                      |       |                    |       |                        |       |
| **Liabilities and Stockholders’ Equity**                                                                                                             |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                      |       |                    |       |                        |       |
| Accounts payable and accrued expenses                                                                                                                     |       | $                       | 11,634     |                        | $          | 14,289 |   |
| Deferred revenue                                                                                                                                          |       | 3,965                   |       | 2,089                       |       |
| Accrued pension benefits                                                                                                                                  |       | 631                     |       | 631                         |       |
| Income taxes payable                                                                                                                                      |       | 6,964                   |       | 846                         |       |
| Current installments of long-term debt                                                                                                                    |       | 4,536                   |       | 4,526                       |       |
| Total current liabilities                                                                                                                                 |       | 27,730                  |       | 22,381                      |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Long-term liabilities:                                                                                                                                    |       |                    |       |                        |       |
| Long-term debt, excluding current installments                                                                                                            |       | 46,215                  |       | 48,603                      |       |
| Deferred income taxes                                                                                                                                     |       | 7,334                   |       | 6,997                       |       |
| Pension and postretirement benefits                                                                                                                       |       | 2,737                   |       | 3,139                       |       |
| Other long term liabilities                                                                                                                               |       | 491                     |       | 296                         |       |
| Total liabilities                                                                                                                                         |       | 84,507                  |       | 81,416                      |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Commitments and contingencies                                                                                                                             |       |                    |       |                        |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                |       |                    |       |                        |       |
| Common stock, $0.01 par value, 50,000 shares  authorized, 34,397 shares issued at June 30, 2005, and 33,942 shares  issued at December 31, 2004 |       | 344                     |       | 340                         |       |
| Additional paid-in capital                                                                                                                                |       | 193,071                 |       | 189,608                     |       |
| Unearned compensation — restricted stock                                                                                                             |       | (2,003                  | )          | —                      |       |
| Accumulated other comprehensive loss                                                                                                                      |       | (150                    | )          | (117                        | )          |
| Retained earnings                                                                                                                                         |       | 155,706                 |       | 142,816                     |       |
|                                                                                                                                                      |       | 346,968                 |       | 332,647                     |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Less, treasury shares at cost, 2,077 shares                                                                                                               |       | (37,171                 | )          | (37,171                     | )          |
| Total stockholders’ equity                                                                                                                           |       | 309,797                 |       | 295,476                     |       |
| Total liabilities and stockholders’ equity                                                                                                           |       | $                       | 394,304    |                        | $          | 376,892 |   |

 

*See notes to unaudited condensedconsolidated financial statements.*

 

4

----

 

**Albany Molecular Research, Inc.**

**CondensedConsolidated Statements of Cash Flows**

**(unaudited)**

*(Dollars in thousands)*

 
| ** **                                                                                | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
|                                                                                      |       |                   |       |   |   |
| **Operating activities**                                                                  |       |                   |       |   |   |
| Net  income (loss)                                                                        |       | $                      | 12,890     |   | $ | (18,012 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                   |       |   |   |
| Depreciation  and amortization                                                            |       | 7,765                  |       | 7,206 |   |
| Foreign  exchange loss                                                                    |       | 13                     |       | — |   |
| 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 |   |
| Provision  for bad debts                                                                  |       | (72                    | )          | — |   |
| Equity  in loss of unconsolidated affiliates                                              |       | —                 |       | 65 |   |
| Deferred  income tax expense (benefit)                                                    |       | 325                    |       | (4,098 | ) |
| Loss  on disposal of property, plant and equipment                                        |       | 16                     |       | — |   |
|          Stock-based compensation expense         |       | 161                    |       | — |   |
|                                                                                      |       |                   |       |   |   |
| (Increase)  decrease in:                                                                  |       |                   |       |   |   |
| Accounts  receivable                                                                      |       | (6,168                 | )          | 1,926 |   |
| Royalty  income receivable                                                                |       | (3,695                 | )          | (905 | ) |
| Inventory,  prepaid expenses and other assets                                             |       | 1,191                  |       | (2,806 | ) |
| (Decrease)  increase in:                                                                  |       |                   |       |   |   |
| Accounts  payable and accrued expenses                                                    |       | (2,655                 | )          | (1,609 | ) |
| Income  tax payable                                                                       |       | 6,118                  |       | (996 | ) |
| Deferred  revenue                                                                         |       | 1,876                  |       | 82 |   |
| Pension  and postretirement benefits                                                      |       | (402                   | )          | (594 | ) |
| Other  long-term liabilities                                                              |       | 195                    |       | (17 | ) |
| Net  cash provided by operating activities                                                |       | 17,558                 |       | 12,032 |   |
|                                                                                      |       |                   |       |   |   |
| **Investing activities**                                                                  |       |                   |       |   |   |
| Net purchases  of investment securities                                                   |       | (60,842                | )          | (21,713 | ) |
| Proceeds  from sale of investment securities                                              |       | 55,968                 |       | 43,400 |   |
| Purchases  of property, plant and equipment                                               |       | (6,574                 | )          | (12,771 | ) |
| Proceeds  from disposal of property, plant and equipment                                  |       | 7                      |       | — |   |
| Payments  for patent applications and other costs                                         |       | (98                    | )          | (89 | ) |
| Net  cash (used in) provided by investing activities                                      |       | (11,539                | )          | 8,827 |   |
|                                                                                      |       |                   |       |   |   |
| **Financing activities**                                                                  |       |                   |       |   |   |
| Principal  payments on long-term debt                                                     |       | (2,378                 | )          | (2,369 | ) |
| Proceeds  from sale of common stock                                                       |       | 947                    |       | 810 |   |
| Tax  benefit from exercise of stock options                                               |       | 356                    |       | — |   |
| Net  cash used in financing activities                                                    |       | (1,075                 | )          | (1,559 | ) |
|                                                                                      |       |                   |       |   |   |
| Effect  of exchange rate changes on cash flows                                            |       | (50                    | )          | — |   |
|                                                                                      |       |                   |       |   |   |
| Increase  in cash and cash equivalents                                                    |       | 4,894                  |       | 19,300 |   |
|                                                                                      |       |                   |       |   |   |
| Cash  and cash equivalents at beginning of period                                         |       | 41,171                 |       | 18,187 |   |
|                                                                                      |       |                   |       |   |   |
| Cash  and cash equivalents at end of period                                               |       | $                      | 46,065     |   | $ | 37,487 |   |

 

*See notes to unaudited condensedconsolidated financial statements.*

 

5

----

 

**Note 1 –Summary of Operations and Significant Accounting Policies**

(All amounts inthousands, except per share amounts, unless otherwise noted)

 

**Natureof Business and Operations**

 

Albany Molecular Research, Inc.(the “Company”) is a leading chemistry-based drug discovery and developmentcompany focused on applications for new small molecule prescription drugs. TheCompany conducts research and development projects and collaborates with manyleading pharmaceutical and biotechnology companies, and is developing newchemistry technology for potential pharmaceutical products. The Company engagesin chemistry research, from lead discovery, optimization and development tocommercial manufacturing. As part of its drug discovery strategy, the Companyis also producing novel compound collections and chemical screeningcollections. In addition to its chemistry research services, the Company alsoconducts proprietary research and development to develop new technologies andto discover new lead compounds with commercial potential. The Company seeks tolicense these compounds to third parties in return for up-front service feesand milestone payments as well as recurring royalty payments if these compoundsare developed into new drugs successfully reaching the market.

 

**Basis of Presentation**

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions to Form 10-Qand Rule 10-01 of Regulation S-X. In accordance with Rule 10-01, the unaudited condensed consolidatedfinancial statements do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete consolidated financial statements.  The year-end condensed consolidated balancesheet data was derived from audited consolidated financial statements but doesnot include all disclosures required by accounting principles generallyaccepted in the United States of America. In the opinion of management, all adjustments (consisting of normalrecurring accruals and adjustments) considered necessary for a fair statementof the results for the interim periods have been included.  Operating results for the three and sixmonths ended June 30, 2005 are not necessarily indicative of the resultsthat may be expected for the year ending December 31, 2005.  The accompanying unaudited condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes thereto included in ourAnnual Report on Form 10-K for the year ended December 31, 2004.

 

The accompanyingunaudited condensed consolidated financial statements include the accounts ofAlbany Molecular Research, Inc. and its wholly owned subsidiaries.  All intercompany balances and transactionshave been eliminated during consolidation. Assets and liabilities of non-U.S. operations are translated atperiod-end rates of exchange, and the statements of operations are translatedat the average rates of exchange for the period. Gains or losses resulting fromtranslating non-U.S. currency financial statements are recorded in accumulatedother comprehensive loss in the accompanying June 30, 2005 condensedconsolidated balance sheet.

 

***RevisedClassification of Certain Securities***

 

Effective December 31,2004, we revised the classification of our auction rate municipal bonds asmarketable securities in current assets. Previously, such investments had beenclassified as cash and cash equivalents. Accordingly, we have reflected thesesecurities as marketable securities in the current assets section of ourcondensed consolidated balance sheets as of June 30, 2005 and December 31,2004. We have also made corresponding adjustments to our condensed consolidatedstatements of cash flows for the six months ended June 30, 2004 to reflectthe gross purchases and sales of these securities as investing activitiesrather than as a component of cash and cash equivalents. This reclassificationdoes not affect previously reported consolidated cash flows from operations orfrom financing activities in our previously reported consolidated statements ofcash flows or our previously reported consolidated statements of operations forany period.

 

As originally reported atDecember 31, 2003 and June 30, 2004, $29,250 and $19,600,respectively of these investments were classified as cash equivalents in our condensedconsolidated balance sheets. These investments have been reclassified toshort-term investments from cash and cash equivalents as previously reported.

 

For the six months ended June 30,2004, the change in net cash provided by investing activities from previouslyreported amounts related to these securities was $9,650.

 

6

----

 

**Use ofManagement Estimates**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities, anddisclosures of contingent assets and liabilities, at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Actual results can vary from these estimates.

 

**Contract Revenue Recognition**

 

The Company’s contractrevenue consists primarily of fees earned under contracts with third-partycustomers and reimbursed expenses under such contracts. The Company also seeksto include provisions in certain contracts which contain a combination ofup-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 generatescontract 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 theCompany charges customers an hourly rate plus an allowance for chemicals andother project specific costs. The Company recognizes revenue for time andmaterial contracts based on the number of hours devoted to the projectmultiplied by the customer’s billing rate plus other project specific costsincurred.

 

*Fixed Fee***.**  Under a fixed-fee contract the Companycharges a fixed agreed upon amount for a deliverable. Fixed-fee contracts havefixed deliverables upon completion of the project. The Company recognizesrevenue for fixed fee contracts after projects are completed, delivery is madeand title transfers to the customer and collection is reasonably assured.

 

*Up-Front License Fees, Milestone and Royalty Revenue***.** The Company analyzes its agreements to determine whether the elementscan be separated and accounted for individually or as a single unit ofaccounting in accordance with EITF No. 00-21, *Revenue Arrangements with Multiple Deliverables* and SAB 104,*Revenue Recognition*. Allocationof revenue to individual elements which qualify for separate accounting isbased on the estimated fair value of the respective elements. The Companyrecognizes revenue from up-front non-refundable licensing fees on a straightline 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.

 

*RecurringRoyalty Revenue Recognition*

 

Recurring royaltiesconsist of royalties under a license agreement with Sanofi-Aventis based on theworldwide sales of fexofenadine HCl, marketed as Allegra in the Americas andTelfast elsewhere. The Company records royalty revenue in the period in whichthe sales of Allegra occur. Royalty payments from Sanofi-Aventis are due within45 days after each calendar quarter and are determined based on sales of Allegrain that quarter.

 

7

----

 

**NaturalProduct and Lead Finding Sample Collections**

 

As part of the Company’sstrategy to provide a comprehensive offering of natural product and chemicallead finding discovery services and technologies to its customers, it hasacquired natural product sample collections and related assets and is producingnovel compound libraries and chemical screening collections. The naturalproduct sample collections were acquired in connection with the 2001acquisition of NCE. For internally developed libraries, the Company iscapitalizing the cost of internally producing novel compound and screeningcollections in inventory.  Initial coststo develop novel compound libraries are categorized as research and developmentexpense until such time it becomes probable that a saleable library can besuccessfully produced. As a result, costs for the design, research, and testingof libraries under development are expensed as incurred. Our research chemistsreview the results of analytical procedures to determine if the chemicalreactions were completed as expected and the product purity and product yieldsare within required specifications. This “validation” process determineswhether the chemistry is successful and if a saleable product will result. Wecapitalize costs of production to inventory once the validation process iscompleted and successful production is reasonably assured. If a core reactionis unsuccessful, the library template is abandoned and no further developmenttakes place.

 

Capitalized costs are amortized over the economic lifeof the library (estimated at 3 years) at the greater of (a) the ratio ofthe product’s current gross revenue to the total of current and expected grossrevenues or (b) the straight-line method computed by dividing theremaining unamortized capitalized cost by the remaining economic life of theproduct. The remaining economic life is reassessed at each balance sheet dateand changes in estimate, if appropriate, are made to the amortizationmodel.  Amortization of library inventoriesis included within research and development expense in the consolidated statementsof operations.  Library amortizationexpense was $305 and $609, and $0 and $0 for the three months and six monthsended June 30, 2005 and 2004, respectively.  In addition, the Company monitors thecarrying value of its natural product and lead finding sample collections forimpairment on a quarterly basis.  TheCompany compares the carrying values of these collections to their estimatednet realizable fair values, which are based on estimated future sales of thesecollections, to determine impairment. The Company recognizes an impairment charge for any collection whosecarrying value is greater than its estimated net realizable fair value.

 

During****the quarter ended June 30, 2004, the Company recordeda $5,974 write-down to reduce the carrying value of its natural product andchemical lead finding library inventories. The Company monitors the carryingvalue of its remaining natural product and lead finding sample collections forimpairment on a quarterly basis.  If theCompany is unable to meet forecasted revenues related to those assets, or ifactual market conditions are less favorable than those projected, the Companymay be required to write-down all or a portion of the remaining value ofcertain compound library assets (totaling $3,071 at June 30, 2005),resulting in a future****charge tooperations.  See Note 3 for furtherinformation on the inventory reserves recorded during the quarter ended June 30,2004.

 

**Long-livedAssets**

 

In accordance with the provisions of SFAS 144,*Accounting for Impairment or Disposal of Long-Lived Assets*(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 undiscounted cash flows expected to be generated by the asset group. If the carrying value exceeds the undiscounted cash flows an impairment charge is recorded. An impairment charge is recognized to the extent that the carrying amount of the asset group exceeds their fair value and will reduce only the carrying amounts of the long-lived assets.  The Company utilizes the assistance of an independent valuation firm in determining the fair values.

 

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 the Bothell Research Center and the Mount Prospect Research Center. See Note 5 for further information.

 

8

----

 

**Goodwill**

 

In accordance with theprovisions of SFAS 142, *Goodwill and OtherIntangible Assets*(SFAS 142) the Company performs an annual****assessment of the carrying value of goodwill for potentialimpairment (or on an interim basis if certain triggering events occur).  A determination of impairment is made basedupon the estimated discounted future cash flows of the operations associatedwith 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 importantwhich could result in an impairment include the following:

 

•             significant underperformance relative to historical orprojected future operating results;

 

•             significant changes in the manner of our use of the acquiredassets or the strategy for overall business;

 

•             significant negative industry or economic trends; and

 

•             market capitalization relative to net book value.

 

During the quarter ended June 30, 2004, theCompany recorded goodwill impairment charges of $13,251 and $1,243 relating toits Bothell reporting unit and its Mount Prospect reporting unit.  The Company will perform the annual goodwillassessment for its reporting units during the third quarter of 2005.  If management’s expectations of futureoperating results change, or if there are changes to other assumptions, theestimate of the fair value of our reporting units could change significantly.Such a change could result in additional goodwill impairment charges in futureperiods, which could have a significant impact on our consolidated financialstatements.  Total goodwill recorded in theCompany’s condensed consolidated balance sheet at June 30, 2005 was$25,747, including $23,060 of goodwill associated with the Company’sacquisition of Organichem, Corporation.  SeeNote 6 for further information on the goodwill impairment charges recordedduring the quarter ended June 30, 2004.

 

**Stock Compensation**

 

The Company applies the intrinsic value-based methodof accounting prescribed by Accounting Principles Board (APB) Opinion No. 25,‘‘Accounting for Stock Issued to Employees,’’ and related interpretations, inaccounting for its fixed plan stock options. As such, compensation expensewould be recorded only if, on the date of grant, the current market price ofthe underlying stock exceeded the exercise price. Any compensation expensewould be recognized over the vesting period.

 

The following table illustrates the effect on netincome 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)**                                                                                                           | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  income (loss), as reported                                                                                                                     |       | $                                    | 7,294      |                               | $          | (20,773 | )  | $ | 12,890 |   | $ | (18,012 | ) |
| Add:  Stock-based employee compensation expense  included in reported net income, net of related tax effects                                   |       | 89                                   |       | —                             |       | 105 |   | — |   |
| Deduct:  Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | 653                                  |       | 887                                |       | 1,334 |   | 1,790 |   |
| Pro  Forma net income (loss)                                                                                                                        |       | $                                    | 6,730      |                               | $          | (21,660 | ) | $ | 11,661 |   | $ | (19,802 | ) |
|                                                                                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Earnings  (loss) per share:                                                                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Basic  as reported                                                                                                                                  |       | $                                    | 0.23       |                               | $          | (0.65 | ) | $ | 0.40 |   | $ | (0.57 | ) |
| Basic  pro-forma                                                                                                                                    |       | $                                    | 0.21       |                               | $          | (0.68 | ) | $ | 0.36 |   | $ | (0.63 | ) |
|                                                                                                                                                |       |                                 |       |                               |       |   |   |   |   |
| Diluted  as reported                                                                                                                                |       | $                                    | 0.23       |                               | $          | (0.65 | ) | $ | 0.40 |   | $ | (0.57 | ) |
| Diluted  pro-forma                                                                                                                                  |       | $                                    | 0.21       |                               | $          | (0.68 | ) | $ | 0.36 |   | $ | (0.63 | ) |

 

9

----

 

**Note 2 –Earnings (Loss) Per Share**

 

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

 

*(in thousands)*

 
| ** **                                  | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                  | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted  average common shares outstanding |       | 32,025                               |       | 31,719                             |       | 31,978 |   | 31,627 |   |
| Dilutive  effect of stock options           |       | 234                                  |       | —                             |       | 239 |   | — |   |
| Dilutive  effect of restricted stock        |       | 53                                   |       | —                             |       | 26 |   | — |   |
| Weighted  average common shares outstanding |       | 32,312                               |       | 31,719                             |       | 32,243 |   | 31,627 |   |

 

The Company has excluded the effects of outstandingstock options and warrants from the calculation of diluted loss per share forthe three and six months ended June 30, 2004 because such securities wouldbe anti-dilutive.   The Company hasexcluded certain outstanding stock options and warrants from the calculation ofdiluted earnings per share for the three and six months ended June 30,2005 because the exercise price was greater than the average market price ofthe Company’s common shares during that period, and as such would beanti-dilutive.   The weighted average number of anti-dilutiveoptions and warrants outstanding, prior to consideration of the treasury stockmethod,****were 2,548 and 3,126 for the three monthperiods ended June 30, 2005 and 2004, respectively, and are not includedin the calculation of weighted average common shares outstanding.  The weighted average number of anti-dilutiveoptions and warrants outstanding were 2,726 and 3,079 for the six month periodsended June 30, 2005 and 2004, respectively.

 

**Note 3 –Inventory**

 

Inventory consisted ofthe following at June 30, 2005 and December 31, 2004:

 
| ** **                                  | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials                               |       | $                       | 5,454      |                        | $          | 4,818 |   |
| Work  in process                            |       | 3,491                   |       | 1,273                       |       |
| Finished  goods                             |       | 18,644                  |       | 22,644                      |       |
| Libraries,  net of accumulated amortization |       | 3,071                   |       | 3,680                       |       |
| Total                                       |       | $                       | 30,660     |                        | $          | 32,415 |   |

 

During the quarter ended June 30,2004, the Company determined that the carrying value of its natural product andchemical lead finding libraries exceeded its latest forecasted revenues.  The Company’s forecasted revenues from naturalproduct and chemical lead finding libraries were lowered to reflect lessfavorable market conditions than previously projected.  As a result, the Company recorded a $5,974non-cash charge to reduce the carrying value of its library inventories.  Additionally, the Company determined that itsinventory of raw materials used in discovery and chemical services exceededanticipated usage and accordingly increased its reserves for excess rawmaterials inventories by $888, which was recorded as a component of cost ofcontract revenue in the accompanying condensed consolidated statements ofoperations for the three and six months ended June 30, 2004.

 

**Note 4 – Restructuring of MountProspect**

 

On May 4, 2004, the Company announced plans toconsolidate operations by relocating its Mount 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 MountProspect have been relocated to New York and continue to be fully integratedwith the Company’s drug discovery and development technologies.  The restructuring resulted in the closure ofthe Mount Prospect Research Center in 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 the closure, 33 employees were terminated and25 employees were relocated to facilities in New York.

 

10

----

 

The restructuringliabilities are included in accounts payable and accrued expenses in the accompanyingcondensed consolidated balance sheets. The following table displays therestructuring activity and liability balances:

 
| ** **            | ** ** | **Balance at  December 31,  2004** | ** ** | **Adjustments** | ** ** | **Payments** | ** ** | **Balance at  June 30,  2005** | ** ** |
|-----------------------|------------|----------------------------------------------|------------|-----------------|------------|--------------|------------|------------------------------------------|------------|
| Termination  benefits |       | $                                            | 129        |            | $          | (65          | )          | $                                        | (64        | ) | $ | — |   |
| Asset  disposal costs |       | 513                                          |       | —          |       | —       |       | 513                                      |       |
| Total                 |       | $                                            | 642        |            | $          | (65          | )          | $                                        | (64        | ) | $ | 513 |   |

 

Costs of terminationbenefits relate to severance packages, outplacement services and careercounseling for employees affected by the restructuring. Asset disposal costsrelate primarily to brokerage commissions, legal fees, and marketing expensesassociated with the planned sale of the Mount Prospect Research Centerfacility, which is included in property and equipment held for sale in the condensedconsolidated balance sheet at June 30, 2005.

 

The Company also incurred$85 and $243 in employee and equipment relocation costs during the three andsix months ended June 30, 2005, respectively.  These relocation costs are included under thecaption “selling, general and administrative” in the condensed consolidatedstatement of operations.

 

We are currentlymarketing the Mount Prospect Research Center facility for sale. The facilityqualified for held for sale treatment in accordance with SFAS 144 duringthe fourth quarter of 2004. The long-lived assets associated with MountProspect have been segregated to a separate line item on the condensedconsolidated balance sheet until they are sold and depreciation expense hasceased with respect to those assets. We anticipate the completion of the saleof the facility by June 2006.

 

The above restructuringactivity was recorded exclusively in the AMR operating segment. The net cashoutflow related to the restructuring for the six months ended June 30,2005 was $64.  Anticipated cash outflowsrelated to the restructuring for the remainder of 2005 are $0.

 

**Note 5 - Impairment of Long-Livedand Intangible Assets**

 

During the quarter ended June 30,2004, due to the triggering events discussed in Notes 3 and 4 above, theCompany performed SFAS 144 analyses of its property and equipment for potentialimpairment at its Mount Prospect Research Center and its Bothell facility. TheCompany’s analyses concluded that the carrying value of the respective assetgroups exceeded their fair value.  Theimpairment was allocated to the long-lived assets of the groups on a pro-ratabasis.  Accordingly, our Mount ProspectResearch Center and Bothell Research Center recorded impairment losses onlong-lived assets of $1,615 and $3,113, respectively.  The Company utilized the assistance of anindependent valuation firm in determining fair values.

 

Due to the 2004 write-downof the Company’s natural product libraries, the Company also performed anassessment of the carrying value of its microbial cultures and relatedtechnologies. The microbial cultures and related technologies are the startingmaterials and technology used in the development of the natural productlibraries and therefore would be used to make incremental copies of the naturalproduct libraries.  Based on itsassessment, the Company concluded that the carrying value of the microbialcultures and related technologies was not recoverable, and accordingly recordeda $3,541 impairment charge in the quarter ended June 30, 2004 representingthe entire remaining carrying value of microbial cultures and relatedtechnologies.

 

The components ofintangible assets are as follows:

 
| ** **                    | ** ** | **Cost**   | ** ** | **Accumulated  Amortization** | ** ** | **Net**    | ** ** | **Amortization  Period** | ** ** |
|-------------------------------|------------|------------|------------|-------------------------------|------------|------------|------------|--------------------------|------------|
| **June 30, 2005**        | ** ** | ** ** | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **               | ** ** |
| Patents  and Licensing Rights |       | $          | 1,576      |                          | $          | (326       | )          | $                        | 1,250      |   | 16 years |   |
|                          |       |       |       |                          |       |       |       |                     |       |
| **December 31, 2004**    |       |       |       |                          |       |       |       |                     |       |
| Patents  and Licensing Rights |       | $          | 1,478      |                          | $          | (277       | )          | $                        | 1,201      |   | 16 years |   |

 

Amortization expenserelated to intangible assets for the three and six months ended June 30,2005 and 2004 was $26 and $49, and $155 and $289, respectively.

 

Estimated future annualamortization expense related to intangible assets is approximately $103 peryear through the year ended December 31, 2009.

 

11

----

 

**Note 6 – Goodwill**

 

The carrying amounts ofgoodwill, by segment, as of June 30, 2005 and December 31, 2004 areas follows:

 
| **AMR** | ** ** | **Organichem** | ** ** | **Total** | ** ** |
|---------|------------|----------------|------------|-----------|------------|
| $       | 2,687      |           | $          | 23,060    |       | $ | 25,747 |   |
|         |            |                |            |           |            |  |  |  |

 

During the quarter ended June 30,2004, due to the triggering events discussed in Notes 3 and 5, the Companydetermined that the carrying value of its goodwill at its Bothell reportingunit may be impaired.  Accordingly, theCompany conducted a goodwill impairment review as required under SFAS 142, andconcluded that an impairment had occurred andtherefore recorded a $13,251 goodwill impairment charge, which reflects a fullimpairment of the Bothell goodwill.  Asfurther discussed in Notes 4 and 5, during the quarter ended June 30,2004, the Company announced its decision to close its Mount Prospect facilityand consolidate operations in New York. This restructuring and relatedimpairment of property and equipment were considered triggering events underSFAS 142.  Accordingly, the Companyconducted a goodwill impairment review as required under SFAS 142. The Companycompleted its assessment and concluded that an impairmenthad occurred and recorded a $1,243 goodwill impairment charge based upon avaluation of the reporting unit.

 

In calculating thegoodwill impairment charge, the fair value of the Bothell and Mount Prospectreporting units was determined with the assistance of an independent valuationadvisor using a discounted cash flow valuation approach.  Significant assumptions used in this analysisinclude (i) expected future revenue growth rates, reporting unit profitmargins, and working capital levels, (ii) a discount rate, and (iii) aterminal value multiple. The revenue growth rates, working capital levels andreporting unit profit margins were based on management’s best estimate offuture results.

 

**Note 7 -****Defined Benefit andPostretirement Welfare Plan**

 

Organichem previouslyprovided retirement benefits under two non-contributory defined benefit plansand a non-contributory, unfunded post-retirement welfare plan. Future benefitsunder the defined benefit plans and for salaried participants in thepost-retirement welfare plan have been frozen.

 

***Componentsof 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,** | ** ** |
| ** **                          | ** ** | **2005**                               | ** ** | **2004**                               | ** ** | **2005**                             | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                |       |                                   |       |                                   |       |                                 |       |                                 |       |   |   |   |   |   |   |   |   |
| Service  Cost                       |       | $                                      | —     |                                   | $          | —                               |       | $                                    | 11         |   | $ | 10 |   | $ | — |   | $ | 44 |   | $ | 22 |   | $ | 19 |   |
| Interest  Cost                      |       | 264                                    |       | 301                                    |       | 4                                    |       | 4                                    |       | 581 |   | 600 |   | 8 |   | 8 |   |
| Expected  return on plan assets     |       | (319                                   | )          | (283                                   | )          | —                               |       | —                               |       | (615 | ) | (565 | ) | — |   | — |   |
| Amortization  of prior service cost |       | —                                 |       | —                                 |       | —                               |       | —                               |       | — |   | — |   | — |   | — |   |
| Recognized  net (gain) loss         |       | 10                                     |       | —                                 |       | —                               |       | —                               |       | 10 |   | 3 |   | — |   | — |   |
| Net  Periodic benefit (income) cost |       | $                                      | (45        | )                                      | $          | 20                                   |       | $                                    | 15         |   | $ | 14 |   | $ | (24 | ) | $ | 82 |   | $ | 30 |   | $ | 27 |   |

 

***EmployerContributions***

 

The Company previouslydisclosed in its consolidated financial statements for the year ended December 31,2004 that it expected to contribute $631 to its pension plan in 2005.  Asof June 30, 2005, $481 in contributions have beenmade.  The Company continues to anticipate contributing the additional$150 to fund its pension plan in 2005.

 

12

----

 

**Note 8 -Restricted Stock**

 

In March 2005, theCompensation Committee of the Board of Directors granted an award of 267restricted shares of common stock to employees of the Company under the 1998Stock Option and Incentive Plan.  The shares are issued as restrictedstock and are held in the custody of the Company until all vesting restrictionsare satisfied.  Shares vest under this grant over a period of five years,with 60% vesting after three years of continuous employment from the grant dateand an additional 20% vesting after each of four and five years of continuousemployment from the grant date.  If thevesting terms under which the award was granted are not satisfied, the sharesare forfeited.  Unearned compensation of$2,259 was recorded at the date of award, based on the market value of theshares on the grant date, and is included as a separate component ofshareholders’ equity and is amortized over the applicable vesting period. As of June 30, 2005, a total of 16 shares with an unamortized unearnedcompensation balance of $126 had been forfeited.  The amount amortized to expense during thethree and six months ended June 30, 2005, net of the impact offorfeitures, was approximately $100 and $124, respectively.

 

**Note 9 -Income Taxes**

 

The Company’s 2004effective tax rate was impacted by the impairment of certain nondeductibleitems related to the goodwill impairment charges it recorded in the secondquarter of 2004.  Non-deductibleimpairment charges totaling $17.1 million were treated as infrequent discreteitems in the preparation of the Company’s income tax provision for the threemonths ended June 30, 2004.  Thedifferences between income tax expense and income taxes computed using afederal statutory rate of 35% for the three and six months ended June 30,2005 and 2004, were as follows:

 
| ** **                                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                        | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                              |       |                                 |       |                               |       |   |   |   |   |
| Statutory  tax rate                               |       | 35.0                                 | %          | (35.0                              | )%         | 35.0 | % | (35.0 | )% |
|                                              |       |                                 |       |                               |       |   |   |   |   |
| Increase  (reduction) in tax rate resulting from: |       |                                 |       |                               |       |   |   |   |   |
| Tax-free  interest income                         |       | (0.9                                 | )          | 1.1                                |       | (0.9 | ) | 0.3 |   |
| Goodwill  and intangible asset impairment         |       | —                               |       | 26.6                               |       | — |   | 32.8 |   |
| State  taxes, net of federal benefit              |       | 0.7                                  |       | (0.9                               | )          | 1.4 |   | 0.2 |   |
| Foreign  operations                               |       | 0.5                                  |       | —                             |       | 0.5 |   | — |   |
| Extraterritorial  income credit                   |       | —                               |       | 1.0                                |       | (0.8 | ) | 0.3 |   |
| Domestic  production deduction                    |       | (0.4                                 | )          | —                             |       | (0.4 | ) | — |   |
| Other,  net                                       |       | 1.3                                  |       | (0.5                               | )          | 0.7 |   | 0.4 |   |
|                                              |       | 36.2                                 | %          | (7.7                               | )%         | 35.5 | % | (1.0 | )% |

 

**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 SFAS No. 131,*Disclosures about Segments of an Enterprise andRelated Information*.  TheCompany’s management relies on an internal management accounting system toreport results of the segments.  Thesystem includes revenue and cost information by segment.  The Company’s management makes financialdecisions and allocates resources based on the information it receives fromthis 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.

 

13

----

 

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

 
| ** **                                        | ** ** | **Contract  Revenue** | ** ** | **Recurring  Royalty  Revenue** | ** ** | **Operating  (loss) income** | ** ** | **Depreciation  and  Amortization** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|---------------------------------|------------|------------------------------|------------|-------------------------------------|------------|
| **For the three months ended June 30, 2005** |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                               |       | $                     | 13,356     |                            | $          | 15,892                       |       | $                                   | 16,786     |   | $ | 2,435 |   |
| Organichem                                        |       | 22,592                |       | —                          |       | 4,133                        |       | 1,392                               |       |
| Corporate                                         |       | —                |       | —                          |       | (9,874                       | )          | —                              |       |
| Total                                             |       | $                     | 35,948     |                            | $          | 15,892                       |       | $                                   | 11,045     |   | $ | 3,827 |   |
|                                              |       |                  |       |                            |       |                         |       |                                |       |
| **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 six months ended June 30, 2005**   |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                               |       | $                     | 26,953     |                            | $          | 27,900                       |       | $                                   | 30,486     |   | $ | 4,918 |   |
| Organichem                                        |       | 45,621                |       | —                          |       | 8,730                        |       | 2,846                               |       |
| Corporate                                         |       | —                |       | —                          |       | (19,815                      | )          | —                              |       |
| Total                                             |       | $                     | 72,574     |                            | $          | 27,900                       |       | $                                   | 19,401     |   | $ | 7,764 |   |
|                                              |       |                  |       |                            |       |                         |       |                                |       |
| **For the six months ended June 30, 2004**   |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                               |       | $                     | 26,449     |                            | $          | 23,870                       |       | $                                   | (2,801     | ) | $ | 4,329 |   |
| Organichem                                        |       | 32,483                |       | —                          |       | 7,340                        |       | 2,877                               |       |
| Corporate                                         |       | —                |       | —                          |       | (22,980                      | )          | —                              |       |
| Total                                             |       | $                     | 58,932     |                            | $          | 23,870                       |       | $                                   | (18,441    | ) | $ | 7,206 |   |

 

The following tablesummarizes other information by segment as of June 30, 2005:

 
| ** **                                | ** ** | **As of June 30, 2005** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|
| **(in thousands)**                        | ** ** | **AMR**                      | ** ** | **Organichem** | ** ** | **Total** | ** ** |
|                                      |       |                         |       |   |   |   |   |
| Total  assets                             |       | $                            | 262,299    |   | $ | 132,005 |   | $ | 394,304 |   |
| Goodwill  included in total assets        |       | 2,687                        |       | 23,060 |   | 25,747 |   |
| Investments  in unconsolidated affiliates |       | 956                          |       | — |   | 956 |   |
| Capital  expenditures                     |       | 2,189                        |       | 4,385 |   | 6,574 |   |
|                                           |            |                              |            |  |  |  |  |  |  |  |

 

**Note 11 –Financial Information by Customer Concentration and Geographic Area**

 

Total contract revenuefrom AMR’s three largest customers represented approximately 15%, 8% and 4% ofAMR’s total contract revenue for the three months ended June 30, 2005, and16%, 12% and 6% of total contract revenue for the three months ended June 30,2004. Total contract revenue from AMR’s three largest customers representedapproximately 15%, 10% and 3% of AMR’s total contract revenue for the sixmonths ended June 30, 2005, and 14%, 12% and 6% of total contract revenuefor the six months ended June 30, 2004. Total contract revenue from Organichem’s largest customer, GE Healthcare(GE), represented 71% and 59% of Organichem’s total contract revenue for thethree months ended June 30, 2005 and 2004, respectively.  Total contract revenue from GE represented 76%and 69% of Organichem’s total contract revenue for the six months ended June 30,2005 and 2004, respectively.  GEaccounted for approximately 48% and 38% of the Company’s total contract revenuefor the six months ended June 30, 2005 and 2004, respectively.  GE has discontinued its purchases of one ofthe products it receives from Organichem, and made all of its 2005 purchases inthe first half of the year.  Sales ofthis product totaled $16,962 in the first half of 2005, compared to $7,848 inthe first half of 2004 and $18,133 for the year ended December 31, 2004.

 

14

----

 

The Company’s totalcontract revenue for the three and six months ended June 30, 2005 and 2004was recognized from customers in the following geographic regions:

 
| ** **     | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **     | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|           |       |                                 |       |                               |       |   |   |   |   |
| United  States |       | 49                                   | %          | 66                                 | %          | 49 | % | 61 | % |
| Europe         |       | 48                                   |       | 32                                 |       | 49 |   | 36 | % |
| Other          |       | 3                                    |       | 2                                  |       | 2 |   | 3 |   |
|           |       |                                 |       |                               |       |   |   |   |   |
| Total          |       | 100                                  | %          | 100                                | %          | 100 | % | 100 | % |
|           |       |                                 |       |                               |       |   |   |   |   |

**Note 12 –Comprehensive (Loss) Income**

 

The Company is requiredto report comprehensive income and its components in accordance with theprovisions of SFAS No. 130, *Reporting ComprehensiveIncome.*

 

The following tablepresents the components of the Company’s comprehensive (loss) income for thethree and six months ended June 30, 2005 and 2004:

 

*(inthousands)*

 
| ** **                                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  income (loss)                                                     |       | $                                    | 7,294      |                               | $          | (20,773 | ) | $ | 12,890 |   | $ | (18,012 | ) |
|                                                                   |       |                                 |       |                               |       |   |   |   |   |
| Other  comprehensive loss:                                             |       |                                 |       |                               |       |   |   |   |   |
| Unrealized  gain (loss) on available-for-sale securities, net of taxes |       | 83                                   |       | (324                               | )          | (43 | ) | (367 | ) |
| Unrealized  (loss) gain on interest rate swap, net of taxes            |       | (55                                  | )          | 486                                |       | 60 |   | 304 |   |
| Foreign  currency translation loss                                     |       | (19                                  | )          | —                             |       | (50 | ) | — |   |
| Total  comprehensive income (loss)                                     |       | $                                    | 7,303      |                               | $          | (20,611 | ) | $ | 12,857 |   | $ | (18,075 | ) |

 

**Note 13 –Legal Proceedings**

 

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

 

AMR Technology, asubsidiary of the Company, along with Aventis Pharmaceuticals Inc., the U.S.pharmaceutical business of Sanofi-Aventis S.A., are involved in legalproceedings with several companies seeking to market generic versions ofAllegra.  Beginning in 2001, BarrLaboratories, Inc., Impax Laboratories, Inc., Mylan Pharmaceuticals, Inc.,Teva Pharmaceuticals USA, Dr. Reddy’s Laboratories, Ltd./Dr. Reddy’sLaboratories, Inc., Ranbaxy Laboratories Ltd./Ranbaxy PharmaceuticalsInc., and Sandoz Inc. filed Abbreviated New Drug Applications (ANDAs) withthe U.S. Food and Drug Administration, or FDA, to produce and market genericversions of Allegra products.

 

In response to thefilings described above, beginning in 2001, Aventis Pharmaceuticals filedpatent infringement lawsuits against Barr Laboratories, Impax Laboratories,Mylan Pharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories,Ranbaxy Laboratories Ltd./Ranbaxy PharmaceuticalsInc., and Sandoz.  Each of thelawsuits was filed in the U.S. District Court in New Jersey and allegesinfringement of one or more patents owned by Aventis Pharmaceuticals.  Further, beginning in March 5, 2004, AMRTechnology, along with Aventis Pharmaceuticals, filed suit in the U.S. DistrictCourt in New Jersey against Barr Laboratories, Impax Laboratories, MylanPharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories, AminoChemicals, Ltd., Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., andSandoz, Inc., asserting infringement of two of our U.S. patents that areexclusively licensed to Aventis Pharmaceuticals relating to Allegra andAllegra-D products.

 

15

----

 

In the pendinglitigations, Aventis Pharmaceuticals and AMR Technology have entered intocovenants not to sue the defendants under U.S. Patent No. 5,578,610, whichpatent has not been asserted in the litigation but which Aventis Pharmaceuticalsexclusively licenses from us.  However,we and Aventis Pharmaceuticals have agreed that Aventis Pharmaceuticals willcontinue to pay royalties to us based on that patent under our original licenseagreement with Aventis Pharmaceuticals. Under our arrangements with Aventis Pharmaceuticals, we will receiveroyalties until expiration of the underlying patents (2013 for U.S. Patent No. 5,578,610and 2015 for U.S. Patent No. 5,750,703) unless the patents are earlierdetermined to be invalid.

 

Under applicable federallaw, marketing of an FDA-approved generic version of Allegra may not commenceuntil the earlier of a decision favorable to the generic challenger in thepatent litigation or 30 months after the date the patent infringement lawsuitwas filed. In general, the first generic filer is entitled to a 180-daymarketing exclusivity period upon FDA approval.

 

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

 

**Note 14-Recently Issued Accounting Pronouncements**

 

In November 2004,the FASB issued Statement No. 151, *Inventory Costs — anAmendment of ARB No. 43, Chapter 4,*to clarify the accountingfor abnormal amounts of idle facility expense, freight, handling costs, andwasted material (spoilage).  ThisStatement requires that those items be recognized as current-period chargesregardless of whether they meet the criterion of “so abnormal” as defined inARB No. 43.  In addition, thisStatement requires that allocation of fixed production overheads to the costsof conversion be based on the normal capacity of the productionfacilities.  The provisions of thisStatement are effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005, with earlier application permitted.  This Statement applies to the Company for thefiscal year ending December 31, 2006. The Company will assess the impact of applying this Statement in the secondhalf of 2005.

 

In December 2004,the FASB issued Statement No. 123 (Revised), *Share-BasedPayment (Revised)* (SFAS 123R), which amends FASB Statement No. 123,*Accounting for Stock-Based Compensation*,and supersedes APB Opinion No. 25, *Accounting for StockIssued to Employees,*in establishing standards for the accountingfor transactions in which an entity exchanges its equity instruments for goodsor services, as well as transactions in which an entity incurs liabilities inexchange for goods or services that are based on the fair value of the entity’sequity instruments or that may be settled by the issuance of those equityinstruments.  This Statement requiresthat the cost resulting from all share-based payment transactions be recognizedin the financial statements based on fair value of the share-basedpayment.  This Statement establishes fairvalue as the measurement objective in accounting for share-based paymenttransactions with employees, except for equity instruments held by employeeshare ownership plans.  In April 2005,the SEC issued a Final Rule amending Rule 4-01(A) of Regulation S-X regarding the compliance datefor this Statement.  This Statementapplies to the Company beginning with the quarter ending March 31,2006.  The Company expects that as aresult of adopting this Statement that the Company will recognize expense inthe consolidated statement of operations for the fair value of share optionsand restricted stock awards issued to its employees, as well as for the portionof the purchase discount on the market price of the Company’s common stockoffered to employees in conjunction with the Company’s Employee Stock PurchasePlan that is considered compensatory based on the guidance in SFAS 123R.  The Company has not completed itsdetermination, however, it is expected that the application of this Statementwill have a material impact on the Company’s results of operations.

 

In October 2004, thePresident signed the American Jobs Creation Act of 2004 (the “Act”). The Actprovides a deduction for income from qualified domestic production activities,which will be phased in from 2005 through 2010. In return, the Act alsoprovides for a two-year phase-out of the existing extra-territorial incomeexclusion (ETI) for foreign sales that was viewed to be inconsistent withinternational trade protocols by the European Union.  In December 2004,the FASB issued Staff Position No. FAS 109-1, *Applicationof FASB Statement No. 109, Accounting for Income Taxes, to the TaxDeduction on Qualified Production Activities Provided by the American JobsCreation Act of 2004.*  ThisStaff Position clarifies that the tax deduction for qualified domesticproduction activities provided by the American Jobs Creation Act of 2004 (theAct) should be accounted for as a special deduction under FAS 109 as opposed toa tax-rate deduction.  The phase-in of thetax deduction and the phase-out of the ETI exclusion beginswith qualifying production activities and foreign sales for the year ending December 31,2005.  The Company has included the taximpact of the Act and the impact of applying the Staff Position in itsprovision for income taxes for the three and six months ended June 30,2005.

 

16

----

 

In May 2005, theFASB issued Statement No. 154, *Accounting For Changes andError Corrections: a replacement of APB Opinion No. 20 and FASB Statement No. 3*(SFAS 154).  SFAS 154 revises theaccounting for the impact of the application of voluntary changes in accountingprinciple.  SFAS 154 changes therequirement in APB Opinion No. 20 from recognizing most voluntary changesin accounting principle by including in net income of the period of the changethe cumulative effect of changing to the new principle to requiringretrospective application of the change in principle to the earliest reportingperiod that is practicable, with a corresponding cumulative adjustment to theearliest reporting period presented.  SFAS154 also requires disclosures distinguishing between the retrospectiveapplication of changes in accounting principle and the restatement of financialstatements for correction of an error. The provisions of this Statement are effective for accounting changesmade in fiscal years beginning after December 15, 2005.  The application of this Statement is notexpected to have a material impact on the Company’s financial position orresults of operations.

 

17

----

 

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

 

**Forward-LookingStatements**

 

The following discussionof our results of operations and financial condition should be read inconjunction with the accompanying Condensed Consolidated Financial Statementsand the Notes thereto included within this report. This quarterly report on Form 10-Qcontains “forward-looking statements” within the meaning of Section 27A ofthe Securities Act of 1933, as amended (the “Securities Act”), and Section 21Eof the Securities Exchange 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 and include,but are not limited to, statements concerning the Mount Prospect ResearchCenter, pension plan contributions, GE Healthcare, contract revenue and costs,the ongoing Allegra patent infringement litigation, customer spending andbusiness trends, foreign operations (including Singapore and India), clinicalsupply manufacturing, management’s strategic plans, and research and developmentprojects and expenses, selling, general and administrative expenses andextension of our line of credit.  TheCompany’s actual results may differ materially from such forward-lookingstatements as a result of numerous factors, some of which the Company may notbe able to predict and may not be within the Company’s control.  Factors that could cause such differencesinclude, but are not limited to, the risk that the Company will not achieve thecost savings expected to result from the closure and relocation of its MountProspect operations, the Company’s ability to recruit and retain experiencedscientists, trends in pharmaceutical and biotechnology companies outsourcingchemical research and development, the loss of a significant customer, sales ofAllegra (including any deviations in estimates provided by Sanofi-Aventis) andthe Company’s receipt of significant royalties from the Allegra licenseagreement, the risk that Allegra may be approved for over-the-counter use andClaritin’s approval for over-the-counter use, the Company’s and Sanofi-Aventis’ability to successfully enforce their respective intellectual property, patentrights and technology, including with respect to the generic companies’Abbreviated New Drug Application filings, the integration and operating risksassociated with the Company’s acquisition of Organichem, the Company’s abilityto successfully develop novel compounds and lead candidates in its researchprograms and collaborative arrangements, the Company’s ability to take advantageof proprietary technology and expand the scientific tools available to it, theability of the Company’s strategic investments and acquisitions to perform asexpected and any goodwill impairment related to such investments andacquisitions, the Company’s ability to successfully complete its ongoingexpansion projects on schedule, the Company’s ability to execute its businessplan for compound and chemical screening libraries, and the Company’s abilityto effectively manage its growth, as well as those discussed in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2004 asfiled with the Securities and Exchange Commission on March 16, 2005.  All forward-looking statements are made as ofthe date of this report, and we do not undertake to update any suchforward-looking statements in the future. References to “we,” “us,” and “our,” refers to Albany Molecular Research, Inc.and its subsidiaries, taken as a whole.

 

**Overview**

 

We are a leadingchemistry-based drug discovery and development company, focused on identifyingand developing novel biologically active small molecules with applications inthe prescription drug market. We engage in comprehensive chemistry researchfrom lead discovery, optimization and development to commercial manufacturingand conduct cell and non-cell based high throughput screening on a variety ofbiological targets. We perform contract research services for many of theleading pharmaceutical and biotechnology companies and also conduct our owninternal proprietary research and development to discover newtherapeutically-active lead compounds with commercial potential. We anticipatethat we would then license these compounds to third parties in return forup-front service fees and milestone payments as well as recurring royaltypayments if these compounds are developed into new commercial drugs. In 1995,our proprietary research and development activities led to the development,patenting and licensing of a substantially pure form of, and a manufacturingprocess for, the active ingredient in the non-sedating antihistaminefexofenadine HCl marketed by Sanofi-Aventis S.A. as Allegra in the Americas andas Telfast elsewhere. In addition, certain of our discovery technologycontracts provide for us to receive milestone and royalty payments fordiscoveries that lead to commercial products.

 

18

----

 

Our total revenue for thequarter ended June 30, 2005 was $51.8 million, including $35.9 millionfrom our chemistry contract business, as compared to total revenue of $42.0million for the quarter ended June 30, 2004.  Contract revenue for the second quarter of2005 increased $7.8 million from $28.1 million in the second quarter of 2004.  The increase is due in part to the timing ofdelivery requirements for one of the products sold to Organichem’s largestcustomer, GE Healthcare (GE). GE has discontinued its purchases of this productafter 2005, and has made all of its 2005 purchases in the first half of theyear.  Sales of this product totaled $7.0million in the second quarter of 2005, compared to $3.9 million in the secondquarter of 2004.  Organichem contractrevenue increased an additional $3.7 million in the second quarter of 2005 fromthe second quarter of 2004 due to an increase in clinical supply manufacturingprojects as we continue to transition our large-scale manufacturing focus inthis area.  AMR contract revenueincreased $1.0 million in the second quarter of 2005 from the second quarter of2004, as a decrease in discovery services revenue of $0.8 million was offset byan increase in development and small-scale GMP manufacturing revenue of $1.8million, reflecting the continuing trends of customer preference forlater-stage development services and the impact of increased internationalcompetition on chemistry outsourcing.  Consolidated gross margin was 18.4% for thequarter ended June 30, 2005 compared to (2.5)%for the quarter ended June 30, 2004. Gross profit margin for Organichem in the second quarter of 2005 was 18.3%,compared to 26.0% in the second quarter of 2004.  The decline inOrganichem’s gross margin is primarily attributable to the transition of thisfacility from the manufacturing of commercial products to the manufacturing of clinicalsupply compounds for use in its customers’ clinical trials.  Gross margin at the AMR operating segment increasedto 18.6% in the second quarter of 2005 compared to (38.8)%for the same period in 2004, primarily due to the write-down in the carryingvalue of the Company’s natural product and chemical library inventories of $6.0million and the $0.9 million provision for excess raw materials incurred in2004, as well as the impact of additional contract revenue on the fixed costcomponents of AMRI’s contract business in 2005.

 

During the quarter ended June 30,2005, we generated $10.4 million****in cash fromoperations and spent $4.9 million in capital on our facilities andequipment, primarily related to the expansion of our manufacturing suites at Organichem.  As of June 30, 2005, we had $143.3million in cash, cash equivalents and investments and $50.8 million inbank and other related debt.

 

We continue to pursue ourplans to establish lower-cost international operations, including the commencementof operations at our Singapore Research Centre during the second quarter.  We also expect to begin operations in Indiaduring the second half of 2005. We believe the ability to offer customers achoice of business models and cost structures to meet their drug discoveryneeds will help to strengthen our global competitive advantage.

 

Total contract revenuefrom Organichem’s largest customer, GE, represented 71% and 59% of Organichem’stotal contract revenue for the quarter ended June 30, 2005 and 2004,respectively.  GE accounted for approximately48% and 38% of our consolidated contract revenue for the quarter ended June 30,2005 and 2004, respectively.  As notedabove, GE has discontinued purchases of one of the products we sell to them inthe third quarter of 2005.  We expect anoverall decrease in large-scale manufacturing contract revenue at Organichem inthe second half of 2005 from the six months ended June 30, 2005 due to theaccelerated shipment of this product to GE in the first half of the year.  Our objective is to recoup the revenuesassociated with these sales decreases through increased sales of anotherproduct to GE, as well as continued growth in the area of clinical supplymanufacturing for advanced stage human trials. Clinical supply manufacturing represented 17% of Organichem’s totalcontract revenue for the six months ended June 30, 2005, compared to 10%of total contract revenue for the six months ended June 30, 2004.  We expect the trend of increased growth inclinical supply manufacturing to continue in future periods.

 

Included in total revenuefor the quarter ended June 30, 2005 was $15.9 million in royaltiescompared to $13.9 million for the quarter ended June 30, 2004.  The increase in Allegra royalties is due toan increase in worldwide sales of Allegra as reported to us by Sanofi-Aventis,as well as an increase in royalty payments in certain countries.

 

19

----

 

**Results of Operations – ThreeMonths and Six Months Ended June 30, 2005 Compared to Three Months and SixMonths Ended June 30, 2004**

 

***Revenues***

 

*Totalcontract revenue*

 

Contract revenue consistsprimarily of fees earned under contracts with our third party customers.  Our contract revenues for each of our AMR andOrganichem segments were as follows:

 
| ** **         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)** | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|               |       |                                 |       |                               |       |   |   |   |   |
| AMR                |       | $                                    | 13,356     |                               | $          | 12,383 |   | $ | 26,953 |   | $ | 26,449 |   |
| Organichem         |       | 22,592                               |       | 15,735                             |       | $ | 45,621 |   | $ | 32,483 |   |
| Total              |       | $                                    | 35,948     |                               | $          | 28,118 |   | $ | 72,574 |   | $ | 58,932 |   |

 

AMR contract revenues forthe quarter ended June 30, 2005, increased $1.0 million to $13.4 millionas compared to $12.4 million for the same quarter in the prior year.  The increase is primarily due to increasedcustomer demand for chemical development, small-scale GMP manufacturing andanalytical services as customers continue to focus on development-stageprojects.  This increase is partiallyoffset by a decrease in demand for discovery phase research and development servicesbased on the shift in customer spending to development-stage services as notedabove, as well as continued international competition and related pricingpressures.  We see these trends continuing,and have pursued strategies to establish lower-cost international operations inSingapore and India.  We commencedoperations in our Singapore Research Centre during the second quarter, andexpect to begin operations in India during the second half of 2005.  While the revenue from our internationaloperations is not expected to be material to consolidated contract revenue in2005, we believe the ability to offer customers a choice of business models andcosts structures to meet their drug discovery needs will help to strengthen ourcompetitive advantage.

 

Organichem contractrevenues for the second quarter of 2005 were $22.6 million, an increase of $6.9million compared to contract revenue of $15.7 million during the second quarterof 2004.  Organichem’s contract revenueincreased primarily due to a shift in the timing of delivery requirements for oneof its products from its largest customer, GE.  GE has discontinued its purchases of thisproduct, and has made all of its 2005 purchases in the first half of theyear.    Sales of this product totaled $7.0 million inthe second quarter of 2005, compared to $3.9 million in the second quarter of2004.  The remainder of the increase inOrganichem’s contract revenue for the second quarter of 2005 is due toincreased sales of clinical supply products for advanced stage human clinicaltrials as we shift the focus of our large-scale manufacturing operations.  We expect the trend of increased growth inclinical supply manufacturing to continue in future periods.

 

For the six months ended June 30,2005, AMR contract revenue has increased 2% from the six months ended June 30,2004, as increases in development-stage services have been largely offset bydecreases in discovery phase services as noted above.  Organichem contract revenues for the sixmonths ended June 30, 2005 increased 40% from the six months ended June 30,2004 due to a shift in the timing of delivery requirement for one of itsproducts from GE.  Sales of this producttotaled $17.0 million for the six months ended June 30, 2005, compared to$7.8 million for the six months ended June 30, 2004.    Theremainder of the increase in Organichem’s contract revenue for the six monthsended June 30, 2005 is due to increased sales of clinical supply productsfor advanced stage human clinical trials.

 

*Recurringroyalty revenue*

 

We earn royalties underour licensing agreement with Sanofi-Aventis S.A. for the active ingredient in Allegra.  Royalties were as follows:

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2005**                             | ** ** | **2004**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(in thousands)**                   | ** ** |
| $                                    | 15,892     |                               | $          | 13,878 |   | $ | 27,900 |   | $ | 23,870 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The increase in royaltyrevenue for the three and six months ended June 30, 2005 was attributableto increased worldwide sales of Allegra, as well as higher royalty payments incertain countries.

 

20

----

 

***Costs and Expenses***

 

*Cost ofcontract revenue*

 

Our cost of contractrevenue consists primarily of compensation and associated fringe benefits foremployees, chemicals, depreciation and other indirect project relatedcosts.  Cost of contract revenue for ourAMR and Organichem segments were as follows:

 
| **Segment**              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)**       | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                     |       |                                 |       |                               |       |   |   |   |   |
| AMR                      |       | $                                    | 10,868     |                               | $          | 17,190 |   | $ | 21,572 |   | $ | 27,546 |   |
| Organichem               |       | 18,459                               |       | 11,637                             |       | 36,891 |   | 25,143 |   |
| Total                    |       | $                                    | 29,327     |                               | $          | 28,827 |   | $ | 58,463 |   | $ | 52,689 |   |
|                     |       |                                 |       |                               |       |   |   |   |   |
| AMR Gross Margin         |       | 18.6                                 | %          | (38.8                              | )%         | 20.0 | % | (4.1 | )% |
| Organichem Gross  Margin |       | 18.3                                 | %          | 26.0                               | %          | 19.1 | % | 22.5 | % |
| Total Gross  Margin      |       | 18.4                                 | %          | (2.5                               | )%         | 19.4 | % | 10.6 | % |

 

AMR had a contractrevenue gross margin of 18.6% and 20% for the three and six months ended June 30,2005, respectively, compared to negative contract revenue gross margin of(38.8%) and (4.1%) for the same periods in 2004.  The increase in gross margin largely resultedfrom the reduction in carrying value of our natural product and chemicallibrary inventories by $6.0 million and $0.9 million in additional raw materialinventory reserves incurred in the second quarter of 2004, as well as theimpact of additional contract revenues in relation to the fixed cost componentsof AMR’s contract business in 2005.   Organichem’s contract revenue gross margin decreased to 18.3% and 19.1%for the three and six months ended June 30, 2005 compared to 26.0% and22.5% for the same periods in 2004.  Thedecrease is due to the transition of our large-scale manufacturing facilityfrom specializing in the manufacturing of commercial products to themanufacturing of clinical supply compounds for in use in clinical trials.  We expect the costs incurred in providing contractservices at AMR for the remainder of 2005 to remain consistent with the amountsincurred in the first half of 2005.  Weexpect the trend of downward pressure on our margins to continue at Organichemas we continue the transition of our facility to maximize our clinical compoundmanufacturing capabilities.

 

*Technologyincentive award*

 

We maintain a TechnologyDevelopment Incentive Plan, the purpose of which is to stimulate and encouragenovel innovative technology development by our employees.  This plan allows eligible participants toshare in a percentage of the net revenue earned by us relating to patentedtechnology with respect to which the eligible participant is named as aninventor.  The award is currently payableprimarily to Dr. Thomas D’Ambra, the Chief Executive Officer and Presidentof the Company.  The incentive award wasas follows:

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                   | ** ** |
|                                 |       |                               |       |   |   |   |   |
| $                                    | 1,594      |                               | $          | 1,387 |   | $ | 2,795 |   | $ | 2,385 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The increase wasattributed to increased Allegra royalties for 2005 as compared to 2004.

 

21

----

 

*Researchand development*

 

Research and developmentexpense consists of compensation and benefits for scientific personnel for workperformed on proprietary technology development, research projects, costs ofchemicals and other out of pocket costs and overhead costs. We utilize ourexpertise in small molecule chemistry, biocatalysis and natural products toperform our internal research and development projects.  The goal of these programs is to discover newcompounds with commercial potential.  Wewould then seek to license these compounds to a third party in return for acombination of up-front license fees, milestone payments and recurring royaltypayments if these compounds are successfully developed into new drugs and reachthe market.  In addition, research anddevelopment is performed at Organichem related to the improvement of productionprocesses as well as research related to the potential manufacture of newproducts.  Research and developmentexpenses were as follows:

 

| **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                   | ** ** |
|                                 |       |                               |       |   |   |   |   |
| $                                    | 3,480      |                               | $          | 5,368 |   | $ | 6,969 |   | $ | 13,248 |   |
|                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

The decrease in R&D expenseduring the three months and six months ended June 30, 2005 is the resultof initiatives we undertook to reorganize our internal departments in order tohave a more formalized and structured R&D business group, and we have begunto more narrowly focus the scope of our research and developmentactivities.  In addition, the decrease inR&D expense for the six months ended June 30, 2005 is also due to thefact that R&D expenses for the six months ended June 30, 2004 include a$3.1 million charge recorded for the issuance of warrants to Bristol-MyersSquibb (BMS) in conjunction with our acquisition of intellectual property relatedto our central nervous system (CNS) programs.

 

R&D spending related to individualprojects may fluctuate based on the results of those projects. Projectingexpected project completion dates and anticipated revenue from our internalresearch programs is not practical at this time due to the early stages of theprojects and the inherent risks related to the development of new drugs.  Our internal central nervous system programis our most advanced opportunity to generate revenue, and we expect that asignificant portion of our 2005 research and development costs will be incurredin the further development of this project. We have selected drug candidates from the CNS program to proceedinto toxicity and safety pharmacology testing, with a view to finalizing theselection of a compound or compounds with respect to which we expect tosubsequently file an Investigative New Drug (IND) application with the UnitedStates Food and Drug Administration (FDA) for purposes of commencing humanclinical trials, should continued biological evaluation remain favorable.  We expect research and development expensesto increase in the second half of 2005 as we continue to advance our centralnervous system programs.  While wecontinue to invest in this program, we are also beginning to seek discussionsto license this technology in exchange for a combination of up-front licensefees, milestones and royalty payments. In addition to our central nervoussystem program, the Company also continues to utilize our proprietarytechnologies, including our biocatalysis and natural product capabilities, tofurther advance other early stage internal research programs.

 

*Selling,general and administrative*

 

Selling, general andadministrative expenses consists of compensation and related fringe benefitsfor marketing and administrative employees, professional service fees,marketing costs and all costs related to facilities and informationservices.  Selling, general andadministrative expenses were as follows:

 

| **Three  Months Ended June 30,** | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
| **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                    | ** ** |
|                                  |       |                                |       |   |   |   |   |
| $                                     | 6,394      |                                | $          | 5,811 |   | $ | 12,846 |   | $ | 9,732 |   |
|                                       |            |                                     |            |  |  |  |  |  |  |  |  |

 

22

----

 

The increase in selling,general, and administrative expenses for the three months ended June 30,2005 is due to the addition of $0.3 million in administrative costs associatedwith our Singapore operations; an increase in salary and benefit expenses of$0.5 million due to the addition of administrative and business developmentpersonnel, as well as the reallocation of certain personnel expenses to moreappropriately reflect the current use of these resources.   Theseincreases are partially offset by a decrease in professional fees of $0.7million due to the timing of incurring these costs in the current year, anoverall decrease in Sarbanes-Oxley compliance service costs, and additionallythe three months ended June 30, 2004 included additional accounting andvaluation service fees associated with the impairment analyses performed at ourBothell and Mount Prospect facilities.

 

The increase in selling,general, and administrative expenses for the six months ended June 30,2005 is due to the addition of $0.6 million in administrative costs associatedwith our Singapore operations; an increase in salary and benefit expenses of $1.2million due to the addition of administrative and business developmentpersonnel, as well as the reallocation of certain personnel expenses to moreappropriately reflect the current use of these resources; and $0.5 million inadditional facilities costs associated with the classification of MountProspect facility costs as administrative while it is being held for sale andour corporate headquarters facility, which opened in February 2004.  These increases are partially offset by adecrease in professional fees of $0.3 million due to an overall decrease inSarbanes-Oxley compliance service costs, and additionally the six months ended June 30,2004 included additional accounting and valuation service fees associated withthe impairment analyses performed at our Bothell and Mount Prospectfacilities.  We expect selling, generaland administrative costs to remain consistent with amounts incurred in thefirst half of 2005 for the remainder of the year.

 

*Impairment and RestructuringCharges*

 

As of June 30, 2004 we completed an in-depthreview of the carrying value of all of our natural product and chemicalcompound library inventories. As a result of this review, which was based onexpected future revenues, it was determined that a significant write-down inthe carrying value of library inventories was required. The reduction in thecarrying value of the library inventories reflects the less favorable marketconditions than previously projected.

 

The write-down of libraryinventories triggered an assessment of the recoverability of certain otherrelated long-lived assets and goodwill within the Bothell reporting unit,including the goodwill and intangibles which resulted from the 2001 acquisitionof New Chemical Entities (NCE), in accordance with the provisions of SFAS 144and SFAS 142. Based on our review, we determined that an impairment of certainrelated goodwill and long-lived assets had occurred.

 

In addition, we initiateda restructuring which resulted in the closure of our Mount Prospect ResearchCenter and the consolidation of Mount Prospect’s operations in our New Yorkfacilities. The restructuring triggered an assessment of the carrying value ofthe Mount Prospect Research Center property and equipment and related goodwill.Based on its review, and in accordance with the provisions of SFAS 144 and SFAS142, we determined that an impairment of certain related goodwill and propertyand equipment had occurred.  Further,during the second quarter of 2004 we incurred restructuring costs related tothe Mount Prospect restructuring.

 

Based on the foregoing,during the quarter ended June 30, 2004, the Company recorded pre-taxcharges and incurred restructuring costs related to its Bothell and MountProspect businesses as follows:

 
| ** **                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **(in thousands)**                 | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                               |       |                                 |       |                               |       |   |   |   |   |
| 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 |   |
|                                    |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

23

----

 

Property &Equipment Impairment

 

The $4.7 million propertyand equipment impairment charge recorded in the second quarter of 2004 relatesto two impairment analyses performed as a result of certain triggeringevents.  A $1.6 million property andequipment impairment charge was recorded due to our Mount Prospect ResearchCenter facility closure.  During thequarter ended June 30, 2004, we announced the closure of the MountProspect facility.  It was determinedthat the carrying value of the assets was in excess of the fair value of theasset group and we recorded a write-down of $1.6 million. Additionally, a$3.1 million property and equipment impairment charge was recorded due to animpairment analysis that was performed as a result of the reduction in

thecarrying value of the library inventories at our Bothell Research Center.  As a result of the impairment analysis, itwas determined that the carrying value of the assets was in excess of the fairvalue of the asset group and we recorded a write-down of $3.1 million. Therevised carrying value of the assets is being depreciated over the averageremaining life of the primary assets of the group.

 

Goodwill Impairment

 

As a result of thereduction in carrying value of our natural product libraries and relatedlong-lived assets at our Bothell reporting unit and the announced closure ofour Mount Prospect reporting unit, we performed goodwill impairment analyses oneach of these reporting units as of June 30, 2004.  As a result of these analyses, we recorded a$13.3 million goodwill impairment charge related to our Bothell reporting unitand a $1.2 million impairment charge related to our Mount Prospect reportingunit. In calculating the goodwill impairment charges, the fair value of thereporting units was determined with assistance from an independent valuationadvisor.  The valuations were based upona discounted cash flow approach. Significant assumptions used in the analysis include (i) expectedfuture revenue growth rates, reporting unit profit margins, and working capitallevels, (ii) a discount rate, and (iii) a terminal value multiple.The revenue growth rates, working capital levels and reporting unit profitmargins were based on management’s best estimate of future results.

 

Intangible AssetImpairment

 

As a result of ourreduction in the quarter ending June 30, 2004 of the carrying value of ournatural product libraries, we also performed an assessment of the carryingvalue of our microbial cultures and related technologies, which are thestarting materials and technology used in the development of the naturalproduct libraries.  Based on ourassessment, we concluded that the carrying value of the microbial cultures andrelated technologies was not recoverable, and accordingly recorded animpairment charge of $3.5 million representing the entire remaining carryingvalue of microbial cultures and related technologies.

 

Restructuring

 

On May 4, 2004 weannounced our plan to consolidate operations by relocating our Mount Prospectfacility operations to our facilities in New York.  During the second quarter of 2004 we incurredrestructuring costs totaling $0.4 million, consisting primarily of terminationbenefits.

 

*Interest income (expense), net*

 
| ** **            | ** ** | **Three  Months Ended June 30,** | ** **   | **Six  Months Ended June 30,** | ** ** |
|-----------------------|------------|---------------------------------------|--------------|-------------------------------------|------------|
| ** **            | ** ** | **2005**                              | ** **   | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                  |       | **(in thousands)**                    | *** *** |
| Interest  Expense     |       | $                                     | (563         | )                                   | $          | (285 | ) | $ | (1,041 | ) | $ | (724 | ) |
| Interest  Income      |       | 883                                   |         | 527                                 |       | 1,561 |   | 1,026 |   |
| Interest  income, net |       | $                                     | 320          |                                | $          | 142 |   | $ | 520 |   | $ | 302 |   |

 

The increase in interestexpense for the three and six months ended June 30, 2005 was due toincreases in the rates paid on the Company’s variable rate debt that were nothedged by its interest rate swaps.  Inaddition, the increase in interest expense for the six months ended June 30,2005 is due in part to the capitalization of interest costs incurred during theconstruction of the Company’s headquarters facility in the first quarter of2004.

 

The increase in interestincome was primarily due to increases in the rates earned on interest-bearingcash accounts, other short-term cash equivalents, and investment securities, aswell as increase in the balances held in these accounts of approximately $21.6million.

 

24

----

 

*Incometax expense (benefit)*.

 

| **Three  Months Ended June 30,** | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|
| **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                    | ** ** |
|                                  |       |                                |       |   |   |   |   |
| $                                     | 4,138      |                                | $          | (1,670 | ) | $ | 7,101 |   | $ | (183 | ) |
|                                       |            |                                     |            |  |  |  |  |  |  |  |  |

 

Our income tax expense(benefit) for the three and six months ended June 30, 2004, reflects thegoodwill and intangible asset impairment charges as non-deductible taxitems.  The increase in the effectiverate resulted primarily from the impact the revised 2004 projected annualresults had in relationship to the 2004 projected annual permanentdifferences.  We expect our 2005effective tax rate to be approximately 36% for the full year, which isconsistent with the Company’s historical experience excluding the impact of the2004 impairment charges.

 

**Liquidity and Capital Resources**

 

We have historicallyfunded our business through operating cash flows, proceeds from borrowings andthe issuance of equity securities. During the first six months of 2005, we generated cash of $17.6 millionfrom operating activities.  The primarysources of operating cash flows are payments received for the performance ofcontracted chemistry services and royalty payments received from Sanofi-Aventisbased upon a percentage of sales of Allegra. The primary uses of operating cash flows are the payment of compensationand benefits to both scientific and administrative personnel, purchases ofinventory and supplies, and payment of occupancy costs.  A substantial majority of the uses ofoperating cash flows pertain to the Company’s research and development andcontract service business activities.

 

During the first sixmonths of 2005, we used $11.5 million in investing activities, resulting fromthe use of $6.6 million for the acquisition of property and equipment, andpurchases of investment securities net of proceeds from sales and maturities of$4.9 million.  During the first sixmonths of 2005, we used $1.1 million for financing activities, consisting of$2.4 million in long-term debt repayments, offset by $1.2 million provided byproceeds and tax benefits realized from stock option and stock purchase planexercises.

 

Working capital was$191.6 million at June 30, 2005 as compared to $179.8 million as of December 31,2004.  The primary sources of theincrease were an increase in cash and investments due to the collection ofAllegra royalty revenues, an increase in royalty receivables, and an increasein accounts receivable due to timing of shipments to Organichem’s largestcustomer, GE Healthcare.  These increaseswere partially offset by an increase in income taxes payable due to the accrualof estimated income tax expense on the Company’s pre-tax income during thefirst six months of 2005.    During 2005, we anticipate making $0.6million in defined benefit pension plan contributions, $0.5 million of whichwas paid in the first six months.

 

We entered into a creditfacility consisting of $30.0 million term loan and $35.0 million line of creditto fund the acquisition of Organichem during 2003.  On June 30, 2005, the Company amendedthe credit facility to extend the maturity date on the line of credit from February 2006to June 2010.   The term loan matures in February, 2008.  As of June 30, 2005, the interest rateon $14.3 million of the outstanding term loan balance was 4.86% and theinterest rate on the remaining $6.1 million was 4.59%.  The line of credit bears interest at avariable rate based on the Company’s leverage ratio.  As of June 30, 2005, the outstandingbalance of the line of credit was $25.5 million and the interest rate was 4.43%.  The credit facility contains certainfinancial covenants, including a maximum leverage ratio, a minimum requiredoperating cash flow coverage ratio, a minimum earningsbefore interest and taxes to interest ratio and a minimum current ratio.  Other covenants include limits on assetdisposals and the payment of dividends. As of June 30, 2005 we were in compliance with all covenants underthe credit facility.

 

The disclosure ofpayments we have committed to make under our contractual obligations is setforth under the heading “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Liquidity and Capital Resources” under Item7 of our 2004 Form 10-K. Excluding the extension of the maturity date onthe line of credit from 2006 to 2010, the repayment of $2.2 million outstandingunder our credit facility, and $0.5 million in defined benefit pension plancontributions, as described above, there have been no material changes to ourcontractual obligations since December 31, 2004.

 

25

----

 

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

 

The recurring royaltieswe receive on the sales of Allegra have historically provided a materialportion of our operating cash flows.  Asdiscussed in Part II, Item I of this Form 10-Q, several genericmanufacturers have filed ANDA applications with the FDA seeking authorizationto produce and market a generic version of Allegra.  We and Aventis Pharmaceuticals have filedseveral patent infringement suits against these generic companies alleginginfringement of certain U.S. patents. Should we or Sanofi-Aventis be unsuccessful in defending these patentswe would experience a material decrease in operating cash flows.

 

**CriticalAccounting Policies and Estimates**

Our discussion andanalysis of our financial condition and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States of America.The preparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses, and related disclosure of contingent assets and liabilities. On anon-going basis, we evaluate our estimates, including those related to baddebts, inventories, intangible assets, equity investments, unbilled revenue,income taxes and contingencies. We base our estimates on historical experienceand on various other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

 

We refer to the policiesand estimates set forth in the section “Management’s Discussion andAnalysis of Financial Condition and Results of Operation — Critical AccountingEstimates” of our Annual Report on Form 10-K for the fiscal year ended December 31,2004.  There have been no materialchanges or modifications to the policies since December 31, 2004.

 

Item 3.  Quantitative and Qualitative Disclosuresabout Market Risk

 

There are no materialchanges in market risks since our annual report on Form 10-K for the yearended December 31, 2004.

 

Item4.  Controls and Procedures

 

*Disclosure Controls and Procedures*

 

As required by rule 13a-15(b) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), as of the endof the period covered by this Quarterly Report our management conducted anevaluation with the participation of our Chief Executive Officer and ChiefFinancial Officer, regarding the effectiveness of our disclosure controls andprocedures.  In designing and evaluatingour disclosure controls and procedures, we recognize that any controls andprocedures, no matter how well designed and operated, can provide only reasonableassurance of achieving the desired control objectives, and our managementnecessarily was required to apply its judgment in evaluating and implementingpossible controls and procedures. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that, as of theend of the period covered by this Quarterly Report, our disclosure controls andprocedures were effective in that they provide reasonable assurance thatinformation required to be disclosed by us in the reports we file or submitunder the Exchange Act is recorded, processed, summarized and reported, withinthe time periods specified in the Securities and Exchange Commission’s rules andforms.  We intend to review and documentour disclosure 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.

 

26

----

 

*Internal Control OverFinancial Reporting*

 

As disclosed in theCompany’s Annual Report on Form 10-K for the year ended December 31,2004, the Company did not maintain effective controls over inventory valuationat the Company’s large scale manufacturing facility as of December 31,2004. Specifically, during the fourth quarter of 2004, the Company failed toidentify certain obsolete inventory during its year end reconciliation processand also failed to demonstrate that its controls over ensuring a complete andadequate review for excess inventory had been performed by management in atimely manner. In addition, the Company failed to maintain an adequate level ofdocumentary evidence to demonstrate that its amortization period for deferredinventory variances was accurate. Furthermore, during the year-endreconciliation of unbilled project costs the Company failed to identify aproject which had been billed but for which the related costs had not beenexpensed. Certain of these control deficiencies resulted in audit adjustmentsto the Company’s December 31, 2004 inventory balance,however, they did not result in the restatement of any of the Company’s annualor interim consolidated financial statements. Additionally, these controldeficiencies result in more than a remote likelihood that a misstatement to theinventory and cost of sales accounts resulting in a material misstatement toannual or interim financial statements would not be prevented or detected.Accordingly, management determined that these deficiencies constituted amaterial weakness. Because of this material weakness, management concluded thatthe Company did not maintain effective internal control over financialreporting as of December 31, 2004 based on the criteria in the *Internal Control—Integrated Framework*.

 

The Company is in theprocess of remediating the identified material weakness in the Company’sinternal control over financial reporting, including implementing new controlsas disclosed in the Company’s Annual Report on Form 10-K for the yearended December 31, 2004 to ensure that all obsolete inventoryis appropriately reserved for. These controls include an enhancedreconciliation process for system generated obsolete inventory reports to thegeneral ledger reserve account to ensure that the general ledger reserveaccount is accurate and complete. Further, increased internal documentation hasbeen prepared to support the Company’s excess inventory reserves. With regardto the Company’s analysis of the amortization period for deferred inventoryvariances, the Company has implemented new procedures to analyze the deferredinventory amortization period, including documentation of the method used tocalculate the amortization period. With respect to the Company’s accumulatedunbilled project costs, the Company has implemented procedures to ensurecompleted projects are removed from the account balance in a timely manner.These procedures include a review of the projects included in the accountbalance by additional Company personnel. Furthermore, during the fourth quarterof 2004 the Company initiated the process of identifying an Enterprise ResourcePlanning (ERP) application that, once implemented, will provide additionalenhancements of the Company’s current internal control environment. The Companyhas also committed additional external resources to perform a review of theinventory accounting procedures at its large scale manufacturing facility inorder to identify additional process enhancements.  Management will test these controls inconjunction with the Company’s year-end controls testing process.

 

Other than asdescribed immediately above, there were no changes in our internal control overfinancial reporting that occurred during the period covered by this QuarterlyReport on Form 10-Q that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

27

----

 

PART II - OTHER INFORMATION

 

Item 1.    Legal Proceedings

 

The Company, from time totime, may be involved in various claims and legal proceedings arising in theordinary course of business. Except as noted below in regards to litigationrelating to Allegra, the Company is not currently a party to any such claims orproceedings which, if decided adversely to the Company, would eitherindividually or in the aggregate have a material adverse effect on the Company’sbusiness, financial condition, results of operations or cash flows.

 

AMR Technology, a subsidiaryof the Company, along with Aventis Pharmaceuticals Inc., the U.S.pharmaceutical business of Sanofi-Aventis S.A., are involved in legalproceedings with several companies seeking to market generic versions ofAllegra.  Beginning in 2001, BarrLaboratories, Inc., Impax Laboratories, Inc., Mylan Pharmaceuticals, Inc.,Teva Pharmaceuticals USA, Dr. Reddy’s Laboratories, Ltd./Dr. Reddy’sLaboratories, Inc., Ranbaxy Laboratories Ltd./Ranbaxy PharmaceuticalsInc., and Sandoz Inc. filed Abbreviated New Drug Applications (ANDAs) withthe U.S. Food and Drug Administration, or FDA, to produce and market genericversions of Allegra products.

 

In response to thefilings described above, beginning in 2001, Aventis Pharmaceuticals filedpatent infringement lawsuits against Barr Laboratories, Impax Laboratories,Mylan Pharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories,Ranbaxy Laboratories Ltd./Ranbaxy PharmaceuticalsInc., and Sandoz.  Each of thelawsuits was filed in the U.S. District Court in New Jersey and allegesinfringement of one or more patents owned by Aventis Pharmaceuticals.  Further, beginning in March 5, 2004, AMRTechnology, along with Aventis Pharmaceuticals, filed suit in the U.S. DistrictCourt in New Jersey against Barr Laboratories, Impax Laboratories, MylanPharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories, AminoChemicals, Ltd., Ranbaxy Laboratories Ltd./Ranbaxy Pharmaceuticals Inc., andSandoz, Inc., asserting infringement of two of our U.S. patents that areexclusively licensed to Aventis Pharmaceuticals relating to Allegra andAllegra-D products.

 

In the pendinglitigations, Aventis Pharmaceuticals and AMR Technology have entered intocovenants not to sue the defendants under U.S. Patent No. 5,578,610, whichpatent has not been asserted in the litigation but which AventisPharmaceuticals exclusively licenses from us. However, we and Aventis Pharmaceuticals have agreed that AventisPharmaceuticals will continue to pay royalties to us based on that patent underour original license agreement with Aventis Pharmaceuticals.  Under our arrangements with AventisPharmaceuticals, we will receive royalties until expiration of the underlyingpatents (2013 for U.S. Patent No. 5,578,610 and 2015 for U.S. Patent No. 5,750,703)unless the patents are earlier determined to be invalid.

 

Under applicable federallaw, marketing of an FDA-approved generic version of Allegra may not commenceuntil the earlier of a decision favorable to the generic challenger in thepatent litigation or 30 months after the date the patent infringement lawsuitwas filed. In general, the first generic filer is entitled to a 180-daymarketing exclusivity period upon FDA approval.

 

28

----

 

Item4.        Submission of Matters to aVote of Security Holders

 

The Company held itsAnnual Meeting of Stockholders (the “Annual Meeting”) on May 18, 2005.  At the Annual Meeting, stockholders of theCompany voted to elect Frank W. Haydu, III and Arthur J. Roth to serve as Class IDirectors of the Company for three-year terms, such terms to continue until theAnnual Meeting of Stockholders in 2008 and until their respective successorsare duly elected and qualified.  Thevotes cast for, and withheld from, the election of the aforementioned Directorsare listed below:

 

| ** **                | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|---------------------------|------------|------------|------------|--------------|------------|
|                      |       |       |       |         |       |
| Frank  W. Haydu, III |       | 29,924,247 |       | 761,616      |       |
|                      |       |       |       |         |       |
| Arthur  J. Roth           |       | 28,924,731 |       | 761,132      |       |

 

The following individualscontinued as directors following the meeting: Paul S. Anderson, Donald E.Kuhla, Kevin O’Connor, Thomas E. D’Ambra, and Anthony P. Tartaglia.

 

Item 6.    Exhibits

 

(a)       Exhibits.

 

10.1         SecondAmendment, dated as of June 30, 2005, to Credit Agreement between AlbanyMolecular Research, Inc. and Bank of America, N.A., JPMorgan Chase Bank,N.A. and Citizens Bank of Massachusetts (filed herewith).

 

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

 

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

 

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

 

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

 

29

----

 

SIGNATURES

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                            | ALBANY MOLECULAR  RESEARCH, INC. |
|---------------------------------|----------------------------------|
|                            |                             |   |
|                            |                             |   |
| Date:  August 8, 2005 | By:                              | /s/ Thomas E. D’Ambra,  Ph.D. |   |
|                            |                             | Thomas E. D’Ambra,  Ph.D. |
|                            |                             | Chairman of the Board, President  and Chief Executive  Officer |
|                            |                             | (Authorized Officer) |
|                            |                             |   |
| Date:  August 8, 2005 | By:                              | /s/ Mark T. Frost |   |
| ** **                      | ** **                       | **Mark T. Frost** |
|                            |                             | Chief Financial  Officer, Secretary and Treasurer  (Authorized Officer and Principal Financial Officer) |

 

30

----