**UNITED STATESSECURITIES 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 September 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              ** |

 

**Commissionfile number:  0-25323**

 

**ALBANY MOLECULAR RESEARCH, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

(Addressof principal executive offices)

 

**(518) 464-0279**

(Registrant’stelephone number, including area code)

 

**N/A**

(Formername, 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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

 

Yes         o            No           ý

 

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

 

| **Class**                     | ** ** | **Outstanding at November 3, 2005** |
|-------------------------------|------------|------------------------------------------|
| Common  Stock, $.01 par value |       | 32,358,834                               |

 

 

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ALBANY MOLECULAR RESEARCH, INC.

INDEX

 
| Part I.       | Financial Information | 3                                                                                           |
|--------------------|-----------------------|---------------------------------------------------------------------------------------------|
|               |                  |                                                                                        |   |
|               | Item 1.               | Condensed Consolidated Financial Statements (Unaudited)                                     | 3 |
|               |                  |                                                                                        |   |
|               |                  | Condensed Consolidated Statements of Operations                                             | 3 |
|               |                  | Condensed Consolidated Balance Sheets                                                       | 4 |
|               |                  | Condensed Consolidated Statements of Cash Flows                                             | 5 |
|               |                  | Notes to Condensed Consolidated Financial Statements                                        | 6 |
|               |                  |                                                                                        |   |
|               | Item 2.               | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 18 |
|               |                  |                                                                                        |   |
|               | Item 3.               | Quantitative and Qualitative Disclosures  About Market Risk                                 | 26 |
|               |                  |                                                                                        |   |
|               | Item 4.               | Controls and Procedures                                                                     | 26 |
|               |                  |                                                                                        |   |
| Part II.      | Other Information     | 28                                                                                          |
|               |                  |                                                                                        |   |
|               | Item 1.               | Legal Proceedings                                                                           | 28 |
|               |                  |                                                                                        |   |
|               | Item 6.               | Exhibits                                                                                    | 29 |
|               |                  |                                                                                        |   |
| Signatures         | 29                    |
|               |                  |                                                                                        |   |
| Exhibit Index |                  |

 

2

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PART I — FINANCIAL INFORMATION

 

Item 1.    Condensed ConsolidatedFinancial Statements

 

**AlbanyMolecular Research, Inc.**

**Condensed Consolidated Statements of Operations**

**(unaudited)**

 
| ** **                                             | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **(Dollars in thousands, except  for per share data)** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Contract  revenue                                      |       | $                            | 31,550     |                         | $          | 28,703 |   | $ | 104,124 |   | $ | 87,635 |   |
| Recurring  royalties                                   |       | 12,779                       |       | 11,917                       |       | 40,679 |   | 35,787 |   |
| Total  revenue                                         |       | 44,329                       |       | 40,620                       |       | 144,803 |   | 123,422 |   |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Cost of  contract revenue                              |       | 26,137                       |       | 23,275                       |       | 84,600 |   | 69,990 |   |
| Write-down  of library inventories                     |       | —                       |       | —                       |       | — |   | 5,974 |   |
| Total cost  of contract revenue                        |       | 26,137                       |       | 23,275                       |       | 84,600 |   | 75,964 |   |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Technology  incentive award                            |       | 1,277                        |       | 1,193                        |       | 4,072 |   | 3,578 |   |
| Research and  development                              |       | 4,070                        |       | 5,186                        |       | 11,039 |   | 18,434 |   |
| Selling,  general and administrative                   |       | 6,331                        |       | 6,439                        |       | 19,177 |   | 16,171 |   |
| Property and  equipment impairment                     |       | —                       |       | —                       |       | — |   | 4,728 |   |
| Goodwill  impairment                                   |       | —                       |       | —                       |       | — |   | 14,494 |   |
| Intangible  asset impairment                           |       | —                       |       | —                       |       | — |   | 3,541 |   |
| Restructuring  charge                                  |       | —                       |       | 230                          |       | — |   | 656 |   |
| Total costs  and expenses                              |       | 37,815                       |       | 36,323                       |       | 118,888 |   | 137,566 |   |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Income  (loss) from operations                         |       | 6,514                        |       | 4,297                        |       | 25,915 |   | (14,144 | ) |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Equity in  loss of unconsolidated affiliates           |       | —                       |       | —                       |       | — |   | (65 | ) |
| Interest  (expense) income, net                        |       | 561                          |       | (23                          | )          | 1,081 |   | 279 |   |
| Other  (expense) income, net                           |       | (137                         | )          | —                       |       | (67 | ) | 9 |   |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Income  (loss) before income tax expense               |       | 6,938                        |       | 4,274                        |       | 26,929 |   | (13,921 | ) |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Income tax  expense                                    |       | 2,565                        |       | 1,384                        |       | 9,666 |   | 1,201 |   |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Net income  (loss)                                     |       | $                            | 4,373      |                         | $          | 2,890 |   | $ | 17,263 |   | $ | (15,122 | ) |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Basic  earnings (loss) per share                       |       | $                            | 0.14       |                         | $          | 0.09 |   | $ | 0.54 |   | $ | (0.48 | ) |
|                                                   |       |                         |       |                         |       |   |   |   |   |
| Diluted  earnings (loss) per share                     |       | $                            | 0.13       |                         | $          | 0.09 |   | $ | 0.53 |   | $ | (0.48 | ) |

 

*See notes to unaudited condensed consolidatedfinancial statements.*

 

3

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**AlbanyMolecular Research, Inc.**

**Condensed Consolidated Balance Sheets**

**(unaudited)**

 
| **(Dollars and share amounts in  thousands)**                                                                                                                  | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                           |       |                         |       |                        |       |
| **Assets**                                                                                                                                                     |       |                         |       |                        |       |
| Current  assets:                                                                                                                                               |       |                         |       |                        |       |
| Cash and  cash equivalents                                                                                                                                     |       | $                            | 17,634     |                        | $          | 41,171 |   |
| Investment  securities, available-for-sale                                                                                                                     |       | 100,221                      |       | 92,578                      |       |
| Accounts  receivable, net                                                                                                                                      |       | 20,651                       |       | 14,263                      |       |
| Royalty  income receivable                                                                                                                                     |       | 12,783                       |       | 12,178                      |       |
| Inventories                                                                                                                                                    |       | 35,396                       |       | 32,415                      |       |
| Prepaid  expenses and other current assets                                                                                                                     |       | 4,031                        |       | 3,914                       |       |
| Property and  equipment held for sale                                                                                                                          |       | 5,627                        |       | 5,627                       |       |
| Total  current assets                                                                                                                                          |       | 196,343                      |       | 202,146                     |       |
|                                                                                                                                                           |       |                         |       |                        |       |
| Property, plant  and equipment, net                                                                                                                            |       | 147,240                      |       | 145,753                     |       |
|                                                                                                                                                           |       |                         |       |                        |       |
| Other  assets:                                                                                                                                                 |       |                         |       |                        |       |
| Goodwill                                                                                                                                                       |       | 25,747                       |       | 25,747                      |       |
| Intangible  assets and patents, net                                                                                                                            |       | 1,347                        |       | 1,201                       |       |
| Equity  investments in unconsolidated affiliates                                                                                                               |       | 956                          |       | 956                         |       |
| Other assets                                                                                                                                                   |       | 1,176                        |       | 1,089                       |       |
| Total other  assets                                                                                                                                            |       | 29,226                       |       | 28,993                      |       |
|                                                                                                                                                           |       |                         |       |                        |       |
| Total assets                                                                                                                                                   |       | $                            | 372,809    |                        | $          | 376,892 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                 |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                          |       |                         |       |                        |       |
| Accounts  payable and accrued expenses                                                                                                                         |       | $                            | 13,055     |                        | $          | 14,289 |   |
| Deferred  revenue                                                                                                                                              |       | 4,861                        |       | 2,089                       |       |
| Accrued  pension benefits                                                                                                                                      |       | 631                          |       | 631                         |       |
| Income taxes  payable                                                                                                                                          |       | 3,895                        |       | 846                         |       |
| Current  installments of long-term debt and capital leases                                                                                                     |       | 4,536                        |       | 4,526                       |       |
| Total  current liabilities                                                                                                                                     |       | 26,978                       |       | 22,381                      |       |
|                                                                                                                                                           |       |                         |       |                        |       |
| Long-term  liabilities:                                                                                                                                        |       |                         |       |                        |       |
| Long-term  debt and capital leases, excluding current installments                                                                                             |       | 19,595                       |       | 48,603                      |       |
| Deferred  income taxes                                                                                                                                         |       | 8,936                        |       | 6,997                       |       |
| Pension and  postretirement benefits                                                                                                                           |       | 2,521                        |       | 3,139                       |       |
| Other long  term liabilities                                                                                                                                   |       | 242                          |       | 296                         |       |
| Total  liabilities                                                                                                                                             |       | 58,272                       |       | 81,416                      |       |
|                                                                                                                                                           |       |                         |       |                        |       |
| Commitments  and contingencies (notes 1 and 7)                                                                                                                 |       |                         |       |                        |       |
|                                                                                                                                                           |       |                         |       |                        |       |
| Stockholders’  equity:                                                                                                                                    |       |                         |       |                        |       |
| Common  stock, $0.01 par value, 50,000 shares authorized, 34,436 shares issued at September 30,  2005, and 33,942 shares issued at December 31, 2004 |       | 344                          |       | 340                         |       |
| Additional  paid-in capital                                                                                                                                    |       | 193,239                      |       | 189,608                     |       |
| Unearned  compensation — restricted stock                                                                                                                 |       | (1,798                       | )          | —                      |       |
| Accumulated  other comprehensive loss                                                                                                                          |       | (156                         | )          | (117                        | )          |
| Retained  earnings                                                                                                                                             |       | 160,079                      |       | 142,816                     |       |
|                                                                                                                                                           |       | 351,708                      |       | 332,647                     |       |
| Less,  treasury shares at cost, 2,077 shares                                                                                                                   |       | (37,171                      | )          | (37,171                     | )          |
| Total  stockholders’ equity                                                                                                                               |       | 314,537                      |       | 295,476                     |       |
| Total  liabilities and stockholders’ equity                                                                                                               |       | $                            | 372,809    |                        | $          | 376,892 |   |

 

*See notes to unaudited condensed consolidatedfinancial statements.*

 

4

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**AlbanyMolecular Research, Inc.**

**Condensed Consolidated Statements of Cash Flows**

**(unaudited)**

 
| ** **                                                                                | ** ** | **Nine Months Ended**        | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| **(Dollars in thousands)**                                                                | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| **Operating  activities**                                                                 |       |                         |       |   |   |
| Net income  (loss)                                                                        |       | $                            | 17,263     |   | $ | (15,122 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                         |       |   |   |
| Depreciation  and amortization                                                            |       | 11,536                       |       | 11,429 |   |
| Foreign  exchange loss                                                                    |       | 9                            |       | — |   |
| Write-down  of library inventories                                                        |       | —                       |       | 5,974 |   |
| Property and  equipment impairment                                                        |       | —                       |       | 4,728 |   |
| Goodwill  impairment                                                                      |       | —                       |       | 14,494 |   |
| Intangible  asset impairment                                                              |       | —                       |       | 3,541 |   |
| Warrant  issuance expense                                                                 |       | —                       |       | 3,053 |   |
| Allowance  for bad debts                                                                  |       | (72                          | )          | 4 |   |
| Equity in  income (loss) of unconsolidated affiliates                                     |       | —                       |       | 65 |   |
| Deferred  income tax expense (benefit)                                                    |       | 1,921                        |       | (4,099 | ) |
| Loss on  disposal of property, plant and equipment                                        |       | 169                          |       | — |   |
| Stock-based  compensation expense                                                         |       | 256                          |       | — |   |
| (Increase)  decrease in:                                                                  |       |                         |       |   |   |
| Accounts  receivable                                                                      |       | (6,316                       | )          | (513 | ) |
| Royalty  income receivable                                                                |       | (605                         | )          | 1,008 |   |
| Unbilled  services                                                                        |       | (217                         | )          | 151 |   |
| Inventory,  prepaid expenses and other assets                                             |       | (3,793                       | )          | (4,475 | ) |
| (Decrease)  increase in:                                                                  |       |                         |       |   |   |
| Accounts  payable and accrued expenses                                                    |       | (1,234                       | )          | (756 | ) |
| Income tax  payable                                                                       |       | 3,049                        |       | 1,077 |   |
| Deferred  revenue                                                                         |       | 2,772                        |       | 328 |   |
| Pension and  postretirement benefits                                                      |       | (618                         | )          | (1,614 | ) |
| Other long-term  liabilities                                                              |       | (54                          | )          | (28 | ) |
| Net cash  provided by operating activities                                                |       | 24,066                       |       | 19,245 |   |
|                                                                                      |       |                         |       |   |   |
| **Investing  activities**                                                                 |       |                         |       |   |   |
| Net  (purchases) maturities of investment securities                                      |       | (95,083                      | )          | 5,148 |   |
| Proceeds  from sale of investment securities                                              |       | 87,114                       |       | 16,100 |   |
| Purchases of  property, plant and equipment                                               |       | (11,958                      | )          | (17,698 | ) |
| Proceeds  from disposal of property, plant and equipment                                  |       | 27                           |       | — |   |
| Payments for  patent applications and other costs                                         |       | (219                         | )          | (169 | ) |
| Net cash  (used in) provided by investing activities                                      |       | (20,119                      | )          | 3,381 |   |
|                                                                                      |       |                         |       |   |   |
| **Financing  activities**                                                                 |       |                         |       |   |   |
| Principal  payments on long-term debt                                                     |       | (28,998                      | )          | (3,445 | ) |
| Proceeds  from sale of common stock                                                       |       | 1,225                        |       | 1,095 |   |
| Tax benefit  from exercise of stock options                                               |       | 356                          |       | — |   |
| Net cash  used in financing activities                                                    |       | (27,417                      | )          | (2,350 | ) |
|                                                                                      |       |                         |       |   |   |
| Effect of  exchange rate changes on cash flows                                            |       | (67                          | )          | — |   |
|                                                                                      |       |                         |       |   |   |
| (Decrease)  increase in cash and cash equivalents                                         |       | (23,537                      | )          | 20,276 |   |
|                                                                                      |       |                         |       |   |   |
| Cash and  cash equivalents at beginning of period                                         |       | 41,171                       |       | 18,187 |   |
|                                                                                      |       |                         |       |   |   |
| Cash and  cash equivalents at end of period                                               |       | $                            | 17,634     |   | $ | 38,463 |   |

 

*See notes to unaudited condensed consolidatedfinancial statements.*

 

5

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

(All amounts in thousands, except per share amounts, unless otherwisenoted)

 

**Nature of Business and Operations**

 

Albany Molecular Research, Inc. (the “Company”) is a global drugdiscovery and development company focused on applications for new smallmolecule prescription drugs. The Company conducts research and developmentprojects and collaborates with many leading pharmaceutical and biotechnologycompanies, and is developing new chemistry technology for potentialpharmaceutical products. The Company engages in chemistry research, from leaddiscovery, optimization and development to commercial manufacturing. As part ofits drug discovery strategy, the Company is also producing novel compoundcollections and chemical screening collections. In addition to its chemistryresearch services, the Company also conducts proprietary research anddevelopment to develop new technologies and to discover new lead compounds withcommercial potential. The Company seeks to license these compounds to thirdparties in return for up-front service fees and milestone payments as well asrecurring royalty payments if these compounds are developed into new drugssuccessfully reaching the market.

 

**Basis of Presentation**

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and with theinstructions to Form 10-Q and Rule 10-01 of Regulation S-X.  In accordance with Rule 10-01, theunaudited condensed consolidated financial statements do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete consolidated financialstatements.  The December 31, 2004condensed consolidated balance sheet data was derived from audited consolidatedfinancial statements but does not include all disclosures required byaccounting principles generally accepted in the United States of America.  In the opinion of management, all adjustments(consisting of normal recurring accruals and adjustments) considered necessaryfor a fair statement of the results for the interim periods have been included.  Operating results for the three and ninemonths ended September 30, 2005 are not necessarily indicative of theresults that 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.

 

Theaccompanying unaudited condensed consolidated financial statements include theaccounts of Albany Molecular Research, Inc. and its wholly ownedsubsidiaries.  All intercompany balancesand transactions have been eliminated during consolidation.  Assets and liabilities of non-U.S. operationsare translated at period-end rates of exchange, and the statements ofoperations are translated at the average rates of exchange for the period.Gains or losses resulting from translating non-U.S. currency financialstatements are recorded in accumulated other comprehensive loss in the accompanyingSeptember 30, 2005 condensed consolidated balance sheet.

 

***RevisedClassification of Certain Securities***

* *

Effective December 31, 2004, we revisedthe classification of our auction rate municipal bonds as investment securitiesin current assets. Previously, such investments had been classified as cash andcash equivalents. We have made corresponding reclassifications to our condensedconsolidated statements of cash flows for the nine months ended September 30,2004 to reflect the gross purchases and sales of these securities as investingactivities rather than as a component of cash and cash equivalents. For thenine months ended September 30, 2004, the change in net cash provided byinvesting activities from previously reported amounts related to these securitieswas $925.  This reclassification does notaffect previously reported consolidated cash flows from operations or fromfinancing activities in our previously reported consolidated statements of cashflows or our previously reported consolidated statements of operations for anyperiod.

 

At December 31, 2003 and September 30, 2004, $29,250 and$28,325, respectively, of these investments were classified as cash equivalentsin our condensed consolidated balance sheets. These investments have beenreclassified to investment securities from cash and cash equivalents aspreviously reported.

 

**Use of Management Estimates**

 

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

 

6

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**Contract Revenue Recognition**

 

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

 

The Company generates contract revenue on the following basis:

 

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

 

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

 

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

 

*Up-Front License Fees,Milestone and 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 will recognizerevenue arising from a milestone payment upon the successful achievement of theevent, and the resolution of any uncertainties or contingencies regardingpotential collection of the related payment, or if appropriate over theremaining term of the agreement.

 

*Recurring Royalty RevenueRecognition*

 

Recurring royalties consist of royalties under a license agreement withSanofi-Aventis based on the worldwide sales of fexofenadine HCl, marketed asAllegra in the Americas and Telfast elsewhere. The Company records royaltyrevenue in the period in which the sales of Allegra occur. Royalty paymentsfrom Sanofi-Aventis are due within 45 days after each calendar quarter andare determined based on sales of Allegra in that quarter.

 

**NaturalProduct and Lead Finding Sample Collections.**

 

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

 

7

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Capitalizedcosts are amortized over the economic life of the library (estimated at 3years) at the greater of (a) the ratio of the product’s current grossrevenue to the total of current and expected gross revenues or (b) thestraight-line method computed by dividing the remaining unamortized capitalizedcost by the remaining economic life of the product. The remaining economic lifeis reassessed at each balance sheet date and changes in estimate, ifappropriate, are made to the amortization model.  Amortization of library inventories isincluded within research and development expense in the consolidated statementsof operations.  Library amortizationexpense was $304 and $913, for the three months and nine months ended September 30,2005, respectively, and $230 for the three months and nine months ended September 30,2004.  In addition, the Company monitorsthe carrying value of its natural product and lead finding sample collectionsfor impairment 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 recorded a $5,974 write-down to reduce the carrying value ofits natural product and chemical lead finding library inventories. The Companymonitors the carrying value of its remaining natural product and lead findingsample collections for impairment on a quarterly basis.  If the Company is unable to meet forecastedrevenues related to those assets, or if actual market conditions are lessfavorable than those projected, the Company may be required to write-down allor a portion of the remaining value of certain compound library assets(totaling $2,716 at September 30, 2005), resulting in a future****charge to operations. See Note 3 for further information on the inventory reserves recordedduring the quarter ended June 30, 2004.

 

**Long-lived Assets**

 

In accordance with the provisions of SFAS 144,*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.

 

**Goodwill**

 

In accordance with the provisions of SFAS 142, *Goodwill andOther Intangible 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 theCompany would be required to record a charge to its results of operations.Factors the Company considers important which could result in an impairmentinclude the following:

 

•              significantunderperformance relative to historical or projected future operating results;

 

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

 

•              significantnegative industry or economic trends; and

 

•              marketcapitalization relative to net book value.

 

8

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During thequarter ended June 30, 2004, the Company recorded goodwill impairmentcharges of $13,251 and $1,243 relating to its Bothell reporting unit and itsMount Prospect reporting unit.  TheCompany performed the annual goodwill assessment for its reporting units duringthe third quarter of 2005.  Based on theresults of these assessments, no additional goodwill impairment wasidentified.   If management’sexpectations of future operating results change, or if there are changes toother assumptions, the estimate of the fair value of our reporting units couldchange significantly. Such a change could result in additional goodwillimpairment charges in future periods, which could have a significant impact onour consolidated financial statements. Total goodwill recorded in the Company’s condensed consolidated balancesheet at September 30, 2005 was $25,747, including $23,060 of goodwillassociated with the Company’s acquisition of Organichem Corporation.  See Note 6 for further information on thegoodwill impairment charges recorded during the quarter ended June 30,2004.

 

**StockCompensation**

 

As allowed byFASB Statement No. 123, *Accounting for Stock-BasedCompensation,*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, in accountingfor its fixed plan stock options. As such, compensation expense would berecorded only if, on the date of grant, the current market price of theunderlying stock exceeded the exercise price. Any compensation expense would berecognized over the vesting period.

 

The followingtable illustrates the effect on net income and earnings per share if theCompany had applied the fair value recognition provisions of FASB Statement No. 123**to stock-based employee compensation.

 
| ** **                                                                                                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in thousands, except per share  data)**                                                                                                                 | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income  (loss), as reported                                                                                                                            |       | $                                          | 4,373      |                                      | $          | 2,890 |   | $ | 17,263 |   | $ | (15,122 | ) |
| Add:  Stock-based employee compensation expense  included in reported net income, net of related tax effects                                          |       | 61                                         |       | —                                    |       | 166 |   | — |   |
| Deduct:   Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects. |       | 579                                        |       | 866                                       |       | 1,878 |   | 2,572 |   |
| Pro Forma  net income (loss)                                                                                                                               |       | $                                          | 3,855      |                                      | $          | 2,024 |   | $ | 15,551 |   | $ | (17,694 | ) |
|                                                                                                                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Earnings  (loss) per share:                                                                                                                                |       |                                       |       |                                      |       |   |   |   |   |
| Basic as  reported                                                                                                                                         |       | $                                          | 0.14       |                                      | $          | 0.09 |   | $ | 0.54 |   | $ | (0.48 | ) |
| Basic  pro-forma                                                                                                                                           |       | $                                          | 0.12       |                                      | $          | 0.06 |   | $ | 0.49 |   | $ | (0.56 | ) |
|                                                                                                                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Diluted as  reported                                                                                                                                       |       | $                                          | 0.13       |                                      | $          | 0.09 |   | $ | 0.53 |   | $ | (0.48 | ) |
| Diluted  pro-forma                                                                                                                                         |       | $                                          | 0.12       |                                      | $          | 0.06 |   | $ | 0.48 |   | $ | (0.56 | ) |

 

**Note 2 –Earnings (Loss) Per Share**

 

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

 
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in thousands)**                          | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                        |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average common shares outstanding  |       | 32,097                                     |       | 31,804                                    |       | 32,018 |   | 31,627 |   |
| Dilutive  effect of stock options           |       | 258                                        |       | 305                                       |       | 247 |   | — |   |
| Dilutive  effect of restricted stock        |       | 79                                         |       | —                                    |       | 43 |   | — |   |
| Weighted  average common shares outstanding |       | 32,434                                     |       | 32,046                                    |       | 32,308 |   | 31,627 |   |

 

9

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The Companyhas excluded the effects of all outstanding stock options and warrants from thecalculation of weighted average common shares outstanding for the nine monthsended September 30, 2004 because such securities would beanti-dilutive.   The weighted averagenumber of anti-dilutive options and warrants outstanding, prior to considerationof the treasury stock method,****were 2,408 and2,972 for the three month periods ended September 30, 2005 and 2004,respectively, and are not included in the calculation of weighted averagecommon shares outstanding.  The weightedaverage number of anti-dilutive options and warrants outstanding was 2,555 forthe nine month period ended September 30, 2005.

 

**Note 3 – Inventory**

 

Inventory consisted of the following at September 30, 2005 and December 31,2004:

 
| ** **                                  | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw  materials                              |       | $                            | 6,767      |                        | $          | 4,818 |   |
| Work in  process                            |       | 3,081                        |       | 1,273                       |       |
| Finished  goods                             |       | 22,832                       |       | 22,644                      |       |
| Libraries,  net of accumulated amortization |       | 2,716                        |       | 3,680                       |       |
| Total                                       |       | $                            | 35,396     |                        | $          | 32,415 |   |

 

During the quarter ended June 30, 2004, the Company determinedthat the carrying value of its natural product and chemical lead findinglibraries exceeded its latest forecasted revenues.  The Company’s forecasted revenues fromnatural product and chemical lead finding libraries were lowered to reflectless favorable 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 recorded a decrease in the carrying value ofraw materials inventories of $330 and $1,218, respectively, which were recordedas a component of cost of contract revenue in the accompanying condensedconsolidated statements of operations for the three and nine months ended September 30,2004, respectively.

 

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

 

On May 4,2004, the Company announced plans to consolidate operations by relocating itsMount Prospect, IL operations to the Company’s facilities in New York.  The Company’s proprietary biocatalysistechnology platform, drug metabolism screening, research fermentation andchemical development technologies in Mount Prospect have been relocated to NewYork and continue to be fully integrated with the Company’s drug discovery anddevelopment technologies.  Therestructuring resulted in the closure of the Mount Prospect Research Center inthe fourth quarter of 2004.   Theconsolidation was initiated as a result of a lack of anticipated growth in theCompany’s chemical development services at the facility. As a result of theclosure, 33 employees were terminated and 25 employees were relocated tofacilities in New York.

 

The restructuring liabilities are included inaccounts payable and accrued expenses in the accompanying condensedconsolidated balance sheets. The following table displays the restructuringactivity and liability balances:

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

 

Costs of termination benefits relate to severance packages,outplacement services and career counseling for employees affected by therestructuring. Asset disposal costs relate primarily to brokerage commissions,legal fees, and marketing expenses associated with the planned sale of theMount Prospect Research Center facility, which is included in property andequipment held for sale in the condensed consolidated balance sheet at September 30,2005.

 

The Companyalso incurred $8 and $251 in employee and equipment relocation costs during thethree and nine months ended September 30, 2005, respectively.  These relocation costs are included under thecaption “selling, general and administrative” in the condensed consolidatedstatement of operations.

 

We are currently marketing theMount Prospect Research Center facility for sale. The facility qualified forheld for sale treatment in accordance with SFAS 144 during the fourthquarter of 2004. The long-lived assets associated with Mount Prospect have beensegregated to a separate line item on the condensed consolidated balance sheetuntil they are sold and depreciation expense has ceased with respect to thoseassets. We anticipate the completion of the sale of the facility by June 2006.

 

10

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The above restructuring activity was recorded exclusively in the AMRoperating segment. The net cash outflow related to the restructuring for thenine months ended September 30, 2005 was $64.  Anticipated cash outflows related to therestructuring for the remainder of 2005 are $0.

 

**Note 5 – Impairment of Long-Lived andIntangible Assets**

 

During the quarter ended June 30, 2004, due to the triggeringevents discussed in Notes 3 and 4 above, the Company performed SFAS 144analyses of its property and equipment for potential impairment at its MountProspect Research Center and its Bothell facility. The Company’s analysesconcluded that the carrying value of the respective asset groups exceeded theirfair value.  The impairment was allocatedto the long-lived assets of the groups on a pro-rata basis.  Accordingly, our Mount Prospect ResearchCenter and Bothell Research Center recorded impairment losses on long-livedassets of $1,615 and $3,113, respectively. The Company utilized the assistance of an independent valuation firm indetermining fair values.

 

Due to the 2004 write-down of the Company’s natural product libraries,the Company also performed an assessment of the carrying value of its microbialcultures and related technologies. The microbial cultures and relatedtechnologies are the starting materials and technology used in the developmentof the natural product libraries and therefore would be used to makeincremental copies of the natural product libraries.  Based on its assessment, the Companyconcluded that the carrying value of the microbial cultures and relatedtechnologies was not recoverable, and accordingly recorded a $3,541 impairmentcharge in the quarter ended June 30, 2004 representing the entireremaining carrying value of microbial cultures and related technologies.

 

The components ofintangible assets are as follows:

 
| ** **                    | ** ** | **Cost**   | ** ** | **Accumulated  Amortization** | ** ** | **Net**    | ** ** | **Amortization  Period** | ** ** |
|-------------------------------|------------|------------|------------|-------------------------------|------------|------------|------------|--------------------------|------------|
| **September 30,  2005**  | ** ** | ** ** | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **               | ** ** |
| Patents and  Licensing Rights |       | $          | 1,697      |                          | $          | (350       | )          | $                        | 1,347      |   | 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 nine months ended September 30,2005 and 2004 was $24 and $55, and $73 and $344, respectively.

 

Estimated future annual amortization expense related to intangibleassets is approximately $111 per year through the year ended December 31,2009.

 

**Note 6 – Goodwill**

 

The carrying amounts of goodwill, by segment, as of September 30,2005 and December 31, 2004 are as follows:

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

 

During the quarter ended June 30, 2004, due to the triggeringevents discussed in Notes 3 and 5, the Company determined that the carryingvalue of its goodwill at its Bothell reporting unit may be impaired.  Accordingly, the Company conducted a goodwillimpairment review as required under SFAS 142, and concluded that an impairmenthad occurred and therefore recorded a $13,251 goodwill impairment charge, whichreflects a full impairment of the Bothell goodwill.  As further discussed in Notes 4 and 5, duringthe quarter ended June 30, 2004, the Company announced its decision toclose its Mount Prospect facility and consolidate operations in New York. Thisrestructuring and related impairment of property and equipment were consideredtriggering events under SFAS 142. Accordingly, the Company conducted a goodwill impairment review asrequired under SFAS 142. The Company completed its assessment and concludedthat an impairment had occurred and recorded a $1,243 goodwill impairmentcharge based upon a valuation of the reporting unit.

 

In calculating the goodwill impairment charge, the fair value of theBothell and Mount Prospect reporting units was determined with the assistanceof an independent valuation advisor using a discounted cash flow valuationapproach.  Significant assumptions usedin this analysis include (i) expected future revenue growth rates,reporting unit profit margins, and working capital levels, (ii) a discountrate, and (iii) a terminal value multiple. The revenue growth rates, workingcapital levels and reporting unit profit margins were based on management’sbest estimate of future results.

 

11

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

 

Organichem previously provided retirement benefits under twonon-contributory defined benefit plans and a non-contributory, unfundedpost-retirement welfare plan. Future benefits under the defined benefit plansand for salaried participants in the post-retirement welfare plan have beenfrozen.

 

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

 
| ** **                          | ** ** | **Pension  Benefits**                      | ** ** | **Postretirement  Benefits**               | ** ** | **Pension  Benefits**                     | ** ** | **Postretirement  Benefits**              | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **Three Months  Ended September 30,** | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
| ** **                          | ** ** | **2005**                                   | ** ** | **2004**                                   | ** ** | **2005**                                  | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                |       |                                       |       |                                       |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Service Cost                        |       | $                                          | —     |                                       | $          | (5                                        | )          | $                                         | 25         |   | $ | 6 |   | $ | — |   | $ | 39 |   | $ | 47 |   | $ | 25 |   |
| Interest  Cost                      |       | 290                                        |       | 277                                        |       | 11                                        |       | 4                                         |       | 871 |   | 877 |   | 19 |   | 12 |   |
| Expected  return on plan assets     |       | (308                                       | )          | (260                                       | )          | —                                    |       | —                                    |       | (923 | ) | (825 | ) | — |   | — |   |
| Amortization  of prior service cost |       | —                                     |       | —                                     |       | —                                    |       | —                                    |       | — |   | — |   | — |   | — |   |
| Recognized  net (gain) loss         |       | 6                                          |       | (3                                         | )          | 6                                         |       | —                                    |       | 16 |   | — |   | 6 |   | — |   |
| Net Periodic  benefit (income) cost |       | $                                          | (12        | )                                          | $          | 9                                         |       | $                                         | 42         |   | $ | 10 |   | $ | (36 | ) | $ | 91 |   | $ | 72 |   | $ | 37 |   |

 

***Employer Contributions***

 

The Company previously disclosed in its consolidated financialstatements for the year ended December 31, 2004 that it expected tocontribute $631 to its pension plan in 2005.  As of September 30,2005, $737 in contributions have been made.  The increase in contributionsmade in relation to the expected contributions previously disclosed is due toadditional contributions made by the Company in 2005 related to requiredcontributions for the prior plan year. The Company does not expect to make anyadditional contributions to the plans in 2005.

 

**Note 8  Restricted Stock**

 

In March 2005, the Compensation Committee of the Board ofDirectors granted an award of 267 restricted shares of common stock toemployees of the Company under the 1998 Stock Option and Incentive Plan. The shares are issued as restricted stock and are held in the custody of theCompany until all vesting restrictions are satisfied.  Shares vest underthis grant over a period of five years, with 60% vesting after three years ofcontinuous employment from the grant date and an additional 20% vesting aftereach of four and five years of continuous employment from the grant date.  If the vesting terms under which the awardwas granted are not satisfied, the shares are forfeited.  Unearned compensation of $2,259 was recordedat the date of award, based on the market value of the shares on the grantdate, and is included as a separate component of shareholders’ equity and isamortized over the applicable vesting period.  As of September 30,2005, a total of 29 shares with an unamortized unearned compensation balance of$229 had been forfeited.  The amountamortized to expense during the three and nine months ended September 30,2005, net of the impact of forfeitures, was approximately $95 and $219,respectively.

 

12

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**Note 9 – Income Taxes**

 

The Company’s 2004 effective tax rate was impacted by the impairment ofcertain nondeductible items related to the goodwill impairment charges itrecorded in the second quarter of 2004. Non-deductible impairment charges totaling $17.1 million were treated asinfrequent discrete items in the preparation of the Company’s income taxprovision for the three months ended June 30, 2004.  The differences between income tax expenseand income taxes computed using a federal statutory rate of 35% for the threeand nine months ended September 30, 2005 and 2004, were as follows:

 
| ** **                                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 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                          |       | (1.5                                      | )          | (2.9                                     | )          | (1.1 | ) | (0.6 | ) |
| Goodwill and intangible asset impairment          |       | —                                    |       | —                                   |       | — |   | 42.9 |   |
| State taxes, net of federal benefit               |       | 3.1                                       |       | 4.0                                      |       | 1.9 |   | 0.9 |   |
| Foreign operations                                |       | 1.3                                       |       | —                                   |       | 0.7 |   | 42.9 |   |
| Extraterritorial income credit                    |       | (2.7                                      | )          | (4.0                                     | )          | (1.2 | ) | (0.9 | ) |
| Domestic production deduction                     |       | 0.2                                       |       | —                                   |       | (0.2 | ) | (0.9 | ) |
| Other, net                                        |       | 1.6                                       |       | 0.3                                      |       | 0.8 |   | 1.3 |   |
|                                              |       | 37.0                                      | %          | 32.4                                     | %          | 35.9 | % | 8.6 | % |

 

**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.

 

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

 
| ** **                                              | ** ** | **Contract  Revenue** | ** ** | **Recurring  Royalty  Revenue** | ** ** | **Operating  (loss) income** | ** ** | **Depreciation  and  Amortization** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|---------------------------------|------------|------------------------------|------------|-------------------------------------|------------|
| **For the three months ended  September 30, 2005** |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                     |       | $                     | 12,902     |                            | $          | 12,779                       |       | $                                   | 14,114     |   | $ | 2,338 |   |
| Organichem                                              |       | 18,648                |       | —                          |       | 2,802                        |       | 1,434                               |       |
| Corporate                                               |       | —                |       | —                          |       | (10,402                      | )          | —                              |       |
| Total                                                   |       | $                     | 31,550     |                            | $          | 12,779                       |       | $                                   | 6,514      |   | $ | 3,772 |   |
|                                                    |       |                  |       |                            |       |                         |       |                                |       |
| **For the three months ended  September 30, 2004** |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                     |       | $                     | 13,698     |                            | $          | 11,917                       |       | $                                   | 12,077     |   | $ | 2,765 |   |
| Organichem                                              |       | 15,005                |       | —                          |       | 3,846                        |       | 1,451                               |       |
| Corporate                                               |       | —                |       | —                          |       | (11,626                      | )          |                                |       |
| Total                                                   |       | $                     | 28,703     |                            | $          | 11,917                       |       | $                                   | 4,297      |   | $ | 4,216 |   |
|                                                    |       |                  |       |                            |       |                         |       |                                |       |
| **For the nine months ended  September 30, 2005**  |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                     |       | $                     | 39,855     |                            | $          | 40,679                       |       | $                                   | 44,598     |   | $ | 7,256 |   |
| Organichem                                              |       | 64,269                |       | —                          |       | 11,532                       |       | 4,280                               |       |
| Corporate                                               |       | —                |       | —                          |       | (30,215                      | )          |                                |       |
| Total                                                   |       | $                     | 104,124    |                            | $          | 40,679                       |       | $                                   | 25,915     |   | $ | 11,536 |   |
|                                                    |       |                  |       |                            |       |                         |       |                                |       |
| **For the nine months ended  September 30, 2004**  |       |                  |       |                            |       |                         |       |                                |       |
| AMR                                                     |       | $                     | 40,147     |                            | $          | 35,787                       |       | $                                   | 9,276      |   | $ | 7,082 |   |
| Organichem                                              |       | 47,488                |       | —                          |       | 11,186                       |       | 4,328                               |       |
| Corporate                                               |       | —                |       | —                          |       | (34,606                      | )          |                                |       |
| Total                                                   |       | $                     | 87,635     |                            | $          | 35,787                       |       | $                                   | (14,144    | ) | $ | 11,410 |   |
|                                                         |            |                       |            |                                 |            |                              |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

13

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The following tablesummarizes other information by segment as of and for the nine months ended September 30,2005:

 
| ** **                               | ** ** | **As of and for nine months ended  September 30, 2005** | ** ** |
|------------------------------------------|------------|--------------------------------------------------------------|------------|
| **(in thousands)**                       | ** ** | **AMR**                                                      | ** ** | **Organichem** | ** ** | **Total** | ** ** |
|                                     |       |                                                         |       |   |   |   |   |
| Total assets                             |       | $                                                            | 233,961    |   | $ | 138,848 |   | $ | 372,809 |   |
| Goodwill included in total assets        |       | 2,686                                                        |       | 23,061 |   | 25,747 |   |
| Investments in unconsolidated affiliates |       | 956                                                          |       | — |   | 956 |   |
| Capital expenditures                     |       | 5,103                                                        |       | 6,855 |   | 11,958 |   |
|                                          |            |                                                              |            |  |  |  |  |  |  |  |

 

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

 

Total contract revenue from AMR’s three largest customers representedapproximately 16%, 7% and 6% of AMR’s total contract revenue for the threemonths ended September 30, 2005, and 12%, 11% and 7% of total contractrevenue for the three months ended September 30, 2004. Total contractrevenue from AMR’s three largest customers represented approximately 15%, 9%and 5% of AMR’s total contract revenue for the nine months ended September 30,2005, and 14%, 11% and 5% of total contract revenue for the nine months ended September 30,2004.  Total contract revenue fromOrganichem’s largest customer, GE Healthcare (GE), represented 54% and 67% ofOrganichem’s total contract revenue for the three months ended September 30,2005 and 2004, respectively.  Totalcontract revenue from GE represented 70% and 71% of Organichem’s total contractrevenue for the nine months ended September 30, 2005 and 2004, respectively.  GE accounted for approximately 43% and 37% ofthe Company’s total contract revenue for the nine months ended September 30,2005 and 2004, respectively.  Beginningin the third quarter of 2005, GE discontinued its purchases of one of theproducts it receives from Organichem. GE made all of its 2005 purchases andreceived all of its shipments of this product in the first half of theyear.  Sales of this product totaled$16,962 in 2005, compared to $10,418 for the nine months ended September 30,2004 and $18,133 for the year ended December 31, 2004.

 

The Company’s total contract revenue for the three and nine monthsended September 30, 2005 and 2004 was recognized from customers in thefollowing geographic regions:

 
| ** **    | ** ** | **Three Months Ended September 30,** | *** *** | **Nine Months Ended September 30,** | *** *** |
|---------------|------------|-------------------------------------------|--------------|------------------------------------------|--------------|
| ** **    | ** ** | **2005**                                  | ** **   | **2004**                                 | ** **   | **2005** | ** ** | **2004** | ** ** |
|          |       |                                      |         |                                     |         |   |   |   |   |
| United States |       | 62                                        | %            | 64                                       | %            | 53 | % | 62 | % |
| Europe        |       | 33                                        | %            | 34                                       | %            | 44 | % | 35 | % |
| Other         |       | 5                                         | %            | 2                                        | %            | 3 | % | 3 | % |
|          |       |                                      |         |                                     |         |   |   |   |   |
| Total         |       | 100                                       | %            | 100                                      | %            | 100 | % | 100 | % |

 

14

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

 

The Company is required to report comprehensive income and itscomponents in accordance with the provisions of SFAS No. 130, *Reporting Comprehensive Income.*

 

The following table presents the components of the Company’scomprehensive income (loss)  for thethree and nine months ended September 30, 2005 and 2004:

 
| ** **                                                             | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in thousands)**                                                     | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss)                                                      |       | $                                         | 4,373      |                                     | $          | 2,890 |   | $ | 17,263 |   | $ | (15,122 | ) |
|                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| Other comprehensive loss:                                              |       |                                      |       |                                     |       |   |   |   |   |
| Unrealized (loss) gain on  available-for-sale securities, net of taxes |       | (52                                       | )          | 107                                      |       | (95 | ) | (153 | ) |
| Unrealized gain (loss) on Interest Rate  Swap, net of taxes            |       | 62                                        |       | (180                                     | )          | 122 |   | 124 |   |
| Foreign currency translation loss                                      |       | (17                                       | )          | —                                   |       | (67 | ) | — |   |
| Total comprehensive income (loss)                                      |       | $                                         | 4,366      |                                     | $          | 2,817 |   | $ | 17,223 |   | $ | (15,151 | ) |

 

**Note 13 –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. pharmaceuticalbusiness of Sanofi-Aventis S.A., are involved in legal proceedings with severalcompanies seeking to market generic versions of Allegra. Beginning in 2001,Barr Laboratories, Inc., Impax Laboratories, Inc., MylanPharmaceuticals, Inc., Teva Pharmaceuticals USA, Dr. Reddy’sLaboratories, Ltd./Dr. Reddy’s Laboratories, Inc., RanbaxyLaboratories Ltd./Ranbaxy Pharmaceuticals Inc., and Sandoz Inc. filedAbbreviated New Drug Applications (ANDAs) with the U.S. Food and DrugAdministration, or FDA, to produce and market generic versions of Allegraproducts.

 

In response to the filingsdescribed above, beginning in 2001, Aventis Pharmaceuticals filed patentinfringement lawsuits against Barr Laboratories, Impax Laboratories, MylanPharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories, RanbaxyLaboratories Ltd./Ranbaxy Pharmaceuticals Inc., 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, AMR Technology, along with AventisPharmaceuticals, filed suit in the U.S. District Court in New Jersey againstBarr Laboratories, Impax Laboratories, Mylan Pharmaceuticals, TevaPharmaceuticals, Dr. Reddy’s Laboratories, Amino Chemicals, Ltd., RanbaxyLaboratories Ltd./Ranbaxy Pharmaceuticals Inc., and Sandoz, Inc.,asserting infringement of two of our U.S. patents that are exclusively licensedto Aventis Pharmaceuticals relating to Allegra and Allegra-D products.

 

In the pending litigations,Aventis Pharmaceuticals and AMR Technology have entered into covenants not tosue the defendants under U.S. Patent No. 5,578,610, which patent has notbeen asserted in the litigation but which Aventis Pharmaceuticals exclusively licensesfrom 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 ourarrangements with Aventis Pharmaceuticals, we will receive royalties untilexpiration 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.

 

On September 6, 2005,Barr Pharmaceuticals, Inc. and Teva Pharmaceuticals Industries Ltd.announced that they have entered into an agreement for the launch of FexofenadineHydrochloride 30 mg, 60 mg and 180 mg Tablets, the generic version of Allegratablets in the United States.  The launchof the generic product is considered an “at-risk” launch due to the on-goinglitigation.  This generic launch may havea material impact on Allegra sales, which would in turn impact the Company’sroyalty revenue.  The launch is notexpected to impact non-U.S. sales of Allegra.

 

15

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On September 20, 2005,AMR Technology, along with Aventis Pharmaceuticals, filed a Motion forPreliminary Injunction in the U.S. District Court in New Jersey seeking toenjoin Barr Pharmaceuticals,  Inc., TevaPharmaceuticals Ltd., Ranbaxy Laboratories, Ltd. and Amino Chemicals, Ltd. fromthe sale of generic versions of Allegra in the United States.  The hearing on the Motion for PreliminaryInjunction commenced on October 27, 2005, and is currently ongoing.

 

Should the Company beunsuccessful in defending these patents we would experience a material decreasein operating cash flows and a material adverse effect on our results ofoperations and financial condition.

 

**Note 14 – Subsequent Event**

 

On October 20, 2005, Albany Molecular Research, Inc. (the “Company”)and AMR Technology, Inc., a wholly-owned subsidiary of the Company,entered into a License and Research Agreement (the “Agreement”) withBristol-Myers Squibb Company (“BMS”). This Agreement replaces the existing License Agreement (the “ExistingLicense Agreement”) between the Company, BMS, and Bristol-Myers Squibb PharmaCompany (formerly DuPont Pharmaceuticals Company) dated March 15, 2002 andsubsequently amended on September 11, 2003 and January 7, 2004,cancels all warrants issued to BMS to purchase the Company’s shares under theExisting License Agreement, and provides BMS with an exclusive, worldwidelicense to develop and commercialize potential products from the Company’samine neurotransmitter reuptake inhibitors identified in one of the Company’sproprietary research programs.

 

Under the terms of the Agreement, the Company will receive anon-refundable, non-creditable up-front payment of $8 million.  In addition, the Agreement provides for theestablishment of a research program with an initial term of three years, andprovides BMS with the option to extend the research program on an annual basisthereafter.  The objective of theresearch program is to research, discover and identify amine neurotransmitterreuptake inhibitors for BMS to develop and commercialize.  BMS will fund approximately $10 million inresearch and development over the initial three year term.  Under the research program, the Company’sscientists will provide medicinal and analytical chemistry support services toBMS in conjunction with its development and commercialization of productsderived from the technology licensed from the Company.  The Agreement also sets forth milestoneevents that, if achieved by these products, would entitle the Company tonon-refundable, non-creditable milestone payments of up to $66 million for eachof the first and second products to achieve these events, and up to $21.75million for each subsequent product to achieve these events.  The Agreement also provides for the Companyto receive royalty payments on worldwide sales of any such product that iscommercialized.

 

**Note 15-Recently Issued Accounting Pronouncements**

 

In November 2004, the FASB issuedStatement 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 thefourth quarter of 2005.

 

In December 2004, the FASB issuedStatement No. 123 (Revised), *Share-Based Payment(Revised)* (SFAS 123R), which amends FASB Statement No. 123, *Accounting for Stock-Based Compensation*, and supersedes APBOpinion 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 employee shareownership plans.  In April 2005, theSEC issued a Final Rule amending Rule 4-01(A) ofRegulation S-X regarding the compliance date for this Statement.  This Statement applies to the Companybeginning with the quarter ending March 31, 2006.  The Company expects that as a result ofadopting this Statement that the Company will recognize expense in theconsolidated statement of operations for the fair value of share options andrestricted stock awards issued to its employees, as well as for the portion of thepurchase discount on the market price of the Company’s common stock offered toemployees in conjunction with the Company’s Employee Stock Purchase Plan thatis 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.

 

16

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In October 2004, the President signed the American Jobs CreationAct of 2004 (the “Act”). The Act provides a deduction for income from qualifieddomestic production activities, which will be phased in from 2005 through 2010.In return, the Act also provides for a two-year phase-out of the existingextra-territorial income exclusion (ETI) for foreign sales that was viewed tobe inconsistent with international 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 ofthe tax deduction and the phase-out of the ETI exclusion begins with qualifyingproduction 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 nine months ended September 30,2005.

 

In May 2005, the FASB issued Statement No. 154,*Accounting For Changes and Error Corrections: areplacement 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 requiring retrospectiveapplication of the change in principle to the earliest reporting period that ispracticable, with a corresponding cumulative adjustment to the earliestreporting period presented.  SFAS 154also requires disclosures distinguishing between the retrospective applicationof changes in accounting principle and the restatement of financial statementsfor correction of an error.  Theprovisions of this Statement are effective for accounting changes made infiscal 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.

 

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

 

**Forward-Looking Statements**

 

The following discussion of our results of operations and financialcondition should be read in conjunction with the accompanying CondensedConsolidated Financial Statements and the Notes thereto included within thisreport. This quarterly report on Form 10-Q contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended (the “Securities Act”), and Section 21E of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”).  These statements may be identified byforward-looking words such as “may,” “could,” “should,” “would,” “will,” “intend,”“expect,” “anticipate,” “believe,” and “continue” or similar words and include,but are not limited to, statements concerning the Mount Prospect ResearchCenter, pension plan contributions, GE Healthcare, contract revenues, costs andmargins, royalty revenues, the ongoing Allegra patent infringement litigation,Allegra royalty revenue, customer spending and business trends, foreignoperations (including Singapore and India), clinical supply manufacturing,management’s strategic plans, research and development projects and expenses,selling, general and administrative expenses and tax rates.  The Company’s actual results may differmaterially from such forward-looking statements as a result of numerousfactors, some of which the Company may not be able to predict and may not bewithin the Company’s control.  Factorsthat could cause such differences include, but are not limited to, the riskthat the Company will not achieve the cost savings expected to result from theclosure and relocation of its Mount Prospect operations, the Company’s abilityto recruit and retain experienced scientists, trends in pharmaceutical andbiotechnology companies outsourcing chemical research and development, the lossof a significant customer, sales of Allegra (including any deviations in salesestimates provided by Sanofi-Aventis) and the Company’s receipt of significantroyalties from the Allegra license agreement, the risk that Allegra may beapproved for over-the-counter use and Claritin’s approval for over-the-counteruse, the Company’s and Sanofi-Aventis’ ability to successfully enforce theirrespective intellectual property, patent rights and technology, including withrespect to the generic companies’ Abbreviated New Drug Application filings, theintegration and operating risks associated with the Company’s acquisition ofOrganichem, the Company’s ability to successfully develop novel compounds andlead candidates in its research programs and collaborative arrangements, theCompany’s performance under the collaboration with BMS, BMS’s continuousutilization of the Company’s services at levels set forth in the contract withBMS, BMS’s continued pursuit of programs under which the Company providesservices, delay or denial of marketing approvals from the FDA resulting from,among other things, adverse FDA decisions or interpretations of data thatdiffer from BMS’s interpretations and that may require additional clinicaltrials or potential changes in the cost, scope and duration of clinical trials,if approved the inability to successfully launch, increase sales of or sustainthe product or products in the market, the inability to successfully andefficiently scale-up manufacturing for commercialized compounds, the outcome ofclinical work that will be required to commercialize compounds, the Company’sability to take advantage of proprietary technology and expand the scientifictools available to it, the ability of the Company’s strategic investments andacquisitions to perform as expected and any goodwill impairment related to suchinvestments and acquisitions, the Company’s ability to successfully completeits ongoing expansion projects on schedule, the risks associated withinternational operations, especially in India and Singapore, the Company’sability to execute its business plan for compound and chemical screeninglibraries, and the Company’s ability to effectively manage its growth, as wellas those discussed in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2004 as filed with the Securities and ExchangeCommission on March 16, 2005.  Allforward-looking statements are made as of the date of this report, and we donot undertake to update any such forward-looking statements in the future.  References to “we,” “us,” and “our,” refersto Albany Molecular Research, Inc. and its subsidiaries, taken as a whole.

 

**Overview**

 

We are a global drug discovery and development company, focused onidentifying and developing novel biologically active small molecules withapplications in the prescription drug market. We engage in comprehensivechemistry research from lead discovery, optimization and development to commercialmanufacturing and conduct cell and non-cell based high throughput screening ona variety of biological targets. We perform contract research services for manyof the leading pharmaceutical and biotechnology companies and also conduct ourown internal 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 manufacturing processfor, the active ingredient in the non-sedating antihistamine fexofenadine HClmarketed by Sanofi-Aventis S.A. as Allegra in the Americas and as Telfastelsewhere. In addition, certain of our discovery technology contracts providefor us to receive milestone and royalty payments for discoveries that lead tocommercial products.

 

Our total revenue for the quarter ended September 30, 2005 was$44.3 million, including $31.6 million from our chemistry contractbusiness, as compared to total revenue of $40.6 million for the quarter ended September 30,2004. Contract revenue for the third quarter of 2005 increased $2.8 millionfrom $28.7 million in the third quarter of 2004.  The increase is due to an increase inclinical supply manufacturing revenue of $4.4 million, partially offset by adecrease in commercial supply manufacturing revenue of $0.8 million as wecontinue to transition our large-scale manufacturing focus in this area.  AMR contract revenue decreased $0.8 millionin the third quarter of 2005 from the third quarter of 2004, due primarily to adecrease in discovery services revenue, reflecting the continuing trends ofcustomer preference for later-stage development services and the impact ofincreased international competition on chemistry outsourcing.

 

18

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Consolidated gross margin was 17.2% for the quarter ended September 30,2005 compared to 18.9% for the quarter ended September 30, 2004. Grossprofit margin for Organichem in the third quarter of 2005 was 15.0%, comparedto 25.6% in the third quarter of 2004. The decline in Organichem’s grossmargin is primarily attributable to the transition of this facility from themanufacturing of commercial products to the manufacturing of clinical supplycompounds for use in its customers’ clinical trials.  Gross margin at the AMR operating segmentincreased to 20.2% in the third quarter of 2005 compared to 11.6% for the sameperiod in 2004, primarily due to a reduction in compensation and benefit costsof $1.4 million due to a reduction in scientific personnel, as well as the $0.3million provision for excess raw materials incurred in the third quarter of2004.

 

During the quarter ended September 30, 2005, we generated $6.5million****in cash from operations and spent $5.4million in capital on our facilities and equipment, primarily related to theexpansion of our manufacturing suites at Organichem and the construction oflaboratory facilities at our Singapore and Hyderabad Research Centres.  In addition, we spent $26.6 million inreducing outstanding debt, including a $25.5 million paydown on the Company’soutstanding line of credit balance.   Asof September 30, 2005, we had $117.9 million in cash, cash equivalents andinvestments and $24.1 million in bank and other related debt.

 

We continue to pursue our plans to establish lower-cost internationaloperations, including the commencement of operations at our Singapore ResearchCentre and Hyderabad Research Centre during the second and third quarters,respectively.  We believe the ability tooffer customers a choice of business models and cost structures to meet theirdrug discovery needs will help to strengthen our global competitive advantage.

 

Total contract revenue from Organichem’s largest customer, GE, represented54% and 67% of Organichem’s total contract revenue for the quarter ended September 30,2005 and 2004, respectively.  GEaccounted for approximately 31% and 35% of our consolidated contract revenuefor the quarter ended September 30, 2005 and 2004, respectively.  GE discontinued purchases of one of theproducts we sell to them in the second quarter of 2005.  We expect an overall decrease in large-scalemanufacturing contract revenue at Organichem in the second half of 2005 fromthe six months ended June 30, 2005 due to the accelerated shipment of thisproduct to GE in the first half of the year. Our long-term objective is to recoup the revenues associated with thesesales decreases through continued growth in the area of clinical supplymanufacturing for advanced stage human trials as well as through increasedsales of another product to GE.  In August 2005,we extended our agreement to supply GE through 2010.  Clinical supply manufacturing represented 20%of Organichem’s total contract revenue for the nine months ended September 30,2005, compared to 11% of total contract revenue for the nine months ended September 30,2004.

 

Included in total revenue for the quarter ended September 30, 2005was $12.8 million in royalties compared to $11.9 million for the quarter ended September 30,2004.  The increase in Allegra royaltiesis due to an increase in worldwide sales of Allegra as reported to us bySanofi-Aventis, as well as an increase in royalty payments in certaincountries.

 

On September 6, 2005,Barr Pharmaceuticals, Inc. and Teva Pharmaceuticals Industries Ltd.announced that they have entered into an agreement for the launch ofFexofenadine Hydrochloride 30 mg, 60 mg and 180 mg Tablets, the generic versionof Allegra tablets in the United States. The launch of the generic product is considered an “at-risk” launch dueto the on-going litigation.

 

On September 20, 2005,AMR Technology, along with Aventis Pharmaceuticals, filed a Motion forPreliminary Injunction in the U.S. District Court in New Jersey seeking toenjoin Barr Pharmaceuticals,  Inc., TevaPharmaceuticals Ltd., Ranbaxy Laboratories, Ltd. and Amino Chemicals, Ltd. fromthe sale of generic versions of Allegra in the United States.  The hearing on the Motion for PreliminaryInjunction commenced on October 27, 2005, and is currently ongoing.

 

This generic launch may havea material adverse impact on Allegra sales, which would in turn adverselyimpact the Company’s royalty revenue. The launch is not expected to impact non-U.S. sales of Allegra.

 

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**Results of Operations – Three Months and Nine Months Ended September 30,2005 Compared to Three Months and Nine Months Ended September 30, 2004**

 

***Revenues***

 

*Total contract revenue*

 

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

 
| ** **         | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in thousands)** | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|               |       |                                      |       |                                     |       |   |   |   |   |
| AMR                |       | $                                         | 12,902     |                                     | $          | 13,698 |   | $ | 39,855 |   | $ | 40,147 |   |
| Organichem         |       | 18,648                                    |       | 15,005                                   |       | 64,269 |   | 47,488 |   |
| Total              |       | $                                         | 31,550     |                                     | $          | 28,703 |   | $ | 104,124 |   | $ | 87,635 |   |

 

AMR contract revenues for the quarter ended September 30, 2005,decreased $0.8 million to $12.9 million as compared to $13.7 million for thesame quarter in the prior year.  Thedecrease is primarily related to a decrease in demand for discovery phaseresearch and development services, due to continued international competition andrelated pricing pressures.     Wecurrently expect the trend of strong demand for our development-stage servicesto continue, and we have seen a recent trend of increased demand for discoveryphase research and development services. We commenced operations in our Singapore Research Centre and Hyderabad,India Research Centre during the second and third quarters of 2005,respectively.  While the revenue from ourinternational operations is not expected to be material to consolidatedcontract revenue in 2005, we believe the ability to offer customers a choice ofbusiness models and costs structures to meet their drug discovery needs willhelp to strengthen our competitive position and enable the Company to takeadvantage of current market conditions.

 

Organichem contract revenues for the third quarter of 2005 were $18.6million, an increase of $3.6 million compared to contract revenue of $15.0million during the third quarter of 2004. Organichem’s contract revenue increased primarily due to increased salesof clinical supply products for advanced stage human clinical trials, partiallyoffset by a decrease in commercial supply manufacturing revenue as we continueto transition our large-scale manufacturing focus in this area.   We expect the trend of increased growth inclinical supply manufacturing to continue in future periods.

 

For the nine months ended September 30, 2005, AMR contract revenuehas decreased 1% from the nine months ended September 30, 2004, asincreases in development-stage services have been largely offset by decreasesin discovery phase services as noted above. Organichem contract revenues for the nine months ended September 30,2005 increased 35% from the nine months ended September 30, 2004 due to ashift in the timing of delivery requirement for one of its products fromGE.  GE has discontinued itspurchases of this product, and made all of its 2005 purchases in the first halfof the year. Sales of this product totaled $17.0 million for thenine months ended September 30, 2005, compared to $10.4 million for thenine months ended September 30, 2004. The remainder of the increase inOrganichem’s contract revenue for the nine months ended September 30, 2005is due to increased sales of clinical supply products for advanced stage humanclinical trials.

 

*Recurring royalty revenue*

 

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

 

| **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                         | 12,779     |                                     | $          | 11,917 |   | $ | 40,679 |   | $ | 35,787 |   |
|                                           |            |                                          |            |  |  |  |  |  |  |  |  |

 

The increase in royalty revenue for the three and nine months ended September 30,2005 was attributable to increased worldwide sales of Allegra, as well ashigher royalty payments in certain countries.

 

On September 6, 2005,Barr Pharmaceuticals, Inc. and Teva Pharmaceuticals Industries Ltd.announced that they have entered into an agreement for the launch ofFexofenadine Hydrochloride 30 mg, 60 mg and 180 mg Tablets, the generic versionof Allegra tablets in the United States. The launch of the generic product is considered an “at-risk” launch dueto the on-going litigation.

 

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On September 20, 2005,AMR Technology, along with Aventis Pharmaceuticals, filed a Motion forPreliminary Injunction in the U.S. District Court in New Jersey seeking toenjoin Barr Pharmaceuticals,  Inc., TevaPharmaceuticals Ltd., Ranbaxy Laboratories, Ltd. and Amino Chemicals, Ltd. fromthe sale of generic versions of Allegra in the United States.  The hearing on the Motion for PreliminaryInjunction commenced on October 27, 2005 and is currently ongoing.

 

If we are unsuccessful inthe Preliminary Injunction proceedings, the generic launch may have a materialadverse impact on Allegra sales, which would in turn adversely impact theCompany’s royalty revenue and operating cash flows.  The launch is not expected to impact non-U.S.sales of Allegra.

 

***Costs and Expenses***

 

*Cost of contract revenue*

 

Our cost of contract revenue consists primarily of compensation andassociated fringe benefits for employees, chemicals, depreciation and otherindirect project related costs.  Cost ofcontract revenue for our AMR and Organichem segments were as follows:

 
| **Segment**             | ** **   | **Three Months Ended September 30,** | ** **   | **Nine Months Ended September 30,** | ** **   |
|-------------------------|--------------|-------------------------------------------|--------------|------------------------------------------|--------------|
| **(in thousands)**      | ** **   | **2005**                                  | ** **   | **2004**                                 | ** **   | **2005** | ** ** | **2004** | ** ** |
| *** ***            | *** *** | *** ***                              | *** *** | *** ***                             | *** *** | *** *** | *** *** | *** *** | *** *** |
| AMR                     |         | $                                         | 10,291       |                                     | $            | 12,114 |   | $ | 31,863 |   | $ | 39,660 |   |
| Organichem              |         | 15,846                                    |         | 11,161                                   |         | 52,737 |   | 36,304 |   |
| Total                   |         | $                                         | 26,137       |                                     | $            | 23,275 |   | $ | 84,600 |   | $ | 75,964 |   |
|                    |         |                                      |         |                                     |         |   |   |   |   |
| AMR Gross Margin        |         | 20.2                                      | %            | 11.5                                     | %            | 20.1 | % | 1.2 | % |
| Organichem Gross Margin |         | 15.0                                      | %            | 25.6                                     | %            | 17.9 | % | 23.6 | % |
| Total Gross Margin      |         | 17.2                                      | %            | 18.9                                     | %            | 18.8 | % | 13.3 | % |

 

AMR had a contract revenue gross margin of 20.2% and 20.1% for the threeand nine months ended September 30, 2005, respectively, compared tocontract revenue gross margin of 11.5% and 1.2% for the same periods in 2004.The increase in gross margin for the three months ended September 30, 2005compared to the three months ended September 30, 2004 is due to areduction in compensation and benefits expense of $1.4 million due to areduction in scientific personnel, as well as the $0.3 million provision forexcess raw materials incurred in the third quarter of 2004.  The increase in gross margin for the ninemonths ended September 30, 2005 compared to the nine months ended September 30,2004 largely resulted from the reduction in carrying value of our naturalproduct and chemical library inventories by $6.0 million and $1.2 million inadditional raw material inventory reserves incurred in the second and thirdquarters of 2004, as well as the reduction in scientific personnel as notedabove.   Organichem’s contract revenuegross margin decreased to 15.0% and 17.9% for the three and nine months ended September 30,2005 compared to 25.6% and 23.6% for the same periods in 2004. The decrease isdue to the transition of our large-scale manufacturing facility fromspecializing in the manufacturing of commercial products to the manufacturingof clinical supply compounds for use in clinical trials.  We currently expect the costs incurred inproviding contract services at AMR for the remainder of 2005 to remainconsistent with the amounts incurred in the first half of 2005.  We currently expect the trend of downwardpressure on our margins to continue at Organichem as we continue the transitionof our facility to maximize our clinical compound manufacturing capabilities.

 

*Technology incentive award*

 

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

 

| **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                         | 1,277      |                                     | $          | 1,193 |   | $ | 4,072 |   | $ | 3,578 |   |
|                                           |            |                                          |            |  |  |  |  |  |  |  |  |

 

The increase was attributed to increased Allegra royalties for 2005 ascompared to 2004.

 

21

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*Research and development*

 

Research and development expense consists of compensation and benefitsfor scientific personnel for work performed on proprietary technologydevelopment, research projects, costs of chemicals and other out of pocket costsand overhead costs. We utilize our expertise in small molecule chemistry,biocatalysis and natural products to perform our internal research anddevelopment projects.  The goal of theseprograms is to discover new compounds with commercial potential. We would thenseek to license these compounds to a third party in return for a combination ofup-front license fees, milestone payments and recurring royalty payments ifthese compounds are successfully developed into new drugs and reach the market.In addition, research and development is performed at Organichem related to theimprovement of production processes as well as research related to thepotential manufacture of new products. Research and development expenses were as follows:

 

| **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                         | 4,070      |                                     | $          | 5,186 |   | $ | 11,039 |   | $ | 18,434 |   |
|                                           |            |                                          |            |  |  |  |  |  |  |  |  |

 

The decrease in R&D expense during the three months and nine monthsended September 30, 2005 is the result of initiatives we undertook toreorganize our internal departments in order to have a more formalized andstructured R&D business group, and we have begun to more narrowly focus thescope of our research and development activities.  In addition, the decrease in R&D expensefor the nine months ended September 30, 2005 is also due to the fact thatR&D expenses for the nine months ended September 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 propertyrelated to our central nervous system (CNS) programs.

 

R&Dspending related to individual projects may fluctuate based on the results ofthose projects. Projecting expected project completion dates and anticipated revenuefrom our internal research programs is not practical at this time due to theearly stages of the projects and the inherent risks related to the developmentof new drugs. Our internal central nervous system program was our most advancedopportunity to generate revenue.  On October 20,2005 we entered into a License and Research Agreement with Bristol-Myers Squibb(BMS), whereby we have licensed the technology developed in the CNS program toBMS.    Under the terms of the Agreement, we willreceive a non-refundable, non-creditable up-front payment of $8 million.  In addition, BMS will fund $10 million inresearch and development over the initial three year term.  The Company’s scientists will providemedicinal and analytical chemistry support services to BMS in conjunction withits development and commercialization of products derived from the technologylicensed from the Company.  The Agreementalso sets forth milestone events that, if achieved by these products, wouldentitle the Company to non-refundable, non-creditable milestone payments of upto $66 million for each of the first and second products to achieve theseevents, and up to $21.75 million for each subsequent product to achieve theseevents.  The Agreement also provides forthe Company to receive royalty payments on worldwide sales of any such productthat is commercialized.    As a result ofentering into the License and Research Agreement with BMS, we currently expectresearch and development expenses to decrease for the remainder of 2005, as asignificant portion of the research development costs incurred in 2005 relatedto the continued development of the CNS program.  Certain of the costs, however, will shift tocost of contract revenue related to the contract research we will be performingfor BMS.  We continue to utilize ourproprietary technologies, including our biocatalysis and natural productcapabilities, to further advance other early stage internal research programs.

 

*Selling, general and administrative*

 

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

 

| **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                         | 6,331      |                                     | $          | 6,439 |   | $ | 19,177 |   | $ | 16,171 |   |
|                                           |            |                                          |            |  |  |  |  |  |  |  |  |

 

22

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The decrease in selling, general, and administrative expenses for thethree months ended September 30, 2005 is due to $1.1 million of employeerelocation costs associated with the closure of our Mount Prospect facilityincurred during the three months ended September 30, 2004, as well as adecrease in professional fees of $0.3 million due to the timing of incurringthese costs in the current year and an overall decrease in Sarbanes-Oxleycompliance service costs. These decreases are largely offset by the addition of$0.8 million in start-up and administrative costs associated with our Singaporeand India operations, and an increase in salary and benefit expenses of $0.4million 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.

 

The increase in selling, general, and administrative expenses for thenine months ended September 30, 2005 is due to the addition of $1.7million in start-up and administrative costs associated with our Singapore andIndia operations; an increase in salary and benefit expenses of $2.0 milliondue to the addition of administrative and business development personnel, aswell as the reallocation of certain personnel expenses to more appropriatelyreflect the current use of these resources; and $0.7 million in additionalfacilities costs associated with the classification of Mount Prospect facilitycosts as administrative while it is being held for sale and our corporateheadquarters facility, which opened in February 2004.  These increases are partially offset by $1.4million of employee relocation costs associated with the closure of our MountProspect facility incurred during the nine months ended September 30, 2004,as well a decrease in professional fees of $0.6 million due to an overalldecrease in Sarbanes-Oxley compliance service costs and additional accountingand valuation service fees associated with the impairment analyses performed atour Bothell and Mount Prospect facilities in 2004.  We currently expect an increase selling,general and administrative costs in the fourth quarter of 2005 in comparison toquarterly amounts incurred to date for the first nine months of 2005 due toincreased personnel costs and the timing of incurring professional servicescosts.

 

*Impairment and Restructuring Charges*

 

As of June 30,2004 we completed an in-depth review of the carrying value of all of ournatural product and chemical compound library inventories. As a result of thisreview, which was based on expected future revenues, it was determined that asignificant write-down in the carrying value of library inventories wasrequired. The reduction in the carrying value of the library inventoriesreflects the less favorable market conditions than previously projected.

 

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

 

In addition, we initiated a restructuring which resulted in the closureof our Mount Prospect Research Center and the consolidation of Mount Prospect’soperations in our New York facilities. The restructuring triggered anassessment of the carrying value of the Mount Prospect Research Center propertyand equipment and related goodwill. Based on its review, and in accordance withthe provisions of SFAS 144 and SFAS 142, we determined that an impairment ofcertain related goodwill and property and equipment had occurred.  Further, during the second quarter of 2004 weincurred restructuring costs related to the Mount Prospect restructuring.

 

Based on the foregoing, during the three and nine months ended September 30,2004, the Company recorded pre-tax charges and incurred restructuring costsrelated to its Bothell and Mount Prospect businesses as follows:

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **(in thousands)**                | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                              |       |                                       |       |                                      |       |   |   |   |   |
| Property and equipment impairment |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | 4,728 |   |
| Goodwill impairment               |       | —                                     |       | —                                    |       | — |   | 14,494 |   |
| Intangible asset impairment       |       | —                                     |       | —                                    |       | — |   | 3,541 |   |
| Restructuring charge              |       | —                                     |       | 230                                       |       | — |   | 656 |   |
|                                   |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |

 

23

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Property & Equipment Impairment

 

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

 

Goodwill Impairment

 

As a result of the reduction in carrying value of our natural productlibraries and related long-lived assets at our Bothell reporting unit and theannounced closure of our Mount Prospect reporting unit, we performed goodwillimpairment analyses on each of these reporting units as of June 30,2004.  As a result of these analyses, werecorded a $13.3 million goodwill impairment charge related to our Bothellreporting unit and a $1.2 million impairment charge related to our MountProspect reporting unit. In calculating the goodwill impairment charges, thefair value of the reporting units was determined with assistance from anindependent valuation advisor.  Thevaluations were based upon a discounted cash flow approach.  Significant assumptions used in the 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.

 

Intangible Asset Impairment

 

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

 

Restructuring

 

On May 4, 2004 we announced our plan to consolidate operations byrelocating our Mount Prospect facility operations to our facilities in NewYork.  During the second quarter of 2004we incurred restructuring costs totaling $0.4 million, consisting primarily oftermination benefits.

 

*Interest income (expense), net*

 
| ** **                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                     | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(in thousands)**                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest (expense)             |       | $                                          | (468       | )                                         | $          | (403 | ) | $ | (1,509 | ) | $ | (1,128 | ) |
| Interest income                |       | 1,029                                      |       | 380                                       |       | 2,590 |   | 1,407 |   |
| Interest (expense) income, net |       | $                                          | 561        |                                      | $          | (23 | ) | $ | 1,081 |   | $ | 279 |   |

 

The increase in interest expense for the three and nine months ended September 30,2005 was due to increases in the rates paid on the Company’s variable rate debtthat were not hedged by its interest rate swaps. In addition, the increase ininterest expense for the nine months ended September 30, 2005 is due inpart to the capitalization of interest costs incurred during the constructionof the Company’s headquarters facility in the first quarter of 2004.

 

The increase in interest income was primarily due to increases in therates earned on short-term cash equivalents and investment securities, as wellas an effort by management to maximize balances held in short-term cashequivalent accounts, which are higher yielding than interest-bearing cashaccounts.

 

As a result of the repayment of the outstanding balance on our line ofcredit, we currently expect our interest expense and interest income todecrease in future periods.

 

24

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*Income tax expense*

 

| **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| **(in thousands)**                        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                         | 2,565      |                                     | $          | 1,384 |   | $ | 9,666 |   | $ | 1,201 |   |
|                                           |            |                                          |            |  |  |  |  |  |  |  |  |

 

Our income tax expense for the three and nine months ended September 30,2004, reflects the goodwill and intangible asset impairment charges asnon-deductible tax items.  The increasein the effective rate resulted primarily from the impact the revised 2004projected annual results had in relationship to the 2004 projected annualpermanent differences. We expect our 2005 effective tax rate to beapproximately 36% for the full year, which is consistent with the Company’shistorical experience excluding the impact of the 2004 impairment charges.

 

**Liquidity and Capital Resources**

 

We have historically funded our business through operating cash flows,proceeds from borrowings and the issuance of equity securities. During thefirst nine months of 2005, we generated cash of $24.1 million from operatingactivities. The primary sources of operating cash flows are payments receivedfor the performance of contracted chemistry services and royalty paymentsreceived from Sanofi-Aventis based upon a percentage of sales of Allegra.  In addition, we expect the receipt of an $8million up-front fee in conjunction with our Licensing and Research Agreement withBristol-Myers Squibb to provide an additional significant source of operatingcash flows in the fourth quarter of 2005. 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 majorityof the uses of operating cash flows pertain to the Company’s research anddevelopment and contract service business activities.

 

During the first nine months of 2005, we used $20.1 million in investingactivities, resulting from the use of $12.0 million for the acquisition ofproperty and equipment, and purchases of investment securities net of proceedsfrom sales and maturities of $8.0 million. During the first nine months of2005, we used $27.4 million for financing activities, consisting of $29.0million in long-term debt repayments, offset by $1.6 million provided byproceeds and tax benefits realized from stock option and stock purchase planexercises.

 

Working capital was $169.4 million at September 30, 2005 ascompared to $179.8 million as of December 31, 2004. The primary source ofthe decrease was an decrease in cash and investments due to the paydown of theoutstanding balance on the Company’s line of credit, an increase in deferredrevenue due to the timing of customer payments in relation to execution ofcontract deliverables and an increase in income taxes payable due to theaccrual of estimated income tax expense on the Company’s pre-tax income duringthe first nine months of 2005.  These itemsare partially offset by an increase in accounts receivable due to timing ofshipments to Organichem’s customers. During 2005, we anticipate making $0.7million in defined benefit pension plan contributions, all of which were paidin the first nine months.

 

We entered into a credit facility consisting of $30.0 million term loanand $35.0 million line of credit to fund the acquisition of Organichem during2003. On June 30, 2005, the Company amended the credit facility to extendthe maturity date on the line of credit from February 2006 to June 2010.The term loan matures in February, 2008. As of September 30, 2005, theinterest rate on $14.3 million of the outstanding term loan balance was 4.49%and the interest rate on the remaining $5.0 million was 4.74%.  The line of credit bears interest at avariable rate based on the Company’s leverage ratio.  As of September 30, 2005, theoutstanding balance of the line of credit was $0.  The credit facility contains certainfinancial covenants, including a maximum leverage ratio, a minimum requiredoperating cash flow coverage ratio, a minimum earnings before interest andtaxes to interest ratio and a minimum current ratio.  Other covenants include limits on assetdisposals and the payment of dividends. As of September 30, 2005 we were in compliance with all covenantsunder the credit facility.

 

The disclosure of payments we have committed to make under ourcontractual obligations is set forth under the heading “Management’s Discussionand Analysis of Financial Condition and Results of Operations—Liquidity andCapital Resources” under Item 7 of our 2004 Form 10-K. Excluding theextension of the maturity date on the line of credit from 2006 to 2010, therepayment of $29.0 million outstanding under our credit facility, and $0.7million in defined benefit pension plan contributions, as described above,there have been no material changes to our contractual obligations since December 31,2004.

 

25

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

 

The recurringroyalties we receive on the sales of Allegra have historically provided amaterial portion of our operating cash flows. As discussed in Part II, Item I of this Form 10-Q, severalgeneric manufacturers have filed ANDA applications with the FDA seekingauthorization to produce and market a generic version of Allegra.  Additionally, Barr Pharmaceuticals, Inc.and Teva Pharmaceuticals Industries Ltd. announced that they have entered intoan agreement for the launch of Fexofenadine Hydrochloride 30 mg, 60 mg and 180mg Tablets, the generic version of Allegra Tablets in the United States.  The launch of the generic product isconsidered an “at-risk” launch due to the on-going litigation.  This generic launch may have a materialimpact on Allegra sales, which would in turn impact the Company’s royaltyrevenue.  The launch is not expected toimpact non-U.S. sales of Allegra.  Weand Aventis Pharmaceuticals have filed several patent infringement suitsagainst these generic companies alleging infringement of certain U.S.patents.  Should we or Sanofi-Aventis beunsuccessful in defending these patents we would experience a material decreasein operating cash flows and a material adverse effect on our results ofoperations and financial condition.

 

**Critical Accounting Policies and Estimates**

 

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

 

We refer to the policies and estimates set forth in the section ”Management’sDiscussion and Analysis of Financial Condition and Results of Operation —Critical Accounting Estimates” of our Annual Report on Form 10-K for thefiscal year ended December 31, 2004. There have been no material changes or modifications to the policiessince December 31, 2004.

 

Item3.  Quantitative and QualitativeDisclosures about Market Risk

 

There are no material changes in market risks since our annual reporton Form 10-K for the year ended December 31, 2004.

 

Item4.  Controls and Procedures

 

*DisclosureControls and Procedures*

 

As required byrule 13a-15(b) under the Securities Exchange Act of 1934, as amended(the “Exchange Act”), as of the end of the period covered by this QuarterlyReport our management conducted an evaluation with the participation of ourChief Executive Officer and Chief Financial Officer, regarding theeffectiveness of our disclosure controls and procedures.  In designing and evaluating our disclosurecontrols and procedures, we recognize that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and our management necessarily wasrequired to apply its judgment in evaluating and implementing possible controlsand procedures. Based upon that evaluation, our Chief Executive Officer andChief Financial Officer have concluded that, as of the end of the periodcovered by this Quarterly Report, our disclosure controls and procedures were effectivein that they provide reasonable assurance that information required to bedisclosed by us in the reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.  We intend to review and document ourdisclosure controls and procedures, including our internal controls andprocedures for financial reporting, on an ongoing basis, and may from time totime make changes aimed at enhancing their effectiveness and to ensure that oursystems evolve with our business.

 

26

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*InternalControl Over Financial Reporting*

 

As disclosedin the Company’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 didnot result in the restatement of any of the Company’s annual or interimconsolidated financial statements. Additionally, these control deficienciesresult in more than a remote likelihood that a misstatement to the inventoryand cost of sales accounts resulting in a material misstatement to annual orinterim financial statements would not be prevented or detected. Accordingly,management determined that these deficiencies constituted a material weakness.Because of this material weakness, management concluded that the Company did notmaintain effective internal control over financial reporting as of December 31,2004 based on the criteria in the *InternalControl—Integrated Framework*.

 

The Company is in the process of remediating the identified materialweakness in the Company’s internal control over financial reporting, includingimplementing new controls as disclosed in the Company’s Annual Report on Form 10-Kfor the year ended 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 third quarterof 2005, the Company began the process of implementing an Enterprise ResourcePlanning (ERP) application that, once completed, 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 as described above, there were nochanges in our internal control over financial reporting that occurred duringthe period covered by this Quarterly Report on Form 10-Q that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

27

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PART II -OTHER INFORMATION

 

Item 1.    Legal Proceedings

 

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

 

AMR Technology, a 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, Barr Laboratories, Inc., Impax Laboratories, Inc.,Mylan Pharmaceuticals, Inc., Teva Pharmaceuticals USA, Dr. Reddy’sLaboratories, Ltd./Dr. Reddy’s Laboratories, Inc., Ranbaxy LaboratoriesLtd./Ranbaxy Pharmaceuticals Inc., and Sandoz Inc. filed Abbreviated New DrugApplications (ANDAs) with the U.S. Food and Drug Administration, or FDA, toproduce and market generic versions of Allegra products.

 

In response to the filingsdescribed above, beginning in 2001, Aventis Pharmaceuticals filed patentinfringement lawsuits against Barr Laboratories, Impax Laboratories, MylanPharmaceuticals, Teva Pharmaceuticals, Dr. Reddy’s Laboratories, RanbaxyLaboratories Ltd./Ranbaxy Pharmaceuticals Inc., 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, AMR Technology, along with AventisPharmaceuticals, filed suit in the U.S. District Court in New Jersey againstBarr Laboratories, Impax Laboratories, Mylan Pharmaceuticals, TevaPharmaceuticals, Dr. Reddy’s Laboratories, Amino Chemicals, Ltd., RanbaxyLaboratories Ltd./Ranbaxy Pharmaceuticals Inc., and Sandoz, Inc.,asserting infringement of two of our U.S. patents that are exclusively licensedto Aventis Pharmaceuticals relating to Allegra and Allegra-D products.

 

In the pending litigations,Aventis Pharmaceuticals and AMR Technology have entered into covenants not tosue the defendants under U.S. Patent No. 5,578,610, which patent has notbeen asserted in the litigation but which Aventis Pharmaceuticals exclusivelylicenses from us. However, we and Aventis Pharmaceuticals have agreed thatAventis Pharmaceuticals will continue to pay royalties to us based on thatpatent under our original license agreement with Aventis Pharmaceuticals. Underour arrangements with Aventis Pharmaceuticals, we will receive royalties untilexpiration of the underlying patents (2013 for U.S. Patent No. 5,578,610and 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.

 

On September 6, 2005,Barr Pharmaceuticals, Inc. and Teva Pharmaceuticals Industries Ltd.announced that they have entered into an agreement for the launch ofFexofenadine Hydrochloride 30 mg, 60 mg and 180 mg Tablets, the generic versionof Allegra tablets in the United States. The launch of the generic product is considered an “at-risk” launch dueto the on-going litigation.  This genericlaunch may have a material impact on Allegra sales, which would in turn impactthe Company’s royalty revenue.  The launchis not expected to impact non-U.S. sales of Allegra.

 

On September 20, 2005,AMR Technology, along with Aventis Pharmaceuticals, filed a Motion forPreliminary Injunction in the U.S. District Court in New Jersey seeking toenjoin Barr Pharmaceuticals,  Inc., TevaPharmaceuticals Ltd., Ranbaxy Laboratories, Ltd. and Amino Chemicals, Ltd. fromthe sale of generic versions of Allegra in the United States.  The hearing on the Motion for PreliminaryInjunction commenced on October 27, 2005, and is currently ongoing.

 

Should the Company beunsuccessful in defending these patents we would experience a material decreasein operating cash flows and a material adverse effect on our results ofoperations and financial condition.

 

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Item 6.    Exhibits

 

(a)       Exhibits.

 

10.1         SupplyAgreement, dated as of August 31, 2005, between Organichem Corporation andAmersham Health AS, a wholly-owned subsidiary of GE Healthcare, Inc.(filed herewith with certain information omitted pursuant to a request forconfidential treatment and filed separately with the Securities and ExchangeCommission).

 

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.

 

 

SIGNATURES

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
|                               | ALBANY MOLECULAR RESEARCH, INC. |
|------------------------------------|---------------------------------|
|                               |                            |   |
|                               |                            |   |
| Date:   November 4, 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) |

 

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