**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 1O-Q**

 

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

 

**For thequarterly period ended March 31, 2006**

 

**Or**

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

 

**CommissionFile Number: 0-50523**

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **51-0418085**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                            |       |                                 |
| **P.O. Box 5350, Princeton, New Jersey**                   | ** ** | **08543-5350**                       |
| (Address of principal executive offices)                        |       | (Zip Code)                           |

 

**(609) 452-3600**

(Registrant’s telephone number, including area code)

 

**Not Applicable**

(Former name, former address and former fiscal year, if changed sincelast 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 such shorter period that the registrantwas required to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.    Yes ý     No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Large acceleratedfiler   o   Acceleratedfiler  o   Non-accelerated filer  ý

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yeso    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 May 5, 2006** |
|-------------------------------|------------|--------------------------------|
| Common Stock, $0.01 par value |       | 15,280,761                     |

 

 

----

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 

 
| **Item**          | ** **            | ** **                                                                                  | ** **                                                                   | ** ** | ** ** |
|-------------------|-----------------------|---------------------------------------------------------------------------------------------|------------------------------------------------------------------------------|------------|------------|
|              |                  |                                                                                        |                                                                         |       |
| PART I.      | FINANCIAL INFORMATION | 3                                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 1.           |                  | Financial Statements (Unaudited):                                                           | 3                                                                            |
|              |                  |                                                                                        |                                                                         |       |
|              |                  |                                                                                        | Balance Sheets as of March 31, 2006 and December 31, 2005               | 3          |
|              |                  |                                                                                        |                                                                         |       |
|              |                  |                                                                                        | Statements of Operations for the Three  Months Ended March 31, 2006 and 2005 | 4          |
|              |                  |                                                                                        |                                                                         |       |
|              |                  |                                                                                        | Statements of Cash Flows for the Three  Months Ended March 31, 2006 and 2005 | 5          |
|              |                  |                                                                                        |                                                                         |       |
|              |                  |                                                                                        | Notes to Unaudited Financial Statements                                      | 6          |
|              |                  |                                                                                        |                                                                         |       |
| Item 2.           |                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 12                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 3.           |                  | Quantitative and Qualitative Disclosures  about Market Risk                                 | 20                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 4.           |                  | Controls and Procedures                                                                     | 20                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| PART II.     | OTHER INFORMATION     | 21                                                                                          |
|              |                  |                                                                                        |                                                                         |       |
| Item 1.           |                  | Legal Proceedings                                                                           | 21                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 1A.          |                  | Risk Factors                                                                                | 21                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 2.           |                  | Unregistered Sales of Equity Securities and  Use of Proceeds                                | 23                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 3.           |                  | Defaults upon Senior Securities                                                             | 23                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 4.           |                  | Submission of Matters to a Vote of Security  Holders                                        | 23                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 5.           |                  | Other Information                                                                           | 23                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Item 6.           |                  | Exhibits                                                                                    | 23                                                                           |
|              |                  |                                                                                        |                                                                         |       |
| Signatures        |                  |                                                                                        |                                                                         | 25         |
|              |                  |                                                                                        |                                                                         |       |
| Index to Exhibits |                  | 26                                                                                          |

 

2

----

 

**PART I - FINANCIALINFORMATION**

 

**Item 1. FinancialStatements (Unaudited)**

 

**PharmacopeiaDrug Discovery, Inc.**

**Balance Sheets**

**(Amounts inthousands, except share and per share data)**

 
| ** **                                                                                                                          | ** ** | **March 31,**   | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                                                                          | ** ** | **2006**        | ** ** | **2005**         | ** ** |
| ** **                                                                                                                          | ** ** | **(unaudited)** | ** ** | ** **       | ** ** |
| **ASSETS**                                                                                                                          |       |            |       |             |       |
| Current  assets:                                                                                                                    |       |            |       |             |       |
| Cash and cash equivalents                                                                                                           |       | $               | 13,419     |             | $          | 11,680 |   |
| Marketable securities                                                                                                               |       | 12,137          |       | 18,686           |       |
| Accounts receivable                                                                                                                 |       | 6,627           |       | 2,256            |       |
| Prepaid expenses and other current assets                                                                                           |       | 882             |       | 771              |       |
| Total current assets                                                                                                                |       | 33,065          |       | 33,393           |       |
|                                                                                                                                |       |            |       |             |       |
| Property and  equipment, net                                                                                                        |       | 10,360          |       | 10,548           |       |
| Deferred  compensation plan assets                                                                                                  |       | 1,840           |       | 1,904            |       |
| Other assets                                                                                                                        |       | 174             |       | 174              |       |
| Total assets                                                                                                                        |       | $               | 45,439     |             | $          | 46,019 |   |
|                                                                                                                                |       |            |       |             |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                      | ** ** | ** **      | ** ** | ** **       | ** ** |
| Current  liabilities:                                                                                                               |       |            |       |             |       |
| Accounts payable                                                                                                                    |       | $               | 1,774      |             | $          | 1,112 |   |
| Accrued liabilities                                                                                                                 |       | 2,760           |       | 3,350            |       |
| Restructuring reserve                                                                                                               |       | 286             |       | 908              |       |
| Deferred revenue, current portion                                                                                                   |       | 4,086           |       | 3,492            |       |
| Total current liabilities                                                                                                           |       | 8,906           |       | 8,862            |       |
|                                                                                                                                |       |            |       |             |       |
| Deferred  compensation plan                                                                                                         |       | 1,840           |       | 1,904            |       |
| Deferred  revenue, long-term                                                                                                        |       | 3,966           |       | —           |       |
| Other  liabilities, long-term                                                                                                       |       | 1,333           |       | —           |       |
|                                                                                                                                |       |            |       |             |       |
| Commitments  and contingencies                                                                                                      |       | —          |       | —           |       |
|                                                                                                                                |       |            |       |             |       |
| Stockholders’  equity:                                                                                                         |       |            |       |             |       |
| Preferred stock, $.01 par value, 2,500,000  shares authorized, none issued and outstanding                                          |       | —          |       | —           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 15,241,200 and 14,988,915 shares issued and outstanding,  respectively |       | 153             |       | 150              |       |
| Additional paid-in capital                                                                                                          |       | 60,399          |       | 58,751           |       |
| Accumulated deficit                                                                                                                 |       | (31,056         | )          | (23,373          | )          |
| Accumulated other comprehensive loss                                                                                                |       | (102            | )          | (146             | )          |
| Deferred compensation                                                                                                               |       | —          |       | (129             | )          |
| Total stockholders’ equity                                                                                                     |       | 29,394          |       | 35,253           |       |
| Total liabilities and stockholders’ equity                                                                                     |       | $               | 45,439     |             | $          | 46,019 |   |

 

See accompanying notes to these unauditedfinancial statements

 

3

----

 

**Pharmacopeia Drug Discovery, Inc.**

**Statements of Operations**

**(Amounts in thousands, except share and per share data)**

 
| ** **                                            | ** ** | **For the Three Months** | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|
| ** **                                            | ** ** | **Ended March 31,**      | ** ** |
| ** **                                            | ** ** | **2006**                 | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(unaudited)**          | ** ** |
| Net revenue                                           |       | $                        | 4,116      |   | $ | 5,691 |   |
|                                                  |       |                     |       |   |   |
| Collaborative research and development  expense       |       | 3,333                    |       | 5,626 |   |
| Proprietary research and development  expense         |       | 6,292                    |       | 2,241 |   |
| Sales, general and administrative expense             |       | 2,447                    |       | 2,663 |   |
| Interest and other income, net                        |       | (281                     | )          | (209 | ) |
|                                                  |       | 11,791                   |       | 10,321 |   |
| Loss before  income taxes                             |       | (7,675                   | )          | (4,630 | ) |
| Provision for income taxes                            |       | 8                        |       | 10 |   |
| Net loss                                              |       | $                        | (7,683     | ) | $ | (4,640 | ) |
|                                                  |       |                     |       |   |   |
| Net loss per  share:                                  |       |                     |       |   |   |
| - Basic and diluted                                   |       | $                        | (0.51      | ) | $ | (0.38 | ) |
|                                                  |       |                     |       |   |   |
| Weighted  average number of common stock outstanding: |       |                     |       |   |   |
| - Basic and diluted                                   |       | 15,102,449               |       | 12,353,553 |   |

 

See accompanying notes to these unauditedfinancial statements

 

4

----

 

**Pharmacopeia Drug Discovery, Inc.**

**Statements of Cash Flows**

**(Amounts in thousands)**

 
| ** **                                                                      | ** ** | **For the Three Months** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                      | ** ** | **Ended March 31,**      | ** ** |
| ** **                                                                      | ** ** | **2006**                 | ** ** | **2005** | ** ** |
| ** **                                                                      | ** ** | **(unaudited)**          | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                          |       |                     |       |   |   |
| Net loss                                                                        |       | $                        | (7,683     | ) | $ | (4,640 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities |       |                     |       |   |   |
| Depreciation and amortization                                                   |       | 517                      |       | 583 |   |
| Contribution of stock to 401(k) Plan                                            |       | 124                      |       | 107 |   |
| Share-based compensation                                                        |       | 415                      |       | 40 |   |
| Changes in assets and liabilities:                                              |       |                     |       |   |   |
| Accounts receivable                                                             |       | (4,371                   | )          | (1,732 | ) |
| Prepaid expenses and other current assets                                       |       | (111                     | )          | 424 |   |
| Other assets                                                                    |       | —                   |       | (42 | ) |
| Accounts payable                                                                |       | 662                      |       | 500 |   |
| Accrued liabilities                                                             |       | 743                      |       | (54 | ) |
| Restructuring reserve                                                           |       | (622                     | )          | (708 | ) |
| Deferred revenue                                                                |       | 5,065                    |       | 74 |   |
| Net cash used in operating activities                                           |       | (5,261                   | )          | (5,448 | ) |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                          |       |                     |       |   |   |
| Capital expenditures, net                                                       |       | (329                     | )          | (185 | ) |
| Purchases of marketable securities                                              |       | (1,000                   | )          | (12,922 | ) |
| Proceeds from sale and maturities of  marketable securities                     |       | 7,593                    |       | 15,979 |   |
| Net cash provided by investing activities                                       |       | 6,264                    |       | 2,872 |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                          |       |                     |       |   |   |
| Proceeds from issuance of common stock                                          |       | 736                      |       | 85 |   |
| Investment by Accelrys, Inc.                                                    |       | —                   |       | 46 |   |
| Net cash provided by financing activities                                       |       | 736                      |       | 131 |   |
| Net increase  (decrease) in cash and equivalents                                |       | 1,739                    |       | (2,445 | ) |
| Cash and  equivalents, beginning of period                                      |       | 11,680                   |       | 20,173 |   |
| Cash and  equivalents, end of period                                            |       | $                        | 13,419     |   | $ | 17,728 |   |

 

Noncash transactions for the three months ended March 31, 2006 are asfollows:

 

•      TheCompany incurred research and development costs of $2 million associated withthe licensing of the DARA (defined in Note 3) program from BMS (defined in Note3). These costs have been included in accrued liabilities and otherliabilities, long-term at March 31, 2006. See Note 3 to the FinancialStatements for disclosure of the Company’s License Agreement with BMS.

•      TheCompany recorded the fair value of two warrants issued as part of its Product Developmentand Commercialization Agreement with GSK (defined in Note 2) as an increase toadditional paid-in capital and a decrease to deferred revenue. The fair valueof the warrants amounted to approximately $505 thousand. See Note 2 to theFinancial Statements for disclosure of the Company’s agreement with GSK.

 

See accompanying notes to these unaudited financial statements

 

5

----

 

**PharmacopeiaDrug Discovery, Inc.**

**Notes to Unaudited Financial Statements**

 

**1.   Background and Basis ofPresentation**

 

Pharmacopeia DrugDiscovery, Inc. (Pharmacopeia or the Company) was incorporated in 2002 asa wholly owned subsidiary of Accelrys, Inc. (Accelrys), formerlyPharmacopeia, Inc. On April 30, 2004 (the distribution date),Accelrys spun-off 100 percent of the shares of Pharmacopeia in a pro ratatax-free distribution and distributed to its stockholders of record one shareof Pharmacopeia common stock for every two shares of Accelrys common stock held.A total of 12,181,471 shares were distributed.

 

Accelrys contributed cash, cash equivalentsand marketable securities to Pharmacopeia such that upon consummationof the distribution on April 30, 2004, Pharmacopeia had cash, cashequivalents and marketable securities aggregating $46.5 million and allinter-company balances due to Accelrys were forgiven in their entirety byAccelrys and treated as a capital contribution; accordingly, such balances werereflected as investment by Accelrys for periods prior to April 30, 2004,at which time the amount was reclassified to additional paid-in capital. Earningsand losses accumulated in retained earnings (deficit) starting May 1,2004.

 

Pharmacopeiais committed to creating and delivering novel therapeutics to addresssignificant medical needs. Using proprietary technologies and processes, theCompany seeks to identify, optimize and develop novel drug candidates throughits own internally-funded drug discovery programs and in collaborations withmajor pharmaceutical and biotechnology companies.  The Company’scollaborative research efforts have resulted in a portfolio of three partneredprograms (comprised of four compounds) that have been advanced into humanclinical trials, in addition to eight programs in preclinical development, andmultiple other partnered programs in discovery.  Pharmacopeia has one internalprogram in preclinical development and four internal programs in advanceddiscovery.

 

The accompanying unauditedfinancial statements have been prepared in accordance with U. S. generallyaccepted accounting principles for interim financial information and withinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,these unaudited financial statements do not include all of the information anddisclosures required by U. S. generally accepted accounting principles forcomplete financial statements. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation of the financial statements have been included. Interim resultsare not necessarily indicative of the results that may be expected for the year.The unaudited interim financial statements should be read in conjunction withthe financial statements and notes thereto included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005.

 

**2.**   **Significant Collaborations**

 

For the three months endedMarch 31, 2006 and 2005, the Company’s research collaborations withSchering Corporation and Schering-Plough Ltd., accounted for 63% and 64%,respectively, of revenue. Researchfunding from the Schering-Plough agreements is recognized as revenue asservices are performed. Milestone payments are recognized as revenue when themilestones are achieved. Our longstanding research collaborationswith Schering-Plough will reach maturity in August 2006. Currently, we areplanning for full-time employee (FTE) funding from the Schering-Ploughcollaborations ceasing at that time. We will continue to be entitled topayments resulting from the successful achievement by Schering-Plough, if any,of preclinical and clinical milestones as well as royalty payments from sales,if any, of products resulting from compounds already delivered by us andaccepted by Schering-Plough under the collaborations. The expiration of thisagreement, should the revenue not be supplemented or replaced, would have amaterial adverse effect on the Company’s results of operations because of theresulting decrease in its revenue. Failureto replace the funding from the Schering-Plough collaborations would have amaterial adverse effect on the Company’s business as it is currently conductedand its financial condition. If adequate funds are not available, the Companymay be required to curtail operations significantly, or to obtain funds byentering into arrangements with collaborative partners or others that mayrequire the Company to relinquish rights to certain of its technologies,products or potential markets that the Company would not otherwise relinquish.

 

For the three months endedMarch 31, 2006 and 2005, the Company’s research collaborations with N.V. Organon(Organon) accounted for 21% and 20%, respectively, of revenue. The principal agreement with Organon, entered into inFebruary 2002, has a stated research term of five years. Under thisagreement, Pharmacopeia receives research funding to conduct its drug discoveryactivities to identify and optimize new drug candidates for multipletherapeutic targets provided by Organon. This revenue is recognized on astraight-line basis over the term of the collaboration. For funding received inadvance of the Company’s performance of research and development activities,the Company records deferred revenue.

 

6

----

 

Included in deferred revenue at March 31, 2006 and 2005 wasapproximately $2.2 million and $2.3 million, respectively, relating to thiscollaboration. The Company may receive milestone payments upon the successfulachievement of preclinical and clinical milestones. These milestone payments willbe recognized as revenue when the milestones are achieved. Upon successfulcommercialization of any product resulting from this relationship, Pharmacopeiawill be entitled to receive royalties on sales of that product. Theexpiration of this agreement, should the revenue not be supplemented orreplaced, would have a material adverse effect on the Company’s results ofoperations because of the resulting decrease in revenue.

 

No other customer accounted for more than 10% of total revenue in the threemonths ended March 31, 2006 and 2005.

 

**ProductDevelopment and Commercialization Agreement with GSK**

 

On March 24, 2006, theCompany and SmithKlineBeecham Corporation and Glaxo Group Limited (togetherGSK) entered into a product development and commercialization agreement (theGSK Agreement). The GSK Agreementprovides that GSK will have an exclusive option, exercisable at defined pointsduring the development process for each program (up to the point of clinicalproof of concept), to license that program for a specified payment amount. Uponlicensing a program, GSK is obligated to conduct preclinical development and/orclinical trials and commercialize pharmaceutical products resulting from suchlicensed programs on a worldwide basis (the GSK License Obligations). If GSKdoes not exercise its option to license a program, the Company will retain allrights to that program and may continue to develop the program andcommercialize any products resulting from the program, or it may elect tocease progressing the program and/or seek other partners for the furtherdevelopment and commercialization. In addition, the Company will retain rightsto each program for which GSK has not fulfilled its GSK License Obligations.

 

Under the terms ofthe GSK Agreement, the Company will receive up to $15.0 million in cashpayments from GSK, including $5.0 million that we received in April 2006. Up tothe remaining $10.0 million will be payable to the Company upon its fulfillmentof certain conditions related to the initial discovery activities to beconducted by the Company. The Company’s role in the alliance is to (i) identifyand (ii) advance molecules in chosen therapeutic programs into developmentcandidates and (iii) subject to certain provisions in the agreement, furtherdevelop the candidates to clinical “proof of concept” (a demonstration ofefficacy in man). In addition the cash payments above, the Company is entitledto receive success-based milestone payments from GSK for each drug developmentprogram pursued under the alliance and the potential for double-digit royaltiesupon the successful commercialization by GSK of any product resultingtherefrom.

 

The Company andGSK each have the right to terminate the GSK Agreement in its sole discretionunder certain specified circumstances at any time during the term of the GSKAgreement. If the Company exercises its discretionary termination right at anytime during the first five years of the term, under certain circumstances, it couldbe required to refund to GSK a portion of the up to $15.0 million referred toabove.

 

In connection withthe GSK Agreement, the Company issued two warrants to GSK for thepurchase of up to an aggregate of 176,367 shares of our common stock at anexercise price of $5.67 per share, which is a 25% premium over the trailing30-day closing price average preceding March 24, 2006. The warrants areexercisable at any time before the earlier to occur of (i) March 24,2011 and (ii) the effective date of certain types of terminations of theproduct development and commercialization agreement that the Company and GSKentered into. These warrants were issued in a transaction not involving apublic offering under Section 4(2) of the Securities Act of 1933, asamended. The fair value of the warrants has been determined to be $505thousand. This amount was calculated using the Black-Scholes pricing model withthe following assumptions: 80% volatility; expected term of 5 years; 4.66%risk-free rate; and 0% dividend.

 

Upon execution of the GSK agreement, GSK had a legal obligation to paythe Company $5.0 million. As such, included in accounts receivable at March 31,2006 is the $5.0 million due from GSK. The Company recorded deferred revenueassociated with this receivable, net of the fair value of the warrants, of approximately$4.5 million, of which approximately $0.5 million dollars has been classifiedin deferred revenue, current portion and approximately $4.0 million has beenclassified in deferred revenue, long-term. Revenue will be recognized on aproportional performance basis as work progresses.

 

**3.**   **License Agreement with Bristol-Myers Squibb**

 

On March 27, 2006, the Company and Bristol-MyersSquibb Company (BMS) entered into an exclusive licensing agreement providingthe Company worldwide development and commercialization rights to certain compoundsdiscovered by BMS that possess dual angiotensin (AT1) and endothelin(ETA) receptor antagonist (DARA) activity. Under the agreement, theCompany acquired exclusive rights to lead and backup DARA development candidatesunder the BMS patents claiming these compounds. The Company plans to initiatepreclinical development studies regarding the DARA program immediately.

 

7

----

 

Under the terms of the agreement, in lieu of an upfrontcash payment, the Company will provide BMS a set of compound libraries, over aperiod of approximately three years and pay BMS milestone payments upon theachievement of clinical and regulatory milestones, and royalties on sales ofproducts, if any, resulting from the program. In the event the Company fails todeliver the aforementioned libraries to BMS, the Company would be required makecash payments on a pro rata basis of up to $2.0 million.

 

The Company accounted for this transaction inaccordance with Accounting Principle Board Opinion 29, “Accounting forNonmonetary Transactions” as amended by SFAS No. 153 “Exchanges of NonmonetaryAssets.” The Company estimates that the fair value of the compound libraryservices to be provided to BMS is approximately $2.0 million. As such, and inaccordance with SFAS No. 2 “Accounting for Research and Development Costs” theCompany recorded a charge of $2.0 million to proprietary research anddevelopment expense in the three months ended March 31, 2006 and recorded aliability for the estimated fair value of the compound library services, ofwhich, $0.7 million is classified in current liabilities and $1.3 million isclassified in other liabilities, long-term at March 31, 2006.

 

**4.**   **Net Loss Per Share**

 

TheCompany computes net income (loss) per share in accordance with Statement ofFinancial Accounting Standard No. 128, “Earnings Per Share” (SFAS 128).Under the provisions of SFAS 128, basic net income (loss) per share is computedby dividing the net income (loss) for the period by the weighted-average numberof common shares outstanding during the period. Diluted net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted-average number of common and dilutive common equivalent sharesoutstanding during the period. The Company has a net loss for the periodspresented; accordingly, the inclusion of common stock equivalents foroutstanding stock options would be anti-dilutive and, therefore, the weightedaverage shares used to calculate both basic and diluted earnings per share arethe same.

 

**5.**   **Segment Information**

 

The Company classifies its business operations in oneoperating segment. All of the Company’s revenues are generated from thissegment. Revenue was derived from customers located in the following geographicregions:

 
| ** **             | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------|------------|----------------------------------|------------|
| ** **             | ** ** | **2006**                         | ** ** | **2005** | ** ** |
|                   |       |                             |       |   |   |
| Customers  located in: |       |                             |       |   |   |
| United States          |       | 34                               | %          | 45 | % |
| Europe                 |       | 66                               | %          | 54 | % |
| Asia                   |       | —                           |       | 1 | % |

 

**6.**   **Share-Based Compensation**

 

Prior to January 1, 2006and as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”(SFAS 123), the Company elected to follow Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” (APB 25) and relatedinterpretations in accounting for its employee stock option plans. Under APB25, the Company did not recognize share-based compensation expense at the time of option grant because theexercise price of the stock option equaled the fair market value of theunderlying common stock on the date of grant.

 

Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No. 123(revised 2004), “Share-Based Payment” (SFAS 123R), using themodified-prospective transition method. This statement is a revision to SFAS123, supersedes APB 25 and amends SFAS No. 95, “Statement of Cash Flows.”  Under this transition method, compensationcost recognized includes compensation costs for all share-based paymentsgranted prior to, but not yet vested as of December 31, 2005 based on the grantdate fair value estimated in accordance with the original provisions of SFAS123, and compensation cost for all share-based payments granted subsequent toDecember 31, 2005 based on the grant date fair value estimated in accordancewith provisions of SFAS 123R. Results for prior periods have not been restated.

 

The fair value of theseequity awards was estimated at the date of grant using a Black-Scholes optionpricing model with the following weighted average assumptions for the threemonths ended March 31, 2006 and 2005, respectively:

 

8

----

 
| ** **               | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Dividend  yield          |       | 0.00     | %          | 0.00     | %          |
| Expected  volatility     |       | 80.00    | %          | 85.24    | %          |
| Risk-free  interest rate |       | 4.66     | %          | 4.33     | %          |
| Expected  life (years)   |       | 6.25     |       | 5.75     |       |
| Forfeiture  Rate         |       | 5.24     | %          | n/a      |       |

 

Asa result of adopting SFAS 123R, the Company’s net income and basic and dilutedearnings per share for the quarter ended March 31, 2006 were $394 thousand and$.03 per share, respectively, lower than if the Company had continued toaccount for its share-based compensation under APB 25. At March 31, 2006, therewas approximately $3.4 million of unrecognized compensation costs, net ofestimated forfeitures, related to share-based payments which are expected to berecognized over a weighted average period of 1.5 years. Total share-based compensationcosts for the three months ended March 31, 2006 were approximately $415thousand. The aggregate intrinsic value of options exercised during the threemonths ended March 31, 2006 and 2005 was approximately $285 thousand and$122 thousand, respectively. Cash proceeds from stock options exercised duringthe three months ended March 31, 2006 and 2005 was approximately $736thousand and $85 thousand, respectively.

 

Thefollowing table illustrates the effect on operating results and per shareinformation had the Company accounted for its share-based compensation inaccordance with SFAS 123R for the three months ended March 31, 2005 (inthousands, except per share data):

 
| Net loss:                                                                                                                                     |   |   |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| As reported                                                                                                                                   |   | $      | (4,640 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                                                 |   | 40     |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (558   | )      |
| Pro forma                                                                                                                                     |   | $      | (5,158 | ) |
| Basic and diluted net loss per common share:                                                                                                  |   |   |   |
| As reported                                                                                                                                   |   | $      | (0.38  | ) |
| Pro forma                                                                                                                                     |   | $      | (0.42  | ) |

 

*Stock Plans*

 

Pharmacopeia had twoStock Plans, the 2004 Stock Incentive Plan (the Plan), which was approved bythe Company’s Board of Directors on April 6, 2004, and the 2004 EmployeeStock Purchase Plan (ESPP), which was approved by the Company’s Board ofDirectors on May 1, 2004. Effective May 31, 2005 the ESPP was terminatedby the Company.

 

In accordance with thePlan, Pharmacopeia may grant up to an aggregate of 2,400,000 shares of stockoptions, restricted stock, common stock, performance awards, deferred stockunits and stock appreciation rights to officers, directors, employees, salesrepresentatives and consultants of Pharmacopeia. Under the Plan no more than500,000 shares of Incentive Stock Options and 400,000 shares of stock awardsand performance shares may be granted. The term of each incentive andnon-qualified stock option is ten years. Vesting generally occurs over a periodof not greater than five years. As of March 31, 2006, there were approximately 1,323,000shares reserved underlying options made under the Plan and approximately 1,077,000shares available for future grants under the Plan.

 

Prior to the spin-off,the Board of Directors resolved to adopt the following Accelrys stock optionplans: the 1994 Incentive Stock Plan, the 1995 Director’s Option Plan, and the2000 Stock Option Plan under which grants of options and restricted stock hadbeen made to Pharmacopeia employees. Generally, all outstanding options topurchase Accelrys common stock under these Accelrys Stock Option Plans wereconverted to options to purchase Pharmacopeia stock, in order to maintain thethen existing intrinsic value and maintain the ratio of the then existingexercise price per share to the market value per share in accordance withapplicable accounting standards. As of March 31, 2006, there wereapproximately 3,062,000 shares reserved underlying options made under theseplans. No additional options may be granted to Pharmacopeia employees fromthese plans. As of March 31, 2006, there were approximately 5,000 shares ofrestricted stock outstanding from these plans

 

A summary of the stockoption activity and weighted average exercise prices follows (in thousands,except per share data):

 

9

----

 
| ** **                                                         | ** ** | **For the Three Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                 | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | **Common  Stock  Options**               | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Common  Stock  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding  at beginning of quarter:                              |       | 4,280                                    |       | $6.83 |   | 3,933 |   | $7.10 |   |
| Granted                                                            |       | 359                                      |       | $4.68 |   | 295 |   | $5.48 |   |
| Exercised                                                          |       | (229                                     | )          | $3.22 |   | (41 | ) | $2.07 |   |
| Expired                                                            |       | (25                                      | )          | $8.33 |   | (91 | ) | $8.37 |   |
| Outstanding  at end of quarter:                                    |       | 4,385                                    |       | $6.84 |   | 4,096 |   | $7.00 |   |
|                                                               |       |                                     |       |   |   |   |   |   |   |
| Exercisable  at end of quarter                                     |       | 3,148                                    |       |   |   | 2,586 |   |   |   |
|                                                               |       |                                     |       |   |   |   |   |   |   |
| Weighted average fair value of options granted  during the quarter |       |                                     |       | $3.40 |   |   |   | $3.96 |   |

 

A summary of stockoptions outstanding and exercisable as of March 31, 2006 follows (in thousands,except per share data):

 
| ** **                                  | ** ** | ** **               | ** ** | **Options Outstanding**                        | ** ** | **Options Exercisable**           | ** ** |
|---------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.00-$5.00                                 |       | 1,666                    |       | 6.49                                                |       | $4.04                                  |       | 948 |   | $3.79 |   |
| $5.01-$10.00                                |       | 2,302                    |       | 5.07                                                |       | $6.72                                  |       | 1,779 |   | $6.92 |   |
| $10.01-$15.00                               |       | 62                       |       | 3.48                                                |       | $12.27                                 |       | 61 |   | $12.28 |   |
| $15.01-$20.00                               |       | 355                      |       | 3.77                                                |       | $19.74                                 |       | 360 |   | $19.74 |   |
|                                        |       | 4,385                    |       | 5.48                                                |       | $6.84                                  |       | 3,148 |   | $7.53 |   |
|                                        |       |                     |       |                                                |       |                                   |       |   |   |   |   |   |   |
| Aggregate intrinsic value                   |       | $3,878                   |       |                                                |       |                                   |       |   | $2,520 |   |   |   |   |

 

At March 31, 2006, there were approximately 4,325,000 optionsoutstanding that had vested or are expected to vest. The weighted-averageexercise price of these options was $6.84 per option; the weighted-averageremaining contractual life of these options was 5.48 years; and the aggregateintrinsic value of these options was approximately $3.8 million.

** **

**7.**   **Restructuring and severance obligations**

 

During the year ended December 31, 2004, the Companyexecuted a restructuring plan for the purpose of making its research anddevelopment activities more efficient by eliminating unnecessary facilities. Alsoa reduction in force of six administrative Pharmacopeia employees occurredduring that year. As a result, restructuring related charges of approximately$5.9 million, as outlined below, were recognized as operating expense duringthe year ended December 31, 2004.

 

The following table summarizes the activity and balance of therestructuring reserve at March 31, 2006 (in thousands):

 
| ** **                       | ** ** | **Severance Cost for  Involuntary Employee  Terminations** | ** ** | **Costs to Exit Leased  Facility** | ** ** | **Total** | ** ** |
|----------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------|------------|-----------|------------|
| Restructuring  charges           |       | $                                                                         | 132        |                                              | $          | 5,718     |       | $ | 5,850 |   |
| Utilization  of Reserves:        |       |                                                                      |       |                                              |       |      |       |
| Cash payments                    |       | (132                                                                      | )          | (4,352                                            | )          | (4,484    | )          |
| Write-off leasehold improvements |       | —                                                                    |       | (458                                              | )          | (458      | )          |
| Balance at  December 31, 2005    |       | $                                                                         | —     |                                              | $          | 908       |       | $ | 908 |   |
| Utilization  of Reserves:        |       |                                                                      |       |                                              |       |      |       |
| Cash payments                    |       | —                                                                    |       | (622                                              | )          | (622      | )          |
| Balance at  March 31, 2006       |       | $                                                                         | —     |                                              | $          | 286       |       | $ | 286 |   |

 

**Duringthe year ended December 31, 2005 the Company incurred approximately $1.5 millionof expense related to**

 

10

----

 

**severancepayable to two former executives of the Company. These charges consisted of$1.3 million in connection with cash payment obligations to these formerexecutives, as well as a noncash charge of $0.2 million. These expenses wereclassified as sales, general and administrative expense in the Company’sStatement of Operations. The remaining severance obligation to theseindividuals was $27 thousand and is classified under accrued liabilities in theCompany’s Balance Sheet as of March 31, 2006.**

** **

**8**.   Commitments andContingencies

** **

**Royalties/ColumbiaDispute**

** **

In accordance with FASBStatement No. 5, “Accounting for Contingencies” and FASB InterpretationNo. 14, “Reasonable Estimation of the Amount of a Loss” the Companyaccrued and recognized as operating expense a charge of $1.0 million for theyear ended December 31, 2004 for the probable outcome of the resolution of adispute between the Company, on the one hand, and the Trustees of ColumbiaUniversity in the City of New York (Columbia) and Cold Spring Harbor Laboratory(Cold Spring), on the other hand, in connection with the License Agreement (theOriginal Agreement) dated July 16, 1993 and as amended October 6, 1995 among them.

 

On May 24, 2005, theparties to the Original Agreement entered into a license agreement (theAgreement) that amended and restated the Original Agreement. The Agreementprovides that in connection with the resolution of the dispute the Company willpay Columbia and Cold Spring an aggregate of $1.0 million dollars in twoinstallments of $500 thousand.

 

The first installment waspaid in June 2005. As of March 31, 2006, the remaining $500 thousandobligation to be paid to Columbia and Cold Spring, in connection with theAgreement, is included in accrued liabilities on the Company’s balance sheetand is scheduled to be paid in June 2006.

 

Under the Agreement, theCompany has an exclusive license for technology used in its proprietarycombinatorial chemistry encoding technology, Encoded Combinatorial Libraries onPolymeric Support, or ECLiPS®.  The Agreement obligates the Company to paya minimum annual license fee of $100 thousand to Columbia and Cold Spring. Theterm of the Agreement is the later of (i)  July 16, 2013 or(ii) the expiration of the last patent relating to the technology, atwhich time the Company will have a fully paid license to the technology. The license granted to the Company under the Agreement can be terminated byColumbia and Cold Spring (i) upon 30 days written notice to the Company ifthe Company materially breaches the Agreement and the Company fails to curesuch material breach in accordance with the Agreement or (ii) if theCompany commits any act of bankruptcy, becomes insolvent, files a petitionunder any bankruptcy or insolvency act or has any such petition filed againstit that is not dismissed within 60 days.  The Company is obligated to payroyalties to Columbia and Cold Spring based upon net sales of pharmaceuticalproducts the Company develops, as well as a percentage of all other payments(such as milestones and royalties) the Company receives from customers in casesin which the Company has utilized the technology licensed from Columbia andCold Spring.

 

**ProductDevelopment and Commercialization Agreement with GSK**

** **

As described in Note 2 to the Financial Statements, the Company and GSK each have the right to terminatethe GSK Agreement in its sole discretion under certain specified circumstancesat any time during the term of the GSK Agreement. If the Company exercises itsdiscretionary termination right at any time during the first five years of the term,under certain circumstances, it could be required to refund to GSK a portion ofthe up to $15.0 million.

 

**LicenseAgreement with BMS**

** **

As described in Note 3 to the Financial Statements,under the terms of the agreement, in lieu of an upfront cash payment, theCompany is to provide BMS a set of compound libraries, over a period ofapproximately three years and pay BMS milestone payments upon the achievementof clinical and regulatory milestones, and royalties on sales of products, ifany, resulting from the program. In the event the Company fails to deliver theaforementioned libraries to BMS, the Company would be required make cashpayments on a pro rata basis of up to $2.0 million.

 

**9**.   Subsequent Event

** **

On May 4, 2006, theCompany announced that it had accepted the resignation of Michio Soga, itsformer Executive Vice President and Chief Financial Officer, effective May 3,2006. The Company also announced that Brian M. Posner, who had served as theCompany’s Vice President and Chief Accounting Officer, was promoted to theoffice of Executive Vice President, Chief Financial Officer and Treasurer.

 

11

----

 

In connection with anamended and restated severance agreement between the Company and Mr. Soga, theCompany expects to record a charge in the three months ending June 30, 2006 ofapproximately $155 thousand.

 

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

** **

**FORWARD-LOOKINGSTATEMENTS**

** **

This Report on Form 10-Qcontains forward-looking statements regarding us and our business, financialcondition, results of operations and prospects within the meaning of thePrivate Securities Litigation Reform Act of 1995.  Such forward-lookingstatements include those that express plans, anticipation, intent, contingency,goals, targets or future development and/or otherwise are not statements ofhistorical fact.  These forward-looking statements are based on ourcurrent expectations and projections about future events and they are subjectto risks and uncertainties known and unknown that could cause actual resultsand developments to differ materially from those expressed or implied in suchstatements.  These forward-looking statements include statements about thefollowing:

 

•      the plannedcessation of full-time employee funding from our existing collaborations withSchering-Plough;

 

•      ourintentions regarding the establishment and continuation of drug discovery anddevelopment collaborations with leading pharmaceutical and biotechnologyorganizations, in particular, the continuation and funding level of ourexisting collaboration with Organon and the establishment of our new product developmentand commercialization collaboration with GSK;

 

•      our abilityto develop our DARA compounds successfully;

 

•      our abilityto raise additional capital;

 

•      our abilityto build our pipeline of novel drug candidates, through our owninternally-funded drug discovery programs, our collaborations and in-licensing;

 

•      ouranticipated operating results, financial condition, liquidity and capitalresources;

 

•      ourexpectations concerning the development priorities of our collaborativepartners, and their ability to successfully develop compounds;

 

•      ourexpectations concerning the legal protections afforded by U.S. andinternational patent laws;

 

•      our beliefsas to the trends and opportunities impacting us and our industry;

 

•      our estimatesof the market opportunity for our product candidates; and

 

•      our abilityto acquire or invest in complementary businesses or technologies.

 

In some cases, you can identifyforward-looking statements by terminology, such as “expects,” “anticipates,” “intends,”“plans,” “believes,” “seeks,” “estimates,” or the negative of such terms orother similar expressions.  Factors that could cause or contribute todifferences in results and outcomes include, without limitation, thosediscussed elsewhere in this Report in Part II, Item 1A. “Risk Factors” and inthis Item 2 as well as those discussed in our other Securities and ExchangeCommission (SEC) filings.

 

We urge you to carefully read andconsider the disclosures found in these filings, all of which are available inthe SEC EDGAR database at www.sec.gov.  You are urged not to place unduereliance on any such forward-looking statements, any of which may turn out tobe wrong due to inaccurate assumptions, unknown risks, uncertainties or otherfactors.  We undertake no obligation to (and expressly disclaim any suchobligation to) revise or update the statements made herein or the risk factorsthat may relate thereto whether as a result of new information, future eventsor otherwise.

 

**TheCompany**

** **

**Overview**

** **

Weare committed to creating and delivering novel therapeutics to addresssignificant medical needs.  Using proprietary

 

12

----

 

technologiesand processes, we seek to identify, optimize and develop novel drug candidatesthrough our own internally-funded drug discovery programs and in collaborationswith major pharmaceutical and biotechnology companies.  Our collaborativeresearch efforts have resulted in a portfolio of three partnered programs(comprised of four compounds) that have been advanced into human clinicaltrials, in addition to eight programs in preclinical development, and multipleother partnered programs in discovery.  We have one internal program inpreclinical development and four internal programs in advanced discovery.

 

Ourmost advanced internal program is in preclinical development and focuses ondual angiotensin (AT1) and endothelin (ETA) receptor antagonists (DARA) forcardiovascular disease. We licensed our DARA program from Bristol-Myers SquibbCompany in March 2006. Our other internal proprietary research programs areprimarily focused on immunobiology and immunological diseases.  We fullyfund these programs and retain intellectual property and ownership rights toany compounds discovered.  At an appropriate point, we may license one ormore of these compounds or programs to a partner (probably a largerpharmaceutical or biotechnology organization).

 

For our internally-funded drugdiscovery programs, we focus the majority our efforts on those programs thatare targeted towards immunobiology and immunological diseases such asrheumatoid arthritis, psoriasis and other inflammatory diseases for severalreasons:

 

•      We believemany existing therapies for these diseases are lacking in one or more respects. For example, methotrexate, the standard of care for rheumatoid arthritis, hasserious side effects while newer biologicals are costly and may have safety andimmunogenic concerns;

 

•      We believethat a drug developed to provide immunosuppressant therapy for transplantpatients is likely to also offer medical benefit and commercial opportunity inother chronic diseases with similar underlying etiologies;

 

•      The lastdecade has seen significant progress in the understanding of the biologyunderlying the immune system and immunological diseases and its involvement inother therapeutic segments like Alzheimer’s disease, atherosclerosis and cancer;

 

•      We believea treatment developed for one immunobiological disease may be further developedfor another and, consequently, an investment in one therapeutic approach maypotentially yield products for multiple disorders;

 

•      We havesignificant internal expertise and experience in immunological diseases as aresult our proven record of delivering candidates in these therapeutic segmentsto our collaborators; and

 

•      There areincreasing commercial opportunities provided by a large, growing population ofpatients with immunological disorders including chronic and acute inflammation,autoimmune diseases, asthma and transplant rejection.

 

We are building expertise andextending our capabilities into preclinical and clinical development so that wecan advance both internal and partnered programs into clinicaldevelopment.  In addition to our proprietary research, we have drugdiscovery collaborations with leading pharmaceutical companies andbiotechnology companies, including a product development and commercializationcollaboration with GSK(entered into in March 2006). We continue to seek to establish broad,multi-year alliances with the potential to result in drug candidates in whichwe retain significant rights. We anticipate participating in the clinicaldevelopment of some of the compounds that may result from thesecollaborations.  As a consequence, our goal is to enter into alliances inwhich we receive improved collaborative research funding, milestone paymentsand royalties on net sales compared to collaborations we entered into in thepast.

 

In March 2006, we entered into a productdevelopment and commercialization agreement with GSK (the GSK Agreement)providing for the formation of a new drug discovery and development alliance. Ourrole in the alliance is to (i) identify and (ii) advance molecules in chosentherapeutic programs into development candidates and (iii) subject to the GSKoptions described below, further develop the candidates to clinical “proof ofconcept” (a demonstration of efficacy in man).

 

The GSK Agreement provides that GSK will have anexclusive option, exercisable at defined points during the development processfor each program (up to the point of clinical proof of concept), to licensethat program for a specified payment amount. Upon licensing a program, GSK isobligated to conduct clinical trials and commercialize pharmaceutical productsresulting from such

 

13

----

 

licensed programson a worldwide basis (the GSK License Obligations). If GSK does not exerciseits option to license a program, we will retain all rights to that program andmay continue to develop the program and commercialize any productsresulting from the program, or we may elect to cease progressing theprogram and/or seek other partners for the further development andcommercialization. In addition, we will retain rights to each program for whichGSK has not fulfilled its GSK License Obligations.

 

Under the terms of the GSK Agreement, we will receiveup to $15.0 million in cash payments from GSK, including $5.0 million that wereceived in April 2006. Up to the remaining $10.0 million will be payable to usupon our fulfillment of certain conditions related to the initial discovery activitiesto be conducted by us. In addition, we are entitled to receive success-basedmilestone payments from GSK for each drug development program pursued under thealliance and the potential for double-digit royalties upon the successfulcommercialization by GSK of any product resulting therefrom.

 

GSK and we each have the right to terminate the GSKAgreement in its or our sole discretion under certain specified circumstancesat any time during the term of the GSK Agreement. If we exercise ourdiscretionary termination right at any time during the first five years of the term,under certain circumstances, we could be required to refund to GSK a portion ofthe up to $15.0 million referred to above.

 

We expect to contribute thefollowing to collaborative drug discovery programs:

 

•      high andultra high throughput screening capabilities that enable us to test hundreds ofthousands to millions of compounds per week against disease-related targets toidentify active compounds that are further studied to determine if they meetthe criteria of an early lead compound;

 

•      pharmacologicalresults *in vitro*and *in vivo*;

 

•      optimizedlead compounds resulting from the iterative modification of the molecularstructure of early lead compounds to increase structural novelty, potency,selectivity and pharmacokinetic properties and reduce side effects;

 

•      potentialdevelopment candidates resulting from lead optimization studies that meetspecific potency, selectivity and safety criteria and possessing theappropriate pharmacokinetic properties consistent with advancement to furtherstages of drug discovery and development; and

 

•      potentialproduct candidates for clinical evaluation.

 

Our contribution to our product development andcommercialization collaboration with GSK will extend to developing activemolecules using our medicinal chemistry, biology, and pharmacology capabilitiesinto development candidates and, subject to GSK’s licensing options, furtherdeveloping the candidates to clinical proof of concept.

 

Our collaborative drug discoveryefforts have resulted in three therapeutic programs currently with candidatesin Phase I clinical trials targeting rheumatoid arthritis, an allergy/asthmaindication and chronic obstructive pulmonary disease (COPD).  We initiallyidentified p38 kinase inhibitor lead compounds in 1997 and entered into acollaborative partnering agreement with Bristol-Myers Squibb in 1999. Thiscollaboration resulted in a compound that advanced to clinical trials inAugust 2003.  A second compound resulting from that partnership,which is a back-up candidate, advanced to Phase I clinical trials in Canada inDecember 2005. A third compound discovered in our laboratories, aimed at anallergy/asthma indication, was the basis of a collaboration with DaiichiPharmaceutical Co. and resulted in a drug candidate that advanced to clinicaltrials in November 2003. Our Schering-Plough relationship produced acompound which advanced to clinical trials in March 2004 for COPD. Associated with these development programs, we have received milestone paymentsfrom each of Bristol-Myers Squibb, Daiichi and Schering-Plough and, to theextent the compounds successfully progress through clinical development, wewill be entitled to receive additional milestone payments.  We are alsoentitled under the agreements with each of these partners to receive royaltieson the commercial sale, if any, of most new drugs resulting from these collaborations. However, numerous additional studies are required to fully assess the potentialof these clinical candidates before they reach the marketplace, and the resultsfrom preclinical studies and clinical studies conducted to date with these compoundsare not necessarily indicative of the results that may be obtained in futureclinical studies.

 

14

----

 

In addition to the compounds in theclinic, eight more partnered programs are at various stages of preclinicaldevelopment, the point at which compounds are tested for safety in animals.This stage is prior to the filing of an Investigational New Drug, or IND,application and the compound’s exposure to humans during Phase I of clinicaldevelopment.

 

Preclinical and clinicaldevelopment of drug candidates is a long, expensive and uncertainprocess.  We continue to pursue the discovery and development of productcandidates using our integrated technology platform in both our internal andcollaborative programs. The drug candidates described above are at an earlystage, and none has received regulatory approval for commercial sale. Both our partnered clinical candidates and our internally-derived compoundsface the substantial risk of failure inherent in drug discovery anddevelopment.  At any stage of the clinical development process, ourcollaborators, or we, may decide to discontinue development of our productcandidates. To date, none of the compounds to which we hold complete or partialrights has reached the stage of a commercial product and, although we havereceived license and milestone fees, we may never receive any royalty payments,or any additional license and milestone fees, under our current or any futurecollaborations. We do not expect that our product candidates will becommercially available for many years, if ever.

 

During the three monthsended March 31, 2006 and 2005, we earned approximately $2.6 million and $3.6million, respectively, or 63% and 64%, respectively, of our revenue under ourresearch collaboration agreements with Schering-Plough, of which $1.6 millionand $2.6 million was full-time employee (FTE) funding and $1.0 million wasmilestone payments in each of the respective periods.

 

Our longstanding research collaborations with Schering-Plough willreach maturity in August 2006. Currently, we are planning for full-timeemployee (FTE) funding from the Schering-Plough collaborations ceasing at thattime. The planned cessation of FTE funding will have no impact on other areasof the collaborations, including the ongoing Phase I clinical trial in aninflammatory indication and multiple preclinical programs. We will continue tobe entitled to payments resulting from the successful achievement bySchering-Plough, if any, of preclinical and clinical milestones as well asroyalty payments from sales, if any, of products resulting from compoundsalready delivered by us and accepted by Schering-Plough under thecollaborations. In March 2006, we entered into a product development andcommercialization collaboration with GSK, and we are currently discussingpotential partnerships with other companies to establish broad, multi-yearalliances that, consistent with our business strategy, have the potential toprovide us with a larger share of product ownership than previouscollaborations. There is no assurance that we will be successful in further establishingsuch alliances. Failure to replace the revenue from the Schering-Ploughcollaborations would have a material adverse effect on our results of operations.Revenue recognition of funding from any new alliances may be different fromrevenue recognition of funding from the Schering-Plough collaborations. Failureto replace the funding from the Schering-Plough collaborations would have amaterial adverse effect on our business as it is currently conducted and ourfinancial condition. If adequate funds are not available, we may be required tocurtail operations significantly or to obtain funds by entering intoarrangements with collaborative partners or others that may require us torelinquish rights to certain of our technologies, products or potential marketsthat we would not otherwise relinquish.

 

During the three monthsended March 31, 2006 and 2005, we earned approximately $0.9 million and $1.2million, respectively, or 21% and 20%, respectively, of our revenue, all ofwhich was FTE research funding under our research collaboration agreements withOrganon. The 2002 agreement with Organon has a stated research term of fiveyears. The expiration of this agreement, should the revenue not be supplementedor replaced, would have a material adverse effect on our’s results ofoperations because of the resulting decrease in revenue.

 

From time to time we haveconsidered, and we will continue to consider strategic initiatives intended tofurther the development of our business.  In addition, we consideropportunities to expand our product pipeline through the acquisition orin-licensing of, or investment in, product development candidates, and weintend to continue to explore and evaluate those opportunities.

 

**Liquidityand Capital Resources**

** **

Prior to our spin-off from Accelrys in April2004, we had funded our activities primarily through Accelrys’ consolidatedoperations, including revenue derived from collaborative partnerships andmilestone payments. Accelrys contributed cash, cash equivalents and marketablesecurities such that upon consummation of the spin-off, we had cash, cashequivalents and marketable securities aggregating $46.5 million.

 

As of March 31, 2006,we had cash, cash equivalents and marketable securities of $25.6 millioncompared to $30.4 million at December 31, 2005, representing 56% and 66% of ourtotal assets, respectively. We invest excess cash in highly

 

15

----

 

liquidinvestment-grade marketable securities, including corporate bonds and UnitedStates government and agency securities.

 

The following is a summary ofselected cash flow information for the three months ended March 31,2006 and 2005:

 
| ** **                                 | ** ** | **For the Three Months Ended** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|
| ** **                                 | ** ** | **March 31,**                  | ** ** |
| ** **                                 | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Net loss                                   |       | $                              | (7,683     | ) | $ | (4,640 | ) |
| Adjustments  for noncash operating items   |       | 1,056                          |       | 730 |   |
|                                       |       |                           |       |   |   |
| Net cash  operating loss                   |       | (6,627                         | )          | (3,910 | ) |
| Net change  in assets and liabilities      |       | 1,366                          |       | (1,538 | ) |
|                                       |       |                           |       |   |   |
| Net cash  used in operating activities     |       | $                              | (5,261     | ) | $ | (5,448 | ) |
|                                       |       |                           |       |   |   |
| Net cash  provided by operating activities |       | $                              | 6,264      |   | $ | 2,872 |   |
|                                       |       |                           |       |   |   |
| Net cash  provided by financing activities |       | $                              | 736        |   | $ | 131 |   |

 

 

**Netcash used in operating activities**

 

Net cash operatingoutflows for the three months ended March 31, 2006 and 2005 have resultedprimarily from our operating loss due to our funding of our proprietaryinternal drug discovery efforts and the payment of restructuring expensesrelated to the 2004 consolidation of our facilities.

 

**Netcash provided by investing activities**

 

Net cash providedby investing activities for the three months ended March 31, 2006 and 2005 relatedprimarily to the net sales and maturities of marketable securities, partiallyoffset by capital expenditures for research and development and informationtechnology equipment.

 

**Net cashprovided by financing activities**

** **

Net cash providedby financing activities for the three months ended March 31, 2006 and 2005 consistedprimarily of proceeds from the issuance of common stock in connection withexercises of stock options.

 

**Liquidity andCapital Resources Outlook**

 

We expect to continue to useour capital to fund operating losses. We expect that our research anddevelopment expenditures will continue to increase in the future as we increaseour internal drug discovery efforts. Our DARA program, which is our mostadvanced internal program, is in preclinical development, which is asignificant, time-consuming and costly research and development process. Conductingour own drug discovery research and development is a key component of ourbusiness model.

 

In addition, ourcapital requirements may increase in future periods as we seek to expand ourtechnology platform through investments, licensing arrangements, technologyalliances, or acquisitions.

 

We anticipate that ourcapital resources will be adequate to fund our operations at their currentlevels at least through March 31, 2007. Asof March 31, 2006, we had cash, cash equivalents and marketable securitiesaggregating $25.6 million. In addition, as of March 31, 2006, we had deferredrevenue, long-term of approximately $4.0 million and other liabilities,long-term of approximately $1.3 million, which represents services to beprovided by the Company subsequent to March 31, 2007. However, there can be no assurance that changes will not occur that wouldconsume available capital resources before then.

 

Ourcapital requirements depend on numerous factors, including our ability tocontinue and extend existing collaborative agreements and to enter intoadditional arrangements. Approximately 84% of our revenue for the three months endedMarch 31, 2006 and 2005, respectively, was generated from ourcollaborations with Schering-Plough and Organon.

 

16

----

 

Our longstanding research collaborations withSchering-Plough will reach maturity in August 2006. Currently, we are planningfor full-time employee (FTE) funding from the Schering-Plough collaborationsceasing at that time. The planned cessation of FTE funding will have no impacton other areas of the collaborations, including the ongoing Phase I clinicaltrial in an inflammatory indication and multiple preclinical programs. We willcontinue to be entitled to payments resulting from the successful achievementby Schering-Plough, if any, of preclinical and clinical milestones as well asroyalty payments from sales, if any, of products resulting from compoundsalready delivered by us and accepted by Schering-Plough under thecollaborations. In March 2006, we entered into a collaboration with GSK, and weare currently discussing potential partnerships with other companies toestablish broad, multi-year alliances that, consistent with our businessstrategy, have the potential to provide us with a larger share of productownership than previous collaborations. There is no assurance that we will besuccessful in further establishing such alliances. Failure to replace thefunding from the Schering-Plough collaborations would have a material adverseeffect on our business as it is currently conducted and its financialcondition. If adequate funds are not available, we may be required to curtailoperations significantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

 

Inaddition, our capital requirements depend on competing technological and marketdevelopments, changes in our existing collaborative relationships, the cost offiling, prosecuting, defending, and enforcing patent claims and otherintellectual property rights and the outcome of related litigation, thepurchase of additional capital equipment, acquisitions of other businesses ortechnologies, and the progress of our collaborators’ milestone and royaltyproducing activities. Prior to exhausting our current capital resources, wewill need to raise additional funds to finance our operating activities orenter into strategic initiatives intended to further the development of ourbusiness. There can be no assurance that additional funding, if necessary, willbe available to us on favorable terms, if at all. Our forecasts of the periodof time through which our financial resources will be adequate to support ouroperations are forward-looking information, and actual results could vary. Thefactors described earlier in this section will impact our future capitalrequirements and the adequacy of our available funds.

 

In connection with our product development and commercialization agreementwith GSK, we received $5.0 million in April 2006. This amount was included inaccounts receivable at March 31, 2006. The GSK agreement has a research term offive years. As part of the GSK agreement, we will receive up to an additional$10.0 million of research and development funding over the research term.

 

**Results of Operations**

 

This section should be read in conjunctionwith the discussion under “Liquidity and Capital Resources”.

 

**Threemonths ended March 31, 2006 and 2005**

 

Our net revenue decreased 28% to$4.1 million in the three months ended March 31, 2006 compared to $5.7 million in the three months endedMarch 31, 2005. Net revenue consists of the funding ofour collaborative research activities, as well as our earning of milestones,success fees and license revenue if and as our discoveries progress through ourcollaborators’ development processes. Net revenue for the three months ended March 31, 2006 and 2005 is summarized as follows:

 
| ** **                      | ** ** | **For the three months ended March 31,** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                 | ** ** | **2005** | ** ** |
|                            |       |                                     |       |   |   |
| Collaborative  research funding |       | $                                        | 2,991      |   | $ | 4,508 |   |
| Milestones  and success fees    |       | 1,000                                    |       | 1,000 |   |
| License  revenue                |       | 125                                      |       | 183 |   |
|                            |       | $                                        | 4,116      |   | $ | 5,691 |   |

 

Schering-Plough accounted for 63%and 64% of our net revenue in the three months ended March 31, 2006 and 2005, respectively, including $1.0million of our milestones and success fees revenue recorded in each of thethree months ended March 31, 2006 and 2005, respectively.

 

Organon accounted for 21% and 20%of our net revenue in the three months ended March 31, 2006 and 2005,respectively.

 

17

----

 

The decrease in collaborative researchfunding in the three months ended March 31, 2006 was largely due to the reductionin funding from our collaborations with Schering-Plough and the expiration ofother collaborative research and development agreements.

 

Collaborative research and development expense includes the labor,material, equipment and allocated facilities cost of our scientific staff thatis working on collaborative partnerships. Collaborative research anddevelopment expenses decreased 41% to $3.3 million in the three months ended March 31, 2006 comparedto $5.6 million in the three months ended March 31, 2005. This decrease was due to decreasedresources allocated to our collaborative partnerships largely due to thereduced staffing on our collaboration with Schering-Plough and the expirationof other collaborative research and development agreements. This decrease wasoffset by the recognition of share-based compensation costs of $78 thousand associatedwith our adoption of SFAS 123R.

 

Proprietary research and development expense includes research and developmentacquisition costs, labor, material, equipment and allocated facilities cost ofscientific staff working on self-funded internal drug discovery programs. Usingproprietary technologies and processes, we seek to discover and develop noveldrug candidates to advance internally as well as with strategic partners. Our mostadvanced internal program is in preclinical development and focuses on dualangiotensin (AT1) and endothelin (ETA) receptor antagonists (DARA) forcardiovascular disease. We licensed our DARA program from Bristol-Myers SquibbCompany in March 2006. In addition, we currently have several internalprograms in advanced preclinical optimization. Proprietary research anddevelopment expenses increased 181% to $6.3 million in the three months ended March31, 2006 compared to $2.2 million in the three months ended March 31, 2005. Thisincrease was partially due to our licensing of the DARA compounds, for which werecorded a $2.0 million charge. Exclusive of this charge, proprietary research anddevelopment expenditures increased 92%. This increase was primarily related to resourcesexpended on our JAK-3 program for transplant rejection, our Adenosine A2aantagonists program for Parkinson’s disease, our CCR-1 antagonists program forrheumatoid arthritis and multiple sclerosis, and our recognition of share-basedcompensation costs of $91 thousand associated with our adoption of SFAS 123R. Becauseof the speculative nature of these internal drug discovery projects, it is notpossible to estimate completion dates, or estimated costs of completion. Additionally,from time to time, certain staff and other research and development resourcesmay be temporarily redirected from one project to another, which redirectionmay also delay or impact the cost of internal drug discovery projects.

 

Sales, general and administrative expense decreased by 8% to $2.4 millionin the three months ended March 31, 2006 compared to $2.7 million in the threemonths ended March 31, 2005.  The decrease in sales, general and administrativeexpense is attributable to lower recruiting and consulting costs offset by therecognition of share-based compensation costs of $246 thousand associated withour adoption of SFAS 123R.

 

Interest and other income, net increased to $281 thousand in the threemonths ended March31, 2006 compared to $209 thousand in the three months ended March 31, 2005. This increase is due to higher yields on our investments.

 

We recorded an income tax provision of $8 thousand and $10 thousand forthe three months ended March 31, 2006 and 2005, respectively.

 

As a result of the net revenues and expenses described above, wegenerated a net loss of $7.7 million ($0.51 per basic and diluted share) in thethree months ended March 31, 2006, compared to a net loss of $4.6million ($0.38 per basic and diluted share) in the three months ended March 31, 2005.

 

**Contractual Obligations**

 

For a discussion of our contractual obligations, see “Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations”in our report on Form 10-K for the year ended December 31, 2005. Seediscussion of Product Development and Commercialization Agreement with GSK andLicense Agreement with BMS in Note 2 and Note 3, respectively, to the FinancialStatements for new contractual obligations as of March 31, 2006.

 

**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. Our net loss is highly dependent onthe continued funding and success of our research and development programs withour existing collaborators. Our longstanding researchcollaborations with Schering-Plough will reach maturity in August 2006.Currently, we are planning for full-time employee (FTE) funding from theSchering-Plough collaborations ceasing at that time. The planned cessation ofFTE funding will have no impact on other areas of the collaborations, includingthe ongoing Phase I clinical trial in an inflammatory indication and multiplepreclinical programs. We will continue to be entitled to payments resultingfrom the successful achievement by Schering-Plough, if any, of

 

18

----

 

preclinical and clinical milestones as well as royalty payments fromsales, if any, of products resulting from compounds already delivered by us andaccepted by Schering-Plough under the collaborations. In March 2006, we enteredinto a product development and commercialization collaboration with GSK, and weare currently discussing potential partnerships with other companies to establishbroad, multi-year alliances that, consistent with our business strategy, havethe potential to provide us with a larger share of product ownership thanprevious collaborations. There is no assurance that we will be successful infurther establishing such alliances. Failure to replace the revenue from theSchering-Plough collaborations would have a material adverse effect on ourresults of operations. Revenue recognition of funding from any new alliancesmay be different from revenue recognition of funding from the Schering-Ploughcollaborations. Theprincipal agreement with Organon, entered into in February 2002, has astated research term of five years. Failure to replace the revenue fromthe Organon collaborations would have a material adverse effect on our resultsof operations. On a quarterly basis, ourfuture operating results are likely to be highly volatile because they dependupon our receipt of milestone payments from our collaborators. We may notreceive milestone payments on a regular basis or at all.

 

We expect to incur losses in future periodsand these losses may grow as a result of the increased level of investment wehave determined to make in our internal proprietary programs in the future aswell as the results of those programs. Our internal proprietary research anddevelopment costs are expected to continue to increase due to our efforts toprogress the DARA compounds into clinical trials.

 

Effective January 1, 2006, we adopted SFAS 123R “Share-Based Payment.” Theadoption of SFAS 123R had and will continue to have a significant impact on ourresults of operations, however, there will be no impact on the Company’s cashflows.

 

There is no assurance that we will everachieve profitable operations, or that profitable operations, if achieved,could be sustained on a continuing basis.

 

**Critical Accounting Policies**

 

The preparation of ourfinancial statements and disclosures involve the use of judgments and estimates.We believe the following critical accounting policies that we follow involvesignificant judgments and use estimates.

 

*Revenue Recognition*

 

Contract revenue isgenerally recognized either (i) on a proportional performance basis, forcontracts specifying payment for services over a given period, or (ii) asservices are performed under the agreement for contracts specifying payment ona full-time employee basis.

 

Revenue earned relatedto up-front product and technology license fees is recognized in accordancewith Staff Accounting Bulletin 104 issued by the SEC and EITF Issue 00-21, “RevenueArrangements with Multiple Deliverables” issued by the FASB. Accordingly,amounts received under multiple-element arrangements requiring ongoing servicesor performance by us are recognized over the period of such services orperformance.

 

Revenue from milestonesis recognized when earned, as evidenced by written acknowledgement from thecollaborator, provided that (i) the milestone event is substantive and itsachievability was not reasonably assured at the inception of the agreement, and(ii) our performance obligation after the milestone achievement willcontinue to be funded by the collaborator at a comparable level to before themilestone achievement. If both of these criteria are not met, the milestonepayment is recognized over the remaining minimum period of our performanceobligations under the arrangement. Royalties are recognized as earned inaccordance with the terms of various research and collaboration agreements.

 

*Long-Lived Assets*

 

We review long-livedassets, including leasehold improvements, property and equipment, and acquiredtechnology rights, for impairment whenever events or changes in businesscircumstances indicate that the carrying amount of the assets may not be fullyrecoverable. This requires us to estimate future cash flows related to theseassets. Actual results could differ from these estimates, which may affect thecarrying amount of assets and the actual amortization expense. As of March 31,2006, we had long-lived assets with a net book value of $10.4 million.

 

19

----

 

**NewAccounting Pronouncements**

 

Prior to January 1, 2006and as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”(SFAS 123), the Company elected to follow Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” (APB 25) and relatedinterpretations in accounting for its participation in Pharmacopeia’s employeestock option plans. Under APB 25, the Company did not recognize share-basedcompensation expense at the time ofoption grant because the exercise price of the stock option equaled the fairmarket value of the underlying common stock on the date of grant.

 

Effective January 1,2006, the Company adopted the fair value recognition provisions of SFAS No. 123(revised 2004), “Share-Based Payment” (SFAS 123R), using themodified-prospective transition method. This statement is a revision to SFAS123, supersedes APB 25 and amends SFAS No. 95, “Statement of Cash Flows.”  Under this transition method, compensation costrecognized includes compensation costs for all share-based payments grantedprior to, but not yet vested as of December 31, 2005 based on the grant datefair value estimated in accordance with the original provisions of SFAS 123,and compensation cost for all share-based payments granted subsequent toDecember 31, 2005 based on the grant date fair value estimated in accordancewith provisions of SFAS 123R. Results for prior periods have not been restated.

 

Asa result of adopting SFAS 123R, the Company’s net income and basic and dilutedearnings per share for the quarter ended March 31, 2006 were $394 thousand and$.03 per share, respectively, lower than if the Company had continued toaccount for its share-based compensation under APB 25. At March 31, 2006, therewas approximately $3.4 million of unrecognized compensation costs, net ofestimated forfeitures, related to share-based payments which are expected to berecognized over a weighted average period of 1.5 years. Total share-basedcompensation costs for the three months ending March 31, 2006 wereapproximately $415 thousand.

 

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

 

Our international salesgenerally are denominated in United States Dollars, and are, therefore, notexposed to changes in foreign currency exchange rates.

 

We do not use derivativefinancial instruments for trading or speculative purposes. However, weregularly invest excess cash in overnight repurchase agreements that aresubject to changes in short-term interest rates. We believe that the marketrisk arising from holding these financial instruments is minimal.

 

Our exposure to marketrisks associated with changes in interest rates relates primarily to theincrease or decrease in the amount of interest income earned on our investmentportfolio since we have minimal debt. We ensure the safety and preservation ofinvested funds by limiting default risks, market risk and reinvestment risk. Wemitigate default risk by investing in investment grade securities. A hypothetical100 basis point adverse move in interest rates along the entire interest rateyield curve would not have materially affected the fair value of our interestsensitive financial instruments as of March 31, 2006.

 

**Item 4. Controls and Procedures**

 

Forthe three months ended March 31, 2006, our management carried out an evaluation, under thesupervision and with the participation of our President and Chief ExecutiveOfficer and our Executive Vice President and Chief Financial Officer (ourprincipal financial officer and chief accounting officer), of the effectivenessof our disclosure controls and procedures pursuant to Rules 13a-15 and 15d-15under the Securities Exchange Act of 1934, or the Exchange Act, as of the endof the period covered by this report. Based upon this evaluation, our Presidentand Chief Executive Officer and our Executive Vice President and ChiefFinancial Officer concluded that as of March 31, 2006, our disclosure controls andprocedures are effective to ensure that the information required to bedisclosed by us in reports filed under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the rules andforms of the SEC. Our management, including our President and Chief ExecutiveOfficer and our Executive Vice President and Chief Financial Officer, does notexpect that our disclosure controls or our internal controls will prevent allerrors and all fraud. A control system, no matter how well designed andoperated, cannot provide assurance that the objectives of the control systemare met, and no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within a company have beendetected.

 

Additionally,our President and Chief Executive Officer and our Executive Vice President and ChiefFinancial Officer determined that there were no changes in our internal controlover financial reporting during the quarterly period ended March 31, 2006, that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

20

----

 

**PART II. OTHER INFORMATION**

 

**Item 1.****     ****Legal Proceedings**

 

We are not currently aparty to any legal proceedings the negative outcome of which to us would have amaterial adverse effect on our business, financial condition or results ofoperations.

 

**Item 1A.****  ****Risk Factors**

 

Ourperformance and financial results are subject to risks and uncertainties,including, but not limited to, the specific risks disclosed in Item 1A. RiskFactors in our Annual Report on Form 10-K for the year ended December 31, 2005.Except as noted below, there have been no material changes to the risk factorsdisclosed in the 10-K.

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

***Our revenue ishighly concentrated in our two largest collaborators. The planned cessation offull-time employee funding from Schering-Plough would have a material adverseeffect on our business as it is currently conducted, our financial conditionand our results of operations if we are unable to replace this funding. Inaddition, the termination of our collaboration with Organon would have amaterial adverse effect on our results of operations if we were unable toreplace the revenue from this collaboration.***

 

During the three months ended March 31, 2006 and 2005, weearned approximately $3.5 million and $4.8 million, respectively, orapproximately 84% of our revenue for each respective three month period, underour research collaboration agreements with two collaborators, Schering-Ploughand Organon. In March 2006, we entered into a product development andcommercialization collaboration with GSK, and we are currently discussingpotential partnerships with other companies to establish broad, multi-yearalliances that, consistent with our business strategy, have the potential toprovide us with a larger share of product ownership than previouscollaborations. There is no assurance that we will be successful in furtherestablishing such alliances.

 

During the three months ended March 31, 2006 and 2005, we earnedapproximately $2.6 million and $3.6 million, or 63% and 64% of our revenue,respectively, of which $1.6 million and $2.6 million was full-time employee(FTE) funding, respectively and $1.0 million was milestone payments in each of therespective periods, under our research collaboration agreements withSchering-Plough, one of our longest-standing collaborative partners. Thesecollaborations with Schering-Plough will reach maturity in August 2006.Currently, we are planning for the FTE funding from the Schering-Ploughcollaborations ceasing at that time. The planned cessation of FTE funding willhave no impact on other areas of the collaborations, including the ongoingPhase I clinical trial in an inflammatory indication and multiple preclinicalprograms. We will continue to be entitled to payments resulting from thesuccessful achievement by Schering-Plough, if any, of preclinical and clinicalmilestones as well as royalty payments from sales, if any, of productsresulting from compounds already delivered by us and accepted bySchering-Plough under the collaborations. Failure to replace the revenue fromthe Schering-Plough collaborations would have a material adverse effect on ourresults of operations. Revenue recognition of funding from any new alliancesmay be different from revenue recognition of funding from the Schering-Ploughcollaborations. Failure to replace the funding from the Schering-Ploughcollaborations would have a material adverse effect on our business as it iscurrently conducted and our financial condition. If adequate funds are notavailable, we may be required to curtail operations significantly or to obtainfunds by entering into arrangements with collaborative partners or others thatmay require us to relinquish rights to certain of our technologies, products orpotential markets that we would not otherwise relinquish.

 

During the three months ended March 31, 2006 and 2005, we earnedapproximately $0.9 million and $1.2 million, respectively, or 21% and 20%,respectively, of our revenue, all of which was FTE funding under our researchcollaboration agreements with Organon, our second largest collaborator. Theprincipal agreement with Organon, entered into in February 2002, has a statedresearch term of five years. Failure to replace the revenue from the Organoncollaborations would have a material adverse effect on our results ofoperations because of the resulting decrease in revenue.

 

***If we consume cashmore quickly than expected, and if we are unable to raise additional capital,we may be forced to curtail operations.***

 

We anticipate that our capital resources, including our existing cash,cash equivalents and marketable securities as of March 31, 2006 ofapproximately $25.6 million, will be adequate to fund our operations at theircurrent levels at least through March 31, 2007.

 

21

----

 

However, changes may occur that would cause us to consume availablecapital resources before that time. Examples of relevant potential changes inour capital resources include:

 

•      changesin other existing collaborative relationships, including the funding we receivein connection with those relationships;

 

•      thecosts associated with our drug discovery and development activities;

 

•      acquisitionsof other businesses or technologies;

 

•      thepurchase of additional capital equipment;

 

•      cash refunds we may be required to make toGSK if, prior to March 24, 2011, we exercise our discretionary terminationright under our product development and commercialization agreement with GSK;

 

•      cashpayments we may be required to make to BMS if we fail to deliver certaincompound libraries under our license agreement with BMS;

 

•      penaltieswe may be required to pay the purchasers in the private placement transactionwe closed in August 2005 if we fail to comply with certain covenants andobligations related to that transaction;

 

•      competingtechnological and market developments;

 

•      thecost of filing, prosecuting, defending and enforcing patent claims and otherintellectual property rights, and the outcome of related litigation; and

 

•      theprogress of our milestone and royalty producing activities.

 

We intend to raise additional capital. The capital could be raisedthrough public or private financings involving debt or common or other classesof our equity. Any issuance of equity securities would dilute our currentstockholders’ percentage ownership of us. As of March 31, 2006, there wereapproximately 4,385,000 stock options outstanding and approximately 5,000shares of unvested restricted stock granted under our various equitycompensation plans. These equity instruments represent approximately 29% of ourshares outstanding at March 31, 2006. The significant dilution represented byour outstanding equity compensation awards may make it more difficult for us toraise additional capital. Additional capital may not be available on favorableterms, or at all. If adequate funds are not available, we may be required tocurtail operations significantly or to obtain funds by entering intoarrangements with collaborative partners or others that may require us torelinquish rights to certain of our technologies, products or potential marketsthat we would not otherwise relinquish.

 

***Because our DARA compounds are in preclinical development, there is a high risk that further development and testing will demonstrate that they are not suitable for commercialization.***

 

We have no products that have received regulatory approval for commercial sale. Our DARA compounds are in preclinical development, and we face the substantial risks of failure inherent in developing drugs based on new technologies.

 

Our DARA compounds must satisfy rigorous standards of safety and efficacy before the United States Food and Drug Administration (FDA) and foreign regulatory authorities will approve them for commercial use. We will need to conduct significant additional preclinical testing and, if such preclinical testing is successful, clinical trials, to demonstrate the safety and efficacy of our DARA compounds to the satisfaction of the FDA and foreign regulatory authorities to obtain product approval.

 

Preclinical testing and clinical development are long, expensive and uncertain processes. It may take us many years to complete testing and trials, if any, and failure can occur at any stage of testing or trials. Success in preclinical testing and early clinical trials does not ensure that later clinical trials will be successful. We may suffer significant setbacks in advanced clinical trials, even after promising results in earlier trials. We may not be able to enroll a sufficient number of patients to complete our clinical trials in a timely manner. Based on results at any stage of preclinical testing or clinical trials, we may decide to discontinue development of our DARA compounds.

 

22

----

 

We do not know whether any future clinical trials of our DARA compounds will demonstrate sufficient safety and efficacy necessary to obtain the requisite regulatory approvals or will result in marketable products. Our failure to adequately demonstrate the safety and efficacy of our DARA compounds under development will prevent receipt of FDA and foreign regulatory approvals and, ultimately, their commercialization.

 

***We had net losses inrecent years, and our future profitability is uncertain.***

 

Duringthe three months ended March 31, 2006, we had a net loss of approximately$7.7 million. Thenet loss was primarily due to our licensing of the DARA program from BMS, ourcontinued focus on internal research and development, the decrease in revenuefrom our collaborations with Schering-Plough, and increased compensation costsassociated with the adoption of SFAS 123R.

 

Our longstanding research collaboration with Schering-Plough will reachmaturity in August 2006. Currently, we are planning for FTE funding from theSchering-Plough collaborations ceasing at that time. In addition, under theprincipal agreement with Organon, the research term expires in February 2007.Failure to replace the revenue from our collaborations with Schering-Plough andOrganon would have a material adverse effect on our results of operations.

 

The adoption of the Financial Accounting Standards Board Statement No.123R “Share-Based Payment” had and will continue to have a significant impacton our results of operations. Our adoption of SFAS 123R was effective January1, 2006.

 

On a quarterly basis, our future operating results are likely to behighly volatile depending upon our receipt of milestone payments from ourcollaborators. We may not receive milestone payments on a regular basis or atall. Our ability to achieve profitability, if ever, will be significantlyimpacted by the level of investment we determine to make in our internalproprietary programs in the future as well as the results of those programs.

 

Continuing net losses may limit our ability to fund our operations, andwe may not generate income from operations in the future.

 

**Item 2.****     ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

**OnMarch 24, 2006, pursuant to the terms of the product development andcommercialization agreement we entered into with GSK, we issued two warrants toGSK for the purchase of up to an aggregate of 176,367 shares of our commonstock at an exercise price of $5.67 per share, which is a 25% premium over thetrailing 30-day closing price average preceding such date. The warrants areexercisable at any time before the earlier to occur of (i) March 24,2011 and (ii) the effective date of certain types of terminations of the productdevelopment and commercialization agreement that we entered into with GSK.These warrants were issued in a transaction not involving a public offeringunder Section 4(2) of the Securities Act of 1933, as amended.**

** **

**Item 3.**      **Defaults upon Senior Securities**

 

None.

 

**Item 4.****     ****Submission of Matters to aVote of Security Holders.**

 

None.

 

**Item 5.****     ****Other Information**

 

None.

 

**Item 6.****     ****Exhibits**

 
| **Exhibits.** | ** ** | ** **                                                                                 |
|---------------|------------|--------------------------------------------------------------------------------------------|
|          |       |                                                                                       |
| 4.1           |       | Form  of Warrant to Purchase Common Stock.(1)                                              |
|          |       |                                                                                       |
| 10.1          |       | Product  Development and Commercialization Agreement among SmithKlineBeecham  Corporation, |

 

23

----

 
|   |   | doing  business as GlaxoSmithKline, Glaxo Group Limited and Pharmacopeia Drug  Discovery, Inc., dated as of March 24, 2006.(1)(2)                                                                                                                                                             |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                          |
| 10.2   |   | License  Agreement, dated as of March 27, 2006, between Pharmacopeia Drug Discovery,  Inc. and Bristol-Myers Squibb Company.(1)(2)                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                          |
| 31.1   |   | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-l4(a) of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.(1)                              |
|   |   |                                                                                                                                                                                                                                                                                          |
| 31.2   |   | Certification  of the Principal Financial Officer and Chief Accounting Officer of Pharmacopeia  Drug Discovery, Inc. pursuant to Rule 13a-14(a) of the Securities  Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.(1) |
|   |   |                                                                                                                                                                                                                                                                                          |
| 32.1   |   | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.(1)                                                                          |
|   |   |                                                                                                                                                                                                                                                                                          |
| 32.2   |   | Certification  of the Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.(1)                                            |

 

----

(1)    Filed herewith.

 

(2)    Confidential treatment of certainprovisions of this exhibit has been requested.

 

24

----

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                           | PHARMACOPEIA  DRUG  DISCOVERY, INC. |
|--------------------------------|-------------------------------------|
|                           |                                |
| Date:  May  12, 2006 | By:                                 | /s/  Leslie J. Browne, Ph.D. |
|                           |                                | Leslie  J. Browne, Ph.D. |
|                           |                                | President,  Chief Executive Officerand Director |
|                           |                                | (Principal  Executive Officer) |
|                           |                                |   |
|                           | By:                                 | /s/  Brian M. Posner |
|                           |                                | Brian  M. Posner |
|                           |                                | Executive  Vice President, |
|                           |                                | Chief  Financial Officer and Treasurer |
|                           |                                | (Principal  Financial Officer and Chief Accounting Officer) |

 

25

----

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**INDEX TOEXHIBITS**

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                                                    |
|---------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                                                                                                          |
| 4.1           |       | Form  of Warrant to Purchase Common Stock.(1)                                                                                                                                                                                                                                                 |
|          |       |                                                                                                                                                                                                                                                                                          |
| 10.1          |       | Product  Development and Commercialization Agreement among SmithKlineBeecham  Corporation, doing business as GlaxoSmithKline, Glaxo Group Limited and  Pharmacopeia Drug Discovery, Inc., dated as of March 24, 2006.(1)(2)                                                                   |
|          |       |                                                                                                                                                                                                                                                                                          |
| 10.2          |       | License  Agreement, dated as of March 27, 2006, between Pharmacopeia Drug Discovery,  Inc. and Bristol-Myers Squibb Company.(1)(2)                                                                                                                                                            |
|          |       |                                                                                                                                                                                                                                                                                          |
| 31.1          |       | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-l4(a) of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.(1)                              |
|          |       |                                                                                                                                                                                                                                                                                          |
| 31.2          |       | Certification  of the Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.(1) |
|          |       |                                                                                                                                                                                                                                                                                          |
| 32.1          |       | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.(1)                                                                          |
|          |       |                                                                                                                                                                                                                                                                                          |
| 32.2          |       | Certification  of the Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.(1)                                            |

 

----

(1)    Filed herewith.

 

(2)    Confidential treatment of certainprovisions of this exhibit has been requested.

 

26

----