**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 1O-Q**

**(Mark One)**

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

 

**For the quarterly period endedJune 30, 2006**

** **

**Or**

 

 

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

 

**Commission File 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, ifchanged since last report)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filing requirementsfor the past 90 days.    Yes x     No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Largeaccelerated filer   o   Acceleratedfiler  o   Non-accelerated filer  x

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o    Nox

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date:
| ** ** | **Class**                      | ** ** | **Outstanding  at July 31, 2006** | ** ** |
|------------|--------------------------------|------------|-----------------------------------|------------|
|       | Common Stock,  $0.01 par value |       | 15,301,676                        |       |

 

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

**Form 10-Q**

**Table of Contents**
| Item               | ** **                                                                                  | ** ** | ** ** | ** ** |
|--------------------|---------------------------------------------------------------------------------------------|------------|------------|------------|
|               |                                                                                        |       |
| PART I.       | FINANCIAL  INFORMATION                                                                      | 2          |
|               |                                                                                        |       |
| Item 1.            | Financial  Statements (Unaudited):                                                          | 2          |
|               |                                                                                        |       |
|               | Balance  Sheets as of June 30, 2006 and December 31, 2005                              | 2          |
|               |                                                                                        |       |
|               | Statements  of Operations for the Three Months and Six Months Ended June 30, 2006 and  2005 | 3          |
|               |                                                                                        |       |
|               | Statements  of Cash Flows for the Six Months Ended June 30, 2006 and 2005                   | 4          |
|               |                                                                                        |       |
|               | Notes to Unaudited Financial Statements                                                     | 5          |
|               |                                                                                        |       |
| Item 2.            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 12         |
|               |                                                                                        |       |
| Item 3.            | Quantitative  and Qualitative Disclosures about Market Risk                                 | 22         |
|               |                                                                                        |       |
| Item 4.            | Controls and  Procedures                                                                    | 23         |
|               |                                                                                        |       |
| PART II.      | OTHER  INFORMATION                                                                          | 23         |
|               |                                                                                        |       |
| Item  1.           | Legal Proceedings                                                                           | 23         |
|               |                                                                                        |       |
| Item  1A.          | Risk Factors                                                                                | 23         |
|               |                                                                                        |       |
| Item 2.            | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 25         |
|               |                                                                                        |       |
| Item 3.            | Defaults upon  Senior Securities                                                            | 25         |
|               |                                                                                        |       |
| Item 4.            | Submission of  Matters to a Vote of Security Holders                                        | 26         |
|               |                                                                                        |       |
| Item  5.           | Other Information                                                                           | 26         |
|               |                                                                                        |       |
| Item 6.            | Exhibits                                                                                    | 26         |
|               |                                                                                        |       |
| Signatures         | 28                                                                                          |
|               |                                                                                        |
| Index to  Exhibits | 29                                                                                          |

 

 

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**PART I- FINANCIAL INFORMATION**

**Item 1. Financial Statements (Unaudited)**

**Pharmacopeia Drug Discovery, Inc.Balance Sheets(Amounts in thousands, except share and per share data)**
| ** **                                                                                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                          | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                          | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash  and cash equivalents                                                                                                          |       | $                 | 34,015     |                  | $          | 11,680 |   |
| Marketable  securities                                                                                                              |       | 6,069             |       | 18,686                |       |
| Accounts  receivable                                                                                                                |       | 235               |       | 2,256                 |       |
| Prepaid expenses  and other current assets                                                                                          |       | 934               |       | 771                   |       |
| Total current  assets                                                                                                               |       | 41,253            |       | 33,393                |       |
|                                                                                                                                |       |              |       |                  |       |
| Property and equipment,  net                                                                                                        |       | 10,585            |       | 10,548                |       |
| Deferred compensation  plan assets                                                                                                  |       | 1,830             |       | 1,904                 |       |
| Other assets                                                                                                                        |       | 174               |       | 174                   |       |
| Total assets                                                                                                                        |       | $                 | 53,842     |                  | $          | 46,019 |   |
|                                                                                                                                |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                      |       |              |       |                  |       |
| Current liabilities:                                                                                                                |       |              |       |                  |       |
| Accounts payable                                                                                                                    |       | $                 | 2,530      |                  | $          | 1,112 |   |
| Accrued liabilities                                                                                                                 |       | 2,769             |       | 3,350                 |       |
| Restructuring  reserve                                                                                                              |       | —            |       | 908                   |       |
| Deferred  revenue, current portion                                                                                                  |       | 8,863             |       | 3,492                 |       |
| Total current  liabilities                                                                                                          |       | 14,162            |       | 8,862                 |       |
|                                                                                                                                |       |              |       |                  |       |
| Deferred compensation  plan                                                                                                         |       | 1,830             |       | 1,904                 |       |
| Deferred revenue,  long-term                                                                                                        |       | 13,498            |       | —                |       |
| 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, 15,294,775 and 14,988,915  shares issued and outstanding, respectively |       | 153               |       | 150                   |       |
| Additional  paid-in capital                                                                                                         |       | 61,176            |       | 58,751                |       |
| Accumulated  deficit                                                                                                                |       | (38,234           | )          | (23,373               | )          |
| Accumulated  other comprehensive loss                                                                                               |       | (76               | )          | (146                  | )          |
| Deferred  compensation                                                                                                              |       | —            |       | (129                  | )          |
| Total  stockholders’ equity                                                                                                    |       | 23,019            |       | 35,253                |       |
| Total liabilities and  stockholders’ equity                                                                                    |       | $                 | 53,842     |                  | $          | 46,019 |   |

 

See accompanyingnotes to these unaudited financial statements

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**Pharmacopeia Drug Discovery, Inc.Statements of Operations(Amounts in thousands, except share and per share data)**

 
| ** **                                            | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                            | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** |
| ** **                                            | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(unaudited)**                         | ** ** | **(unaudited)**                       | ** ** |
| Net revenue                                           |       | $                                       | 3,292      |                                  | $          | 5,231 |   | $ | 7,408 |   | $ | 10,922 |   |
|                                                  |       |                                    |       |                                  |       |   |   |   |   |
| Collaborative research and development expense        |       | 2,979                                   |       | 4,616                                 |       | 6,312 |   | 10,242 |   |
| Proprietary research and development expense          |       | 5,468                                   |       | 2,455                                 |       | 11,760 |   | 4,696 |   |
| Sales, general and administrative expense             |       | 2,424                                   |       | 3,163                                 |       | 4,871 |   | 5,826 |   |
| Restructuring and other charges (credits)             |       | (88                                     | )          | —                                |       | (88 | ) | — |   |
| Interest and other income, net                        |       | (333                                    | )          | (297                                  | )          | (614 | ) | (506 | ) |
|                                                  |       | 10,450                                  |       | 9,937                                 |       | 22,241 |   | 20,258 |   |
| Loss before  income taxes                             |       | (7,158                                  | )          | (4,706                                | )          | (14,833 | ) | (9,336 | ) |
| Provision for income taxes                            |       | 20                                      |       | 4                                     |       | 28 |   | 14 |   |
| Net loss                                              |       | $                                       | (7,178     | )                                     | $          | (4,710 | ) | $ | (14,861 | ) | $ | (9,350 | ) |
|                                                  |       |                                    |       |                                  |       |   |   |   |   |
| Net loss per  share:                                  |       |                                    |       |                                  |       |   |   |   |   |
| — Basic and diluted                              |       | $                                       | (0.47      | )                                     | $          | (0.38 | ) | $ | (0.98 | ) | $ | (0.75 | ) |
|                                                  |       |                                    |       |                                  |       |   |   |   |   |
| Weighted average  number of common stock outstanding: |       |                                    |       |                                  |       |   |   |   |   |
| — Basic and  diluted                             |       | 15,263,977                              |       | 12,427,767                            |       | 15,237,364 |   | 12,390,660 |   |

 

See accompanyingnotes to these unaudited financial statements

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**Pharmacopeia Drug Discovery, Inc.Statements of Cash Flows(Amounts in thousands)**
| ** **                                                                      | ** ** | **For the Six Months** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                      | ** ** | **Ended June 30,**          | ** ** |
| ** **                                                                      | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                                                      | ** ** | **(unaudited)**                       | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                          |       |                                  |       |   |   |
| Net loss                                                                        |       | $                                     | (14,861    | ) | $ | (9,350 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities |       |                                  |       |   |   |
| Depreciation and amortization                                                   |       | 961                                   |       | 1,175 |   |
| Contribution of stock to 401(k) Plan                                            |       | 219                                   |       | 203 |   |
| Share-based compensation                                                        |       | 926                                   |       | 256 |   |
| Restructuring credit                                                            |       | (88                                   | )          | — |   |
| Gain on sale of property and equipment                                          |       | (3                                    | )          | — |   |
| Changes in assets and liabilities:                                              |       |                                  |       |   |   |
| Accounts receivable                                                             |       | 2,021                                 |       | 412 |   |
| Prepaid expenses and other current assets                                       |       | (163                                  | )          | 285 |   |
| Other assets                                                                    |       | —                                |       | (42 | ) |
| Accounts payable                                                                |       | 1,418                                 |       | 507 |   |
| Accrued liabilities                                                             |       | 752                                   |       | (238 | ) |
| Restructuring reserve                                                           |       | (820                                  | )          | (1,285 | ) |
| Deferred revenue                                                                |       | 19,374                                |       | 103 |   |
| Net cash provided by (used in) operating activities                             |       | 9,736                                 |       | (7,974 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                          |       |                                  |       |   |   |
| Capital expenditures, net                                                       |       | (998                                  | )          | (436 | ) |
| Proceeds from sale of property and equipment                                    |       | 3                                     |       | — |   |
| Purchases of marketable securities                                              |       | (1,000                                | )          | (5,525 | ) |
| Proceeds from sale and maturities of marketable  securities                     |       | 13,687                                |       | 7,098 |   |
| Net cash provided by investing activities                                       |       | 11,692                                |       | 1,137 |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                          |       |                                  |       |   |   |
| Proceeds from issuance of common stock                                          |       | 907                                   |       | 218 |   |
| Investment by Accelrys, Inc.                                                    |       | —                                |       | 47 |   |
| Net cash provided by financing activities                                       |       | 907                                   |       | 265 |   |
| Net increase  (decrease) in cash and equivalents                                |       | 22,335                                |       | (6,572 | ) |
| Cash and  equivalents, beginning of period                                      |       | 11,680                                |       | 20,173 |   |
| Cash and  equivalents, end of period                                            |       | $                                     | 34,015     |   | $ | 13,601 |   |
|                                                                            |       |                                  |       |   |   |

 

Noncashtransactions for the six months ended June 30, 2006 are as follows:

·                  TheCompany incurred research and development costs of $2.0 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 June 30, 2006. See Note 3 to the Financial Statementsfor disclosure of the Company’s License Agreement with BMS.

·                  TheCompany recorded the fair value of two warrants issued as part of its ProductDevelopment and Commercialization Agreement with GSK (defined in Note 2) as anincrease to additional paid-in capital and a decrease to deferred revenue. Thefair value of the warrants amounted to approximately $505 thousand. See Note 2to the Financial Statements for disclosure of the Company’s agreement with GSK.

Seeaccompanying notes to these unaudited financial statements

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**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 stockheld. A total of 12,181,471 shares were distributed.

Pharmacopeia is committed to creating anddelivering novel therapeutics to address significant medical needs. Usingproprietary technologies and processes, the Company seeks to identify, optimizeand develop novel drug candidates through its own internally-funded drugdiscovery and development programs and in collaborations with majorpharmaceutical and biotechnology companies.  The Company’s collaborative researchefforts have resulted in a portfolio of three partnered programs (comprised offour compounds) that have been advanced into human clinical trials, in additionto seven programs in preclinical development, and multiple other partneredprograms in discovery.  Pharmacopeia has one internal program inpreclinical development and four internal programs in advanced discovery.

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 theinformation and disclosures required by U. S. generally accepted accountingprinciples for complete financial statements. In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary fora fair presentation of the financial statements have been included. Interimresults are not necessarily indicative of the results that may be expected forthe year. The unaudited interim financial statements should be read inconjunction with the financial statements and notes thereto included in theCompany’s Annual Report on Form 10-K for the year ended December 31,2005.

**2.**   Significant Collaborations

**Collaboration and License Agreements withSchering-Plough**

Forthe three months ended June 30, 2006 and 2005, the Company’s researchcollaborations with Schering Corporation and Schering-Plough Ltd. (Schering-Plough),accounted for 45% and 49%, respectively, of revenue. For the six months endedJune 30, 2006 and 2005, the Company’s research collaborations withSchering-Plough, accounted for 55% and 57%, respectively, of revenue. Research funding from theSchering-Plough agreements is recognized as revenue as services are performed.Milestone payments are recognized as revenue when the milestones are achieved.For funding received in advance of the Company’s performance of research anddevelopment activities, the Company records deferred revenue. Included indeferred revenue at June 30, 2006 was approximately $0.1 million relating tothese collaborations. There was no deferred revenue recorded relating to thesecollaborations at June 30, 2005. Currently, the Company is planning forfull-time employee funding from the Schering-Plough collaborations to cease inAugust 2006.  The Company expects torecord revenue from these collaborations through early October 2006, at whichtime the Company expects its wind-down research activities under thecollaborations to cease. The Company will continue to be entitled to paymentsresulting from the successful achievement by Schering-Plough, if any, ofpreclinical and clinical milestones as well as royalty payments from sales, ifany, of products resulting from compounds already delivered by the Company andaccepted by Schering-Plough under the collaborations.

**Collaborationand License Agreement with Organon**

For the three monthsended June 30, 2006 and 2005, the Company’s research collaborations with N.V.Organon (Organon) accounted for 26% and 29%, respectively, of revenue. For thesix months ended June 30, 2006 and 2005, the Company’s research collaborationswith Organon accounted for 23% and 25%, respectively, of revenue. Under its agreement withOrganon, the Company received quarterly research funding to conduct its drugdiscovery activities to identify and optimize new drug candidates for multipletherapeutic targets provided by Organon. The Company has received all of itsresearch funding under the Organon agreement, the research term of whichexpires in February 2007.  Researchfunding from the Organon agreement is recognized as revenue on a straight-linebasis over the term of the agreement. For funding received in advance of the Company’s performance of researchand development activities, the Company records deferred revenue. Included indeferred revenue at June 30, 2006 and 2005 was approximately $2.3 million and$2.1 million, respectively, relating to this collaboration. The Company mayreceive milestone

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paymentsupon the successful achievement by Organon, if any, of preclinical research,preclinical development and clinical development milestones. These milestonepayments will be recognized as revenue when the milestones are achieved. Uponsuccessful commercialization of any product resulting from this relationship,Pharmacopeia will be entitled to receive royalties on sales of that product.

**ProductDevelopment and Commercialization Agreement with GSK**

On March 24, 2006,the Company and SmithKlineBeecham Corporation and Glaxo Group Limited (togetherGSK) entered into a product development and commercialization agreement (theGSK Agreement). 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 preclinical development and/or clinical trials andcommercialize pharmaceutical products resulting from such licensed programs ona worldwide basis (the GSK License Obligations). If GSK does not exercise itsoption to license a program, the Company will retain all rights to that programand may continue to develop the program and commercialize any productsresulting from the program, or it may elect to cease progressing theprogram and/or seek other partners for the further development andcommercialization. In addition, the Company will retain rights to each programfor which GSK has not fulfilled its GSK License Obligations.

Under the terms of the GSK Agreement, theCompany will receive up to $15.0 million in cash payments from GSK related tothe initial discovery activities to be conducted by the Company, including $5.0million that the Company received in April 2006. Up to the remaining $10.0million will be payable to the Company upon its fulfillment of certainconditions related to the initial discovery activities to be conducted by theCompany. The Company’s role in the alliance is to (i) identify and (ii) advancemolecules in chosen therapeutic programs into development candidates and (iii)subject to certain provisions in the agreement, further develop the candidatesto clinical “proof of concept” (a demonstration of efficacy in man). Inaddition to the cash payments above, the Company is entitled to receivesuccess-based milestone payments, starting in preclinical research, from GSKfor each drug development program pursued under the alliance and the potentialfor double-digit royalties upon the successful commercialization by GSK of anyproduct resulting therefrom.

In April 2006, theCompany received $5.0 million in connection with the execution of the GSKAgreement. The Company recorded deferred revenue associated with the payment,net of the fair value of the warrants described below, of approximately $4.5million. As of June 30, 2006, approximately $0.5 million was classified indeferred revenue, current portion and approximately $3.9 million has beenclassified in deferred revenue, long-term. The Company will recognize revenueon a proportional performance basis as it performs the required discoveryactivities in an amount from time to time less than or equal to the non-refundableportion of payments received in connection with the GSK Agreement.  For the three months ended June 30, 2006, theCompany recognized revenue of approximately $51 thousand under the GSKAgreement.

The Company and GSK each have the right toterminate the GSK Agreement in its sole discretion under certain specifiedcircumstances at any time during the term of the GSK Agreement. If the Companyexercises its discretionary termination right at any time during the first fiveyears of the term, under certain circumstances, it could be required to refundto GSK a portion of the up to $15.0 million referred to above. However,there are no instances where the deferred revenue would be amortized below theamount that could be potentially refundable pursuant to the terms of the GSKAgreement.  Further, should GSK exerciseits discretionary termination rights, there are no provisions in the GSKAgreement that would require the Company to refund payments received relatingto its performance of initial discovery activities under the GSK Agreement.

In connection with the GSK Agreement, theCompany issued two warrants to GSK for the purchase of up to anaggregate of 176,367 shares of our common stock at an exercise price of $5.67per share, which is a 25% premium over the trailing 30-day closing priceaverage preceding March 24, 2006. The warrants are exercisable at any timebefore the earlier to occur of (i) March 24, 2011 and (ii) theeffective date of certain types of terminations of the product development andcommercialization agreement that the Company and GSK entered into. Thesewarrants were issued in a transaction not involving a public offering underSection 4(2) of the Securities Act of 1933, as amended. The fairvalue of the warrants has been determined to be $505 thousand. This amount wascalculated using the Black-Scholes pricing model with the followingassumptions: 80% volatility; expected term of 5 years; 4.66% risk-free rate;and 0% dividend.

**Collaborationand License Agreement with Cephalon**

On May 18, 2006, theCompany entered into a collaboration and license agreement (the CephalonAgreement) with Cephalon, Inc. (Cephalon) providing for the formation of anew drug discovery, development and commercialization alliance. Under 

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the Cephalon Agreement, the Company received anup-front, non-refundable payment of $15.0 million in June 2006 to support theCompany’s research and development efforts on behalf of the alliance over athree year period.

As part of and during theinitial phase of the alliance, Cephalon will be responsible for identifying hitand lead compounds.  The Company andCephalon will then work collaboratively to advance the lead compounds toclinical candidates.  The Company will beprincipally responsible for medicinal chemistry and primary biology researchand development, and Cephalon will provide further biology support, especiallypreclinical disease models, as required by the Cephalon Agreement.

Upon the nomination, ifany, of clinical candidates by the alliance, Cephalon will be primarily responsiblefor their development and commercialization. The Company will retain an option to develop certain candidates from thealliance, subject to Cephalon’s agreeing to such development.  For each clinical candidate, if any, advancedunder the alliance, the developing company will make clinical, regulatory andsales milestone payments to the non-developing company.  In addition, the company commercializing eachresulting product, if any, will pay the non-commercializing company up todouble-digit royalties based on the sales level achieved.

Each of the Company andCephalon has the right to terminate the Cephalon Agreement under certainspecified circumstances at any time during the term of the CephalonAgreement.  In addition, Cephalon has theright to terminate the Cephalon Agreement in its sole discretion, upon ninetydays written notice to the Company, during the initial three-year phase of thealliance, which phase may be extended by agreement of the parties.  No such termination shall require the Companyto refund to Cephalon any or all of the above research and development funding.

Dr. FrankBaldino, Jr., one of the Company’s directors, currently serves as theChairman and Chief Executive Officer of Cephalon.

As stated above, under the Cephalon Agreement, the Companyreceived a non-refundable payment and is principally responsible for performingmedicinal chemistry and primary biology research and development. The revenuefor this research and development is recognized on a proportional performance basis,which is expected to approximate straight-line recognition of revenue over theinitial three year term of the alliance. Included in deferred revenue at June30, 2006 was approximately $14.6 million, of which $9.6 million was classifiedas long-term. The Company may receive milestone payments upon the successfulachievement, if any, of preclinical and clinical milestones. These milestonepayments will be recognized as revenue when the milestones are achieved. Uponsuccessful commercialization of any product resulting from this relationship,the Company will be entitled to receive royalties on sales of that product. Forthe three months ended June 30, 2006, the Company’s alliance with Cephalonaccounted for 13% of revenue. Prior to May 18, 2006, the Company was notengaged in any research collaborations with Cephalon, and therefore there wasno revenue in the three months ended June 30, 2005.

**OtherItems**

No other customeraccounted for more than 10% of total revenue in the three or six month periodsended June 30, 2006 and 2005.

Failure to earn additional research and milestonepayments under the Company’s current collaborations and collaborations it seeksto enter into would have a material adverse effect on the Company’s financialcondition and its results of operations. If the Company fails to earn adequate additional research and milestonepayments, it may be required to curtail operations significantly or to obtainfunds by entering into arrangements with collaborative partners or others thatmay require the Company to relinquish rights to certain of its technologies,products or potential markets that it would not otherwise relinquish.

**3.**   License Agreementwith Bristol-Myers Squibb

On March 27, 2006, theCompany and Bristol-Myers Squibb Company (BMS) entered into an exclusivelicensing agreement providing the Company worldwide development andcommercialization rights to certain compounds discovered by BMS that possessdual angiotensin (AT1)and endothelin (ETA)receptor antagonist (DARA) activity. Under the agreement, the Company acquiredexclusive rights to lead and backup DARA development candidates under the BMSpatents claiming these compounds. The Company initiated preclinical developmentactivities for the DARA program after entering into the agreement.

Under the terms of theagreement, in lieu of an upfront cash payment, the Company is providing BMS aset of compound libraries, over a period of approximately three years followingthe execution of the agreement and will pay BMS milestone payments upon theachievement of successive clinical and regulatory events in the United Statesand certain other jurisdictions, and royalties on sales of products, if any,resulting from the DARA program. The first such milestone payment related to aclinical event would be the payment of $1.0 million upon the start, if any, ofa Phase 1 clinical trial for the DARA program. In the event the Company failsto 

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deliver the aforementioned libraries to BMS, theCompany would be required to make cash payments to BMS on a pro rata basis ofup to $2.0 million.

The Company accounted forthis transaction in accordance with Accounting Principle Board Opinion 29, “Accountingfor Nonmonetary Transactions” as amended by Statement of Financial AccountingStandards (SFAS) No. 153 “Exchanges of Nonmonetary Assets.” The Companyestimates that the fair value of the compound library services to be providedto BMS is approximately $2.0 million. As such, and in accordance with SFAS No.2 “Accounting for Research and Development Costs,” the Company recorded anon-cash charge of $2.0 million to proprietary research and development expensein the six months ended June 30, 2006 and recorded a liability for theestimated fair value of the compound library services, of which $0.7 million isclassified in current liabilities and $1.3 million is classified in otherliabilities, long-term as of June 30, 2006.

**4.**   Net Loss Per Share

TheCompany computes net income (loss) per share in accordance with SFASNo. 128, “Earnings Per Share” (SFAS 128). Under the provisions of SFAS128, basic net income (loss) per share is computed by dividing the net income(loss) for the period by the weighted-average number of common sharesoutstanding during the period. Diluted net income (loss) per share is computedby dividing the net income (loss) for the period by the weighted-average numberof common and dilutive common equivalent shares outstanding during the period.The Company had a net loss for the periods presented; accordingly, theinclusion of common stock equivalents for outstanding stock options would beanti-dilutive and, therefore, the weighted average shares used to calculateboth basic and diluted earnings per share are the same.

**5.**   Segment Information

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

|                        | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **             | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|                   |       |                                            |       |                                          |       |   |   |   |   |
| Customers  located in: |       |                                            |       |                                          |       |   |   |   |   |
| United States          |       | 45                                              | %          | 47                                            | %          | 36 | % | 46 | % |
| Europe                 |       | 55                                              | %          | 52                                            | %          | 64 | % | 53 | % |
| Asia                   |       | —                                          |       | 1                                             | %          | — |   | 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.

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The fair value of theseequity awards was estimated at the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions for the sixmonths ended June 30, 2006 and 2005, respectively:

|                          | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|--------------------------|------------|-------------|------------|-------------|------------|
| Dividend yield           |       | 0.00        | %          | 0.00        | %          |
| Expected  volatility     |       | 80.00-90.00 | %          | 75.00-85.24 | %          |
| Risk-free  interest rate |       | 4.66-5.06   | %          | 3.86-4.33   | %          |
| Expected life  (years)   |       | 6.25        |       | 5.00-5.75   |       |
| Forfeiture Rate          |       | 5.24-5.83   | %          | n/a         |       |

 

As aresult of adopting SFAS 123R, the Company’s net income and basic and dilutedearnings per share for the three and six month periods ended June 30, 2006 were$490 thousand and $.03 per share, and $884 thousand and $.06 per sharerespectively, lower than if the Company had continued to account for itsshare-based compensation under APB 25. These amounts include a charge ofapproximately $79 thousand relating to the accelerated vesting of certain stockoptions of the Company’s former Executive Vice President and Chief FinancialOfficer. See Note 7 to the Financial Statements for further discussion. As ofJune 30, 2006, there was approximately $3.2 million of unrecognizedcompensation costs, net of estimated forfeitures, related to share-basedpayments which are expected to be recognized over a weighted average period of1.4 years. The aggregate intrinsic value of options exercised during the threemonths ended June 30, 2006 and 2005 was approximately $46 thousand and $33thousand, respectively. The aggregate intrinsic value of options exercisedduring the six months ended June 30, 2006 and 2005 was approximately $331thousand and $155 thousand, respectively. Cash proceeds from stock optionsexercised during the three months ended June 30, 2006 and 2005 wasapproximately $171 thousand and $41 thousand, respectively.  Cash proceeds from stock options exercisedduring the six months ended June 30, 2006 and 2005 was approximately $907thousand and $126 thousand, respectively. Total share-based compensation costsfor the three and six month periods ended June 30, 2006 were approximately $511thousand and $926 thousand, respectively, which includes approximately $21thousand and $42 thousand, respectively, relating to the vesting of restrictedstock awards.

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 six months ended June 30, 2005 (in thousands,except per share data):

| Net loss:                                                                                                                                     |   |   |    |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|---------|
| As reported                                                                                                                                   |   | $      | (9,350  | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                                                 |   | 256    |    |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |   | (1,099 | )       |
| Pro forma                                                                                                                                     |   | $      | (10,193 | ) |
| Basic and  diluted net loss per common share:                                                                                                 |   |   |    |
| As reported                                                                                                                                   |   | $      | (0.75   | ) |
| Pro forma                                                                                                                                     |   | $      | (0.82   | ) |

 

*Stock Plans*

Pharmacopeia had two Stock Plans, the 2004 StockIncentive Plan (the Plan), which was approved by the Company’s Board ofDirectors on April 6, 2004, and the 2004 Employee Stock Purchase Plan(ESPP), which was approved by the Company’s Board of Directors on May 1,2004. Effective May 31, 2005 the ESPP was terminated by the Company.

In accordance with the Plan, Pharmacopeia may grant upto an aggregate of 2,400,000 shares of stock options, restricted stock, commonstock, performance awards, deferred stock units and stock appreciation rightsto officers, directors, employees, sales representatives and consultants ofPharmacopeia. Under the Plan no more than 500,000 shares of Incentive StockOptions and 400,000 shares of stock awards and performance shares may begranted.  The term of each incentive andnon-qualified stock option is ten years. Vesting generally occurs over a periodof not greater than five years.  As ofJune 30, 2006 , there were approximately 1,290,000 shares reserved underlyingoptions made under the Plan and approximately 1,110,000 shares available forfuture grants under the Plan.

Prior to the spin-off, the Board of Directors resolvedto adopt the following Accelrys stock option plans: the 1994 Incentive StockPlan, the 1995 Director’s Option Plan, and the 2000 Stock Option Plan underwhich grants of options and restricted stock had been made to Pharmacopeiaemployees.  Generally, all outstandingoptions to purchase Accelrys common stock under these Accelrys Stock OptionPlans were converted to options to purchase Pharmacopeia stock, in order tomaintain the then existing intrinsic value and maintain the ratio of the thenexisting exercise price per share to the market value per share in accordancewith applicable accounting standards.  Asof June 30, 2006, there were approximately 3,009,000 shares reserved underlyingoptions made under these plans.  No 

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additional options may be granted to Pharmacopeiaemployees from these plans.  As of June30, 2006, there were approximately 5,000 shares of restricted stock outstandingfrom these plans.

A summary of the stock option activity and weightedaverage exercise prices follows (in thousands, except per share data):

|                                                                     | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                          | ** ** | **Common  Stock  Options**                        | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Common  Stock  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of quarter:                               |       | 4,385                                             |       | $ | 6.83 |   | 4,096 |   | $ | 7.00 |   |
| Granted                                                             |       | 126                                               |       | $ | 6.17 |   | 239 |   | $ | 4.27 |   |
| Exercised                                                           |       | (34                                               | )          | $ | 5.02 |   | (15 | ) | $ | 2.78 |   |
| Expired                                                             |       | (178                                              | )          | $ | 5.14 |   | (40 | ) | $ | 7.20 |   |
| Outstanding at  end of quarter:                                     |       | 4,299                                             |       | $ | 6.90 |   | 4,280 |   | $ | 6.86 |   |
|                                                                |       |                                              |       |   |   |   |   |   |   |
| Exercisable at  end of quarter                                      |       | 3,214                                             |       |   |   | 2,895 |   |   |   |
|                                                                |       |                                              |       |   |   |   |   |   |   |
| Weighted average  fair value of options  granted during the quarter |       |                                              |       | $ | 4.80 |   |   |   | $ | 3.09 |   |

 

A summary of stockoptions outstanding and exercisable as of June 30, 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                                 |       | 1,509                    |       | 5.73                                                |       | $                                      | 4.03       |   | 1,011 |   | $ | 3.83 |   |
| $5.01-$10.00                                |       | 2,392                    |       | 5.14                                                |       | $                                      | 6.71       |   | 1,805 |   | $ | 6.93 |   |
| $10.01-$15.00                               |       | 46                       |       | 4.38                                                |       | $                                      | 12.58      |   | 46 |   | $ | 12.60 |   |
| $15.01-$20.00                               |       | 352                      |       | 3.56                                                |       | $                                      | 19.74      |   | 352 |   | $ | 19.74 |   |
|                                        |       | 4,299                    |       | 5.21                                                |       | $                                      | 6.90       |   | 3,214 |   | $ | 7.44 |   |
|                                        |       |                     |       |                                                |       |                                   |       |   |   |   |   |
| Aggregate Intrinsic  Value                  |       | $                        | 409        |                                                |       |                                   |       |   | $         367 |   |   |   |
|                                             |            |                          |            |                                                     |            |                                        |            |  |  |  |  |  |  |  |

 

As ofJune 30, 2006, there were approximately 4,235,000 options outstanding, net ofestimated forfeitures, that had vested or are expected to vest. Theweighted-average exercise price of these options was $6.90 per option; theweighted-average remaining contractual life of these options was 5.21 years;and the aggregate intrinsic value of these options was approximately $406thousand.

**7.**   Restructuring and severanceobligations

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.Also a 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 expenseduring the year ended December 31, 2004.

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Thefollowingtable summarizes the activity and balance of the restructuring reserve at June30, 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                    |       | —                                                                    |       | (820                                              | )          | (820      | )          |
| Reserve Adjustment               |       |                                                                      |       | (88                                               | )          | (88       | )          |
| Balance at June 30,  2006        |       | $                                                                         | —     |                                              | $          | —    |       | $ | — |   |

 

**During the year ended December 31, 2005 the Companyincurred approximately $1.5 million of expense related to severance payable totwo former executives of the Company. These charges consisted of $1.3 millionin connection with cash payment obligations to these former executives, as wellas a noncash charge of $0.2 million. These expenses were classified as sales,general and administrative expense in the Company’s Statement of Operations.The remaining severance obligation to these individuals was $22 thousand and isclassified under accrued liabilities in the Company’s Balance Sheet as of June30, 2006.**

On May 4, 2006,the Company announced that it had accepted the resignation of its thenExecutive Vice President and Chief Financial Officer, effective May 3, 2006.The Company also announced that Brian M. Posner, who had served as the Company’sVice President and Chief Accounting Officer, was promoted to the office ofExecutive Vice President, Chief Financial Officer, and Treasurer. As a resultand in connection with a severance agreement, the Company recorded a chargeduring the three months ending June 30, 2006 of approximately $182 thousand, ofwhich cash and benefit obligations of approximately $103 thousand was recordedin accrued liabilities as of June 30, 2006 and approximately $79 thousandrelating to stock option vesting acceleration was credited to additionalpaid-in capital, as required by FAS 123R. These expenses were classified assales, general and administrative expense in the Company’s Statement ofOperations.

**8**.   Commitments andContingencies

**Royalties/ColumbiaDispute**

In accordance withFASB Statement No. 5, “Accounting for Contingencies” and FASBInterpretation No. 14, “Reasonable Estimation of the Amount of a Loss” theCompany accrued and recognized as operating expense a charge of $1.0 millionfor the year ended December 31, 2004 for the probable outcome of the resolutionof a dispute 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 amongthem.

On May 24,2005, the parties to the Original Agreement entered into a license agreement(the Agreement) that amended and restated the Original Agreement. The Agreementprovided that in connection with the resolution of the dispute, the Company payColumbia and Cold Spring an aggregate of $1.0 million dollars in twoinstallments of $500 thousand.  The firstinstallment was paid in June 2005, and the second installment was paid inJune 2006.

Under theAgreement, the Company has an exclusive license for technology used in itsproprietary combinatorial chemistry encoding technology, Encoded CombinatorialLibraries on Polymeric Support, or ECLiPS®.  The Agreement obligates theCompany to pay a minimum annual license fee of $100 thousand to Columbia andCold Spring. The term of the Agreement is the later of (i) July 16,2013 or (ii) the expiration of the last patent relating to the technology,at which time the Company will have a fully paid license to thetechnology.  The license granted to the Company under the Agreement can beterminated by Columbia and Cold Spring (i) upon 30 days written notice tothe Company if the Company materially breaches the Agreement and the Companyfails to cure such material breach in accordance with the Agreement or(ii) if the Company commits any act of bankruptcy, becomes insolvent,files a petition under any bankruptcy or insolvency act or has any suchpetition filed against it that is not dismissed within 60 days.  TheCompany is obligated to pay royalties to Columbia and Cold Spring based uponnet sales of pharmaceutical products the Company develops, as well as apercentage of all other payments (such as milestones and royalties) the Companyreceives from customers in cases in which the Company has utilized thetechnology licensed from Columbia and Cold Spring.

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**Product Development andCommercialization Agreement with GSK**

As described in Note 2 tothe Financial Statements, each of the Company and GSK has the right toterminate the GSK Agreement in its sole discretion under certain specifiedcircumstances at any time during the term of the GSK Agreement. If the Companyexercises its discretionary termination right at any time during the first fiveyears of the term, under certain circumstances, it could be required to refundto GSK a portion of the up to $15.0 million. Further, should GSKexercise its discretionary termination rights, there are no provisions in theGSK Agreement that would require the Company to refund payments receivedrelating to its performance of initial discovery activities under the GSKAgreement.

The Company’s role in the alliance is to(i) identify and (ii) advance molecules in chosen therapeutic programs intodevelopment candidates and (iii) subject to certain provisions in theagreement, further develop the candidates to clinical “proof of concept” (ademonstration of efficacy in man). As of June 30, 2006, the Company hadapproximately $4.4 million of deferred revenue related to research anddevelopment activities that are to be provided to GSK by the Company subsequentto June 30, 2006.

**License Agreement withBMS**

As described in Note 3 tothe Financial Statements, under the terms of the agreement, in lieu of anupfront cash payment, the Company is providing BMS a set of compound libraries,over a period of approximately three years following the execution of theagreement and will pay BMS milestone payments upon the achievement ofsuccessive clinical and regulatory events in the United States and certainother jurisdictions, and royalties on sales of products, if any, resulting fromthe DARA program. The first such milestone payment related to a clinical eventwould be the payment of $1.0 million upon the start, if any, of a Phase 1clinical trial for the DARA program. We plan to file an Investigational New Drug(IND) application in the first quarter of 2007. In the event the Company failsto deliver the aforementioned libraries to BMS, the Company would be requiredto make cash payments on a pro rata basis of up to $2.0 million.

**Collaboration and LicenseAgreement with Cephalon**

As described in Note 2 tothe Financial Statements, under the Cephalon Agreement, the Company received anup-front, non-refundable payment of $15.0 million in June 2006 to support theCompany’s research and development efforts on behalf of the alliance over athree year period.  The Company will beprincipally responsible for performing medicinal chemistry and primary biologyresearch and development over the alliance term, as required by the CephalonAgreement. As of June 30, 2006, the Company had approximately $14.6 million ofdeferred revenue related to research and development activities that are to be provided to Cephalon by the Companysubsequent to June 30, 2006.

**9**.   Related Party Transactions

As described inNote 2 to the Financial Statements, the Company entered into the CephalonAgreement.One of the Company’s directors currently serves as theChairman and Chief Executive Officer of Cephalon.

**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

**FORWARD-LOOKINGSTATEMENTS**

This Report on Form 10-Q containsforward-looking statements regarding us and our business, financial condition,results of operations and prospects within the meaning of the PrivateSecurities Litigation Reform Act of 1995.  Such forward-looking statementsinclude those that express plans, anticipation, intent, contingency, goals,targets or future development and/or otherwise are not statements of historicalfact.  These forward-looking statements are based on our currentexpectations and projections about future events and they are subject to risksand uncertainties known and unknown that could cause actual results anddevelopments to differ materially from those expressed or implied in suchstatements.  These forward-looking statements include statements about thefollowing:

·                  our abilityto develop our DARA program successfully;

·                  our abilityto successfully perform under our collaborations with GSK and Cephalon;

·              thecessation of full-time employee funding from our existing collaboration withSchering-Plough and quarterly research funding from our existing collaborationwith Organon;

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·                  our abilityto raise additional capital;

·                  ourintentions regarding the establishment and continuation of drug discovery anddevelopment collaborations with leading pharmaceutical and biotechnologyorganizations;

·                  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 capital resources;

·                  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;

·                  ourestimates of 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 and considerthe disclosures found in these filings, all of which are available in the SECEDGAR database at www.sec.gov.  You are urged not to place undue relianceon any such forward-looking statements, any of which may turn out to be wrongdue 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.

**The Company**

**Overview**

We are committed to creating anddelivering novel therapeutics to address significant medical needs. Usingproprietary technologies and processes, we seek to identify, optimize and developnovel drug candidates through our own internally-funded drug discovery programsand in collaborations with major pharmaceutical and biotechnologycompanies.  Our collaborative research efforts have resulted in aportfolio of three partnered programs (comprised of four compounds) that havebeen advanced into human clinical trials, in addition to seven programs inpreclinical development, and multiple other partnered programs indiscovery.  We have one internal program in preclinical development andfour internal programs in advanced discovery.

Our most advanced internal program is inpreclinical development and focuses on dual angiotensin (AT1) and endothelin (ETA) receptorantagonists (DARA) for cardiovascular disease. We licensed our DARA programfrom Bristol-Myers Squibb Company (BMS) in March 2006. We have initiatedpreclinical development studies for the DARA program and have a preliminaryInvestigational New Drug (IND) meeting with the United States Food and DrugAdministration (FDA) scheduled for mid-August 2006. We plan to file an INDapplication with the FDA in the first quarter of 2007.

Our other internal proprietary researchprograms are primarily focused on immunobiology and immunologicaldiseases.  We fully fund these programs and retain intellectual propertyand ownership rights to any compounds discovered.  At an appropriatepoint, we may license one or more of these compounds or programs to a partner(probably a larger pharmaceutical or biotechnology organization).

For our internally-funded drug discoveryprograms, we focus the majority of our efforts on those programs that aretargeted towards immunobiology and immunological diseases such as rheumatoidarthritis, psoriasis and other inflammatory diseases for

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several reasons:

·                  We believemany existing therapies for these diseases are lacking in one or morerespects.  For example, methotrexate, the standard of care for rheumatoidarthritis, has serious side effects while newer biologicals are costly and mayhave safety and immunogenic 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 oncology, cardiovascular and neurologicaldiseases;

·                  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 of our proven record of delivering candidates in these therapeuticsegments to 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 and extendingour capabilities into preclinical and clinical development so that we canadvance both internal and partnered programs into clinical development. In addition to our proprietary research and development, we have collaborationswith leading pharmaceutical companies and biotechnology companies, includingproduct development and commercialization collaborations with GSK(entered into in March 2006) and Cephalon (entered into in May 2006).  We continue to seek to establish a limitednumber of broad, multi-year alliances with the potential to result in drugcandidates in which we retain significant rights. We anticipate participatingin the clinical development of some of the compounds that may result from thesecollaborations.

In March 2006, we entered into aproduct development and commercialization agreement with GSK (the GSKAgreement) providing for the formation of a new drug discovery and developmentalliance. Our role in the alliance is to (i) identify and (ii) advance moleculesin chosen therapeutic programs into development candidates and (iii) subject tothe GSK options described below, further develop the candidates to clinical “proofof concept” (a demonstration of efficacy in man).

The GSK Agreement provides that GSK willhave an exclusive option, exercisable at defined points during the developmentprocess for each program (up to the point of clinical proof of concept), tolicense that program for a specified payment amount. Upon licensing a program,GSK is obligated to conduct clinical trials and commercialize pharmaceuticalproducts resulting from such licensed programs on a worldwide basis (the GSKLicense Obligations). If GSK does not exercise its option to license a program,we will retain all rights to that program and may continue to develop theprogram and commercialize any products resulting from the program, or wemay elect to cease progressing the program and/or seek other partners forthe further development and commercialization. In addition, we will retainrights to each program for which GSK has not fulfilled its GSK LicenseObligations.

Under the terms of the GSK Agreement, wewill receive up to $15.0 million in cash payments from GSK related to initialdiscovery activities to be conducted by us, 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 initial discoveryactivities to be conducted by us. In addition, we are entitled to receive success-basedmilestone payments, starting in preclinical research, from GSK for each drugdevelopment program pursued under the alliance and the potential fordouble-digit royalties upon the successful commercialization by GSK of anyproduct resulting therefrom.

GSK and we each have the right toterminate the GSK Agreement in its or our sole discretion under certainspecified circumstances at any time during the term of the GSK Agreement. If weexercise our discretionary termination right at any time during the first fiveyears of the term, under certain circumstances, we could be required to refundto GSK a portion of the up to $15.0 million referred to above. However,there are no instances where the deferred revenue would be amortized below theamount that could be potentially refundable pursuant to the terms of the GSKAgreement.  Further, should GSK exerciseits discretionary termination rights, there are no provisions in the GSKAgreement that would require us to refund payments received relating to ourperformance of initial discovery activities under the agreement.

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Our contribution to our productdevelopment and commercialization collaboration with GSK will extend todeveloping active molecules using our medicinal chemistry, biology, andpharmacology capabilities into development candidates and, subject to GSK’slicensing options, further developing the candidates to clinical proof ofconcept.

In May, 2006, we enteredinto a collaboration and license agreement with Cephalon (the CephalonAgreement) providing for the formation of a new drug discovery, development andcommercialization alliance.  Under theCephalon Agreement, we received an up-front, non-refundable payment of $15.0million in June 2006 to support our research and development efforts on behalfof the alliance over a three year period.

As part of and during theinitial phase of the alliance, Cephalon will be responsible for identifying hitand lead compounds.  We and Cephalon willthen work collaboratively to advance the lead compounds to clinical candidates.  We will be principally responsible formedicinal chemistry and primary biology research and development, and Cephalonwill provide further biology support, especially preclinical disease models, asrequired by the Cephalon Agreement.

Upon the nomination, ifany, of clinical candidates by the alliance, Cephalon will be primarilyresponsible for their development and commercialization.  We will retain an option to develop certaincandidates from the alliance, subject to Cephalon’s agreeing to suchdevelopment.  For each clinicalcandidate, if any, advanced under the alliance, the developing company willmake clinical, regulatory and sales milestone payments to the non-developingcompany.  In addition, the companycommercializing each resulting product, if any, will pay thenon-commercializing company up to double-digit royalties based on the saleslevel achieved.

We and Cephalon each hasthe right to terminate the Cephalon Agreement under certain specifiedcircumstances at any time during the term of the Cephalon Agreement.  In addition, Cephalon has the right toterminate the Cephalon Agreement in its sole discretion, upon ninety dayswritten notice to us, during the initial three-year phase of the alliance,which phase may be extended by agreement of the parties.  No such termination shall require us to refundto Cephalon any or all of the above research and development funding.

Dr. FrankBaldino, Jr., one of our directors, currently serves as the Chairman andChief Executive Officer of Cephalon.

Our collaborative drug discovery effortshave resulted in three therapeutic programs currently with candidates in PhaseI clinical trials targeting rheumatoid arthritis, an allergy/asthma indicationand chronic obstructive pulmonary disease (COPD).  We initially identifiedp38 kinase inhibitor lead compounds in 1997 and entered into a collaborativepartnering agreement with BMS in 1999. This collaboration resulted in acompound that advanced to clinical trials in August 2003.  A secondcompound resulting from that partnership, which is a back-up candidate,advanced to Phase I clinical trials in Canada in December 2005. A thirdcompound discovered in our laboratories, aimed at an allergy/asthma indication,was the basis of a collaboration with Daiichi Pharmaceutical Co. and resultedin a drug candidate that advanced to clinical trials in November 2003. OurSchering-Plough relationship produced a compound which advanced to clinicaltrials in March 2004 for COPD.  Associated with these developmentprograms, we have received milestone payments from each of BMS, Daiichi andSchering-Plough and, to the extent the compounds successfully progress throughclinical development, we will be entitled to receive additional milestonepayments.  We are also entitled under the agreements with each of thesepartners to receive royalties on the commercial sale, if any, of most new drugsresulting from these collaborations.  However, numerous additional studiesare required to fully assess the potential of these clinical candidates beforethey reach the marketplace, and the results from preclinical studies andclinical studies conducted to date with these compounds are not necessarilyindicative of the results that may be obtained in future clinical studies.

In addition to the compounds in theclinic, seven 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 clinical development.

Preclinical and clinical development ofdrug candidates is a long, expensive and uncertain process.  We continueto pursue the discovery and development of product candidates using ourintegrated technology platform in both our internal and collaborative programs.The drug candidates described above are at an early stage, and none hasreceived regulatory approval for commercial sale.  Both our partneredclinical candidates and our internally-derived compounds face the substantialrisk of failure inherent in drug research and development.  At any stageof the clinical development process, our collaborators, or we, may decide todiscontinue development of our product candidates. To date, none of thecompounds to which we hold complete or partial rights has reached the stage ofa commercial product and, although we have received license and milestone fees,we may never receive any royalty payments, or any additional license andmilestone fees, under our current or any future collaborations. We do not expectthat our product candidates will be commercially available for many years, ifever.

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During the six monthsended June 30, 2006 and 2005, we earned approximately $4.1 million and $6.2million, respectively, or 55% and 57%, respectively, of our revenue under ourresearch collaboration agreements with Schering-Plough, of which $3.1 millionand $5.2 million was full-time employee (FTE) funding and $1.0 million wasmilestone payments in each of the respective six month periods.

Currently,we are planning for full-time employee funding from the Schering-Ploughcollaborations to cease in August 2006. We expect to record revenue from these collaborations through earlyOctober 2006, at which time we expect our wind-down research activities underthe collaborations to cease. We will continue to be entitled to paymentsresulting from the successful achievement by Schering-Plough, if any, ofpreclinical and clinical milestones as well as royalty payments from sales, ifany, of products resulting from compounds already delivered by us and acceptedby Schering-Plough under the collaborations.

Duringthe six months ended June 30, 2006 and 2005, we earned approximately $1.7million and $2.7 million, respectively, or 23% and 25%, respectively, of ourrevenue, all of which was FTE research funding for the six months ended June30, 2006 and $0.5 million was milestone payments during the six months endedJune 30, 2005, under our research collaboration agreement with Organon. Under our agreement withOrganon, we received quarterly research funding to conduct our drug discoveryactivities to identify and optimize new drug candidates for multipletherapeutic targets provided by Organon. We have received all of our research funding under the OrganonAgreement, the research term of which expires in February 2007.  We may receive milestone payments upon thesuccessful achievement of preclinical research, preclinical development andclinical development milestones. Upon successful commercialization of anyproduct resulting from this relationship, we will be entitled to receiveroyalties on sales of that product.

Failureto earn additional research and milestone payments under our currentcollaborations and additional collaborations we seek to enter into would have amaterial adverse effect on our financial condition and our results ofoperations.  If we fail to earn adequateadditional research and milestone payments, 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.

From time to time we have considered, andwe will continue to consider strategic initiatives intended to further thedevelopment of our business.  In addition, we consider opportunities toexpand our product pipeline through the acquisition or in-licensing of, orinvestment in, product development candidates, and we intend to continue to exploreand evaluate those opportunities.

**Liquidity and Capital Resources**

Prior to our spin-off from Accelrys in April 2004, wehad funded our activities primarily through Accelrys’ consolidated operations,including revenue derived from collaborative partnerships and milestonepayments. Accelrys contributed cash, cash equivalents and marketable securitiessuch that upon consummation of the spin-off, we had cash, cash equivalents andmarketable securities aggregating $46.5 million.

As of June 30, 2006, we had cash, cash equivalents andmarketable securities of $40.1 million compared to $30.4 million at December31, 2005, representing 74% and 66% of our total assets, respectively. We investexcess cash in highly liquid investment-grade marketable securities, includingcorporate bonds and United States government and agency securities.

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The following is a summary ofselected cash flow information for the six months ended June 30, 2006 and 2005:

 

|                                                      | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Net loss                                             |       | $                                                 | (14,861    | ) | $ | (9,350 | ) |
| Adjustments for  noncash operating items             |       | 2,015                                             |       | 1,634 |   |
|                                                 |       |                                              |       |   |   |
| Net cash  operating loss                             |       | (12,846                                           | )          | (7,716 | ) |
| Net change in  assets and liabilities                |       | 22,582                                            |       | (258 | ) |
|                                                 |       |                                              |       |   |   |
| Net cash  provided by (used in) operating activities |       | $                                                 | 9,736      |   | $ | (7,974 | ) |
|                                                 |       |                                              |       |   |   |
| Net cash  provided by investing activities           |       | $                                                 | 11,692     |   | $ | 1,137 |   |
|                                                 |       |                                              |       |   |   |
| Net cash  provided by financing activities           |       | $                                                 | 907        |   | $ | 265 |   |

 

**Net cash provided by (used in) operating activities**

Net cashprovided by operating activities for the six months ended June 30, 2006 and2005 resulted primarily from the receipt of a $5.0 million upfront paymentreceived in April 2006 relating to the GSK Agreement and a $15.0 millionupfront non-refundable payment received in June 2006 relating to the CephalonAgreement, offset by our operating loss due to our funding of our proprietaryinternal drug research and development efforts and the payment of restructuringexpenses related to the 2004 consolidation of our facilities. Absent thereceipt of the $20.0 million from GSK and Cephalon, our net cash used inoperating activities would have been approximately $10.3 million, whichreflects approximately $8.0 million of research funding and milestonepayments from our collaborations with Schering-Plough and Organon.  Net cash operating outflows for the sixmonths ended June 30, 2005 was primarily a result of our operating loss due toour funding of our proprietary internal drug research and development effortsand the payment of restructuring expenses related to the 2004 consolidation ofour facilities.

**Net cash provided by investing activities**

Net cashprovided by investing activities for the six months ended June 30, 2006 and2005 related primarily to the net sales and maturities of marketablesecurities, partially offset by capital expenditures for research anddevelopment and information technology equipment.

**Net cash provided by financing activities**

Net cashprovided by financing activities for the six months ended June 30, 2006consisted primarily of proceeds from the issuance of common stock in connectionwith exercises of stock options. Net cash provided by financing activities forthe six months ended June 30, 2005 consisted primarily of proceeds from theissuance of common stock in connection with exercises of stock options and ourESPP. The ESPP was terminated in May 2005.

**Liquidity and Capital Resources Outlook**

We expectto continue to use our capital to fund operating losses. We expect that ourresearch and development expenditures will continue to increase in the futureas we increase our internal drug research and development efforts. Conductingour own drug discovery research and development is a key component of ourbusiness model.  Our DARA program,which is our most advanced internal program, is currently in preclinicaldevelopment, and we expect to file an IND application for the DARA program inthe first quarter of 2007. Preclinical development studies and clinical trialsare significant, time-consuming and costly processes.

Inaddition, our capital requirements may increase in future periods as weseek to expand our technology platform through investments, licensingarrangements, technology alliances, or acquisitions.

We anticipate that our capital resources will beadequate to fund our operations at their current levels at least through June30, 2007. As of June 30, 2006, wehad cash, cash equivalents and marketable securities aggregating $40.1 million.Also, as of June 30, 2006, we had deferred revenue of approximately $22.4million relating to upfront payments received from our collaborations inadvance of research and development activities that are to be provided by ussubsequent to June 30, 2006, of which $13.5 million was classified aslong-term. Additionally, we had other liabilities of approximately$2.0 million relating to the delivery of a set of compound libraries overthe next three years pursuant to our licensing agreement with BMS, of which$1.3 million was classified as long-term as of June 30, 2006. There can be no assurance that changes will notoccur that would consume available capital resources before then.

Our capital requirements depend onnumerous factors, including our ability to continue and extend existingcollaborative

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agreements and to enter intoadditional arrangements. Approximately 71% and 78% of our revenue for the threemonths ended June 30, 2006 and 2005, respectively, was generated from ourcollaboration with Schering-Plough and Organon. In addition, approximately 78%and 82% of our revenue for the six months ended June 30, 2006 and 2005,respectively, was generated from these collaborations.

Currently, we are planning for full-time employeefunding from the Schering-Plough collaborations to cease in August 2006. Wewill continue to be entitled to payments resulting from the successfulachievement by Schering-Plough, if any, of preclinical and clinical milestonesas well as royalty payments from sales, if any, of products resulting fromcompounds already delivered by us and accepted by Schering-Plough under thecollaborations.

Under ouragreement with Organon, we received quarterly research funding to conduct ourdrug discovery activities to identify and optimize new drug candidates formultiple therapeutic targets provided by Organon.  We have received all of our research fundingunder the Organon agreement, the research term of which expires in February2007.  We may receive milestone paymentsupon the successful achievement of preclinical research, preclinicaldevelopment and clinical development milestones. Upon successfulcommercialization of any product resulting from this relationship, we will beentitled to receive royalties on sales of that product.

Failure to earn additional research and milestonepayments under our current collaborations and additional collaborations we seekto enter into would have a material adverse effect on our financial conditionand our results of operations.  If wefail to earn adequate additional research and milestone payments, we may berequired to curtail operations significantly or to obtain funds by enteringinto arrangements 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.

In addition, our capitalrequirements depend on competing technological and market developments, changesin our existing collaborative relationships, the cost of filing, prosecuting,defending, and enforcing patent claims and other intellectual property rightsand the outcome of related litigation, the purchase of additional capitalequipment, acquisitions of other businesses or technologies, and the progressof our collaborators’ milestone and royalty producing activities. Prior toexhausting our current capital resources, we will need to raise additionalfunds to finance our operating activities or enter into strategic initiativesintended to further the development of our business. There can be no assurancethat additional funding, if necessary, will be available to us on favorableterms, if at all. Our forecasts of the period of time through which ourfinancial resources will be adequate to support our operations areforward-looking information, and actual results could vary. The factorsdescribed earlier in this section will impact our future capital requirementsand the adequacy of our available funds.

**Results ofOperations**

This section should be read in conjunction with thediscussion under “Liquidity and Capital Resources.”

**Three months endedJune 30, 2006 and 2005**

Our net revenue decreased 37% to$3.3 million in the three months ended June 30, 2006compared to $5.2 million in the three months ended June 30, 2005. Net revenue consists of the funding of ourcollaborative 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 June 30, 2006 and 2005 is summarized as follows:

|                                 | ** ** | **Three months ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                            |       |                                                |       |   |   |
| Collaborative  research funding |       | $                                                   | 3,167      |   | $ | 4,548 |   |
| Milestones and  success fees    |       | —                                              |       | 500 |   |
| License revenue                 |       | 125                                                 |       | 183 |   |
|                            |       | $                                                   | 3,292      |   | $ | 5,231 |   |

 

Schering-Plough accounted for45% and 49% of our net revenue in the three months ended June 30, 2006 and 2005, respectively.  Organon accounted for 26% and 29% of our netrevenue in the three months ended June 30, 2006 and 2005, respectively.Cephalon accounted for 13% of our net revenue in the three months ended June30, 2006. Our alliance with Cephalon commenced in May 2006 and therefore therewas no corresponding revenue in the three months ended June 30, 2005.

The decrease in collaborativeresearch funding in the three months ended June 30, 2006 was largely due to thereduction in

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funding from our collaborationswith Schering-Plough and the expiration of other collaborative research anddevelopment agreements, partially offset by the revenue generated from the ournew alliances with Cephalon and GSK.

Collaborative research and development expenseincludes the labor, material, equipment and allocated facilities cost of ourscientific staff that is working on collaborative partnerships. Collaborativeresearch and development expenses decreased 35% to $3.0 million in the threemonths ended June30, 2006 compared to $4.6 million in the three months ended June 30, 2005. Thisdecrease was due to decreased resources allocated to our collaborativepartnerships largely due to the reduced staffing on our collaborations withSchering-Plough and the expiration of other collaborative research anddevelopment agreements. This decrease was offset by costs associated withresearch and development activities relating to our new collaborationpartnerships with Cephalon and GSK, and the recognition of share-basedcompensation costs of $80 thousand associated with our adoption of SFAS 123R.

Proprietary research and development expense includesresearch and development acquisition costs, labor, material, equipment andallocated facilities cost of scientific staff working on self-funded internaldrug discovery programs. Using proprietary technologies and processes, we seekto discover and develop novel drug candidates to advance internally as well aswith strategic partners. Our most advanced internal program is inpreclinical development and focuses on dual angiotensin (AT1) andendothelin (ETA) receptorantagonists (DARA) for cardiovascular disease. We licensed our DARA programfrom BMS in March 2006. In addition, we currently have several internalprograms in advanced preclinical optimization. Proprietary research anddevelopment expenses increased 123% to $5.5 million in the three months endedJune 30, 2006 compared to $2.5 million in the three months ended June 30, 2005.This increase was primarily attributable to costs relating to preclinicaldevelopment studies for our DARA program, resources expended on our JAK-3program for transplant rejection, our Adenosine A2a antagonists program forParkinson’s disease, our CCR-1 antagonists program for rheumatoid arthritis andmultiple sclerosis, and our recognition of share-based compensation costs of$94 thousand associated with our adoption of SFAS 123R. Because of thespeculative 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 developmentresources may be temporarily redirected from one project to another, whichredirection may also delay or impact the cost of internal drug discoveryprojects.

Sales, general and administrative expense decreased by23% to $2.4 million in the three months ended June 30, 2006compared to $3.2 million in the three months ended June 30, 2005.  Thedecrease in sales, general and administrative expense is attributable toapproximately $1.0 million in severance costs incurred in the three monthsended June 30, 2005, and lower consulting and travel costs offset byapproximately $182 thousand in severance costs incurred and the recognition ofshare-based compensation costs of $237 thousand associated with our adoption ofSFAS 123R in the three months ended June 30, 2006.

Restructuring and other charges decreased byapproximately $88 thousand, which relates to an adjustment to our restructuringcost estimate to reflect our actual restructuring costs.

Interest and other income, net increased to $333thousand in the three months ended June 30, 2006 compared to $297 thousand in the threemonths ended June 30,2005.  This increase is due to higher yields on our investments.

We recorded an income tax provision of $20 thousandand $4 thousand for the three months ended June 30, 2006 and2005, respectively, related to minimum state income taxes. The increase relatesto temporary differences in revenue recognition between generally acceptedaccounting principles and applicable tax law.

As a result of the net revenues and expenses describedabove, we generated a net loss of $7.2 million ($0.47 per basic and dilutedshare) in the three months ended June 30, 2006, compared to a net loss of $4.7million ($0.38 per basic and diluted share) in the three months ended June 30, 2005.

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**Six months endedJune 30, 2006 and 2005**

Our net revenue decreased 32% to$7.4 million in the six months ended June 30, 2006compared to $10.9 million in the six months ended June 30, 2005. Net revenue consists of the funding of ourcollaborative 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 six months ended June 30, 2006 and 2005 is summarized as follows:

|                                 | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
|                            |       |                                              |       |   |   |
| Collaborative  research funding |       | $                                                 | 6,158      |   | $ | 9,056 |   |
| Milestones and  success fees    |       | 1,000                                             |       | 1,500 |   |
| License revenue                 |       | 250                                               |       | 366 |   |
|                            |       | $                                                 | 7,408      |   | $ | 10,922 |   |

 

Schering-Plough accounted for55% and 57% of our net revenue in the six months ended June 30, 2006 and 2005, respectively, including $1.0 millionof our milestones and success fees revenue recorded in each of the six monthsended June 30, 2006 and 2005, respectively. Organon accounted for 23% and 25% of our net revenue in the six monthsended June 30, 2006 and 2005, respectively, including $0.5 million of ourmilestones and success fees recorded in the six months ended June 30, 2005.

The decrease in collaborativeresearch funding in the six months ended June 30, 2006 was largely due to thereduction in funding from our collaborations with Schering-Plough and theexpiration of other collaborative research and development agreements,partially offset by the revenue generated from the our new alliances withCephalon and GSK.

Collaborative research and development expenseincludes the labor, material, equipment and allocated facilities cost of ourscientific staff that is working on collaborative partnerships. Collaborativeresearch and development expenses decreased 38% to $6.3 million in the sixmonths ended June30, 2006 compared to $10.2 million in the six months ended June 30, 2005. Thisdecrease was due to decreased resources allocated to our collaborativepartnerships largely due to the reduced staffing on our collaborations withSchering-Plough and the expiration of other collaborative research anddevelopment agreements. This decrease was offset by costs associated withresearch and development activities relating to our new collaborationpartnerships with Cephalon and GSK, and the recognition of share-basedcompensation costs of $158 thousand associated with our adoption of SFAS 123R.

Proprietary research and development expense includesresearch and development acquisition costs, labor, material, equipment andallocated facilities cost of scientific staff working on self-funded internaldrug discovery programs. Using proprietary technologies and processes, we seekto discover and develop novel drug candidates to advance internally as well aswith strategic partners. Our most advanced internal program is inpreclinical development and focuses on dual angiotensin (AT1) andendothelin (ETA) receptorantagonists (DARA) for cardiovascular disease. We licensed our DARA programfrom BMS in March 2006. In addition, we currently have several internalprograms in advanced preclinical optimization. Proprietary research anddevelopment expenses increased 150% to $11.8 million in the six months endedJune 30, 2006 compared to $4.7 million in the six months ended June 30, 2005.This increase was partially due to our licensing of the DARA program, for whichwe recorded a $2.0 million charge. Exclusive of this charge, proprietaryresearch and development expenditures increased 108%. This increase was primarilyattributable to costs relating to preclinical development studies for our DARAprogram, resources expended on our JAK-3 program for transplant rejection, ourAdenosine A2a antagonists program for Parkinson’s disease, our CCR-1antagonists program for rheumatoid arthritis and multiple sclerosis, and ourrecognition of share-based compensation costs of $185 thousand associated withour adoption of SFAS 123R. Because of the speculative nature of these internaldrug discovery projects, it is not possible to estimate completion dates, orestimated costs of completion. Additionally, from time to time, certain staffand other research and development resources may be temporarily redirected fromone project to another, which redirection may also delay or impact the cost ofinternal drug discovery projects.

Sales, general and administrative expense decreased by16% to $4.9 million in the six months ended June 30, 2006compared to $5.8 million in the six months ended June 30, 2005.  Thedecrease in sales, general and administrative expense is attributable toapproximately $1.0 million in severance costs incurred in the six months endedJune 30, 2005, and lower consulting, recruiting and travel costs offset byapproximately $182 thousand in severance costs incurred and the recognition ofshare-based compensation costs of $462 thousand associated with our adoption ofSFAS 123R in the six months ended June 30, 2006.

Restructuring and other charges decreased byapproximately $88 thousand, which relates to an adjustment to our restructuringcost estimate to reflect our actual restructuring costs.

Interest and other income, net increased to $614thousand in the six months ended June 30, 2006 compared to $506 thousand in the sixmonths ended June 30,2005.  This increase is due to higher yields on our investments.

We recorded an income tax provision of $28 thousandand $14 thousand for the six months ended June 30, 2006 and 2005, respectively, related tominimum state income taxes. The increase relates to temporary differences inrevenue recognition between

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generally accepted accounting principles andapplicable tax law.

As aresult of the net revenues and expenses described above, we generated a netloss of $14.9 million ($0.98 per basic and diluted share) in the six monthsended June30, 2006, compared to a net loss of $9.4 million ($0.75 per basic anddiluted share) in the six months ended June 30, 2005.

**ContractualObligations**

For adiscussion of our contractual obligations, see “Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operations” in our report onForm 10-K for the year ended December 31, 2005. See discussion of theProduct Development and Commercialization Agreement with GSK and theCollaboration and License Agreement with Cephalon in Note 2, and the LicenseAgreement with BMS in Note 3, respectively, to the Financial Statements for newcontractual obligations as of June 30, 2006.

**Net Loss Outlook**

We have had net losses in recent years and we expect toincur losses in future periods. Our net loss is highly dependent on thecontinued funding and success of our research and development programs with ourexisting collaborators. Currently, we are planning for full-timeemployee funding from the Schering-Plough collaborations to cease in August2006. We expect to record revenue from this collaboration through early October2006, at which time we expect our wind-down research activities under thecollaborations to cease. We will continue to be entitled to payments resultingfrom the successful achievement by Schering-Plough, if any, of preclinical andclinical milestones as well as royalty payments from sales, if any, of productsresulting from compounds already delivered by us and accepted bySchering-Plough under the collaborations.

On May 18, 2006, we entered into acollaboration and license agreement with Cephalon. Under the CephalonAgreement, we received a $15.0 million non-refundable payment to support ourresearch and development efforts and we are principally responsible forperforming medicinal chemistry and primary biology research and development.The revenue for this research and development is recognized on a proportionalperformance basis, which is expected to approximate straight-line recognitionover the initial three year term of the alliance.

Failure to earnadditional research and milestone payments under our current collaborations andcollaborations we seek to enter into would have a material adverse effect onour financial condition and our results of operations.  If we fail to earn adequate additionalresearch and milestone payments, we may be required to curtail operationssignificantly 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.

We expect to incur losses in future periods and theselosses may grow as a result of the increased level of investment we havedetermined to make in our internal proprietary programs in the future as wellas the results of those programs. Our internal proprietary research anddevelopment costs are expected to continue to increase due to our efforts toprogress the DARA program into clinical trials. We expect to file an INDapplication for the DARA program in the first quarter of 2007.

EffectiveJanuary 1, 2006, we adopted SFAS 123R “Share-Based Payment.” The adoption ofSFAS 123R has had and will continue to have a significant impact on our resultsof operations, however, there will be no impact on the Company’s cash flows.

There is no assurance that we will ever achieveprofitable operations, or that profitable operations, if achieved, could besustained on a continuing basis.

**CriticalAccounting Policies**

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

*RevenueRecognition*

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.

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Revenue earned related toup-front product and technology license fees is recognized in accordance withStaff 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-LivedAssets*

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 June 30,2006, we had long-lived assets with a net book value of $10.6 million.

**New AccountingPronouncements**

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, 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.

As aresult of adopting SFAS 123R, the Company’s net income and basic and dilutedearnings per share for the six months ended June 30, 2006 were $884 thousandand $.06 per share, respectively, lower than if the Company had continued toaccount for its share-based compensation under APB 25. These amounts include acharge of approximately $79 thousand relating to the accelerated vesting ofcertain stock options of the Company’s former Executive Vice President andChief Financial Officer. See Note 7 to the Financial Statements for furtherdiscussion. At June 30, 2006, there was approximately $3.2 million ofunrecognized compensation costs, net of estimated forfeitures, related toshare-based payments which are expected to be recognized over a weightedaverage period of 1.4 years. Total share-based compensation costs for the sixmonths ending June 30, 2006 were approximately $926 thousand, which includesapproximately $42 thousand relating to the vesting of restricted stock awards.

**Item 3. Quantitative and Qualitative 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.

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A hypothetical 100 basispoint adverse move in interest rates along the entire interest rate yield curvewould not have materially affected the fair value of our interest sensitivefinancial instruments as of June 30, 2006.

**Item 4. Controlsand Procedures**

Forthe three months ended June30, 2006, our management carried out an evaluation, under thesupervision and with the participation of our President and Chief ExecutiveOfficer and our Executive Vice President, Chief Financial Officer and Treasurer(our principal financial officer and chief accounting officer), of theeffectiveness of our disclosure controls and procedures pursuant toRules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, or theExchange Act, as of the end of the period covered by this report. Based uponthis evaluation, our President and Chief Executive Officer and our ExecutiveVice President, Chief Financial Officer and Treasurer concluded that as of June 30, 2006, ourdisclosure controls and procedures were effective to ensure that theinformation required to be disclosed by us in reports filed under the ExchangeAct was recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC. Our management, including ourPresident and Chief Executive Officer and our Executive Vice President, ChiefFinancial Officer and Treasurer, does not expect that our disclosure controlsor our internal controls will prevent all errors and all fraud. A controlsystem, no matter how well designed and operated, cannot provide assurance thatthe objectives of the control system are met, and no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within a company have been detected.

Additionally,our President and Chief Executive Officer and our Executive Vice President,Chief Financial Officer and Treasurer determined that there were no changes inour internal control over financial reporting during the three month periodended June30, 2006, that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II.OTHER INFORMATION**

**Item 1.   LegalProceedings**

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

**Item 1A.   RiskFactors**

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 TOOUR BUSINESS AND INDUSTRY**

***Future cash inflows from our existingcollaborations is highly dependent on our and our collaborators’ ability toadvance collaborative programs and thereby achieve additional research andmilestone payments.   Failure to earnsignificant future milestone payments under our collaborations would have amaterial adverse effect on our business as it is currently conducted, ourfinancial condition and our results of operations if we are unable to replacethis funding.***

Duringthe sixmonths ended June 30, 2006 and 2005, we earned approximately $5.8million and $8.9 million, or approximately 78% and 82%, respectively, of ourrevenue for each respective six month period, under our research collaborationagreements with two collaborators, Schering-Plough and Organon.  Currently, we are planning for full-timeemployee funding from the Schering-Plough collaborations to cease in August2006. We expect to record revenue from these collaborations through earlyOctober 2006, at which time we expect our wind-down research activities tocease. 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. Under ouragreement with Organon, we received quarterly research funding to conduct ourdrug discovery activities to identify and optimize new drug candidates formultiple therapeutic targets provided by Organon.  Organon made its final payment of suchquarterly research funding to us under the agreement in May 2006.  We may receive milestone payments upon thesuccessful achievement of preclinical research, preclinical development andclinical development milestones. Upon successful commercialization of anyproduct resulting from this relationship, we will be entitled to receiveroyalties on sales of that product.

In March 2006, weentered into a product development and commercialization collaboration withGSK.  Under theterms of the GSK Agreement, we will receive up to $15.0 million in cashpayments from GSK related to initial discovery activities to be conducted byus, including $5.0 million that we received in April 2006. Up to the remaining$10.0 million will be payable to us upon our

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fulfillment of certain conditions related to initial discovery activitiesto be conducted by us.  In additionto those cash payments, we are entitled to receive success-based milestonepayments, starting in preclinical research, 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.

InMay, 2006, we entered into a collaboration and license agreement with Cephalon,and we received an up-front, non-refundable payment of $15.0 million in June2006 to support our research and development efforts on behalf of the allianceover a three year period.  For eachclinical candidate, if any, advanced under the collaboration with Cephalon, thedeveloping company will make clinical, regulatory and sales milestone paymentsto the non-developing company.  Inaddition, the company commercializing each resulting product, if any, will paythe non-commercializing company up to double-digit royalties based on the saleslevel achieved.

Failure to earnadditional research and milestone payments under our current collaborations andadditional collaborations we seek to enter into would have a material adverseeffect on our business as it is currently conducted, our financial condition,and our results of operations.  If wefail to earn adequate additional research and milestone payments, we may berequired to curtail operations significantly or to obtain funds by enteringinto arrangements 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.

***If we consume cash more quickly thanexpected, and if we are unable to raise additional capital, we may be forced tocurtail operations.***

Weanticipate that our capital resources, including our existing cash, cashequivalents and marketable securities as of June 30, 2006 ofapproximately $40.1 million, will be adequate to fund our operations at theircurrent levels at least through June 30, 2007. Also, as of June 30, 2006, wehad deferred revenue of approximately $22.4 million relating to upfrontpayments received from our collaborations in advance of research anddevelopment activities that are to be performed by us subsequent to June 30,2006, of which $13.5 million was classified as long-term. Additionally, wehad other liabilities of approximately $2.0 million relating to thedelivery of a set of compound libraries over the next three years pursuant toour licensing agreement with BMS, of which $1.3 million was classified aslong-term as of June 30, 2006. Changes may occur that would cause us toconsume available capital resources before that time. Examples of relevantpotential changes in our capital resources include:

·                  the costs associated with our drugresearch and development activities;

·                  changes in existing collaborativerelationships, including the funding we receive in connection with thoserelationships;

·                  the progress of our milestone androyalty producing activities;

·                  acquisitions of other businesses ortechnologies;

·                  the purchase of additional capitalequipment;

·                  cash refunds we may be required tomake to GSK if, prior to March 24, 2011, we exercise our discretionarytermination right under our product development and commercialization agreementwith GSK;

·                  cash payments we may be required tomake to BMS if we fail to deliver certain compound libraries under our licenseagreement with BMS;

·                  penalties we may be required to paythe purchasers in the private placement transaction we closed in August 2005 ifwe fail to comply with certain covenants and obligations related to thattransaction;

·                  competing technological and marketdevelopments; and

·                  the cost of filing, prosecuting,defending and enforcing patent claims and other intellectual property rights,and the outcome of related litigation.

Weintend to raise additional capital. The capital could be raised through publicor private financings involving debt or common or other classes of our equity.Any issuance of equity securities would dilute our current stockholders’percentage ownership of us. As of June 30, 2006, there were approximately4,299,000 stock options outstanding and approximately 5,000 shares of unvestedrestricted stock granted under our various equity compensation plans. Theseequity instruments represent approximately 28% of our shares outstanding atJune 30, 2006. The significant dilution represented by our outstanding equitycompensation awards may make it more

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difficult for us to raise additional capital.Additional capital may not be available on favorable terms, or at all. Ifadequate funds are not available, we may be required to curtail operations significantlyor to obtain funds by entering into arrangements with collaborative partners orothers that may require us to relinquish rights to certain of our technologies,products or potential markets that we would not otherwise relinquish.

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

We have noproducts that have received regulatory approval for commercial sale. Our DARAprogram is in preclinical development, and we face the substantial risks offailure inherent in developing drugs based on new technologies. We plan to filean IND application for our DARA program with the FDA in the first quarter of2007.

Our DARA program must satisfy rigorous standards of safety and efficacy before the 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 program 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 program.

We do not know whether any future clinical trials of our DARA program 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 program under development will prevent receipt of FDA and foreign regulatory approvals and, ultimately, their commercialization.

***We had net losses in recent years, and ourfuture profitability is uncertain.***

Duringthe six months ended June 30, 2006, we had a net loss of approximately $14.9million.  The net loss was primarily due to our licensing of the DARAprogram from BMS and costs associated with developing the program, 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.

Currently,we are planning for full-time employee funding from the Schering-Ploughcollaborations to cease in August 2006. We expect to record revenue from these collaborations through earlyOctober 2006, at which time we expect our wind-down research activities underthe collaborations to cease.  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.

Theadoption of the Financial Accounting Standards Board Statement No. 123R “Share-BasedPayment” had and will continue to have a significant impact on our results ofoperations. Our adoption of SFAS 123R was effective January 1, 2006.

On aquarterly basis, our future operating results are likely to be highly volatiledepending upon our receipt of milestone payments from our collaborators. We maynot receive milestone payments on a regular basis or at all. Our ability toachieve profitability, if ever, will be significantly impacted by the level ofinvestment we determine to make in our internal proprietary programs in thefuture as well as the results of those programs.

Continuingnet losses may limit our ability to fund our operations, and we may notgenerate income from operations in the future.

**Item 2.   UnregisteredSales of Equity Securities and Use of Proceeds**

**None.**

**Item 3.**   Defaultsupon Senior Securities

None.

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**Item 4.   Submissionof Matters to a Vote of Security Holders.**

On May 4, 2006, we held our AnnualMeeting of Stockholders in Cranbury, New Jersey.  The following matterswere submitted to a vote of security holders.

Our stockholders voted to elect thefollowing members of our Board of Directors for terms of three years each:

| Nominee                  | ** ** | **In Favor** | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|--------------------------|------------|-------------------|------------|-------------|------------|-------------|------------|
| Carol A. Ammon           |       | 11,371,014        |       | 8,898       |       | —      |       |
| Paul A. Bartlett, Ph.D.  |       | 10,980,054        |       | 399,858     |       | —      |       |
| Joseph A. Mollica, Ph.D. |       | 11,087,190        |       | 292,722     |       | —      |       |

 

Our directors whose terms of officecontinued after the meeting include three Class III directors whose termexpires in 2007, Steven J. Burakoff, M.D., James J. Marino and Bruce A.Peacock, and three Class I directors whose term expires in 2008, FrankBaldino, Jr., Ph.D., Leslie J. Browne, Ph.D. and Gary E. Costley, Ph.D.

Our stockholders voted as follows toratify the appointment of Ernst & Young LLP as our independentexternal auditors for the fiscal year ending December 31, 2006: 11,365,428shares were voted in favor of ratification, 12,118 shares were voted againstratification, and 2,365 shares abstained from voting.

**Item 5.**   Other Information

None.

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

| Exhibits. | ** ** | ** **                                                                                                                                                                                                                                                                                   |
|-----------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.1      |       | Collaboration and License Agreement between  Pharmacopeia Drug Discovery, Inc. and Cephalon, Inc., dated May 18,  2006.(1)(2)                                                                                                                                                                |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.2      |       | Amendment No. 1, dated August 3, 2006, to amended  and restated Employment Agreement between Pharmacopeia Drug Discovery, Inc.  and Leslie Johnston Browne, Ph.D.(1)(3)                                                                                                                      |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.3      |       | Amendment No. 2, dated August 3, 2006, to Severance  Agreement between Pharmacopeia Drug Discovery, Inc. and Stephen C.  Costalas.(1)(3)                                                                                                                                                     |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.4      |       | Amendment No. 2, dated August 3, 2006, to Severance  Agreement between Pharmacopeia Drug Discovery, Inc. and David M. Floyd.(1)(3)                                                                                                                                                           |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.5      |       | Amendment No. 1, dated August 3, 2006, to Severance Agreement  between Pharmacopeia Drug Discovery, Inc. and Brian M. Posner.(1)(3)                                                                                                                                                          |
|      |       |                                                                                                                                                                                                                                                                                         |
| 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) |

 

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| 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) |

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(1)             Filedherewith.

(2)             Confidentialtreatment of certain provisions of this exhibit has been requested.

(3)             Compensationplan or arrangement in which directors or executive officers are eligible toparticipate.

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**SIGNATURES**

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

 
|                                 |   | PHARMACOPEIA DRUG  DISCOVERY, INC. |
|---------------------------------|--------|------------------------------------|
|                            |   |                               |
|                            |   |                               |
| Date:  August 4, 2006 |   | By:                                |   | /s/ Leslie J. Browne, Ph.D. |
|                            |   |                               |   | Leslie J. Browne, Ph.D.  President, Chief Executive Officer and 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) |
|                            |   |
|                            |   |
|                            |   |

 

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**PHARMACOPEIA DRUGDISCOVERY, INC.**

**INDEX TO EXHIBITS**
| Exhibits. | ** ** | ** **                                                                                                                                                                                                                                                                                   |
|-----------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.1      |       | Collaboration and License Agreement between  Pharmacopeia Drug Discovery, Inc. and Cephalon, Inc., dated May 18,  2006.(1)(2)                                                                                                                                                                |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.2      |       | Amendment No. 1, dated August 3, 2006, to amended  and restated Employment Agreement between Pharmacopeia Drug Discovery, Inc.  and Leslie Johnston Browne, Ph.D.(1)(3)                                                                                                                      |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.3      |       | Amendment No. 2, dated August 3, 2006, to Severance  Agreement between Pharmacopeia Drug Discovery, Inc. and Stephen C.  Costalas.(1)(3)                                                                                                                                                     |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.4      |       | Amendment No. 2, dated August 3, 2006, to Severance  Agreement between Pharmacopeia Drug Discovery, Inc. and David M. Floyd.(1)(3)                                                                                                                                                           |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.5      |       | Amendment No. 1, dated August 3, 2006, to Severance  Agreement between Pharmacopeia Drug Discovery, Inc. and Brian M.  Posner.(1)(3)                                                                                                                                                         |
|      |       |                                                                                                                                                                                                                                                                                         |
| 31.1      |       | Certification of the Principal Executive 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)                              |
|      |       |                                                                                                                                                                                                                                                                                         |
| 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)             Filedherewith.

(2)             Confidentialtreatment of certain provisions of this exhibit has been requested.

(3)             Compensationplan or arrangement in which directors or executive officers are eligible toparticipate.

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