**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM1O-Q**

 
| **(Mark  One)**                                       |
|-------------------------------------------------------|
| **ý**                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                  |
| **For the quarterly period ended September 30, 2004** |
|                                                  |
| **Or**                                                |
|                                                  |
| **o**                                                 | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                  |
| **Commission File Number: 0-50523**                   |

 

**PHARMACOPEIADRUG DISCOVERY, INC.**

(Exactname of registrant as specified in its charter)

 
| **Delaware**                                                                        | ** ** | **51-0418085**                        |
|-------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of  incorporation or organization)                    |       | (I.R.S.  Employer Identification No.) |
|                                                                                |       |                                  |
| **P.O. Box 5350, Princeton, New Jersey**                                            | ** ** | **08543-5350**                        |
| (Address  of principal executive offices)                                           |       | (Zip  Code)                           |
|                                                                                |       |                                  |
| **(609) 452-3600**                                                                  |
| (Registrant’s  telephone number, including area code)                          |
|                                                                                |
| **Not Applicable**                                                                  |
| (Former  name, former address and former fiscal year, if changed since last report) |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or suchshorter period that the registrant was required to file such reports) and (2)has been subject to such filing requirements for the past 90days.    Yes ý     Noo

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes o    Noý

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate:

 
| **Class**                      | ** ** | **Outstanding  at November 5, 2004** |
|--------------------------------|------------|--------------------------------------|
| Common  Stock, $0.01 par value |       | 12,303,978                           |

 

 

----

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**          | ** **            | ** **                                                                                                | ** ** |
|-------------------|-----------------------|-----------------------------------------------------------------------------------------------------------|------------|
|              |                  |                                                                                                      |       |
| PART I.           | FINANCIAL INFORMATION |                                                                                                      |
|              |                  |                                                                                                      |       |
| Item 1.           |                  | Financial  Statements (Unaudited):                                                                        |       |
|              |                  |                                                                                                      |       |
|              |                  | Balance Sheets as of September 30, 2004  and December 31, 2003                                       |       |
|              |                  |                                                                                                      |       |
|              |                  | Statements  of Operations for each of the Three Months and Nine Months Ended September  30, 2004 and 2003 |       |
|              |                  |                                                                                                      |       |
|              |                  | Statements  of Cash Flows for each of the Nine Months Ended September 30, 2004 and 2003                   |       |
|              |                  |                                                                                                      |       |
|              |                  | Notes to  Unaudited Financial Statements                                                                  |       |
|              |                  |                                                                                                      |       |
| Item  2.          |                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations               |       |
|              |                  |                                                                                                      |       |
|              |                  | Certain Risks  Related to Our Business                                                                    |       |
|              |                  |                                                                                                      |       |
| Item  3.          |                  | Quantitative  and Qualitative Disclosures about Market Risk                                               |       |
|              |                  |                                                                                                      |       |
| Item 4.           |                  | Controls and  Procedures                                                                                  |       |
|              |                  |                                                                                                      |       |
| PART II.          | OTHER INFORMATION     |                                                                                                      |
|              |                  |                                                                                                      |       |
| Item 1.           |                  | Legal Proceedings                                                                                         |       |
|              |                  |                                                                                                      |       |
| Item  2.          |                  | Unregistered  Sales of Equity Securities and Use of Proceeds                                              |       |
|              |                  |                                                                                                      |       |
| Item 3.           |                  | Defaults upon  Senior Securities                                                                          |       |
|              |                  |                                                                                                      |       |
| Item  4.          |                  | Submission  of Matters to a Vote of Security Holders                                                      |       |
|              |                  |                                                                                                      |       |
| Item 5.           |                  | Other Information                                                                                         |       |
|              |                  |                                                                                                      |       |
| Item 6.           |                  | Exhibits                                                                                                  |       |
|              |                  |
| Signatures        |                  |
|              |                  |
| Index of Exhibits |                  |

 

i

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.  UnauditedFinancial Statements**

 

**Pharmacopeia DrugDiscovery, Inc.**

**Balance Sheets**

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

 
| ** **                                                                                                                                                           | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                           | ** ** | **(unaudited)**         | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                           | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current assets:                                                                                                                                                      | ** ** | ** **              | ** ** | ** **             | ** ** |
| Cash and cash equivalents                                                                                                                                            |       | $                       | 13,621     |                   | $          | 524 |   |
| Marketable securities                                                                                                                                                |       | 26,803                  |       | —                 |       |
| Accounts receivable                                                                                                                                                  |       | 1,820                   |       | 2,302                  |       |
| Prepaid expenses and other current assets                                                                                                                            |       | 887                     |       | 1,159                  |       |
| Total current assets                                                                                                                                                 |       | 43,131                  |       | 3,985                  |       |
|                                                                                                                                                                 |       |                    |       |                   |       |
| Property and equipment, net                                                                                                                                          |       | 11,228                  |       | 6,957                  |       |
| Other assets                                                                                                                                                         |       | 101                     |       | 110                    |       |
| Total assets                                                                                                                                                         |       | $                       | 54,460     |                   | $          | 11,052 |   |
|                                                                                                                                                                 |       |                    |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                        |       |                    |       |                   |       |
| Current liabilities:                                                                                                                                                 |       |                    |       |                   |       |
| Accounts payable                                                                                                                                                     |       | $                       | 1,242      |                   | $          | 2,809 |   |
| Accrued liabilities                                                                                                                                                  |       | 2,503                   |       | 951                    |       |
| Restructuring reserve, current portion                                                                                                                               |       | 2,462                   |       | —                 |       |
| Deferred revenue, current portion                                                                                                                                    |       | 2,751                   |       | 2,660                  |       |
| Total current liabilities                                                                                                                                            |       | 8,958                   |       | 6,420                  |       |
|                                                                                                                                                                 |       |                    |       |                   |       |
| Restructuring reserve, long-term                                                                                                                                     |       | 1,480                   |       | —                 |       |
| Deferred revenue, long-term                                                                                                                                          |       | —                  |       | 325                    |       |
|                                                                                                                                                                 |       |                    |       |                   |       |
| 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, 12,280,556 and 12,181,471 shares outstanding at September  30, 2004 and December 31, 2003, respectively |       | 123                     |       | —                 |       |
| Additional paid-in capital                                                                                                                                           |       | 49,425                  |       | —                 |       |
| Deferred compensation                                                                                                                                                |       | (294                    | )          | —                 |       |
| Accumulated deficit                                                                                                                                                  |       | (5,109                  | )          | —                 |       |
| Accumulated other comprehensive loss                                                                                                                                 |       | (123                    | )          | —                 |       |
| Investment by Accelrys, Inc.                                                                                                                                         |       | —                  |       | 4,307                  |       |
| Total stockholders’ equity                                                                                                                                      |       | 44,022                  |       | 4,307                  |       |
| Total liabilities and stockholders’ equity                                                                                                                      |       | $                       | 54,460     |                   | $          | 11,052 |   |

 

See accompanying notes to theseunaudited financial statements.

 

1

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**Pharmacopeia DrugDiscovery, Inc.**

**Statements of Operations**

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

 
| ** **                                            | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
|                                                  |       | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** |   |
|                                                  |       | **(unaudited)**                               |       | **(unaudited)**                              |       |
| Revenues                                              |       | $                                             | 6,376      |                                         | $          | 7,422 |   | $ | 16,852 |   | $ | 21,957 |   |
| Cost of revenue                                       |       | 5,244                                         |       | 5,535                                        |       | 15,779 |   | 16,707 |   |
| Gross margin                                          |       | 1,132                                         |       | 1,887                                        |       | 1,073 |   | 5,250 |   |
|                                                  |       |                                          |       |                                         |       |   |   |   |   |
| Operating costs and expenses:                         |       |                                          |       |                                         |       |   |   |   |   |
| Research and development                              |       | 1,551                                         |       | 769                                          |       | 4,325 |   | 2,723 |   |
| Sales, general and administrative                     |       | 2,592                                         |       | 1,504                                        |       | 7,255 |   | 4,455 |   |
| Restructuring and other charges                       |       | —                                        |       | —                                       |       | 5,947 |   | — |   |
| Total operating costs and expenses                    |       | 4,143                                         |       | 2,273                                        |       | 17,527 |   | 7,178 |   |
| Operating loss                                        |       | (3,011                                        | )          | (386                                         | )          | (16,454 | ) | (1,928 | ) |
| Interest and other income, net                        |       | 166                                           |       | 3                                            |       | 225 |   | 16 |   |
| Loss before tax provision                             |       | (2,845                                        | )          | (383                                         | )          | (16,229 | ) | (1,912 | ) |
| Provision for income taxes                            |       | 51                                            |       | —                                       |       | 64 |   | 107 |   |
| Net loss                                              |       | $                                             | (2,896     | )                                            | $          | (383 | ) | $ | (16,293 | ) | $ | (2,019 | ) |
|                                                  |       |                                          |       |                                         |       |   |   |   |   |
| Net loss per share:                                   |       |                                          |       |                                         |       |   |   |   |   |
| - Basic and diluted                                   |       | $                                             | (0.24      | )                                            | $          | (0.03 | ) | $ | (1.34 | ) | $ | (0.17 | ) |
|                                                  |       |                                          |       |                                         |       |   |   |   |   |
| Weighted average number of common stock  outstanding: |       |                                          |       |                                         |       |   |   |   |   |
| - Basic and diluted                                   |       | 12,220,495                                    |       | 12,155,751                                   |       | 12,185,379 |   | 12,155,751 |   |

 

See accompanying notes to theseunaudited financial statements.

 

2

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**Pharmacopeia DrugDiscovery, Inc.**

**Statements of Cash Flows**

**(Amounts inthousands)**

 
| ** **                                                                      | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
|                                                                            |       | **2004**                                     | ** ** | **2003** |   |
|                                                                            |       | **(unaudited)**                              |       |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                           |       |                                         |       |   |   |
| Net loss                                                                        |       | $                                            | (16,293    | ) | $ | (2,019 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities |       |                                         |       |   |   |
| Depreciation and amortization                                                   |       | 1,312                                        |       | 1,291 |   |
| Contribution of stock to 401(k) Plan                                            |       | 148                                          |       | — |   |
| Amortization of deferred compensation                                           |       | 60                                           |       | — |   |
| Changes in assets and liabilities:                                              |       |                                         |       |   |   |
| Trade receivables                                                               |       | 482                                          |       | (993 | ) |
| Prepaid expenses and other current assets                                       |       | 272                                          |       | 3 |   |
| Other assets                                                                    |       | 9                                            |       | 80 |   |
| Accounts payable                                                                |       | (1,567                                       | )          | (517 | ) |
| Accrued liabilities                                                             |       | 1,552                                        |       | (125 | ) |
| Restructuring reserve                                                           |       | 4,400                                        |       | — |   |
| Deferred revenue                                                                |       | (234                                         | )          | (3,266 | ) |
| Net cash used in operating activities                                           |       | (9,859                                       | )          | (5,546 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                           |       |                                         |       |   |   |
| Capital expenditures, net                                                       |       | (6,041                                       | )          | (663 | ) |
| Purchases of marketable securities                                              |       | (16,132                                      | )          | — |   |
| Proceeds from sale of marketable securities                                     |       | 30,859                                       |       | — |   |
| Net cash provided by (used in) investing  activities                            |       | 8,686                                        |       | (663 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                           |       |                                         |       |   |   |
| Proceeds from issuance of common stock                                          |       | 286                                          |       | — |   |
| Investment by Accelrys, Inc.                                                    |       | 13,984                                       |       | 1,657 |   |
| Net cash provided by financing activities                                       |       | 14,270                                       |       | 1,657 |   |
| Net increase (decrease) in cash and  equivalents                                |       | 13,097                                       |       | (4,552 | ) |
| Cash and equivalents, beginning of period                                       |       | 524                                          |       | 6,737 |   |
| Cash and equivalents, end of period                                             |       | $                                            | 13,621     |   | $ | 2,185 |   |
|                                                                            |       |                                         |       |   |   |
| SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:                                 |       |                                         |       |   |   |
| Cash paid during the period for:                                                |       |                                         |       |   |   |
| Interest                                                                        |       | $                                            | —     |   | $ | — |   |
| Income tax                                                                      |       | $                                            | —     |   | $ | 90 |   |

 

NON-CASHFINANCING:

 

Includedin the capital contribution by Accelrys upon distribution was $41,652 ofmarketable securities.

 

See accompanying notes to theseunaudited financial statements.

 

3

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** **

**Pharmacopeia DrugDiscovery, Inc.**

**Notes to UnauditedFinancial Statements**

 

**1.  Background andBasis of Presentation**

 

PharmacopeiaDrug Discovery, Inc. (“Pharmacopeia” or the “Company”) was incorporated on May31, 2002 as a wholly owned subsidiary of Accelrys, Inc. (“Accelrys”), formerlyPharmacopeia, Inc. On December 18, 2003, Accelrys announced its plans tospin-off 100 percent of the shares of Pharmacopeia in a pro rata tax-freedistribution to its stockholders, subject to the satisfaction of certainconditions. Upon completion of the distribution on April 30, 2004,Accelrys distributed to its stockholders of record one share of Pharmacopeiacommon stock for every two shares of Accelrys common stock held. A total of12,181,471 shares were distributed. The financial statements have been revisedto retroactively reflect the shares distributed for all periods presented priorto the distribution date.

 

Accelrys contributed anamount of cash, cash equivalents and marketable securities to the Companysuch that upon consummation of the distribution on April 30, 2004, Pharmacopeiahad a cash, cash equivalents and marketable securities balance aggregating$46.5 million and all inter-company balances due to Accelrys were forgiven intheir entirety by Accelrys and treated as a capital contribution; accordingly,such balances were reflected as investment by Accelrys for periods prior toApril 30, 2004, at which time the amount was reclassified to additional paid-incapital. Earnings and losses accumulate in retained earnings (deficit) startingMay 1, 2004.

 

Inconnection with the distribution, Accelrys and the Company entered into aseries of agreements, including a master separation and distribution agreement,a transition services agreement, a tax sharing and indemnification agreementand other agreements, which are intended to govern the ongoing relationshipbetween the two companies. See note 7 for further information on thedistribution.

 

Pharmacopeiais a biopharmaceutical company, focused on the creation of new small moleculetherapeutics to address significant unmet medical needs. Using proprietarytechnologies and processes, Pharmacopeia’s scientists identify novel drugcandidates in collaboration with major pharmaceutical and biotechnologycompanies, and, increasingly, through Pharmacopeia’s own internally funded drugdiscovery programs, which are primarily focused on immunobiology andimmunological diseases. Pharmacopeia’s later stage portfolio currentlycomprises multiple partnered programs that have been advanced into humanclinical trials by the Company’s partners and additional programs in late-stagepre-clinical development.  Additionally,Pharmacopeia has approximately 40 partnered and internal programs in discovery,which the Company believes will sustain the Company’s clinical portfolio in thefuture.

 

Wehave a license agreement with Columbia University and Cold Spring HarborLaboratory that grants us an exclusive, worldwide license to certain technologyfor making and using combinatorial chemical libraries for the development ofhuman pharmaceutical products.  The termof the agreement is the later of (i) 20 years or (ii) the expiration of thelast patent relating to the technology, at which time we will have a fully paidlicense to the technology.  Thisagreement requires us to pay minimum annual fees and certain royalties of atleast $100 thousand per year.

 

Forperiods prior to the distribution date, Pharmacopeia’s financial statementswere derived from the financial statements and accounting records of Accelrysusing the historical results of operations and historical basis of the assetsand liabilities of the Company’s business. Management believes the assumptionsunderlying the financial statements are reasonable. The financial statementsincluded herein may not necessarily reflect the Company’s results ofoperations, financial position and cash flows in the future or what its resultsof operations, financial position and cash flows would have been had theCompany been a stand-alone company during the periods presented.

 

Forperiods prior to the distribution date, the financial statements includedallocations of certain Accelrys corporate headquarter assets, liabilities andexpenses relating to the Company’s business that have been transferred to theCompany from Accelrys. General corporate overhead has been allocated based onthe Company’s revenue as a percentage of Accelrys’s total revenue. Generalcorporate overhead primarily includes salary and expenses for executivemanagement, finance, legal, human resources, information services and investorrelations, and was $0 and $354 thousand for the quarters ended September 30,2004 and 2003, respectively, and $668 thousand and $1,068 thousand in the ninemonths ended September 30, 2004 and 2003, respectively.  These costs are included in sales, generaland administrative expenses in the accompanying statements of operations.

 

Theaccompanying unaudited financial statements have been prepared in accordancewith U. S. generally accepted accounting principles for interim financialinformation and with instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, theseunaudited financial statements do not include all of the information anddisclosures required by U. S. generally accepted accounting principles forcomplete financial statements. The December 31, 2003 financial informationhas been extracted from the audited

 

4

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financialstatements included in the Company’s registration statement on Form 10 datedApril 19, 2004 (the “Form 10”), which was filed in conjunction with theCompany’s spin-off from Accelrys. In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation of the financial statements have been included.  Interim results are not necessarilyindicative of the results that may be expected for the year. The unauditedinterim financial statements should be read in conjunction with the financialstatements and notes thereto as of December 31, 2003 included in the Form10.

 

**2. Significant Collaborations**

 

Forthe quarters ended September 30, 2004 and 2003 the Company’s research collaborationswith Schering-Plough accounted for 61% and 42%, respectively, of revenue.  For the nine months ended September 30, 2004and 2003, the Company’s research collaborations with Schering-Plough accountedfor 62% and 45%, respectively, of revenue. In the third quarter of 2003, theCompany entered into new drug discovery collaborations with Schering-Plough,which continue certain existing programs and implement a number of newactivities. The new agreements continue the Company’s collaboration with thispartner through at least August 2006 and, under their terms, may beextended by the parties for up to three additional years based upon progressmade in the programs governed by the agreements. The agreements may beterminated in August 2006 and Schering-Plough’s funding obligations may bereduced significantly before that time. Under these agreements, Pharmacopeia receives research funding which isrecognized as revenue as services are performed. The Company may receivemilestones upon the successful achievement of preclinical and clinicalmilestones. Milestone payments will be recognized as revenue when themilestones are achieved. Upon successful commercialization of any productresulting from this relationship, Pharmacopeia will be entitled to receiveroyalties on sales of that product.

 

Forthe quarters ended September 30, 2004 and 2003, the Company’s researchcollaborations with N.V. Organon (“Organon”) accounted for 14% and 19%,respectively, of revenue.  For the ninemonths ended September 30, 2004 and 2003, the Company’s research collaborationswith Organon accounted for 16% and 20 %, respectively, of revenue.  The principal agreement with Organon, enteredinto in February 2002, has a stated term of five years; however, Organonhas the right to terminate the agreement in 2005 if Pharmacopeia is unable todeliver compounds meeting the criteria specified in the agreement. Under thisagreement, Pharmacopeia receives research funding to conduct its drug discoveryactivities to identify and optimize new drug candidates for multipletherapeutic targets provided by Organon. This revenue is recognized on astraight-line basis over the term of the collaboration. The Company may receivemilestones upon the successful achievement of preclinical and clinical milestones.These milestones will be recognized as revenue when the milestones areachieved. Upon successful commercialization of any product resulting from thisrelationship, Pharmacopeia will be entitled to receive royalties on sales ofthat product.

 

**3.  Net Loss Per Share**

** **

TheCompany computes net income (loss) per share in accordance with Statement ofFinancial Accounting Standard No. 128, “Earnings Per Share” (“SFAS 128”).  Under the provisions of SFAS 128, basic netincome (loss) per share is computed by dividing the net income (loss) for theperiod by the weighted-average number of common shares outstanding during theperiod.  Diluted net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted-average number of common and dilutive common equivalent sharesoutstanding during the period.  Dilutedearnings per share include the potentially dilutive effect of outstanding stockoptions, or other dilutive securities. Shares outstanding for the Company forthe period prior to the distribution are calculated based on the 12,181,471shares distributed in the spin-off, adjusted for unvested restricted shares(see notes 1 and 7). The Company has a net loss for the periods presented;accordingly, the inclusion of common stock equivalents for outstanding stockoptions would be anti-dilutive and, therefore, the weighted-average shares usedto calculate both basic and diluted loss per share are the same.

 

**4.  Segment Information**

 

TheCompany classifies its business operations in one operating segment.  All of the Company’s revenues are generatedfrom this segment.  In the quarters endedSeptember 30, 2004 and 2003, approximately 48% and 43%, respectively, of theCompany’s revenue from customers was derived from within the United States, 51%and 56%, respectively, was derived from Europe, and 1% and 1%, respectively,was derived from Asia.  In the ninemonths ended September 30, 2004 and 2003, approximately 44% and 34%,respectively, of the Company’s revenue from customers was derived from withinthe United States, 52% and 61%, respectively, was derived from Europe, and 4%and 5%, respectively, was derived from Asia.

 

**5.  Stock-BasedCompensation**

 

Generally,any outstanding options to purchase Accelrys common stock under Accelrys incentivecompensation plans have been adjusted or converted to options to purchasePharmacopeia common stock to maintain the intrinsic value existing at the timeof the distribution and maintain the ratio existing at the time of thedistribution of the exercise price per share to the market value per share inaccordance with applicable accounting standards.

 

5

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Statementof Financial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation” (“SFAS 123”) encourages, but does not require, companies torecord compensation cost for stock-based compensation plans at fair value.  As permitted by SFAS 123, the Company haselected to continue following Accounting Principles Board Opinion No. 25“Accounting for Stock Issued to Employees” (“APB 25”) and relatedinterpretations, to account for stock-based compensation.  Under APB 25, no compensation expense isrecognized at the time of option grant because the exercise price of theCompany’s employee stock options equals the fair market value of the underlyingcommon stock on the date of grant.

 

Hadthe Company followed the fair value measurement provisions of SFAS 123, thefollowing table summarizes the pro forma net loss and pro forma net loss pershare that would have been recorded (in thousands, except per share data):

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss:                                                                                                                                     |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                    | (2,896     | )                                   | $          | (383 | ) | $ | (16,293 | ) | $ | (2,019 | ) |
|                                                                                                                                          |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Add: Stock-based employee compensation  expense included in reported net loss                                                                 |       | 26                                   |       |                                |       | 60 |   |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (595                                 | )          | (474                                | )          | (1,646 | ) | (1,336 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (3,465     | )                                   | $          | (857 | ) | $ | (17,879 | ) | $ | (3,355 | ) |
| Basic and diluted net loss per common  share:                                                                                                 |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                    | (0.24      | )                                   | $          | (0.03 | ) | $ | (1.34 | ) | $ | (0.17 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (0.28      | )                                   | $          | (0.07 | ) | $ | (1.47 | ) | $ | (0.28 | ) |

 

Thefair value of each option granted during 2004 and 2003 is estimated on the dateof grant using the Black-Scholes option-pricing model with the followingassumptions:

 
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0        | %          | 0        | %          |
| Expected volatility     |       | 85.24    | %          | 86.49    | %          |
| Risk-free interest rate |       | 3.75     | %          | 3.74     | %          |
| Expected life (years)   |       | 5.8      |       | 6.5      |       |

 

**6.  Restructuring**

 

Duringthe quarter ended March 31, 2004, the Company executed a restructuringplan for the purpose of making its research and development activities moreefficient by eliminating unnecessary facilities. Also a reduction in force ofsix administrative Pharmacopeia employees occurred during that quarter, of whomall were terminated as of June 30, 2004. As a result, restructuring related charges of approximately $5.9million, as outlined below, were recognized as operating expense during thequarter ended March 31, 2004.

 

Thefollowing table summarizes the activity and balance of the restructuringreserve at September 30, 2004 (dollars in thousands):

 

**2004 PDDI Restructuring**

 
| ** **                       | ** ** | **Severance Cost for Involuntary Employee Terminations** | ** ** | **Costs to Exit Leased Facility** | ** ** | **Total** | ** ** |
|----------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Restructuring charges            |       | $                                                        | 132        |                              | $          | 5,718     |       | $ | 5,850 |   |
| Utilization of Reserves:         |       |                                                     |       |                              |       |      |       |
| Cash                             |       | (132                                                     | )          | (1,318                            | )          | (1,450    | )          |
| Write-off Leasehold Improvements |       | —                                                   |       | (458                              | )          | (458      | )          |
| Balance at September 30, 2004    |       | $                                                        | —     |                              | $          | 3,942     |       | $ | 3,942 |   |

 

6

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** **

**7.  Spin-off ofPharmacopeia Drug Discovery, Inc.**

 

OnApril 30, 2004, Accelrys completed the spin-off of Pharmacopeia into anindependent, separately traded and publicly held company through thedistribution to its stockholders of a dividend of one share of Pharmacopeiacommon stock for every two shares of Accelrys common stock held.  Accelrys received an opinion of counsel thatthe transaction would qualify as tax-free to Accelrys stockholders, except forcash received in lieu of any fractional share interests.

 

Inconnection with the distribution, Accelrys and the Company entered into theagreements described below.

 

*Master Separation and DistributionAgreement*

 

TheCompany entered into a master separation and distribution agreement withAccelrys providing for, among other things, certain corporate transactionsrequired to effect the distribution and other arrangements between the Companyand Accelrys subsequent to the distribution. In particular, the agreementprovided for ownership of the business, assets and liabilities necessary forownership of the continuation of the Company’s business directly or indirectly,by the Company, and Accelrys’s remaining business assets and liabilities,directly or indirectly, by Accelrys.

 

*Transition Services Agreement*

 

TheCompany entered into a transition services agreement with Accelrys, pursuant towhich Accelrys will provide Pharmacopeia and Pharmacopeia will provide Accelryscertain services during a transition period that commenced on the distributiondate. The obligation to provide services will terminate no later than the firstanniversary of the distribution date.

 

Underthe terms of the transition services agreement, Accelrys will provide theCompany with business development, financial information systems advice andsupport, support for the maintenance of corporate records and personneladministration and services. Pharmacopeia will provide Accelrys with officespace during the transition period.

 

Thetransition services agreement also provided that Accelrys make available a sumof $1 million to be held as a “Services Fund” in a segregated account, in trustfor the benefit of Pharmacopeia and Accelrys. Pharmacopeia may use the Services Fund towards securing any serviceAccelrys agrees to provide Pharmacopeia under the transition services agreementif Pharmacopeia and Accelrys cannot resolve any dispute relating to theperformance or nonperformance of such service by Accelrys after good faithnegotiations. The Company will also use a portion of the Services Fund toacquire a financial system appropriate for its business and is entitled to usea portion of the Services Fund to update its corporate website and to acquireor license certain software packages appropriate for supporting the internaloperations of its business. The amount remaining in the Services Fund as ofApril 30, 2005, less applicable deductions, will be remitted to Accelrys.  The $1 million available under the ServicesFund is not included in the Company’s cash and cash equivalents balance as ofSeptember 30, 2004.

 

Inaddition, Accelrys made a capital contribution of $750 thousand in relation tocosts, expenses and fees associated with Pharmacopeia’s consolidation of itsfacilities.

 

*Tax Sharing and Indemnification Agreement*

 

Inorder to allocate the Company’s responsibilities for taxes and certain othertax matters, the Company and Accelrys entered into a tax sharing andindemnification agreement.

 

Underthe tax sharing and indemnification agreement, Accelrys is responsible forfiling all federal consolidated income tax returns and all consolidated,combined, or unitary state and local income tax returns including Pharmacopeiafor all periods through the distribution date, and for paying all taxes relatedto those returns. Accelrys will act as the Company’s agent in connection withthe filing of those returns, paying those taxes and responding to any auditsthat may arise in connection with those returns. Accelrys will be entitled toany refunds of income taxes related to those returns, and (except for certainspin-off taxes discussed below) will be responsible for any increased taxpayments related to those returns as a result of any audits.

 

Pharmacopeiais responsible for all state and local taxes imposed on it computed on aseparate-company basis, and will be entitled to any refund of such taxes.

 

7

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TheCompany and Accelrys have made certain covenants to each other in connectionwith the spin-off that Pharmacopeia may not take certain actions without firstobtaining an unqualified opinion of counsel that such actions will not causethe spin-off to become taxable. If the Company breaches any of the covenants inthe tax sharing and indemnification agreement, and if its breach results intaxes being imposed on Accelrys in connection with the spin-off, thenPharmacopeia will be liable for those taxes. Furthermore, the Company will beresponsible for taxes that may be imposed on Accelrys pursuant to IRSSection 355(e) of the Internal Revenue Code of 1986, as amended, inconnection with the transaction that results in a change in control ofPharmacopeia, even though Pharmacopeia may have obtained an opinion of counselprior to the transaction.

 

*Employee Matters Agreement*

 

TheCompany and Accelrys entered into an employee matters agreement that allocatedresponsibilities and obligations with respect to certain employee benefit plansand other employment related matters.

 

Underthe employee matters agreement, the Company and Accelrys identified thosecurrent and former employees employed (or, in the case of former employees, whowere employed) in the Accelrys business and those employees employed in thePharmacopeia business. Pharmacopeia assumed all the employee benefit plan,workers compensation, unemployment compensation, bonus, fringe benefit andvacation liabilities, which related to its current and former employees as ofthe distribution date. The Company will also, generally, recognize any serviceearned by its employees with Accelrys for purposes of determining eligibilityfor and vesting in any benefits.

 

Duringthe transition period, which began on the distribution date and will end nolater than December 31, 2004, Pharmacopeia employees may continue theirparticipation in plans maintained by Accelrys. As of October 1, 2004,Pharmacopeia had established its own employee benefit plans.

 

TheCompany has agreed with Accelrys that the distribution is not a severance ofemployment for the purposes of any employee benefit plan that Pharmacopeia orAccelrys maintains.

 

*Patent and Software License Agreement*

 

The Company andAccelrys entered into a patent and software cross-licensing agreement betweenAccelrys and Pharmacopeia in regards to certain intellectual property rights soas to assure continued access to such intellectual property, most of which issignificant to the uninterrupted availability of certain of the products andservices of the Company.

 

Under the patent and softwarelicense agreement, Accelrys granted Pharmacopeia a worldwide, paid-up,royalty-free, irrevocable, nontransferable and nonexclusive license to usecertain software products for the sole purpose of processing the work ofPharmacopeia’s business. The license is in effect until April 30, 2007,unless earlier terminated by either party or Accelrys under certain limitedcircumstances or extended by mutual written agreement by the Company andAccelrys.

** **

**Pursuant to the patent and software licenseagreement, Accelrys granted Pharmacopeia a worldwide, paid-up, royalty-free,irrevocable, nontransferable, and non-exclusive license to certainAccelrys-owned patents. This license is in effect until the last of the patentsmade part of the patent and software license agreement expires.**

** **

**Pursuant to the patent and softwarelicense agreement, Pharmacopeia granted Accelrys a worldwide, paid-up,royalty-free, irrevocable,**

**nontransferable, and non-exclusivelicense to certain Pharmacopeia-owned patents. This license is in effect untilthe last of the Pharmacopeia-owned patents made part of the patent and softwarelicense agreement expires.**

 

8

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**8.  Commitments andContingencies**

 

On August 23, 2004, Columbia UniversityScience and Technology Ventures (“Columbia”) provided the Company with a noticeof material breach of the License Agreement, dated July 16, 1993 and as amendedOctober 6, 1995, among the Company, the Trustees of Columbia University in theCity of New York and Cold Spring Harbor Laboratory (the “Agreement”) arisingfrom an alleged underpayment by the Company of certain royalties under theAgreement. In correspondence initiated by Columbia, the amount of the allegedunderpayment has been estimated to be at least $1.12 million for the periodfrom July 1, 2001 through June 30, 2003. The Agreement covers the Company’score tagging technology used in its proprietary combinatorial chemistryencoding technology, Encoded Combinatorial Libraries on Polymeric Support, oreCLIPS®.

 

The parties have a mutual obligation underthe terms of the Agreement to negotiate in good faith to resolve the dispute.As a result of the discussions that have taken place to date, Columbia and ColdSpring Harbor have agreed not to terminate the Company’s license under theAgreement earlier than February 22, 2005.

 

The Company does not believe that it hasunderpaid the royalties at issue or that it is in material breach under theagreement, however, management has determined that it is probable that therewill be a cost to settle and resolve this matter with Columbia.  While the Company is in the process ofnegotiating a resolution of this matter, in accordance with FASB Statement No.5, “Accounting for Contingencies” and FASB Interpretation No. 14, “ReasonableEstimation of the Amount of a Loss” the Company has estimated a range of costsfor the probable financial outcomes of this resolution.  Since no amount within this range is a betterestimate than any other amount, the minimum amount of the range has beenaccrued and is included in Sales, General and Administrative expenses in theStatement of Operations.  Managementbelieves that any resolution of the dispute will not have a material adverseeffect on the financial condition of the Company.

 

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

 

Forward-Looking Statements

 

This Quarterly 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 statements include those which express plans,anticipation, intent, contingency, goals, targets or future development and/orotherwise are not statements of historical fact.  These forward-looking statements are based onour current expectations and projections about future events and they aresubject to risks and uncertainties known and unknown which could cause actualresults and developments to differ materially from those expressed or impliedin such statements.  Theseforward-looking statements include statements about the following:

 

•      ourintentions regarding the establishment and continuation of drug discovery collaborationswith leading pharmaceutical and biotechnology organizations;

 

•      ourability to build our pipeline of novel drug candidates, both through thirdparty collaborations and our own internally-funded drug discovery programs;

 

•      ourintentions to build upon our position as a leading chemistry provider;

 

•      ourexpectations regarding the potential benefits to us of the separation of us andAccelrys,  our former parent;

 

•      ouranticipated operating results, financial condition, liquidity and capital resources;

 

•      ourplan to build and capitalize on our extensive database of chemical reactions;

 

•      ourbelief that pharmaceutical companies will continue to outsource chemistryservices at increasing rates;

 

•      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;

 

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•      ourbeliefs as to the trends and opportunities impacting us and our history;

 

•      ourestimates of the market opportunity for our product candidates;

 

•      ourability to raise additional capital;

 

•      ourability to acquire or invest in complementary businesses or technologies, or toin-license potential product candidates;

 

•      thedistribution being tax-free to Accelrys and its stockholders for federal incometax purposes and under section 355 of the Internal Revenue Code of 1986,as amended;

 

•      ourrelationship with Accelrys after the distribution; and

 

•      ourexpectations concerning the composition of our board of directors and executivemanagement group.

 

In some cases, you can identifyforward-looking statements by terminology, such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “seeks,” “estimates,” or the negative of suchterms or other similar expressions. Factors that could cause or contribute to differences in results andoutcomes include, without limitation, those discussed elsewhere in this Reportin Item 2.  “Management’s Discussion andAnalysis of Financial Condition and Results of Operations (including asubsection thereof entitled “Certain Risks Related to Our Business”) anddiscussed in our other Securities and Exchange Commission (“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 areurged not to place undue reliance on any such forward-looking statements, anyof which may turn out to be wrong due to inaccurate assumptions, unknown risks,uncertainties or other factors.  Weundertake no obligation to (and expressly disclaim any such obligation to)revise or update the statements made herein or the risk factors that may relatethereto whether as a result of new information, future events or otherwise.

 

**The Company**

 

**Overview**

 

We are a biopharmaceutical company, focusedon the creation of new small molecule therapeutics to address significant unmetmedical needs.  Small molecule drugcandidates typically are orally available (i.e., may be taken in capsule ortablet form) and offer manufacturing and delivery advantages over other typesof therapeutics.  Using proprietarytechnologies and processes, our experienced scientists identify leads andoptimize them to novel drug candidates through research collaborations withmajor pharmaceutical and biotechnology companies and increasingly through ourown internally-funded drug discovery programs, which are primarily focused onimmunobiology and immunological diseases. Our collection of approximately 7.5 million proprietary compounds, whichwe believe is one of the largest in the pharmaceutical industry based uponpublicly available information from the websites of our major competitors and certainother companies in the pharmaceutical industry, is available for use in ourcollaborative and internal research programs and forms the basis of our growingpipeline of potential drug candidates. Our later stage portfolio currently comprises multiple partneredprograms that have been advanced into human clinical trials by our partners andadditional programs in late-stage pre-clinical development.  Additionally, we have approximately 40partnered and internal programs in discovery,which we believe will sustain the Company’s clinical portfolio in the future.

 

We have drug discovery collaborations withleading pharmaceutical companies and emerging biotechnology companies.  Our contributions to our partners’ drugdiscovery programs include:  the provisionof large, diverse libraries of proprietary drug-like chemical compounds fromwhich potential therapeutic candidates can be identified; our high throughputand ultra high throughput screening of these compounds against moleculartargets of interest provided by the partner in which we test a disease-relatedtarget against tens of thousands (with respect to high throughput) or tohundreds of thousands (with respect to ultra high throughput) of our potentialsmall molecule therapeutic compounds per week; our optimization of activecompounds identified in the screening process, in which we refine the molecularstructure of the lead compounds in an attempt to improve their efficacy,potency and safety; our provision of medicinal chemistry capabilities through whichour scientists design, synthesize (i.e., physically make in our laboratories)and optimize those lead compounds that we or our collaborators believe arepotential drug candidates; and our delivery of other expertise such aspharmacology traditionally performed by research divisions withinpharmaceutical and biotechnology companies. Our collaborative agreements typically require our customers to fund ourresearch, and provide for our receipt of significant milestone payments if andas our discoveries progress through the development process.  Thereafter, should any of these drugcandidates become pharmaceutical products we typically would be entitled toreceive royalty payments calculated as a percentage of the net sales

 

 

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of the products.  Our business is highly dependent upon theextent to which the pharmaceutical and biotechnology companies collaborate withoutside companies for drug discovery expertise. The willingness of pharmaceutical and biotechnology companies to expandor continue drug discovery collaborations or outsource services to enhancetheir research and development activities are based on certain factors that arebeyond our control.  There can be noassurance that our existing collaborative relationships will continue, that wewill develop new relationships with similar large organizations on termsfavorable to us, that any of our existing or new alliances will producesubstantial revenue or profit opportunities, or that the scientific outcomes ofany of these programs will be successful.

 

In addition to collaborative drug discovery,we conduct proprietary research to discover new drug-like lead compounds withcommercial potential.  Unlike our typicalcollaborative partnerships, we provide the required funding for theseprograms.  As we do not receive fundingfrom third party collaborators with respect to these proprietary programs, weretain all intellectual property and ownership rights in any compoundsdiscovered.  At an appropriate point, wemay determine to license one or more of these compounds to a third party(usually a larger pharmaceutical organization). Licensing at this point in the compound’s development enables us to takeadvantage of the additional resources, expertise and technologies of thelicensee company in order to further the development of the compound.  We enter into such licenses with thirdparties in return for up-front fees and milestone payments, as well asrecurring royalty payments if these compounds are developed into new commercialdrugs.  These agreements convert ourproprietary programs into collaborative partnerships, typically at a moreadvanced state of the drug development process.

 

Our drug discovery efforts have produced fourclinical candidates so far.  Our firstcandidate, a p38 MAP kinase inhibitor for rheumatoid arthritis developed incollaboration with Bristol-Myers Squibb Company, commenced clinical trials inAugust 2003.  This potential newdrug, a small molecule optimized from our proprietary compound collection (andthe product of one of our internal development programs), currently is in PhaseI of clinical testing.  A second of ourproprietary internal compounds targets an allergic asthma indication andcommenced clinical trials in November 2003.  This clinical candidate is a product of ourcollaboration with Daiichi Pharmaceutical Co. Our third candidate, a compound targeting a respiratory indicationdeveloped in collaboration with Schering-Plough Corporation, commenced clinicaltrials in December 2003.  TheSchering-Plough relationship produced a second clinical candidate, which is ourfourth clinical candidate, in March 2004, when Schering-Plough initiatedclinical trials for an inflammation indication with respect to another compounddiscovered in the collaboration.  We havereceived significant milestone payments from each of Bristol-Myers Squibb,Daiichi and Schering-Plough and, to the extent the compounds progress throughclinical development, we will be entitled to receive additional milestonepayments.  We are also entitled under theagreements with each of these partners to receive royalties on the commercialsale, if any, of a new drug emanating from the relationship.  Although these collaborators currently areperforming clinical trials of prospective pharmaceutical products containingour proprietary compounds, numerous additional studies will be necessary tosupport the further development of these product candidates.  Results from preclinical studies conducted todate on these product candidates are not necessarily indicative of the resultsthat may be obtained in future clinical studies.  There can be no assurance that thesecollaborators will continue these programs.

 

In addition, we are involved in over 40 otherdrug development programs in the preclinical stage, some with collaborativepartners and others within our internal discovery program.  Three of these programs are at various stagesof the Good Laboratory Practice (GLP) Toxicity evaluation, the point at whichcompounds are tested for safety prior to Investigational New Drug applicationfiling and their introduction into humans during Phase I of clinicaldevelopment.  Approximately half of theseprograms are in various phases of preclinical research, from advanced stages oflead optimization to “hit-to-lead” studies. The remaining programs are in early stages, including development ofbiological assays for testing of compounds and the screening of our proprietarylibraries against selected disease targets. In our collaborative programs we typically hold a financial interest inany active compounds that we identify through our screening and any drugcandidate(s) that we help to optimize. In our proprietary programs, we hold all rights to the compounds untilwe choose to enter into partnership arrangements with pharmaceutical companies.

 

Preclinical and clinical development of drugcandidates is a long, expensive and uncertain process.  Our candidates are at an early stage, as noneof our compounds are contained in products that have received regulatoryapproval for commercial sale.  All of ourcompounds, including our clinical candidates, face the substantial risks offailure inherent in developing drugs.  Atany stage of the clinical development process, our collaborators or we maydecide to discontinue development of our product candidates.  We do not expect that our product candidateswill be commercially available for many years, if ever.  In addition, we pursue the discovery andinitial development of product candidates using our integrated technologyplatform in both our internal and collaborative programs to implement ourstrategy of reducing the cost and time incurred by the pharmaceutical industryin developing drug candidates.  To date,we have not identified a therapeutic candidate that has been developed into acommercial drug and, although we have received license and milestone fees, wemay never receive any royalty payments, or any additional license and milestonefees, under our current or any future collaborations.

 

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On April 30, 2004, Accelrys (formerlyPharmacopeia, Inc.), then our sole stockholder, distributed all outstandingshares of our common stock to the holders of common stock of Accelrys.  We thereafter began operations as anindependent, separately traded and publicly held company.  The distribution was made without payment ofany consideration or the exchange of any shares by Accelrys stockholders.  In the distribution, Accelrys stockholdersreceived one share of our common stock for every two shares of Accelrys commonstock held of record.  The stock tradedas when issued from April 20, 2004 through April 30, 2004 and began regulartrading on The NASDAQ National Market on May 3, 2004 under the trading symbol“PCOP.”

 

On August 23, 2004, Columbia UniversityScience and Technology Ventures (“Columbia”) provided us with a notice ofmaterial breach of the License Agreement, dated July 16, 1993 and as amendedOctober 6, 1995, among us, the Trustees of Columbia University in the City ofNew York and Cold Spring Harbor Laboratory (the “Agreement”) arising from analleged underpayment by us of certain royalties under the Agreement. Incorrespondence initiated by Columbia, the amount of the alleged underpayment hasbeen estimated to be at least $1.12 million for the period from July 1, 2001through June 30, 2003. We do not believe that we have underpaid the royaltiesat issue or that we are in material breach under the Agreement. The Agreementcovers our core tagging technology used in our proprietary combinatorialchemistry encoding technology, Encoded Combinatorial Libraries on PolymericSupport, or eCLIPS®.

 

The parties have a mutual obligation underthe terms of the Agreement to negotiate in good faith to resolve the dispute.As a result of the discussions that have taken place to date, Columbia and ColdSpring Harbor have agreed not to terminate our license under the Agreementearlier than February 22, 2005.

 

We do not believe that we have underpaid theroyalties at issue or that we are in material breach under the agreement,however, management has determined that there will be a cost to settle andresolve this matter with Columbia.  Whilewe are in the process of negotiating a resolution of this matter, in accordancewith FASB Statement No. 5, “Accounting for Contingencies” and FASBInterpretation No. 14, “Reasonable Estimation of the Amount of a Loss” we haveestimated a range of costs for the probable financial outcomes of thisresolution.  Since no amount within thisrange is a better estimate than any other amount, the minimum amount of therange has been accrued and is included in Sales, General and Administrativeexpenses in the Statement of Operations. We believe that any resolution of the dispute will not have a materialadverse effect on our financial condition.

 

**Liquidity and Capital Resources**

 

 Prior to the distribution we had funded ouractivities primarily through Accelrys’s consolidated operations, includingrevenue derived from collaborative partnerships, and milestone payments.Accelrys contributed an amount of cash, cash equivalents and marketablesecurities such that upon consummation of the distribution on April 30, 2004,we had a cash, cash equivalents and marketable securities balance aggregating$46.5 million.

 

In connection with thedistribution, Accelrys and we entered into a transition services agreement thatprovides that Accelrys will make available a sum of $1 million to be held as a“Services Fund” in a segregated account, in trust for the benefit of us andAccelrys.  We may use the Services Fundtowards securing any service Accelrys agrees to provide under the transitionservices agreement if we and Accelrys cannot resolve any dispute relating to theperformance or nonperformance of such service by Accelrys after good faithnegotiations. We will also use a portion of the Services Fund to acquire afinancial system appropriate for our business and are entitled to use a portionof the Services Fund to update our corporate website and to acquire or licensecertain software packages appropriate for supporting the internal operations ofour business. The amount remaining in the Services Fund, less applicabledeductions, will be remitted to Accelrys. The $1 million available under the Services Fund is notincluded in our cash and cash equivalents balance as of September 30, 2004.

 

Accelrysmade a capital contribution to us of $750 thousand in relation to costs,expenses and fees associated with the consolidation of our facilities.

 

Asof September 30, 2004, we had cash, cash equivalents and marketable securitiesof $40.4 million compared to $524 thousand at December 31, 2003,representing 74% and 5% of our total assets, respectively. We invest excesscash in highly liquid investment-grade marketable securities, includingcorporate bonds and United States government and agency securities.

 

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Thefollowing is a summary of selected cash flow information for the nine monthsended September 30, 2004 and 2003:

** **
| ** **                                           | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net loss                                             |       | $                                    | (16,293    | ) | $ | (2,019 | ) |
| Adjustments for noncash operating items              |       | 1,520                                |       | 1,291 |   |
|                                                 |       |                                 |       |   |   |
| Net cash operating loss                              |       | (14,773                              | )          | (728 | ) |
| Net change in assets and liabilities                 |       | 4,914                                |       | (4,818 | ) |
|                                                 |       |                                 |       |   |   |
| Net cash used in operating activities                |       | $                                    | (9,859     | ) | $ | (5,546 | ) |
|                                                 |       |                                 |       |   |   |
| Net cash provided by (used in) investing  activities |       | $                                    | 8,686      |   | $ | (663 | ) |
|                                                 |       |                                 |       |   |   |
| Net cash provided by financing activities            |       | $                                    | 14,270     |   | $ | 1,657 |   |

 

**Net cash used in operating activities**

 

Netoperating cash outflows for the nine months ended September 30, 2004 haveresulted primarily from our operating loss due to our decrease in revenue andour increase in the funding of our internal drug discovery efforts.

 

**Net cash provided by investing activities**

 

Cashprovided by investing activities for the nine months ended September 30, 2004relates primarily to the sales and maturities of marketable securitiespartially offset by expenditures for leasehold improvements undertaken in connectionwith the consolidation of our facilities to one location.

 

**Net cash provided by financing activities**

 

Netcash provided by financing activities for the nine months ended September 30,2004 consists of the capital contribution made to us by Accelrys upon thedistribution and proceeds from the issuance of common stock in connection withour employee stock option and employee stock purchase plans.

 

**Liquidity and Capital Resources Outlook**

 

Weexpect to continue to use our capital to fund operating losses. We expect thatour research and development expenditures will increase in the future as weincrease our internal drug discovery efforts to add to our pipeline ofprograms.  Conducting our own drugdiscovery research is a key component of our business model.

 

Inaddition, our capitalrequirements may increase in future periods as we seek to expand our technologyplatform through investments, licensing arrangements, technology alliances, oracquisitions.

 

We are obligated to pay approximately $3.9million in costs in connection with a facility we exited in the first quarterof 2004. The lease on this facility expires in April 2006.

 

We anticipate that our capital resources will beadequate to fund our operations at least through 2005. However, there can be no assurance that changes will not occur thatwould consume available capital resources before then. Our capital requirementsdepend on numerous factors, including our ability to continue and extendexisting agreements and to enter into additional arrangements.  Approximately 62% and 16% of our revenue forthe nine months ended September 30, 2004 was generated from our collaborationswith Schering Plough and N.V. Organon, respectively.  The collaborations with Schering Plough arescheduled to expire in 2006.  Theprincipal agreement with N.V. Organon is scheduled to expire in 2007.  Under certain circumstances funding fromthese collaborations may be reduced significantly before these agreementsexpire.  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 customers’ 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 assurance

 

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that additional funding, ifnecessary, will be available on favorable terms, if at all.  Our forecasts of the period of time throughwhich our financial resources will be adequate to support our operations areforward-looking information, and actual results could vary.  The factors described earlier in this paragraphwill impact our future capital requirements and the adequacy of our availablefunds.

 

**Results ofOperations**

 

**Threemonths ended September 30, 2004 and 2003**

 

Our revenue decreased14% to $6.4 million in the quarter ended September 30, 2004 compared to $7.4million in the quarter ended September 30, 2003.  The decrease was primarily due to a decreasein lead optimization revenue due to the expiration of one of our collaborationswith N.V. Organon, no revenue being recognized from our screening servicesactivities with Novartis, and reduced revenue from our collaborations withSchering-Plough. Revenue from our collaborations with Celgene and Altanapartially offset the decrease in revenue.  Milestone revenue of $1.5 million was recorded in the quarter endedSeptember 30, 2004 compared to $1.3 million recorded in the quarter endedSeptember 30, 2003.

######  

Cost of revenueincludes the labor, material, equipment and allocated facilities cost of ourscientific staff who are working on collaborative partnerships. Gross margindecreased to $1.1 million in the quarter ended September 30, 2004 from $1.9million in the quarter ended September 30, 2003.  Gross margin as a percentage of revenue was18% for the quarter ended September 30, 2004, compared to 25% of revenue in thequarter ended September 30, 2003.  Thegross margin decreased substantially due to the decrease in service revenue,which resulted in the under-absorption of fixed costs allocated tocollaborative partnerships.

 

Research anddevelopment expenses include labor, material, equipment and allocatedfacilities cost of scientific staff working on

unfunded internal drugdiscovery projects. Internal drug discovery projects are focused on thecreation of new small molecule

therapeutics usingproprietary technologies and our collection of 7.5 million proprietarycompounds to identify and optimize novel

drug candidates.Because of the speculative nature of these internal drug discovery projects, itis not possible to estimate completion dates, or estimated costs of completion.Additionally, from time to time, depending on requirements under collaborativepartnership work, certain staff and other research and development resourcesmay be temporarily redirected to collaborative partnership work which redirectionmay also delay or impact the cost of internal drug discovery projects.Consistent with our strategy, research and development expenses increased 102%to $1.6 million in the quarter ended September 30, 2004 compared to $800thousand in the quarter ended September 30, 2003.

 

Sales, general andadministrative expenses increased by 72% to $2.6 million in the quarter endedSeptember 30, 2004 compared to $1.5 million in the quarter ended September 30,2003.  The increase in sales, general andadministrative expenses is primarily attributable to additional costsassociated with our being an independent company, including salary and expensesfor executive management, finance, legal, human resources, informationservices, investor relations, and corporate governance. Prior to thedistribution, general corporate overhead had been allocated had based on ourrevenue as a percentage of Accelrys’ s total revenue.  The increase in sales, general andadministrative expenses is also attributable to the recording of an accrual forthe minimum cost estimated by management to resolve our dispute with Columbia.

 

Interest and other income net increased to$166 thousand in the three months ended September 30, 2004 compared to $3thousand in the three months ended September 30, 2003.  This increase is due to significantly highercash, cash equivalents and marketable securities balances due to the capitalcontribution from Accelrys at the time of the distribution.

 

We recorded an incometax provision for the quarter ended September 30, 2004 related to state incomeand corporate franchise taxes.

 

As a result of therevenues and costs described above, we generated a net loss of $2.9 million($0.24 per diluted share) in the quarter ended September 30, 2004 compared to anet loss of $400 thousand ($0.03 per diluted share) in the quarter endedSeptember 30, 2003.

** **

**Ninemonths ended September 30, 2004 and 2003**

 

Our revenue decreased23% to $16.9 million in the nine months ended September 30, 2004 compared to$22.0 million in the nine months ended September 30, 2003.  The decrease was primarily due to a decreasein milestone revenue, a decrease in lead optimization revenue due to theexpiration of one of our collaborations with N.V. Organon, the significantreduction in our screening services activities with Novartis, and reducedrevenue from our collaborations with Schering-Plough. Revenue from ourcollaborations with Celgene, Taiho, Neurocrine, and Altana partially offset thedecrease in revenue.  Milestone revenuerecorded in the nine months ended September 30, 2004 and 2003 was $2.5 million,and $2.8 million, respectively. Excluding the revenue from milestones, revenue decreased 25% to $14.4million in the nine months ended September 30, 2004 compared to $19.2 millionin the nine months ended September 30, 2003.

 

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Cost of revenueincludes the labor, material, equipment and allocated facilities cost of ourscientific staff that are working on collaborative partnerships. Gross margindecreased to $1.1 million in the nine months ended September 30, 2004 from $5.3million in the nine months ended September 30, 2003.  Gross margin as a percentage of revenue was6% for the nine months ended September 30, 2004, compared to 24% of revenue inthe nine months ended September 30, 2003. The gross margin decreased substantially due to the decrease inmilestone revenue, which carries no significant associated cost of revenue, andthe decrease in service revenue resulting in the under-absorption of fixed costsallocated to collaborative partnerships.

 

Research anddevelopment expenses include labor, material, equipment and allocatedfacilities cost of scientific staff working on unfunded internal drug discoveryprojects. Our internal drug discovery projects are focused on the creation ofnew small molecule therapeutics using proprietary technologies and ourcollection of proprietary compounds to identify and optimize novel drugcandidates. Because of the speculative nature of these internal drug discoveryprojects, it is not possible to estimate completion dates, or estimated costsof completion. Additionally, from time to time, depending on requirements undercollaborative partnership work, certain staff and other research anddevelopment resources may be temporarily redirected to collaborativepartnership work which redirection may also delay or impact the cost ofinternal drug discovery projects. Consistent with our strategy, research anddevelopment expenses increased 59% to $4.3 million in the nine months endedSeptember 30, 2004 compared to $2.7 million in the nine months ended September30, 2003.

 

Sales, general andadministrative expenses increased by 63% to $7.3 million in the nine monthsended September 30, 2004 compared to $4.5 million in the nine months endedSeptember 30, 2003.  The increase insales, general and administrative expenses is primarily attributable toadditional costs associated with our being an independent company, includingsalary and expenses for executive management, finance, legal, human resources,information services, investor relations, and corporate governance. Prior tothe distribution, general corporate overhead had been allocated based on ourrevenue as a percentage of Accelrys’ s total revenue. The increase in sales,general and administrative is also due to moving costs incurred in theconsolidation of our research and development facilities and the recording ofan accrual for the minimum cost estimated by management to resolve our disputewith Columbia.

 

During the nine monthsended September 30, 2004, we undertook a restructuring and certain otheractions.  Accordingly, restructuring andother charges of $5.9 million were incurred. The chargeincluded severance payments, the cost to exit a leased facility, and theacceleration of a deferred compensation charge.

 

Interest and other income net increased to$225 thousand in the nine months ended September 30, 2004 compared to $16thousand in the nine months ended September 30, 2003.  This increase is due to significantly highercash, cash equivalents and marketable securities balances due to the capitalcontribution from Accelrys at the time of the distribution.

 

We recorded an incometax provision for the nine months ended September 30, 2004 related to stateincome and corporate franchise taxes. The provision for the nine months endedSeptember 30, 2003 included foreign taxes, as well as corporate franchisetaxes.

 

As a result of therevenues and costs described above, we generated a net loss of $16.3 million($1.34 per diluted share) in the nine months ended September 30, 2004, comparedto a net loss of $2.0 million ($0.17 per diluted share) in the nine monthsended September 30, 2003.

 

**Net Loss Outlook**

 

We have had net lossesin recent years and we expect to incur losses in future periods. We are highlydependent on the success of our research and development programs with ourexisting collaborators and our ability to successfully, cost effectively andtimely develop, introduce and market new collaborative arrangements. On a quarterlybasis, our future operating results are likely to be highly volatile because itdepends upon our receipt of milestone payments from our collaborators. We maynot receive milestone payments on a regular basis or at all. In addition, ourability to achieve profitability will be significantly impacted by theincreased level of investment we have determined to make in our internalproprietary programs in the future as well as the results of those programs. Webelieve that we may incur higher sales, general, and administrative costs thanthe historical amounts reflected in the financial statements since we are nowoperating as an independent public company. There is no assurance that we willever achieve profitable operations, or that profitable operations, if achieved,could be sustained on a continuing basis.

 

**CriticalAccounting Policies**

 

The preparation of our financial statementsand disclosures involve the use of judgments and estimates. We believe thefollowing critical accounting policies involve significant judgments andestimates used.

 

*RevenueRecognition*-Contractrevenue is recognized either (i) ratably over the term of the agreement, whichapproximates the performance of services, for contracts specifying payment forservices over a given period, or (ii) as services are performed under theagreement for contracts specifying payment on a full-time employee basis.

 

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Revenue earned related to up-front productand technology license fees is recognized in accordance with Staff AccountingBulletin 104 issued by the SEC. Accordingly, amounts received undermultiple-element arrangements requiring ongoing services or performance by usare recognized over the period of such services or performance.

 

Revenue from milestones are recognized whenearned, as evidenced by written acknowledgement from the collaborator, providedthat (i) the milestone event is substantive and its achievability was notreasonably assured at the inception of the agreement, and (ii) our performanceobligation after the milestone achievement will continue to be funded by thecollaborator at a comparable level to before the milestone achievement. If bothof these criteria are not met, the milestone payment is recognized over theremaining minimum period of our performance obligations under the arrangement.Royalties are recognized as earned in accordance with the terms of variousresearch and collaboration agreements.

 

*Long-LivedAssets-*We reviewlong-lived assets, including leasehold improvements, property and equipment,and acquired technology rights, for impairment whenever events or changes inbusiness circumstances indicate that the carrying amount of the assets may notbe fully recoverable. This requires us to estimate future cash flows related tothese assets. Actual results could differ from these estimates, which mayaffect the carrying amount of assets and the actual amortization expense. As ofSeptember 30, 2004, we had long-lived assets with a net book value of $11.3million.

 

**Certain RisksRelated to Our Business**

 

As further described herein, our performanceand financial results are subject to risks and uncertainties including, but notlimited to, the following specific risks:

 

**RISKS RELATED TOESTABLISHING OUR COMPANY AS INDEPENDENT FROM ACCELRYS**

 

***We have no current history of operating asan independent company.***

 

Although Accelrys, Inc. was operatedexclusively as a chemistry-based collaborative drug discovery business prior toits acquisition of its software business, our management team has not recentlyoperated our company as a public, stand-alone company, and we have a new boardof directors appointed by Accelrys, most of whom previously served on the boardof directors of Accelrys prior to the distribution. Our ability to satisfy ourobligations and increase revenues will be solely dependent upon the futureperformance of the businesses we own and operate, and we will not be able torely upon the financial and other resources and cash flows of those businesslines remaining with Accelrys.  Since wedo not have an operating history as a separate entity, it will be difficult foranyone to accurately forecast our future revenue and other operating results.

 

***Our historical financial information maynot be representative of our results as a separate company.***

 

The historical financial information includedin this report differs from the results of operations, financial condition andcash flows that would have been achieved had we been operated independentlyduring the period and as of the dates presented.  Prior to the distribution, our businesseswere operated by Accelrys as part of its broader corporate organization ratherthan as a stand-alone company. Historically, Accelrys performed certain corporate functions for us,including legal services, treasury administration, insurance administration,internal audit and corporate income tax administration.  Now that the distribution is complete,Accelrys will not provide assistance to us, other than to provide variouscorporate support, information systems and human resources services during atransition period.

 

We are in the process of creating our own, orengaging third parties to provide, corporate administrative functions toreplace many of the corporate administrative functions Accelrys provided priorto the distribution.  We may incur costsfor these functions that are higher than the amounts reflected in ourhistorical financial information.

 

Our historical financial information containsassumptions about our expenses that may change, such as:

 

•      ourhistorical financial information reflects allocations, primarily with respectto corporate overhead, for services provided to us by Accelrys which may notreflect the actual costs we will incur for similar services as a stand-alone company;and

 

•      ourhistorical financial information does not reflect changes that we expect tooccur in the future as a result of our separation from Accelrys, includingchanges in how we fund our operations as well as tax and employee matters.

 

Although we believe that our historicalfinancial statements allocate to us a reasonable share of such expenses, wecannot assure you that our actual costs will not increase, perhapssubstantially.  We also are nowresponsible for the additional costs associated with being an independentpublic company, including costs related to corporate governance, listed andregistered securities and investor relations matters.

 

Accordingly, to the extent that ourhistorical financial information is not reflective of what our results ofoperations, financial condition and cash flows would have been had we been anindependent company during the periods presented, that historical financialinformation will not

 

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be a reliable indicator of what our resultsof operations, financial condition and cash flows will be in the future.  Therefore, you should not make anyassumptions regarding our future performance based on the historical financialinformation in this report.

 

***Our stock price may be volatile, and yourinvestment in our stock could decline in value.***

 

The market price for our common stock hasbeen highly volatile and may continue to be highly volatile in the future.  During quarter ended September 30, 2004 theclosing price was $4.72 per share at its low point in September 2004 and $6.23per share at its high point in July 2004. Our quarterly operating results, changes in general conditions in theeconomy or the financial markets, and other developments affecting ourcompetitors or us could cause the market price of our common stock to fluctuatesubstantially.  In recent years, thestock market has experienced significant price and volume fluctuations.

 

While we are unaware of a specific reasonthat any of the following factors will have a material impact on our stockprice, the following factors, in addition to the factors described in the otherrisk factors contained in this report, may have a significant impact on themarket price of our common stock:

 

•      announcementsof technological innovations or new commercial products by our competitors orus;

 

•      announcementsby us or our competitors of significant acquisitions, strategic partnerships orjoint ventures;

 

•      developmentsconcerning proprietary rights, including patents;

 

•      publicityconcerning the status of potential drug products under development by us or ourcollaborators or our competitors and their partners;

 

•      litigation;

 

•      economicand other external factors or other disasters or crises;

 

•      actualor anticipated period-to-period fluctuations in our financial results;

 

•      changesin financial estimates prepared by securities analysts; and

 

•      thegeneral performance of the equity markets and, in particular, thebiopharmaceutical sector of the equity markets.

 

***We have agreed to certain restrictions topreserve the tax treatment of the distribution, which will reduce our strategicand operating flexibility.***

 

Accelrys obtained an opinion from DechertLLP, its counsel, to the effect that the distribution qualifies as a transactionthat is generally tax-free under Sections 355 and/or 368(a)(1)(D) of theInternal Revenue Code of 1986, as amended (the “Code”). Current tax lawgenerally creates a presumption that the distribution would be taxable toAccelrys but not to its stockholders if we engage in, or enter into anagreement to engage in, a transaction that would result in a 50 percent orgreater change by vote or by value in our stock ownership during the four-yearperiod beginning on the date that begins two years before the distributiondate, unless it is established that the transaction is not pursuant to a planor series of transactions related to the distribution.

 

Temporary U.S. Treasury regulations currentlyin effect generally provide that whether an acquisition transaction and adistribution are part of a plan is determined based on all of the facts andcircumstances, including but not limited to those specific factors listed inthe regulations. In addition, the regulations provide several “safe harbors”for acquisition transactions that are not considered to be part of a plan.

 

We and Accelrys have entered into a taxsharing agreement under which we have made certain covenants to each other inconnection with the distribution that we may not take certain actions without firstobtaining an unqualified opinion of counsel or an Internal Revenue Serviceruling that such actions will not cause the distribution to becometaxable.  Pursuant to these covenants,generally (1) we may not liquidate, merge, or consolidate with any otherperson, sell our assets except in the ordinary course of business, or enterinto any substantial negotiations, agreements, or arrangements with respect toany such transaction, for at least six months after the distribution date; (2)we will, for two years after the distribution date, continue the active conductof the drug discovery business; (3) we will not repurchase our stock except incertain circumstances permitted by the Internal Revenue Service; (4) we willnot take any actions inconsistent with the representations made in connectionwith the issuance by Dechert LLP of its opinion with respect to thedistribution; and (5) we will not take or fail to take any other action thatwould result in any tax being imposed on the distribution.  Accelrys may seek an injunction to enforcethese covenants.  Particularly during thesix-month period following the distribution, these restrictions couldsubstantially limit our strategic and operational flexibility, including ourability to finance our operations by

 

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issuing equity securities, to makeacquisitions using equity securities, to repurchase our equity securities, toraise money by selling assets, or to enter into business combinationtransactions.

 

***We have agreed to indemnify Accelrys fortaxes and related losses resulting from any actions we take that cause thedistribution to fail to qualify as a tax-free transaction.***

 

We have agreed to indemnify Accelrys for anytaxes and related losses (including any applicable interest and penalties, allrelated accounting, legal and other professional fees, all related court costsand all costs, expenses and damages associated with related stockholderlitigation or controversies and any amount paid in respect of the liability ofstockholders) resulting from a breach of any of the covenants describedabove.  Furthermore, we will beresponsible for taxes that may be imposed upon Accelrys pursuant tosection 355(e) of the Code in connection with a transaction that resultsin a change in control of us, even though we will have obtained an InternalRevenue Service ruling or an unqualified opinion of counsel prior to thetransaction.  The amount of anyindemnification payments could be substantial. The amount of Accelrys taxes for which we are agreeing to indemnifyAccelrys will be based on the excess of the aggregate fair market value of ourstock as of the distribution date over Accelrys tax basis in our stock.

 

***We may be required to indemnify Accelrys,or may not be able to collect on indemnification rights from Accelrys***

 

Under the terms of the master separation anddistribution agreement and the tax sharing and indemnification agreement thatwe entered into with Accelrys, we and Accelrys agreed to indemnify one anotherfrom and after the distribution with respect to the indebtedness, liabilitiesand obligations retained by our respective companies.  These indemnification obligations could besignificant.  Our ability to satisfy anysuch indemnification obligations will depend upon the future financial strengthof our company.  We cannot determinewhether we will have to indemnify Accelrys for any substantialobligations.  We also cannot assure youthat, if Accelrys becomes obligated to indemnify us for any substantial obligations,Accelrys will have the ability to satisfy those obligations.  Any payment by Accelrys or us pursuant tothese indemnification provisions could have a material adverse effect on itsbusiness.  Any failure by Accelrys or usto satisfy its indemnification obligations could have a material adverse effecton the other company’s business.

 

***We will need to obtain financing on astand-alone basis, which may be difficult because our financial and otherresources may not be as strong as those of Accelrys prior to the distribution.***

 

Historically, all of our financing was doneby Accelrys at the parent level. We anticipate that our capital resources,including our existing cash, cash equivalents and marketable securities as ofSeptember 30, 2004 of approximately $40.4 million, will be adequate to fund ouroperations at least through 2005.  Anyfuture financing that we need to obtain will have to be raised on a stand-alonebasis without reference to or reliance on Accelrys’ financial condition andwill be based upon our balance sheet.  Inaddition, we may be required to agree to abide by restrictive covenants thatmay limit our ability to do business as a condition to securing debt or equityfinancing.  We may not be able to secureadequate debt or equity financing on desirable terms or at all.  We have less financial and other resourcesthan Accelrys had prior to the distribution. Our ability to obtain financing, and the terms thereof, will in largepart depend on our financial condition and performance.  There can be no assurance that we will beable to obtain financing.  The cost to usof stand-alone financing may be materially higher than the cost of financingthat we incurred as part of Accelrys.

 

**RISKSRELATED TO OUR BUSINESS AND INDUSTRY**

 

***Our business is highly dependent upon theextent to which the pharmaceutical and biotechnology industries collaboratewith drug discovery companies for one or more aspects of their drug discoveryprocess.***

 

We are highly dependent on pharmaceutical andbiotechnology companies continuing to collaborate with outside companies toobtain drug discovery expertise. Our revenue depends to a large extent onresearch and development expenditures by the pharmaceutical and biotechnologyindustries, particularly companies outsourcing research and developmentprojects and adding new and improved technologies to accelerate their drugdiscovery and development initiatives. Our capabilities include aspects of thedrug discovery process that pharmaceutical companies have traditionallyperformed internally. Although there is a history among pharmaceutical andbiotechnology companies of outsourcing drug research and development functions,this practice may not continue.

 

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The willingness of these companies to expandor continue drug discovery collaborations or outsourcing of services to enhancetheir research and development activities is based on certain factors that arebeyond our control. While we are unaware of a specific reason that any of the followingfactors will have a material impact on the willingness of current or potentialcollaborators to expand or continue drug discovery collaborations, examples ofrelevant factors include collaborators’ spending priorities among various typesof research activities, their ability to hire and retain qualified scientists,their approach regarding expenditures during recessionary periods and theirpolicies regarding the balance of research expenditures versus costcontainment. Also, general economic downturns in our customers’ industries orany decrease in our customers’ research and development expenditures could harmour operations, as could increased popularity of management theories, whichcounsel against outsourcing of critical business functions. Continuedconsolidation in the pharmaceutical and biotechnology industries may furtherdecrease the number of potential customers. In addition, the popularity ofscientific thinking that disfavors expensive products, such as large diverselibraries could negatively impact our revenue or our sales mix. Any decrease indrug discovery spending by pharmaceutical and biotechnology companies couldcause our revenue to decline and adversely impact our profitability.

 

Our ability to convince these companies touse our drug discovery technology and capabilities rather than develop theminternally will depend on many factors, including our ability to:

 

•      developdrug discovery technologies that will result in the identification ofhigher-quality drug candidates;

 

•      providescientists and technologies that are of the highest caliber; and

 

•      achieveintended results in a timely fashion, with acceptable quality and at anacceptable cost.

 

The importance of these factors varies fromcollaborator to collaborator, and we may be unable to meet any or all of themfor some or all of our collaborators in the future.

 

***Our revenue is highly concentrated in ourlargest collaborators and the termination of our collaboration with any ofthese collaborators would have a material adverse effect on our business,financial condition and results of operations.***

 

During the nine months ended September 30,2004, we earned approximately $10.5 million, or 62% of our revenue, under ourresearch collaboration agreements with Schering-Plough, one of ourlongest-standing collaborative partners. In the third quarter of 2003, weentered into new multiyear drug discovery collaboration agreements withSchering-Plough, which continue certain existing programs and implement anumber of new activities. The new agreements continue our collaboration withthis partner through at least August 2006 and, under their terms, may beextended by the parties for up to three additional years based upon progressmade in the programs governed by the agreements. The agreements may beterminated in August 2006. The agreements provide that Schering-Plough’sfunding obligations may be reduced significantly before that time. There can beno assurance that the results of our collaboration with Schering-Plough will besufficient to cause Schering-Plough not to exercise its rights to terminate theagreements, or not to exercise its rights to reduce its funding obligations. Inlight of the significance to us of the Schering-Plough relationship, thetermination of our collaboration agreements or the reduction in funding fromthe agreements would have a material adverse effect on us.

 

During the nine months ended September 30,2004, we earned approximately $2.7 million, or 16% of our revenue, under ourresearch collaboration agreements with N.V. Organon, our second largestcustomer. The principal agreement with N.V. Organon, entered into inFebruary 2002, has a stated term of five years; however, N. V. Organon hasthe right to terminate the agreement if we are unable to deliver compounds meetingthe criteria specified in the agreement. We have already delivered the firstsuch compound required under this agreement to N.V. Organon. A seconddeliverable timepoint occurs in 2005. If we are unable to deliver compoundsmeeting the criteria specified in the agreement, Organon has the right toterminate the agreement. There can be no assurance that these compounds will becompliant, or that the future compliant compounds will be delivered before theenumerated dates. The termination of this agreement would have a materialadverse effect on us because of the resulting decrease in our revenue.

 

During the year ended December 31, 2003,we earned approximately $3.4 million, or 11.4% of our revenue, under ourresearch collaboration agreements with Novartis AG, our third largest customerin that year. We have completed all of the required services under our Novartisagreements.   Although the agreement wasextended by Novartis in 2004 we have not yet initiated additional revenuegenerating activities.  In addition, wehave received all compensation with regard to collaborative services underthese agreements. If we are unable to enter into agreements with othercollaborators, there could be a material adverse effect on us because of theresulting decrease in our revenue.

 

***If our collaborators are not able tosuccessfully develop our existing clinical candidates, our business will beharmed.***

 

Our collaborators, Bristol-Myers SquibbCompany, Daiichi Pharmaceutical Co. and Schering-Plough Corporation, currentlyare performing clinical trials of prospective pharmaceutical productscontaining our proprietary compounds. In each case, the collaborator isresponsible for the development of these potential products, the level ofresources devoted to such development and the decision as to when, or whether,

 

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such development should cease. Numerousadditional studies are necessary to support the further development of theseproduct candidates. Results from preclinical studies conducted to date on theseproduct candidates are not necessarily indicative of the results that may beobtained in clinical studies. Results from additional studies could cause ourcollaborators to discontinue or limit development of these product candidates.There can be no assurance that Bristol-Myers Squibb, Daiichi or Schering-Ploughwill continue to develop these programs. In addition, our collaborators maypursue alternative technologies or drug candidates, either on their own or incollaboration with others, that compete with our clinical candidates. If ourcollaborators do not continue their development efforts or if such efforts donot result in positive clinical results, we will not receive additionalmilestone and royalty payments from those efforts, and the market price of ourcommon stock will be materially and adversely affected.

 

***We have been alleged to be in materialbreach of the license agreement covering our core tagging technology used ineCLIPS®, our proprietary combinatorial chemistry encoding technology***.

 

On August 23, 2004, Columbia UniversityScience and Technology Ventures (“Columbia”) provided us with a notice ofmaterial breach of the License Agreement, dated July 16, 1993 and as amendedOctober 6, 1995, among us, the Trustees of Columbia University in the City ofNew York and Cold Spring Harbor Laboratory (the “Agreement”) arising from analleged underpayment by us of certain royalties under the Agreement. Incorrespondence initiated by Columbia, the amount of the alleged underpaymenthas been estimated to be at least $1.12 million for the period from July 1,2001 through June 30, 2003. We do not believe that we have underpaid theroyalties at issue or that we are in material breach under the Agreement. TheAgreement covers our core tagging technology used in our proprietarycombinatorial chemistry encoding technology, Encoded Combinatorial Libraries onPolymeric Support, or eCLIPS®.

 

The parties have a mutual obligation underthe terms of the Agreement to negotiate in good faith to resolve the dispute.As a result of the negotiations that have taken place to date, Columbia andCold Spring Harbor have agreed not to terminate our license under the Agreementearlier than February 22, 2005.

 

Disputes of this type are often extremelyexpensive, highly uncertain and divert management’s attention and resources.

 

***The development of our products is at anearly stage and is uncertain.***

 

Drug development is a highly uncertainprocess. Our approach and technology may never result in a commercial drug.None of our compounds are contained in products that have received regulatoryapproval for commercial sale, and currently we have only four candidates withrespect to which clinical trials (i.e., human testing) have been commenced. Allof our therapeutic candidates, including these clinical candidates, face thesubstantial risks of failure inherent in the drug development process. Anypotential pharmaceutical product emanating from one of our internal orcollaborative programs must satisfy rigorous standards of safety and efficacybefore the United States Food and Drug Administration (FDA) and foreignregulatory authorities will approve them for commercial use. To satisfy thesestandards, significant additional research, preclinical studies (i.e., animaltesting) and clinical trials will be required.

 

Preclinical and clinical development of drugcandidates is a long, expensive and uncertain process. Failure can occur at anystage of testing. Success in preclinical testing does not ensure that clinicaltrials will be successful. Based on results at any stage of productdevelopment, our development collaborators or we may decide to discontinuedevelopment of our product candidates.

 

Our product candidates and research programsare in the early stages of development and require significant, time-consumingand costly research and development, testing and regulatory approvals. We donot expect that our product candidates will be commercially available for manyyears, if ever. In addition, we pursue the discovery and initial development ofproduct candidates using our integrated technology platform in both ourinternal and collaborative programs to implement our strategy of reducing thecost and time incurred by the pharmaceutical industry in developing drugcandidates. To date, we have not identified a therapeutic candidate that hasbeen developed into a commercial drug using our platform. It is uncertainwhether our technology platform will achieve these goals at all or whether itwill be competitive with platforms used by our competitors.

 

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

 

We anticipate that our capital resources,including our existing cash, cash equivalents and marketable securities as ofSeptember 30, 2004 of approximately $40.4 million, will be adequate to fund ouroperations at least through 2005. However, changes may occur that would consumeavailable capital resources before that time. While we are unaware of aspecific reason that any such factor will have a material impact on our capitalrequirements, examples of relevant factors include:

 

•      the costs associated with drug discoveryservices;

 

•      our internal proprietary drug discoveryactivities;

 

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•      competing technological and marketdevelopments;

 

•      changes in our existing collaborativerelationships;

 

•      the cost of filing, prosecuting, defendingand enforcing patent claims and other intellectual property rights, and theoutcome of related litigation;

 

•      the purchase of additional capital equipment;

 

•      acquisitions of other businesses ortechnologies; and

 

•      the progress of our milestone and royaltyproducing activities.

 

If we determine that we must raise additionalcapital, the capital could be raised through public or private financingsinvolving debt or equity. However, additional capital may not be available onfavorable terms, or at all. If adequate funds are not available, 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.

 

***Disputes may arise between ourcollaborative partners and us as to royalties and milestones to which we areentitled.***

 

The compound basis for drugs developed by acustomer may be a derivative or optimized version of the compound screened oroptimized by us. While our existing collaborative agreements provide that wewill receive milestone payments and royalties with respect to certain productsdeveloped from certain derivative compounds, there can be no assurance thatdisputes will not arise over the application of payment provisions to suchproducts. There can be no assurance that current or future collaborativepartners will not pursue alternative technologies, or develop alternativeproducts either on their own or in collaboration with others, including ourcompetitors, as a means for developing treatments based on the targets whichare the subject of the collaborative arrangements with us.

 

***We may not successfully enter intoadditional collaborations or services agreements that allow us to participatein the future success of our product candidates through milestone, royaltyand/or license payments, and we may never receive any milestone, royalty and/orlicense payments under our current or any future collaborations.***

 

One of our business strategies is to expandour proprietary pipeline of drug candidates and to then enter intocollaborations for the development of these drug candidates that will allow usto earn milestone, royalty and/or license payments. Our proprietary drugdiscovery program is in its early stage of development and is unproven.Although we have expended, and continue to expend, time and money on internalresearch and development programs, we may be unsuccessful in creating valuableproprietary drug candidates that would enable us to form additionalcollaborations and receive milestone, royalty and/or license payments.

 

Our collaborations and internal programs maynot result in the discovery of potential drug candidates that will be safe oreffective. Although we have received license and milestone fees to date, we maynever receive any royalty payments, or any additional license and milestonefees, under our current or any future collaborations. Our receipt of any futuremilestone, royalty or license payments depends on many factors, includingwhether our collaborators desire to or are able to continue to pursue apotential drug candidate and the ultimate commercial success of the drug.Development and commercialization of potential drug candidates depend not onlyon the achievement of research objectives by our collaborators and us, but alsoon each collaborator’s financial, competitive, marketing and strategicconsiderations and regulation in the United States and other countries. Ifunforeseen complications arise in the development or commercialization of thepotential drug candidates by our collaborators, we may not realize milestone,royalty or license payments.

 

***The drug research and development industryis highly competitive and subject to technological change, and we may not havethe resources necessary to compete successfully.***

 

Many of our competitors have access togreater financial, technical, research, marketing, sales, distribution, serviceand other resources than we do. Moreover, the pharmaceutical and biotechnologyindustries are characterized by continuous technological innovation. Weanticipate that we will face increased competition in the future as newcompanies enter the market and our competitors make advanced

 

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technologies available. Technologicaladvances or entirely different approaches that we or one or more of ourcompetitors develop may render our products, services and expertise obsolete oruneconomical. Additionally, the existing approaches of our competitors or newapproaches or technologies that our competitors develop may be more effectivethan those we develop. We may not be able to compete successfully with existingor future competitors.

 

In addition, due to improvements in globalcommunications, combined with the supply of lower cost Ph.D. level scientifictalent in offshore locations such as China, India and Eastern Europe, we facethe growing threat of competition for our services.

 

***If we cannot manage the multiplerelationships and interests involved in our collaborative arrangements and drugdiscovery programs, our business, financial condition and results of operationsmay be materially adversely affected.***

 

We may need to successfully structure andmanage multiple drug discovery programs and collaborative relationships,including maintaining confidentiality of the research being performed formultiple collaborators. We may be unable to manage successfully conflictsbetween competing drug development programs of third parties to which we offerservices. From time to time, more than one of our collaborators may want toperform research concerning the same or molecularly similar disease targets.Because of that, we may be required to reconcile our relationships with thosecollaborators, particularly if both want to establish exclusive relationshipswith us with respect to that target or if one collaborator has an existingarrangement with us and the other would like us to perform services regarding atarget restricted by that arrangement. Further, if we are working with acollaborator regarding a particular target, another of our collaborators may beresearching the same target in one of its internal programs of which we have noknowledge. As a result, potential conflicts involving us may arise due to thiscompetition between collaborators in a particular disease field of interest.Conflicts also may arise between our collaborators as to proprietary rights toparticular compounds in our libraries or as to proprietary rights to biologicaltargets such as receptors or enzymes against which we screen compounds in ourlibraries. The occurrence of conflicts, or the perception of conflicts, couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

***If we use hazardous materials in a mannerthat causes injury or violates laws, we may be liable for damages.***

 

Our activities involve the use of potentiallyharmful hazardous materials, chemicals and various radioactive compounds. Thesematerials are utilized in the performance of our assay development,high-throughput screening and chemistry optimization services, and includecommon organic solvents, such as acetone, hexane, methylene chloride,acetonitrile, and isopropyl and methyl alcohol as well as common acids andbases. The waste from utilization of these solvents and other materials isdisposed of through licensed third-party contractors. Further, we utilize anextremely wide variety of chemicals in the performance of our assaydevelopment, screening and optimization services. These chemicals, such asreagents, buffers and inorganic salts, typically are employed in extremelysmall amounts in connection with the work performed in our laboratories.

 

We cannot completely eliminate the risk ofaccidental contamination or injury from the use, storage, handling or disposalof these materials. In the event of contamination or injury, we could be heldliable for damages that result. We maintain insurance coverage againstenvironmental hazards arising from the storage and disposal of the materialsutilized in our business. Although our management believes that such insurancehas terms, including coverage limits, which are appropriate for our business,liabilities arising from the use, storage, handling or disposal of thesematerials could exceed our insurance coverage as well as our resources. We aresubject to federal, state and local laws and regulations governing the use,storage, handling and disposal of these materials and specified waste products.The cost of compliance with these laws and regulations could be significant. Toour knowledge, we have not been, and currently are not, the subject of anygovernmental investigation concerning the violation of these federal, state andlocal laws and regulations. There can be no assurance that we will not be thesubject of future investigations by governmental authorities.

 

***We and our products are subject to strictgovernment regulation, which may limit the development of products by us or ourcollaborators.***

 

Regulation by governmental entities in theUnited States and other countries will be a significant factor in theproduction and marketing of any pharmaceutical products our customers or we maydevelop. The

 

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nature and the extent to which governmentregulation may apply to our customers and us will vary depending on the natureof the pharmaceutical products, if any. Virtually all pharmaceutical productsrequire regulatory approval prior to commercialization. If we or ourcollaborators or licensees fail to obtain, or encounter delays in obtaining ormaintaining, regulatory approvals, our financial results could be adverselyaffected. Similar regulatory procedures are required in countries outside theUnited States.

 

In addition, new legislation related tohealth care could reduce the prices pharmaceutical and biotechnology companiescan charge for drugs they sell which, in turn, could reduce the amounts thatthey have available for collaborative relationships with us or for the purchaseof our services. If pharmaceutical and biotechnology companies decrease theresources they devote to the research and development of new drugs, the numberof collaborations we conclude and the amount of and profitability of serviceswe perform could be adversely impacted and our revenue and profitabilityreduced. If prices that pharmaceutical and biotechnology companies can chargefor drugs they sell decrease, the royalties, if any, we receive from the saleof products could also decrease, which would reduce our revenue andprofitability.

 

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

 

For the fiscal years ended December 31,2001, 2002 and 2003, we had net losses of approximately $6.6 million, $2.1million and $2.8 million, respectively. During the nine month period ended September 30, 2004, we had net lossesof approximately $16.3 million, including restructuring and other charges of$5.9 million.  Continuing net losses maylimit our ability to fund our operations and we may not generate income fromoperations in the future.

 

While we are unaware of a specific reasonthat any of the following factors is likely to occur, our future profitabilitydepends upon many factors, including several that are beyond our control. Thesefactors include:

 

•      changes in the demand for collaborativerelationships with us;

 

•      termination or reduction of funds underexisting collaborative relationships;

•      the introduction of competitive drugdiscovery services;

 

•      changes in the research and developmentbudgets of our customers and potential customers; and

 

•      our ability to successfully, cost effectivelyand timely develop, introduce and market new collaborative arrangements, aswell as the related services.

 

On a quarterly basis, our future operatingresults are likely to be highly volatile depending upon our receipt ofmilestone payments from our collaborators. We may not receive milestonepayments on a regular basis or at all. Our ability to achieve profitabilitywill be significantly impacted by the level of investment we determine to makein our internal proprietary programs in the future as well as the results ofthose programs.

 

***Rapid changes in technology could have anadverse impact on our business.***

 

Rapid technological change and uncertainty dueto new and emerging technologies characterize the drug discovery industry. Wemay be unable to develop, integrate and market, on a timely basis, new andenhanced services necessary to keep pace with competitors. Our services andtechnologies may be rendered obsolete by the offerings of our competitors.Although we do not believe there are currently new significant technologiesthat we need to incorporate in our business to remain competitive in ourindustry, failure to anticipate or to respond to changing technologies, orsignificant delays in the development or introduction of services, could causecustomers to delay or decide against purchases of our services.

 

***Failure to attract and retain skilledpersonnel could materially and adversely affect us.***

 

We are a small company, and our successdepends in part on the continued service of key scientific, businessdevelopment and management personnel, including our president and chiefexecutive officer Leslie J. Browne Ph.D., and our ability to identify, hire andretain additional personnel. There is intense competition for qualifiedpersonnel. In particular, we believe that there is a shortage of scientistsqualified to work in drug discovery. There is significant competition amongdrug discovery and development companies to hire such scientists. Immigrationlaws may further restrict our ability to attract or hire qualified personnel.We may not be able to continue to attract and retain the personnel necessaryfor our growth and development. Failure to attract and retain key personnelcould have a material adverse effect on our business, financial condition andresults of operations. Further, we are highly dependent on the principalmembers of our scientific, business development and management staff. One or moreof these key

 

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employees could retire or otherwise leave ouremploy within the foreseeable future, and the loss of any of these people couldhave a material adverse effect on our business, financial condition and resultsof operations. We do not, and do not intend to, maintain key person lifeinsurance on the life of any employee.

 

***Some of our development and marketingactivities are, or will be, conducted by third parties. If these third partiesfail to perform their functions satisfactorily, our revenue and earnings couldbe delayed, reduced or eliminated.***

 

The ultimate success of our business planheavily depends upon the successful discovery, development andcommercialization of pharmaceutical products. Our endeavors will result incommercialized pharmaceutical products, if at all, only after significantpreclinical and clinical development, requisite regulatory approvals,establishment of manufacturing capabilities and successful marketing. We do notcurrently have the technology, facilities, personnel or experience toaccomplish all of these tasks on our own, and we will likely not have all thenecessary resources in the foreseeable future. Therefore, we continue to dependheavily upon the expertise and dedication of sufficient resources bycollaborative partners to develop and commercialize products primarily based onlead compounds discovered by us. If a collaborative partner fails to develop orcommercialize a compound or product with respect to which it has rights fromus, we may not receive any future milestone payments or royalties associatedwith that compound or product. Similarly, while we are unaware of a specificreason that any of the following factors will be experienced by our strategic collaborators,because we rely heavily on them, our revenue could be adversely affected if ourcollaborators:

 

•      fail to select a target or product candidatewe have identified for subsequent development;

 

•      fail to gain the requisite regulatoryapprovals of product candidates;

 

•      do not successfully commercialize productsbased on the compounds that we originate;

 

•      do not conduct their collaborative activitiesin a timely manner;

 

•      do not devote sufficient time or resources toour partnered programs or potential products;

 

•      terminate their alliances or arrangementswith us;

 

•      develop, either alone or with others,products that may compete with our product candidates;

 

•      dispute our respective allocations of rightsto any products or technology developed during our collaborations; or

 

•      merge with or are acquired by a third partythat seeks to terminate our collaboration.

 

***We are subject to risks associated with theoperation of an international business***

 

In the nine month period ended September 30,2004, approximately 56% of our revenue was derived from customers outside theUnited States. Approximately 52% of our revenue was derived from customers inEurope, and approximately 4% was derived from customers in the Asia/Pacificregion. We anticipate that international revenue will continue to account for asignificant percentage of our overall revenue. While we are unaware of aspecific reason that any of the following factors will have a material impacton our revenue, our international operations are subject to the risk factorsinherent in the conduct of international business, including:

 

•      unexpected changes in regulatoryrequirements;

 

•      longer payment cycles;

 

•      import and export license requirements;

 

•      tariffs and other barriers;

 

•      political and economic instability;

 

•      limited intellectual property protection;

 

•      difficulties in collecting trade receivables;

 

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•      difficulties in staffing and managing foreignjoint venture operations; and

 

•      potentially adverse tax consequences.

 

We may not be able to sustain or increase ourinternational revenue. Any of the foregoing factors may have a material adverseeffect on our international operations and, therefore, our business, financialcondition and results of operations.

 

***We may not realize revenue from ourextensive business development efforts.***

 

Our collaborative relationships and therelated services involve lengthy sales cycles, often requiring us to expendconsiderable financial and personnel resources without any assurance thatrevenue will be recognized. These cycles typically are long for a number ofreasons. Factors include the strategic nature of our partnerships, the size ofmany such transactions, the confidential and proprietary nature of the biologicaltargets against which we screen our chemical compound libraries, and the uniqueterms typically found in each of the transactions. As a result, we may expendsubstantial funds and effort to negotiate agreements for collaborativearrangements or services, but may ultimately be unable to complete thetransaction and recognize revenue. In these circumstances, our business,financial condition and results of operations will be adversely affected.

 

***Our operations may be interrupted by theoccurrence of a natural disaster or other catastrophic event at our primaryfacilities.***

 

We depend on our laboratories and equipmentfor the continued operation of our business. Our research and developmentoperations and administrative functions are primarily conducted at ourfacilities in the Princeton, New Jersey area. Although we have contingencyplans in effect for natural disasters or other catastrophic events,catastrophic events could still disrupt our operations. Even though we carrybusiness interruption insurance policies, we may suffer losses as a result ofbusiness interruptions that exceed the coverage available under our insurancepolicies. Any natural disaster or catastrophic event in our facilities or theareas in which they are located could have a significant negative impact on ouroperations.

 

***Because we do not intend to pay dividends,you will benefit from an investment in our common stock only if it appreciatesin value.***

 

We have never declared or paid any cashdividend on common stock. We currently intend to retain our future earnings, ifany, to finance the expansion of our business and do not expect to pay any cashdividends in the foreseeable future. As a result, the success of yourinvestment in our common stock will depend entirely upon any future appreciationin its value. There is no guarantee that our common stock will appreciate invalue or even maintain the price at which your shares traded immediately afterthe distribution.

 

***Anti-takeover provisions underSection 203 of the Delaware General Corporation Law, provisions in ouramended and restated certificate of incorporation and amended and restatedbylaws, and our adoption of a stockholder rights plan may render more difficultthe accomplishment of mergers or the assumption of control by a principalstockholder, making more difficult the removal of management.***

 

Section 203 of the Delaware GeneralCorporation Law may delay or deter attempts to secure control of our companywithout the consent of our management. In general, Section 203 prohibits apublicly held Delaware corporation from engaging in a business combination withan interested stockholder for a period of three years following the date theperson becomes an interested stockholder, unless certain conditions are met.

 

Our amended and restated certificate ofincorporation and amended and restated bylaws contain several provisions thatcould delay or make more difficult the acquisition of our company through ahostile tender offer, open market purchases, proxy contest, merger or othertakeover attempt that a stockholder might consider in his or her best interest,including those attempts that might result in a premium over the market priceof our common stock. Such provisions include the issuance of preferred stockwithout approval of the holders of our common stock, the classification of ourboard of directors, the election and removal of directors, restrictions on theability of stockholders to take action without a meeting, restrictions onstockholders’ ability to call a special meeting and advance notice proceduresregarding any proposal of stockholder business to be discussed at astockholders meeting.

 

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We have adopted a stockholder rights plan,which is triggered upon commencement or announcement of a hostile tender offeror when any one person or group acquires 15% or more of our common stock. Therights plan, once triggered, enables stockholders to purchase our common stock,and the stock of the entity acquiring us, at reduced prices. These provisionsof our governing documents, stockholder rights plan and Delaware law could havethe effect of delaying, deferring or preventing a change of control, includingwithout limitation a proxy contest, making more difficult the acquisition of asubstantial block of our common stock. The provisions could also limit theprice that investors might be willing to pay in the future for shares of ourcommon stock. Further, the existence of these anti-takeover measures may causepotential bidders to look elsewhere, rather than initiating acquisitiondiscussions with us.

 

***If we choose to acquire new andcomplementary businesses, products or technologies instead of developing themourselves, we may be unable to complete these acquisitions or to successfullyintegrate an acquired business or technology in a cost-effective andnon-disruptive manner.***

 

From time to time, we may choose to acquirecomplementary businesses, products or technologies instead of developing themourselves. We do not know if we will be able to complete any acquisitions, orwhether we will be able to successfully integrate any acquired businesses,operate them profitably or retain their key employees. Integrating anybusiness, product or technology we acquire could be expensive and time-consuming,disrupt our ongoing business and distract company management. In addition, inorder to finance any acquisition, we might need to raise additional fundsthrough public or private equity or debt financings. In that event, we could beforced to obtain financing on less than favorable terms and, in the case ofequity financing, on terms that may result in dilution to our stockholders. lfwe are unable to integrate any acquired entities, products or technologieseffectively, our business will suffer. In addition, under certaincircumstances, amortization of assets or charges resulting from the costs ofacquisitions could harm our business and operating results.

 

**CERTAINRISKS RELATED TO INTELLECTUAL PROPERTY**

 

***Positions taken by the U.S. Patent andTrademark Office or non-U.S. patent and trademark officials may preclude usfrom obtaining sufficient or timely protection for our intellectual property.***

 

The patent positions of pharmaceutical andbiotechnology companies are uncertain and involve complex legal and factualquestions. The coverage claimed in a patent application can be significantlyreduced before the patent is issued. There is a significant risk that the scopeof a patent may not be sufficient to prevent third parties from marketing otherproducts or technologies with the same functionality of our products andtechnologies. Consequently, some or all of our patent applications may notissue into patents, and any issued patents may provide ineffective remedies orbe challenged or circumvented.

 

***Third parties may have filed patentapplications of which we may or may not have knowledge, and which may adverselyaffect our business.***

 

Patent applications in the United States aremaintained in secrecy for 18 months from filing or until a patent issues. Undercertain circumstances, patent applications are never published but remain insecrecy until issuance. As a result, others may have filed patent applicationsfor products or technology covered by one or more pending patent applicationsupon which we are relying. If applications covering similar technologies wereto be filed before our applications, our patent applications may not begranted. There may be third-party patents, patent applications and otherintellectual property or information relevant to our chemical compositions andother technologies that are not known to us, that block us or compete with ourchemical compositions or other technologies, or limit the scope of patentprotection available to us. Moreover, from time to time, patents may issue whichblock or compete with our chemical compositions or other technologies, or limitthe scope of patent protection available to us. Litigation may be necessary toenforce patents issued to us or to determine the scope and validity of theintellectual property rights of third parties.

 

***We may not be able to protect adequatelythe trade secrets and confidential information that we disclose to ouremployees.***

 

We rely upon trade secrets, technicalknow-how and continuing technological innovation to develop and maintain ourcompetitive position. Competitors through their independent discovery (orimproper means, such as unauthorized disclosure or industrial espionage) maycome to know our proprietary information. We generally require employees andconsultants to execute confidentiality and assignment-of-inventions

 

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agreements. These agreements typicallyprovide that all materials and confidential information developed by or madeknown to the employee or consultant during his, her or its relationship with usare to be kept confidential, and that all inventions arising out of theemployee’s relationship with us are our exclusive property. Our employees andconsultants may breach these agreements, and in some instances we may not havean adequate remedy. Additionally, in some instances, we may have failed torequire that employees and consultants execute confidentiality andassignment-of-inventions agreements.

 

***Foreign laws may not afford us sufficientprotections for our intellectual property, and we may not seek patentprotection outside the United States.***

 

We believe that our success depends, in part,upon our ability to obtain international protection for our intellectualproperty. However, the laws of some foreign countries may not be ascomprehensive as those of the United States and may not be sufficient toprotect our proprietary rights abroad. In addition, we may decide not to pursuepatent protection outside the United States, because of cost and confidentialityconcerns. Accordingly, our international competitors could obtain foreignpatent protection for, and market overseas, products and technologies for whichwe are seeking U.S. patent protection and may be able to use these products andtechnologies to compete against us.

 

***We may not be able to adequately defend ourintellectual property from third party infringement, and third party challengesto our intellectual property may adversely affect our rights and be costly andtime consuming.***

 

Some of our competitors have, or areaffiliated with companies having, substantially greater resources than we have,and those competitors may be able to sustain the costs of complex patentlitigation to a greater degree and for longer periods of time than us.Uncertainties resulting from the initiation and continuation of any patent orrelated litigation could have a material adverse effect on our ability tocompete in the marketplace pending resolution of the disputed matters. If ourcompetitors prepare and file patent applications in the United States thatclaim technology also claimed by us, we may have to participate in interferenceproceedings declared by the U.S. Patent and Trademark Office to determine thepriority of invention, which could result in substantial costs to us, even ifthe outcome is favorable to us. Similarly, opposition proceedings may occuroverseas, which may result in the loss or narrowing of the scope of claims orlegal rights. Such proceedings will at least result in delay in the issuance ofenforceable claims. An adverse outcome could subject us to significantliabilities to third parties and require us to license disputed rights fromthird parties or cease using the technology.

 

***A patent issued to us may not besufficiently broad to protect adequately our rights in intellectual property towhich the patent relates.***

 

Even if patents are issued to us, thesepatents may not sufficiently protect our interest in our chemical compositionsor other technologies because the scope of protection provided by any patentsissued to or licensed by us are subject to the uncertainty inherent in patentlaw. Third parties may be able to design around these patents or develop uniqueproducts providing effects similar to our products. In addition, others maydiscover uses for our chemical compositions or technologies other than thoseuses covered in our patents, and these other uses may be separately patentable.A number of pharmaceutical and biotechnology companies, and research andacademic institutions, have developed technologies, filed patent applicationsor received patents on various technologies that may be related to ourbusiness. Some of these technologies, patent applications or patents mayconflict with our technologies, patent applications or patents. These conflictscould also limit the scope of patents, if any, that we may be able to obtain,or result in the denial of our patent applications. We are not currently awareof any such patent applications or patents that could have a material adverseeffect on our business.

 

***We may be subject to claims of infringementby third parties.***

 

Third parties may claim infringement by us oftheir intellectual property rights. In addition, to the extent our employeesare involved in research areas similar to those areas in which they wereinvolved at their former employers, we may be subject to claims that one of ouremployees, or we, have inadvertently or otherwise used or disclosed the allegedtrade secrets or other proprietary information of a former employer. From timeto time, we have received letters claiming or suggesting that our products oractivities may infringe third party patents or other intellectual propertyrights. Our products may infringe patent or other intellectual property rightsof third parties. A number of patents may have been issued or may be issued inthe future that could cover certain aspects of our technology and that couldprevent us from using technology that we use or expect to use. We may berequired to seek licenses for, or otherwise acquire

 

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rights to, technology as a result of claimsof infringement. We may not possess proper ownership or access rights to theintellectual property we use. Third parties or other companies may bringinfringement suits against us. Any claims, with or without merit, could be timeconsuming to defend, result in costly litigation, divert management’s attentionand resources or require us to enter into royalty or licensing agreements.Royalty or licensing agreements, if required, may not be available on termsacceptable to us, if at all. In the event of a successful claim of productinfringement against us, our failure or inability to license or design aroundthe infringed technology could have a material adverse effect on our business,financial condition and results of operations. We are not currently involved inactions of this type that are material to our business.

 

**Item3. Quantitative and Qualitative Disclosures about Market Risk**

 

Our international sales generallyare denominated in United States Dollars, and are, therefore, not exposed tochanges in foreign currency exchange rates.

 

We do not usederivative financial instruments for trading or speculative purposes.  However, we regularly invest excess cash in overnightrepurchase agreements that are subject to changes in short-term interestrates.  We believe that the market riskarising from holding these financial instruments is minimal.

 

Our exposure to market risksassociated with changes in interest rates relates primarily to the increase ordecrease in the amount of interest income earned on our investment portfoliosince we have minimal debt.  We ensurethe safety and preservation of invested funds by limiting default risks, marketrisk and reinvestment risk.  We mitigatedefault risk by investing in investment grade securities.  A hypothetical 100 basis point adverse movein interest rates along the entire interest rate yield curve would notmaterially affect the fair value of our interest sensitive financialinstruments at September 30, 2004.

 

**Item4.  Controls and Procedures**

 

For the quarterly period ending September 30,2004 we carried out an evaluation, under the supervision and with theparticipation of our management, including our President and Chief ExecutiveOfficer and our Vice President, Finance (the principal finance and accountingofficer), of the effectiveness of the design and operation of our disclosurecontrols and procedures pursuant to Rules 13a-15 and 15d-15 under theSecurities Exchange Act of 1934, or the Exchange Act, as of the end of theperiod covered by this report.  OurPresident and Chief Executive Officer and our Vice President, Finance concludedthat there were no significant changes in our disclosure controls andprocedures or in other factors that could significantly affect our disclosurecontrols and procedures during the quarterly period.  Based upon this evaluation, our President andChief Executive Officer and our Vice President, Finance concluded that as ofSeptember 30, 2004, our disclosure controls and procedures have been designedand are being operated in a manner that provides reasonable assurance that theinformation required to be disclosed by us in reports filed under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC. Our management, including our President and Chief Executive Officer andVice President, Finance, does not expect that our disclosure controls or ourinternal controls will prevent all errors and all fraud.  A control system, no matter how well designedand operated, cannot provide assurance that the objectives of the controlsystem are met, and no evaluation of controls can provide absolute assurancethat all control issues and instances of fraud, if any, within a company havebeen detected.

 

Additionally, our President and ChiefExecutive Officer and Vice President, Finance determined that there were nochanges in our internal control over financial reporting during the quarterlyperiod ended September 30, 2004, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II.  OTHERINFORMATION**

 

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

 

Presently, we are not party to anylitigation.

 

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

 

**None.**

 

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

 

None.

 

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

 

None.

** **

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

 

(a) None.

 

(b) None.

 

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

 

Exhibits.

 

31.1**                **Certification of the Principal Executive Officer of Pharmacopeia DrugDiscovery, Inc. pursuant to Rule 13a-l4 of the Securities Exchange Act of 1934,as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Actof 2002(1)

 

31.2**                **Certification of the Principal Financial Officer of Pharmacopeia DrugDiscovery, Inc. pursuant to Rule 13a-14 of the Securities Exchange Act of 1934,as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Actof 2002(1)

 

32.1**                **Certification of the Chief Executive Officer of Pharmacopeia DrugDiscovery, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002(1)

 

32.2**                **Certification of the Principal Financial Officer of Pharmacopeia DrugDiscovery, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002(1)

 

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(1)           Filed herewith.

 

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**SIGNATURES**

 

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

 
|                               | PHARMACOPEIA DRUG  DISCOVERY, INC. |
|------------------------------------|------------------------------------|
|                               |                               |
| Date:  November  8, 2004 | By:                                | /s/ Leslie J. Browne,  Ph.D. |
|                               |                               | Leslie J. Browne, Ph.D. |
|                               |                               | President and Chief  Executive Officer |
|                               |                               |
|                               |                               |
|                               | By:                                | /s/ Brian M. Posner |
|                               |                               | Brian M. Posner |
|                               |                               | Vice President, Finance |

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**INDEX TOEXHIBITS**

 
| **No.** | ** ** | **EXHIBIT**                                                        |
|---------|------------|--------------------------------------------------------------------|
|    |       |                                                               |
| 31.1    |       | Section 302  Certification of the Principal Executive Officer |
|    |       |                                                               |
| 31.2    |       | Section 302  Certification of the Principal Financial Officer |
|    |       |                                                               |
| 32.1    |       | Section 906  Certification of the Chief Executive Officer     |
|    |       |                                                               |
| 32.2    |       | Section 906  Certification of the Principal Financial Officer |

 

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