**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 1O-Q**

 

| **(Mark One)**                                         |
|--------------------------------------------------------|
| **ý**                                             | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                   |
| **For the quarterly period ended March 31, 2004** |
|                                                   |
| **or**                                                 |
|                                                   |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                   |
| **Commission File Number: 0-50523**                    |

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

(Exact name of registrant as specified in its charter)

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

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.    Yes ý     No o    (The registrant hasnot been subject to such filing requirements for the past 90 days.)

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

Yeso    No ý

 

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

 

| **Class**                     |   | **Outstanding  at May 24, 2004** |
|-------------------------------|--------|----------------------------------|
| Common Stock, $0.01 par value |   | 12,181,471                       |

 

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**           |                  |                                                                                        |   |
|--------------------|-----------------------|---------------------------------------------------------------------------------------------|--------|
|               |                  |                                                                                        |   |
| PART I.            | FINANCIAL INFORMATION | 1                                                                                           |
|               |                  |                                                                                        |   |
| Item 1.            |                  | Financial Statements (Unaudited):                                                           | 1      |
|               |                  |                                                                                        |   |
|               |                  | Balance  Sheets as of March 31, 2004 and December 31, 2003                        | 1      |
|               |                  |                                                                                        |   |
|               |                  | Statements of Operations for each of the Three Months Ended  March 31, 2004 and 2003   | 2      |
|               |                  |                                                                                        |   |
|               |                  | Statements of Cash Flows for each of the Three Months Ended  March 31, 2004 and 2003   | 3      |
|               |                  |                                                                                        |   |
|               |                  | Notes to Unaudited Financial Statements                                                     | 4      |
|               |                  |                                                                                        |   |
| Item 2.            |                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 9      |
|               |                  |                                                                                        |   |
|               |                  | Certain Risks Related to Our Business                                                       | 15     |
|               |                  |                                                                                        |   |
| Item 3.            |                  | Quantitative and Qualitative Disclosures  about Market Risk                                 | 27     |
|               |                  |                                                                                        |   |
| Item 4.            |                  | Controls and Procedures                                                                     | 27     |
|               |                  |                                                                                        |   |
| PART II.           | OTHER INFORMATION     | 28                                                                                          |
|               |                  |                                                                                        |   |
| Item 1.            |                  | Legal Proceedings                                                                           | 28     |
|               |                  |                                                                                        |   |
| Item 2.            |                  | Changes in Securities, Use of Proceeds and  Issuer Purchases of Equity Securities           | 28     |
|               |                  |                                                                                        |   |
| Item 3.            |                  | Defaults upon Senior Securities                                                             | 28     |
|               |                  |                                                                                        |   |
| Item 4.            |                  | Submission of Matters to a Vote of Security  Holders                                        | 28     |
|               |                  |                                                                                        |   |
| Item 5.            |                  | Other Information                                                                           | 28     |
|               |                  |                                                                                        |   |
| Item 6.            |                  | Exhibits and Reports on Form 8-K                                                            | 28     |
|               |                  |
| Signatures         | 29                    |
|               |                  |
| Index  of Exhibits | 30                    |

 

i

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**PARTI - FINANCIAL INFORMATION**

 

**Item 1****.  Unaudited Financial Statements**

 

**PharmacopeiaDrug Discovery, Inc.**

**Balance Sheets**

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

 
|                                                                                                                                        |   | **March 31,  2004** |   | **December 31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
| **ASSETS**                                                                                                                                  |   |                     |   |                        |   |
| Current assets:                                                                                                                             |   |                     |   |                        |   |
| Cash and cash equivalents                                                                                                                   |   | $                        | 368    |                        | $      | 524 |   |
| Accounts receivable                                                                                                                         |   | 497                      |   | 2,302                       |   |
| Prepaid expenses and other current assets                                                                                                   |   | 996                      |   | 1,159                       |   |
| Total current assets                                                                                                                        |   | 1,861                    |   | 3,985                       |   |
|                                                                                                                                        |   |                     |   |                        |   |
| Property and equipment, net                                                                                                                 |   | 11,121                   |   | 6,957                       |   |
| Other assets                                                                                                                                |   | 108                      |   | 110                         |   |
| Total assets                                                                                                                                |   | $                        | 13,090 |                        | $      | 11,052 |   |
|                                                                                                                                        |   |                     |   |                        |   |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                                                                               |   |                     |   |                        |   |
| Current liabilities:                                                                                                                        |   |                     |   |                        |   |
| Accounts payable                                                                                                                            |   | $                        | 800    |                        | $      | 2,809 |   |
| Accrued liabilities                                                                                                                         |   | 4,111                    |   | 951                         |   |
| Deferred revenue, current portion                                                                                                           |   | 3,058                    |   | 2,660                       |   |
| Total current liabilities                                                                                                                   |   | 7,969                    |   | 6,420                       |   |
|                                                                                                                                        |   |                     |   |                        |   |
| Restructuring reserve, long-term                                                                                                            |   | 2,655                    |   | —                      |   |
| Deferred revenue, long-term                                                                                                                 |   | 274                      |   | 325                         |   |
|                                                                                                                                        |   |                     |   |                        |   |
| Stockholder’s 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, 12,181,471  shares outstanding at March 31, 2004 and December 31, 2003 |   | —                   |   | —                      |   |
| Investment by Pharmacopeia, Inc.                                                                                                            |   | 2,192                    |   | 4,307                       |   |
| Total stockholder’s equity                                                                                                             |   | 2,192                    |   | 4,307                       |   |
| Total liabilities and stockholder’s equity                                                                                             |   | $                        | 13,090 |                        | $      | 11,052 |   |

 

See accompanying notes tothese unaudited financial statements.

 

1

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**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Operations**

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

 
|                                                 |   | **For the Three Months  Ended March 31,** |   |
|------------------------------------------------------|--------|------------------------------------------------|--------|
|                                                 |   | **2004**                                       |   | **2003** |   |
| Revenues                                             |   | $                                              | 5,369  |   | $ | 7,521 |   |
| Cost of revenue                                      |   | 5,550                                          |   | 5,776 |   |
| Gross margin                                         |   | (181                                           | )      | 1,745 |   |
|                                                 |   |                                           |   |   |   |
| Operating costs and expenses:                        |   |                                           |   |   |   |
| Research and development                             |   | 1,389                                          |   | 1,042 |   |
| Sales, general and administrative                    |   | 2,419                                          |   | 1,543 |   |
| Restructuring and other charges                      |   | 5,947                                          |   | — |   |
| Total operating costs and expenses                   |   | 9,755                                          |   | 2,585 |   |
| Operating loss                                       |   | (9,936                                         | )      | (840 | ) |
| Interest and other income, net                       |   | 3                                              |   | 9 |   |
| Loss before tax provision                            |   | (9,933                                         | )      | (831 | ) |
| Provision for income taxes                           |   | 3                                              |   | 107 |   |
| Net loss                                             |   | $                                              | (9,936 | ) | $ | (938 | ) |
|                                                 |   |                                           |   |   |   |
| Net loss per share:                                  |   |                                           |   |   |   |
| - Basic and diluted                                  |   | $                                              | (0.82  | ) | $ | (0.08 | ) |
|                                                 |   |                                           |   |   |   |
| Weighted average number of common stock outstanding: |   |                                           |   |   |   |
| - Basic and diluted                                  |   | 12,181,471                                     |   | 12,181,471 |   |

 

See accompanying notes tothese unaudited financial statements.

 

2

----

 

**PharmacopeiaDrug Discovery, Inc.**

**Statements of CashFlows**

**(Amounts inthousands)**

 
|                                                                              |   | **For the Three Months  Ended March 31,** |   |
|-----------------------------------------------------------------------------------|--------|------------------------------------------------|--------|
|                                                                              |   | **2004**                                       |   | **2003** |   |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                        |   |                                           |   |   |   |
| Net loss                                                                          |   | $                                              | (9,936 | ) | $ | (938 | ) |
| Adjustments to reconcile net loss to net cash provided from operating  activities |   |                                           |   |   |   |
| Depreciation and amortization                                                     |   | 449                                            |   | 456 |   |
| Changes in assets and liabilities:                                                |   |                                           |   |   |   |
| Trade receivables                                                                 |   | 1,805                                          |   | 90 |   |
| Prepaid expenses and other current assets                                         |   | 163                                            |   | (705 | ) |
| Other assets                                                                      |   | 2                                              |   | (117 | ) |
| Accounts payable                                                                  |   | (2,009                                         | )      | (502 | ) |
| Accrued liabilities                                                               |   | 3,160                                          |   | 57 |   |
| Restructuring reserve, long-term                                                  |   | 2,655                                          |   | — |   |
| Deferred revenue                                                                  |   | 347                                            |   | (3,109 | ) |
| Net cash used in operating activities                                             |   | (3,364                                         | )      | (4,768 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                             |   |                                           |   |   |   |
| Capital expenditures, net                                                         |   | (4,613                                         | )      | (86 | ) |
| Net cash used in investing activities                                             |   | (4,613                                         | )      | (86 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                             |   |                                           |   |   |   |
| Investment by Pharmacopeia, Inc.                                                  |   | 7,821                                          |   | (96 | ) |
| Net cash provided by (used in) financing activities                               |   | 7,821                                          |   | (96 | ) |
| Net decrease in cash and equivalents                                              |   | (156                                           | )      | (4,950 | ) |
| Cash and equivalents, beginning of period                                         |   | 524                                            |   | 6,737 |   |
| Cash and equivalents, end of period                                               |   | $                                              | 368    |   | $ | 1,787 |   |
|                                                                              |   |                                           |   |   |   |
| SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:                              |   |                                           |   |   |   |
| Cash paid during the period for:                                                  |   |                                           |   |   |   |
| Interest                                                                          |   | $                                              | — |   | $ | — |   |
| Income tax                                                                        |   | $                                              | 3      |   | $ | 94 |   |

 

See accompanying notes tothese unaudited financial statements.

 

3

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**PharmacopeiaDrug Discovery, Inc.**

**Notes toUnaudited Financial Statements**

 

**1.  Background and Basis of Presentation**

 

Pharmacopeia Drug Discovery, Inc(“PDD” or the Company”) was incorporated on May 31, 2002 as a wholly ownedsubsidiary of Pharmacopeia, Inc. (“Pharmacopeia”). On December 18, 2003,Pharmacopeia announced its plans to spin-off 100 percent of the shares of PDDin a pro rata tax-free distribution to its stockholders, subject to thesatisfaction of certain conditions. Upon completion of the distribution onApril 30, 2004, Pharmacopeia distributed to all of its stockholders ofrecord one share of PDD common stock for every two shares of Pharmacopeiacommon stock held. A total of 12,181,471 shares were distributed. The financialstatements have been revised to retroactively reflect this distribution for allperiods presented.  The invested equityby Pharmacopeia, which includes the accumulated historical changes inPharmacopeia’s investment in the Company forms the ongoing additional paid-incapital of the Company.   See note 7 forfurther information on the distribution.

 

In connection with thedistribution, Pharmacopeia and the Company entered into a series of agreements,including a master separation and distribution agreement, a transition servicesagreement, a tax sharing and indemnification agreement and other agreements,which are intended to govern the ongoing relationship between the twocompanies.

 

PDD designs, develops, markets andsupports science and technology-based products and services intended to improveand accelerate the process of drug discovery. The Company provides drugdiscovery services to pharmaceutical and biotechnology companies based onproprietary combinatorial chemistry and high-throughput screening technologies.

 

PDD’s financial statements havebeen derived from the financial statements and accounting records ofPharmacopeia using the historical results of operations and historical basis ofthe assets and liabilities of the Company’s business. Management believes theassumptions underlying the financial statements are reasonable. However, thefinancial statements included herein may not necessarily reflect the Company’sresults of operations, financial position and cash flows in the future or whatits results of operations, financial position and cash flows would have beenhad the Company been a stand-alone company during the periods presented.

 

The financial statements includeallocations of certain Pharmacopeia corporate headquarter assets, liabilitiesand expenses relating to the Company’s business that have been transferred tothe Company from Pharmacopeia. General corporate overhead has been allocatedbased on the Company’s revenue as a percentage of Pharmacopeia’s total revenue.General corporate overhead primarily includes salary and expenses for executivemanagement, finance, legal, human resources, information services and investorrelations, and were $537 thousand and $357 thousand in the three months endedMarch 31, 2004 and 2003, respectively. These costs are included in sales,general and administrative expenses in the accompanying statements ofoperations.

 

The accompanying unauditedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States 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 generally accepted accounting principles for completefinancial statements. The December 31, 2003 financial information has beenextracted from the audited financial statements included in the Company’sregistration statement on Form 10 dated April 19, 2004 (the “Form 10”), whichwas filed in conjunction with the Company’s spin-off from Pharmacopeia. In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation of the financialstatements have been included.  Interimresults are not necessarily indicative of the results that may be expected forthe year. The unaudited interim financial statements should be read inconjunction with the financial statements and notes thereto as ofDecember 31, 2003 included in the Company’s Form 10.

 

4

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**2.Significant Collaborations**

 

For the quarters endedMarch 31, 2004 and 2003, the Company’s research collaborations withSchering-Plough accounted for 69% and 46%, respectively, of revenue. In thethird quarter of 2003, the Company entered into new drug discoverycollaborations with Schering-Plough, which continue certain existing programsand implement a number of new activities. The new agreements continue theCompany’s collaboration with this partner through at least August 2006and, under their terms, may be extended by the parties for up to threeadditional years based upon progress made in the programs governed by theagreements. The agreements may be terminated at the end of the third year, andSchering-Plough’s funding obligations may be reduced significantly before thattime.  Under these agreements, PDDreceives research funding which is recognized as revenue as services areperformed. The Company may receive milestones upon the successful achievementof preclinical and clinical milestones. Milestone payments will be recognizedas revenue when the milestones are achieved. Upon successful commercializationof any product resulting from this relationship, PDD will be entitled to receiveroyalties on sales of that product.

 

For the quarters endedMarch 31, 2004 and 2003, the Company’s research collaborations with N.V.Organon accounted for 16% and 20%, respectively, of revenue.  The current 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 PDD is unable to delivercompounds meeting the criteria specified in the agreement. Under thisagreement, PDD 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 clinicalmilestones. These milestones will be recognized as revenue when the milestonesare achieved. Upon successful commercialization of any product resulting fromthis relationship, PDD will be entitled to receive royalties on sales of thatproduct.

 

**3.  Net Loss Per Share**

** **

The Company computes net income(loss) per share in accordance with Statement of Financial Accounting StandardNo. 128, “Earnings Per Share” (“SFAS 128”). Under the provisions of SFAS 128, basic net income (loss) per share iscomputed by dividing the net income (loss) for the period by theweighted-average number of common shares outstanding during the period.  Diluted net income (loss) per share iscomputed 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.  The Company has a net loss for the periods presented; accordingly,the inclusion of common stock equivalents for outstanding stock options wouldbe anti-dilutive and, therefore, the weighted-average shares used to calculateboth basic and diluted loss per share are the same.

 

For each period presented basic anddiluted net loss per share are calculated based on the 12,181,471 sharesdistributed in the spin-off (see notes 1 and 7).

 

**4.  Segment Information**

 

The Company classifies its businessoperations in one operating segment. All of the Company’s revenues are generated from this segment. In thequarters ended March 31, 2004 and 2003, approximately 43% and 25%,respectively, of the Company’s revenue from unaffiliated customers was derivedfrom within the United States, 54% and 61%, respectively, was derived fromEurope, and 3% and 14%, respectively, was derived from Asia.

 

**5.  Stock-Based Compensation**

 

Generally, any outstanding optionsto purchase Pharmacopeia common stock under Pharmacopeia incentive compensationplans have been adjusted or converted to options to purchase PDD common stockto maintain the then-existing intrinsic value and maintain the ratio of thethen-existing exercise price per share to the market value per share inaccordance with applicable accounting standards.

 

5

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Statement of Financial AccountingStandards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”)encourages, but does not require, companies to record compensation cost forstock-based compensation plans at fair value. As permitted by SFAS 123, the Company has elected to continue followingAccounting Principles Board Opinion No. 25 “Accounting for Stock Issued toEmployees” (“APB 25”) and related interpretations, to account for stock-basedcompensation.  Under APB 25, nocompensation expense is recognized at the time of option grant because theexercise price of the Company’s employee stock options equals the fair marketvalue of the underlying common stock on the date of grant.

 

Had the Company followed the fairvalue measurement provisions of SFAS 123, the following table summarizes thepro forma net loss and pro forma net loss per share that would have beenrecorded (in thousands, except per share data):

 
|                                                                                                                                         |   | **Three Months Ended March 31,** |    |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|---------|
|                                                                                                                                         |   | **2004**                              |    | **2003** |   |
| Net loss:                                                                                                                                    |   |                                  |    |   |   |
| As reported                                                                                                                                  |   | $                                     | (9,936  | ) | $ | (938 | ) |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards, net of related tax effects |   | (601                                  | )       | (908 | ) |
| Pro forma                                                                                                                                    |   | $                                     | (10,537 | ) | $ | (1,846 | ) |
| Basic and diluted net loss per common share:                                                                                                 |   |                                  |    |   |   |
| As reported                                                                                                                                  |   | $                                     | (0.82   | ) | $ | (0.08 | ) |
| Pro forma                                                                                                                                    |   | $                                     | (0.87   | ) | $ | (0.15 | ) |

 

The fair value of each optiongranted during 2004 and 2003 is estimated on the date of grant using the Black-Scholesoption-pricing model with the following assumptions:

 
|                    |   | **2004** |   | **2003** |   |
|-------------------------|--------|----------|--------|----------|--------|
| Dividend yield          |   | 0        | %      | 0        | %      |
| Expected volatility     |   | 85.24    | %      | 88.28    | %      |
| Risk-free interest rate |   | 3.31     | %      | 3.25     | %      |
| Expected life (years)   |   | 5.8      |   | 6.5      |   |

 

**6.  Restructuring**

 

During the quarter endedMarch 31, 2004, the Company executed a restructuring plan for the purposeof making its research and development activities more efficient by eliminatingunnecessary facilities. Also a reduction in force of six administrative PDDemployees occurred during the quarter, of which five employees were terminatedas of March 31, 2004.  As a result,restructuring related charges of approximately $5.9 million,  as outlined below, were recognized asoperating expense during the quarter ended March 31, 2004.

 

The following table summarizes theactivity and balance of the restructuring reserve liability during the quarterended March 31, 2004 (dollars in thousands):

 

6

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|                             |   | **Severance Cost for  Involuntary Employee  Terminations** |   | **Costs to Exit Leased  Facility** |   | **Total** |   |
|----------------------------------|--------|------------------------------------------------------------|--------|------------------------------------|--------|-----------|--------|
| Restructuring charges            |   | $                                                          | 132    |                               | $      | 5,718     |   | $ | 5,850 |   |
| Utilization of Reserves:         |   |                                                       |   |                               |   |      |   |
| Cash                             |   | (44                                                        | )      |                               |   | (44       | )      |
| Write-off Leasehold Improvements |   | —                                                     |   | (458                               | )      | (458      | )      |
| Balance at March 31, 2004   |   | $                                                          | 88     |                               | $      | 5,260     |   | $ | 5,348 |   |

 

**7.  Subsequent Events – Spin-off of PharmacopeiaDrug Discovery, Inc.**

 

On April 30, 2004,Pharmacopeia completed the spin-off of PDD into an independent, separatelytraded, publicly held company through the distribution to its stockholders of adividend of one share of PDD common stock for every two shares of Pharmacopeiacommon stock held.  Pharmacopeiareceived an opinion of counsel that the transaction will qualify as a tax-freeto Pharmacopeia shareholders, except for cash received in lieu of anyfractional share interests.

 

On the date of the distribution,Pharmacopeia made a capital contribution of $46.5 million to PDD.

 

In connection with thedistribution, Pharmacopeia, Accelrys, Inc. a wholly-owned subsidiary ofPharmacopeia, and the Company entered into the agreements described below.

 

*Master Separationand Distribution Agreement*

 

The Company entered into a masterseparation and distribution agreement with Pharmacopeia and Accelrys providingfor, among other things, certain corporate transactions required to effect thedistribution and other arrangements between the Company and Pharmacopeiasubsequent to the distribution. In particular, the agreement provided forownership of the business, assets and liabilities necessary for ownership of thecontinuation of the Company’s business directly or indirectly, by the Company,and Pharmacopeia’s remaining business assets and liabilities, directly orindirectly, by Accelrys.

 

*TransitionServices Agreement*

 

The Company entered into atransition services agreement with Pharmacopeia and Accelrys, pursuant to whichAccelrys will provide PDD and PDD will provide Accelrys certain services duringa transition period that commenced on the distribution date and the obligationto provide services will terminate no later than the first anniversary of thedistribution date.

 

Under the terms of the transitionservices agreement, Accelrys will provide the Company with businessdevelopment, financial information systems advice and support, support for themaintenance of corporate records and personnel administration and services. PDDwill provide Accelrys with office space during the transition period.

 

The transition services agreementalso provides that Pharmacopeia will make available a sum of $1 million to beheld as a “Services Fund” in a segregated account, in trust for the benefit ofPDD and Accelrys.  PDD may use theServices Fund towards securing any service Accelrys agrees to provide PDD underthe transition services agreement if PDD and Accelrys cannot resolve anydispute relating to the performance or nonperformance of such service byAccelrys after good faith negotiations. The Company will also use a portion ofthe Services Fund to acquire a financial system appropriate for its businessand is entitled to use a portion of the Services Fund to update its corporatewebsite and to acquire or license certain software packages appropriate forsupporting the internal operations of its business. The amount remaining in theServices Fund, less applicable deductions, will be remitted to Accelrys.

 

In addition, the transitionservices agreement provides that Pharmacopeia will make available a sum of $750thousand to PDD in relation to any and all costs, expenses and fees not paidprior to the distribution date, associated with PDD’s consolidation of itsfacilities, including but not limited to construction and waste costs, expensesand fees.

 

7

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*Tax Sharing andIndemnification Agreement*

 

In order to allocate the Company’sresponsibilities for taxes and certain other tax matters, the Company andPharmacopeia entered into a tax sharing and indemnification agreement.

 

Under the tax sharing andindemnification agreement, Pharmacopeia will be responsible for filing allfederal consolidated income tax returns and all consolidated, combined, orunitary state and local income tax returns including PDD for all periodsthrough the distribution date, and for paying all taxes related to thosereturns. Pharmacopeia will act as the Company’s agent in connection with thefiling of those returns, paying those taxes and responding to any audits thatmay arise in connection with those returns. Pharmacopeia 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.

 

PDD will be responsible for allstate and local taxes imposed on it computed on a separate-company basis, andwill be entitled to any refund of such taxes.

 

The Company and Pharmacopeia havemade certain covenants to each other in connection with the spin-off that PDDmay not take certain actions without first obtaining an unqualified opinion ofcounsel that such actions will not cause the spin-off to become taxable. If theCompany breaches any of the covenants in the tax sharing and indemnificationagreement, and if PDD’s breach results in taxes being imposed on Pharmacopeiain connection with the spin-off, then PDD will be liable for those taxes.Furthermore, the Company will be responsible for taxes that may be imposed onPharmacopeia pursuant to IRS Section 355(e) of the Internal Revenue Codeof 1986, as amended, in connection with the transaction that results in achange in control of PDD, even though PDD may have obtained an opinion ofcounsel prior to the transaction.

 

*Employee MattersAgreement*

 

The Company and Pharmacopeiaentered into an employee matters agreement that allocated responsibilities andobligations with respect to certain employee benefit plans and other employmentrelated matters.

 

Under the employee mattersagreement, the Company and Pharmacopeia identified those current and formeremployees employed (or, in the case of former employees, who were employed) inthe Pharmacopeia business and those employees employed in the PDD business. PDDassumed all the employee benefit plan, workers compensation, unemploymentcompensation, bonus, fringe benefit and vacation liabilities, which related toits current and former employees as of the distribution date. The Company willalso, generally, recognize any service earned by its employees withPharmacopeia for purposes of determining eligibility for and vesting in anybenefits.

 

During the transition period, whichbegan on the distribution date and will end no later than December 31,2004, PDD employees may continue their participation in plans maintained byPharmacopeia. The transition period with respect to any particular employeebenefit (for example, the 401(k) savings plan or medical plan) may end prior toDecember 31, 2004 if Pharmacopeia and PDD agree on such an earlier date.During the transition period, the Company will have input in the sharedemployee benefit plans with regard to its employees. However, Pharmacopeia willbe responsible for maintaining and administering these plans, notifyingvendors, third party administrators, insurance companies and other serviceproviders regarding the distribution, and will indemnify PDD for anyliabilities that arise from a failure of Pharmacopeia to fulfill itsobligations under the employee matters agreement. Pharmacopeia will not imposea fee on PDD under the employee matters agreement for the maintenance andadministration of these plans. PDD, however, will be responsible for the prorata portion of the costs and expenses incurred for the benefit its employeesand former employees under these plans.

 

The Company has agreed withPharmacopeia that the distribution is not a severance of employment for thepurposes of any employee benefit plan that PDD or Pharmacopeia maintains.

 

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*Patent andSoftware License Agreement*

 

The Company and Pharmacopeia entered into apatent and software cross-licensing agreement between Pharmacopeia and PDD inregards to certain intellectual property rights so as to assure continuedaccess to such intellectual property, most of which is significant to theuninterrupted availability of certain of the products and services of the Company.

 

Underthe patent and software license agreement, Pharmacopeia granted to PDD aworldwide, paid-up, royalty-free, irrevocable, nontransferable and nonexclusivelicense to use certain software products for the sole purpose of processing thework of PDD’s business. The license is in effect until April 30, 2007,unless earlier terminated by either party or Pharmacopeia under certain limitedcircumstances or extended by mutual written agreement by the Company andPharmacopeia.

 

**Pursuant tothe patent and software license agreement, Pharmacopeia granted PDD aworldwide, paid-up, royalty-free, irrevocable, nontransferable, andnon-exclusive license to certain Pharmacopeia-owned patents. This license is ineffect until the last of the patents made part of the patent and softwarelicense agreement expires.**

** **

**Pursuant tothe patent and software license agreement, PDD granted Pharmacopeia aworldwide, paid-up, royalty-free, irrevocable, nontransferable, andnon-exclusive license to certain PDD-owned patents. This license is in effectuntil the last of the PDD-owned patents made part of the patent and softwarelicense agreement expires.**

 

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

 

Forward-LookingStatements

 

This QuarterlyReport on Form 10-Q contains forward-looking statements regarding us and ourbusiness, financial condition, results of operations and prospects within themeaning of the Private Securities Litigation Reform Act of 1995.  Such forward-looking statements includethose which express plans, anticipation, intent, contingency, goals, targets orfuture development and/or otherwise are not statements of historical fact.  These forward-looking statements are basedon our 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.  These forward-lookingstatements include statements about the following:

 

•                  ourintentions regarding the establishment of drug discovery collaborations withleading 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 andPharmacopeia,  our former parent;

 

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

 

•                  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;

 

•                  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;

 

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

 

•                  thedistribution being tax-free to Pharmacopeia and its stockholders for federalincome tax purposes and under section 355 of the Internal Revenue Code of1986, as amended;

 

•                  ourrelationship with Pharmacopeia after the distribution; and

 

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

 

In some cases,you can identify forward-looking statements by terminology, such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or thenegative of such terms or other similar expressions.  Factors that could cause or contribute to differences in resultsand outcomes include, without limitation, those discussed elsewhere in thisReport in Item 2.  “Management’sDiscussion and Analysis of Financial Condition and Results of Operations(including a subsection thereof entitled “Certain Risks Related to OurBusiness”) and discussed in our other Securities and Exchange Commission(“SEC”) filings.

 

We urge you tocarefully read and consider the disclosures found in these filings, all ofwhich are available in the SEC EDGAR database at www.sec.gov.  You are urged not to place undue reliance onany such forward-looking statements, any of which may turn out to be wrong dueto inaccurate assumptions, unknown risks, uncertainties or other factors.  We undertake no obligation to (and expresslydisclaim any such obligation to) revise or update the statements made herein orthe risk factors that may relate thereto whether as a result of newinformation, future events or otherwise.

 

**TheCompany**

 

**Overview**

 

We are achemistry-based collaborative drug discovery company, focused on the creationof new small molecule therapeutics. Small molecule drug candidates typically are orally available (i.e., maybe taken in capsule or tablet form) and offer manufacturing and deliveryadvantages over other types of therapeutics. Using proprietary technologies and processes, our experienced scientistsidentify and optimize novel drug candidates through research collaborationswith major pharmaceutical and biotechnology companies and through our owninternally-funded drug discovery programs. 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 andcertain other companies in the pharmaceutical industry, is available for use inour collaborative and internal research programs and forms the basis of ourgrowing pipeline of potential drug candidates. Three of our proprietary compounds commenced clinical trials in thesecond half of 2003, and a fourth compound commenced clinical trials in thefirst quarter of 2004.

 

We have drugdiscovery collaborations with leading pharmaceutical companies and emergingbiotechnology companies.  Ourcontributions to our partners’ drug discovery programs include:  the provision of large, diverse libraries ofproprietary drug-like chemical compounds from which potential therapeuticcandidates can be identified; our high throughput and ultra high throughputscreening of these compounds against disease targets of interest provided bythe partner in which we test a disease-related target against tens of thousands(with respect to high throughput) or to hundreds of thousands (with respect toultra high throughput) of our potential small molecule therapeutic compoundsper week; our optimization of active compounds identified in the screeningprocess, in which we refine the molecular structure of the lead compounds in anattempt to improve their efficacy, potency and safety; our provision of medicinalchemistry capabilities through which our scientists design, synthesize (i.e.,physically make in our laboratories) and optimize those lead compound that weor our collaborators believe are potential drug candidates; and our delivery ofother services (such as *in vitro* pharmacology) traditionallyperformed by research divisions within pharmaceutical and biotechnologycompanies.  Our collaborative agreementstypically require our customers to fund our provision of services, and providefor our receipt of significant milestone payments if and as our discoveriesprogress through the development process. Thereafter, should any of these drug candidates become pharmaceuticalproducts we typically would be entitled to receive royalty payments calculatedas a percentage of the net sales of the products.  Our business is highly dependent upon the extent to which thepharmaceutical and biotechnology companies collaborate with outside companiesfor drug discovery expertise.  Thewillingness of pharmaceutical and biotechnology

 

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companies to expand or continue drug discovery collaborations oroutsource services to enhance their research and development activities isbased on certain factors that are beyond our control.  There can be no assurance that our existing collaborativerelationships will continue, that we will develop new relationships withsimilar large organizations on terms favorable to us, that any of our existingor new alliances will produce substantial revenue or profit opportunities, orthat the scientific outcomes of any of these programs will be successful.

 

In addition tocollaborative drug discovery, we conduct proprietary research to discover newdrug-like lead compounds with commercial potential.  Unlike our typical collaborative partnerships, we provide therequired funding for these programs.  Aswe do not receive funding from third party collaborators with respect to theseproprietary programs, we retain all intellectual property and ownership rightsin any compounds discovered.  At anappropriate point, we may determine to license one or more of these compoundsto a third party (usually a larger pharmaceutical organization).  Licensing at this point in the compound’sdevelopment enables us to take advantage of the additional resources, expertiseand technologies of the licensee company in order to further the development ofthe compound.  We enter in such licenseswith third parties in return for up-front fees and milestone payments, as wellas recurring royalty payments if these compounds are developed into newcommercial drugs.  These agreementsconvert our proprietary programs into collaborative partnerships, typically ata more advanced state of the drug development process.

 

Our drug discoveryefforts have produced four clinical candidates so far.  Our first candidate, a p38 Kinase Inhibitorfor rheumatoid arthritis developed in collaboration with Bristol-Myers SquibbCompany, commenced clinical trials in August 2003.  This potential new drug, a small moleculefrom our proprietary compound collection (and the product of one of ourinternal development programs), currently is in Phase I of clinicaltesting.  A second of our proprietaryinternal compounds targets an inflammation indication and commenced clinicaltrials in November 2003.  Thisclinical candidate is a product of our collaboration with DaiichiPharmaceutical Co.  Our third candidate,a compound targeting a respiratory indication developed in collaboration withSchering-Plough Corporation, commenced clinical trails inDecember 2003.  The Schering-Ploughrelationship produced a second clinical candidate, which is our fourth clinicalcandidate, in March 2004, when Schering-Plough initiated clinical trialsfor an inflammation indication with respect to another compound discovered inthe collaboration.  We have receivedsignificant milestone payments from each of Bristol-Myers Squibb, Daiichi andSchering-Plough and, to the extent the compounds progress through the clinicalprocess, we will be entitled to receive additional milestone payments.  We are also entitled under the agreementswith each of these partners to receive royalties on the commercial sale, ifany, of a new drug emanating from the relationship.  Although these collaborators currently are performing clinicaltrials of prospective pharmaceutical products containing our proprietarycompounds, numerous additional studies will be necessary to support the furtherdevelopment of these product candidates. Results from preclinical studies conducted to date on these productcandidates are not necessarily indicative of the results that may be obtainedin future clinical studies.  There canbe no assurance that these collaborators will continue these programs.

 

In addition,we are involved in over 40 other drug development programs in the preclinicalstage, some with collaborative partners and others within our internaldiscovery program.  Two of theseprograms are at various stages of the Good Laboratory Practice (GLP) Toxicitystudy process, the point at which compounds are tested for safety prior totheir introduction into humans during Phase I of the clinical developmentprocess.  Approximately 20 of theseprograms are in various phases of preclinical development, from advanced stagesof lead optimization down through “hit-to-lead” studies.  The remaining programs are in early stages,including development of biological assays for testing of compounds and thescreening of our proprietary libraries against selected disease targets.  In our collaborative programs we typicallyhold a financial interest in any active compounds we identify through ourscreening and any drug candidate(s) we help to optimize.  In our proprietary programs, we hold allrights to the compounds and typically enter into partnership arrangements withpharmaceutical companies once the program has reached an appropriatestage.  In our view, a pipeline of thesize and quality we have developed holds great potential for the introductionof one or more drugs into the market.

 

Preclinicaland clinical development of drug candidates is a long, expensive and uncertainprocess.  Our candidates are at an earlystage, as none of our compounds are contained in products that have receivedregulatory approval for commercial sale. All of our compounds, including our clinical candidates, face thesubstantial risks of failure inherent in developing drugs.  At any stage of the clinical developmentprocess,

 

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our collaborators or we may decide to discontinue development of ourproduct candidates.  We do not expectthat our product candidates will be commercially available for many years, ifever.  In addition, we pursue thediscovery and initial development of product candidates using our integratedtechnology platform in both our internal and collaborative programs toimplement our strategy of reducing the cost and time incurred by thepharmaceutical industry in developing drug candidates.  To date, we have not identified a therapeuticcandidate that has been developed into a commercial drug using our platformand, although we have received license and milestone fees, we may never receiveany royalty payments, or any additional license and milestone fees, under ourcurrent or any future collaborations.

 

OnApril 30, 2004, Pharmacopeia, then our sole stockholder, distributed (thedistribution) all outstanding shares of our common stock to the holders ofcommon stock of Pharmacopeia We thereafter began operations as an independent,separately traded, publicly held company. The distribution was made without payment of any consideration or theexchange of any shares by Pharmacopeia stockholders.  In the distribution, Pharmacopeia stockholders received one shareof our common stock for every two shares of Pharmacopeia common stock held ofrecord.  The stock traded as when issuedfrom April 20, 2004 through April 30, 2004 and began regular trading on TheNasdaq National Market on May 3, 2004 under the trading symbol “PCOP.”

 

**Liquidityand Capital Resources**

 

We have funded our activities to dateprimarily through Pharmacopeia’s consolidated operations, including revenuederived from collaborative partnerships, and milestone payments. On the date ofthe distribution, Pharmacopeia made a capital contribution of $46.5 million tous.

 

Inconnection with the distribution, Pharmacopeia, Accelrys, and we entered into atransition services agreement that provides that Pharmacopeia will makeavailable a sum of $1 million to be held as a “Services Fund” in a segregatedaccount, in trust for the benefit of us and Accelrys.  We may use the Services Fund towards securing any serviceAccelrys agrees to provide under the transition services agreement if we andAccelrys cannot resolve any dispute relating to the performance ornonperformance of such service by Accelrys after good faith negotiations. Wewill also use a portion of the Services Fund to acquire a financial systemappropriate for our business and are entitled to use a portion of the ServicesFund to update our corporate website and to acquire or license certain softwarepackages appropriate for supporting the internal operations of our business.The amount remaining in the Services Fund, less applicable deductions, will beremitted to Accelrys.

 

Inaddition, the transition services agreement provides that Pharmacopeia willmake available a sum of $750 thousand to usin relation to any and all costs, expenses and fees not paid prior to thedistribution date, associated with our consolidation of our facilities,including but not limited to construction and waste costs, expenses and fees.

 

As of March 31, 2004, we hadcash and cash equivalents of $368 thousand compared to $524 thousand atDecember 31, 2003. In the quarter ended March 31, 2004, we used cashof $3.4 million in our operating activities. This compares to a use of $4.8million in the quarter ended March 31, 2003. The decrease was due to anincrease in accrued liabilities and restructuring reserves and a decrease inaccounts receivables, partially offset by a larger loss and a decrease inaccounts payable in the first quarter of 2004 compared to the first quarter of2003. Our capital expenditures increased by $4.5 million in the first quarterof 2004 compared to the first quarter of 2003. This increase in capitalexpenditures is due to the building of additional laboratory space at one ofour locations in connection with the consolidation of our facilities to onesite. The net amount transferred from Pharmacopeia to us increased by $7.9million in the quarter ended March 31, 2004 compared to the quarter endedMarch 31, 2003.

 

**Liquidity andCapital Resources Outlook**

 

We expect to continue to use ourcapital to fund operating losses. We expect that our research and developmentexpenditures will increase in the future as we increase our internal drugdiscovery efforts to add to our pipeline of programs.  Conduct of our own drug discovery research is a key component ofour business model.

 

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In addition, our capital requirements may also increasein future periods as we seek to expand our technology platform throughinvestments, licensing arrangements, technology alliances, or acquisitions.

 

We anticipate that ourcapital resources, including the $46.5 million contribution we received in thedistribution, will be adequate to fund our operations at least through 2005. However, there can be no assurance that changeswill not occur that would consume available capital resources before then. Ourcapital requirements depend on numerous factors, including our ability toextend existing agreements and to enter into additional arrangements, competingtechnological and market developments, changes in our existing collaborativerelationships, the cost of filing, prosecuting, defending, and enforcing patentclaims and other intellectual property rights and the outcome of relatedlitigation, the purchase of additional capital equipment, acquisitions of otherbusinesses or technologies, and the progress of our customers’ milestone androyalty producing activities. Prior to exhausting our current capitalresources, we will need to raise additional funds to finance our operatingactivities or enter into strategic initiatives intended to further thedevelopment of our business. There can be no assurance that additional funding,if necessary, 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 thisparagraph will impact our future capital requirements and the adequacy of ouravailable funds.

 

**Resultsof Operations**

 

**Three months endedMarch 31, 2004 and 2003**

 

Our revenue decreased 29% to $5.4 million inthe quarter ended March 31, 2004 compared to $7.5 million in the quarterended March 31, 2003.  The decreasewas primarily due to a decrease in milestone revenue, a decrease in leadoptimization revenue due to the expiration of one of our collaborations withN.V. Organon, and reduced revenue from our collaborations with ScheringPlough.  Milestone revenue recorded inthe quarters ended March 31, 2004 and 2003 was $1.0 million, and $1.9million, respectively.  Excluding therevenue from milestones, revenue decreased 22% to $4.4 million in the quarterended March 31, 2004 compared to $5.6 million in the quarter endedMarch 31, 2003.

######  

Cost of revenue includes the labor, material,equipment and allocated facilities cost of our scientific staff who are workingon collaborative partnerships. Gross margin decreased to ($0.2 million)  in the quarter ended March 31, 2004from $1.7 million in the quarter ended March 31, 2003.  Gross margin as a percentage of revenue was(3%) for the quarter ended March 31, 2004, compared to 23% of revenue inthe quarter ended March 31, 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 underabsorption of fixed costsallocated to collaborative partnerships.

 

Research and development expenses includelabor, material, equipment and allocated facilities cost of scientific staffworking on unfunded internal drug discovery projects. Internal drug discoveryprojects are focused on the creation of new small molecule therapeutics usingproprietary technologies and our collection of 7.5 million proprietarycompounds to identify and optimize novel drug candidates. Because of thespeculative nature of these internal drug discovery projects, it is notpossible to estimate completion dates, or estimated costs of completion.Additionally, from time to time, depending on requirements under collaborativepartnership work, certain staff and other research and development resourcesmay be temporarily redirected to collaborative partnership work whichredirection may also delay or impact the cost of internal drug discoveryprojects. Research and development expenses increased 33% to $1.4 million inthe quarter ended March 31, 2004 compared to $1.0 million in the quarterended March 31, 2003. The increase is consistent with our decision toincrease our investment in our proprietary research drug discovery efforts.

 

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Sales, general and administrative expensesincreased by 57% to $2.4 million in the quarter ended March 31, 2004compared to $1.5 million in the quarter ended March 31, 2003.  The increase in sales, general and administrativeexpenses is primarily attributable to moving costs incurred in theconsolidation of our research and development facilities and an increase inallocated corporate costs.

 

During the quarter ended March 31, 2004,we undertook a restructuring and certain other actions.  Accordingly, restructuring and other chargesof $5.9 million were incurred.  The charge included severance payments, thecost to exit a leased facility, and the acceleration of a deferred compensationcharge.

 

We recorded an income tax provision for thequarter ended March 31, 2004 related to corporate franchise taxes. Theprovision for the quarter ended March 31, 2003 included foreign taxes, aswell as corporate franchise taxes.

 

As a result of the revenues and costsdescribed above, the Company generated a net loss of $9.9 million ($0.82 perdiluted share) in the quarter ended March 31, 2004 compared to a net lossof $0.9 million ($0.08 per diluted share) in the quarter ended March 31,2003.

 

**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. We are highly dependent on thesuccess of our research and development programs with our existingcollaborators and our ability to successfully, cost effectively and timelydevelop, introduce and market new collaborative arrangements. On a quarterlybasis, our future profitability is 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. Thereis no assurance that we will ever achieve profitable operations or thatprofitable operations, if achieved, could be sustained on a continuing basis.

 

**Critical Accounting Policies**

 

The preparation of our financial statements and disclosures involve theuse of judgments and estimates. We believe the following critical accountingpolicies involve significant judgments and estimates used.

 

*Revenue Recognition*-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.

 

Revenue earned related to up-front product and technology license feesis recognized in accordance with Staff Accounting Bulletin 101 issued by theSEC. Accordingly, amounts received under multiple-element arrangementsrequiring ongoing services or performance by us are recognized over the periodof such services or performance.

 

Revenue from milestones are recognized when earned, as evidenced bywritten acknowledgement from the collaborator, provided that (i) the milestoneevent is substantive and its achievability was not reasonably assured at theinception of the agreement, and (ii) our performance obligation after themilestone achievement will continue to be funded by the collaborator at acomparable level to before the milestone achievement. If both of these criteriaare not met, the milestone payment is recognized over the remaining minimumperiod of our performance obligations under the arrangement. Royalties arerecognized as earned in accordance with the terms of various research andcollaboration agreements.

 

*Long-Lived Assets-*Wereview long-lived assets, including leasehold improvements, property andequipment, and acquired technology rights, for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. This requires us to estimate future cashflows related to these assets. Actual results could differ from theseestimates, which may affect the carrying amount of assets and the actualamortization expense. As at March 31, 2004, we had long-lived assets witha net book value of $11.2 million.

 

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**Certain RisksRelated to Our Business**

 

As further described herein, our performance and financial results aresubject to risks and uncertainties including, but not limited to, the followingspecific risks:

 

**RISKSRELATED TO ESTABLISHING OUR COMPANY AS INDEPENDENT FROM PHARMACOPEIA**

 

***We have no currenthistory of operating as an independent company.***

 

Although Pharmacopeia was operated exclusively as a chemistry-based collaborativedrug discovery business prior to its acquisition of Molecular Simulations, Inc.in 1998, our management team has not recently operated our company as a public,stand-alone company, and we have a new board of directors appointed byPharmacopeia. Our ability to satisfy our obligations and increase revenues willbe solely dependent upon the future performance of the businesses we own andoperate, and we will not be able to rely upon the financial and other resourcesand cash flows of those business lines remaining with Pharmacopeia.  Since we do not have an operating history asa separate entity, it will be difficult for anyone to accurately forecast ourfuture revenue and other operating results.

 

***Our historicalfinancial information may not be representative of our results as a separatecompany.***

 

The historical financial information included in this report differfrom the results of operations, financial condition and cash flows that wouldhave been achieved had we been operated independently during the period and asof the dates presented.  Prior to thedistribution, our businesses were operated by Pharmacopeia as part of itsbroader corporate organization rather than as a stand-alone company.  Historically, Pharmacopeia performed certaincorporate functions for us, including legal services, treasury administration,insurance administration, internal audit and corporate income taxadministration.  Now that thedistribution is complete, Pharmacopeia will not provide assistance to us, otherthan to provide various corporate support, information systems and humanresources services during a transition period.

 

We are in the process of creating our own, or engaging third parties toprovide, corporate administrative functions to replace many of the corporateadministrative functions Pharmacopeia provided prior to the distribution.  We may incur costs for these functions thatare higher than the amounts reflected in our historical financial information.

 

Our historical financial information contains assumptions about ourexpenses that may change, such as:

 

•                  ourhistorical financial information reflects allocations, primarily with respectto corporate overhead, for services provided to us by Pharmacopeia which maynot reflect the actual costs we will incur for similar services as astand-alone company; and

 

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

 

Although we believe that our historical financial statements allocateto us a reasonable share of such expenses, we cannot assure you that our actualcosts will not increase, perhaps substantially.  We also are now responsible for the additional costs associatedwith being an independent public company, including costs related to corporategovernance, listed and registered securities and investor relations matters.

 

Accordingly, to the extent that our historical financial information isnot reflective of what our results of operations, financial condition and cashflows would have been had we been an independent company during the periodspresented, that historical financial information will not be a reliableindicator of what our results of operations, financial condition and cash flowswill be in the future.  Therefore, youshould not make any assumptions regarding our future performance based on thefinancial information in this information statement.

 

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***Our stock price maybe volatile, and your investment in our stock could decline in value.***

 

Our quarterlyoperating results, changes in general conditions in the economy or thefinancial markets and other developments affecting our competitors or us couldcause the market price of our common stock to fluctuate substantially.  In recent years, the stock market hasexperienced significant price and volume fluctuations.

 

While we areunaware of a specific reason that any of the following factors will have amaterial impact on our stock price, the following factors, in addition to thefactors described in the other risk factors contained in this report, may havea significant impact on the market 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 tocertain restrictions to preserve the tax treatment of the distribution, whichwill reduce our strategic and operating flexibility.***

 

Pharmacopeia obtained an opinion from Dechert LLP, its counsel, to theeffect that the distribution qualifies as a transaction that is generallytax-free under Sections 355 and/or 368(a)(1)(D) of the Internal Revenue Code of1986, as amended (the “Code”). Current tax law generally creates a presumptionthat the distribution would be taxable to Pharmacopeia but not to itsstockholders if we engage in, or enter into an agreement to engage in, atransaction that would result in a 50 percent or greater change by vote or byvalue in our stock ownership during the four-year period beginning on the datethat begins two years before the distribution date, unless it is establishedthat the transaction is not pursuant to a plan or series of transactionsrelated to the distribution.

 

Temporary U.S.Treasury regulations currently in effect generally provide that whether anacquisition transaction and a distribution are part of a plan is determinedbased on all of the facts and circumstances, including but not limited to thosespecific factors listed in the regulations. In addition, the regulationsprovide several “safe harbors” for acquisition transactions that are notconsidered to be part of a plan.

 

We andPharmacopeia have entered into a tax sharing agreement under which we have madecertain covenants to each other in connection with the distribution that we maynot take certain actions without first obtaining an unqualified opinion ofcounsel or an Internal Revenue Service ruling that such actions will not causethe distribution to become taxable. Pursuant to these covenants, generally (1) we may not liquidate, merge,or consolidate with any other person, sell our assets except in the ordinarycourse of business, or enter into any substantial negotiations, agreements, orarrangements with respect to any such transaction, for at least six monthsafter the distribution date; (2) we will, for two years after the distributiondate, continue the active conduct of the drug discovery business; (3) we willnot repurchase our stock except in certain circumstances permitted by theInternal Revenue Service; (4) we will not take any actions inconsistent withthe representations made in connection with the issuance by Dechert LLP of itsopinion with respect to the transaction; and (5) we will not take or fail totake any other action that would result in any tax being imposed on thedistribution.  Pharmacopeia may seek aninjunction to enforce these covenants. Particularly during the six-month period following the distribution,these restrictions could substantially limit our strategic and operationalflexibility, including our ability to finance our operations by

 

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issuing equity securities, to make acquisitions using equitysecurities, to repurchase our equity securities, to raise money by sellingassets, or to enter into business combination transactions.

 

***We have agreed toindemnify Pharmacopeia for taxes and related losses resulting from any actionswe take that cause the distribution to fail to qualify as a tax-freetransaction.***

 

We have agreed to indemnify Pharmacopeia for any taxes and relatedlosses (including any applicable interest and penalties, all relatedaccounting, legal and other professional fees, all related court costs and allcosts, expenses and damages associated with related stockholder litigation orcontroversies and any amount paid in respect of the liability of stockholders)resulting from a breach of any of the covenants described above.  Furthermore, we will be responsible fortaxes that may be imposed upon Pharmacopeia pursuant to section 355(e) ofthe Code in connection with a transaction that results in a change in controlof us, even though we will have obtained an Internal Revenue Service ruling oran unqualified opinion of counsel prior to the transaction.  The amount of any indemnification paymentscould be substantial.  The amount ofPharmacopeia taxes for which we are agreeing to indemnify Pharmacopeia will bebased on the excess of the aggregate fair market value of our stock as of thedistribution date over Pharmacopeia tax basis in our stock.

 

***We may be requiredto indemnify Pharmacopeia, or may not be able to collect on indemnificationrights from Pharmacopeia***

 

Under the terms of the master separation and distribution agreement andthe tax sharing and indemnification agreement that we entered into withPharmacopeia, we and Pharmacopeia will agree to indemnify one another from andafter the distribution with respect to the indebtedness, liabilities andobligations that will be 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 Pharmacopeia for any substantialobligations.  We also cannot assure youthat, if Pharmacopeia becomes obligated to indemnify us for any substantialobligations, Pharmacopeia will have the ability to satisfy thoseobligations.  Any payment byPharmacopeia or us pursuant to these indemnification provisions could have amaterial adverse effect on its business. Any failure by Pharmacopeia or us to satisfy its indemnificationobligations could have a material adverse effect on the other company’sbusiness.

 

***We will need toobtain financing on a stand-alone basis, which may be difficult because ourfinancial and other resources may not be as strong as those of Pharmacopeiaprior to the distribution.***

 

Historically, all of our financing was done by Pharmacopeia at theparent level. We anticipate that our capital resources, including the $46.5million contribution we received in the distribution, will be adequate to fundour operations at least through 2005. Any future financing that we need to obtain will have to be raised on a stand-alonebasis without reference to or reliance on Pharmacopeia financial condition andwill be based upon our balance sheet. In addition, we may be required to agree to abide by restrictivecovenants that may limit our ability to do business as a condition to securingdebt or equity financing.  We may not beable to secure adequate debt or equity financing on desirable terms or atall.  We have less financial and otherresources than Pharmacopeia had prior to the distribution.  Our ability to obtain financing, and theterms thereof, will in large part depend on our financial condition andperformance.  There can be no assurancethat we will be able to obtain financing. The cost to us of stand-alone financing may be materially higher thanthe cost of financing that we incurred as part of Pharmacopeia.

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

***Our business ishighly dependent upon the extent to which the pharmaceutical and biotechnicalindustries collaborate with drug discovery companies for one or more aspects oftheir drug discovery process.***

 

We are highly dependent on pharmaceutical and biotechnology companiescontinuing to collaborate with outside companies to obtain drug discoveryexpertise. Our revenue depends to a large extent on research and developmentexpenditures by the pharmaceutical and biotechnology industries, particularlycompanies outsourcing research and development projects and adding new andimproved technologies to accelerate their drug discovery and developmentinitiatives. Our capabilities include aspects of the drug discovery processthat pharmaceutical companies have traditionally performed internally. Althoughthere is a history among pharmaceutical and biotechnology companies ofoutsourcing drug research and development functions, this practice may notcontinue.

 

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The willingness of these companies to expand or continue drug discoverycollaborations or outsourcing of services to enhance their research anddevelopment activities is based on certain factors that are beyond our control.While we are unaware of a specific reason that any of the following factorswill 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 to use our drug discoverycapabilities rather than develop them internally 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 from collaborator tocollaborator, and we may be unable to meet any or all of them for some or allof our collaborators in the future.

 

***Our revenue ishighly concentrated in our largest collaborators and the termination of ourcollaboration with any of these collaborators would have a material adverseeffect on our business, financial condition and results of operations.***

 

During the quarter ended March 31, 2004, we earned approximately$3.7 million, or 69% of our revenue, under our research collaborationagreements with Schering-Plough, one of our longest-standing collaborativepartners. In the third quarter of 2003, we entered into new multiyear drugdiscovery collaboration agreements with Schering-Plough, which continue certainexisting programs and implement a number of new activities. The new agreementscontinue our collaboration with this partner through at least August 2006and, under their terms, may be extended by the parties for up to threeadditional years based upon progress made in the programs governed by theagreements. The agreements may be terminated at the end of the third year, andSchering-Plough’s funding obligations may be reduced significantly before thattime. There can be no assurance that the results of our collaboration with Schering-Ploughwill be sufficient to cause Schering-Plough not to exercise its rights toterminate the agreements. In light of the significance to us of theSchering-Plough relationship, the termination of our collaboration agreementswould have a material adverse effect on us.

 

During the quarter ended March 31, 2004, we earned approximately$0.9 million, or 16% of our revenue, under our research collaborationagreements with N.V. Organon, our second largest customer. The principalagreement with N.V. Organon, entered into in February 2002, has a statedterm of five years; however, N. V. Organon has the right to terminate theagreement in 2005 if we are unable to deliver compounds meeting the criteriaspecified in the agreement. We timely delivered the first compound requiredunder this agreement for inspection and verification by N. V. Organon. However,there can be no assurance that these compounds will be compliant, or thatfuture compliant compounds will be delivered before the enumerated dates. The terminationof this agreement would have a material adverse effect on us because of theresulting decrease in our revenue.

 

During the year ended December 31, 2003, we earned approximately$3.4 million, or 11.4% of our revenue, under our research collaborationagreements with Novartis AG, our third largest customer in that year. We havecompleted all of the required services under our Novartis agreements. Inaddition, we have received all compensation with regard to collaborativeservices under these agreements. If we are unable to

 

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enter into agreements with other collaborators, there could be amaterial adverse effect on us because of the resulting decrease in our revenue.

 

***If our collaboratorsare not able to successfully develop our existing clinical candidates, ourbusiness will be harmed.***

 

Our collaborators, Bristol-Myers Squibb Company, Daiichi PharmaceuticalCo. and Schering-Plough Corporation, currently are performing clinical trialsof prospective pharmaceutical products containing our proprietary compounds. Ineach case, the collaborator is responsible for the development of thesepotential products, the level of resources devoted to such development and thedecision as to when, or whether, 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.

 

***The development ofour products is at an early stage and is uncertain.***

 

Drug development is a highly uncertain process. Our approach andtechnology may never result in a commercial drug. None of our compounds arecontained in products that have received regulatory approval for commercialsale, and currently we have only four candidates with respect to which clinicaltrials (i.e., human testing) have been commenced. All of our therapeuticcandidates, including these clinical candidates, are in development, and facethe substantial 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 drug candidates is a long,expensive and uncertain process. Failure can occur at any stage of testing.Success in preclinical testing does not ensure that clinical trials will besuccessful. Based on results at any stage of product development, ourdevelopment collaborators or we may decide to discontinue development of ourproduct candidates.

 

Our product candidates and research programs are in the early stages ofdevelopment and require significant, time-consuming and costly research anddevelopment, testing and regulatory approvals. We do not expect that ourproduct candidates will be commercially available for many years, if ever. Inaddition, we pursue the discovery and initial development of product candidatesusing our integrated technology platform in both our internal and collaborativeprograms to implement our strategy of reducing the cost and time incurred bythe pharmaceutical industry in developing drug candidates. To date, we have notidentified a therapeutic candidate that has been developed into a commercialdrug using our platform. It is uncertain whether our technology platform willachieve these goals at all or whether it will be competitive with platformsused by our competitors.

 

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

 

We anticipate that our capital resources, including the $46.5 millioncapital contribution we received in the distribution, will be adequate to fundour operations at least through 2005. However, changes may occur that wouldconsume available 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 costsassociated with drug discovery services;

 

•                  our internalproprietary drug discovery activities;

 

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•                  competingtechnological and market developments;

 

•                  changes in ourexisting collaborative relationships;

 

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

 

•                  the purchase ofadditional capital equipment;

 

•                  acquisitions ofother businesses or technologies; and

 

•                  the progress ofour milestone and royalty producing activities.

 

If we determine that we must raise additional capital, the capitalcould be raised through public or private financings involving debt or equity.However, additional capital may not be available on favorable terms, or at all.If adequate funds are not available, we may be required to curtail operationssignificantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

 

***Disputes may arisebetween our collaborative partners and us as to royalties and milestones to whichwe are entitled.***

 

The compound basis for drugs developed by a customer may be aderivative or optimized version of the compound screened or optimized by us.While our existing collaborative agreements provide that we will receivemilestone payments and royalties with respect to certain products developedfrom certain derivative compounds, there can be no assurance that disputes willnot arise over the application of payment provisions to such products. Therecan be no assurance that current or future collaborative partners will notpursue alternative technologies, or develop alternative products either ontheir own or in collaboration with others, including our competitors, as ameans for developing treatments based on the targets which are the subject ofthe collaborative arrangements with us.

 

***We may notsuccessfully enter into additional collaborations or services agreements thatallow us to participate in the future success of our product candidates throughmilestone, royalty and/or license payments, and we may never receive anymilestone, royalty and/or license payments under our current or any futurecollaborations.***

 

One of our business strategies is to expand our proprietary pipeline ofdrug candidates and to then enter into collaborations for the development ofthese drug candidates that will allow us to earn milestone, royalty and/orlicense payments. Our proprietary drug discovery program is in its early stageof development and is unproven. Although we have expended, and continue toexpend, time and money on internal research and development programs, we may beunsuccessful in creating valuable proprietary drug candidates that would enableus to form additional collaborations and receive milestone, royalty and/orlicense payments.

 

Our collaborations and internal programs may not result in thediscovery of potential drug candidates that will be safe or effective. Althoughwe have received license and milestone fees to date, we may never receive anyroyalty payments, or any additional license and milestone fees, under ourcurrent or any future collaborations. Our receipt of any future milestone,royalty or license payments depends on many factors, including whether ourcollaborators desire to or are able to continue to pursue a potential drugcandidate and the ultimate commercial success of the drug. Development andcommercialization of potential drug candidates depend not only on theachievement of research objectives by our collaborators and us, but also oneach 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 researchand development industry is highly competitive and subject to technologicalchange, and we may not have the resources necessary to compete successfully.***

 

Many of our competitors have access to greater financial, technical,research, marketing, sales, distribution, service and other resources than wedo. Moreover, the pharmaceutical and biotechnology industries are characterizedby continuous technological innovation. We anticipate that we will faceincreased competition in the future as new companies enter the market and ourcompetitors make advanced

 

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technologies available. Technological advances or entirely differentapproaches that we or one or more of our competitors develop may render ourproducts, services and expertise obsolete or uneconomical. Additionally, theexisting approaches of our competitors or new approaches or technologies thatour competitors develop may be more effective than those we develop. We may notbe able to compete successfully with existing or future competitors.

 

In addition, due to improvements in global communications, combinedwith the supply of lower cost Ph.D. level scientific talent in offshorelocations such as China, India and Eastern Europe, we face the growing threatof competition for our services.

 

***If we cannot managethe multiple relationships and interests involved in our collaborativearrangements and drug discovery programs, our business, financial condition andresults of operations may be materially adversely affected.***

 

We may need to successfully structure and manage multiple drugdiscovery programs and collaborative relationships, including maintainingconfidentiality of the research being performed for multiple collaborators. Wemay be unable to manage successfully conflicts between competing drugdevelopment programs of third parties to which we offer services. From time totime, more than one of our collaborators may want to perform researchconcerning the same or molecularly similar disease targets. Because of that, wemay be required to reconcile our relationships with those collaborators,particularly if both want to establish exclusive relationships with us withrespect to that target or if one collaborator has an existing arrangement withus and the other would like us to perform services regarding a targetrestricted by that arrangement. Further, if we are working with a collaboratorregarding a particular target, another of our collaborators may be researchingthe same target in one of its internal programs of which we have no knowledge.As a result, potential conflicts involving us may arise due to this competitionbetween collaborators in a particular disease field of interest. Conflicts alsomay arise between our collaborators as to proprietary rights to particularcompounds in our libraries or as to proprietary rights to biological targetssuch as receptors or enzymes against which we screen compounds in ourlibraries. The occurrence of conflicts could have a material adverse effect onour business, financial condition and results of operations.

 

***If we use hazardousmaterials in a manner that causes injury or violates laws, we may be liable fordamages.***

 

Our activities involve the use of potentially harmful hazardousmaterials, chemicals and various radioactive compounds. These materials areutilized in the performance of our assay development, high-throughput screeningand chemistry optimization services, and include common organic solvents, suchas acetone, hexane, methylene chloride, acetonitrile, and isopropyl and methylalcohol as well as common acids and bases. The waste from utilization of thesesolvents and other materials is disposed of through licensed third-partycontractors. Further, we utilize an extremely wide variety of chemicals in theperformance of our assay development, screening and optimization services.These chemicals, such as reagents, buffers and inorganic salts, typically areemployed in extremely small amounts in connection with the work performed inour laboratories.

 

We cannot completely eliminate the risk of accidental contamination orinjury from the use, storage, handling or disposal of these materials. In theevent of contamination or injury, we could be held liable for damages thatresult. We maintain insurance coverage against environmental hazards arisingfrom the storage and disposal of the materials utilized in our business.Although our management believes that such insurance has terms, includingcoverage limits, which are appropriate for our business, liabilities arisingfrom the use, storage, handling or disposal of these materials could exceed ourinsurance coverage as well as our resources. We are subject to federal, stateand local laws and regulations governing the use, storage, handling anddisposal of these materials and specified waste products. The cost ofcompliance with these laws and regulations could be significant. To ourknowledge, 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 productsare subject to strict government regulation, which may limit the development ofproducts by us or our collaborators.***

 

Regulation by governmental entities in the United States and othercountries will be a significant factor in the production and marketing of anypharmaceutical products our customers or we may develop. The

 

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nature and the extent to which government regulation may apply to ourcustomers and us will vary depending on the nature of the pharmaceuticalproducts, if any. Virtually all pharmaceutical products require regulatoryapproval prior to commercialization. If we or our collaborators or licenseesfail to obtain, or encounter delays in obtaining or maintaining, regulatoryapprovals, our financial results could be adversely affected. Similarregulatory procedures are required in countries outside the United States.

 

In addition, new legislation related to health care could reduce theprices pharmaceutical and biotechnology companies can charge for drugs theysell which, in turn, could reduce the amounts that they have available forcollaborative relationships with us or for the purchase of our services. Ifpharmaceutical and biotechnology companies decrease the resources they devoteto the research and development of new drugs, the number of collaborations weconclude and the amount of and profitability of services we perform could beadversely impacted and our revenue and profitability reduced. If prices thatpharmaceutical and biotechnology companies can charge for drugs they selldecrease, the royalties, if any, we receive from the sale of products couldalso decrease, which would reduce our revenue and profitability.

 

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

 

For the fiscal years ended December 31, 2001, 2002 and 2003, wehad net losses of approximately $6.6 million, $2.1 million and $2.8 million,respectively.  During the three monthperiod ended March 31, 2004, we had net losses of approximately $9.9million, including restructuring and other charges of $5.9 million.  Continuing net losses may limit our abilityto fund our operations and we may not generate income from operations in thefuture.

 

While we are unaware of a specific reason that any of the followingfactors is likely to occur, our future profitability depends upon many factors,including several that are beyond our control. These factors include:

 

•                  changes in thedemand for collaborative relationships with us, or for our services;

 

•                  the introductionof competitive drug discovery services;

 

•                  changes in theresearch and development budgets of our customers and potential customers; and

 

•                  our ability tosuccessfully, cost effectively and timely develop, introduce and market newcollaborative arrangements, as well as the related services.

 

On a quarterly basis, our future profitability is likely to be highlyvolatile because it depends upon our receipt of milestone payments from ourcollaborators. We may not receive milestone payments on a regular basis or atall. Our ability to achieve profitability will be significantly impacted by thelevel of investment we determine to make in our internal proprietary programsin the future as well as the results of those programs.

 

***Rapid changes intechnology could have an adverse impact on our business.***

 

Rapid technological change and uncertainty due to new and emergingtechnologies characterize the drug discovery industry. We may be unable todevelop, integrate and market, on a timely basis, new and enhanced servicesnecessary to keep pace with competitors. Our services and technologies may berendered obsolete by the offerings of our competitors. Although we do notbelieve there are currently new significant technologies that we need toincorporate in our business to remain competitive in our industry, failure toanticipate or to respond to changing technologies, or significant delays in thedevelopment or introduction of services, could cause customers to delay ordecide against purchases of our services.

 

***Failure to attractand retain skilled personnel could materially and adversely affect us.***

 

Our success depends in part on the continued service of key scientific,business development and management personnel and our ability to identify, hireand retain 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 ormore of these key

 

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employees could retire or otherwise leave our employ within theforeseeable future, and the loss of any of these people could have a materialadverse effect on our business, financial condition and results of operations.We are currently conducting a search to hire a chief executive officer. Dr.Joseph A. Mollica, Ph.D. is expected to serve as our President and ChiefExecutive Officer until a successor is appointed. We do not, and do not intendto, maintain key person life insurance on the life of any employee.

 

***Some of ourdevelopment and marketing activities are, or will be, conducted by thirdparties. If these third parties fail to perform their functions satisfactorily,our revenue and earnings could be delayed, reduced or eliminated.***

 

The ultimate success of our business plan heavily depends upon thesuccessful discovery, development and commercialization of pharmaceuticalproducts. Our endeavors will result in commercialized pharmaceutical products,if at all, only after significant preclinical and clinical development,requisite regulatory approvals, establishment of manufacturing capabilities andsuccessful marketing. We do not currently have the technology, facilities,personnel or experience to accomplish all of these tasks on our own, and wewill likely not have all the necessary resources in the foreseeable future.Therefore, we continue to depend heavily upon the expertise and dedication ofsufficient resources by collaborative partners to develop and commercializeproducts primarily based on lead compounds discovered by us. If a collaborativepartner fails to develop or commercialize a compound or product with respect towhich it has rights from us, we may not receive any future milestone paymentsor royalties associated with that compound or product. Similarly, while we areunaware of a specific reason that any of the following factors will beexperienced by our strategic collaborators, because we rely heavily on them,our revenue could be adversely affected if our collaborators:

 

•                  fail to select atarget or product candidate we have identified for subsequent development;

 

•                  fail to gain therequisite regulatory approvals of product candidates;

 

•                  do notsuccessfully commercialize products based on the compounds that we originate;

 

•                  do not conducttheir collaborative activities in a timely manner;

 

•                  do not devotesufficient time or resources to our partnered programs or potential products;

 

•                  terminate theiralliances or arrangements with us;

 

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

 

•                  dispute ourrespective allocations of rights to any products or technology developed duringour collaborations; or

 

•                  merge with orare acquired by a third party that seeks to terminate our collaboration.

 

***We are subject torisks associated with the operation of an international business***

 

In the quarter ended March 31, 2004, approximately 57% of ourrevenue was derived from customers outside the United States. Approximately 54%of our revenue was derived from customers in Europe, and approximately 3% wasderived from customers in the Asia/Pacific region. We anticipate thatinternational revenue will continue to account for a significant percentage ofour overall revenue. While we are unaware of a specific reason that any of thefollowing factors will have a material impact on our revenue, our internationaloperations are subject to the risk factors inherent in the conduct ofinternational business, including:

 

•                  unexpectedchanges in regulatory requirements;

 

•                  longer paymentcycles;

 

•                  import andexport license requirements;

 

•                  tariffs andother barriers;

 

•                  political andeconomic instability;

 

•                  limitedintellectual property protection;

 

•                  difficulties incollecting trade receivables;

 

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•                  difficulties instaffing and managing foreign joint venture operations; and

 

•                  potentiallyadverse tax consequences.

 

We may not be able to sustain or increase our international revenue.Any of the foregoing factors may have a material adverse effect on ourinternational operations and, therefore, our business, financial condition andresults of operations.

 

***We may not realizerevenue from our extensive business development efforts.***

 

Our collaborative relationships and the related services involvelengthy sales cycles, often requiring us to expend considerable financial andpersonnel resources without any assurance that revenue will be recognized.These cycles typically are long for a number of reasons. Factors include thestrategic nature of our partnerships, the size of many such transactions, theconfidential and proprietary nature of the biological targets against which wescreen our chemical compound libraries, and the unique terms typically found ineach of the transactions. As a result, we may expend substantial funds andeffort to negotiate agreements for collaborative arrangements or services, butmay ultimately be unable to complete the transaction and recognize revenue. Inthese circumstances, our business, financial condition and results ofoperations will be adversely affected.

 

***Our operations maybe interrupted by the occurrence of a natural disaster or other catastrophicevent at our primary facilities.***

 

We depend on our laboratories and equipment for the continued operationof our business. Our research and development operations and administrativefunctions are primarily conducted at our facilities in the Princeton, NewJersey area. Although we have contingency plans in effect for natural disastersor other catastrophic events, catastrophic events could still disrupt ouroperations. Even though we carry business interruption insurance policies, wemay suffer losses as a result of business interruptions that exceed thecoverage available under our insurance policies. Any natural disaster orcatastrophic event in our facilities or the areas in which they are locatedcould have a significant negative impact on our operations.

 

***Because we do notintend to pay dividends, you will benefit from an investment in our commonstock only if it appreciates in value.***

 

We have never declared or paid any cash dividend on common stock. Wecurrently intend to retain our future earnings, if any, to finance theexpansion of our business and do not expect to pay any cash dividends in theforeseeable future. As a result, the success of your investment in our commonstock will depend entirely upon any future appreciation in its value. There isno guarantee that our common stock will appreciate in value or even maintainthe price at which your shares traded immediately after the distribution.

 

***Anti-takeoverprovisions under Section 203 of the Delaware General Corporation Law,provisions in our amended and restated certificate of incorporation and amendedand restated bylaws, and our adoption of a stockholder rights plan may rendermore difficult the accomplishment of mergers or the assumption of control by aprincipal stockholder, making more difficult the removal of management.***

 

Section 203 of the Delaware General Corporation Law may delay ordeter attempts to secure control of our company without the consent of ourmanagement. In general, Section 203 prohibits a publicly-held Delawarecorporation from engaging in a business combination with an interestedstockholder for a period of three years following the date the person becomesan interested stockholder, unless certain conditions are met.

 

Our amended and restated certificate of incorporation and amended andrestated bylaws contain several provisions that could delay or make moredifficult the acquisition of our company through a hostile tender offer, openmarket purchases, proxy contest, merger or other takeover attempt that astockholder might consider in his or her best interest, including thoseattempts that might result in a premium over the market price of our commonstock. Such provisions include the issuance of preferred stock without approvalof the holders of our common stock, the classification of our board ofdirectors, the election and removal of directors, restrictions on the abilityof stockholders to take action without a meeting, restrictions on stockholders’ability to call a special meeting and advance notice procedures regarding anyproposal of stockholder business to be discussed at a stockholders meeting.

 

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We have adopted a stockholder rights plan, which is triggered uponcommencement or announcement of a hostile tender offer or when any one personor group acquires 15% or more of our common stock. The rights plan, oncetriggered, enables stockholders to purchase our common stock, and the stock ofthe entity acquiring us, at reduced prices. These provisions of our governingdocuments, stockholder rights plan and Delaware law could have the effect ofdelaying, deferring or preventing a change of control, including withoutlimitation 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 toacquire new and complementary businesses, products or technologies instead ofdeveloping them ourselves, we may be unable to complete these acquisitions orto successfully integrate an acquired business or technology in acost-effective and non-disruptive manner.***

 

From time to time, we may choose to acquire complementary businesses,products or technologies instead of developing them ourselves. We do not knowif we will be able to complete any acquisitions, or whether we will be able tosuccessfully integrate any acquired businesses, operate them profitably orretain their key employees. Integrating any business, product or technology weacquire could be expensive and time-consuming, disrupt our ongoing business anddistract company management. In addition, in order to finance any acquisition,we might need to raise additional funds through public or private equity ordebt financings. In that event, we could be forced to obtain financing on lessthan favorable terms and, in the case of equity financing, on terms that mayresult in dilution to our stockholders. lf we are unable to integrate anyacquired entities, products or technologies effectively, our business willsuffer. In addition, under certain circumstances, amortization of assets orcharges resulting from the costs of acquisitions could harm our business andoperating results.

 

**CERTAIN RISKS RELATED TO INTELLECTUALPROPERTY**

 

***Positions taken bythe U.S. Patent and Trademark Office or non-U.S. patent and trademark officialsmay preclude us from obtaining sufficient or timely protection for ourintellectual property.***

 

The patent positions of pharmaceutical and biotechnology companies areuncertain and involve complex legal and factual questions. The coverage claimedin a patent application can be significantly reduced before the patent isissued. There is a significant risk that the scope of a patent may not besufficient to prevent third parties from marketing other products ortechnologies with the same functionality of our products and technologies.Consequently, some or all of our patent applications may not issue intopatents, and any issued patents may provide ineffective remedies or bechallenged or circumvented.

 

***Third parties mayhave filed patent applications of which we may or may not have knowledge, andwhich may adversely affect our business.***

 

Patent applications in the United States are maintained in secrecy for18 months from filing or until a patent issues. Under certain circumstances,patent applications are never published but remain in secrecy until issuance.As a result, others may have filed patent applications for products ortechnology covered by one or more pending patent applications upon which we arerelying. If applications covering similar technologies were to be filed beforeour applications, our patent applications may not be granted. There may bethird-party patents, patent applications and other intellectual property orinformation relevant to our chemical compositions and other technologies thatare not known to us,  that block us orcompete with our chemical compositions or other technologies, or limit thescope of patent protection available to us. Moreover, from time to time,patents may issue which block or compete with our chemical compositions orother technologies, or limit the scope of patent protection available to us.Litigation may be necessary to enforce patents issued to us or to determine thescope and validity of the intellectual property rights of third parties.

 

***We may not be ableto protect adequately the trade secrets and confidential information that wedisclose to our employees.***

 

We rely upon trade secrets, technical know-how and continuingtechnological innovation to develop and maintain our competitive position.Competitors through their independent discovery (or improper means, such asunauthorized disclosure or industrial espionage) may come to know ourproprietary information. We generally require employees and consultants toexecute confidentiality and assignment-of-inventions

 

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agreements. These agreements typically provide that all materials andconfidential information developed by or made known to the employee orconsultant during his, her or its relationship with us are to be keptconfidential, and that all inventions arising out of the employee’srelationship with us are our exclusive property. Our employees and consultantsmay breach these agreements, and in some instances we may not have an adequateremedy. Additionally, in some instances, we may have failed to require thatemployees and consultants execute confidentiality and assignment-of-inventionsagreements.

 

***Foreign laws may notafford us sufficient protections for our intellectual property, and we may notseek patent protection outside the United States.***

 

We believe that our success depends, in part, upon our ability toobtain international protection for our intellectual property. However, thelaws of some foreign countries may not be as comprehensive as those of theUnited States and may not be sufficient to protect our proprietary rightsabroad. In addition, we may decide not to pursue patent protection outside theUnited States, because of cost and confidentiality concerns. Accordingly, ourinternational competitors could obtain foreign patent protection for, andmarket overseas, products and technologies for which we are seeking U.S. patentprotection and may be able to use these products and technologies to competeagainst us.

 

***We may not be ableto adequately defend our intellectual property from third party infringement,and third party challenges to our intellectual property may adversely affectour rights and be costly and time consuming.***

 

Some of our competitors have, or are affiliated with companies having,substantially greater resources than we have, and those competitors may be ableto sustain the costs of complex patent litigation to a greater degree and forlonger periods of time than us. Uncertainties resulting from the initiation andcontinuation of any patent or related litigation could have a material adverse effecton our ability to compete in the marketplace pending resolution of the disputedmatters. If our competitors prepare and file patent applications in the UnitedStates that claim technology also claimed by us, we may have to participate ininterference proceedings declared by the U.S. Patent and Trademark Office todetermine the priority of invention, which could result in substantial costs tous, even if the outcome is favorable to us. Similarly, opposition proceedingsmay occur overseas, which may result in the loss or narrowing of the scope ofclaims or legal rights. Such proceedings will at least result in delay in theissuance of enforceable claims. An adverse outcome could subject us tosignificant liabilities to third parties and require us to license disputedrights from third parties or cease using the technology.

 

***A patent issued tous may not be sufficiently broad to protect adequately our rights inintellectual property to which the patent relates.***

 

Even if patents are issued to us, these patents may not sufficientlyprotect our interest in our chemical compositions or other technologies becausethe scope of protection provided by any patents issued to or licensed by us aresubject to the uncertainty inherent in patent law. Third parties may be able todesign around these patents or develop unique products providing effectssimilar to our products. In addition, others may discover uses for our chemicalcompositions or technologies other than those uses covered in our patents, andthese other uses may be separately patentable. A number of pharmaceutical andbiotechnology companies, and research and academic institutions, have developedtechnologies, filed patent applications or received patents on varioustechnologies that may be related to our business. Some of these technologies,patent applications or patents may conflict with our technologies, patentapplications or patents. These conflicts could also limit the scope of patents,if any, that we may be able to obtain, or result in the denial of our patentapplications. We are not currently aware of any such patent applications orpatents that could have a material adverse effect on our business.

 

***We may be subject toclaims of infringement by third parties.***

 

Third parties may claim infringement by us of their intellectualproperty rights. In addition, to the extent our employees are involved inresearch areas similar to those areas in which they were involved at theirformer employers, we may be subject to claims that one of our employees, or we,have inadvertently or otherwise used or disclosed the alleged trade secrets orother proprietary information of a former employer. From time to time, we havereceived letters claiming or suggesting that our products or activities mayinfringe third party patents or other intellectual property rights. Ourproducts may infringe patent or other intellectual property rights of thirdparties. A number of patents may have been issued or may be issued in thefuture 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 claims of infringement. We may notpossess proper ownership or access rights to the intellectual property we use.Third parties or other companies may bring infringement suits against us. Anyclaims, with or without merit, could be time consuming to defend, result incostly litigation, divert management’s attention and resources or require us toenter into royalty or licensing agreements. Royalty or licensing agreements, ifrequired, may not be available on terms acceptable to us, if at all. In theevent of a successful claim of product infringement against us, our failure orinability to license or design around the infringed technology could have amaterial adverse effect on our business, financial condition and results ofoperations. We are not currently involved in actions of this type that arematerial to our business.

 

**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

 

Our international sales generally are denominated inUnited States Dollars, and are, therefore, not exposed to changes in foreigncurrency exchange rates.

 

We do not use derivative financialinstruments for trading or speculative purposes.  However, we regularly invest excess cash in overnight repurchaseagreements that are subject to changes in short-term interest rates.  We believe that the market risk arising fromholding these financial instruments is minimal.

 

Our exposure to market risks associated with changes ininterest rates relates primarily to the increase or decrease in the amount ofinterest income earned on our investment portfolio since we have minimaldebt.  We ensure the safety andpreservation of invested funds by limiting default risks, market risk andreinvestment risk.  We mitigate defaultrisk by investing in investment grade securities.  A hypothetical 100 basis point adverse move in interest ratesalong the entire interest rate yield curve would not materially affect the fairvalue of our interest sensitive financial instruments at March 31, 2004.

 

**Item4.  Controls and Procedures**

 

For the quarterly period ending March 31, 2004 we carried out anevaluation, under the supervision and with the participation of our management,including our President and Chief Executive Officer and our Vice President,Finance (the principal finance and accounting officer), of the effectiveness ofthe design and operation of our disclosure controls and procedures pursuant toRules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, or theExchange Act, as of the end of the period covered by this report.  Our President and Chief Executive Officerand our Vice President, Finance concluded that there were no significantchanges in our disclosure controls and procedures or in other factors thatcould significantly affect our disclosure controls and procedures during thequarterly period.  Based upon thisevaluation, our President and Chief Executive Officer and our Vice President,Finance concluded that as of March 31, 2004, our disclosure controls andprocedures have been designed and are being operated in a manner that providesreasonable assurance that the information required to be disclosed by theCompany in reports filed under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the rules andforms of the SEC.  The Company’smanagement, including the Chief Executive Officer and Vice President, Finance,does not expect that our disclosure controls or our internal controls willprevent all errors and all fraud.  Acontrol system, no matter how well designed and operated, cannot provide assurancethat the objectives of the control system are met, and no evaluation ofcontrols can provide absolute assurance that all control issues and instancesof fraud, if any, within a company have been detected.

 

Additionally, our President and Chief Executive Officer and VicePresident, Finance determined that there were no changes in our internalcontrol over financial reporting during the quarterly period endedMarch 31, 2004, that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**PARTII.  OTHER INFORMATION**

 

**Item1.****           Legal Proceedings**

 

From time to time we may be a party to certain litigation in theordinary course of our business, and we do not believe these matters, even ifadversely adjudicated or settled, would have a material adverse effect on ourfinancial condition or results of operations.

 

**Item 2.****           Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities**

 

None.

 

**Item3.**           **Defaults upon Senior Securities**

 

None.

 

**Item4.****           Submission of Mattersto a Vote of Security Holders.**

 

None.

 

**Item5.****           Other Information**

 

None.

 

**Item6.****           Exhibits and Reports onForm 8-K**

 

(a) Exhibits.

 
| 31.1   |   | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, 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 Act of 2002(1) |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                              |
| 31.2   |   | Certification  of the Principal Financial Officer of Pharmacopeia Drug Discovery, 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 Act of 2002(1) |
|   |   |                                                                                                                                                                                                                                              |
| 32.1   |   | Certification  of the Chief Executive Officer of Pharmacopeia Drug Discovery, Inc. pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002(1)                                        |
|   |   |                                                                                                                                                                                                                                              |
| 32.2   |   | Certification  of the Principal Financial Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002(1)                                    |

 

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(1)                                  Filedherewith.

 

(b)Reports on Form 8-K.

 

None.

 

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**SIGNATURES**

 

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

 
|                                       | PHARMACOPEIA  DRUG DISCOVERY, INC. |
|--------------------------------------------|------------------------------------|
|                                       |                               |
| Date::  June  2,  2004 | By:                                | /s/ Joseph A. Mollica |
|                                       |                               | Joseph  A. Mollica |
|                                       |                               | Chairman,  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 TO EXHIBITS**

 
| **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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