**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 1O-Q**

**(MarkOne)**
| **ý**                                             | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| ** **                                             | ** **                                                                                              |
| **For the  quarterly period ended September 30, 2006** |
| ** **                                             | ** **                                                                                              |
| **Or**                                                 |
| ** **                                             |                                                                                                    |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number: 0-50523**

**PHARMACOPEIADRUG 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)

**NotApplicable**

(Former name, former address and former fiscal year, if changed sincelast report)

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

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

Largeaccelerated filer  o   Acceleratedfiler  o   Non-acceleratedfiler  x

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

Yes  o   No  x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date:

| Class                          | ** ** | **Outstanding at October 31, 2006** |
|--------------------------------|------------|-------------------------------------|
| Common Stock,  $0.01 par value |       | 21,122,923                          |

 

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

**Form 10-Q**

**Table of Contents**
| Item              | ** ** | ** **                                                                                        | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------|------------|
|              |       |                                                                                              |       |
| PART I.      |       | FINANCIAL INFORMATION                                                                             | 2          |
|              |       |                                                                                              |       |
| Item 1.           |       | Financial  Statements (Unaudited):                                                                | 2          |
|              |       |                                                                                              |       |
|              |       | Balance  Sheets as of September 30, 2006 and December 31, 2005                               | 2          |
|              |       |                                                                                              |       |
|              |       | Statements  of Operations for the Three Months and Nine Months Ended September 30, 2006  and 2005 | 3          |
|              |       |                                                                                              |       |
|              |       | Statements  of Cash Flows for the Nine Months Ended September 30, 2006 and 2005                   | 4          |
|              |       |                                                                                              |       |
|              |       | Notes to  Unaudited Financial Statements                                                          | 5          |
|              |       |                                                                                              |       |
| Item 2.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations       | 13         |
|              |       |                                                                                              |       |
| Item 3.           |       | Quantitative  and Qualitative Disclosures about Market Risk                                       | 21         |
|              |       |                                                                                              |       |
| Item 4.           |       | Controls and Procedures                                                                           | 21         |
|              |       |                                                                                              |       |
| PART II.     |       | OTHER INFORMATION                                                                                 | 21         |
|              |       |                                                                                              |       |
| Item 1.           |       | Legal  Proceedings                                                                                | 21         |
|              |       |                                                                                              |       |
| Item 1A.          |       | Risk  Factors                                                                                     | 21         |
|              |       |                                                                                              |       |
| Item 2.           |       | Unregistered Sales  of Equity Securities and Use of Proceeds                                      | 24         |
|              |       |                                                                                              |       |
| Item 3.           |       | Defaults upon  Senior Securities                                                                  | 24         |
|              |       |                                                                                              |       |
| Item 4.           |       | Submission of  Matters to a Vote of Security Holders                                              | 24         |
|              |       |                                                                                              |       |
| Item 5.           |       | Other  Information                                                                                | 24         |
|              |       |                                                                                              |       |
| Item 6.           |       | Exhibits                                                                                          | 24         |
|              |       |                                                                                              |       |
| Signatures        | 26         |
|              |       |                                                                                              |       |
| Index to Exhibits |       |

 

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**PART I - FINANCIAL INFORMATION**

**Item 1. FinancialStatements (Unaudited)**

**Pharmacopeia Drug Discovery, Inc.**

**Balance Sheets**

**(Amounts in thousands, except share and per share data)**
| ** **                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                          | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                                                                                                          | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                          | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                                          |       | $                      | 25,979     |                  | $          | 11,680 |   |
| Marketable  securities                                                                                                              |       | 5,036                  |       | 18,686                |       |
| Accounts  receivable                                                                                                                |       | 2,008                  |       | 2,256                 |       |
| Prepaid expenses  and other current assets                                                                                          |       | 1,131                  |       | 771                   |       |
| Total current  assets                                                                                                               |       | 34,154                 |       | 33,393                |       |
|                                                                                                                                |       |                   |       |                  |       |
| Property and equipment,  net                                                                                                        |       | 11,314                 |       | 10,548                |       |
| Deferred compensation  plan assets                                                                                                  |       | 1,873                  |       | 1,904                 |       |
| Other assets                                                                                                                        |       | 174                    |       | 174                   |       |
| Total assets                                                                                                                        |       | $                      | 47,515     |                  | $          | 46,019 |   |
|                                                                                                                                |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                      |       |                   |       |                  |       |
| Current liabilities:                                                                                                                |       |                   |       |                  |       |
| Accounts payable                                                                                                                    |       | $                      | 2,720      |                  | $          | 1,112 |   |
| Accrued  liabilities                                                                                                                |       | 2,883                  |       | 3,350                 |       |
| Restructuring  reserve                                                                                                              |       | —                 |       | 908                   |       |
| Deferred  revenue, current portion                                                                                                  |       | 7,615                  |       | 3,492                 |       |
| Total current  liabilities                                                                                                          |       | 13,218                 |       | 8,862                 |       |
|                                                                                                                                |       |                   |       |                  |       |
| Deferred compensation  plan                                                                                                         |       | 1,873                  |       | 1,904                 |       |
| Deferred revenue,  long-term                                                                                                        |       | 12,154                 |       | —                |       |
| Other liabilities,  long-term                                                                                                       |       | 1,333                  |       | —                |       |
|                                                                                                                                |       |                   |       |                  |       |
| Commitments and  contingencies                                                                                                      |       | —                 |       | —                |       |
|                                                                                                                                |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                          |       |                   |       |                  |       |
| Preferred stock,  $.01 par value, 2,500,000 shares authorized, none issued and outstanding                                          |       | —                 |       | —                |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized, 15,317,300 and 14,988,915  shares issued and outstanding, respectively |       | 153                    |       | 150                   |       |
| Additional  paid-in capital                                                                                                         |       | 61,760                 |       | 58,751                |       |
| Accumulated  deficit                                                                                                                |       | (42,946                | )          | (23,373               | )          |
| Accumulated  other comprehensive loss                                                                                               |       | (30                    | )          | (146                  | )          |
| Deferred compensation                                                                                                               |       | —                 |       | (129                  | )          |
| Total  stockholders’ equity                                                                                                    |       | 18,937                 |       | 35,253                |       |
| Total liabilities and  stockholders’ equity                                                                                    |       | $                      | 47,515     |                  | $          | 46,019 |   |

 

See accompanying notes to these unaudited financial statements

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**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Operations**

**(Amountsin thousands, except share and per share data)**
| ** **                                            | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                            | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                            | ** ** | **2006**                                | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(unaudited)**                         | ** ** | **(unaudited)**                        | ** ** |
| Net revenue                                           |       | $                                       | 6,257      |                                   | $          | 3,908 |   | $ | 13,665 |   | $ | 14,830 |   |
|                                                  |       |                                    |       |                                   |       |   |   |   |   |
| Collaborative research and development expense        |       | 3,448                                   |       | 4,145                                  |       | 9,760 |   | 14,387 |   |
| Proprietary research and development expense          |       | 5,801                                   |       | 2,730                                  |       | 17,561 |   | 7,426 |   |
| Sales, general and administrative expense             |       | 2,130                                   |       | 2,038                                  |       | 7,001 |   | 7,864 |   |
| Restructuring and other charges (credits)             |       | —                                  |       | —                                 |       | (88 | ) | — |   |
| Interest and other income, net                        |       | (419                                    | )          | (275                                   | )          | (1,033 | ) | (781 | ) |
|                                                  |       | 10,960                                  |       | 8,638                                  |       | 33,201 |   | 28,896 |   |
| Loss before  income taxes                             |       | (4,703                                  | )          | (4,730                                 | )          | (19,536 | ) | (14,066 | ) |
| Provision for income taxes                            |       | 9                                       |       | 7                                      |       | 37 |   | 21 |   |
| Net loss                                              |       | $                                       | (4,712     | )                                      | $          | (4,737 | ) | $ | (19,573 | ) | $ | (14,087 | ) |
|                                                  |       |                                    |       |                                   |       |   |   |   |   |
| Net loss per  share:                                  |       |                                    |       |                                   |       |   |   |   |   |
| - Basic and diluted                                   |       | $                                       | (0.31      | )                                      | $          | (0.33 | ) | $ | (1.28 | ) | $ | (1.08 | ) |
|                                                  |       |                                    |       |                                   |       |   |   |   |   |
| Weighted average  number of common stock outstanding: |       |                                    |       |                                   |       |   |   |   |   |
| - Basic and  diluted                                  |       | 15,297,476                              |       | 14,264,615                             |       | 15,244,905 |   | 13,023,929 |   |

 

See accompanying notes to these unaudited financial statements

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**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Cash Flows**

**(Amountsin thousands)**
| ** **                                                                      | ** ** | **For the Nine Months** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                      | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                                      | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                                                      | ** ** | **(unaudited)**                        | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                          |       |                                   |       |   |   |
| Net loss                                                                        |       | $                                      | (19,573    | ) | $ | (14,087 | ) |
| Adjustments to reconcile net loss to net cash provided  by operating activities |       |                                   |       |   |   |
| Depreciation and amortization                                                   |       | 1,406                                  |       | 1,712 |   |
| Contribution of stock to 401(k) Plan                                            |       | 311                                    |       | 299 |   |
| Share-based compensation                                                        |       | 1,418                                  |       | 281 |   |
| Adjustment to accrued restructuring charges                                     |       | (88                                    | )          | — |   |
| Gain on sale of property and equipment                                          |       | (3                                     | )          | — |   |
| Changes in assets and liabilities:                                              |       |                                   |       |   |   |
| Accounts receivable                                                             |       | 248                                    |       | 322 |   |
| Prepaid expenses and other current assets                                       |       | (360                                   | )          | 313 |   |
| Other assets                                                                    |       | —                                 |       | (42 | ) |
| Accounts payable                                                                |       | 1,608                                  |       | 227 |   |
| Accrued liabilities                                                             |       | 866                                    |       | (50 | ) |
| Restructuring reserve                                                           |       | (820                                   | )          | (1,862 | ) |
| Deferred revenue                                                                |       | 16,782                                 |       | 36 |   |
| Net cash provided by (used in) operating activities                             |       | 1,795                                  |       | (12,851 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                          |       |                                   |       |   |   |
| Capital expenditures, net                                                       |       | (2,172                                 | )          | (928 | ) |
| Proceeds from sale of property and equipment                                    |       | 3                                      |       | — |   |
| Purchases of marketable securities                                              |       | (1,000                                 | )          | (10,536 | ) |
| Proceeds from sale and maturities of marketable  securities                     |       | 14,766                                 |       | 10,557 |   |
| Net cash provided by (used in) investing activities                             |       | 11,597                                 |       | (907 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                          |       |                                   |       |   |   |
| Proceeds from issuance of common stock                                          |       | 907                                    |       | 7,872 |   |
| Investment by Accelrys, Inc.                                                    |       | —                                 |       | 47 |   |
| Net cash provided by financing activities                                       |       | 907                                    |       | 7,919 |   |
| Net increase  (decrease) in cash and equivalents                                |       | 14,299                                 |       | (5,839 | ) |
| Cash and  equivalents, beginning of period                                      |       | 11,680                                 |       | 20,173 |   |
| Cash and equivalents,  end of period                                            |       | $                                      | 25,979     |   | $ | 14,334 |   |

 

Noncash transactions for the ninemonths ended September 30, 2006 were as follows:

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

Seeaccompanying notes to these unaudited financial statements

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**Pharmacopeia Drug Discovery, Inc.**

**Notes to Unaudited Financial Statements**

**1.   Background and Basis ofPresentation**

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

Pharmacopeia is committed to creating anddelivering novel therapeutics to address significant medical needs. Usingproprietary technologies and processes, the Company seeks to identify, optimizeand develop novel drug candidates through its own internally-funded drugdiscovery and development programs and in collaborations with majorpharmaceutical and biotechnology companies.  The Company’s collaborative researchefforts have resulted in a portfolio of three partnered programs (comprisingfour compounds) that are being actively pursued in human clinical trials, inaddition to six partnered programs in preclinical development, and multipleother partnered programs in discovery.  Pharmacopeia has one internalprogram in preclinical development and four internal programs in advanceddiscovery.

The accompanying unauditedfinancial statements have been prepared in accordance with U. S. generallyaccepted accounting principles for interim financial information and withinstructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, these unaudited financial statements do not include all of theinformation and disclosures required by U. S. generally accepted accountingprinciples for complete financial statements. In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary fora fair presentation of the financial statements have been included. Interimresults are not necessarily indicative of the results that may be expected forthe year. The unaudited interim financial statements should be read inconjunction with the financial statements and notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005.

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

**ProductDevelopment and Commercialization Agreement with GSK**

In March 2006, theCompany and SmithKlineBeecham Corporation and Glaxo Group Limited (togetherGSK) entered into a product development and commercialization agreement (theGSK Agreement). The GSK Agreementprovides that GSK will have an exclusive option, exercisable at defined pointsduring the development process for each program (up to the point of clinicalproof of concept), to license that program. Upon licensing a program, GSK isobligated to conduct preclinical development and/or clinical trials andcommercialize pharmaceutical products resulting from such licensed programs ona worldwide basis (the GSK License Obligations). If GSK does not exercise itsoption to license a program, the Company will retain all rights to that programand may continue to develop the program and commercialize any productsresulting from the program, or it may elect to cease progressing theprogram and/or seek other partners for the further development andcommercialization. In addition, the Company will retain rights to each programfor which GSK has not fulfilled its GSK License Obligations.

Under the terms of the GSK Agreement, theCompany may receive up to $15.0 million in cash payments from GSK related tothe initial discovery activities to be conducted by the Company, including $5.0million that the Company received in April 2006. Up to the remaining $10.0 millionwill be payable to the Company upon its fulfillment of certain conditionsrelated to the initial discovery activities to be conducted by the Company. TheCompany’s role in the alliance is to (i) identify and (ii) advance molecules inchosen therapeutic programs to development stage and (iii) subject to certainprovisions in the GSK Agreement, further develop the candidates to clinical “proofof concept” (a demonstration of efficacy in man). In addition to the cashpayments above, the Company is entitled to receive success-based milestonepayments, starting in preclinical research, from GSK for each drug developmentprogram pursued under the alliance and the potential for double-digit royaltiesupon the successful commercialization by GSK of any product resultingtherefrom. In the event that GSK does not exercise its option to license aprogram and the Company continues to develop the program and commercialize anyproducts resulting from the program, the Company will be obligated to pay GSKsuccess-based milestone payments and royalties upon successfulcommercialization, if any. The Company has agreed that it will not screen itscompound library for other collaborators, or for its own account, against anytarget it screens under the GSK Agreement for a specified period.

The Company and GSK each have the right toterminate the GSK Agreement in its sole discretion under certain specified

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circumstances at any time during the termof the GSK Agreement. In addition, the Company and GSK each have the right to terminatethe GSK Agreement under circumstances that are customary in these types ofagreements.  If the Company exercises itsdiscretionary termination right at any time during the first five years of theterm, under certain circumstances, it could be required to refund to GSK aportion of the up to $15.0 million related to initial discovery activities tobe conducted by the Company referred to above. The amount of any such refund will be calculated based upon when duringthe term of the GSK Agreement that termination occurs.  However, there are no instances where thedeferred revenue would be amortized below the amount that could be potentiallyrefundable pursuant to the terms of the GSK Agreement.  Further, shouldGSK exercise its discretionary termination rights, there are no provisions inthe GSK Agreement that would require the Company to refund payments receivedrelating to its performance of initial discovery activities under the GSKAgreement.

In April 2006, theCompany received $5.0 million in connection with the execution of the GSKAgreement. The Company recorded deferred revenue associated with the payment,net of the fair value of the warrants described below, of approximately $4.5million. As of September 30, 2006, approximately $0.5 million was classified indeferred revenue, current portion and approximately $3.9 million has beenclassified in deferred revenue, long-term. The Company will recognize revenueon a proportional performance basis as it performs the required discoveryactivities in an amount from time to time less than or equal to thenon-refundable portion of payments received in connection with the GSKAgreement.  For the three months endedSeptember 30, 2006, the Company recognized revenue of approximately $93thousand under the GSK Agreement.

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

**Collaborationand License Agreement with Cephalon**

In May 2006, the Companyentered into a Collaboration and License Agreement (the Cephalon Agreement)with Cephalon, Inc. (Cephalon) providing for the formation of a new drugdiscovery, development and commercialization alliance.  Under the Cephalon Agreement, the Companyreceived an up-front, non-refundable payment of $15.0 million in June 2006 tosupport the Company’s research efforts.  

As part of and during theinitial phase of the alliance, Cephalon will be responsible for identifying hitand lead compounds.  The Company andCephalon will then work collaboratively to advance the lead compounds to clinicalcandidates.  The Company will beprincipally responsible for medicinal chemistry and primary biology research,and Cephalon will provide further biology support, especially preclinicaldisease models, as required by the Cephalon Agreement. The Company has agreedthat it will not screen its compound library for other collaborators, or forits own account, against any target it works on under the Cephalon Agreementfor a specified period.

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

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

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

As stated above, under the Cephalon Agreement, the Companyreceived a non-refundable payment of $15.0 million and is principallyresponsible for performing medicinal chemistry and primary biology research.The revenue for this research is recognized

6

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on a proportional performance basis, which is expected toapproximate straight-line recognition of revenue over the initial three yearterm of the alliance. Included in deferred revenue at September 30, 2006 wasapproximately $13.3 million related to the Cephalon Agreement, of which $8.3million was classified as long-term. The Company may receive milestone paymentsupon the successful achievement, if any, of preclinical and clinicalmilestones. These milestone payments will be recognized as revenue when themilestones are achieved. Upon successful commercialization of any productresulting from this relationship, the Company will be entitled to receiveroyalties on sales of that product. For the three and nine month periods ended September30, 2006, the Company’s alliance with Cephalon accounted for 20% and 12%,respectively, of revenue. Prior to May 18, 2006, the Company was not engaged inany research collaborations with Cephalon, and therefore there was no revenuein the corresponding three and nine month periods ended September 30, 2005.

**Collaborationand License Agreement with Organon**

For the three monthsended September 30, 2006 and 2005, the Company’s research collaborations withN.V. Organon (Organon) accounted for 46% and 24%, respectively, of revenue,including $2.0 million in milestones and success fees recorded in the threemonths ended September 30, 2006. For the nine months ended September 30, 2006and 2005, the Company’s research collaborations with Organon accounted for 34%and 24%, respectively, of revenue, including $2.0 million and $0.5 million inmilestones and success fees recorded in each respective period. Under its agreement withOrganon, the Company received quarterly research funding to conduct its drugdiscovery activities to identify and optimize new drug candidates for multipletherapeutic targets provided by Organon. The Company has received all of itsresearch funding under the Organon agreement, the research term of whichexpires in February 2007.  Research fundingfrom the Organon agreement is recognized as revenue on a proportionalperformance basis, which is expected to approximate straight-line recognitionover the term of the agreement.  Forfunding received in advance of the Company’s performance of research anddevelopment activities, the Company records deferred revenue. Included indeferred revenue at September 30, 2006 and 2005 was approximately $1.4 millionand $2.2 million, respectively, relating to this collaboration. The Company mayreceive milestone payments upon the successful achievement by Organon, if any,of preclinical research, preclinical development and clinical developmentmilestones. These milestone payments will be recognized as revenue when themilestones are achieved. Upon successful commercialization of any productresulting from this relationship, Pharmacopeia will be entitled to receiveroyalties on sales of that product. 

**Collaborationand License Agreements with Schering-Plough**

Forthe three months ended September 30, 2006 and 2005, the Company’s researchcollaborations with Schering Corporation and Schering-Plough Ltd. (togetherSchering-Plough), accounted for 28% and 51%, respectively, of revenue,including $1.0 million in milestones and success fees recorded in the threemonths ended September 30, 2006. For the nine months ended September 30, 2006and 2005, the Company’s research collaborations with Schering-Plough, accountedfor 43% and 55%, respectively, of revenue, including $2.0 million and $1.0million in milestones and success fees recorded in each respective period. Research funding from theSchering-Plough agreements is recognized as revenue as services are performed.Milestone payments are recognized as revenue when the milestones are achieved.For funding received in advance of the Company’s performance of research anddevelopment activities, the Company records deferred revenue. Included indeferred revenue at September 30, 2006 was approximately $56 thousand relatingto these collaborations. There was no deferred revenue recorded relating tothese collaborations at September 30, 2005. The Company’s collaborationswith Schering-Plough were recently extended, and the Company expects to receivefunding and record revenue from these collaborations through early April 2007,at which time the Company expects its research activities under thecollaborations to cease. The Company will continue to be entitled to paymentsresulting from the successful achievement by Schering-Plough, if any, ofpreclinical and clinical milestones as well as royalty payments from sales, ifany, of products resulting from compounds already delivered by the Company andaccepted by Schering-Plough under the collaborations.  

**OtherItems**

No othercollaborator accounted for more than 10% of total revenue in the three or ninemonth periods ended September 30, 2006 and 2005.

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

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**3.**   **License Agreement withBristol-Myers Squibb**

In March 2006, theCompany and Bristol-Myers Squibb Company (BMS) entered into an exclusivelicensing agreement providing the Company worldwide development andcommercialization rights to certain compounds discovered by BMS that possessdual angiotensin (AT1) and endothelin (ETA) receptor antagonist (DARA)activity. Under the agreement, the Company acquired exclusive rights to leadand backup DARA development candidates under the BMS patents claiming thesecompounds. The Company is conducting preclinical development studies withPS433540, a compound from the DARA program, and had a preliminaryinvestigational new drug (IND) meeting with the United States Food and DrugAdministration (FDA) in August 2006. The Company plans to file an INDapplication with the FDA and initiate dosing in humans in the first quarter of2007.

Under the terms of theagreement, in lieu of an upfront cash payment, the Company is providing BMS aset of compound libraries, over a period of approximately three years followingthe execution of the agreement and will pay BMS milestone payments upon theachievement of successive clinical and regulatory events in the United Statesand certain other jurisdictions, and royalties on sales of products, if any,resulting from the DARA program. The first such milestone payment related to aclinical event would be the payment of $1.0 million upon the start, if any, ofa Phase I clinical trial for the DARA program. In the event the Company failsto deliver the aforementioned libraries to BMS, the Company would be requiredto make cash payments to BMS on a pro rata basis of up to $2.0 million.

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

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

The Company computes netincome (loss) per share in accordance with SFAS No. 128, “Earnings PerShare” (SFAS 128). Under the provisions of SFAS 128, basic net income (loss)per share is computed by dividing the net income (loss) for the period by theweighted-average number of common shares outstanding during the period. Dilutednet income (loss) per share is computed by dividing the net income (loss) forthe period by the weighted-average number of common and dilutive commonequivalent shares outstanding during the period. The Company had a net loss forthe periods presented; accordingly, the inclusion of common stock equivalentsfor outstanding stock options would be anti-dilutive and, therefore, theweighted average shares used to calculate both basic and diluted earnings pershare are the same.

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

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

|                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **             | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                   |       |                                                 |       |                                                |       |   |   |   |   |
| Customers  located in: |       |                                                 |       |                                                |       |   |   |   |   |
| United States          |       | 39                                                   | %          | 45                                                  | %          | 41 | % | 43 | % |
| Europe                 |       | 61                                                   | %          | 54                                                  | %          | 59 | % | 56 | % |
| Asia                   |       | —                                               |       | 1                                                   | %          | — |   | 1 | % |

 

**6.**   **Share-BasedCompensation**

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

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

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

|                          | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|--------------------------|------------|-------------|------------|-------------|------------|
| Dividend yield           |       | 0.00        | %          | 0.00        | %          |
| Expected  volatility     |       | 80.00-90.00 | %          | 75.00-85.24 | %          |
| Risk-free  interest rate |       | 4.66-5.06   | %          | 3.86-4.33   | %          |
| Expected life  (years)   |       | 6.25        |       | 5.00-5.75   |       |
| Forfeiture Rate          |       | 5.24-6.93   | %          | n/a         |       |

 

As a result of adoptingSFAS 123R, the Company’s net income and basic and diluted earnings per sharefor the three and nine month periods ended September 30, 2006 were $0.5 millionand $.03 per share, and $1.4 million and $.09 per share respectively, lowerthan if the Company had continued to account for its share-based compensationunder APB 25. As of September 30, 2006, there was approximately $3.3 million ofunrecognized compensation costs, net of estimated forfeitures, related toshare-based payments which are expected to be recognized over a weightedaverage period of 1.4 years. The cash proceeds and related aggregate intrinsicvalue of options exercised during the three months ended September 30, 2006were minimal. There were no stock option exercises during the three monthsended September 30, 2005. The aggregate intrinsic value of options exercisedduring the nine months ended September 30, 2006 and 2005 was approximately $331thousand and $155 thousand, respectively. Cash proceeds from stock optionsexercised during the nine months ended September 30, 2006 and 2005 wasapproximately $907 thousand and $126 thousand, respectively. In addition to theexpense incurred related to stock option grants, during the three and ninemonth periods ended September 30, 2006 the Company also incurred share-basedcompensation costs of approximately $21 thousand and $63 thousand,respectively, relating to the vesting of restricted stock awards.

The following tableillustrates the effect on operating results and per share information had theCompany accounted for its share-based compensation in accordance with SFAS 123Rfor the three and nine months ended September 30, 2005 (in thousands, except pershare data):

|                                                                                                                                               | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | ** **                                                     | ** ** | ** **                                                    | ** ** |
| Net loss:                                                                                                                                     |       |                                                           |       |                                                          |       |
| As reported                                                                                                                                   |       | $                                                              | (4,737     | )                                                             | $          | (14,087 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                                                 |       | 25                                                             |       | 281                                                           |       |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | (413                                                           | )          | (1,512                                                        | )          |
| Pro forma                                                                                                                                     |       | $                                                              | (5,125     | )                                                             | $          | (15,318 | ) |
| Basic and  diluted net loss per common share:                                                                                                 |       |                                                           |       |                                                          |       |
| As reported                                                                                                                                   |       | $                                                              | (0.33      | )                                                             | $          | (1.08 | ) |
| Pro forma                                                                                                                                     |       | $                                                              | (0.36      | )                                                             | $          | (1.18 | ) |

 

*Stock Plans*

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

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In accordance with the Plan, Pharmacopeia may grant upto an aggregate of 2,400,000 shares of stock options, restricted stock, commonstock, performance awards, deferred stock units and stock appreciation rightsto officers, directors, employees, sales representatives and consultants ofPharmacopeia. Under the Plan no more than 500,000 shares of Incentive StockOptions and 400,000 shares of stock awards and performance shares may begranted.  The term of each incentive andnon-qualified stock option is ten years. Vesting generally occurs over a periodof not greater than five years.  As ofSeptember 30, 2006, there were approximately 1,305,000 shares reservedunderlying options granted under the Plan and approximately 1,095,000 sharesavailable for future grants under the Plan.

Prior to the spin-off, the Company adopted thefollowing Accelrys stock option plans: the 1994 Incentive Stock Plan, the 1995Director’s Option Plan, and the 2000 Stock Option Plan under which grants ofoptions and restricted stock had been made to Pharmacopeia employees.  Generally, all outstanding options topurchase Accelrys common stock under these Accelrys Stock Option Plans wereconverted to options to purchase Pharmacopeia stock, in order to maintain thethen existing intrinsic value and maintain the ratio of the then existingexercise price per share to the market value per share in accordance withapplicable accounting standards.  As ofSeptember 30, 2006, there were approximately 2,906,000 shares reservedunderlying options made under these plans. No additional options may be granted to Pharmacopeia employees fromthese plans.  As of September 30, 2006,there were approximately 5,000 shares of restricted stock outstanding fromthese plans.

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

|                                                                    | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | **Common  Stock  Options**                               | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Common  Stock  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of quarter:                              |       | 4,298                                                    |       | $ | 6.90 |   | 4,281 |   | $ | 6.86 |   |
| Granted                                                            |       | 15                                                       |       | $ | 4.46 |   | 11 |   | $ | 3.92 |   |
| Exercised                                                          |       | —                                                   |       | — |   | — |   | — |   |
| Expired                                                            |       | (102                                                     | )          | $ | 8.30 |   | (7 | ) | $ | 11.52 |   |
| Outstanding at  end of quarter:                                    |       | 4,211                                                    |       | $ | 6.87 |   | 4,285 |   | $ | 6.86 |   |
|                                                               |       |                                                     |       |   |   |   |   |   |   |
| Exercisable at  end of quarter                                     |       | 3,254                                                    |       |   |   | 3,080 |   |   |   |
|                                                               |       |                                                     |       |   |   |   |   |   |   |
| Weighted average  fair value of options granted during the quarter |       |                                                     |       | $ | 3.46 |   |   |   | $ | 2.83 |   |

 

A summary of stockoptions outstanding and exercisable as of September 30, 2006 follows (inthousands, except per share data):

|                                             | ** ** | ** **               | ** ** | **Options Outstanding**                        | ** ** | **Options Exercisable**           | ** ** |
|---------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.00-$5.00                                 |       | 1,498                    |       | 5.52                                                |       | $                                      | 4.03       |   | 1,071 |   | $ | 3.84 |   |
| $5.01-$10.00                                |       | 2,322                    |       | 4.94                                                |       | $                                      | 6.66       |   | 1,793 |   | $ | 6.85 |   |
| $10.01-$15.00                               |       | 46                       |       | 4.20                                                |       | $                                      | 12.58      |   | 46 |   | $ | 12.60 |   |
| $15.01-$20.00                               |       | 345                      |       | 3.30                                                |       | $                                      | 19.74      |   | 344 |   | $ | 19.74 |   |
|                                        |       | 4,211                    |       | 5.00                                                |       | $                                      | 6.87       |   | 3,254 |   | $ | 7.30 |   |
|                                        |       |                     |       |                                                |       |                                   |       |   |   |   |   |
| Aggregate Intrinsic  Value                  |       | $                        | 323        |                                                |       |                                   |       |   | $ | 304 |   |   |   |
|                                             |            |                          |            |                                                     |            |                                        |            |  |  |  |  |  |  |  |  |

 

As ofSeptember 30, 2006, there were approximately 4,144,000 options outstanding, netof estimated forfeitures, that had vested or are expected to vest. Theweighted-average exercise price of these options was $6.87 per option; theweighted-average remaining contractual life of these options was 5.00 years;and the aggregate intrinsic value of these options was approximately $321thousand.

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

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

The following table summarizes theactivity and balance of the restructuring reserve at September 30, 2006 (inthousands):

|                                  | ** ** | **Severance Cost for  Involuntary Employee  Terminations** | ** ** | **Costs to Exit  Leased Facility** | ** ** | **Total** | ** ** |
|----------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------|------------|-----------|------------|
| Restructuring  charges           |       | $                                                                         | 132        |                                              | $          | 5,718     |       | $ | 5,850 |   |
| Utilization of  Reserves:        |       |                                                                      |       |                                              |       |      |       |
| Cash payments                    |       | (132                                                                      | )          | (4,352                                            | )          | (4,484    | )          |
| Write-off leasehold improvements |       | —                                                                    |       | (458                                              | )          | (458      | )          |
| Balance at  December 31, 2005    |       | $                                                                         | —     |                                              | $          | 908       |       | $ | 908 |   |
| Utilization of  Reserves:        |       |                                                                      |       |                                              |       |      |       |
| Cash payments                    |       | —                                                                    |       | (820                                              | )          | (820      | )          |
| Reserve Adjustment               |       |                                                                      |       | (88                                               | )          | (88       | )          |
| Balance at  September 30, 2006   |       | $                                                                         | —     |                                              | $          | —    |       | $ | — |   |

 

**8**.   Commitments and Contingencies

**ProductDevelopment and Commercialization Agreement with GSK**

As described in Note 2 tothe Financial Statements, the Companyand GSK each have the right to terminate the GSK Agreement in its solediscretion under certain specified circumstances at any time during the term ofthe GSK Agreement. In addition, the Company and GSK each have the right toterminate the GSK Agreement under circumstances that are customary in thesetypes of agreements.  If the Companyexercises its discretionary termination right at any time during the first fiveyears of the term, under certain circumstances, it could be required to refundto GSK a portion of the up to $15.0 million related to initial discoveryactivities to be conducted by the Company referred to above. The amount of anysuch refund will be calculated based upon when during the term of the GSKAgreement that termination occurs. However, there are no instances where the deferred revenue would be amortizedbelow the amount that could be potentially refundable pursuant to the terms ofthe GSK Agreement.  Further, should GSK exercise its discretionarytermination rights, there are no provisions in the GSK Agreement that wouldrequire the Company to refund payments received relating to its performance ofinitial discovery activities under the GSK Agreement.

The Company’s role in the alliance is to(i) identify and (ii) advance molecules in chosen therapeutic programs todevelopment stage and (iii) subject to certain provisions in the GSK Agreement,further develop the candidates to clinical “proof of concept” (a demonstrationof efficacy in man). As of September 30, 2006, the Company had approximately$4.4 million of deferred revenue related to services that are to be provided toGSK by the Company subsequent to September 30, 2006.

**License Agreementwith BMS**

As described in Note 3 tothe Financial Statements, under the terms of the agreement, in lieu of anupfront cash payment, the Company is providing BMS a set of compound libraries,over a period of approximately three years following the execution of theagreement and will pay BMS milestone payments upon the achievement ofsuccessive clinical and regulatory events in the United States and certainother jurisdictions, and royalties on sales of products, if any, resulting fromthe DARA program. The first such milestone payment related to a clinical eventwould be the payment of $1.0 million upon the start, if any, of a Phase Iclinical trial for the DARA program. In the event the Company fails to deliverthe aforementioned libraries to BMS, the Company would be required to make cashpayments on a pro rata basis of up to $2.0 million.

**Collaboration andLicense Agreement with Cephalon**

As described in Note 2 tothe Financial Statements, under the Cephalon Agreement, the Company received anup-front, non-refundable payment of $15.0 million in June 2006 to support theCompany’s research efforts.  The Companywill be principally responsible for performing medicinal chemistry and primarybiology research over the alliance term, as required by the Cephalon

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Agreement. As ofSeptember 30, 2006, the Company had approximately $13.3 million of deferredrevenue related to services that are to be provided to Cephalon by the Companysubsequent to September 30, 2006.

**Milestone andRoyalty Commitments**

Under the terms ofcertain agreements to which the Company is a party, it is possible that theCompany may become obligated to pay aggregate milestone payments totaling up to$238 million upon the achievement of successive clinical and regulatory eventsand royalties on sales of products, if any, resulting from programs for whichthe Company has development responsibility under such agreements.  The Company will not be responsible for thepayment of future milestone and/or royalty payments in the event thatdevelopment of such a program is discontinued. Preclinical and clinical development of drug candidates is a long,expensive and uncertain process.  At anystage of the preclinical or clinical development process, the Company maydecide to discontinue the development of its product candidates.  To date, none of the compounds to which theCompany holds complete or partial rights has reached the stage of commercialproduct.  The Company expects that itsproduct candidates will not be commercially available for many years, if ever.

**9**.   Related Party Transaction

As described inNote 2 to the Financial Statements, in May 2006, the Company entered into theCephalon Agreement.One of the Company’s directors currently serves as theChairman and Chief Executive Officer of Cephalon. During the three months endedSeptember 30, 2006, the Company recognized revenue of approximately $1.3million relating to this collaboration.

**10**.   Subsequent Event – Sale ofSecurities

**On October 13, 2006,the Company entered into an Underwriting Agreement (the Underwriting Agreement)with CIBC World Markets Corp. and Merriman Curhan Ford & Co. (theUnderwriters), for which CIBC World Markets Corp. acted as representative,relating to the issuance and sale by the Company to the Underwriters ofapproximately 5.8 million shares of the Company’s common stock at a purchaseprice per share of $4.28. The Company also agreed to sell warrants to purchaseapproximately 1.45 million shares of its common stock to the Underwriters at apurchase price of $0.125 per warrant, with an exercise price of $5.14 pershare. The warrants are exercisable from April 19, 2007 through April 19, 2012.The aggregate gross proceeds of the transaction were approximately $25.0 million.On October 18, 2006, the Company received proceeds of approximately $23.0million from the transaction, net of certain transaction costs. The shares andwarrants were offered through a prospectus supplement pursuant to the Company’seffective shelf registration statement.**

**11.    NewAccounting Pronouncements**

**Accountingfor Uncertain Tax Positions**

In June 2006, the Financial Accounting Standards Board(FASB) issued Interpretation No. 48, “Accounting for Uncertainty in TaxPositions – an Interpretation of FASB Statement No. 109” (FIN48).  FIN 48 applies to all open tax positions accounted for inaccordance with SFAS No. 109, “Accounting for Income Taxes” and isintended to result in increased relevance and comparability in financialreporting of income taxes and to provide more information about the uncertaintyin income tax assets and liabilities. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. The Company is currently evaluating theimpact of FIN 48 on its financial position and results of operations.

**Fair ValueMeasurements**

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements,” (SFAS 157). SFAS 157 establishes a framework for measuringfair value in accordance with generally accepted accounting principles andexpands disclosures about fair value measurements. SFAS 157 is effective forfiscal years beginning after November 15, 2007 and interim periods within thosefiscal years. The Company is currently evaluating the impact of SFAS 157 onits financial position and results of operations.

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

**FORWARD-LOOKING STATEMENTS**

This Report on Form 10-Q contains forward-looking statements regardingus and our business, financial condition, results of operations and prospectswithin the meaning of the Private Securities Litigation Reform Act of1995.  Such forward-looking statements include those that express plans,anticipation, intent, contingency, goals, targets or future development and/orotherwise are not statements of historical fact.  These forward-lookingstatements are based on our current expectations and projections about futureevents and they are subject to risks and uncertainties known and unknown thatcould cause actual results and developments to differ materially from thoseexpressed or implied in such statements.  These forward-looking statementsinclude statements about the following:

·      our ability to develop our DARA programsuccessfully;

·      our ability to successfully perform underour collaborations with GSK and Cephalon;

·      our ability to raise additional capital;

·      our intentions regarding the establishmentand continuation of drug discovery and development collaborations with leadingpharmaceutical and biotechnology organizations;

·      the cessation of quarterly researchfunding from our existing collaboration with Organon;

·      our ability to build our pipeline of noveldrug candidates, through our own internally-funded drug discovery programs, ourcollaborations and in-licensing;

·      our anticipated operating results,financial condition, liquidity and capital resources;

·      our expectations concerning thedevelopment priorities of our collaborative partners, and their ability tosuccessfully develop compounds;

·      our expectations concerning the legalprotections afforded by U.S. and international patent laws;

·      our beliefs as to the trends andopportunities impacting us and our industry;

·      our estimates of the market opportunityfor our product candidates; and

·      our ability to acquire or invest incomplementary businesses or technologies.

In some cases, you can identify forward-looking statements by terminology,such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,”“estimates,” or the negative of such terms or other similar expressions. Factors that could cause or contribute to differences in results and outcomesinclude, without limitation, those discussed elsewhere in this Report in PartII, Item 1A. “Risk Factors” and in this Item 2, as well as those discussed inour other Securities and Exchange Commission (SEC) filings.

We urge you to carefully read and consider the disclosures found in thesefilings, all of which are available in the SEC EDGAR database atwww.sec.gov.  You are urged not to place undue reliance on any suchforward-looking statements, any of which may turn out to be wrong due toinaccurate assumptions, unknown risks, uncertainties or other factors.  Weundertake no obligation to (and expressly disclaim any such obligation to)revise or update the statements made herein or the risk factors that may relatethereto whether as a result of new information, future events or otherwise.

**The Company**

**Overview**

We are committed tocreating and delivering novel therapeutics to address significant medicalneeds. Using proprietary technologies and processes, we seek to identify,optimize and develop novel drug candidates through our own internally-fundeddrug discovery and development programs and in collaborations with majorpharmaceutical and biotechnology companies. Our collaborative research effortshave resulted in a portfolio of three partnered programs (comprising fourcompounds) that are being actively pursued in human clinical trials, with sixadditional programs in preclinical development. We have one internal program in preclinical development and fourinternal programs in advanced discovery.

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Our most advanced internal program, ourDARA program, is in preclinical development and focuses on dual angiotensin(AT1) and endothelin (ETA) receptor antagonists (DARA) for cardiovascular andrenal disease.  We licensed our DARA program from BMS in March 2006.  PS433540, a compound from the DARA program,possesses the actions of two product classes in a single compound.  We believe that PS433540 has the potential tobe a significant step forward in the management and treatment of multiplecardiovascular and renal disease states.  We believe that PS433540administered as a single agent will have a superior profile to monotherapy withan angiotensin receptor blocker or the co-administration of an endothelinreceptor antagonist and an angiotensin receptor antagonist for the treatment ofcertain forms of hypertension and diabetic nephropathy.

We are conducting preclinical developmentstudies with PS433540 and had a preliminary IND meeting with the FDA in August2006.  We plan to file an IND with the FDA and initiate dosing in humansin the first quarter of 2007.  Our goalis to demonstrate in Phase I clinical trials that PS433540 blocks the actionsof both angiotensin II and endothelin at their respective receptors in man. Wealso expect to initiate a Phase Ib hypertension study to evaluateantihypertensive activity of PS433540 prior to the end of 2007, and to initiatePhase II clinical studies with PS433540 in the second half of 2008.

Our other internalproprietary research programs are primarily focused on immunobiology(inflammatory and immunological diseases). We fully fund these programs and retainintellectual property and ownership rights to any compounds discovered. At anappropriate point, we may license one or more of these compounds or programs toa partner (probably a larger pharmaceutical or biotechnology organization).

We are building expertiseand extending our capabilities into preclinical and clinical development sothat we can advance both internal and partnered programs into clinicaldevelopment. In addition to our proprietary research and development, we havecollaborations with leading pharmaceutical companies and biotechnologycompanies, including product development and commercialization collaborationswith GlaxoSmithKline (entered into in March 2006) and Cephalon (entered into inMay 2006).  We may continue to seek toestablish a limited number of broad, multi-year alliances with the potential toresult in drug candidates in which we retain significant rights. We anticipateparticipating in the clinical development of some of the compounds that mayresult from these collaborations.

Our collaborativeresearch efforts have resulted in a portfolio of three partnered programscurrently with candidates in Phase I clinical trials targeting rheumatoidarthritis, chronic obstructive pulmonary disease (COPD) and oncology. Weinitially identified p38 kinase inhibitor lead compounds in 1997 and enteredinto a collaborative partnering agreement with BMS in 1999. This collaborationresulted in a compound that entered clinical trials in August 2003. A secondcompound resulting from that partnership, which is a back-up candidate, enteredPhase I clinical trials in Canada in December 2005. Our Schering-Ploughrelationship produced a CXCR2 antagonist which entered clinical trials in March2004 for COPD and a second compound which entered clinical trials in September2006 in the oncology therapeutic area.

Associated with theseclinical development programs, we have received milestone payments from BMS andSchering-Plough and, to the extent the compounds successfully progress throughclinical development and registration, we will be entitled to receiveadditional milestone payments. We are also entitled under the agreements witheach of these partners to receive royalties on the commercial sale, if any, ofmost new drugs resulting from these collaborations. However, numerousadditional studies are required to fully assess the potential of these clinicalcandidates before they reach the marketplace, and the results from preclinicalstudies and clinical studies conducted to date with these compounds are notnecessarily indicative of the results that may be obtained in future clinicalstudies.

In addition, acompound discovered in our laboratories, aimed at an allergy/asthma indication,was the basis of a collaboration with Daiichi Pharmaceutical Co. (Daiichi)which resulted in a drug candidate that entered clinical trials in November2003. Daiichi informed us on November 1, 2006 that it had decided to placethe IND for that program on inactive status. Inactive status means that an INDremains in effect and has not been withdrawn by its sponsor or terminated bythe FDA. We anticipate that we will be discussing plans, if any, for theprogram in late 2006.

Six more partneredprograms are at various stages of preclinical development, the point at whichcompounds are tested for safety in animals and are subjected to other studiesrequired prior to testing compounds in humans. This stage is prior to thefiling of an IND application and the compound’s exposure to humans duringPhase I of clinical development.

Preclinical andclinical development of drug candidates is a long, expensive and uncertainprocess. We continue to pursue the discovery and development of productcandidates in both our internal and collaborative programs. The drug candidatesdescribed above are at an early stage, and none have received regulatoryapproval for commercial sale. Both our partnered clinical candidates and ourinternally developed compounds face the substantial risk of failure inherent indrug discovery and development. At any stage of the clinical developmentprocess, we or our collaborators may decide to discontinue development of ourproduct candidates. To date, none of the compounds in which we hold complete orpartial rights has reached the stage of a commercial product and, although wehave received license and milestone fees, we may never receive any royaltypayments, or any additional license and milestone fees, under our current orany future collaborations. We do not expect that our product candidates will becommercially available for

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many years, ifever.

Fromtime to time we have considered, and we will continue to consider strategicinitiatives intended to further the development of our business. In addition,we consider opportunities to expand our product pipeline through the acquisitionor in-licensing of, or investment in, product development candidates, and weintend to continue to explore and evaluate those opportunities.

**Liquidity and Capital Resources**

As of September 30, 2006, we hadcash, cash equivalents and marketable securities of $31.0 million compared to$30.4 million at December 31, 2005, representing 65% and 66% of our totalassets, respectively. We make investments in highly liquid investment-grademarketable securities, including corporate bonds and United States governmentand agency securities. In addition, as of September 30, 2006, we had deferredrevenue and other liabilities of approximately $21.8 million relating toresearch and development activities that are to be provided by us subsequent toSeptember 30, 2006, of which $13.5 was classified as long-term.

The following is a summary ofselected cash flow information for the nine months ended September 30, 2006 and2005 (in thousands):
|                                                      | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| Net loss                                             |       | $                                                       | (19,573    | ) | $ | (14,087 | ) |
| Adjustments for  noncash operating items             |       | 3,044                                                   |       | 2,292 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash  operating loss                             |       | (16,529                                                 | )          | (11,795 | ) |
| Net change in  assets and liabilities                |       | 18,324                                                  |       | (1,056 | ) |
|                                                 |       |                                                    |       |   |   |
| Net cash  provided by (used in) operating activities |       | $                                                       | 1,795      |   | $ | (12,851 | ) |
|                                                 |       |                                                    |       |   |   |
| Net cash  provided by (used in) investing activities |       | $                                                       | 11,597     |   | $ | (907 | ) |
|                                                 |       |                                                    |       |   |   |
| Net cash provided by  financing activities           |       | $                                                       | 907        |   | $ | 7,919 |   |

 

**Net cash provided by (used in) operatingactivities**

Net cash provided by operatingactivities for the nine months ended September 30, 2006 resulted primarily fromthe receipt of a $5.0 million upfront payment received in April 2006 relatingto the GSK Agreement and a $15.0 million upfront non-refundable paymentreceived in June 2006 relating to the Cephalon Agreement, offset by ouroperating loss due to our funding of our proprietary internal drug research anddevelopment efforts and the payment of restructuring expenses related to the2004 consolidation of our facilities. Absent the receipt of the $20.0 millionfrom GSK and Cephalon, our net cash used in operating activities would havebeen approximately $18.2 million.  Netcash used in operating activities for the nine months ended September 30, 2005was primarily a result of our operating loss due to our funding of ourproprietary internal drug research and development efforts and the payment ofrestructuring expenses related to the 2004 consolidation of our facilities.

**Net cash provided by (used in) investingactivities**

Net cash provided by investingactivities for the nine months ended September 30, 2006 related primarily tothe net sales and maturities of marketable securities, partially offset bycapital expenditures for research and development and information technologyequipment and software. Net cash used in investing activities for the ninemonths ended September 30, 2005 related primarily to capital expenditures forresearch and development and information technology equipment, partially offsetby net sales and maturities of marketable securities.

**Net cash provided by financingactivities**

Net cash provided by financingactivities for the nine months ended September 30, 2006 consisted primarily ofproceeds from the issuance of common stock in connection with exercises ofstock options. Net cash provided by financing activities for the nine monthsended September 30, 2005 consisted primarily of proceeds from the sale ofapproximately 2.4 million shares of newly

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issued common stock in July 2005.  Net proceeds from this sale were approximately$7.7 million. In addition, we also received a capital contribution fromAccelrys (our former parent company) and proceeds from the issuance of commonstock in connection with our employee stock option plan.  See “Liquidity and Capital Resources Outlook”below for discussion of our sale of securities in October 2006.

**Liquidity and Capital Resources Outlook**

We expect to continue to use ourcapital to fund operating losses. Our net cash used in operating activities forthe three months ended September 30, 2006 would have been approximately $9.6million, had we not received approximately $0.6 million in FTE funding and a$1.0 million milestone payment from Schering-Plough during the quarter. Weexpect the funding for our research activities under the Schering-Ploughcollaborations to cease in early April 2007. We will continue to beentitled to payments resulting from the successful achievement bySchering-Plough of preclinical and clinical milestones, if any.  We expect that our research and development expenditureswill continue to increase in the future as we increase our internal drugresearch and development efforts. Conducting our own drug discovery researchand development is a key component of our business model.  Our DARA program, which is our most advancedinternal program, is currently in preclinical development, and we expect tofile an IND application for the DARA program in the first quarter of 2007.Preclinical development studies and clinical trials are significant,time-consuming and costly processes.

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

On October 13, 2006, we enteredinto the Underwriting Agreement with the Underwriters, for which CIBC WorldMarkets Corp. acted as representative, relating to the issuance and sale by usto the Underwriters of approximately 5.8 million shares of our common stock ata purchase price per share of $4.28. We also agreed to sell warrants topurchase approximately 1.45 million shares of its common stock to theUnderwriters at a purchase price of $0.125 per warrant, with an exercise priceof $5.14 per share. The warrants are exercisable from April 19, 2007 throughApril 19, 2012. The aggregate gross proceeds of the transaction wereapproximately $25.0 million.  On October18, 2006, we received proceeds of approximately $23.0 million from thetransaction, net of certain transaction costs. The shares and warrants wereoffered through a prospectus supplement pursuant to our effective shelfregistration statement.

We anticipate that our capital resources will beadequate to fund our operations at their current levels at least throughDecember 31, 2007. However, there can be noassurance that changes will not occur that would consume available capitalresources before then.  As ofSeptember 30, 2006, we had cash, cash equivalents and marketable securitiesaggregating $31.0 million. Additionally, we received approximately $23.0million on October 18, 2006 representing net proceeds in connection with thesale of securities discussed in Note 10 to the Financial Statements. Also as ofSeptember 30, 2006, we had deferred revenue and other liabilities ofapproximately $21.8 million relating to research and development activitiesthat are to be provided by us subsequent to September 30, 2006, of which $13.5million was classified as long-term. 

Our capital requirements dependon numerous factors, including our ability to continue and extend existingcollaborative agreements and to enter into additional arrangements.Approximately 93% and 75% of our revenue for the three months ended September30, 2006 and 2005, respectively, was generated from our collaborations withSchering-Plough, Organon, and Cephalon. In addition, approximately 88% and 79%of our revenue for the nine months ended September 30, 2006 and 2005,respectively, was generated from these collaborations.

Ourcollaborations with Schering-Plough were recently extended, and we expect toreceive funding and record revenue from these collaborations through earlyApril 2007, at which time we expect our research activities under thecollaborations to cease.  We willcontinue to be entitled to payments resulting from the successful achievementby Schering-Plough, if any, of preclinical and clinical milestones as well asroyalty payments from sales, if any, of products resulting from compoundsalready delivered by us and accepted by Schering-Plough under thecollaborations.  

Under our agreement with Organon,we received quarterly research funding to conduct our drug discovery activitiesto identify and optimize new drug candidates for multiple therapeutic targetsprovided by Organon.  We have receivedall of our research funding under the Organon agreement, the research term ofwhich expires in February 2007.  We mayreceive milestone payments upon the successful achievement of preclinicalresearch, preclinical development and clinical development milestones. Uponsuccessful commercialization of any product resulting from this relationship,we will be entitled to receive royalties on sales of that product.

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

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

**Resultsof Operations**

Thissection should be read in conjunction with the discussion under “Liquidity andCapital Resources”.

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

Our net revenue increased 60% to $6.3 million in thethree months ended September30, 2006 compared to $3.9 million inthe three months ended September30, 2005. Net revenue consists ofthe funding of our collaborative research activities, as well as our earning ofmilestones, success fees and license revenue if and as our discoveries progressthrough our collaborators’ development processes. Net revenue for the threemonths ended September30, 2006 and 2005 is summarized asfollows (in thousands):
|                                 | ** ** | **Three months ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
|                            |       |                                                     |       |   |   |
| Collaborative  research funding |       | $                                                        | 3,132      |   | $ | 3,758 |   |
| Milestones and  success fees    |       | 3,000                                                    |       | — |   |
| License revenue                 |       | 125                                                      |       | 150 |   |
|                            |       | $                                                        | 6,257      |   | $ | 3,908 |   |

 

Schering-Plough accounted for 28% and 51% of our netrevenue in the three months ended September 30, 2006 and 2005, respectively, including $1.0 of our milestone and success feesrevenue recorded in the three months ended September 30, 2006.  Organon accounted for 46% and 24% of our netrevenue in the three months ended September 30, 2006 and 2005, respectively,including $2.0 million of our milestone and success fees revenue recorded inthe three months ended September 30, 2006. Cephalon accounted for 20% of ournet revenue in the three months ended September 30, 2006. Our alliance withCephalon commenced in May 2006 and therefore there was no corresponding revenuein the three months ended September 30, 2005.

The decrease in collaborative research funding in thethree months ended September 30, 2006 was largely due to the reduction infunding from our collaborations with Schering-Plough and the expiration ofother collaborative research and development agreements, partially offset bythe revenue generated from the our new alliances with Cephalon and GSK.

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expensesdecreased 17% to $3.4 million in the three months ended September 30, 2006compared to $4.1 million in the three months ended September 30, 2005. This decrease was due todecreased resources allocated to our collaborative partnerships largely due tothe reduced staffing on our collaborations with Schering-Plough and theexpiration of other collaborative research and development agreements. Thisdecrease was partially offset by costs associated with research and developmentactivities relating to our new collaboration partnerships with Cephalon andGSK, and the recognition of share-based compensation costs of $91 thousandassociated with our adoption of SFAS 123R.

Proprietaryresearch and development expense includes research and development acquisitioncosts, labor, material, equipment and allocated facilities cost of scientificstaff working on self-funded internal drug discovery programs. Usingproprietary

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technologies andprocesses, we seek to discover and develop novel drug candidates to advanceinternally as well as with strategic partners. Our mostadvanced internal program is our DARA program, which is in preclinicaldevelopment.  In addition, wecurrently have four internal programs in advanced preclinical optimization.Proprietary research and development expenses increased 112% to $5.8 million inthe three months ended September 30, 2006 compared to $2.7 million in the threemonths ended September 30, 2005. This increase was primarily attributable tocosts relating to preclinical development studies for our DARA program,resources expended on our JAK-3 program, our Adenosine A2a program, our CCR-1program, and our recognition of share-based compensation costs of $102 thousandassociated with our adoption of SFAS 123R. Because of the speculative nature ofthese internal drug discovery projects, it is not possible to estimatecompletion dates or costs of completion. Additionally, from time to time,certain staff and other research and development resources may be temporarilyredirected from one project to another, which redirection may also delay orimpact the cost of internal drug discovery projects.

Sales,general and administrative expense increased by 5% to $2.1 million in the threemonths ended September30, 2006 compared to $2.0 million in the three months ended September30, 2005.  The increase in sales, general and administrative expense isattributable to the recognition of share-based compensation costs of $279thousand associated with our adoption of SFAS 123R and increased legal andconsulting costs, offset by lower compensation and severance costs in the threemonths ended September 30, 2006. 

Interestand other income, net increased to $419 thousand in the three months ended September 30, 2006compared to $275 thousand in the three months ended September 30, 2005.  This increase is due tohigher yields on our investments.

Werecorded an income tax provision of $9 thousand and $7 thousand for the threemonths ended September30, 2006 and 2005, respectively, related to minimum state income taxes. 

As aresult of the net revenues and expenses described above, we generated a netloss of $4.7 million ($0.31 per basic and diluted share) in the three monthsended September30, 2006, compared to a net loss of $4.7 million ($0.33 per basic anddiluted share) in the three months ended September 30, 2005.

**Nine months endedSeptember 30, 2006 and 2005**

Our net revenue decreased 8% to $13.7 million in thenine months ended September30, 2006 compared to $14.8 millionin the nine months ended September30, 2005. Net revenue consists ofthe funding of our collaborative research activities, as well as our earning ofmilestones, success fees and license revenue if and as our discoveries progressthrough our collaborators’ development processes. Net revenue for the ninemonths ended September30, 2006 and 2005 is summarized asfollows (in thousands):
|                                 | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------|------------|-------------------------------------|------------|
| ** **                      | ** ** | **2006**                            | ** ** | **2005** | ** ** |
| Collaborative  research funding |       | $                                   | 9,290      |   | $ | 12,814 |   |
| Milestones and  success fees    |       | 4,000                               |       | 1,500 |   |
| License revenue                 |       | 375                                 |       | 516 |   |
|                            |       | $                                   | 13,665     |   | $ | 14,830 |   |

 

Schering-Plough accounted for 43% and 55% of our netrevenue in the nine months ended September 30, 2006 and 2005, respectively, including $2.0 million and $1.0 million of ourmilestones and success fees revenue recorded in each respective period.  Organon accounted for 34% and 24% of our netrevenue in the nine months ended September 30, 2006 and 2005, respectively,including $2.0 million and $0.5 million of our milestones and success feesrecorded each respective period. Cephalon accounted for 12% of our net revenuein the nine months ended September 30, 2006. Our alliance with Cephaloncommenced in May 2006 and therefore there was no corresponding revenue in thenine months ended September 30, 2005. 

The decrease in collaborative research funding in thenine months ended September 30, 2006 was largely due to the reduction infunding from our collaborations with Schering-Plough and the expiration ofother collaborative research and development agreements, partially offset bythe revenue generated from the our new alliances with Cephalon and GSK.

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expensesdecreased 32% to $9.8 million in the nine months ended September 30, 2006compared to $14.4 million in the nine months ended September 30, 2005. This decrease was due todecreased resources allocated to our collaborative partnerships largely due tothe reduced staffing on our

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collaborationswith Schering-Plough and the expiration of other collaborative research anddevelopment agreements. This decrease was offset by costs associated withresearch and development activities relating to our new collaborationpartnerships with Cephalon and GSK, and the recognition of share-basedcompensation costs of $250 thousand associated with our adoption of SFAS 123R.

Proprietaryresearch and development expense includes research and development acquisitioncosts, labor, material, equipment and allocated facilities cost of scientificstaff working on self-funded internal drug discovery programs. Usingproprietary technologies and processes, we seek to discover and develop novel drugcandidates to advance internally as well as with strategic partners. Our mostadvanced internal program is our DARA program, which is in preclinicaldevelopment. We licensed our DARA program from BMS in March 2006. In addition, wecurrently have four internal programs in advanced preclinical optimization.Proprietary research and development expenses increased 136% to $17.6 millionin the nine months ended September 30, 2006 compared to $7.4 million in thenine months ended September 30, 2005. This increase was partially due to ourlicensing of the DARA program, for which we recorded a $2.0 million charge.Exclusive of this charge, proprietary research and development expendituresincreased 110%. This increase was primarily attributable to costs relating topreclinical development studies for our DARA program, resources expended on ourJAK-3 program, our Adenosine A2a program, our CCR-1 program, and ourrecognition of share-based compensation costs of $287 thousand associated withour adoption of SFAS 123R. Because of the speculative nature of these internaldrug discovery projects, it is not possible to estimate completion dates orcosts of completion. Additionally, from time to time, certain staff and otherresearch and development resources may be temporarily redirected from oneproject to another, which redirection may also delay or impact the cost ofinternal drug discovery projects.

Sales,general and administrative expense decreased by 11% to $7.0 million in the ninemonths ended September30, 2006 compared to $7.9 million in the nine months ended September 30,2005.  The decrease in sales, general and administrative expense isattributable to approximately $1.1 million in severance costs incurred in thenine months ended September 30, 2005, and lower consulting, recruiting, traveland certain compensation costs offset by the recognition of share-basedcompensation costs of $741 thousand associated with our adoption of SFAS 123Rand approximately $182 thousand in severance costs, which includes $79 thousandrelating to the acceleration of vesting of certain stock options, in the ninemonths ended September 30, 2006.

Restructuringand other charges decreased by approximately $88 thousand, which relates to anadjustment to our restructuring cost estimate to reflect our actualrestructuring costs.

Interestand other income, net increased to $1.0 million in the nine months ended September 30, 2006compared to $781 thousand in the nine months ended September 30, 2005.  This increase is due tohigher yields on our investments.

Werecorded an income tax provision of $37 thousand and $21 thousand for the ninemonths ended September30, 2006 and 2005, respectively, related to minimum state income taxes.The increase relates to temporary differences in revenue recognition betweengenerally accepted accounting principles and applicable tax law.

As aresult of the net revenues and expenses described above, we generated a netloss of $19.6 million ($1.28 per basic and diluted share) in the nine monthsended September30, 2006, compared to a net loss of $14.1 million ($1.08 per basic anddiluted share) in the nine months ended September 30, 2005.

**ContractualObligations**

For adiscussion of our contractual obligations, see “Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operations” in our report onForm 10-K for the year ended December 31, 2005. See discussion of theProduct Development and Commercialization Agreement with GSK and theCollaboration and License Agreement with Cephalon in Note 2, the LicenseAgreement with BMS in Note 3, and certain of our milestone and royaltycommitments in Note 8, respectively, to the Financial Statements for newcontractual obligations as of September 30, 2006.

**Net LossOutlook**

We have had net losses in recent years and we expect toincur losses in future periods. Our net loss is highly dependent on thecontinued funding and success of our research and development programs with ourexisting collaborators. Our collaborations with Schering-Plough wererecently extended and we expect to record revenue from these collaborationsthrough early April 2007, at which time we expect our research activities underthe collaborations to cease.   We willcontinue to be entitled to payments resulting from the successful achievementby Schering-Plough, if any, of preclinical and clinical milestones as well asroyalty payments from sales, if any, of products resulting from compoundsalready delivered by us and accepted by Schering-Plough under thecollaborations.

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Failureto earn additional research and milestone payments under our currentcollaborations and collaborations we seek to enter into would have a materialadverse effect on our financial condition and our results of operations.  If we fail to earn adequate additionalresearch and milestone payments, we may be required to curtail operationssignificantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

We expect to incur losses in future periods and theselosses are expected to increase as compared to prior periods as a result of theincreased level of investment we have determined to make in our internalproprietary programs in the future as well as the results of those programs.Our internal proprietary research and development costs are expected tocontinue to increase due to our efforts to progress the DARA program intoclinical trials. We expect to file an IND application for the DARA program inthe first quarter of 2007.

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

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

**CriticalAccounting Policies**

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

*RevenueRecognition*

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

Revenue earned related toup-front product and technology license fees is recognized in accordance withStaff Accounting Bulletin 104 issued by the SEC and Emerging Issues Task ForceIssue 00-21, “Revenue Arrangements with Multiple Deliverables” issued by theFASB. Accordingly, amounts received under multiple-element arrangementsrequiring ongoing services or performance by us are recognized over the periodof such services or performance.

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

*Long-LivedAssets*

We review long-livedassets, including leasehold improvements, property and equipment, and acquiredtechnology rights, for impairment whenever events or changes in businesscircumstances indicate that the carrying amount of the assets may not be fullyrecoverable. This requires us to estimate future cash flows related to theseassets. Actual results could differ from these estimates, which may affect thecarrying amount of assets and the actual amortization expense. As of September30, 2006, we had long-lived assets with a net book value of $11.3 million.

**New AccountingPronouncements**

*Accounting for Uncertain Tax Positions*

In June 2006, the FASBissued Interpretation No. 48, “Accounting for Uncertainty in Tax Positions – anInterpretation of FASB Statement No. 109” (FIN 48).  FIN 48 appliesto all open tax positions accounted for in accordance with SFAS No. 109, “Accountingfor Income Taxes” and is intended to result in increased relevance andcomparability in financial reporting of income taxes and to

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providemore information about the uncertainty in income tax assets and liabilities.FIN 48 is effective for fiscal years beginning after December 15, 2006. We arecurrently evaluating the impact of FIN 48 on our financial position and resultsof operations.

*Fair Value Measurements*

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements,” (SFAS 157). SFAS 157establishes a framework for measuring fair value in accordance with generallyaccepted accounting principles and expands disclosures about fair valuemeasurements. SFAS 157 is effective for fiscal years beginning after November15, 2007 and interim periods within those fiscal years. We are currentlyevaluating the impact of SFAS No. 157 on our financial position and results ofoperations.

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

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

We do not use derivativefinancial instruments for trading or speculative purposes. However, weregularly invest our cash in overnight repurchase agreements that are subjectto changes in short-term interest rates. We believe that the market riskarising from holding these financial instruments is minimal.

Our exposure to marketrisks associated with changes in interest rates relates primarily to theincrease or decrease in the amount of interest income earned on our investmentportfolio since we have minimal debt. We ensure the safety and preservation ofinvested funds by limiting default risks, market risk and reinvestment risk. Wemitigate default risk by investing in investment grade securities. Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would not have materially affected the fair value ofour interest sensitive financial instruments as of September 30, 2006.

**Item 4. Controls and Procedures**

Forthe three months ended September30, 2006, our management carried out an evaluation, under thesupervision and with the participation of our President and Chief ExecutiveOfficer and our Executive Vice President, Chief Financial Officer and Treasurer(our principal financial officer and chief accounting officer), of theeffectiveness of our disclosure controls and procedures pursuant toRules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, or theExchange Act, as of the end of the period covered by this report. Based uponthis evaluation, our President and Chief Executive Officer and our ExecutiveVice President, Chief Financial Officer and Treasurer concluded that as of September 30, 2006,our disclosure controls and procedures were effective to ensure that theinformation required to be disclosed by us in reports filed under the ExchangeAct was recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC. Our management, including ourPresident and Chief Executive Officer and our Executive Vice President, ChiefFinancial Officer and Treasurer, does not expect that our disclosure controlsor our internal controls will prevent all errors and all fraud. A controlsystem, no matter how well designed and operated, cannot provide assurance thatthe objectives of the control system are met, and no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within a company have been detected.

Additionally,our President and Chief Executive Officer and our Executive Vice President,Chief Financial Officer and Treasurer determined that there were no changes inour internal control over financial reporting during the three month periodended September30, 2006, that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II. OTHER INFORMATION**

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

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

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

Our performance andfinancial results are subject to risks and uncertainties, including, but notlimited to, the specific risks disclosed in Item 1A. Risk Factors in our AnnualReport on Form 10-K for the year ended December 31, 2005. Except as notedbelow, there have been no material changes to the risk factors disclosed in theForm 10-K.

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**RISKSRELATED TO OUR BUSINESS AND INDUSTRY**

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

Weanticipate that our capital resources, including our existing cash, cashequivalents and marketable securities as of September 30, 2006 ofapproximately $31.0 million and the approximately $23.0 million in cashproceeds we received on October 18, 2006 resulting from our sale of securities(see Note 10 to the Financial Statements for disclosure of this subsequentevent), will be adequate to fund our operations at their current levels atleast through December 31, 2007. In addition, as of September 30, 2006, we haddeferred revenue and other liabilities of approximately $21.8 million relatingto research and development activities that are to be performed by ussubsequent to September 30, 2006. However, changes may occur that would cause us to consume available capitalresources before that time. Examples of relevant potential changes in ourcapital resources include:

·      thecosts associated with our drug research and development activities;

·      changesin existing collaborative relationships, including the funding we receive inconnection with those relationships;

·      theprogress of our milestone and royalty producing activities;

·      acquisitionsof other businesses or technologies;

·      thepurchase of additional capital equipment;

·      cashrefunds we may be required to make to GSK if, prior to March 24, 2011, we exerciseour discretionary termination right under the GSK Agreement;

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

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

·      competingtechnological and market developments; and

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

Failureto earn additional research and milestone payments under our currentcollaborations and additional collaborations we seek to enter into would have amaterial adverse effect on our business as it is currently conducted, ourfinancial condition and our results of operations.  If we fail to earn adequate additionalresearch and milestone payments, we may be required to curtail operationssignificantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

InOctober 2006, we raised capital through a public financing of common stock andwarrants (see Note 10 to the Financial Statements for disclosure of thissubsequent event). Our issuance of approximately 5.8 million shares of commonstock in connection with this financing resulted in significant dilution of theholdings of our stockholders that owned stock prior to the financing. It islikely that we will raise capital in the future. The capital could be raisedthrough public or private financings involving debt or common stock or otherclasses of our equity. Further issuances of equity securities will furtherdilute our stockholders’ percentage ownership. As of October 18, 2006, there were approximately 3,841,000 stock optionsoutstanding, approximately 1,626,000 warrants outstanding, which includesapproximately 176,000 warrants issued in connection with the GSK Agreement andapproximately 1,450,000 warrants issued in connection with the UnderwritingAgreement, and approximately 5,000 shares of unvested restricted stock granted underour various equity compensation plans. These equity instruments representapproximately 26% of our shares outstanding at October 18, 2006. Thesignificant dilution represented by our outstanding warrants and equitycompensation awards may make it more difficult for us to raise additionalcapital. Additional capital may not be available on favorable terms, or at all.  If

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adequate funds arenot available, we may be required to curtail operations significantly or toobtain funds by entering into arrangements with collaborative partners orothers that may require us to relinquish rights to certain of our technologies,products or potential markets that we would not otherwise relinquish.

***Because our DARA program is in preclinical development, there is a highrisk that further development and testing will demonstrate that the DARAcompounds are not suitable for commercialization. In addition, because weexclusively licensed our product candidate PS433540 from BMS, any dispute withBMS may adversely affect our ability to develop and commercialize PS433540.***

Wehave no products that have received regulatory approval for commercial sale.Our DARA program, including PS5433540, is in preclinical development, and weface the substantial risks of failure inherent in developing drugs based on newtechnologies. We plan to file an IND application for our DARA program with theFDA in the first quarter of 2007. 

OurDARA program must satisfy rigorous standards of safety and efficacy before theFDA and foreign regulatory authorities will approve them for commercial use. Wewill need to conduct significant additional preclinical testing and, if suchpreclinical testing is successful, clinical trials, to demonstrate the safetyand efficacy of our DARA program to the satisfaction of the FDA and foreignregulatory authorities to obtain product approval.

Preclinicaltesting and clinical development are long, expensive and uncertain processes.It may take us many years to complete testing and trials, if any, and failurecan occur at any stage of testing or trials. Success in preclinical testing andearly clinical trials does not ensure that later clinical trials will besuccessful. We may suffer significant setbacks in advanced clinical trials,even after promising results in earlier trials. We may not be able to enroll asufficient number of patients to complete our clinical trials in a timelymanner. Based on results at any stage of preclinical testing or clinicaltrials, we may decide to discontinue development of our DARA program.

We donot know whether any future clinical trials of our DARA program willdemonstrate sufficient safety and efficacy necessary to obtain the requisiteregulatory approvals or will result in marketable products. Our failure toadequately demonstrate the safety and efficacy of our DARA program underdevelopment will prevent receipt of FDA and foreign regulatory approvals and,ultimately, their commercialization.

Ifthere is any dispute between us and BMS regarding our rights under the licenseagreement between us and BMS under which we licensed exclusive worldwide rightsto our DARA program, including PS5433540, our ability to develop andcommercialize PS433540 may be adversely affected. Any loss of our rights fromBMS could delay or completely terminate our product development efforts forPS433540 and other compounds licensed from BMS. 

***We are dependent on our collaborations, and events involving thesecollaborations or any future collaborations could prevent us from developing orcommercializing product candidates.***

Thesuccess of our current business strategy will depend in part on our ability tosuccessfully establish new strategic collaborations. Since we do not currentlypossess the resources necessary to independently develop and commercialize allof the product candidates that may be discovered through our drug discoverytechnology, we may need to enter into additional collaborative agreements toassist in the development and commercialization of some of these productcandidates or in certain markets for a particular product candidate.Establishing strategic collaborations is difficult and time-consuming.Potential collaborators may reject collaborations based upon their assessmentof our financial, regulatory or intellectual property position, and our discussionswith potential collaborators may not lead to the establishment of newcollaborations on acceptable terms.

We andour present and future collaborators may fail to develop or effectivelycommercialize products covered by our present and future collaborations if:

·      we donot achieve our objectives under our collaboration agreements;

·      we orour collaborators are unable to obtain patent protection for the productcandidates or proprietary technologies we discover in our collaborations;

·      we areunable to manage multiple simultaneous product discovery and developmentcollaborations;

·      ourpotential collaborators are less willing to expend their resources on ourprograms due to their focus on other programs or as a result of general marketconditions;

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·      ourcollaborators become competitors of ours or enter into agreements with ourcompetitors;

·      we orour collaborators encounter regulatory hurdles that prevent commercializationof our product candidates; 

·      wedevelop products and processes or enter into additional collaborations thatconflict with the business objectives of our other collaborators; or

·      our collaborators elect to terminate ourpartnerships under the permitted circumstances.

If weor our collaborators are unable to develop or commercialize products as aresult of the occurrence of any one or a combination of these events, we willbe prevented from developing and commercializing such product candidates.Moreover, disputes may arise with respect to the ownership of rights to anytechnology or products developed with any current or future partner. Lengthynegotiations with potential new partners or disagreements between us and ourpartners may lead to delays or termination in the research, development orcommercialization of product candidates. If we are not able to establishadditional partnerships on terms that are favorable to us or if a significantnumber of our existing partnerships are terminated and we cannot replace them,we may be required to increase our internal product development andcommercialization efforts. Any of the foregoing may materially harm ourbusiness, financial condition and results of operations.

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

Duringthe nine months ended September 30, 2006, we had a net loss of approximately$19.6 million.  The net loss was primarily due to our licensing of theDARA program from BMS and costs associated with developing the program, ourcontinued focus on internal research and development, the decrease in revenuefrom our collaborations with Schering-Plough, and increased compensation costsassociated with the adoption of SFAS 123R.

Ourcollaborations with Schering-Plough were recently extended, and we expect torecord revenue from these collaborations through early April 2007, at whichtime we expect our research activities under the collaborations to cease.  We will continue to be entitled to paymentsresulting from the successful achievement by Schering-Plough, if any, ofpreclinical and clinical milestones as well as royalty payments from sales, ifany, of products resulting from compounds already delivered by us and acceptedby Schering-Plough under the collaborations.

Theadoption of SFAS 123R had and will continue to have a significant impacton our results of operations. Our adoption of SFAS 123R was effective January1, 2006.

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

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

**Item 2.****     ****Unregistered Sales of Equity Securities and Use of Proceeds**

**None.**

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

None.

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

None.

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

None.

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

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| Exhibits. | ** ** | ** **                                                                                                                                                                                                                                                                                   |
|-----------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.1      |       | Amendment No. 2, dated September 25, 2006, to the  Collaboration and License Agreements, effective as of July 9, 2003 (and as  subsequently amended) between (i) the Company and Schering Corporation and  (ii) the Company and Schering-Plough Ltd.(1)(2)                                   |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.2      |       | Amendment No. 1, dated August 10, 2006, to the  Product Development and Commercialization Agreement among the Company,  SmithKline Beecham Corporation, doing business as GlaxoSmithKline, and Glaxo  Group Limited. (1)(2)                                                                  |
|      |       |                                                                                                                                                                                                                                                                                         |
| 31.1      |       | Certification of the Principal Executive Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to Rule 13a-l4(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.(1)                              |
|      |       |                                                                                                                                                                                                                                                                                         |
| 31.2      |       | Certification of the Principal Financial Officer and  Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc. pursuant  to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(1) |
|      |       |                                                                                                                                                                                                                                                                                         |
| 32.1      |       | Certification of the Principal Executive Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.(1)                                                                         |
|      |       |                                                                                                                                                                                                                                                                                         |
| 32.2      |       | Certification of the Principal Financial Officer and  Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc. pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.(1)                                            |

 

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(1)    Filedherewith.

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

25

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**SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|                                    | PHARMACOPEIA DRUG  DISCOVERY, INC. |
|------------------------------------|------------------------------------|
|                               |                               |
| Date:  November  2, 2006 | By:                                | /s/ Leslie J. Browne, Ph.D. |
|                               |                               | Leslie J. Browne, Ph.D. |
|                               |                               | President, Chief Executive Officer  and Director |
|                               |                               | (Principal Executive Officer) |
|                               |                               |
|                               | By:                                | /s/ Brian M. Posner |
|                               |                               | Brian M. Posner |
|                               |                               | Executive Vice President, |
|                               |                               | Chief Financial Officer and Treasurer |
|                               |                               | (Principal Financial Officer and Chief  Accounting Officer) |

 

26

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**PHARMACOPEIADRUG DISCOVERY, INC.**

**INDEX TOEXHIBITS**
| Exhibits. | ** ** | ** **                                                                                                                                                                                                                                                                                   |
|-----------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.1      |       | Amendment No. 2, dated September 25, 2006, to the  Collaboration and License Agreements, effective as of July 9, 2003 (and as  subsequently amended) between (i) the Company and Schering Corporation and  (ii) the Company and Schering-Plough Ltd.(1)(2)                                   |
|      |       |                                                                                                                                                                                                                                                                                         |
| 10.2      |       | Amendment No. 1, dated August 10, 2006, to the  Product Development and Commercialization Agreement among the Company,  SmithKline Beecham Corporation, doing business as GlaxoSmithKline, and Glaxo  Group Limited. (1)(2)                                                                  |
|      |       |                                                                                                                                                                                                                                                                                         |
| 31.1      |       | Certification of the Principal Executive Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.(1)                              |
|      |       |                                                                                                                                                                                                                                                                                         |
| 31.2      |       | Certification of the Principal Financial Officer and  Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc. pursuant  to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(1) |
|      |       |                                                                                                                                                                                                                                                                                         |
| 32.1      |       | Certification of the Principal Executive Officer of  Pharmacopeia Drug Discovery, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.(1)                                                                         |
|      |       |                                                                                                                                                                                                                                                                                         |
| 32.2      |       | Certification of the Principal Financial Officer and  Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc. pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.(1)                                            |

 

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(1)    Filedherewith.

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

----