**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 1O-Q**

 
| **(Mark One)**                                         |
|--------------------------------------------------------|
| **ý**                                             | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                   |
| **For the quarterly period ended March 31, 2005** |
|                                                   |
| **Or**                                                 |
|                                                   |
| **o**                                                  | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                   |
| **Commission File Number: 0-50523**                    |

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

(Exact name of registrant as specified in its charter)

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

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.    Yes ý     Noo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes o    Noý

 

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

 
| **Class**                     | ** ** | **Outstanding  at May 11, 2005** |
|-------------------------------|------------|---------------------------------------|
| Common Stock, $0.01 par value |       | 12,436,236                            |

 

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**          | ** **            | ** **                                                                                  | ** ** | ** ** |
|-------------------|-----------------------|---------------------------------------------------------------------------------------------|------------|------------|
|              |                  |                                                                                        |       |       |
| PART I.      | FINANCIAL INFORMATION |                                                                                        |       |
|              |                  |                                                                                        |       |       |
| Item 1.           |                  | Financial Statements (Unaudited):                                                           |       |       |
|              |                  |                                                                                        |       |       |
|              |                  | Balance  Sheets as of March 31, 2005 and December 31, 2004                        |       |       |
|              |                  |                                                                                        |       |       |
|              |                  | Statements of Operations for each of the Three Months Ended  March 31, 2005 and 2004   |       |       |
|              |                  |                                                                                        |       |       |
|              |                  | Statements of Cash Flows for each of the Three Months Ended  March 31, 2005 and 2004   |       |       |
|              |                  |                                                                                        |       |       |
|              |                  | Notes to Unaudited Financial Statements                                                     |       |       |
|              |                  |                                                                                        |       |       |
| Item 2.           |                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |       |       |
|              |                  |                                                                                        |       |       |
|              |                  | Certain Risks Related to Our Business                                                       |       |       |
|              |                  |                                                                                        |       |       |
| Item 3.           |                  | Quantitative and Qualitative Disclosures  about Market Risk                                 |       |       |
|              |                  |                                                                                        |       |       |
| Item 4.           |                  | Controls and Procedures                                                                     |       |       |
|              |                  |                                                                                        |       |       |
| PART II.     | OTHER INFORMATION     |                                                                                        |       |
|              |                  |                                                                                        |       |       |
| Item 1.           |                  | Legal Proceedings                                                                           |       |       |
|              |                  |                                                                                        |       |       |
| Item 2.           |                  | Unregistered Sales of Equity Securities and  Use of Proceeds                                |       |       |
|              |                  |                                                                                        |       |       |
| Item 3.           |                  | Defaults upon Senior Securities                                                             |       |       |
|              |                  |                                                                                        |       |       |
| Item 4.           |                  | Submission of Matters to a Vote of Security  Holders                                        |       |       |
|              |                  |                                                                                        |       |       |
| Item 5.           |                  | Other Information                                                                           |       |       |
|              |                  |                                                                                        |       |       |
| Item  6.          |                  | Exhibits                                                                                    |       |       |
|              |                  |                                                                                        |
| Signatures        |                  |                                                                                        |
|              |                  |                                                                                        |
| Index of Exhibits |                  |                                                                                        |

 

----

 

**PART I- FINANCIAL INFORMATION**

 

**Item 1.  Unaudited Financial Statements**

 

**PharmacopeiaDrug Discovery, Inc.**

**Balance Sheets**

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

 
| ** **                                                                                                                          | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **                                                                                                                          | ** ** | **(unaudited)**    | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                          |       |               |       |                  |       |
| Current assets:                                                                                                                     |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                           |       | $                  | 17,728     |                  | $          | 20,173 |   |
| Marketable securities                                                                                                               |       | 17,561             |       | 20,712                |       |
| Accounts receivable                                                                                                                 |       | 2,794              |       | 1,062                 |       |
| Prepaid expenses and other current assets                                                                                           |       | 638                |       | 1,062                 |       |
| Total current assets                                                                                                                |       | 38,721             |       | 43,009                |       |
|                                                                                                                                |       |               |       |                  |       |
| Property and equipment, net                                                                                                         |       | 11,327             |       | 11,725                |       |
| Deferred compensation assets due from  Accelrys, Inc.                                                                          |       | 2,114              |       | 2,140                 |       |
| Other assets                                                                                                                        |       | 173                |       | 131                   |       |
| Total assets                                                                                                                        |       | $                  | 52,335     |                  | $          | 57,005 |   |
|                                                                                                                                |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                       |       |               |       |                  |       |
| Current liabilities:                                                                                                                |       |               |       |                  |       |
| Accounts payable                                                                                                                    |       | $                  | 1,914      |                  | $          | 1,414 |   |
| Accrued liabilities                                                                                                                 |       | 2,820              |       | 2,874                 |       |
| Restructuring reserve, current portion                                                                                              |       | 2,462              |       | 2,462                 |       |
| Deferred revenue, current portion                                                                                                   |       | 3,575              |       | 3,501                 |       |
| Total current liabilities                                                                                                           |       | 10,771             |       | 10,251                |       |
|                                                                                                                                |       |               |       |                  |       |
| Deferred compensation plan                                                                                                          |       | 2,114              |       | 2,140                 |       |
| Restructuring reserve, long-term                                                                                                    |       | 198                |       | 906                   |       |
|                                                                                                                                |       |               |       |                  |       |
| 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, 12,415,253 and 12,354,695 shares issued and outstanding,  respectively |       | 124                |       | 123                   |       |
| Additional paid-in capital                                                                                                          |       | 50,501             |       | 50,263                |       |
| Accumulated deficit                                                                                                                 |       | (10,875            | )          | (6,235                | )          |
| Accumulated other comprehensive loss                                                                                                |       | (270               | )          | (175                  | )          |
| Deferred compensation                                                                                                               |       | (228               | )          | (268                  | )          |
| Total stockholders’ equity                                                                                                     |       | 39,252             |       | 43,708                |       |
| Total liabilities and stockholders’ equity                                                                                     |       | $                  | 52,335     |                  | $          | 57,005 |   |

 

See accompanying notes tothese unaudited financial statements.

 

1

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**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Operations**

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

 
| ** **                                           | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                       | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(unaudited)**                                | ** ** |
| Net revenue                                          |       | $                                              | 5,691      |   | $ | 5,369 |   |
|                                                 |       |                                           |       |   |   |
| Collaborative research and development expense       |       | 5,626                                          |       | 5,550 |   |
| Proprietary research and development expense         |       | 2,241                                          |       | 1,389 |   |
| Sales, general and administrative expense            |       | 2,663                                          |       | 2,419 |   |
| Restructuring and other charges                      |       | —                                         |       | 5,947 |   |
| Interest and other income, net                       |       | (209                                           | )          | (3 | ) |
|                                                 |       | 10,321                                         |       | 15,302 |   |
| Loss before income taxes                             |       | (4,630                                         | )          | (9,933 | ) |
| Provision for income taxes                           |       | 10                                             |       | 3 |   |
| Net loss                                             |       | $                                              | (4,640     | ) | $ | (9,936 | ) |
|                                                 |       |                                           |       |   |   |
| Net loss per share:                                  |       |                                           |       |   |   |
| • Basic and  diluted                            |       | $                                              | (0.38      | ) | $ | (0.82 | ) |
|                                                 |       |                                           |       |   |   |
| Weighted average number of common stock outstanding: |       |                                           |       |   |   |
| • Basic and  diluted                            |       | 12,353,553                                     |       | 12,155,751 |   |

 

See accompanying notes tothese unaudited financial statements.

 

2

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**PharmacopeiaDrug Discovery, Inc.**

**Statements of CashFlows**

**(Amounts inthousands)**

 
| ** **                                                                      | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                                       | ** ** | **2004** | ** ** |
| ** **                                                                      | ** ** | **(unaudited)**                                | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                           | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net loss                                                                        |       | $                                              | (4,640     | ) | $ | (9,936 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities |       |                                           |       |   |   |
| Depreciation and amortization                                                   |       | 583                                            |       | 449 |   |
| Contibution of stock to 401(k) Plan                                             |       | 107                                            |       | — |   |
| Amortization of deferred compensation                                           |       | 40                                             |       | — |   |
| Changes in assets and liabilities:                                              |       |                                           |       |   |   |
| Accounts receivable                                                             |       | (1,732                                         | )          | 1,805 |   |
| Prepaid expenses and other current assets                                       |       | 424                                            |       | 163 |   |
| Other assets                                                                    |       | (42                                            | )          | 2 |   |
| Accounts payable                                                                |       | 500                                            |       | (2,009 | ) |
| Accrued liabilities                                                             |       | (54                                            | )          | 3,160 |   |
| Restructuring reserve                                                           |       | (708                                           | )          | 2,655 |   |
| Deferred revenue                                                                |       | 74                                             |       | 347 |   |
| Net cash used in operating activities                                           |       | (5,448                                         | )          | (3,364 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                           |       |                                           |       |   |   |
| Capital expenditures, net                                                       |       | (185                                           | )          | (4,613 | ) |
| Purchases of marketable securities                                              |       | (12,922                                        | )          | — |   |
| Proceeds from sale of marketable securities                                     |       | 15,979                                         |       | — |   |
| Net cash provided by (used in) investing  activities                            |       | 2,872                                          |       | (4,613 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                           |       |                                           |       |   |   |
| Proceeds from issuance of common stock                                          |       | 85                                             |       | — |   |
| Investment by Accelrys, Inc.                                               |       | 46                                             |       | 7,821 |   |
| Net cash provided by financing activities                                       |       | 131                                            |       | 7,821 |   |
| Net decrease in cash and equivalents                                            |       | (2,445                                         | )          | (156 | ) |
| Cash and equivalents, beginning of period                                       |       | 20,173                                         |       | 524 |   |
| Cash and equivalents, end of period                                             |       | $                                              | 17,728     |   | $ | 368 |   |
|                                                                            |       |                                           |       |   |   |
| SUPPLEMENTAL SCHEDULE OF CASH FLOW  INFORMATION:                           |       |                                           |       |   |   |
| Cash paid during the period for:                                                |       |                                           |       |   |   |
| Interest                                                                        |       | $                                              | —     |   | $ | — |   |
| Income tax                                                                      |       | $                                              | —     |   | $ | 3 |   |

 

See accompanying notes tothese unaudited financial statements.

 

3

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**PharmacopeiaDrug Discovery, Inc.**

**Notes toUnaudited Financial Statements**

 

**1.  Background and Basis of Presentation**

 

Pharmacopeia Drug Discovery, Inc.(“Pharmacopeia” or the “Company”) was incorporated on May 31, 2002 as awholly owned subsidiary of Accelrys, Inc. (“Accelrys”), formerlyPharmacopeia, Inc.  On April 30,2004, 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. The financial statementshave been revised to retroactively reflect the shares distributed for all periodspresented prior to the distribution date.

 

Accelrys contributed cash, cash equivalentsand marketable securities to Pharmacopeiasuch that upon consummation of the distribution on April 30, 2004,Pharmacopeia had a cash, cash equivalents and marketable securities balanceaggregating $46.5 million and all inter-company balances due to Accelrys wereforgiven in their entirety by Accelrys and treated as a capital contribution;accordingly, such balances were reflected as investment by Accelrys for periodsprior to April 30, 2004, at which time the amount was reclassified toadditional paid-in capital. Earnings and losses accumulate in retained earnings(deficit) starting May 1, 2004.

 

In connection with thedistribution, Accelrys and the Company entered into a series of agreements,including a master separation and distribution agreement, a transition servicesagreement, a tax sharing and indemnification agreement and other agreements,which govern the ongoing relationship between the two companies.

 

Pharmacopeia is a biopharmaceuticalcompany, focused on the creation of new small molecule therapeutics to addresssignificant unmet medical needs. Using proprietary technologies and processes,Pharmacopeia identifies, optimizes, and develops novel drug candidates incollaboration with major pharmaceutical and biotechnology companies, and,increasingly, through its own internally funded drug discovery programs.  These programs are primarily focused onimmunobiology and immunological diseases. Pharmacopeia’s later stage portfoliocurrently comprises multiple partnered programs that have been advanced intohuman clinical trials, with further programs in late-stage pre-clinicaldevelopment.  Additionally, Pharmacopeiahas approximately 40 partnered and internal programs in discovery.

 

For periods prior to thedistribution date, Pharmacopeia’s financial statements were derived from thefinancial statements and accounting records of Accelrys using the historicalresults of operations and historical basis of the assets and liabilities of theCompany’s business. Management believes the assumptions underlying thefinancial statements are reasonable. The financial statements included hereinmay not necessarily reflect the Company’s results of operations, financialposition and cash flows in the future or what its results of operations,financial position and cash flows would have been had the Company been astand-alone company during the periods presented.

 

For periods prior to thedistribution date, the financial statements included allocations of certainAccelrys corporate headquarter assets, liabilities and expenses relating to theCompany’s business that have been transferred to the Company from Accelrys.General corporate overhead was allocated based on the Company’s revenue as apercentage of Accelrys’s total revenue. General corporate overhead primarilyincludes salaries and expenses for executive management, finance, legal, humanresources, information services and investor relations, and was $537 thousandfor the quarter ended March 31, 2004. These costs are included in sales, general and administrative expensesin the accompanying statements of operations.

 

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 RegulationS-X.  Accordingly, these unauditedfinancial statements do not include all of the information and disclosuresrequired by U. S. generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation ofthe financial statements have been included. Interim results are not necessarily indicative of the results that maybe expected for the year. The unaudited interim financial statements should beread in conjunction with the financial statements and notes thereto included inthe Company’s Annual Report on Form 10-K for the year ended December 31,2004.

 

**2.Significant Collaborations**

 

Forthe quarters ended March 31, 2005 and 2004 two collaborators accounted foran aggregate of 84% and 85%, respectively, of revenue.  For the quarters ended March 31, 2005and 2004, the Company’s research collaborations with Schering-Plough accountedfor 64% and 69%, respectively, of revenue. In the third quarter of 2003, the Company entered into new drugdiscovery collaborations with Schering-Plough, which continued certain existingprograms and implemented a number of new activities. The new agreementscontinue the Company’s collaboration with Schering-Plough through at least August 2006.  Under the new agreements the Company receives researchfunding on an FTE basis which is recognized as revenue as services areperformed.  Schering-Plough was obligated to fund aspecified number of the Company’s full-time employees (FTEs) in the firstyear.  Subsequently, based on the initialscreening results Schering-Plough decided to focus on optimization programs andterminated the Company’s screening activities on Schering-Plough’s behalf. Thisdecision resulted in an approximately 11% reduction of the number of theCompany’s FTEs whom Schering-Plough was obligated to fund.  Additionally the Company may receivemilestone payments upon the successful achievement of preclinical and clinicalmilestones. Milestone payments will be recognized as revenue to the extent thatmilestones are achieved. Upon successful commercialization of most productsresulting from this relationship, the Company will be entitled to receiveroyalties on sales of those products.  Pursuant to the terms of the 2003 agreements,Schering-Plough has advised the Company that it intends to reduce its FTEfunding by an additional 41% (or approximately $1.1 million per calendarquarter) effective August 2005. Discussions have been initiated regardingthe possible extension or modification of the 2003 agreements.  There can be no assurance that the 2003agreements will be extended beyond August 2006 or that funding will bemaintained at current or expected reduced August 2005 levels beyond August2006 either in the aggregate or on an FTE basis.

 

4

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For the quarters ended March 31,2005 and 2004, the Company’s research collaborations with N.V. Organon (“Organon”)accounted for 20% and 16%, respectively, of revenue.  The principal agreement with Organon, enteredinto in February 2002, has a stated term of five years; however, Organonhas the right to terminate the agreement in 2005 if Pharmacopeia is unable todeliver compounds meeting the criteria specified in the agreement. Under thisagreement, Pharmacopeia receives research funding to conduct its drug discoveryactivities to identify and optimize new drug candidates for multipletherapeutic targets provided by Organon. This revenue is recognized on astraight-line basis over the term of the collaboration. The Company may receivemilestone payments upon the successful achievement of preclinical and clinicalmilestones. These milestone payments will be recognized as revenue to theextent that milestones are achieved. Upon successful commercialization of anyproduct resulting from this relationship, Pharmacopeia will be entitled toreceive royalties on sales of that product.

 

**3.  Net Loss Per Share**

 

The Company computes net income(loss) per share in accordance with Statement of Financial Accounting Standard No. 128,“Earnings Per Share” (“SFAS 128”).  Underthe provisions of SFAS 128, basic net income (loss) per share is computed bydividing the net income (loss) for the period by the weighted-average number ofcommon shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted-average number of common anddilutive common equivalent shares outstanding during the period.  Diluted earnings per share include thepotentially dilutive effect of outstanding stock options, or other dilutivesecurities. Shares outstanding for the Company for the period prior to thedistribution are calculated based on the 12,181,471 shares distributed in thespin-off, adjusted for unvested restricted shares (see note 1). The Company hasa net loss for the periods presented; accordingly, the inclusion of commonstock equivalents for outstanding stock options would be anti-dilutive and,therefore, the weighted-average shares used to calculate both basic and dilutedloss per share are the same.

 

**4.  Segment Information**

 

The Company classifies its businessoperations in one operating segment.  Allof the Company’s revenues are generated from this segment.  In the quarters ended March 31, 2005 and2004, approximately 45% and 43%, respectively, of the Company’s revenue fromcustomers was derived from within the United States, 54% and 54%, respectively,was derived from Europe, and 1% and 3%, respectively, was derived from Asia.

 

**5.  Stock-Based Compensation**

 

Generally, at the distributiondate, any outstanding options to purchase Accelrys common stock held byemployees, directors and consultants of Pharmacopeia under Accelrys incentivecompensation plans were adjusted or converted to options to purchasePharmacopeia common stock to maintain the intrinsic value existing at the timeof the distribution and maintain the ratio existing at the time of thedistribution of the exercise price per share to the market value per share.

 

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

 

In December 2004, the FASBissued Statement of Financial Accounting Standards (SFAS) No 123 (revised2004), “Share-Based Payment” (SFAS No. 123R), which replaces SFAS No. 123and supersedes APB Opinion No. 25 “Accounting for Stock Issued ToEmployees”.  SFAS No. 123R requiresall share-based payments to employees, including grants of employee stockoptions, to be

 

5

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recognized in the financialstatements based on their fair values. The pro forma disclosures previouslypermitted under SFAS No. 123 no longer will be an alternative to financialstatement recognition.  Under SFAS No. 123R,the Company must determine the appropriate fair value model to be used forvaluing share-based payments, the amortization method for compensation cost,and the transition method to be used at date of adoption. The permittedtransition methods include either retrospective or prospective adoption. Underthe retrospective option, prior periods may be restated either as of thebeginning of the year of adoption or for all periods presented. The prospectivemethod requires that compensation expense be recorded for all unvested stockoptions at the beginning of the first quarter of adoption of SFAS No. 123R,while the retrospective methods would record compensation expense for allunvested stock options beginning with the first period presented. The Companyis currently evaluating the requirements of SFAS No. 123R and expects thatadoption of SFAS No. 123R will have a material impact on the Company’sresults of operations. The Company has not yet determined the method ofadoption or the effect of adopting SFAS No. 123R and it has not determinedwhether the adoption will result in amounts that are similar to the current proforma disclosures under SFAS No. 123.

 

On April 14, 2005, theSecurities and Exchange Commission announced the adoption of a new rule thatamends the compliance dates for SFAS No. 123R.  The new rule allows companies toimplement SFAS No. 123R at the beginning of their next fiscal period,therefore, the Company will need to be in compliance with SFAS No. 123Rcommencing with it’s fiscal year beginning January 1, 2006.  The Commission’s new rule does notchange the accounting required by SFAS No. 123R; it changes only the datesfor compliance with the standard.

 

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

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended March 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Net loss:                                                                                                                                     |       |                                 |       |   |   |
| As reported                                                                                                                                   |       | $                                    | (4,640     | ) | $ | (9,936 | ) |
|                                                                                                                                          |       |                                 |       |   |   |
| Add: Stock-based employee compensation expense  included in reported net loss                                                                 |       | 40                                   |       |   |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | (558                                 | )          | (601 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (5,158     | ) | $ | (10,537 | ) |
| Basic and diluted net loss per common  share:                                                                                                 |       |                                 |       |   |   |
| As reported                                                                                                                                   |       | $                                    | (0.38      | ) | $ | (0.82 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (0.42      | ) | $ | (0.87 | ) |

 

The fair value of each optiongranted during 2005 and 2004 is estimated on the date of grant using theBlack-Scholes option-pricing model with the following assumptions:

 
| ** **              | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0.00     | %          | 0.00     | %          |
| Expected volatility     |       | 85.24    | %          | 85.24    | %          |
| Risk-free interest rate |       | 4.33     | %          | 3.31     | %          |
| Expected life (years)   |       | 5.8      |       | 5.8      |       |

 

**6.  Restructuring**

 

During the quarter ended March 31,2004, the Company executed a restructuring plan for the purpose of making itsresearch and development activities more efficient by eliminating unnecessaryfacilities. Also a reduction in force of six administrative Pharmacopeiaemployees occurred during that quarter, of whom all were terminated as of June 30,2004.  As a result, restructuring relatedcharges of approximately $5.9 million were recognized and accrued as operatingexpense during the quarter ended March 31, 2004.

 

6

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The following table summarizes theactivity of the accrued restructuring reserve for the quarter ended March 31,2005 (dollars in thousands):

 
| ** **                        | ** ** | **Costs to Exit Leased  Facility** | ** ** |
|-----------------------------------|------------|------------------------------------|------------|
| Balance at December 31, 2004 |       | $                                  | 3,368      |   |
| Lease payments                    |       | (708                               | )          |
| Balance at March 31, 2005    |       | $                                  | 2,660      |   |

 

**7**.  Commitments and Contingencies

** **

On August 23, 2004,Columbia University Science and Technology Ventures (“Columbia”) provided theCompany with a notice of material breach of the License Agreement, dated July 16,1993 and as amended October 6, 1995, among the Company, the Trustees ofColumbia University in the City of New York and Cold Spring Harbor Laboratory(the “Agreement”) arising from an alleged underpayment by the Company ofcertain royalties under the Agreement. In correspondence initiated by Columbia,the amount of the alleged underpayment has been estimated to be at least $1.12million for the period from July 1, 2001 through June 30, 2003. TheAgreement covers the Company’s core tagging technology used in its proprietarycombinatorial chemistry encoding technology, Encoded Combinatorial Libraries onPolymeric Support, or ECLiPS®.

 

The parties have a mutual obligation under the terms of the Agreementto negotiate in good faith to resolve the dispute. Because of the alleged materialbreach of the Agreement, Columbia and Cold Spring Harbor assert they canterminate the Company’s license under the Agreement.  However, as a result of the discussions thathave taken place to date, Columbia and Cold Spring Harbor have agreed not to seekto terminate the Company’s license under the Agreement earlier than May 23,2005.

 

The Company does not believe that it has underpaid the royalties atissue or that it is in material breach under the Agreement; however, managementhas determined that there will be a cost to settle and resolve this matter withColumbia.  While the Company is in theprocess of negotiating a resolution of this matter, in accordance with FASBStatement No. 5, “Accounting for Contingencies” and FASB Interpretation No. 14,“Reasonable Estimation of the Amount of a Loss” the Company recorded a chargeof $1.0 million in the year ended December 31, 2004 for the probablefinancial outcome of this resolution. This amount is included in accruedliabilities on the Company’s balance sheet as of March 31, 2005.Management believes that any resolution of the dispute will not have a materialadverse effect on the financial condition of the Company.

 

**8.  Subsequent Event**

 

The employment of Stephen A.Spearman, Ph.D. as Executive Vice President and Chief Operating Officer of theCompany terminated effective as of April 15, 2005. Under a severance agreementbetween the Company and Dr. Spearman, Dr. Spearman is entitled to thecontinuation of his base salary at the time of his termination for a period of18 months and a payment equal to 1.5 times his annual target bonus. Inaddition, the severance agreement provides that Dr. Spearman is entitledto outplacement services up to $12 thousand in value, medical coverage for 18months, the vesting of unvested equity compensation plan awards, and theextension of the exercise period of any equity awards for a period of 18 months(or the expiration date if earlier).

 

In connection with its cash payment obligations to Dr. Spearmanthe Company expects to record a charge in the quarter ending June 30, 2005of approximately $770 thousand. In addition, the Company expects to record anon-cash charge of approximately $191 thousand related to the acceleratedvesting of Dr. Spearman’s stock options.

 

**Item2. Management’s Discussion and Analysis of Financial Condition and Results OfOperations.**

** **

Forward-LookingStatements

 

This QuarterlyReport on Form 10-Q contains forward-looking statements regarding usand our business, financial condition, results of operations and prospectswithin the meaning of the Private Securities Litigation Reform Act of1995.  Such forward-looking statementsinclude those which express plans, anticipation, intent, contingency, goals,targets or future development and/or otherwise are not statements of historicalfact.  These forward-looking statementsare based on our current expectations and projections about future events andthey are subject to risks and uncertainties known and unknown which could causeactual results and developments to differ materially from those expressed orimplied in such statements.  Theseforward-looking statements include statements about the following:

 

•      our intentionsregarding the establishment and continuation of drug discovery collaborationswith leading pharmaceutical and biotechnology organizations, in particular, thecontinuation and funding level of such continuation of our existing collaborationswith Schering-Plough and N.V. Organon;

 

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•      our ability tobuild our pipeline of novel drug candidates, both through our owninternally-funded drug discovery programs and third party collaborations;

 

•      our intentionsto build upon our position as a leading chemistry provider;

 

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

 

•      our anticipatedoperating results, financial condition, liquidity and capital resources;

 

•      our plan tobuild and capitalize on our extensive database of chemical reactions;

 

•      our expectationsconcerning the development priorities of our collaborative partners, and theirability to successfully develop compounds;

 

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

 

•      our beliefs asto the trends and opportunities impacting us and our history;

 

•      our estimatesof the market opportunity for our product candidates;

 

•      our ability toraise additional capital;

 

•      our ability toacquire or invest in complementary businesses or technologies, or to in-licensepotential product candidates;

 

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

 

•      ourrelationship with Accelrys after the distribution.

 

In some cases,you can identify forward-looking statements by terminology, such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “seeks,” “estimates,” or the negative of suchterms or other similar expressions. Factors that could cause or contribute to differences in results andoutcomes include, without limitation, those discussed elsewhere in this Reportin Item 2.  “Management’s Discussion andAnalysis of Financial Condition and Results of Operations (including a subsection thereofentitled “Certain Risks Related to Our Business”) and discussed in our otherSecurities and Exchange Commission (“SEC”) filings.

 

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

 

**TheCompany**

** **

**Overview**

** **

We are a biopharmaceutical company focused on thecreation of new small molecule therapeutics to address significant unmetmedical needs.  Using proprietarytechnologies and processes, we identify, optimize and develop novel drug candidatesin collaboration with major pharmaceutical and biotechnology companies andincreasingly through our own internally-funded drug discovery programs.  These programs are primarily focused onimmunobiology and immunological diseases. Our later stage portfolio currentlycomprises multiple-partnered programs that have been advanced into humanclinical trials, with further programs in late-stage pre-clinicaldevelopment.  Additionally, we have approximately 40 partnered andinternal programs in discovery.

 

We have drugdiscovery collaborations with leading pharmaceutical companies and emergingbiotechnology companies.  Our contributions to our partners’ drugdiscovery programs include: our delivery of results (such as *in vitro* and *in vivo*pharmacologyresults) generally obtained internally or achieved by research divisions withinpharmaceutical and biotechnology companies; our “optimization” of the leadcompounds identified through the screening process and subsequent studies, inwhich we refine the molecular structure of the lead compounds to increase theirefficacy, potency and bioavailability, in an effort to reduce their potential

 

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toxicity andenhance safety, and improve their prospects for securing patent protection; ourfurther testing and conduct of scientific studies of these compounds to modifyactivity such that they may be designated “lead” compounds, which are activecompounds which meet specific criteria (such as potency, selectivity,specificity and drug-likeness) that warrant their advancement to further stagesof the drug discovery process; our high throughput and ultra high throughputscreening capabilities that enable us to test these compounds for potentialutility in a lead optimization program by testing them against a disease-relatedcollaborative target (such screening is accomplished at the rate of hundreds ofthousands (with respect to high throughput) to millions (with respect to ultrahigh throughput) of our small molecule lead compounds per week) to identify “activecompounds” (compounds that demonstrate through these biological tests theability to impact the disease target of interest); and making available, on alimited basis via our screening expertise, our large, diverse proprietarylibraries of drug-like chemical compounds from which potential lead compoundscan be identified.

 

Our customers typically fund our research inexchange for intellectual property ownership rights, and provide for ourreceipt of significant milestone payments if and as the compounds progress throughthe development process.  In addition,our collaborative drug discovery agreements typically provide that upon suchapproval we are entitled to receive royalty payments calculated as a percentageof the net sales of the products.  Ourrevenue is highly concentrated in our two largest collaborators,Schering-Plough and N. V. Organon.

 

In addition to collaborativedrug discovery research, we conduct proprietary research primarily focused onimmunological and inflammatory diseases to discover new candidate compoundswith commercial potential. Unlike in our established collaborative businessmodel, we provide the required funding for these programs. As we do not receivefunding from third party collaborators, we retain all intellectual property andownership rights in any compounds discovered. At an appropriate point, we maydetermine to license one or more of these compounds to a third party (usually alarger pharmaceutical or biotechnology organization). Out-licensing at anappropriate point in the compound’s development would enable us to takeadvantage of the additional resources, expertise and technologies of thelicensee company in order to further the development of the compound and would provideus with up-front fees and milestone payments, as well as recurring royaltypayments if these compounds are developed into new commercial drugs. Theseagreements would convert our proprietary programs into collaborativepartnerships and out-licensing agreements, typically at a more advanced stageof the drug development process, and typically on more favorable terms for usdue to the reduction in the risk for the partner and the investment that wehave made advancing the program to the stage at which it is licensed.

 

We chose to focus ourinternally-funded drug discovery programs on immunological and inflammatory diseaseprocesses and the discovery of treatments for diseases such as rheumatoidarthritis, psoriasis and other inflammatory diseases for several reasons.   First, we believe many existing therapiesfor these diseases are lacking in one or more respects.  For example, methotrexate, the standard ofcare for rheumatoid arthritis has serious side effects while newer biologicalsare costly and may have safety concerns. In addition, we believe there are increasing commercial opportunitiesprovided by a large, growing population of older patients with immunobiologicaldiseases including chronic and acute inflammation, autoimmune diseases andasthma.  We also believe the globalmarket for immunosuppressant therapy for transplant patients alone is in excessof $4 billion per year, and a drug developed to meet the needs of such patientsis likely to also offer medical benefit and commercial opportunity in otherchronic diseases with similar underlying etiologies.  We believe the last decade has seensignificant strides in the understanding of the underlying biology of theimmune system and immunological and inflammatory diseases and that the time isright to leverage this new and greater understanding in a commercial and drugdiscovery setting.  We also believe thata treatment developed for one immunobiological disease may be further developedfor another and, consequently, an investment in one treatment may potentiallyyield results for multiple treatments. Finally, we have significant internalexpertise with respect to discovering drug candidates for these diseases.

 

Our drug discovery efforts haveproduced four clinical compounds to date which are under development by ourcollaborators.  We initially developedour first clinical compound, a p38 MAP kinase inhibitor for rheumatoidarthritis and entered into a partnering agreement with Bristol-Myers SquibbCompany in 1999; that compound commenced clinical trials in August 2003. This potential new drug, a small molecule optimized from our proprietarycompound collection, currently is in Phase I of clinical testing.  Asecond of our proprietary internal compounds targets an allergic asthmaindication and commenced clinical trials in November 2003.  Thisclinical compound is a product of our collaboration with Daiichi PharmaceuticalCo.  Our third clinical compound, which targets a respiratory indication,was developed in collaboration with Schering-Plough Corporation and commencedclinical trials in December 2003.  The Schering-Plough relationshipproduced a second clinical compound, which is our fourth in total, in March 2004,when Schering-Plough initiated clinical trials for an inflammation indication.We have received significant milestone payments from each of Bristol-MyersSquibb, Daiichi and Schering-Plough and, to the extent the compoundssuccessfully progress through clinical development, we will be entitled toreceive additional milestone payments.  We are also entitled under theagreements with each of these partners to receive royalties on the commercialsale, if any, of a new drug emanating from the collaboration.  Althoughthese collaborators are currently performing clinical trials of prospectivepharmaceutical products containing our proprietary compounds, numerousadditional studies will be necessary to support the further development ofthese product candidates.  Results from

 

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preclinical studies andclinical studies, if any, conducted to date on these product candidates are notnecessarily indicative of the results that may be obtained in future clinicalstudies.   In addition to thecompounds in the clinic, six more programs are at various stages of preclinicaldevelopment, the point at which compounds are tested for safety in animalsprior to Investigational New Drug application filing and their introductioninto humans during Phase I of clinical development.

 

In addition, we are involved inapproximately 40 other drug discovery programs in the preclinical discoverystage, some with collaborative partners and others within our internaldiscovery program.  Approximately half of these programs are in variousphases of preclinical research, from “hit-to-lead” studies to advanced stagesof lead optimization.  The remainingprograms are in early stages, including development of biological assays fortesting of compounds and the screening of our proprietary compound librariesagainst selected disease targets.  In our collaborative programs wetypically hold a financial interest in any active compounds that we identifythrough our screening and any drug candidate(s) that we help to optimize.

 

Preclinical and clinical development of drugcandidates is a long, expensive and uncertain process.  Our candidates areat an early stage, as none of our compounds are contained in products that havereceived regulatory approval for commercial sale.  All of our compounds,including our clinical candidates, face the substantial risks of failureinherent in developing drugs.  At any stage of the clinical developmentprocess, our collaborators, or we, may decide to discontinue development of ourproduct candidates.  We do not expect that our product candidates will becommercially available for many years, if ever.  In addition, we pursuethe discovery and initial development of product candidates using ourintegrated technology platform in both our internal and collaborative programsto implement our strategy of reducing the cost and time incurred by thepharmaceutical industry in developing drug candidates.  To date, we havenot identified a therapeutic candidate that has been developed into acommercial drug and, although we have received license and milestone fees, wemay never receive any royalty payments, or any additional license and milestonefees, under our current or any future collaborations.

 

On April 30, 2004, Accelrys, then oursole stockholder, distributed all outstanding shares of our common stock to theholders of common stock of Accelrys.  We thereafter began operations as anindependent, separately traded and publicly held company.  Thedistribution was made without payment of any consideration or the exchange ofany shares by Accelrys stockholders.  In the distribution, Accelrysstockholders received one share of our common stock for every two shares ofAccelrys common stock held of record.  The stock traded as when issuedfrom April 20, 2004 through April 30, 2004 and began regular tradingon The NASDAQ National Market on May 3, 2004 under the trading symbol “PCOP.”

 

On August 23, 2004, Columbia UniversityScience and Technology Ventures (“Columbia”) provided us with a notice ofmaterial breach of the License Agreement, dated July 16, 1993 and asamended October 6, 1995, among us, the Trustees of Columbia University inthe City of New York and Cold Spring Harbor Laboratory (the “Agreement”)arising from an alleged underpayment by us of certain royalties under theAgreement. In correspondence initiated by Columbia, the amount of the allegedunderpayment has been estimated to be at least $1.12 million for the periodfrom July 1, 2001 through June 30, 2003. We do not believe that wehave underpaid the royalties at issue or that we are in material breach underthe Agreement. The Agreement covers our core tagging technology used in ourproprietary combinatorial chemistry encoding technology, ECLiPS®.

 

The parties have a mutualobligation under the terms of the Agreement to negotiate in good faith toresolve the dispute. Because of the alleged material breach of the Agreement,Columbia and Cold Spring Harbor assert they can terminate our license under theAgreement.  However, as a result of thediscussions that have taken place to date, Columbia and Cold Spring Harbor haveagreed not to seek to terminate our license under the Agreement earlier than May 23,2005.

 

While we do not believe thatwe have underpaid the royalties at issue or that we are in material breachunder the Agreement, management has determined that there will be a cost tosettle and resolve this matter with Columbia.  While we are in the processof negotiating a resolution of this matter, in accordance with FASB Statement No. 5,“Accounting for Contingencies” and FASB Interpretation No. 14, “ReasonableEstimation of the Amount of a Loss” we have recorded a charge of $1.0 million inthe year ended December 31, 2004 for the probable financial outcome ofthis resolution.  This amount is included in accrued liabilities on ourbalance sheet as of March 31, 2005. We believe that any resolution of the dispute will not have a materialadverse effect on our financial condition.

 

**Liquidityand Capital Resources**

** **

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

 

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As of March 31,2005, we had cash, cash equivalents and marketable securities of $35.3 millioncompared to $40.9 million at December 31, 2004, representing 67% and 72%of our total assets, respectively. We invest excess cash in highly liquidinvestment-grade marketable securities, including corporate bonds and UnitedStates government and agency securities.

 

The following is a summary ofselected cash flow information for the three months ended March 31, 2005and 2004:

 
| ** **                                | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Net loss                                  |       | $                                      | (4,640     | ) | $ | (9,936 | ) |
| Adjustments for noncash operating items   |       | 730                                    |       | 449 |   |
|                                      |       |                                   |       |   |   |
| Net cash operating loss                   |       | (3,910                                 | )          | (9,487 | ) |
| Net change in assets and liabilities      |       | (1,538                                 | )          | 6,123 |   |
|                                      |       |                                   |       |   |   |
| Net cash used in operating activities     |       | $                                      | (5,448     | ) | $ | (3,364 | ) |
|                                      |       |                                   |       |   |   |
| Net cash used in investing activities     |       | $                                      | (2,872     | ) | $ | (4,613 | ) |
|                                      |       |                                   |       |   |   |
| Net cash provided by financing activities |       | $                                      | 131        |   | $ | 7,821 |   |

 

**Netcash used in operating activities**

 

Net operating cashoutflows for the three months ended March 31, 2005 have resulted primarilyfrom our operating loss due to an increase in the funding of our internal drugdiscovery efforts and the payment of restructuring expenses related to the 2004consolidation of our facilities.

 

**Net cashprovided by investing activities**

** **

Cash provided byinvesting activities for the three months ended March 31, 2005 relatesprimarily to the net sales and maturities of marketable securities.

 

**Net cashprovided by financing activities**

** **

Net cash providedby financing activities for the three months ended March 31, 2005 consistsof the capital contribution made to us by Accelrys relating to the transitionservices agreement entered into in connection with the distribution andproceeds from the issuance of common stock in connection with our employeestock option plans.

 

**Liquidity andCapital Resources Outlook**

 

We expect to continue to use ourcapital to fund operating losses. We expect that our research and developmentexpenditures will increase in the future as we increase our internal drugdiscovery efforts.  Conducting our owndrug discovery research is a key component of our business model.

 

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

 

We are obligated to payapproximately $2.6 million in costs in connection with a facility we exited inthe first quarter of 2004. The lease on this facility expires in April 2006.

 

We anticipate that ourcapital resources will be adequate to fund our operations at their currentlevels at least through 2006. However,there can be no assurance that changes will not occur that would consumeavailable capital resources before then. Our capital requirements depend onnumerous factors, including our ability to continue and extend existing collaborativeagreements and to enter into additional arrangements.  Approximately 84% and 85% of our revenue forthe three months ended March 31, 2005 and March 31, 2004, respectively, wasgenerated from our collaborations with Schering Plough and N.V. Organon.  The collaborations with Schering Plough arescheduled to expire in August 2006 and we have been advised thatSchering-Plough intends to reduce by 41% its FTE funding under the 2003 agreementseffective August 2005.  The principalagreement with N.V. Organon is scheduled to expire in 2007.  Under certain circumstances

 

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fundingfrom the Organon collaboration may be reduced significantly before thisagreement expires.  In addition, ourcapital requirements depend on competing technological and market developments,changes in our existing collaborative relationships, the cost of filing,prosecuting, defending, and enforcing patent claims and other intellectualproperty rights and the outcome of related litigation, the purchase ofadditional capital equipment, acquisitions of other businesses or technologies,and the progress of our customers’ milestone and royalty producing activities.Prior to exhausting our current capital resources, we will need to raiseadditional funds to finance our operating activities or enter into strategicinitiatives intended to further the development of our business. There can beno assurance that additional funding, if necessary, will be available onfavorable terms, if at all.  Ourforecasts of the period of time through which our financial resources will beadequate to support our operations are forward-looking information, and actualresults could vary.  The factorsdescribed earlier in this paragraph will impact our future capital requirementsand the adequacy of our available funds.

 

**Resultsof Operations**

 

**Three months ended March 31,2005 and 2004**

** **

Our net revenue increased 6% to $5.7 millionin the quarter ended March 31, 2005 compared to $5.4 million in thequarter ended March 31, 2004.  Netrevenue consists of the funding of our collaborative research activities, aswell as our receipt of milestones, success fees and license revenue if and asour discoveries progress through our collaborators’ development processes.  Net revenue for the three months ended March 31,2005 and 2004 is summarized as follows.

 
| ** **                     | ** ** | **For the three months ended March 31,** | ** ** |
|--------------------------------|------------|-----------------------------------------------|------------|
| ** **                     | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
|                           |       |                                          |       |   |   |
| Collaborative research funding |       | $                                             | 4,508      |   | $ | 4,307 |   |
| Milestones and success fees    |       | 1,000                                         |       | 1,000 |   |
| License revenue                |       | 183                                           |       | 62 |   |
|                           |       | $                                             | 5,691      |   | $ | 5,369 |   |

 

Schering-Plough accounted for 64% and 69% ofour net revenue as of March 31, 2005 and 2004, respectively.  N.V. Organon accounted for 20% and 16% of ournet revenue as of March 31, 2005 and 2004, respectively.  Schering-Plough accounted for 100% of themilestone payments and success fees that we received for each of the quartersended March 31, 2005 and 2004.  Werecognized increased revenue from our collaboration with N.V. Organon and ourrecently announced collaborations with CV Therapeutics and Biovitrum AB.

 

In contrast to many of ourpartnering efforts in the past (with the key exceptions of our relationshipswith Schering-Plough and Organon), we now seek to establish alliances that arebroad in scope and multi-year in term to deliver compounds that are furtherdeveloped than in the past; ideally compounds that are clinical candidates, asopposed to hits or leads.  As a result ofdelivering later-stage compounds, which are of greater value, we will seek toretain a larger share of ownership (as represented by increased royalties onnet sales that may result from the program advancing to the market) in thecompound.  Additionally, we will, whereappropriate, evolve the collaborative model by offering to reduce our researchfees in exchange for greater milestone and royalty commitments from thepartner.

 

Collaborative research and developmentexpense includes the labor, material, equipment and allocated facilities costof our scientific staff that are working on collaborative partnerships.  Collaborative research and developmentexpense was $5.6 million for the three months ended March 31, 2005, unchangedcompared to the three months ended March 31, 2004.

 

Proprietary research and development expenseincludes labor, material, equipment and allocated facilities cost of scientificstaff working on self-funded internal drug discovery programs. Our internaldrug discovery projects are focused on the creation of new small moleculetherapeutics using proprietary technologies and our proprietary collection ofcompounds to identify and optimize novel drug candidates. Because of thespeculative nature of these internal drug discovery projects, it is notpossible to estimate completion dates, or estimated costs of completion.Additionally, from time to time, depending on requirements under collaborativepartnership work, certain staff and other research and development resourcesmay be temporarily redirected to collaborative partnership work whichredirection may also delay or impact the cost of internal drug discoveryprojects. Consistent with our strategy to increase our investment in internaldrug discovery programs, proprietary research and development expensesincreased 61% to $2.2 million for the three months ended March 31, 2005compared to $1.4 million for the three months ended March 31, 2004.

 

Sales, general and administrative expenseincreased by 10% to $2.7 million for the three months ended March 31, 2005compared to $2.4 million for the three months ended March 31, 2004. The increase in sales, general and administrative expense is primarilyattributable to additional costs associated with our being an independentcompany, including salary and expenses for executive

 

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management, finance, legal, human resources,information services, investor relations, and corporate governance. This wasoffset by the moving costs incurred in the three months ended March 31, 2004,in connection with the consolidation of our facilities.  Prior to the distribution, general corporateoverhead had been allocated based on our revenue as a percentage of Accelrys’total revenue.

 

During the quarter endedMarch 31, 2004, we executed a restructuring plan for the purpose of makingour research and developmemt activities more efficient by eliminatingunnecessary facilities. As a result, restructuring related charges of$5.9 million were recognized and accrued as operating expense during thequarter ended March 31, 2004.

 

Interest and other income, net increased to $209thousand for the three months ended March 31, 2005 compared to $3 thousandfor the three months ended March 31, 2004.  This increase is due tosignificantly higher cash, cash equivalents and marketable securities balancesdue to the capital contribution from Accelrys at the time of the distribution.

 

We recorded an income tax provision of $10thousand and $3 thousand for the three months ended March 31, 2005 and 2004,respectively, related to minimum state income taxes.

 

Asa result of the net revenues and costs described above, we generated a net lossof $4.6 million ($0.38 per basic and diluted share) for the three months ended March 31,2005, compared to a net loss of $9.9 million ($0.82 per basic and dilutedshare) for the three months ended March 31, 2004.

 

**Contractual Obligations**

 

For a discussion of our contractual obligations, see “Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in our Form 10-K for the year ended December 31,2004.  No material changes have occurredto contractual obligations subsequent to December 31, 2004.

 

**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. We are highly dependent on the continuedfunding and success of our research and development programs with our existingcollaborators.  One such collaborator,Schering-Plough, has advised us that it plans to exercise its right to reduceby 41% (or approximately $1.1 million per calendar quarter) its funding of ourFTEs effective August 2005.  We are alsohighly dependent on our ability to successfully, cost effectively and timelydevelop, introduce and market new collaborative arrangements. On a quarterlybasis, our future operating results are likely to be highly volatile because theydepend upon our receipt of milestone payments from our collaborators. We maynot receive milestone payments on a regular basis or at all. In addition, ourability to achieve profitability will be significantly impacted by theincreased level of investment we have determined to make in our internalproprietary programs in the future as well as the results of those programs. Webelieve that we may incur higher sales, general and administrative costs thanthe historical amounts reflected in the financial statements since we are nowoperating as an independent public company. There is no assurance that we willever achieve profitable operations, or that profitable operations, if achieved,could be sustained on a continuing basis.

 

**Critical Accounting Policies**

 

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

 

*Revenue Recognition*-Contractrevenue is recognized either (i) on a percentage of completion 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 to up-front product and technology license feesis recognized in accordance with Staff Accounting Bulletin 104 issued by theSEC. Accordingly, amounts received under multiple-element arrangementsrequiring ongoing services or performance by us are recognized over the periodof such services or performance.

 

Revenue from milestones are recognized when earned, as evidenced bywritten acknowledgement from the collaborator, provided that (i) themilestone event is substantive and its achievability was not reasonably assuredat the inception of the agreement, and (ii) our performance obligationafter the milestone achievement will continue to be funded by the collaboratorat a comparable level to before the milestone achievement. If both of thesecriteria are not met, the milestone payment is recognized over the remainingminimum period of our performance obligations under the arrangement. Royaltiesare recognized as earned in accordance with the terms of various research andcollaboration agreements.

 

*Long-Lived Assets-*Wereview long-lived assets, including leasehold improvements, property andequipment, and acquired technology rights, for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. This requires us to estimate future cashflows related to these assets. Actual results could differ from theseestimates, which may affect the carrying amount of assets and the actualamortization expense. As of March 31, 2005, we had long-lived assets witha net book value of $11.5 million.

 

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**Certain Risks Related to Our Business**

** **

Asfurther described herein, our performance and financial results are subject torisks and uncertainties including, but not limited to, the following specificrisks:

 

**RISKSRELATED TO OUR BUSINESS AND INDUSTRY**

 

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

 

During the three months ended March 31,2005, we earned approximately $4.8 million, or 84% of our revenue, under ourresearch collaboration agreements with two collaborators, Schering-Plough andN.V. Organon.  During the three monthsended March 31, 2005, we earned approximately $3.6 million, or 64% of ourrevenue, under our research collaboration agreements with Schering-Plough, oneof our longest-standing collaborative partners. In the third quarter of 2003,we entered into new drug discovery collaborations with Schering-Plough, whichcontinued certain existing programs and implemented a number of new activities.The new agreements continue our collaboration with Schering-Plough through atleast August 2006.  Under the newagreements, we receive research funding on an FTE basis which isrecognized as revenue as services are performed.  Schering-Plough was obligated to funda specified number of our FTEs in the first year.  Subsequently, based on the initial screening results Schering-Plough decided to focuson optimization programs and terminated our screening activities onSchering-Plough’s behalf. This decision resulted in an approximately 11%reduction of the number of our FTEs whom Schering-Plough was obligated to fund.Additionally we may receive milestone payments upon the successfulachievement of preclinical and clinical milestones. Milestone payments will berecognized as revenue to the extent that milestones are achieved. Uponsuccessful commercialization of most products resulting from this relationship,we will be entitled to receive royalties on sales of those products.  Pursuant to the terms of the 2003 agreements,Schering-Plough has advised usthat it intends to reduce its FTE funding by an additional 41% (orapproximately $1.1 million per calendar quarter) effective August 2005.Discussions have been initiated regarding the possible extension ormodification of the 2003 agreements. There can be no assurance that the 2003 agreements will be extended beyondAugust 2006 or that funding will be maintained at current or expectedreduced August 2005 levels beyond August 2006 either in the aggregateor on an FTE basis.  In light of thesignificance to us of the Schering-Plough relationship, the expiration ortermination of our collaborative agreements or our failure to extend, modify orreplace the 2003 agreements would have a material adverse effect on ourbusiness as it is currently conducted, our financial condition and results ofoperations because of the resulting decrease in our revenue.

 

During the quarter ended March 31, 2005,we earned approximately $1.2 million, or 20% of our revenue, under our researchcollaboration agreements with N.V. Organon, our second largest customer. Theprincipal agreement with Organon, entered into in February 2002, has astated term of five years; however, Organon has the right to terminate theagreement if we are unable to deliver compounds meeting the criteria specifiedin the agreement. We have already delivered the first such compound requiredunder this agreement to Organon. A second deliverable time point occurs in2005. If we are unable to deliver compounds meeting the criteria specified inthe agreement, Organon has the right to terminate the agreement. There can be noassurance that these compounds will be compliant or will be delivered beforethe enumerated date. The termination of this agreement would have a materialadverse effect on our business as it is currently conducted, our financialcondition and results of operations because of the resulting decrease in ourrevenue.

 

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

 

Drug development is a highly uncertainprocess. Our approach and technology may never result in a commercial drug.None of our compounds are contained in products that have received regulatoryapproval for commercial sale, and currently we have only four candidates withrespect to which our collaborators have initiated clinical trials (i.e., humantesting). All of our therapeutic candidates, including these clinicalcandidates, face the substantial risks of failure inherent in the drugdevelopment process. Any potential pharmaceutical product emanating from one ofour internal or collaborative programs must satisfy rigorous standards ofsafety and efficacy before the United States Food and Drug Administration (FDA)and foreign regulatory authorities will approve them for commercial use. Tosatisfy these standards, significant additional research, preclinical studies(i.e., animal testing) and clinical trials will be required.

 

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

 

Our product candidates and research programsare in the early stages of development and require significant, time-consumingand costly research and development, testing and regulatory approvals. We donot expect that our product candidates will be commercially available for manyyears, if ever. In addition, we pursue the discovery and initial development ofproduct candidates using our integrated drug discovery technology platform inboth our internal and collaborative programs to implement our strategy ofreducing the cost and time incurred by the pharmaceutical industry in developingdrug candidates. To date, we have not identified a therapeutic candidate thathas been developed into a commercial drug. It is uncertain whether we willachieve these goals at all.

 

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

 

We anticipate that our capital resources,including our existing cash, cash equivalents and marketable securities as of March 31,2005 of approximately $35.3 million, will be adequate to fund our operations attheir current levels at least through 2006. However, changes may occur thatwould consume available capital resources before that time. While we areunaware of a specific reason that any factor will have a material impact on ourcapital requirements, examples of relevant factors include:

 

•      changes in our existing collaborativerelationships, including the revenues we receive in connection with thoserelationships;

 

•      our internal proprietary drug discoveryactivities;

 

•      the costs associated with drug discoveryservices;

 

•      acquisitions of other businesses ortechnologies;

 

•      competing technological and marketdevelopments;

 

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

 

•      the purchase of additional capital equipment;and

 

•      the progress of our milestone and royaltyproducing activities.

 

If we determine that we must raise additionalcapital, the capital could be raised through public or private financingsinvolving debt or equity. However, additional capital may not be available onfavorable terms, or at all. If adequate funds are not available, we may berequired to curtail operations significantly or to obtain funds by enteringinto arrangements with collaborative partners or others that may require us torelinquish rights to certain of our technologies, products or potential marketsthat we would not otherwise relinquish.

 

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

 

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

 

The willingness of these companies to expandor continue drug discovery collaborations or outsourcing of services to enhancetheir research and development activities is based on certain factors that arebeyond our control. While we are unaware of a specific reason that any of thefollowing factors will have a material impact on the willingness of current orpotential collaborators to expand or continue drug discovery collaborations,examples of relevant factors include collaborators’ spending priorities amongvarious types of research activities, their ability to hire and retainqualified scientists, their approach regarding expenditures during recessionaryperiods and their policies regarding the balance of research expendituresversus cost containment. Also, general economic downturns in our customers’industries or any decrease in our customers’ research and developmentexpenditures could harm our operations, as could increased popularity ofmanagement theories, which counsel against outsourcing of critical businessfunctions. Continued consolidation in the pharmaceutical and biotechnologyindustries may further decrease the number of potential customers. In addition,the popularity of scientific thinking that disfavors expensive products, suchas large diverse libraries could negatively impact our revenue or our salesmix. Any decrease in drug discovery spending by pharmaceutical andbiotechnology companies could cause our revenue to decline.

 

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

 

•      develop drug discovery technologies that willresult in the identification of higher-quality drug candidates;

 

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•      provide scientists and technologies that areof the highest caliber; and

 

•      achieve intended results in a timely fashion,with acceptable quality and at an acceptable cost.

 

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

 

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

 

Our collaborators, Bristol-Myers SquibbCompany, Daiichi Pharmaceutical Co. and Schering-Plough Corporation, currentlyare performing clinical trials of prospective pharmaceutical productscontaining our proprietary compounds. In each case, the collaborator isresponsible for the development of these potential products, the level ofresources devoted to such development and the decision as to when, or whether,such development should cease. Numerous additional studies are necessary tosupport the further development of these product candidates. Results frompreclinical studies conducted to date on these product candidates are notnecessarily indicative of the results that may be obtained in clinical studies.Results from additional studies could cause our collaborators to discontinue orlimit development of these product candidates. There can be no assurance thatBristol-Myers Squibb, Daiichi or Schering-Plough will continue to develop theseprograms. In addition, our collaborators may pursue alternative technologies ordrug candidates, either on their own or in collaboration with others, thatcompete with our clinical candidates. If our collaborators do not continuetheir development efforts or if such efforts do not result in positive clinicalresults, we will not receive additional milestone and royalty payments fromthose efforts, and the market price of our common stock will be materially andadversely affected.

 

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

 

On August 23, 2004, Columbia UniversityScience and Technology Ventures (“Columbia”) provided us with a notice ofmaterial breach of the License Agreement, dated July 16, 1993 and asamended October 6, 1995, among us, the Trustees of Columbia University inthe City of New York and Cold Spring Harbor Laboratory (the “Agreement”)arising from an alleged underpayment by us of certain royalties under theAgreement. In correspondence initiated by Columbia, the amount of the allegedunderpayment has been estimated to be at least $1.12 million for the periodfrom July 1, 2001 through June 30, 2003. We do not believe that wehave underpaid the royalties at issue or that we are in material breach underthe Agreement. The Agreement covers our core tagging technology used in ourproprietary combinatorial chemistry encoding technology, ECLiPS®.

 

The parties have a mutualobligation under the terms of the Agreement to negotiate in good faith toresolve the dispute. Because of the alleged material breach of the Agreement,Columbia and Cold Spring Harbor assert they can terminate our license under theagreement.  However, as a result of thediscussions that have taken place to date, Columbia and Cold Spring Harbor haveagreed not to seek to terminate our license under the Agreement earlier than May 23,2005.  While we are in the processof negotiating a resolution of this matter, in accordance with FASB Statement No. 5,“Accounting for Contingencies” and FASB Interpretation No. 14, “ReasonableEstimation of the Amount of a Loss” we recorded a charge of $1.0 million in theyear ended December 31, 2004 for the probable financial outcome of thisresolution.  This amount is included in accrued liabilities on our balancesheet as of March 31, 2005.

 

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

 

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

 

The market price for our common stock hasbeen highly volatile and may continue to be highly volatile in thefuture.  During quarter ended March 31, 2005 the closing price was$4.87 per share at its low point in March 2005 and $5.81 per share at itshigh point in January 2005.  Our quarterly operating results, changesin general conditions in the economy or the financial markets, and otherdevelopments affecting our competitors or us could cause the market price ofour common stock to fluctuate substantially.  In recent years, the stockmarket has experienced significant price and volume fluctuations.

 

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

 

•      publicity concerning the status of potentialdrug products under development by us or our collaborators or our competitorsand their partners;

 

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•      reduction, termination or expiration of ourcollaborations;

 

•      announcements by us or our competitors ofsignificant acquisitions, strategic partnerships or joint ventures;

 

•      announcements of technological innovations ornew commercial products by our competitors or us;

 

•      developments concerning proprietary rights,including patents;

 

•      litigation;

 

•      economic and other external factors or otherdisasters or crises;

 

•      actual or anticipated period-to-periodfluctuations in our financial results;

 

•      changes in financial estimates prepared bysecurities analysts; and

 

•      the general performance of the equity marketsand, in particular, the biopharmaceutical sector of the equity markets.

 

***Disputes may arise between our collaborativepartners and us as to royalties and milestones to which we are entitled.***

 

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

 

***We may not successfully enter intoadditional collaborations that allow us to participate in the future success ofour product candidates through milestone, royalty and/or license payments, andwe may never receive any milestone, royalty and/or license payments under ourcurrent or any future collaborations.***

 

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

 

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

 

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

 

Many of our competitors have access togreater financial, technical, research, marketing, sales, distribution, serviceand other resources than we do. Moreover, the pharmaceutical and biotechnologyindustries are characterized by continuous technological innovation. Weanticipate that we will face increased competition in the future as newcompanies enter the market and our competitors make advanced technologiesavailable. Technological advances or entirely different approaches that we orone or more of our competitors develop may render our products, services andexpertise obsolete or uneconomical. Additionally, the existing approaches ofour competitors or new approaches or technologies that our competitors developmay be more effective than those we develop. We may not be able to competesuccessfully with existing or future competitors.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Regulation by governmental entities in theUnited States and other countries will be a significant factor in theproduction and marketing of any pharmaceutical products our customers or we maydevelop. The nature and the extent to which government regulation may apply toour customers and us will vary depending on the nature of the pharmaceutical products,if any. Virtually all pharmaceutical products require regulatory approval priorto commercialization. If we or our collaborators or licensees fail to obtain,or encounter delays in obtaining or maintaining, regulatory approvals, ourfinancial results could be adversely affected. Similar regulatory proceduresare required in countries outside the United States.

 

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

 

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

 

For the quarterly period ended March 31,2005, we had a net loss of approximately $4.6 million. For the fiscal yearsended December 31, 2004, 2003 and 2002, we had net losses of approximately$17.4 million, $2.8 million and $2.1 million, respectively.

 

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The net loss for the fiscal year ended December 31,2004 included restructuring and other charges of $5.9 million.  Continuingnet losses may limit our ability to fund our operations, and we may notgenerate income from operations in the future.

 

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

 

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

 

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

 

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

 

We are a small company, and our successdepends in part on the continued service of key scientific, businessdevelopment and management personnel, including our president and chiefexecutive officer Leslie J. Browne, Ph.D., and our ability to identify, hireand retain additional personnel. There is intense competition for qualifiedpersonnel. In particular, we believe that there is a shortage of scientistsqualified to work in drug discovery. There is significant competition amongdrug discovery and development companies to hire such scientists. Immigrationlaws may further restrict our ability to attract or hire qualified personnel.We may not be able to continue to attract and retain the personnel necessaryfor our growth and development. Failure to attract and retain key personnelcould have a material adverse effect on our business, financial condition andresults of operations. Further, we are highly dependent on the principalmembers of our scientific, business development and management staff. One ormore of these key employees could retire or otherwise leave our employ withinthe foreseeable future, and the loss of any of these people could have amaterial adverse effect on our business, financial condition and results ofoperations. We do not, and do not intend to, maintain key person life insuranceon the life of any employee.

 

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

 

The ultimate success of our business planheavily depends upon the successful discovery, development and commercializationof pharmaceutical products. Our endeavors will result in commercializedpharmaceutical products, if at all, only after significant preclinical andclinical development, requisite regulatory approvals, establishment ofmanufacturing capabilities and successful marketing. We do not currently havethe technology, facilities, personnel or experience to accomplish all of thesetasks on our own, and we will likely not have all the necessary resources inthe foreseeable future. Therefore, we continue to depend heavily upon theexpertise and dedication of sufficient resources by collaborative partners todevelop and commercialize products primarily based on lead compounds discoveredby us. If a collaborative partner fails to develop or commercialize a compound orproduct with respect to which it has rights from us, we may not receive anyfuture milestone payments or royalties associated with that compound orproduct. Similarly, while we are unaware of a specific reason that any of thefollowing factors will be experienced by our strategic collaborators, becausewe rely heavily on them, our revenue could be adversely affected if ourcollaborators:

 

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

 

•      fail to gain the requisite regulatoryapprovals of product candidates;

 

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

 

•      do not conduct their collaborative activitiesin a timely manner;

 

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

 

•      terminate their alliances or arrangementswith us;

 

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

 

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

 

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

 

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

 

For the three months ended March 31, 2005,approximately 55% of our revenue was derived from customers outside the UnitedStates. During that period, approximately 54% of our revenue was derived fromcustomers in Europe, and approximately 1% was derived from customers in theAsia/Pacific region. We anticipate that international revenue will continue toaccount for a significant percentage of our overall revenue. While we areunaware of a specific reason that any of the following factors will have amaterial impact on our revenue, our international operations are subject to therisk factors inherent in the conduct of international business, including:

 

•      unexpected changes in regulatoryrequirements;

 

•      longer payment cycles;

 

•      import and export license requirements;

 

•      tariffs and other barriers;

 

•      political and economic instability;

 

•      limited intellectual property protection;

 

•      difficulties in collecting trade receivables;

 

•      difficulties in staffing and managing foreignjoint venture operations; and

 

•      potentially adverse tax consequences.

 

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

 

***We may not realize revenue from ourbusiness development efforts.***

 

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

 

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

 

We depend on our laboratories and equipmentfor the continued operation of our business. Our research and developmentoperations and administrative functions are primarily conducted at our facilitiesin the Princeton, New Jersey area. Although we have contingency plans in effectfor natural disasters or other catastrophic events, catastrophic events couldstill disrupt our operations. Even though we carry business interruptioninsurance policies, we may suffer losses as a result of business interruptionsthat exceed the coverage available under our insurance policies. Any naturaldisaster or catastrophic event in our facilities or the areas in which they arelocated could have a significant negative impact on our operations.

 

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

 

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

 

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***Anti-takeover provisions under Section 203of the Delaware General Corporation Law, provisions in our amended and restatedcertificate of incorporation and amended and restated bylaws, and our adoptionof a stockholder rights plan may render more difficult the accomplishment ofmergers or the assumption of control by a principal stockholder, making moredifficult the removal of management.***

 

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

 

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

 

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

 

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

 

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

 

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

 

***We have a limited current history ofoperating as an independent company.***

 

Although Accelrys, Inc. (formerlyPharmacopeia, Inc.) was operated exclusively as a chemistry-basedcollaborative drug discovery business prior to its acquisition of its softwarebusiness, prior to the distribution, our management team had not recentlyoperated our company as a public, stand-alone company. We have a board ofdirectors appointed by Accelrys, most of whom previously served on the board ofdirectors of Accelrys prior to the distribution. Our ability to satisfy ourobligations will be solely dependent upon the future performance of thebusinesses we own and operate, and we will not be able to rely upon thefinancial and other resources and cash flows of those business lines remainingwith Accelrys.  Since we only have a limited operating history as a separateentity, it will be difficult to accurately forecast our future revenue andother operating results.

 

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

 

The historical financial information includedin this report differs from the results of operations, financial condition andcash flows that would have been achieved had we been operated independentlyduring the period and as of the dates presented.  Prior to thedistribution, our businesses were operated by Accelrys as part of its broadercorporate organization rather than as a stand-alone

 

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company.  Historically, Accelrysperformed certain corporate functions for us, including legal services,treasury administration, insurance administration, internal audit and corporateincome tax administration.  Now that the distribution is complete,Accelrys will not provide assistance to us, other than to provide variouscorporate support, information systems and human resources services during atransition period.

 

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

 

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

 

•      our historical financial information reflectsallocations, primarily with respect to corporate overhead, for servicesprovided to us by Accelrys which may not reflect the actual costs we will incurfor similar services as a stand-alone company; and

 

•      our historical financial information does notreflect changes that we expect to occur in the future as a result of ourseparation from Accelrys, including changes in how we fund our operations aswell as tax and employee matters.

 

Although we believe that our historical financialstatements allocate to us a reasonable share of such expenses, we cannot assureyou that our actual costs will not increase, perhaps substantially.  Wealso are now responsible for the additional costs associated with being anindependent public company, including costs related to corporate governance,listed and registered securities and investor relations matters.

 

Accordingly, to the extent that ourhistorical financial information is not reflective of what our results ofoperations, financial condition and cash flows would have been had we been anindependent company during the periods presented, that historical financialinformation will not be a reliable indicator of what our results of operations,financial condition and cash flows will be in the future.  Therefore, youshould not make any assumptions regarding our future performance based on thehistorical financial information in this report.

 

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

 

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

 

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

 

We and Accelrys have entered into a taxsharing agreement under which we have made certain covenants to each other inconnection with the distribution that we may not take certain actions withoutfirst obtaining an unqualified opinion of counsel or an Internal RevenueService ruling that such actions will not cause the distribution to becometaxable.  Pursuant to these covenants, generally (1) we will, for twoyears after the distribution date, continue the active conduct of the drugdiscovery business; (2) we will not repurchase our stock except in certaincircumstances permitted by the Internal Revenue Service; (3) we will nottake any actions inconsistent with the representations made in connection withthe issuance by Dechert LLP of its opinion with respect to the distribution;and (4) we will not take or fail to take any other action that wouldresult in any tax being imposed on the distribution.  Accelrys may seek aninjunction to enforce these covenants.  These restrictions couldsubstantially limit our strategic and operational flexibility, including ourability to finance our operations by issuing equity securities, to makeacquisitions using equity securities, to repurchase our equity securities, toraise money by selling assets, or to enter into business combination transactions.

 

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

 

We have agreed to indemnify Accelrys for anytaxes and related losses (including any applicable interest and penalties, allrelated accounting, legal and other professional fees, all related court costsand all costs, expenses and damages associated with related

 

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stockholder litigation or controversies andany amount paid in respect of the liability of stockholders) resulting from abreach of any of the covenants described above.  Furthermore, we will beresponsible for taxes that may be imposed upon Accelrys pursuant to section 355(e) ofthe Code in connection with a transaction that results in a change in controlof us, even though we will have obtained an Internal Revenue Service ruling oran unqualified opinion of counsel prior to the transaction.  The amount ofany indemnification payments could be substantial.  The amount of Accelrystaxes for which we are agreeing to indemnify Accelrys will be based on theexcess of the aggregate fair market value of our stock as of the distributiondate over Accelrys tax basis in our stock.

 

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

 

Under the terms of the master separation anddistribution agreement and the tax sharing and indemnification agreement thatwe entered into with Accelrys, we and Accelrys agreed to indemnify one anotherfrom and after the distribution with respect to the indebtedness, liabilitiesand obligations retained by our respective companies.  Theseindemnification obligations could be significant.  Our ability to satisfyany such indemnification obligations will depend upon the future financialstrength of our company.  We cannot determine whether we will have toindemnify Accelrys for any substantial obligations.  We also cannot assureyou that, if Accelrys becomes obligated to indemnify us for any substantialobligations, Accelrys will have the ability to satisfy those obligations. Any payment by Accelrys or us pursuant to these indemnification provisionscould have a material adverse effect on its business.  Any failure byAccelrys or us to satisfy its indemnification obligations could have a materialadverse effect on the other company’s business.

 

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

 

Historically, all of our financing was doneby Accelrys at the parent level. We anticipate that our capital resources,including our existing cash, cash equivalents and marketable securities as of March 31,2005 of approximately $35.3 million, will be adequate to fund our operations attheir current levels at least through 2006.  Any future financing that weneed to obtain will have to be raised on a stand-alone basis without referenceto or reliance on Accelrys’ financial condition and will be based upon ourbalance sheet.  In addition, we may be required to agree to abide byrestrictive covenants that may limit our ability to do business as a conditionto securing debt or equity financing.  We may not be able to secureadequate debt or equity financing on desirable terms or at all.  We haveless financial and other resources than Accelrys had prior to thedistribution.  Our ability to obtain financing, and the terms thereof,will in large part depend on our financial condition and performance. There can be no assurance that we will be able to obtain financing.  Thecost to us of stand-alone financing may be materially higher than the cost offinancing that we incurred as part of Accelrys.

 

**CERTAINRISKS RELATED TO INTELLECTUAL PROPERTY**

 

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

 

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

 

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

 

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

 

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

 

We rely upon trade secrets, technicalknow-how and continuing technological innovation to develop and maintain ourcompetitive

 

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position. Competitors through theirindependent discovery (or improper means, such as unauthorized disclosure orindustrial espionage) may come to know our proprietary information. Wegenerally require employees and consultants to execute confidentiality andassignment-of-inventions agreements. These agreements typically provide thatall materials and confidential information developed by or made known to theemployee or consultant during his, her or its relationship with us are to bekept confidential, and that all inventions arising out of the employee’srelationship with us are our exclusive property. Our employees and consultantsmay breach these agreements, and in some instances we may not have an adequateremedy. Additionally, in some instances, we may have failed to require thatemployees and consultants execute confidentiality and assignment-of-inventionsagreements.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Thirdparties may claim infringement by us of their intellectual property rights. Inaddition, to the extent our employees are involved in research areas similar tothose areas in which they were involved at their former employers, we may besubject to claims that one of our employees, or we, have inadvertently or otherwiseused or disclosed the alleged trade secrets or other proprietary information ofa former employer. From time to time, we have received letters claiming orsuggesting that our products or activities may infringe third party patents orother intellectual property rights. Our products may infringe patent or otherintellectual property rights of third parties. A number of patents may havebeen issued or may be issued in the future that could cover certain aspects ofour technology and that could prevent us from using technology that we use orexpect to use. We may be required to seek licenses for, or otherwise acquirerights to, technology as a result of claims of infringement. We may not possessproper ownership or access rights to the intellectual property we use. Thirdparties or other companies may bring infringement suits against us. Any claims,with or without merit, could be time consuming to defend, result in costlylitigation, divert management’s attention and resources or require us to enterinto royalty or licensing agreements. Royalty or licensing agreements, ifrequired, may not be available on terms acceptable to us, if at all. In the

 

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eventof a successful claim of product infringement against us, our failure orinability to license or design around the infringed technology could have amaterial adverse effect on our business, financial condition and results ofoperations. We are not currently involved in actions of this type that arematerial to our business.

 

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

 

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

 

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

 

Our exposure to market risks associated with changes ininterest rates relates primarily to the increase or decrease in the amount ofinterest income earned on our investment portfolio since we have minimal debt.  We ensure the safety and preservation ofinvested funds by limiting default risks, market risk and reinvestmentrisk.  We mitigate default risk byinvesting in investment grade securities. A hypothetical 100 basis point adverse move in interest rates along theentire interest rate yield curve would not materially affect the fair value ofour interest sensitive financial instruments at March 31, 2005.

 

**Item 4.Controls and Procedures**

 

Forthe quarterly period ending March 31, 2005 we carried out an evaluation,under the supervision and with the participation of our management, includingour President and Chief Executive Officer and our Vice President, Finance (theprincipal finance and accounting officer), of the effectiveness of the designand operation of our disclosure controls and procedures pursuant to Rules 13a-15and 15d-15 under the Securities Exchange Act of 1934, or the ExchangeAct, as of the end of the period covered by this report.  Based upon this evaluation, our President andChief Executive Officer and our Vice President, Finance concluded that as of March 31,2005, our disclosure controls and procedures are effective to ensure that theinformation required to be disclosed by us in reports filed under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC.  Our management, including our President andChief Executive Officer and Vice President, Finance, does not expect that ourdisclosure controls or our internal controls will prevent all errors and allfraud.  A control system, no matter howwell designed and operated, cannot provide assurance that the objectives of thecontrol system are met, and no evaluation of controls can provide absoluteassurance that all control issues and instances of fraud, if any, within acompany have been detected.

 

Additionally,our President and Chief Executive Officer and Vice President, Financedetermined that there were no changes in our internal control over financialreporting during the quarterly period ended March 31, 2005, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II.  OTHER INFORMATION**

 

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

 

Presently,we are not party to any litigation.

 

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

 

**None.**

** **

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

 

None.

 

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

 

None.

 

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

 

On January 6, 2005, weentered into a letter agreement with David M. Floyd, Ph.D.  Under this letter agreement, Dr. Floydagreed to assume the position of our Executive Vice President, Discovery andChief Scientific Officer.  Dr. Floydis entitled to an annual base salary of $275,000, subject to adjustment after2005.  Dr. Floyd also is eligible toearn a bonus equal to 35% of his base salary upon achievement of individual andcorporate objectives.  Upon commencementof his employment, Dr. Floyd was granted an option to purchase 150,000shares of our common stock.  Theseoptions are incentive stock options to the extent permitted by applicable law

 

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and vest 25% after one year andmonthly thereafter for the next 36 months. All of Dr. Floyd’s options will vest upon a change in control ofthe Company.  We also agreed to payreasonable fees up to $2,000 associated with Dr. Floyd negotiating hisagreement with us.

 

On January 7, 2005, weentered into a severance agreement with Dr. Floyd.  In the event Dr. Floyd’s employment withus is terminated without “cause” (as defined in the severance agreement) or Dr. Floydterminates for “good reason” (as defined in the severance agreement), then Dr. Floydis entitled, in addition to all accrued, unpaid base salary and benefits, to (1) alump sum payment of one year’s base salary, (2) within 30 days afterthe termination date, a pro rata portion of his target incentive bonus for thecalendar year in which the termination occurred, based on the number of fullmonths employed during the year, (3) continuation of group medicalcoverage until the earlier of one year following termination date or until Dr. Floydhas obtained comparable medical coverage, and (4) immediate vesting ofoptions or other incentive securities pursuant to the terms of the optionagreement or other severance agreements under which granted.  Dr. Floyd must execute a release toreceive payments under his severance agreement. During his employment and for a one year period after termination, Dr. Floydmay not compete with us, solicit or divert any business or any customer fromus, cause any person to not do business with us or solicit for employment acurrent employee or consultant of ours. In the event of termination due to disability, Dr. Floyd willreceive only those benefits provided under our Long Term Disability Plan andhis stock options will be treated under the Disability section of the 2004Stock Incentive Plan.  If Dr. Floydis terminated in connection with a change in control, then he will receive (1) allunpaid compensation and benefits accrued up to termination date, (2) lumpsum of one and one-half times his annual base salary in effect on terminationdate, (3) lump sum of one and one half times his Target Incentive Bonus, (4) groupmedical continuation coverage until the earlier of 18 months aftertermination date or the date Dr. Floyd obtains comparable medicalcoverage, and (5) all unvested stock options or any other unvestedincentive securities vest immediately and must be exercised by the earlier ofone year following termination date or the expiration of the option term.

 

On February 8, 2005, we entered into a severance agreement withBrian M. Posner, our Vice President, Finance. In the event that Mr. Posner is terminated by us without “cause”(as defined in the severance agreement) during the one year period beginning onthe employment start date of a new chief financial officer, Mr. Posnerwill receive (1) any accrued and unpaid base salary and benefits up to thetermination date, (2) six month base salary continuation, (3) groupmedical coverage continuation for twelve months following termination date oruntil Mr. Posner obtains comparable medical coverage elsewhere, (4) outplacementservices up to $10,000, and (5) assurance that the exercise period for anyoptions or awards will end on the earlier of six months from the terminationdate or the termination of term of such option or award.  Mr. Posner must execute a release toreceive payments under his severance agreement. During his employment and for a six month period after termination, Mr. Posnermay not compete with us, solicit or divert any business or any customer fromus, cause any person to not do business with us or solicit for employment acurrent employee or consultant of ours.

 

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

 

Exhibits.

 
| 31.1   |   | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-l4 of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002(1) |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                         |
| 31.2   |   | Certification  of the Principal Financial Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002(1) |
|   |   |                                                                                                                                                                                                                                                         |
| 32.1   |   | Certification  of the Chief Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002(1)                                              |
|   |   |                                                                                                                                                                                                                                                         |
| 32.2   |   | Certification  of the Principal Financial Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002(1)                                          |

 

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(1)           Filed herewith.

 

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**SIGNATURES**

 

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

 
|                                | PHARMACOPEIA  DRUG DISCOVERY,  INC. |
|-------------------------------------|-------------------------------------|
|                                |                                |
| Date:  May 16,  2005 | By:                                 | /s/  Leslie J. Browne, Ph.D. |
|                                |                                | Leslie  J. Browne, Ph.D. |
|                                |                                | President  and Chief Executive Officer |
|                                |                                |
|                                |                                |
|                                | By:                                 | /s/  Brian M. Posner |
|                                |                                | Brian  M. Posner |
|                                |                                | Vice  President, Finance |

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**INDEX TO EXHIBITS**

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

 

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