**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 June 30, 2004** |
|                                                  |   |   |
| **or**                                                |
|                                                  |   |   |
| **o**                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                  |
| **Commission File Number: 0-50523**                   |

 

**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 sincelast report)

 

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

 

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

Yeso    No ý

 

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

 

| **Class**                     | ** ** | **Outstanding at August 2, 2004** |
|-------------------------------|------------|----------------------------------------|
| Common Stock, $0.01 par value |       | 12,241,596                             |

 

 

----

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**           |                  |                                                                                                    |
|--------------------|-----------------------|---------------------------------------------------------------------------------------------------------|
|               |                  |                                                                                                    |
| PART I.            | FINANCIAL INFORMATION |                                                                                                    |
|               |                  |                                                                                                    |   |
| Item 1.            |                  | Financial Statements (Unaudited):                                                                       |   |
|               |                  |                                                                                                    |   |
|               |                  | Balance  Sheets as of June 30, 2004 and December 31, 2003                                     | 1 |
|               |                  |                                                                                                    |   |
|               |                  | Statements of Operations for each of the Three Months and Six Months  Ended June 30, 2004 and 2003 | 2 |
|               |                  |                                                                                                    |   |
|               |                  | Statements of Cash Flows for each of the Six Months Ended  June 30, 2004 and 2003                  | 3 |
|               |                  |                                                                                                    |   |
|               |                  | Notes to Unaudited Financial Statements                                                                 | 4 |
|               |                  |                                                                                                    |   |
| Item 2.            |                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations             | 9 |
|               |                  |                                                                                                    |   |
|               |                  | Certain Risks Related to Our Business                                                                   | 16 |
|               |                  |                                                                                                    |   |
| Item 3.            |                  | Quantitative and Qualitative Disclosures  about Market Risk                                             | 28 |
|               |                  |                                                                                                    |   |
| Item 4.            |                  | Controls and Procedures                                                                                 | 28 |
|               |                  |                                                                                                    |   |
| PART II.           | OTHER INFORMATION     | 28                                                                                                      |
|               |                  |                                                                                                    |   |
| Item 1.            |                  | Legal Proceedings                                                                                       | 28 |
|               |                  |                                                                                                    |   |
| Item 2.            |                  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity  Securities                       | 28 |
|               |                  |                                                                                                    |   |
| Item 3.            |                  | Defaults upon Senior Securities                                                                         | 29 |
|               |                  |                                                                                                    |   |
| Item 4.            |                  | Submission of Matters to a Vote of Security  Holders                                                    | 29 |
|               |                  |                                                                                                    |   |
| Item 5.            |                  | Other Information                                                                                       | 29 |
|               |                  |                                                                                                    |   |
| Item 6.            |                  | Exhibits and Reports on Form 8-K                                                                        | 29 |
|               |                  |                                                                                                    |   |
| Signatures         | 30                    |
|               |                  |
| Index  of Exhibits | 31                    |
|                    |                       |                                                                                                         |  |  |

 

i

----

 

**PARTI - FINANCIAL INFORMATION**

 

**Item 1.  UnauditedFinancial Statements**

 

**PharmacopeiaDrug Discovery, Inc.**

**Balance Sheets**

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

 
| ** **                                                                                                                                                               | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                               |       |                    |       |                        |       |
| Current assets:                                                                                                                                                          |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                |       | $                       | 13,451     |                        | $          | 524 |   |
| Marketable securities                                                                                                                                                    |       | 28,466                  |       | —                      |       |
| Accounts receivable                                                                                                                                                      |       | 1,771                   |       | 2,302                       |       |
| Prepaid expenses and other current assets                                                                                                                                |       | 1,199                   |       | 1,159                       |       |
| Total current assets                                                                                                                                                     |       | 44,887                  |       | 3,985                       |       |
|                                                                                                                                                                     |       |                    |       |                        |       |
| Property and equipment, net                                                                                                                                              |       | 11,222                  |       | 6,957                       |       |
| Other assets                                                                                                                                                             |       | 110                     |       | 110                         |       |
|                                                                                                                                                                     |       | $                       | 56,219     |                        | $          | 11,052 |   |
|                                                                                                                                                                     |       |                    |       |                        |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                           |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                     |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                         |       | $                       | 1,223      |                        | $          | 2,809 |   |
| Accrued liabilities                                                                                                                                                      |       | 1,309                   |       | 951                         |       |
| Restructuring reserve, current portion                                                                                                                                   |       | 2,467                   |       | —                      |       |
| Deferred revenue, current portion                                                                                                                                        |       | 2,765                   |       | 2,660                       |       |
| Total current liabilities                                                                                                                                                |       | 7,764                   |       | 6,420                       |       |
|                                                                                                                                                                     |       |                    |       |                        |       |
| Restructuring reserve, long-term                                                                                                                                         |       | 2,031                   |       | —                      |       |
| Deferred revenue, long-term                                                                                                                                              |       | 274                     |       | 325                         |       |
|                                                                                                                                                                     |       |                    |       |                        |       |
| 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, 12,235,870 and 12,181,471 shares outstanding at  June 30, 2004 and December 31, 2003, respectively |       | 122                     |       | —                      |       |
| Additional paid-in capital                                                                                                                                               |       | 48,732                  |       | —                      |       |
| Deferred compensation                                                                                                                                                    |       | (320                    | )          | —                      |       |
| Accumulated deficit                                                                                                                                                      |       | (2,214                  | )          | —                      |       |
| Accumulated comprehensive income                                                                                                                                         |       | (170                    | )          | —                      |       |
| Investment by Accelrys, Inc.                                                                                                                                             |       | —                  |       | 4,307                       |       |
| Total stockholders’ equity                                                                                                                                          |       | 46,150                  |       | 4,307                       |       |
| Total liabilities and stockholders’ equity                                                                                                                          |       | $                       | 56,219     |                        | $          | 11,052 |   |

 

See accompanying notes tothese unaudited financial statements.

 

1

----

 

**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Operations**

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

 
| ** **                                            | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                                              |       | $                                             | 5,107      |                                        | $          | 7,014 |   | $ | 10,476 |   | $ | 14,535 |   |
| Cost of revenue                                       |       | 4,985                                         |       | 5,396                                       |       | 10,535 |   | 11,172 |   |
| Gross margin                                          |       | 122                                           |       | 1,618                                       |       | (59 | ) | 3,363 |   |
|                                                  |       |                                          |       |                                        |       |   |   |   |   |
| Operating costs and expenses:                         |       |                                          |       |                                        |       |   |   |   |   |
| Research and development                              |       | 1,385                                         |       | 912                                         |       | 2,774 |   | 1,954 |   |
| Sales, general and administrative                     |       | 2,244                                         |       | 1,408                                       |       | 4,663 |   | 2,951 |   |
| Restructuring and other charges                       |       | —                                        |       | —                                      |       | 5,947 |   | — |   |
| Total operating costs and expenses                    |       | 3,629                                         |       | 2,320                                       |       | 13,384 |   | 4,905 |   |
| Operating loss                                        |       | (3,507                                        | )          | (702                                        | )          | (13,443 | ) | (1,542 | ) |
| Interest and other income, net                        |       | 56                                            |       | 4                                           |       | 59 |   | 13 |   |
| Loss before tax provision                             |       | (3,451                                        | )          | (698                                        | )          | (13,384 | ) | (1,529 | ) |
| Provision for income taxes                            |       | 10                                            |       | —                                      |       | 13 |   | 107 |   |
| Net loss                                              |       | $                                             | (3,461     | )                                           | $          | (698 | ) | $ | (13,397 | ) | $ | (1,636 | ) |
|                                                  |       |                                          |       |                                        |       |   |   |   |   |
| Net loss per share:                                   |       |                                          |       |                                        |       |   |   |   |   |
| **•** Basic and diluted                          |       | $                                             | (0.28      | )                                           | $          | (0.06 | ) | $ | (1.10 | ) | $ | (0.13 | ) |
|                                                  |       |                                          |       |                                        |       |   |   |   |   |
| Weighted average number of common stock  outstanding: |       |                                          |       |                                        |       |   |   |   |   |
| **•** Basic and diluted                          |       | 12,179,890                                    |       | 12,155,751                                  |       | 12,167,821 |   | 12,155,751 |   |

 

See accompanying notes tothese unaudited financial statements.

 

2

----

 

**PharmacopeiaDrug Discovery, Inc.**

**Statements of CashFlows**

**(Amounts inthousands)**

 
| ** **                                                                      | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                                    | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                          |       |                                        |       |   |   |
| Net loss                                                                        |       | $                                           | (13,397    | ) | $ | (1,636 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities |       |                                        |       |   |   |
| Depreciation and amortization                                                   |       | 906                                         |       | 878 |   |
| Contribution of stock to 401(k) members                                         |       | 65                                          |       | — |   |
| Amortization of unearned compensation                                           |       | 34                                          |       | — |   |
| Changes in assets and liabilities:                                              |       |                                        |       |   |   |
| Trade receivables                                                               |       | 531                                         |       | (588 | ) |
| Prepaid expenses and other current assets                                       |       | (40                                         | )          | 59 |   |
| Other assets                                                                    |       |                                        |       | (239 | ) |
| Accounts payable                                                                |       | (1,586                                      | )          | (705 | ) |
| Accrued liabilities                                                             |       | 358                                         |       | (734 | ) |
| Restructuring reserve                                                           |       | 4,956                                       |       | — |   |
| Deferred revenue                                                                |       | 54                                          |       | (3,673 | ) |
| Net cash used in operating activities                                           |       | (8,119                                      | )          | (6,638 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                           |       |                                        |       |   |   |
| Capital expenditures, net                                                       |       | (5,629                                      | )          | (260 | ) |
| Purchases of marketable securities                                              |       | (6,171                                      | )          | — |   |
| Proceeds from sale of marketable securities                                     |       | 19,187                                      |       |   |   |
| Net cash provided by (used in) investing  activities                            |       | 7,387                                       |       | (260 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                           |       |                                        |       |   |   |
| Proceeds from issuance of common stock                                          |       | 192                                         |       | — |   |
| Investment by Accelrys, Inc.                                                    |       | 13,467                                      |       | 1,146 |   |
| Net cash provided by financing activities                                       |       | 13,659                                      |       | 1,146 |   |
| Net increase (decrease) in cash and  equivalents                                |       | 12,927                                      |       | (5,752 | ) |
| Cash and equivalents, beginning of period                                       |       | 524                                         |       | 6,737 |   |
| Cash and equivalents, end of period                                             |       | $                                           | 13,451     |   | $ | 985 |   |
|                                                                            |       |                                        |       |   |   |
| SUPPLEMENTAL SCHEDULE OF CASH FLOW  INFORMATION:                           |       |                                        |       |   |   |
| Cash paid during the period for:                                                |       |                                        |       |   |   |
| Interest                                                                        |       | $                                           | —     |   | $ | — |   |
| Income tax                                                                      |       | $                                           | —     |   | $ | — |   |

 

NON-CASH FINANCING:

 

Included in the capitalcontribution by Accelrys upon distribution was $41,652 of marketablesecurities.

 

See accompanying notes tothese unaudited financial statements.

 

3

----

 

**PharmacopeiaDrug Discovery, Inc.**

**Notes toUnaudited Financial Statements**

 

**1.  Background and Basis of Presentation**

 

Pharmacopeia Drug Discovery, Inc(“PDD” or the Company”) was incorporated on May 31, 2002 as a wholly ownedsubsidiary of Accelrys, Inc. (“Accelrys”), formerly Pharmacopeia, Inc. OnDecember 18, 2003, Accelrys announced its plans to spin-off 100 percent ofthe shares of PDD in a pro rata tax-free distribution to its stockholders, subjectto the satisfaction of certain conditions. Upon completion of the distributionon April 30, 2004, Accelrys distributed to its stockholders of record oneshare of PDD common stock for every two shares of Accelrys common stock held. Atotal of 12,181,471 shares were distributed. The financial statements have beenrevised to retroactively reflect the shares distributed  for all periods presented.

 

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

 

 In connection with the distribution, Accelrysand the Company entered into a series of agreements, including a masterseparation and distribution agreement, a transition services agreement, a taxsharing and indemnification agreement and other agreements, which are intendedto govern the ongoing relationship between the two companies. See note 7 forfurther information on the distribution.

 

PDD is a chemistry-based collaborative drug discovery company, focusedon the creation of new small molecule therapeutics.  Using proprietary technologies and processes,the Company’s experienced scientists identify and optimize novel drugcandidates through research collaborations with major pharmaceutical andbiotechnology companies and through the Company’s own internally-funded drugdiscovery programs.

 

For periods prior to thedistribution date, PDD’s financial statements were derived from the financialstatements and accounting records of Accelrys using the historical results ofoperations and historical basis of the assets and liabilities of the Company’sbusiness. Management believes the assumptions underlying the financialstatements are reasonable. The financial statements included herein may notnecessarily reflect the Company’s results of operations, financial position andcash flows in the future or what its results of operations, financial positionand cash flows would have been had the Company been a stand-alone companyduring 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 has been allocated based on the Company’s revenue asa percentage of Accelrys’s total revenue. General corporate overhead primarilyincludes salary and expenses for executive management, finance, legal, humanresources, information services and investor relations, and was $131 thousandand $354 thousand for the quarters ended June 30, 2004 and 2003,respectively, and $668 thousand and $711 thousand in the six months endedJune 30, 2004 and 2003, respectively. 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 Regulation S-X.  Accordingly, these unaudited financialstatements do not include all of the information and disclosures required bygenerally accepted accounting principles for complete financial statements. TheDecember 31, 2003 financial information has been extracted from theaudited financial statements included in the Company’s registration statementon Form 10 dated April 19, 2004 (the “Form 10”), which was filed inconjunction with the Company’s spin-off from Accelrys. In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation of the financial statements havebeen included.  Interim results are notnecessarily indicative of the results that may be expected for the year. Theunaudited interim financial statements should be read in conjunction with thefinancial statements and notes thereto as of December 31, 2003 included inthe Company’s Form 10.

 

4

----

 

**2.Significant Collaborations**

 

For the quarters endedJune 30, 2004 and 2003 the Company’s research collaborations withSchering-Plough accounted for 57% and 49%, respectively, of revenue.  For the six months ended June 30, 2004and 2003, the Company’s research collaborations with Schering-Plough accountedfor 63% and 47%, respectively, of revenue. In the third quarter of 2003, theCompany entered into new drug discovery collaborations with Schering-Plough,which continue certain existing programs and implement a number of newactivities. The new agreements continue the Company’s collaboration with thispartner through at least August 2006 and, under their terms, may beextended by the parties for up to three additional years based upon progressmade in the programs governed by the agreements. The agreements may beterminated at the end of the third year, and Schering-Plough’s fundingobligations may be reduced significantly before that time.  Under these agreements, PDD receives researchfunding which is recognized as revenue as services are performed. The Companymay receive milestones upon the successful achievement of preclinical andclinical milestones. Milestone payments will be recognized as revenue when themilestones are achieved. Upon successful commercialization of any productresulting from this relationship, PDD will be entitled to receive royalties onsales of that product.

 

For the quarters endedJune 30, 2004 and 2003, the Company’s research collaborations with N.V.Organon (“Organon”) accounted for 18% and 22%, respectively, of revenue.  For the six months ended June 30, 2004and 2003, the Company’s research collaborations with Organon accounted for 17%and 21 %, respectively, of revenue.  Thecurrent agreement with Organon, entered into in February 2002, has astated term of five years; however, Organon has the right to terminate theagreement in 2005 if PDD is unable to deliver compounds meeting the criteriaspecified in the agreement. Under this agreement, PDD receives research fundingto conduct its drug discovery activities to identify and optimize new drugcandidates for multiple therapeutic targets provided by Organon. This revenueis recognized on a straight-line basis over the term of the collaboration. TheCompany may receive milestones upon the successful achievement of preclinicaland clinical milestones. These milestones will be recognized as revenue whenthe milestones are achieved. Upon successful commercialization of any productresulting from this relationship, PDD will be entitled to receive royalties onsales of that product.

 

**3.  Net Loss Per Share**

 

The Company computes net income(loss) per share in accordance with Statement of Financial Accounting StandardNo. 128, “Earnings Per Share” (“SFAS 128”). Under the provisions of SFAS 128, basic net income (loss) per share iscomputed by dividing the net income (loss) for the period by theweighted-average number of common shares outstanding during the period.  Diluted net income (loss) per share iscomputed by dividing the net income (loss) for the period by theweighted-average number of common and dilutive common equivalent sharesoutstanding during the period.  Dilutedearnings per share include the potentially dilutive effect of outstanding stockoptions, or other dilutive securities. Shares outstanding for the Company forthe period prior to the distribution are calculated based on the 12,181,471shares distributed in the spin-off, adjusted for unvested restricted shares(see notes 1 and 7). The Company has a net loss for the periods presented;accordingly, the inclusion of common stock equivalents for outstanding stockoptions would be anti-dilutive and, therefore, the weighted-average shares usedto calculate both basic and diluted loss per share are the same.

 

**4.  Segment Information**

 

The Company classifies its businessoperations in one operating segment.  Allof the Company’s revenues are generated from this segment.  In the quarters ended June 30, 2004 and2003, approximately 40% and 33%, respectively, of the Company’s revenue fromunaffiliated customers was derived from within the United States, 51% and 66%,respectively, was derived from Europe, and 9% and 1%, respectively, was derivedfrom Asia.  In the six months endedJune 30, 2004 and 2003, approximately 42% and 29%, respectively, of theCompany’s revenue from unaffiliated customers was derived from within theUnited States, 52% and 63%, respectively, was derived from Europe, 6% and 8%,respectively, was derived from Asia.

 

**5.  Stock-Based Compensation**

 

Generally, any outstanding optionsto purchase Accelrys common stock under Accelrys incentive compensation planshave been adjusted or converted to options to purchase PDD common stock tomaintain the intrinsic value existing at the time of the distribution andmaintain the ratio existing at the time of the distribution of the exerciseprice per share to the market value per share in accordance with applicableaccounting standards.

 

5

----

 

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

 

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

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss:                                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                    | (3,461     | )                                  | $          | (698 | ) | $ | (13,397 | ) | $ | (1,636 | ) |
|                                                                                                                                          |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Add: Stock-based employee compensation  expense included in reported net loss                                                                 |       | 25                                   |       |                               |       | 34 |   |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (619                                 | )          | (435                               | )          | (1,051 | ) | (862 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (4,055     | )                                  | $          | (1,133 | ) | $ | (14,414 | ) | $ | (2,498 | ) |
| Basic and diluted net loss per common  share:                                                                                                 |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                    | (0.28      | )                                  | $          | (0.06 | ) | $ | (1.10 | ) | $ | (0.13 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (0.33      | )                                  | $          | (0.09 | ) | $ | (1.18 | ) | $ | (0.21 | ) |

 

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

 
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0        | %          | 0        | %          |
| Expected volatility     |       | 85.24    | %          | 87.02    | %          |
| Risk-free interest rate |       | 4.35     | %          | 2.84     | %          |
| Expected life (years)   |       | 5.8      |       | 6.6      |       |

 

**6.  Restructuring**

 

During the quarter endedMarch 31, 2004, the Company executed a restructuring plan for the purposeof making its research and development activities more efficient by eliminatingunnecessary facilities. Also a reduction in force of six administrative PDDemployees occurred during that quarter, of whom all were terminated as ofJune 30, 2004.  As a result,restructuring related charges of approximately $5.9 million, as outlined below,were recognized as operating expense during the quarter ended March 31,2004.

 

The following table summarizes theactivity and balance of the restructuring reserve at June 30, 2004(dollars in thousands):

 

6

----

 
| ** **                       | ** ** | **Severance Cost for  Involuntary Employee  Terminations** | ** ** | **Costs to Exit Leased  Facility** | ** ** | **Total** | ** ** |
|----------------------------------|------------|------------------------------------------------------------|------------|------------------------------------|------------|-----------|------------|
| Restructuring charges            |       | $                                                          | 132        |                               | $          | 5,718     |       | $ | 5,850 |   |
| Utilization of Reserves:         |       |                                                       |       |                               |       |      |       |
| Cash                             |       | (122                                                       | )          | (772                               | )          | (894      | )          |
| Write-off Leasehold Improvements |       | —                                                     |       | (458                               | )          | (458      | )          |
| Balance at June 30, 2004    |       | $                                                          | 10         |                               | $          | 4,488     |       | $ | 4,498 |   |

 

**7.  Spin-off of Pharmacopeia Drug Discovery, Inc.**

 

On April 30, 2004, Accelryscompleted the spin-off of PDD into an independent, separately traded, publiclyheld company through the distribution to its stockholders of a dividend of oneshare of PDD common stock for every two shares of Accelrys common stockheld.  Accelrys received an opinion ofcounsel that the transaction would qualify as tax-free to Accelrysstockholders, except for cash received in lieu of any fractional shareinterests.

 

In connection with thedistribution, Accelrys and the Company entered into the agreements describedbelow.

 

*Master Separation and Distribution Agreement*

 

The Company entered into a masterseparation and distribution agreement with Accelrys providing for, among otherthings, certain corporate transactions required to effect the distribution andother arrangements between the Company and Accelrys subsequent to the distribution.In particular, the agreement provided for ownership of the business, assets andliabilities necessary for ownership of the continuation of the Company’sbusiness directly or indirectly, by the Company, and Accelrys’s remainingbusiness assets and liabilities, directly or indirectly, by Accelrys.

 

*TransitionServices Agreement*

 

The Company entered into atransition services agreement with Accelrys, pursuant to which Accelrys willprovide PDD and PDD will provide Accelrys certain services during a transitionperiod that commenced on the distribution date and the obligation to provideservices will terminate no later than the first anniversary of the distributiondate.

 

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

 

The transition services agreementalso provides that Accelrys will make available a sum of $1 million to be heldas a “Services Fund” in a segregated account, in trust for the benefit of PDDand Accelrys.  PDD may use the ServicesFund towards securing any service Accelrys agrees to provide PDD under thetransition services agreement if PDD and Accelrys cannot resolve any disputerelating to the performance or nonperformance of such service by Accelrys aftergood faith negotiations. The Company will also use a portion of the ServicesFund to acquire a financial system appropriate for its business and is entitledto use a portion of the Services Fund to update its corporate website and toacquire or license certain software packages appropriate for supporting the internaloperations of its business. The amount remaining in the Services Fund, lessapplicable deductions, will be remitted to Accelrys.

 

In addition, the transitionservices agreement provides that Accelrys will make available a sum of $750thousand to PDD in relation to any and all costs, expenses and fees not paidprior to the distribution date, associated with PDD’s consolidation of itsfacilities, including but not limited to construction and waste costs, expensesand fees. As of June 30, 2004, $534 thousand is available to PDD for thesepurposes.

 

The amounts made available to PDDunder the transition services agreement are not included in the Company’s cashand cash equivalents balance as of June 30, 2004.

 

7

----

 

*Tax Sharing andIndemnification Agreement*

 

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

 

Under the tax sharing and indemnificationagreement, Accelrys is responsible for filing all federal consolidated incometax returns and all consolidated, combined, or unitary state and local incometax returns including PDD for all periods through the distribution date, andfor paying all taxes related to those returns. Accelrys will act as theCompany’s agent in connection with the filing of those returns, paying thosetaxes and responding to any audits that may arise in connection with thosereturns. Accelrys will be entitled to any refunds of income taxes related tothose returns, and (except for certain spin-off taxes discussed below) will beresponsible for any increased tax payments related to those returns as a resultof any audits.

 

PDD is responsible for all stateand local taxes imposed on it computed on a separate-company basis, and will beentitled to any refund of such taxes.

 

The Company and Accelrys have madecertain covenants to each other in connection with the spin-off that PDD maynot take certain actions without first obtaining an unqualified opinion ofcounsel that such actions will not cause the spin-off to become taxable. If theCompany breaches any of the covenants in the tax sharing and indemnificationagreement, and if PDD’s breach results in taxes being imposed on Accelrys inconnection with the spin-off, then PDD will be liable for those taxes.Furthermore, the Company will be responsible for taxes that may be imposed onAccelrys pursuant to IRS Section 355(e) of the Internal Revenue Code of1986, as amended, in connection with the transaction that results in a changein control of PDD, even though PDD may have obtained an opinion of counselprior to the transaction.

 

*Employee MattersAgreement*

 

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

 

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

 

During the transition period, whichbegan on the distribution date and will end no later than December 31,2004, PDD employees may continue their participation in plans maintained byAccelrys. The transition period with respect to any particular employee benefit(for example, the 401(k) savings plan or medical plan) may end prior toDecember 31, 2004 if Accelrys and PDD agree on such an earlier date.During the transition period, the Company will have input in the sharedemployee benefit plans with regard to its employees. However, Accelrys will beresponsible for maintaining and administering these plans, notifying vendors,third party administrators, insurance companies and other service providersregarding the distribution, and will indemnify PDD for any liabilities thatarise from a failure of Accelrys to fulfill its obligations under the employeematters agreement. Accelrys will not impose a fee on PDD under the employeematters agreement for the maintenance and administration of these plans. PDD, however,will be responsible for the pro rata portion of the costs and expenses incurredfor the benefit its employees and former employees under these plans.

 

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

 

8

----

 

*Patent andSoftware License Agreement*

 

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

 

Underthe patent and software license agreement, Accelrys granted PDD a worldwide,paid-up, royalty-free, irrevocable, nontransferable and nonexclusive license touse certain software products for the sole purpose of processing the work ofPDD’s business. The license is in effect until April 30, 2007, unlessearlier terminated by either party or Accelrys under certain limitedcircumstances or extended by mutual written agreement by the Company andAccelrys.

 

**Pursuant tothe patent and software license agreement, Accelrys granted PDD a worldwide,paid-up, royalty-free, irrevocable, nontransferable, and non-exclusive licenseto certain Accelrys-owned patents. This license is in effect until the last ofthe patents made part of the patent and software license agreement expires.**

** **

**Pursuant tothe patent and software license agreement, PDD granted Accelrys a worldwide,paid-up, royalty-free, irrevocable, nontransferable, and non-exclusive licenseto certain PDD-owned patents. This license is in effect until the last of thePDD-owned patents made part of the patent and software license agreementexpires.**

** **

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

** **

Forward-LookingStatements

 

This QuarterlyReport on Form 10-Q contains forward-looking statements regarding us and ourbusiness, financial condition, results of operations and prospects within themeaning of the Private Securities Litigation Reform Act of 1995.  Such forward-looking statements include thosewhich express plans, anticipation, intent, contingency, goals, targets orfuture development and/or otherwise are not statements of historical fact.  These forward-looking statements are based onour current expectations and projections about future events and they are subjectto risks and uncertainties known and unknown which could cause actual resultsand developments to differ materially from those expressed or implied in suchstatements.  These forward-lookingstatements include statements about the following:

 

**•**                  ourintentions regarding the establishment and continuation of drug discoverycollaborations with leading pharmaceutical and biotechnology organizations;

 

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

 

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

 

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

 

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

 

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

 

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

 

**•**                  ourexpectations concerning the development priorities of our collaborativepartners, and their ability to successfully develop compounds;

 

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

 

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

 

**•**                  ourestimates of the market opportunity for our product candidates;

 

**•**                  ourability to raise additional capital;

 

 

9

----

 

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

 

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

 

**•**                  ourrelationship with Accelrys after the distribution; and

 

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

 

In some cases,you can identify forward-looking statements by terminology, such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or thenegative of such terms or other similar expressions.  Factors that could cause or contribute todifferences in results and outcomes include, without limitation, thosediscussed elsewhere in this Report in Item 2. “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations (including a subsection thereof entitled “Certain RisksRelated to Our Business”) and discussed in our other Securities and ExchangeCommission (“SEC”) filings.

 

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

 

**TheCompany**

** **

**Overview**

** **

We are achemistry-based collaborative drug discovery company, focused on the creationof new small molecule therapeutics. Small molecule drug candidates typically are orally available (i.e., maybe taken in capsule or tablet form) and offer manufacturing and deliveryadvantages over other types of therapeutics. Using proprietary technologies and processes, our experienced scientistsidentify and optimize novel drug candidates through research collaborationswith major pharmaceutical and biotechnology companies and through our owninternally-funded drug discovery programs. Our collection of approximately 7.5 million proprietary compounds, whichwe believe is one of the largest in the pharmaceutical industry based uponpublicly available information from the websites of our major competitors andcertain other companies in the pharmaceutical industry, is available for use inour collaborative and internal research programs and forms the basis of ourgrowing pipeline of potential drug candidates.In the past year several of ourpartners commenced clinical trials with four of our proprietary compounds.

 

We have drugdiscovery collaborations with leading pharmaceutical companies and emergingbiotechnology companies.  Ourcontributions to our partners’ drug discovery programs include:  the provision of large, diverse libraries ofproprietary drug-like chemical compounds from which potential therapeuticcandidates can be identified; our high throughput and ultra high throughputscreening of these compounds against disease targets of interest provided bythe partner in which we test a disease-related target against tens of thousands(with respect to high throughput) or to hundreds of thousands (with respect toultra high throughput) of our potential small molecule therapeutic compoundsper week; our optimization of active compounds identified in the screeningprocess, in which we refine the molecular structure of the lead compounds in anattempt to improve their efficacy, potency and safety; our provision ofmedicinal chemistry capabilities through which our scientists design,synthesize (i.e., physically make in our laboratories) and optimize those leadcompounds that we or our collaborators believe are potential drug candidates;and our delivery of other services (such as *in vitro*pharmacology) traditionally performed by research divisions withinpharmaceutical and biotechnology companies. Our collaborative agreements typically require our customers to fund ourprovision of services, and provide for our receipt of significant milestonepayments if and as our discoveries progress through the developmentprocess.  Thereafter, should any of thesedrug candidates become pharmaceutical products we typically would be entitledto receive royalty payments calculated as a percentage of the net sales of theproducts.  Our business is highlydependent upon the extent to which the pharmaceutical and biotechnologycompanies collaborate with outside companies for drug discovery expertise.  The willingness of pharmaceutical andbiotechnology

 

10

----

 

companies to expand or continue drug discovery collaborations oroutsource services to enhance their research and development activities arebased on certain factors that are beyond our control.  There can be no assurance that our existingcollaborative relationships will continue, that we will develop newrelationships with similar large organizations on terms favorable to us, thatany of our existing or new alliances will produce substantial revenue or profitopportunities, or that the scientific outcomes of any of these programs will besuccessful.

 

In addition tocollaborative drug discovery, we conduct proprietary research to discover newdrug-like lead compounds with commercial potential.  Unlike our typical collaborativepartnerships, we provide the required funding for these programs.  As we do not receive funding from third partycollaborators with respect to these proprietary programs, we retain allintellectual property and ownership rights in any compounds discovered.  At an appropriate point, we may determine tolicense one or more of these compounds to a third party (usually a largerpharmaceutical organization).  Licensingat this point in the compound’s development enables us to take advantage of theadditional resources, expertise and technologies of the licensee company inorder to further the development of the compound.  We enter into such licenses with thirdparties in return for up-front fees and milestone payments, as well asrecurring royalty payments if these compounds are developed into new commercialdrugs.  These agreements convert ourproprietary programs into collaborative partnerships, typically at a moreadvanced state of the drug development process.

 

Our drugdiscovery efforts have produced four clinical candidates so far.  Our first candidate, a p38 Kinase Inhibitorfor rheumatoid arthritis developed in collaboration with Bristol-Myers SquibbCompany, commenced clinical trials in August 2003.  This potential new drug, a small moleculefrom our proprietary compound collection (and the product of one of ourinternal development programs), currently is in Phase I of clinicaltesting.  A second of our proprietaryinternal compounds targets an inflammation indication and commenced clinicaltrials in November 2003.  Thisclinical candidate is a product of our collaboration with DaiichiPharmaceutical Co.  Our third candidate,a compound targeting a respiratory indication developed in collaboration withSchering-Plough Corporation, commenced clinical trials in December 2003.  The Schering-Plough relationship produced asecond clinical candidate, which is our fourth clinical candidate, inMarch 2004, when Schering-Plough initiated clinical trials for aninflammation indication with respect to another compound discovered in thecollaboration.  We have receivedsignificant milestone payments from each of Bristol-Myers Squibb, Daiichi andSchering-Plough and, to the extent the compounds progress through the clinicalprocess, we will be entitled to receive additional milestone payments.  We are also entitled under the agreementswith each of these partners to receive royalties on the commercial sale, ifany, of a new drug emanating from the relationship.  Although these collaborators currently areperforming clinical trials of prospective pharmaceutical products containingour proprietary compounds, numerous additional studies will be necessary tosupport the further development of these product candidates.  Results from preclinical studies conducted todate on these product candidates are not necessarily indicative of the resultsthat may be obtained in future clinical studies.  There can be no assurance that thesecollaborators will continue these programs.

 

In addition,we are involved in over 40 other drug development programs in the preclinicalstage, some with collaborative partners and others within our internaldiscovery program.  Two of these programsare at various stages of the Good Laboratory Practice (GLP) Toxicity studyprocess, the point at which compounds are tested for safety prior to theirintroduction into humans during Phase I of the clinical developmentprocess.  Approximately 20 of theseprograms are in various phases of preclinical development, from advanced stagesof lead optimization down through “hit-to-lead” studies.  The remaining programs are in early stages,including development of biological assays for testing of compounds and thescreening of our proprietary libraries against selected disease targets.  In our collaborative programs we typically holda financial interest in any active compounds we identify through our screeningand any drug candidate(s) we help to optimize. In our proprietary programs, we hold all rights to the compounds andtypically enter into partnership arrangements with pharmaceutical companiesonce the program has reached an appropriate stage.

 

Preclinical and clinical development of drug candidates is a long,expensive and uncertain process.  Ourcandidates are at an early stage, as none of our compounds are contained inproducts that have received regulatory approval for commercial sale.  All of our compounds, including our clinicalcandidates, face the substantial risks of failure inherent in developingdrugs.  At any stage of the clinicaldevelopment process, our collaborators or we may decide to discontinue developmentof our product candidates.  We do notexpect that our product candidates will be commercially available for manyyears, 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 have not identified a therapeuticcandidate that has been developed into a commercial drug using our platformand, although we have received license and milestone fees, we may never receiveany royalty payments, or any additional license and milestone fees, under ourcurrent or any future collaborations.

 

11

----

 

On April 30, 2004, Accelrys (formerly Pharmacopeia, Inc.), thenour sole stockholder, distributed all outstanding shares of our common stock tothe holders of common stock of Accelrys. We thereafter began operations as an independent, separately traded,publicly held company.  The distributionwas made without payment of any consideration or the exchange of any shares byAccelrys stockholders.  In thedistribution, Accelrys stockholders received one share of our common stock forevery two shares of Accelrys common stock held of record.  The stock traded as when issued fromApril 20, 2004 through April 30, 2004 and began regular trading onThe Nasdaq National Market on May 3, 2004 under the trading symbol “PCOP.”

 

OnJuly 19, 2004, we announced the appointment of Leslie J. Browne, Ph.D., asour president and chief executive officer. We expect Dr. Browne’s employment to begin on August 9, 2004.

 

**Liquidityand Capital Resources**

** **

 Priorto the distribution we had funded our activities primarily through Accelrys’sconsolidated operations, including revenue derived from collaborativepartnerships, and milestone payments. Accelrys contributed an amount of cash,cash equivalents and marketable securities such that upon consummation of thedistribution on April 30, 2004, we had a cash, cash equivalents andmarketable securities balance aggregating $46.5 million.

 

Inconnection with the distribution, Accelrys and we entered into a transitionservices agreement that provides that Accelrys will make available a sum of $1million to be held as a “Services Fund” in a segregated account, in trust forthe benefit of us and Accelrys.  We mayuse the Services Fund towards securing any service Accelrys agrees to provideunder the transition services agreement if we and Accelrys cannot resolve anydispute relating to the performance or nonperformance of such service byAccelrys after good faith negotiations. We will also use a portion of theServices Fund to acquire a financial system appropriate for our business andare entitled to use a portion of the Services Fund to update our corporatewebsite and to acquire or license certain software packages appropriate forsupporting the internal operations of our business. The amount remaining in theServices Fund, less applicable deductions, will be remitted to Accelrys.

 

Inaddition, the transition services agreement provides that Accelrys will makeavailable a sum of $750 thousand to usin relation to any and all costs, expenses and fees not paid prior to thedistribution date, associated with our consolidation of our facilities,including but not limited to construction and waste costs, expenses and fees.As of June 30, 2004, $534 thousand is available to complete theconsolidation project.

 

The amounts made available to usunder the transition services agreement are not included in our cash and cashequivalents balance as of  June 30,2004.

 

As of June 30, 2004, we hadcash, cash equivalents and marketable securities of $41.9 million compared to$524 thousand at December 31, 2003, representing 75% and 5% of our totalassets, respectively. We invest excess cash in highly liquid investment-grademarketable securities, including corporate bonds and United States governmentand agency securities.

 

The following is a summary ofselected cash flow information for the six months ended June 30, 2004 and2003:

 
| ** **                                           | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Net loss                                             |       | $                                   | (13,397    | ) | $ | (1,636 | ) |
| Adjustments for noncash operating items              |       | 1,005                               |       | 878 |   |
| Net cash operating loss                              |       | (12,392                             | )          | (758 | ) |
| Net change in assets and liabilities                 |       | 4,273                               |       | (5,880 | ) |
| Net cash used in operating activities                |       | $                                   | (8,119     | ) | $ | (6,638 | ) |
|                                                 |       |                                |       |   |   |
| Net cash provided by (used in) investing  activities |       | $                                   | 7,387      |   | $ | (260 | ) |
|                                                 |       |                                |       |   |   |
| Net cash provided by financing activities            |       | $                                   | 13,659     |   | $ | 1,146 |   |

 

12

----

 

**Netcash used in operating activities**

 

Net operating cashoutflows for the six months ended June 30, 2004 have resulted primarilyfrom our operating loss due to our decrease in revenue and our increase in thefunding of our internal drug discovery efforts.

 

**Net cashprovided by investing activities**

** **

Cash provided byinvesting activities for the six months ended June 30, 2004 relatesprimarily to the sales and maturities of marketable securities partially offsetby expenditures for leasehold improvements undertaken in connection with theconsolidation of our facilities to one location.

 

**Net cashprovided by financing activities**

** **

Net cash providedby financing activities for the six months ended June 30, 2004 consists ofthe capital contribution made to us by Accelrys upon the distribution andproceeds from the issuance of common stock in connection with our employeestock option and employee stock purchase 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 to add to our pipeline of programs.  Conducting our own drug discovery research isa key component of our business model.

 

In addition, ourcapital requirements may increase in future periods as we seek to expand ourtechnology platform through investments, licensing arrangements, technologyalliances, or acquisitions.

 

We are obligated to pay approximately $4.5 million in costs inconnection with a facility we exited in the first quarter of 2004. The lease onthis facility expires in April 2006.

 

We anticipate that ourcapital resources will be adequate to fund our operations at least through2005. However, there can be no assurancethat changes will not occur that would consume available capital resourcesbefore then. Our capital requirements depend on numerous factors, including ourability to extend existing agreements and to enter into additionalarrangements, competing technological and market developments, changes in ourexisting collaborative relationships, the cost of filing, prosecuting,defending, and enforcing patent claims and other intellectual property rightsand the outcome of related litigation, the purchase of additional capitalequipment, acquisitions of other businesses or technologies, and the progressof our customers’ milestone and royalty producing activities. Prior toexhausting our current capital resources, we will need to raise additionalfunds to finance our operating activities or enter into strategic initiativesintended to further the development of our business. There can be no assurancethat additional funding, if necessary, will be available on favorable terms, ifat all.  Our forecasts of the period oftime through which our financial resources will be adequate to support ouroperations are forward-looking information, and actual results could vary.  The factors described earlier in thisparagraph will impact our future capital requirements and the adequacy of ouravailable funds.

 

**Results of Operations**

 

**Three months endedJune 30, 2004 and 2003**

** **

Our revenue decreased 27% to $5.1 million inthe quarter ended June 30, 2004 compared to $7.0 million in the quarterended June 30, 2003.  The decreasewas primarily due to a decrease in lead optimization revenue due to theexpiration of one of our collaborations with N.V. Organon, no revenue beingrecognized from our screening services activities with Novartis, and reducedrevenue from our collaborations with Schering-Plough. Revenue from our newcollaborations with Taiho, Neurocrine, and Altana partially offset the decreasein revenue.   No milestone revenue wasrecorded in the quarter ended June 30, 2004 compared to $100 thousandrecorded in the quarter ended June 30, 2003.

 

Cost of revenue includes the labor, material,equipment and allocated facilities cost of our scientific staff who are workingon collaborative partnerships. Gross margin decreased to $100 thousand in thequarter ended June 30, 2004 from $1.6 million in the quarter endedJune 30, 2003.  Gross margin as apercentage of revenue was 2% for the quarter ended June 30, 2004, comparedto 23% of revenue in the quarter ended June 30, 2003.  The gross margin decreased substantially dueto the decrease in service revenue, which resulted in the under-absorption offixed costs allocated to collaborative partnerships.

 

Research and development expenses includelabor, material, equipment and allocated facilities cost of scientific staffworking on

 

13

----

 

unfunded internal drug discovery projects.Internal drug discovery projects are focused on the creation of new smallmolecule therapeutics using proprietary technologies and our collection of 7.5million proprietary compounds to identify and optimize novel drug candidates.Because of the speculative nature of these internal drug discovery projects, itis not possible to estimate completion dates, or estimated costs of completion.Additionally, from time to time, depending on requirements under collaborativepartnership work, certain staff and other research and development resourcesmay be temporarily redirected to collaborative partnership work whichredirection may also delay or impact the cost of internal drug discoveryprojects. Research and development expenses increased 52% to $1.4 million inthe quarter ended June 30, 2004 compared to $900 thousand in the quarterended June 30, 2003. The increase is consistent with our decision toincrease our investment in our proprietary research drug discovery efforts.

 

Sales, general and administrative expensesincreased by 59% to $2.2 million in the quarter ended June 30, 2004compared to $1.4 million in the quarter ended June 30, 2003.  The increase in sales, general andadministrative expenses is primarily attributable to additional costsassociated with our being an independent company, including salary and expensesfor executive management, finance, legal, human resources, informationservices, investor relations, and corporate governance. Prior to thedistribution, general corporate overhead had been allocated had based on ourrevenue as a percentage of Accelrys’ s total revenue. The increase in sales,general and administrative is also due to moving costs incurred in theconsolidation of our research and development facilities.

 

We recorded an income tax provision for thequarter ended June 30, 2004 related to corporate franchise taxes.

 

As a result of the revenues and costsdescribed above, the Company generated a net loss of $3.5 million ($0.28 perdiluted share) in the quarter ended June 30, 2004 compared to a net lossof $700 thousand ($0.06 per diluted share) in the quarter ended June 30,2003.

 

**Six months ended June 30,2004 and 2003**

** **

Our revenue decreased 28% to $10.5 million inthe six months ended June 30, 2004 compared to $14.5 million in the sixmonths ended June 30, 2003.  Thedecrease was primarily due to a decrease in milestone revenue, a decrease inlead optimization revenue due to the expiration of one of our collaborationswith N.V. Organon, the significant reduction in our screening servicesactivities with Novartis, and reduced revenue from our collaborations withSchering-Plough. Revenue from our new collaborations with Taiho, Neurocrine,and Altana partially offset the decrease in revenue.  Milestone revenue recorded in the six monthsended June 30, 2004 and 2003 was $1.0 million, and $2.0 million,respectively.  Excluding the revenue frommilestones, revenue decreased 24% to $9.5 million in the six months endedJune 30, 2004 compared to $12.5 million in the six months endedJune 30, 2003.

 

Cost of revenue includes the labor, material,equipment and allocated facilities cost of our scientific staff that areworking on collaborative partnerships. Gross margin decreased to ($100)thousand in the six months ended June 30, 2004 from $3.4 million in thesix months ended June 30, 2003.  Grossmargin as a percentage of revenue was (1%) for six months ended June 30,2004, compared to 23% of revenue in the six months ended June 30,2003.  The gross margin decreasedsubstantially due to the decrease in milestone revenue, which carries no significantassociated cost of revenue, and the decrease in service revenue resulting inthe under-absorption of fixed costs allocated to collaborative partnerships.

 

Research and development expenses includelabor, material, equipment and allocated facilities cost of scientific staffworking on unfunded internal drug discovery projects. Our internal drugdiscovery projects are focused on the creation of new small moleculetherapeutics using proprietary technologies and our collection of 7.5 millionproprietary compounds to identify and optimize novel drug candidates. Becauseof the speculative nature of these internal drug discovery projects, it is notpossible to estimate completion dates, or estimated costs of completion.Additionally, from time to time, depending on requirements under collaborativepartnership work, certain staff and other research and development resourcesmay be temporarily redirected to collaborative partnership work whichredirection may also delay or impact the cost of internal drug discoveryprojects. Research and development expenses increased 42% to $2.8 million inthe six months ended June 30, 2004 compared to $2.0 million in the sixmonths ended June 30, 2003. The increase is consistent with our decisionto increase our investment in our proprietary research drug discovery efforts.

 

14

----

 

Sales, general and administrative expensesincreased by 58% to $4.7 million in the six months ended June 30, 2004compared to $3.0 million in the six months ended June 30, 2003.  The increase in sales, general andadministrative expenses is attributable to additional costs associated with ourbeing an independent company, including salary and expenses for executivemanagement, finance, legal, human resources, information services, investorrelations, and corporate governance. Prior to the distribution, generalcorporate overhead had been allocated based on our revenue as a percentage ofAccelrys’ s total revenue. The increase in sales, general and administrative isalso due to moving costs incurred in the consolidation of our research anddevelopment facilities.

 

During the six months ended June 30,2004, we undertook a restructuring and certain other actions.  Accordingly, restructuring and other chargesof $5.9 million were incurred.  The charge included severance payments, thecost to exit a leased facility, and the acceleration of a deferred compensationcharge.

 

We recorded an income tax provision for thesix months ended June 30, 2004 related to corporate franchise taxes. Theprovision for the six months ended June 30, 2003 included foreign taxes,as well as corporate franchise taxes.

 

As a result of the revenues and costsdescribed above, we generated a net loss of $13.4 million ($1.10 per dilutedshare) in the six months ended June 30, 2004, compared to a net loss of$1.6 million ($0.13 per diluted share) in the six months ended June 30,2003.

 

**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. We are highly dependent on thesuccess of our research and development programs with our existingcollaborators and our ability to successfully, cost effectively and timelydevelop, introduce and market new collaborative arrangements. On a quarterlybasis, our future profitability is likely to be highly volatile because itdepends upon our receipt of milestone payments from our collaborators. We maynot receive milestone payments on a regular basis or at all. In addition, ourability to achieve profitability will be significantly impacted by theincreased level of investment we have determined to make in our internalproprietary programs in the future as well as the results of those programs. 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) ratably over the term of the agreement, whichapproximates the performance of services, for contracts specifying payment forservices over a given period, or (ii) as services are performed under theagreement for contracts specifying payment on a full-time employee basis.

 

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

 

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

 

*Long-Lived Assets-*Wereview long-lived assets, including leasehold improvements, property andequipment, and acquired technology rights, for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. This requires us to estimate future cashflows related to these assets. Actual results could differ from these estimates,which may affect the carrying amount of assets and the actual amortizationexpense. As of June 30, 2004, we had long-lived assets with a net bookvalue of $11.3 million.

 

15

----

 

**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:

 

**RISKS RELATED TO ESTABLISHING OUR COMPANY ASINDEPENDENT FROM ACCELRYS**

** **

***We have no current history ofoperating as an independent company.***

 

AlthoughAccelrys, Inc. was operated exclusively as a chemistry-based collaborative drugdiscovery business prior to its acquisition of its software business, ourmanagement team has not recently operated our company as a public, stand-alonecompany, and we have a new board of directors appointed by Accelrys, most ofwhom previously served on the board of directors of Accelrys prior to thedistribution. Our ability to satisfy our obligations and increase revenues willbe solely dependent upon the future performance of the businesses we own andoperate, and we will not be able to rely upon the financial and other resourcesand cash flows of those business lines remaining with Accelrys.  Since we do not have an operating history asa separate entity, it will be difficult for anyone to accurately forecast ourfuture revenue and other operating results.

 

***Our historical financial informationmay not be representative of our results as a separate company.***

 

Thehistorical financial information included in this report differs from theresults of operations, financial condition and cash flows that would have beenachieved had we been operated independently during the period and as of thedates presented.  Prior to thedistribution, our businesses were operated by Accelrys as part of its broadercorporate organization rather than as a stand-alone company.  Historically, Accelrys performed certaincorporate functions for us, including legal services, treasury administration,insurance administration, internal audit and corporate income taxadministration.  Now that thedistribution is complete, Accelrys will not provide assistance to us, otherthan to provide various corporate support, information systems and humanresources services during a transition period.

 

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

 

Ourhistorical financial information contains assumptions about our expenses thatmay 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.

 

Althoughwe believe that our historical financial statements allocate to us a reasonableshare of such expenses, we cannot assure you that our actual costs will notincrease, perhaps substantially.  We alsoare 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 our historical financial information is not reflective ofwhat our results of operations, financial condition and cash flows would havebeen had we been an independent company during the periods presented, thathistorical financial information will not be a reliable indicator of what ourresults of operations, financial condition and cash flows will be in thefuture.  Therefore, you should not makeany assumptions regarding our future performance based on the historicalfinancial information in this report.

 

16

----

 

***Our stock price may be volatile, andyour investment in our stock could decline in value.***

 

The market price for ourcommon stock has been highly volatile and may continue to be highly volatile inthe future.  During May andJune 2004, when our common stock traded independently following thedistribution, the closing price was $5.23 per share at its low point inJune 2004 and $8.18 per share at its high point in May 2004.  Our quarterly operating results, changes ingeneral 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 stock market has experienced significant price andvolume fluctuations.

 

While we are unaware of aspecific reason that any of the following factors will have a material impacton our stock price, the following factors, in addition to the factors describedin the other risk factors contained in this report, may have a significantimpact on the market price of our common stock:

 

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

 

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

 

**•**                  developments concerning proprietary rights, includingpatents;

 

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

 

**•**                  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.

 

***We have agreed to certainrestrictions to preserve the tax treatment of the distribution, which willreduce our strategic and operating flexibility.***

 

Accelrysobtained an opinion from Dechert LLP, its counsel, to the effect that thedistribution qualifies as a transaction that is generally tax-free underSections 355 and/or 368(a)(1)(D) of the Internal Revenue Code of 1986, asamended (the “Code”). Current tax law generally creates a presumption that thedistribution would be taxable to Accelrys but not to its stockholders if weengage in, or enter into an agreement to engage in, a transaction that wouldresult in a 50 percent or greater change by vote or by value in our stockownership during the four-year period beginning on the date that begins twoyears before the distribution date, unless it is established that thetransaction is not pursuant to a plan or series of transactions related to thedistribution.

 

Temporary U.S. Treasuryregulations currently in effect generally provide that whether an acquisitiontransaction and a distribution are part of a plan is determined based on all ofthe facts and circumstances, including but not limited to those specificfactors listed in the regulations. In addition, the regulations provide several“safe harbors” for acquisition transactions that are not considered to be partof a plan.

 

We and Accelrys have enteredinto a tax sharing agreement under which we have made certain covenants to eachother in connection with the distribution that we may not take certain actionswithout first obtaining an unqualified opinion of counsel or an InternalRevenue Service ruling that such actions will not cause the distribution tobecome taxable.  Pursuant to thesecovenants, generally (1) we may not liquidate, merge, or consolidate with anyother person, sell our assets except in the ordinary course of business, orenter into any substantial negotiations, agreements, or arrangements withrespect to any such transaction, for at least six months after the distributiondate; (2) we will, for two years after the distribution date, continue theactive conduct of the drug discovery business; (3) we will not repurchase ourstock except in certain circumstances permitted by the Internal RevenueService; (4) we will not take any actions inconsistent with the representationsmade in connection with the issuance by Dechert LLP of its opinion with respectto the distribution; and (5) we will not take or fail to take any other actionthat would result in any tax being imposed on the distribution.  Accelrys may seek an injunction to enforcethese covenants.  Particularly during thesix-month period following the distribution, these restrictions couldsubstantially limit our strategic and operational flexibility, including ourability to finance our operations by

 

17

----

 

issuingequity securities, to make acquisitions using equity securities, to repurchaseour equity securities, to raise money by selling assets, or to enter intobusiness combination transactions.

 

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

 

Wehave agreed to indemnify Accelrys for any taxes and related losses (includingany applicable interest and penalties, all related accounting, legal and otherprofessional fees, all related court costs and all costs, expenses and damagesassociated with related stockholder litigation or controversies and any amountpaid in respect of the liability of stockholders) resulting from a breach ofany of the covenants described above. Furthermore, we will be responsible for taxes that may be imposed uponAccelrys pursuant to section 355(e) of the Code in connection with atransaction that results in a change in control of us, even though we will haveobtained an Internal Revenue Service ruling or an unqualified opinion ofcounsel prior to the transaction.  Theamount of any indemnification payments could be substantial.  The amount of Accelrys taxes for which we areagreeing to indemnify Accelrys will be based on the excess of the aggregatefair market value of our stock as of the distribution date over Accelrys taxbasis in our stock.

 

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

 

Underthe terms of the master separation and distribution agreement and the taxsharing and indemnification agreement that we entered into with Accelrys, weand Accelrys agreed to indemnify one another from and after the distributionwith respect to the indebtedness, liabilities and obligations retained by ourrespective companies.  Theseindemnification obligations could be significant.  Our ability to satisfy any such indemnificationobligations will depend upon the future financial strength of our company.  We cannot determine whether we will have toindemnify Accelrys for any substantial obligations.  We also cannot assure you that, if Accelrysbecomes obligated to indemnify us for any substantial obligations, Accelryswill have the ability to satisfy those obligations.  Any payment by Accelrys or us pursuant tothese indemnification provisions could have a material adverse effect on itsbusiness.  Any failure by Accelrys or usto satisfy its indemnification obligations could have a material adverse effecton the other company’s business.

 

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

 

Historically,all of our financing was done by Accelrys at the parent level. We anticipatethat our capital resources, including our existing cash, cash equivalents andmarketable securities as of June 30, 2004 of approximately $41.9 million,will be adequate to fund our operations at least through 2005.  Any future financing that we need to obtainwill have to be raised on a stand-alone basis without reference to or relianceon Accelrys’ financial condition and will be based upon our balance sheet.  In addition, we may be required to agree toabide by restrictive covenants that may limit our ability to do business as acondition to securing debt or equity financing. We may not be able to secure adequate debt or equity financing ondesirable terms or at all.  We have lessfinancial and other resources than Accelrys had prior to the distribution.  Our ability to obtain financing, and theterms thereof, will in large part depend on our financial condition and performance.  There can be no assurance that we will beable to obtain financing.  The cost to usof stand-alone financing may be materially higher than the cost of financingthat we incurred as part of Accelrys.

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

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

 

Weare highly dependent on pharmaceutical and biotechnology companies continuingto collaborate with outside companies to obtain drug discovery expertise. Ourrevenue depends to a large extent on research and development expenditures bythe pharmaceutical and biotechnology industries, particularly companiesoutsourcing research and development projects and adding new and improvedtechnologies to accelerate their drug discovery and development initiatives.Our capabilities include aspects of the drug discovery process thatpharmaceutical companies have traditionally performed internally. Althoughthere is a history among pharmaceutical and biotechnology companies ofoutsourcing drug research and development functions, this practice may notcontinue.

 

18

----

 

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

 

Ourability to convince these companies to use our drug discovery technology andcapabilities rather than develop them internally will depend on many factors,including our ability to:

 

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

 

**•**                  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.

 

Theimportance of these factors varies from collaborator to collaborator, and wemay be unable to meet any or all of them for some or all of our collaboratorsin the future.

 

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

 

Duringthe six months ended June 30, 2004, we earned approximately $6.6 million,or 63% of our revenue, under our research collaboration agreements withSchering-Plough, one of our longest-standing collaborative partners. In thethird quarter of 2003, we entered into new multiyear drug discoverycollaboration agreements with Schering-Plough, which continue certain existingprograms and implement a number of new activities. The new agreements continueour collaboration with this partner through at least August 2006 and,under their terms, may be extended by the parties for up to three additionalyears based upon progress made in the programs governed by the agreements. Theagreements may be terminated at the end of the third year. The agreementsprovide unless certain research milestones are achieved Schering-Plough’sfunding obligations may be reduced significantly before that time. There can beno assurance that the results of our collaboration with Schering-Plough will besufficient to cause Schering-Plough not to exercise its rights to terminate theagreements, or not to exercise its rights to reduce its funding obligations. Inlight of the significance to us of the Schering-Plough relationship, thetermination of our collaboration agreements or the reduction in funding fromthe agreements would have a material adverse effect on us.

 

Duringthe six months ended June 30, 2004, we earned approximately $1.8 million,or 17% of our revenue, under our research collaboration agreements with N.V.Organon, our second largest customer. The principal agreement with N.V.Organon, entered into in February 2002, has a stated term of five years;however, N. V. Organon has the right to terminate the agreement if we areunable to deliver compounds meeting the criteria specified in the agreement. Wehave already delivered the first such compound required under this agreement toN.V. Organon. A second deliverable timepoint occurs in 2005. If we are unableto deliver compounds meeting the criteria specified in the agreement, Organonhas the right to terminate the agreement. There can be no assurance that thesecompounds will be compliant, or that the future compliant compounds will bedelivered before the enumerated dates. The termination of this agreement wouldhave a material adverse effect on us because of the resulting decrease in ourrevenue.

 

Duringthe year ended December 31, 2003, we earned approximately $3.4 million, or11.4% of our revenue, under our research collaboration agreements with NovartisAG, our third largest customer in that year. We have completed all of therequired services under our Novartis agreements.   Although the agreement was extended byNovartis in 2004 we have not yet initiated additional revenue generatingactivities.  In addition, we havereceived all compensation with regard to collaborative services under theseagreements. If we are unable to

 

19

----

 

enterinto agreements with other collaborators, there could be a material adverseeffect on us because of the resulting decrease in our revenue.

 

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

 

Ourcollaborators, Bristol-Myers Squibb Company, Daiichi Pharmaceutical Co. andSchering-Plough Corporation, currently are performing clinical trials ofprospective pharmaceutical products containing our proprietary compounds. Ineach case, the collaborator is responsible for the development of thesepotential products, the level of resources devoted to such development and thedecision as to when, or whether, such development should cease. Numerousadditional studies are necessary to support the further development of theseproduct candidates. Results from preclinical studies conducted to date on theseproduct candidates are not necessarily indicative of the results that may beobtained in clinical studies. Results from additional studies could cause our collaboratorsto discontinue or limit development of these product candidates. There can beno assurance that Bristol-Myers Squibb, Daiichi or Schering-Plough willcontinue to develop these programs. In addition, our collaborators may pursuealternative technologies or drug candidates, either on their own or incollaboration with others, that compete with our clinical candidates. If ourcollaborators do not continue their development efforts or if such efforts donot result in positive clinical results, we will not receive additionalmilestone and royalty payments from those efforts, and the market price of ourcommon stock will be materially and adversely affected.

 

***The development of our products is atan early stage and is uncertain.***

 

Drugdevelopment is a highly uncertain process. Our approach and technology maynever result in a commercial drug. None of our compounds are contained inproducts that have received regulatory approval for commercial sale, andcurrently we have only four candidates with respect to which clinical trials(i.e., human testing) have been commenced. All of our therapeutic candidates,including these clinical candidates, face the substantial risks of failureinherent in the drug development process. Any potential pharmaceutical productemanating from one of our internal or collaborative programs must satisfyrigorous standards of safety and efficacy before the United States Food andDrug Administration (FDA) and foreign regulatory authorities will approve themfor commercial use. To satisfy these standards, significant additionalresearch, preclinical studies (i.e., animal testing) and clinical trials willbe required.

 

Preclinicaland clinical development of drug candidates is a long, expensive and uncertainprocess. Failure can occur at any stage of testing. Success in preclinicaltesting does not ensure that clinical trials will be successful. Based onresults at any stage of product development, our development collaborators orwe may decide to discontinue development of our product candidates.

 

Ourproduct candidates and research programs are in the early stages of developmentand require significant, time-consuming and costly research and development,testing and regulatory approvals. We do not expect that our product candidateswill be commercially 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 have notidentified a therapeutic candidate that has been developed into a commercialdrug using our platform. It is uncertain whether our technology platform willachieve these goals at all or whether it will be competitive with platformsused by our competitors.

 

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

 

Weanticipate that our capital resources, including our existing cash, cashequivalents and marketable securities as of June 30, 2004 of approximately$41.9 million, will be adequate to fund our operations at least through 2005.However, changes may occur that would consume available capital resourcesbefore that time. While we are unaware of a specific reason that any suchfactor will have a material impact on our capital requirements, examples ofrelevant factors include:

 

**•**                  the costs associated with drug discoveryservices;

 

**•**                  our internal proprietary drug discoveryactivities;

 

20

----

 

**•**                  competing technological and marketdevelopments;

 

**•**                  changes in our existing collaborativerelationships;

 

**•**                  the cost of filing, prosecuting, defending andenforcing patent claims and other intellectual property rights, and the outcomeof related litigation;

 

**•**                  the purchase of additional capital equipment;

 

**•**                  acquisitions of other businesses ortechnologies; and

 

**•**                  the progress of our milestone and royaltyproducing activities.

 

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

 

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

 

Thecompound basis for drugs developed by a customer may be a derivative oroptimized version of the compound screened or optimized by us. While ourexisting collaborative agreements provide that we will receive milestonepayments and royalties with respect to certain products developed from certainderivative compounds, there can be no assurance that disputes will not ariseover the application of payment provisions to such products. There can be noassurance that current or future collaborative partners will not pursuealternative technologies, or develop alternative products either on their ownor in collaboration with others, including our competitors, as a means fordeveloping treatments based on the targets which are the subject of thecollaborative arrangements with us.

 

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

 

Oneof our business strategies is to expand our proprietary pipeline of drugcandidates and to then enter into collaborations for the development of thesedrug candidates that will allow us to earn milestone, royalty and/or licensepayments. Our proprietary drug discovery program is in its early stage ofdevelopment and is unproven. Although we have expended, and continue to expend,time and money on internal research and development programs, we may be unsuccessfulin creating valuable proprietary drug candidates that would enable us to formadditional collaborations and receive milestone, royalty and/or licensepayments.

 

Ourcollaborations and internal programs may not result in the discovery ofpotential drug candidates that will be safe or effective. Although we havereceived license and milestone fees to date, we may never receive any royaltypayments, or any additional license and milestone fees, under our current orany future collaborations. Our receipt of any future milestone, royalty orlicense payments depends on many factors, including whether our collaboratorsdesire to or are able to continue to pursue a potential drug candidate and theultimate commercial success of the drug. Development and commercialization ofpotential drug candidates depend not only on the achievement of researchobjectives by our collaborators and us, but also on each collaborator’sfinancial, competitive, marketing and strategic considerations and regulationin the United States and other countries. If unforeseen complications arise inthe development or commercialization of the potential drug candidates by ourcollaborators, we may not realize milestone, royalty or license payments.

 

***The drug research and developmentindustry is highly competitive and subject to technological change, and we maynot have the resources necessary to compete successfully.***

 

Manyof our competitors have access to greater financial, technical, research,marketing, sales, distribution, service and other resources than we do.Moreover, the pharmaceutical and biotechnology industries are characterized bycontinuous technological innovation. We anticipate that we will face increasedcompetition in the future as new companies enter the market and our competitorsmake advanced

 

21

----

 

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.

 

Inaddition, due to improvements in global communications, combined with thesupply of lower cost Ph.D. level scientific talent in offshore locations suchas China, India and Eastern Europe, we face the growing threat of competitionfor our services.

 

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

 

Wemay need to successfully structure and manage multiple drug discovery programsand collaborative relationships, including maintaining confidentiality of theresearch being performed for multiple collaborators. We may be unable to managesuccessfully conflicts between competing drug development programs of thirdparties to which we offer services. From time to time, more than one of ourcollaborators may want to perform research concerning the same or molecularlysimilar disease targets. Because of that, we may be required to reconcile ourrelationships with those collaborators, particularly if both want to establishexclusive relationships with us with respect to that target or if onecollaborator has an existing arrangement with us and the other would like us toperform services regarding a target restricted by that arrangement. Further, ifwe are working with a collaborator regarding a particular target, another ofour collaborators may be researching the same target in one of its internalprograms of which we have no knowledge. As a result, potential conflictsinvolving us may arise due to this competition between collaborators in aparticular disease field of interest. Conflicts also may arise between ourcollaborators as to proprietary rights to particular compounds in our librariesor as to proprietary rights to biological targets such as receptors or enzymesagainst which we screen compounds in our libraries. The occurrence ofconflicts, or the perception of conflicts, could have a material adverse effecton our business, financial condition and results of operations.

 

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

 

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

 

Wecannot completely eliminate the risk of accidental contamination or injury fromthe use, storage, handling or disposal of these materials. In the event ofcontamination or injury, we could be held liable for damages that result. Wemaintain insurance coverage against environmental hazards arising from thestorage and disposal of the materials utilized in our business. Although ourmanagement believes that such insurance has terms, including coverage limits,which are appropriate for our business, liabilities arising from the use,storage, handling or disposal of these materials could exceed our insurancecoverage as well as our resources. We are subject to federal, state and locallaws and regulations governing the use, storage, handling and disposal of thesematerials and specified waste products. The cost of compliance with these lawsand regulations could be significant. To our knowledge, we have not been, andcurrently are not, the subject of any governmental investigation concerning theviolation of these federal, state and local laws and regulations. There can beno assurance that we will not be the subject of future investigations bygovernmental authorities.

 

***We and our products are subject tostrict government regulation, which may limit the development of products by usor our collaborators.***

 

Regulationby governmental entities in the United States and other countries will be asignificant factor in the production and marketing of any pharmaceuticalproducts our customers or we may develop. The

 

22

----

 

natureand the extent to which government regulation may apply to our customers and uswill vary depending on the nature of the pharmaceutical products, if any.Virtually all pharmaceutical products require regulatory approval prior tocommercialization. If we or our collaborators or licensees fail to obtain, orencounter delays in obtaining or maintaining, regulatory approvals, ourfinancial results could be adversely affected. Similar regulatory proceduresare required in countries outside the United States.

 

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

 

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

 

Forthe fiscal years ended December 31, 2001, 2002 and 2003, we had net lossesof approximately $6.6 million, $2.1 million and $2.8 million,respectively.  During the six monthperiod ended June 30, 2004, we had net losses of approximately $13.4million, including restructuring and other charges of $5.9 million.  Continuing net losses may limit our abilityto fund our operations and we may not generate income from operations in thefuture.

 

Whilewe are unaware of a specific reason that any of the following factors is likelyto occur, our future profitability depends upon many factors, including severalthat are beyond our control. These factors include:

 

**•**                  changes in the demand for collaborativerelationships with us, or for our services;

 

**•**                  the introduction of competitive drug discoveryservices;

 

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

 

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

 

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

 

***Rapid changes in technology couldhave an adverse impact on our business.***

 

Rapidtechnological change and uncertainty due to new and emerging technologiescharacterize the drug discovery industry. We may be unable to develop,integrate and market, on a timely basis, new and enhanced services necessary tokeep pace with competitors. Our services and technologies may be renderedobsolete by the offerings of our competitors. Although we do not believe thereare currently new significant technologies that we need to incorporate in ourbusiness to remain competitive in our industry, failure to anticipate or to respondto changing technologies, or significant delays in the development orintroduction of services, could cause customers to delay or decide againstpurchases of our services.

 

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

 

Weare a small company, and our success depends in part on the continued serviceof key scientific, business development and management personnel, including our incoming 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

 

23

----

 

employeescould retire or otherwise leave our employ within the foreseeable future, andthe loss of any of these people could have a material adverse effect on ourbusiness, financial condition and results of operations. We do not, and do notintend to, maintain key person life insurance on the life of any employee.

 

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

 

Theultimate success of our business plan heavily depends upon the successfuldiscovery, development and commercialization of pharmaceutical products. Ourendeavors will result in commercialized pharmaceutical products, if at all,only after significant preclinical and clinical development, requisiteregulatory approvals, establishment of manufacturing capabilities and successfulmarketing. We do not currently have the technology, facilities, personnel orexperience to accomplish all of these tasks on our own, and we will likely nothave all the necessary resources in the foreseeable future. Therefore, wecontinue to depend heavily upon the expertise and dedication of sufficientresources by collaborative partners to develop and commercialize productsprimarily based on lead compounds discovered by us. If a collaborative partnerfails to develop or commercialize a compound or product with respect to whichit has rights from us, we may not receive any future milestone payments orroyalties associated with that compound or product. Similarly, while we areunaware of a specific reason that any of the following factors will be experiencedby our strategic collaborators, because we rely heavily on them, our revenuecould be adversely affected if our collaborators:

 

**•**                  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 to ourpartnered programs or potential products;

 

**•**                  terminate their alliances or arrangements withus;

 

**•**                  develop, either alone or with others, productsthat may compete with our product candidates;

 

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

 

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

 

***We are subject to risks associatedwith the operation of an international business***

 

Inthe six month period ended June 30, 2004, approximately 58% of our revenuewas derived from customers outside the United States. Approximately 52% of ourrevenue was derived from customers in Europe, and approximately 6% was derivedfrom customers in the Asia/Pacific region. We anticipate that internationalrevenue will continue to account for a significant percentage of our overallrevenue. While we are unaware of a specific reason that any of the followingfactors will have a material impact on our revenue, our internationaloperations are subject to the risk factors inherent in the conduct ofinternational business, including:

 

**•**                  unexpected changes in regulatory requirements;

 

**•**                  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;

 

24

----

 

**•**                  difficulties in staffing and managing foreignjoint venture operations; and

 

**•**                  potentially adverse tax consequences.

 

Wemay not be able to sustain or increase our international revenue. Any of theforegoing factors may have a material adverse effect on our internationaloperations and, therefore, our business, financial condition and results ofoperations.

 

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

 

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

 

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

 

Wedepend on our laboratories and equipment for the continued operation of ourbusiness. Our research and development operations and administrative functionsare primarily conducted at our facilities in the Princeton, New Jersey area.Although we have contingency plans in effect for natural disasters or othercatastrophic events, catastrophic events could still disrupt our operations.Even though we carry business interruption insurance policies, we may sufferlosses as a result of business interruptions that exceed the coverage availableunder our insurance policies. Any natural disaster or catastrophic event in ourfacilities or the areas in which they are located could have a significantnegative impact on our operations.

 

***Because we do not intend to paydividends, you will benefit from an investment in our common stock only if itappreciates in value.***

 

Wehave never declared or paid any cash dividend on common stock. We currentlyintend to retain our future earnings, if any, to finance the expansion of ourbusiness and do not expect to pay any cash dividends in the foreseeable future.As a result, the success of your investment in our common stock will depend entirelyupon any future appreciation in its value. There is no guarantee that ourcommon stock will appreciate in value or even maintain the price at which yourshares traded immediately after the distribution.

 

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

 

Section 203of the Delaware General Corporation Law may delay or deter attempts to securecontrol of our company without the consent of our management. In general,Section 203 prohibits a publicly-held Delaware corporation from engagingin a business combination with an interested stockholder for a period of threeyears following the date the person becomes an interested stockholder, unlesscertain conditions are met.

 

Ouramended and restated certificate of incorporation and amended and restatedbylaws contain several provisions that could delay or make more difficult theacquisition of our company through a hostile tender offer, open marketpurchases, proxy contest, merger or other takeover attempt that a stockholdermight consider in his or her best interest, including those attempts that mightresult in a premium over the market price of our common stock. Such provisionsinclude the issuance of preferred stock without approval of the holders of ourcommon stock, the classification of our board of directors, the election andremoval of directors, restrictions on the ability of stockholders to takeaction without a meeting, restrictions on stockholders’ ability to call aspecial meeting and advance notice procedures regarding any proposal ofstockholder business to be discussed at a stockholders meeting.

 

25

----

 

Wehave adopted a stockholder rights plan, which is triggered upon commencement orannouncement of a hostile tender offer or when any one person or group acquires15% or more of our common stock. The rights plan, once triggered, enablesstockholders to purchase our common stock, and the stock of the entity acquiringus, at reduced prices. These provisions of our governing documents, stockholderrights plan and Delaware law could have the effect of delaying, deferring orpreventing a change of control, including without limitation a proxy contest,making more difficult the acquisition of a substantial block of our commonstock. The provisions could also limit the price that investors might bewilling to pay in the future for shares of our common stock. Further, theexistence of these anti-takeover measures may cause potential bidders to lookelsewhere, rather than initiating acquisition discussions with us.

 

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

 

Fromtime to time, we may choose to acquire complementary businesses, products ortechnologies instead of developing them ourselves. We do not know if we will beable to complete any acquisitions, or whether we will be able to successfullyintegrate any acquired businesses, operate them profitably or retain their keyemployees. Integrating any business, product or technology we acquire could beexpensive and time-consuming, disrupt our ongoing business and distract companymanagement. In addition, in order to finance any acquisition, we might need toraise additional funds through public or private equity or debt financings. Inthat event, we could be forced to obtain financing on less than favorable termsand, in the case of equity financing, on terms that may result in dilution toour stockholders. lf we are unable to integrate any acquired entities, productsor technologies effectively, our business will suffer. In addition, undercertain circumstances, amortization of assets or charges resulting from thecosts of acquisitions could harm our business and operating results.

 

**CERTAIN RISKS RELATED TO INTELLECTUAL PROPERTY**

 

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

 

Thepatent positions of pharmaceutical and biotechnology companies are uncertain andinvolve complex legal and factual questions. The coverage claimed in a patentapplication can be significantly reduced before the patent is issued. There isa significant risk that the scope of a patent may not be sufficient to preventthird parties from marketing other products or technologies with the samefunctionality of our products and technologies. Consequently, some or all ofour patent applications may not issue into patents, and any issued patents mayprovide ineffective remedies or be challenged or circumvented.

 

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

 

Patentapplications in the United States are maintained in secrecy for 18 months fromfiling or until a patent issues. Under certain circumstances, patentapplications are never published but remain in secrecy until issuance. As aresult, others may have filed patent applications for products or technologycovered by one or more pending patent applications upon which we are relying.If applications covering similar technologies were to be filed before ourapplications, our patent applications may not be granted. There may bethird-party patents, patent applications and other intellectual property or informationrelevant to our chemical compositions and other technologies that are not knownto us, that block us or compete with our chemical compositions or othertechnologies, or limit the scope of patent protection available to us.Moreover, from time to time, patents may issue which block or compete with ourchemical compositions or other technologies, or limit the scope of patentprotection available to us. Litigation may be necessary to enforce patentsissued to us or to determine the scope and validity of the intellectualproperty rights of third parties.

 

***We may not be able to protectadequately the trade secrets and confidential information that we disclose toour employees.***

 

Werely upon trade secrets, technical know-how and continuing technological innovationto develop and maintain our competitive 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

 

26

----

 

agreements.These agreements typically provide that all materials and confidentialinformation developed by or made known to the employee or consultant duringhis, her or its relationship with us are to be kept confidential, and that allinventions arising out of the employee’s relationship with us are our exclusiveproperty. Our employees and consultants may breach these agreements, and insome instances we may not have an adequate remedy. Additionally, in someinstances, we may have failed to require that employees and consultants executeconfidentiality and assignment-of-inventions agreements.

 

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

 

Webelieve that our success depends, in part, upon our ability to obtaininternational protection for our intellectual property. However, the laws ofsome foreign countries may not be as comprehensive as those of the UnitedStates and may not be sufficient to protect our proprietary rights abroad. Inaddition, we may decide not to pursue patent protection outside the UnitedStates, because of cost and confidentiality concerns. Accordingly, ourinternational competitors could obtain foreign patent protection for, andmarket overseas, products and technologies for which we are seeking U.S. patentprotection and may be able to use these products and technologies to competeagainst us.

 

***We may not be able to adequatelydefend our intellectual property from third party infringement, and third partychallenges to our intellectual property may adversely affect our rights and becostly and time consuming.***

 

Someof our competitors have, or are affiliated with companies having, substantiallygreater resources than we have, and those competitors may be able to sustainthe costs of complex patent litigation to a greater degree and for longerperiods of time than us. Uncertainties resulting from the initiation andcontinuation of any patent or related litigation could have a material adverseeffect on our ability to compete in the marketplace pending resolution of thedisputed matters. If our competitors prepare and file patent applications inthe United States that claim technology also claimed by us, we may have toparticipate in interference proceedings declared by the U.S. Patent andTrademark Office to determine the priority of invention, which could result insubstantial costs to us, even if the outcome is favorable to us. Similarly,opposition proceedings may occur overseas, which may result in the loss ornarrowing of the scope of claims or legal rights. Such proceedings will atleast result in delay in the issuance of enforceable claims. An adverse outcomecould subject us to significant liabilities to third parties and require us tolicense disputed rights from third parties or cease using the technology.

 

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

 

Evenif patents are issued to us, these patents may not sufficiently protect ourinterest in our chemical compositions or other technologies because the scope ofprotection provided by any patents issued to or licensed by us are subject tothe uncertainty inherent in patent law. Third parties may be able to designaround these patents or develop unique products providing effects similar toour products. In addition, others may discover uses for our chemicalcompositions or technologies other than those uses covered in our patents, andthese other uses may be separately patentable. A number of pharmaceutical andbiotechnology companies, and research and academic institutions, have developedtechnologies, filed patent applications or received patents on varioustechnologies that may be related to our business. Some of these technologies,patent applications or patents may conflict with our technologies, patent applicationsor patents. These conflicts could also limit the scope of patents, if any, thatwe may be able to obtain, or result in the denial of our patent applications.We are not currently aware of any such patent applications or patents thatcould have a material adverse effect on our business.

 

***We may be subject to claims ofinfringement by 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 orotherwise used or disclosed the alleged trade secrets or other proprietaryinformation of a former employer. From time to time, we have received lettersclaiming or suggesting that our products or activities may infringe third partypatents or other intellectual property rights. Our products may infringe patentor other intellectual property rights of third parties. A number of patents mayhave been issued or may be issued in the future that could cover certainaspects of our technology and that could prevent us from using technology thatwe use or expect to use. We may be required to seek licenses for, or otherwiseacquire

 

27

----

 

rightsto, technology as a result of claims of infringement. We may not possess properownership or access rights to the intellectual property we use. Third partiesor other companies may bring infringement suits against us. Any claims, with orwithout merit, could be time consuming to defend, result in costly litigation,divert management’s attention and resources or require us to enter into royaltyor licensing agreements. Royalty or licensing agreements, if required, may notbe available on terms acceptable to us, if at all. In the event of a successfulclaim of product infringement against us, our failure or inability to licenseor design around the infringed technology could have a material adverse effecton our business, financial condition and results of operations. We are notcurrently involved in actions of this type that are material to our business.

 

**Item3. 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 minimaldebt.  We ensure the safety andpreservation of invested funds by limiting default risks, market risk andreinvestment risk.  We mitigate defaultrisk by investing in investment grade securities.  A hypothetical 100 basis point adverse movein interest rates along the entire interest rate yield curve would notmaterially affect the fair value of our interest sensitive financialinstruments at June 30, 2004.

 

**Item 4.  Controls and Procedures**

 

Forthe quarterly period ending June 30, 2004 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 Rules13a-15 and 15d-15 under the Securities Exchange Act of 1934, or the ExchangeAct, as of the end of the period covered by this report.  Our President and Chief Executive Officer andour Vice President, Finance concluded that there were no significant changes inour disclosure controls and procedures or in other factors that couldsignificantly affect our disclosure controls and procedures during thequarterly period.  Based upon thisevaluation, our President and Chief Executive Officer and our Vice President,Finance concluded that as of June 30, 2004, our disclosure controls andprocedures have been designed and are being operated in a manner that providesreasonable assurance that the information required to be disclosed by us inreports filed under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the rules and forms of theSEC.  Our management, including the ChiefExecutive 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 June 30, 2004, that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PARTII.  OTHER INFORMATION**

 

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

 

Presently,we are not party to any litigation.

 

**Item 2.****          ****Changes in Securi****ties, Use of Proceeds andIssuer Purchases of Equity Securities**

 

**On April 8, 2004, we amendedand restated our certificate of incorporation (as amended, the “Amended andRestated Certificate of Incorporation”) and bylaws (as amended, the “Amendedand Restated Bylaws”), which define the rights of the holders of our commonstock, par value $0.01 per share. The material terms of the Amended andRestated Certificate of Incorporation and the Amended and Restated Bylaws aresummarized in the section entitled “Description of Capital Stock” in ourregistration statement on Form 10 (SEC File No. 0-50523).**

 

28

----

 

**On April 6, 2004, our Board ofDirectors adopted a stockholder rights plan (the “Rights Plan”), whichauthorized and declared a dividend of one preferred share purchase right foreach outstanding share of common stock, par value $0.01 per share, outstandingas of the close of business on April 30, 2004.  The material terms of the Rights Plan aresummarized in the section entitled “Description of Capital Stock” in ourregistration statement on Form 10 (SEC File No. 0-50523).**

** **

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

 

None.

 

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

 

**Prior to the distribution byAccelrys of our common stock to all holders with outstanding Accelrys commonstock, Accelrys, as our sole stockholder and acting by written consent aspermitted by Delaware law, approved the following matters on the dates indicated:(1) on April 5, 2004, the election of Frank Baldino, Jr., Ph.D., Paul A.Bartlett, Ph.D., Gary E. Costley, Ph.D., James J. Marino, Joseph A. Mollica,Ph.D. and Bruce A. Peacock to our board of directors to hold office until theirsuccessors are duly elected and qualified; (2) on April 8, 2004, theAmended and Restated Certificate of Incorporation; and (3) onApril 8, 2004, our adoption of the Pharmacopeia Drug Discovery, Inc. 2004Stock Incentive Plan; and (4) on April 28, 2004, our adoption of thePharmacopeia Drug Discovery, Inc. Employee Stock Purchase Plan.**

** **

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

 

None.

 

**Item 6.****          ****Exhibits and Reports on Form8-K**

 

(a) Exhibits.

 
| 10.1   |   | Employment  Agreement, dated July 14, 2004, between Pharmacopeia Drug Discovery,  Inc. and Leslie J. Browne, Ph.D.  (1)                                                                                                                 |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                              |
| 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)                                    |

 

----

(1)                                  Filed herewith.

 

(b)Reports on Form 8-K.

 

OnApril 22, 2004, we filed a current report on Form 8-K reporting that weexpected to make presentations concerning our business to certain investors andattaching the materials utilized during the presentations as an exhibit to thereport.

 

On May 3, 2004, we filed a current report on Form8-K reporting the distribution by Accelrys of all outstanding shares of ourcommon stock to the holders of common stock of Accelrys.

 

29

----

 

**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:  August 6,  2004 | By:                                 | /s/  Joseph A. Mollica |
|                                  |                                | Joseph  A. Mollica |
|                                  |                                | Chairman,  President and Chief  Executive Officer |
|                                  |                                |   |
|                                  |                                |   |
|                                  | By:                                 | /s/  Brian M. Posner |
|                                  |                                | Brian  M. Posner |
|                                  |                                | Vice  President, Finance |

 

30

----

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**INDEX TO EXHIBITS**

 
| **No.** | ** ** | **EXHIBIT**                                                                           |
|---------|------------|---------------------------------------------------------------------------------------|
|    |       |                                                                                  |
| 10.1    |       | Employment  Agreement between Pharmacopeia Drug Discovery and Leslie J. Browne, Ph.D. |
|    |       |                                                                                  |
| 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                    |

 

31

----