**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934.**

 

**FOR THEQUARTERLY PERIOD ENDED MARCH 31, 2004**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIESEXCHANGE ACT**

 

**FOR THETRANSITION PERIOD FROM                  TO                  **

 

**COMMISSIONFILE NUMBER 000-30469**

 

**deCODE genetics, Inc.**

(Exact Name of Registrant asSpecified in Its Charter)

 
| **Delaware**                                                     |   | **04-3326704**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State  or Other Jurisdiction of  Incorporation or Organization) |   | (I.R.S.  Employer Identification No.) |

 

**STURLUGATA8, IS-101 REYKJAVIK, ICELAND**

(Address of PrincipalExecutive Offices)

 

**+354-570-1900**

(Registrant’s TelephoneNumber, Including Area Code)

 

Indicate by check whether theregistrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days. Yes ýNo o

 

Indicate by check whether theregistrant is an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).  Yes ýNo o

 

The aggregate number of shares of the registrant’s common stockoutstanding on April  30, 2004 was54,501,425 shares of common stock $.001 par value.

 

 

----

 

**deCODEgenetics, Inc.**

 

**INDEX**

 
| PART I.                    | FINANCIAL INFORMATION                                                                                |   |
|----------------------------|------------------------------------------------------------------------------------------------------|--------|
|                       |                                                                                                 |   |
| Item 1.                    | Financial Statements  (unaudited)                                                                    |   |
|                       |                                                                                                 |   |
|                       | Condensed  Consolidated Statements of Operations for the three-months ended March 31,  2004 and 2003 |   |
|                       |                                                                                                 |   |
|                       | Condensed  Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003                    |   |
|                       |                                                                                                 |   |
|                       | Condensed  Consolidated Statements of Cash Flows for the three-months ended March 31,  2004 and 2003 |   |
|                       |                                                                                                 |   |
|                       | Notes  to Condensed Consolidated Financial Statements                                                |   |
|                       |                                                                                                 |   |
| Item 2.                    | Management’s Discussion and  Analysis of Financial Condition and Results of Operations          |   |
|                       |                                                                                                 |   |
| Item 3.                    | Quantitative and Qualitative Disclosures about  Market Risk                                          |   |
|                       |                                                                                                 |   |
| Item 4.                    | Controls and Procedures                                                                              |   |
|                       |                                                                                                 |   |
| PART II. OTHER INFORMATION |                                                                                                 |
|                       |                                                                                                 |   |
| Item 1.                    | Legal proceedings                                                                                    |   |
|                       |                                                                                                 |   |
| Item 2.                    | Changes in securities, use of proceeds and  issuer purchases of equity securities                    |   |
|                       |                                                                                                 |   |
| Item 5.                    | Other Information                                                                                    |   |
|                       |                                                                                                 |   |
| Item 6.                    | Exhibits and  Reports on Form 8-K                                                                    |   |
|                       |                                                                                                 |   |
|                       | (a) Exhibits                                                                                         |   |
|                       |                                                                                                 |   |
|                       | (b) Reports on Form 8-K                                                                              |   |
|                       |                                                                                                 |   |
| Signatures                 |                                                                                                 |
|                       |                                                                                                 |   |
| Index to Exhibits          |                                                                                                 |

 

2

----

 

**PART I.FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

(in thousands, except shareand per share amounts)

unaudited

 
|                                                           |   | **FOR THE  THREE-MONTHS ENDED MARCH 31,** | ** ** |
|----------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                           |   | **2004**                                  |       | **2003** | ** ** |
|                                                           |   |                                      |       |   |   |
| REVENUE                                                        |   | $                                         | 10,282     |   | $ | 11,842 |   |
|                                                           |   |                                      |       |   |   |
| OPERATING EXPENSES                                             |   |                                      |       |   |   |
|                                                           |   |                                      |       |   |   |
| Research and development, including  cost of revenue           |   | 15,433                                    |       | 19,671 |   |
| Selling, general and administrative                            |   | 4,263                                     |       | 4,257 |   |
| Employee termination charges                                   |   | 0                                         |       | 485 |   |
| Total operating expense                                        |   | 19,696                                    |       | 24,413 |   |
| Operating loss                                                 |   | (9,414                                    | )          | (12,571 | ) |
| Interest income                                                |   | 235                                       |       | 355 |   |
| Interest expense                                               |   | (1,199                                    | )          | (916 | ) |
| Other non-operating income and  (expense), net                 |   | (1,658                                    | )          | 90 |   |
| Net Loss                                                       |   | $                                         | (12,036    | ) | $ | (13,042 | ) |
|                                                           |   |                                      |       |   |   |
| Basic and diluted net loss per  share                          |   | $                                         | (0.23      | ) | $ | (0.25 | ) |
|                                                           |   |                                      |       |   |   |
| Shares used in computing basic and  diluted net loss per share |   | 52,927,462                                |       | 51,156,718 |   |

 

The accompanying notes arean integral part of the condensed consolidated financial statements.

 

3

----

 

**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

(in thousands, except shareamounts) 

unaudited

 
|                                                                                                                                    |   | **MARCH 31,  2004** |    | **DECEMBER  31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-------------------------|------------|
|                                                                                                                                    |   |                |    |                    |       |
| ASSETS                                                                                                                                  |   |                |    |                    |       |
| Current assets:                                                                                                                         |   |                |    |                    |       |
| Cash and cash equivalents                                                                                                               |   | $                   | 90,956  |                    | $          | 68,669 |   |
| Receivables                                                                                                                             |   | 5,280               |    | 6,498                   |       |
| Other current assets                                                                                                                    |   | 5,933               |    | 5,894                   |       |
| Total current assets                                                                                                                    |   | 102,169             |    | 81,061                  |       |
| Restricted cash                                                                                                                         |   | 6,000               |    | 6,000                   |       |
| Property and equipment, net                                                                                                             |   | 69,561              |    | 71,590                  |       |
| Goodwill                                                                                                                                |   | 8,863               |    | 8,863                   |       |
| Other long-term assets and deferred charges                                                                                             |   | 5,102               |    | 15,961                  |       |
| Total assets                                                                                                                            |   | $                   | 191,695 |                    | $          | 183,475 |   |
|                                                                                                                                    |   |                |    |                    |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                               |   |                |    |                    |       |
| Current liabilities:                                                                                                                    |   |                |    |                    |       |
| Accounts payable                                                                                                                        |   | $                   | 6,038   |                    | $          | 5,353 |   |
| Accrued expenses and other current  liabilities                                                                                         |   | 8,780               |    | 7,189                   |       |
| Short-term borrowings                                                                                                                   |   | 6,500               |    | 6,500                   |       |
| Current portion of capital lease  obligations                                                                                           |   | 4,718               |    | 5,741                   |       |
| Current portion of long-term debt                                                                                                       |   | 4,867               |    | 4,893                   |       |
| Deferred revenue                                                                                                                        |   | 10,160              |    | 10,518                  |       |
| Total current liabilities                                                                                                               |   | 41,063              |    | 40,194                  |       |
| Capital lease obligations, net of current  portion                                                                                      |   | 2,127               |    | 2,520                   |       |
| Long-term debt, net of current portion                                                                                                  |   | 43,396              |    | 43,847                  |       |
| Deferred revenue                                                                                                                        |   | 8,716               |    | 3,500                   |       |
| Other long-term liabilities                                                                                                             |   | 7                   |    | 7                       |       |
|                                                                                                                                    |   |                |    |                    |       |
| Commitments and contingencies                                                                                                           |   |                |    |                    |       |
|                                                                                                                                    |   |                |    |                    |       |
| Stockholders’ equity:                                                                                                              |   |                |    |                    |       |
| Preferred stock, $0.001 par value;                                                                                                      |   |                |    |                    |       |
| Authorized: 6,716,666 shares Issued and  outstanding: none                                                                              |   | 0                   |    | 0                       |       |
| Common stock, $0.001 par value;                                                                                                         |   |                |    |                    |       |
| Authorized: 100,000,000 shares;  Issued:  54,498,655 and 54,003,970  shares at March 31, 2004 and December 31, 2003, respectively; |   |                |    |                    |       |
| Outstanding: 54,498,655 and 53,735,230  shares at March 31, 2004 and December 31, 2003, respectively                                    |   | 54                  |    | 54                      |       |
| Additional paid-in capital                                                                                                              |   | 442,377             |    | 430,489                 |       |
| Notes receivable                                                                                                                        |   | (3,396              | )       | (4,240                  | )          |
| Deferred compensation                                                                                                                   |   | (365                | )       | (572                    | )          |
| Accumulated deficit                                                                                                                     |   | (342,246            | )       | (330,210                | )          |
| Accumulated other comprehensive income  (loss)                                                                                          |   | (38                 | )       | 3                       |       |
| Treasury stock, 0 and 268,740 shares stated  at cost at March 31, 2004 and December 31, 2003, respectively                              |   | 0                   |    | (2,117                  | )          |
| Total stockholders’ equity                                                                                                         |   | 96,386              |    | 93,407                  |       |
|                                                                                                                                    |   |                |    |                    |       |
| Total liabilities and stockholders’ equity                                                                                         |   | $                   | 191,695 |                    | $          | 183,475 |   |

 

The accompanying notes arean integral part of the condensed consolidated financial statements.

 

4

----

 

**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(in thousands)

unaudited

 
|                                                                                       |   | **FOR THE  THREE-MONTHS ENDED MARCH 31,** |    |
|--------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                                       |   | **2004**                                  |    | **2003** |   |
|                                                                                       |   |                                      |    |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |   |                                      |    |   |   |
| Net loss                                                                                   |   | $                                         | (12,036 | ) | $ | (13,042 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |   |                                      |    |   |   |
| Depreciation and amortization                                                              |   | 2,921                                     |    | 3,941 |   |
| Amortization of deferred stock compensation                                                |   | 261                                       |    | 552 |   |
| Loss on disposal of equipment                                                              |   | 23                                        |    | 0 |   |
| Charges for write-down of obsolete and  excess materials and supplies                      |   | 8                                         |    | 797 |   |
| (Gain)loss on derivative financial  instruments..                                          |   | 1,423                                     |    | (202 | ) |
| Other                                                                                      |   | 22                                        |    | 48 |   |
| Changes in operating assets and  liabilities:                                              |   |                                      |    |   |   |
| Receivables and other assets                                                               |   | 1,204                                     |    | (1,392 | ) |
| Accounts payable, accrued expenses and  other current liabilities                          |   | 2,220                                     |    | (1,558 | ) |
| Deferred research revenue                                                                  |   | 11,176                                    |    | (1,404 | ) |
| Other                                                                                      |   | (174                                      | )       | 0 |   |
|                                                                                       |   |                                      |    |   |   |
| Net cash provided by (used in) operating  activities                                       |   | 7,048                                     |    | (12,260 | ) |
|                                                                                       |   |                                      |    |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |   |                                      |    |   |   |
| Purchase of property and equipment                                                         |   | (693                                      | )       | (325 | ) |
| Proceeds from sale of equipment                                                            |   | 39                                        |    | 0 |   |
| Net cash used in investing activities                                                      |   | (654                                      | )       | (325 | ) |
|                                                                                       |   |                                      |    |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |   |                                      |    |   |   |
| Debt refinancing cost                                                                      |   | (478                                      | )       | 0 |   |
| Issuance of common stock                                                                   |   | 7,688                                     |    | 38 |   |
| Repayment of notes receivable for common  stock .                                          |   | 841                                       |    | 26 |   |
| Proceeds from swap close-out                                                               |   | 9,720                                     |    | 0 |   |
| Installment payments on capital lease  obligations                                         |   | (1,878                                    | )       | (1,501 | ) |
|                                                                                       |   |                                      |    |   |   |
| Net cash provided by (used in) financing  activities                                       |   | 15,893                                    |    | (1,437 | ) |
| Net increase (decrease) in cash and cash  equivalents                                      |   | 22,287                                    |    | (14,022 | ) |
| Cash and cash equivalents at beginning of  period                                          |   | 68,669                                    |    | 87,244 |   |
| Cash and cash equivalents at end of period                                                 |   | $                                         | 90,956  |   | $ | 73,222 |   |

 

The accompanying notes arean integral part of the condensed consolidated financial statements.

 

5

----

 

**deCODEgenetics, Inc.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(tabular amounts inthousands, except share and per share amounts)

 

## ***The Company***

## *** ***

References in this report to deCODE and “we” and “us” refer to deCODEgenetics, Inc., a Delaware company, and deCODE genetics, Inc.’s wholly ownedsubsidiary, Islensk erfdagreining ehf., an Icelandic company registered inReykjavik, and its subsidiaries Encode ehf., deCODE Cancer ehf. andVetrargardurinn ehf. as well as deCODE genetics, Inc.’s wholly ownedsubsidiary, MediChem Life Sciences, Inc., a Delaware corporation, and itssubsidiaries MediChem Research, Inc., ThermoGen, Inc., Emerald BioStructures,Inc., Advanced X-Ray Analytical Services, Inc. and MediChem Management, Inc.

 

With its headquarters in Reykjavik, Iceland, deCODE is a populationgenetics company developing drugs and DNA-based diagnostics based upon itsdiscoveries in the inherited causes of common diseases. deCODE’s populationapproach and resources have enabled it to isolate gene and targets directlyinvolved in the development of many of the biggest challenges to publichealth.  deCODE is focused on turningthese findings into a pipeline of products which it believes will be able tocombat the cause of disease, not just the signs and symptoms. deCODE’scustomers include major pharmaceutical companies, biotechnology firms,pharmacogenomics companies, universities and other research institutions.deCODE’s business is global, with its principal markets in the United Statesand in Europe.

 

deCODE’s primary focus is on the discovery and commercialization ofnovel therapeutics based on genetic information identified in our population-basedgene discovery work. Through the acquisition in March 2002 of MediChem LifeSciences and its subsidiary, Emerald Biostructures, now its pharmaceuticals andbiostructures groups, deCODE has integrated capabilities for applying geneticfindings to the development of drugs, both through its own programs and inalliance with corporate partners. deCODE is also applying the links it hasidentified between genetic factors and disease to create DNA based tests whichcan also be used to identify patients with increased risk of developing adisease or to predict which patients will respond well to a given drugtherapy.  deCODE believes that suchtests will become a standard part of healthcare within the coming decade, makingit possible to gauge individual predisposition to a particular illness and todesign effective preventive strategies; to complement traditional clinicaldiagnoses; and to identify patients who are likely to respond or not respond toparticular drugs.

 

In addition to conducting work on our targets in deCODE’s collaborativeand internal programs, the pharmaceuticals group provides drug discovery workfor our fee-for-service customers. deCODE’s other service offerings include protein crystallization productsand protein structure analysis contract services through it’s Seattle-basedbiostructures group; pharmacogenomics and clinical trials services through it’swholly-owned subsidiary Encode; and DNA analysis serices through it’sgenotyping laboratory in Reykjavik.

 

## ***Basis ofPresentation***

## *** ***

The unaudited condensed consolidated financial statements includedherein have been prepared by deCODE, pursuant to the rules and regulations ofthe Securities and Exchange Commission. Certain information and disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and regulations. The condensedconsolidated balance sheet as of December 31, 2003 has been derived from theaudited financial statements as of that date, but does not include alldisclosures required by accounting principles generally accepted in the UnitedStates of America. deCODE believes the disclosures included in the condensedconsolidated financial statements when read in conjunction with the financialstatements and the notes thereto included in deCODE’s Annual Report on Form10-K are adequate to make the information presented not misleading.

 

Certain reclassifications have been made in thethree-month period ended March 31, 2003 to be consistent with the currentpresentation.  These financialstatements are reported in United States dollars, deCODE’s functional currencyand prepared in accordance with accounting principles generally accepted in theUnited States of America.

 

The condensed consolidated financial statements have been prepared onthe same basis as the annual financial statements and, in the opinion ofmanagement, reflect all adjustments, which include only normal recurringadjustments, necessary for a fair presentation of deCODE’s financial position,results of operations and cash flows for the periods presented. The results ofoperations for the three-month periods ended March 31, 2004 and 2003 are notnecessarily indicative of the results that may be expected for any otherinterim period or for the full fiscal year.

 

***Revenue***

 

deCODE records revenue provided that there ispersuasive evidence that an arrangement exists, the price is fixed anddeterminable and collectibility is reasonably assured.  deCODE has entered into research,development and commercialization alliances and collaborations with majorpharmaceutical and biotechnology companies. The key components of the commercial terms of such alliance arrangementstypically include one or more of the following:  research funding; up-front, exclusivity, technology access, and

 

6

----

 

technology development fees; milestone payments;license or commercialization fees; and royalties or profit sharing from thecommercialization of products.

 

deCODE’s revenues from research and development collaborationagreements are recorded and recognized in accordance with the applicableperformance requirements and terms of the respective contracts, generally either(i) as contract research costs are incurred, usually ratably over the period ofeffort, (ii) according to the level of efforts expended based on the ratio ofcontract research costs incurred to expected total costs, or (iii) upon theachievement of substantive milestones.  deCODE’s accounting recognition policies with respect to eachsignificant element of our revenue is summarized as follows:

 

*Researchfunding and other service fees.*  Research funding is recognizedas earned, typically ratably over the period of effort.  Funding payments are not refundable in theevent that the related efforts are not successful.  Other service revenues from negotiated rate contracts arerecognized based upon the terms of the underlying contract generally either (i)on a per diem basis as services are rendered; (ii) on the basis effortsexpended, generally upon the ratio of costs incurred to total expected costs ofproviding the service; or (iii) upon completion of the service rendered.  Any losses on contracts are provided forwhen they are determinable.  Included inrevenue are billings to customers for the cost of materials purchased bydeCODE.

 

*Milestone payments.*  Forcontracts where (i) the milestone event is substantive, (ii) there issubstantial effort involved in achieving the milestone, (iii) the milestonepayment amount is commensurate with the magnitude of the related achievement,and (iv) the associated follow-on revenue streams bear a reasonablerelationship to one another deCODE recognized revenue using the substantivemilestone method. Under the substantive milestone method deCODE records revenuewhen the milestone has been achieved and payment is due and payable under theterms of the respective agreement and deCODE recognizes revenue whenacknowledgement of having achieved applicable performance requirements isreceived from the collaborator. Milestone payments without the abovecharacteristics are recognized on a retrospective basis over the contractualterm of the underlying agreement.

 

*Up-front, exclusivity, technology access, andtechnology development fees*.  deCODE recognizes revenuefrom non-refundable fees not specifically tied to a separate earnings processratably over the expected customer relationship period or estimated period ofperformance. Changes in estimates could impact revenue in the period theestimate is changed.  If deCODE’sestimate of the period of performance shortens or lengthens, the amount ofrevenue we recognize from such non-refundable fees not specifically tied to aseparate earnings process could increase or decrease in the period the changein estimate becomes known; future related revenues would be adjustedaccordingly.

 

In November 2002, the Emerging Issues Task Force (EITF) reached aconsensus on Issue No. 00-21, “Accounting for Revenue Arrangements withMultiple Deliverables” (EITF No. 00-21). EITF No. 00-21 provides guidance on how to account for arrangements thatinvolve the delivery or performance of multiple products, services and/orrights to use assets. The provisions of EITF No. 00-21 were applicable to revenue arrangements entered intofiscal periods beginning after June 15, 2003. deCODE’s adoption of EITF No. 00-21 did not impact revenue for the yearended December 31, 2003 or the three months ended March 31, 2004; however, thispronouncement will impact the timing of revenue in the future, including therecognition of milestone payments received.

 

Significant elements of our revenue are summarized as follows:

 
|                                                                       |   | **For the  Three Months Ended March 31,** |   |
|----------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                       |   | **2004**                                  |   | **2003** |   |
|                                                                       |   | **(In  thousands)**                       |   |
|                                                                       |   |                                      |   |   |   |
| Research funding and other service fees                                    |   | $                                         | 7,897  |   | $ | 8,601 |   |
| Milestone payments                                                         |   | 165                                       |   | 1,365 |   |
| Up-front, exclusivity, technology access,  and technology development fees |   | 1,000                                     |   | 1,000 |   |
| Other                                                                      |   | 1,220                                     |   | 876 |   |
|                                                                       |   | $                                         | 10,282 |   | $ | 11,842 |   |

 

In general, prerequisites for billings are established by contractualterms including predetermined payment schedules, the achievement of contractmilestones, or submission of appropriate billing detail.  Deferred revenue represents amounts billedin accordance with contract terms but not yet recognized according to ouraccounting policy. Unbilled costs and fees arise when revenue has beenrecognized but customers have not been billed.

 

7

----

 

Two of deCODE’s executive officers own an aggregate 37.5% of the sharecapital and are board members of Prokaria ehf. (Prokaria).  deCODE provides Prokaria certain sequencingand advisory services in exchange for fees and recognized $0 and $7,000 inrevenue in respect of such sequencing services provided during the threemonth-periods ended March 31, 2004 and 2003, respectfully.

 

***Collaborations***

 

*F. Hoffmann-La Roche (Roche)*.

 

*Therapeutics*. In 1998 deCODE entered into aresearch collaboration and cross-license agreement with Roche, which terminatedin 2002, under which deCODE identified key genetic factors involved in tencommon diseases: osteoarthritis, Alzheimer’s disease, schizophrenia, PAOD,stroke, osteoporosis, obesity, anxiety, non-insulin-dependent diabetes andrheumatoid arthritis. In January 2002, deCODE entered into a new three-yearagreement with Roche focused on turning the achievements of the 1998 genediscovery collaboration into novel therapeutics. The 2002 agreement providedthat deCODE would collaborate with respect to four diseases that had been thesubject of the 1998 agreement.  deCODEis currently collaborating on two of those diseases.  Under the 2002 agreement deCODE has received $17,000,000 inresearch funding and may receive an additional $3,000,000 in research fundingduring the remainder of the term of the agreement.  The agreement provides that upon the development of specifiedcompounds during the term of the agreement and for a specified period thereafterdeCODE may receive milestone payments, the amount of which will depend on thetype of compound developed.  Inaddition, deCODE will be entitled to receive royalties on the sales of drugsthat are developed.

 

*Diagnostics*. In June 2001, deCODE signed a five-year alliance with Roche’s diagnosticsdivision to develop and market DNA-based diagnostics for major diseases. Morerecently deCODE has added research programs aimed at developing diagnostics topredict drug response for major therapeutics used to treat those diseases, inorder to help select the most effective treatment of those available.    Under the agreement we have received$30,187,500 in research funding, up-front fees and milestone payments.  deCODE may receive $14,062,500 in additionalresearch funding over the remainder of the term of the agreement as well asmilestone payments upon the achievement of research and developmentmilestones  and royalties on the salesof diagnostic products developed.

 

Revenues from these allianceswith Roche amounted to $3.4 million and $ 5.3 million for the three-monthperiods ended March 31, 2004 and 2003, respectively, representing 33% and 45%of consolidated revenue for the three-month periods ended March 31, 2004 and2003, respectively.

 

*Merck & Co, Inc. (Merck)*.

 

*Obesity*. In September 2002, deCODE entered into an alliance with Merck aimed atdeveloping new treatments for obesity. Under the alliance, deCODE is combiningour research efforts in the genetics of obesity to identify, validate andprioritize a series of drug targets to take into development.  Under the terms of the three-year agreement,which can be extended on a year-to-year basis upon the consent of the parties,deCODE has received research funding, technology access fees and milestone paymentsin the aggregate amount of $14,875,000 and may receive research funding andtechnology access in the future of $9,625,000. In addition, deCODE may receive further research milestone payments andmay receive milestone payments as compounds developed under the allianceadvance in the development process and royalties on successfully marketeddrugs.  Merck may terminate theagreement at any time upon 90 days’ notice or after September 26, 2004 upon 30days’ notice in the event that the research program fails to achieve certainspecified goals.

 

*Information Rich Clinical Trials*.  In February 2004, deCODE entered into anagreement with Merck under which deCODE will conduct information-rich clinicaltrials on a range of Merck’s developmental compounds. The term of the allianceis seven years, subject to termination by Merck after five years. deCODE will,at any given point over the course of the alliance, be conducting concurrenttrials on as many as five Merck compounds. The collaboration involved three agreements: (a) License and ResearchCollaboration Agreement; (b) a Stock and Warrant Purchase Agreement; and (c) aWarrant Agreement.   Under the terms ofthe License and Research Collaboration Agreement, deCODE will receive royaltieson sales of drugs and diagnostics developed as part of the alliance, willreceive milestone payments as compounds or pharmacogenomic tests reach themarket, will receive research funding for the clinical development of compoundsand pharmacogenomic analysis, and received a one-time technology access fee of$10,000,000. There is a contingency clause on the technology access fee ifdeCODE rejects the first two non-exclusive development compounds that Merckpresents to the collaboration, then Merck has the right to request a refund of$2.5 million of the technology access fee. Under the terms of the Stock and Warrant Purchase Agreement, Merck haspurchased 689,703 shares of deCODE’s common stock at a price of $14.50 pershare or $10 million, which represents a premium of $2.7 million to thefair market value of the stock on the effective date of the agreements($10.60).  Accordingly, of the $10million cash received, deCODE has ascribed $7.3 million to the common stock andthe $2.7 million premium to deferred revenue. Under the terms of the Warrant Agreement, deCODE has issued Merck awarrant to purchase up to 1,724,257 of additional shares of our common stock atan exercise price of $29.00 per share over the next five years. The warrantshall be exercisable at the option of Merck as to 344,851 shares for a periodof 30 days commencing on the first, second, third, fourth and fifthanniversaries of the Warrant Agreement with the final portion of warrantsexpiring in March 2009.  Any portion ofthis warrant that is not exercised during an applicable exercise period shallexpire and be of no further force or effect. The warrant was valued at $6.3million using a Black Scholes model with the following assumptions: lives ofone to five years, risk free interest rates of 1.24% to 3.07%, a volatility of90% and no dividend yield.  The one-timetechnology access fee and the premium portion of the equity purchase togetherwith the estimated fair value of the warrant have been deferred and the$6.4 million net amount is included in deferred revenue at March 31,2004 and will be recognized as revenue over the seven year development term.

 

8

----

 

Revenues from the therapeuticsand other alliances with Merck amounted to $1.9 million and $1.8 million forthe three-month periods ended March 31, 2004 and 2003, respectively,representing 18% and 16% of consolidated revenue for the three-month periodsended March 31, 2004 and 2003, respectively.

 

# ***Research and Development Expenses, Including Costs ofRevenue***

# ** **

In accordance with SFAS No.2,  “Accounting for Research andDevelopment Costs,” research and development costs are charged to expense whenincurred.  deCODE’s research anddevelopment expenses consist of the costs of its own internal programs andcosts associated with research and development conducted in collaboration withand for others, consisting  of thefollowing:

 
|                                             |   | **For the  Three Months Ended March 31,** |   |
|--------------------------------------------------|--------|-------------------------------------------|--------|
|                                             |   | **2004**                                  |   | **2003** |   |
|                                             |   | **(In  thousands)**                       |   |
|                                             |   |                                      |   |   |   |
| Salaries and other personnel costs               |   | $                                         | 6,821  |   | $ | 8,120 |   |
| Materials and supplies                           |   | 2,274                                     |   | 3,557 |   |
| Contractor services and other third party  costs |   | 1,913                                     |   | 1,766 |   |
| Overhead expenses                                |   | 1,365                                     |   | 2,351 |   |
| Depreciation and amortization                    |   | 2,812                                     |   | 3,555 |   |
| Stock-based compensation and remuneration        |   | 248                                       |   | 322 |   |
|                                             |   | $                                         | 15,433 |   | $ | 19,671 |   |

 

## ***Stock-BasedCompensation and Remuneration***

 

deCODE follows SFAS No. 123, “Accounting for Stock-Based Compensation”.The provisions of SFAS No. 123 allow companies to either expense the estimatedfair value of stock options granted to employees or to follow the intrinsicvalue method set forth in Accounting Principles Board Opinion No. 25 (APB No.25), Accounting for Stock Issued to Employees, and disclose the pro formaeffects on net loss and net loss per share had the estimated fair value of theoptions granted to employees been expensed. SFAS No. 123 requires companies toexpense the estimated fair value of stock options granted to non-employees.deCODE has elected to follow the intrinsic value method in accounting for itsemployee stock options and follows the fair value method in accounting for itsnon-employee stock options.

 

Stock-based compensation represents the expense charged in thestatements of operations relating to employee stock options granted.Stock-based remuneration represents the expense charged in the statements ofoperations relating to shares of stock issued to non-employees in exchange forservices provided. Stock-based compensation and remuneration are included inthe statements of operations in the following captions:

 
|                               |   | **For the  Three Months  Ended March 31,** |   |
|------------------------------------|--------|--------------------------------------------|--------|
|                               |   | **2004**                                   |   | **2003** |   |
|                               |   | **(In  thousands)**                        |   |
|                               |   |                                       |   |   |   |
| Research and development expense   |   | $                                          | 248    |   | $ | 322 |   |
| General and administrative expense |   | 13                                         |   | 230 |   |
| Total                              |   | $                                          | 261    |   | $ | 552 |   |

 

Had compensation cost for all stock options been determined based onthe fair value at the grant date for awards consistent with the provisions ofSFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation — Transition and Disclosure — an amendment of FASB Statement No.123” (SFAS 148), deCODE’s net loss and basic and diluted net loss per sharewould have been changed to the pro forma amounts indicated below:

 

9

----

 
|                                                                                              |   | **For the  Three Months Ended March 31,**     |    |
|---------------------------------------------------------------------------------------------------|--------|-----------------------------------------------|---------|
|                                                                                              |   | **2004**                                      |    | **2003** |   |
|                                                                                              |   | **(In  thousands, except per share amounts)** |    |
|                                                                                              |   |                                          |    |   |   |
| Net loss attributable to common  stockholders — as reported                                  |   | $                                             | (12,036 | ) | $ | (13,042 | ) |
| Add: Stock-based compensation expense  included in reported net loss                              |   | 261                                           |    | 552 |   |
| Deduct: Total stock-based compensation  expense determined under fair value method for all awards |   | (1,441                                        | )       | (1,193 | ) |
| Net loss — proforma                                                                          |   | $                                             | (13,216 | ) | $ | (13,683 | ) |
| Basic and diluted net loss per share — as  reported                                          |   | $                                             | (0.23   | ) | $ | (0.25 | ) |
| Basic and diluted net loss per share —  proforma                                             |   | (0.25                                         | )       | (0.27 | ) |

 

The effects of applying the provisions of SFAS No. 123 on net loss andnet loss per share as stated above is not necessarily representative of theeffects on reported income or loss for future years due to, among other things,the vesting period of the stock options and the fair value of additional stockoptions that may be granted in future years.

 

In January and February 2004, deCODE granted options to purchase216,967 shares of common stock to employees and a director under the 2002Equity Incentive Plan.

 

## ***Computation of NetLoss Per Common Share***

 

Basic net loss per share is computed using net loss available to commonstockholders and the weighted-average number of commonshares outstanding. Theweighted-average number of common shares outstanding during the period is thenumber of sharesdetermined by relating the portion of time within a reportingperiod that common shares have been outstanding to the total time in thatperiod.

 

Diluted net loss per share is computed using theweighted-average number of common shares outstanding during the period, plusthe dilutive effect of potential common shares. Diluted net loss per share doesnot differ from basic net loss per share in all periods presented as potentialcommon shares are antidilutive for all such periods and are, therefore,excluded from the calculation. Potential common shares excluded from thecalculation of diluted net loss per share as their inclusion would have beenantidilutive were:

 
|                                                                           |   | **March 31,  2004** |   | **March 31,  2003** |   |
|--------------------------------------------------------------------------------|--------|---------------------|--------|---------------------|--------|
|                                                                           |   | **(Shares)**        |   | **(Shares)**        |   |
| Warrants to purchase shares of common stock                                    |   | 3,124,724           |   | 1,851,300           |   |
| Options to purchase shares of common stock                                     |   | 4,181,341           |   | 1,984,554           |   |
| Restricted shares with an associated  outstanding non-recourse promissory note |   | 1,267,756           |   | 2,368,160           |   |
|                                                                           |   | 8,573,821           |   | 6,204,014           |   |

 

**In February 2004, deCODE issued a warrant to purchase1,724,257 shares of common stock at $29.00 per share over five years to acollaborator in connection with a Stock and Warrant Purchase Agreement.  The warrant shall be exercisable at theoption of Merck as to 344,851 shares for a period of 30 days commencing on thefirst, second, third, fourth and fifth anniversaries of the WarrantAgreement.  Any portion of this warrantthat is not exercised during an applicable exercise period shall expire and beof no further force or effect (See “Revenue Recognition” Note).**

 

***Comprehensive Income***

 

Comprehensive income generallyrepresents all changes in stockholders’ equity except those resulting frominvestments or contributions by stockholders. Amounts reported in othercomprehensive income include foreign currency translation adjustments andstandard forward foreign exchange contracts. The following table presents the calculation of comprehensive income(loss):

 

10

----

 
|                               |   | **For the  Three Months Ended March 31,** |    |
|------------------------------------|--------|-------------------------------------------|---------|
|                               |   | **2004**                                  |    | **2003** |   |
|                               |   | **(in  thousands)**                       |    |
|                               |   |                                      |    |   |   |
| Net loss                           |   | $                                         | (12,036 | ) | $ | (13,042 | ) |
| Other comprehensive income (loss): |   |                                      |    |   |   |
| Foreign currency translation       |   | 1                                         |    | 3 |   |
| Forward foreign exchange contract  |   | (42                                       | )       | 0 |   |
| Total comprehensive loss           |   | $                                         | (12,077 | ) | $ | (13,039 | ) |

 

***Employee Termination Costs***

 

Beginning in September 2002, deCODE reduced totalworldwide headcount, focusing in particular on utilizing ongoing processautomation and increased productivity in the core genetics operations inReykjavik.  The following is a scheduleof charges, payments and unpaid termination benefits for the three-monthperiods ended March 31, 2004 and 2003:

 
|                           |   | **For the  Three Months Ended March 31,** |   |
|--------------------------------|--------|-------------------------------------------|--------|
|                           |   | **2004**                                  |   | **2003** |   |
|                           |   | **(In  thousands)**                       |   |
|                           |   |                                      |   |   |   |
| Balance at beginning of period |   | $                                         | 66     |   | $ | 874 |   |
| Additions to accrual           |   | 0                                         |   | 485 |   |
| Payments of benefits           |   | (66                                       | )      | (1,155 | ) |
| Balance at March 31            |   | $                                         | 0      |   | $ | 204 |   |

 

The charges related to termination benefits are for 27 employees duringthe three-month period ended March 31, 2003.

 

## ***DerivativeFinancial Instruments***

 

During the normal course of business, deCODE is exposed to foreigncurrency risk and interest rate risk. These risks can create volatility inearnings and cash flows from period to period. deCODE’s objective is to reducevolatility of earnings and cash flows associated with market risks.

 

deCODE seeks to maintain a desired level of floating-rate debt withrespect to its overall debt portfolio denominated in U.S. Dollars. To this end,deCODE uses interest rate and cross-currency swaps to manage interest rate andforeign currency risk arising from long-term debt obligations denominated inIcelandic krona. These interest rate and cross-currency swaps with a combinednotional amount of 1,730 million Icelandic krona are designated as economichedges of fixed rate foreign currency debt (Tier A and Tier C bonds), but donot qualify for hedge accounting under SFAS 133.  In March 2004, deCODE refinanced its Tier C bonds, with the newinstrument being a variable rate U.S. dollar denominated debt (See Below).  Following-on from this refinancing, deCODEreconsidered its two cross-currency swaps and decided to liquidate themrealizing $9,720,000 in proceeds. deCODE realized a loss on this early termination that, together withunrealized losses on the swaps during the quarter ended March 31, 2004,amounted to $1,473,000.  Cumulativeunrealized gains on the two cross-currency swaps through December 31, 2003 were$11,185,000.  Unrealized gains on thetwo cross-currency swaps in the quarter ended March 31, 2003 were$202,000.  Unrealized and realized gainsand losses on these two cross-currency swaps are included in othernon-operating income and (expense), net in the Condensed ConsolidatedStatements of Operations.

 

In March 2004, deCODE entered into five forward foreign exchangecontracts with an Icelandic financial institution for purposes of hedging aportion of its Icelandic krona-denominated salaries.  At maturity of each contract, deCODE will sell $1,600,000 anddeCODE will receive Icelandic krona at the contracted forward rate.  The contracts mature monthly through July2004.  These forward foreign exchangecontracts are designated as economic hedges of the foreign currency salary cashflows and qualify for hedge accounting under SFAS 133, “Accounting for DerivativeInstruments and Hedging Activities” (SFAS 133). Under SFAS 133 thesecontracts will be marked-to-market at the end of each reporting period and theestimated fair value of these instruments at March 31, 2004 is $59,000, net.  As of March 31, 2004, an unrealized loss of$42,000 was included in accumulated other comprehensive income on the CondensedConsolidated Balance Sheet.  During thequarter ended March 31, 2004, a loss of $17,000 was recorded to operating expensesin the Condensed Consolidated Statements of Operations.

 

The fair value of derivative instruments is sensitive to movements inthe underlying market rates and variables. deCODE monitors the fair value ofderivative instruments on a periodic basis. Fair values are estimated for eachderivative using common market valuation methods with reference to availablemarket data as of the balance sheet date.

 

11

----

 

***Short-Term Borrowings***

 

Short-term borrowings as ofMarch 31, 2004 consists of a $6,500,000 loan with an Icelandic financialinstitution that is due in three traunches of $2,500,000, $2,000,000 and$2,000,000 on May 17, June 23 and July 30, 2004 at an interest rate of 1.90%,2.05% and 2.00%, respectively.

 

***Debt***

** **

*Sale-leaseback Financing*

 

In June 2003, deCODE sold certain laboratory equipment for $4,750,000net cash proceeds and leased the equipment back from the counter-party (anIcelandic leasing company) for an 18-month term.  As ownership of the equipment will be transferred to deCODE atthe end of the lease without any further significant payment, the transactionhas been recorded as a financing and the gain ($1,418,000) has been deferredand is being amortized over the remaining useful life of the leased equipment(3 years).  In January 2004, deCODEexercised its option to extend the loan for an additional 18 month term.

 

*Mortgage Refinancing*

 

In March 2004, we entered into a $17,500,000 term loan with anIcelandic financial institution (the “Lender”) to refinance our Tier C bondsand Tier D bank loan.  The new term loanbears interest at the three-month LIBOR plus 3% (4.11% as of March 31, 2004)until March 1, 2009, at which point, the Lender may adjust the interest marginunilaterally.  The term loan is payablein twenty quarterly payments starting on March 1, 2009 and the final payment isdue on December 1, 2013.  The term loancan be repaid on every anniversary of the loan starting on March 1, 2006, butfor which we will pay a prepayment fee of 1% for every year that remains on theterm loan facility with a maximum fee of 6%.

 

The remaining unamortized borrowing costs and discount associated with the Tier C bonds and Tier Dbank loan, along with borrowing costs associated with the new term loan and thecall penalty associated with the prepayment of Tier C will be amortized tointerest expense over the remaining term of the new loan.

 

*SeniorConvertible Notes*

 

In April 2004,deCODE completed an offering of 3.5% Senior Convertible Notes due 2011 toqualified institutional buyers pursuant to Rule 144A of the Securities Act of1933. From this offering, deCODE received gross proceeds of $150 million.

 

The Notes are convertible into shares ofdeCODE common stock, at the option of the holder, at a price of $14.00 pershare (fair market value of $10.60 on date of issuance), which is equivalent toan initial conversion rate of approximately 71.43 shares per $1,000 principalamount of the Notes.  deCODE may redeemthe Notes beginning April 20, 2009.

 

## ***Guarantees***

## *** ***

In November 2002, the FASB issued FIN No. 45 “Guarantor’s Accountingand Disclosure Requirements for Guarantees, including Indirect Guarantees ofIndebtedness of Others — an interpretation of FASB Statements No. 5, 57 and 107and rescission of FIN 34.” deCODE has applied the disclosure provisions of thisFIN 45 as of March 31, 2004. The following is a summary of deCODE’s agreementsthat it has determined are within the scope of FIN 45.

 

When as part of an acquisition deCODE acquires all of the stock or allof the assets and liabilities of a company, it assumes the liability forcertain events or occurrences that took place prior to the date of acquisition.The maximum potential amount of future payments it could be required to makefor such obligations is undeterminable at this time. deCODE has no liabilitiesrecorded for these liabilities as of March 31, 2004.

 

deCODE enters into indemnification provisions under (i) its agreementswith other companies in its ordinary course of business, typically withbusiness partners, contractors, clinical sites and customers and (ii) itsagreements with investors. Under these provisions deCODE generally indemnifiesand hold harmless the indemnified party for losses suffered or incurred by theindemnified party as a result of deCODE’s activities or, in some cases, as aresult of the indemnified party’s activities under the agreement. Theseindemnification provisions generally survive termination of the underlyingagreement. In addition, in some cases, deCODE has agreed to reimburse employeesfor certain expenses and to provide salary continuation during short termdisability. The maximum potential amount of future payments deCODE could berequired to make under these indemnification provisions is unlimited. deCODEhas not incurred material costs to defend lawsuits or settle claims related tothese indemnification agreements. As a result, the estimated fair value ofthese agreements is minimal. Accordingly, deCODE has no liabilities recordedfor these agreements as of March 31, 2004.

 

12

----

 

## ***Litigation***

 

Other than claims and legal proceedings that arise from time to time inthe ordinary course of its business which are not material, deCODE has nopending legal proceedings except as follows:

 

On or about April 20, 2002, an amended classaction complaint, captioned In re deCODE genetics, Inc. Initial Public OfferingSecurities Litigation (01 Civ. 11219(SAS)), alleging violations of federalsecurities laws was filed in the United States District Court for the SouthernDistrict of New York on behalf of certain purchasers of deCODE common stock.The complaint names deCODE, two of deCODE’s current executive officers (the“Individual Defendants”), and the two lead underwriters (the “UnderwriterDefendants”) for our initial public offering in July 2000 (the “IPO”) asdefendants.

 

In the amended pleading, the plaintiffalleges violations of Section 11 of the Securities Act of 1933 and violationsof Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5promulgated thereunder) against deCODE, the Individual Defendants and theUnderwriter Defendants. In addition, the amended complaint alleges violationsof Section 15 of the Securities Act of 1933, and Section 20(a) of theSecurities Exchange Actof1934 against the Individual Defendants. Generally, the amended complaintalleges that the Underwriter Defendants: (i) solicited and received excessiveand undisclosed commissions from certain investors in exchange for which theUnderwriter Defendants allocated to those investors material portions of theshares of our stock sold in the IPO; (ii) entered into agreements withcustomers whereby the Underwriter Defendants agreed to allocate shares of ourstock sold in the IPO to those customers in exchange for which the customersagreed to purchase additional shares of our stock in the aftermarket atpre-determined prices; and (iii) improperly used their analysts, whopurportedly suffered from conflicts of interest, to manipulate the market. Theamended complaint further alleges that the prospectus incorporated into theregistration statement for the IPO was materially false and misleading in thatit failed to disclose these arrangements. The amended complaint also allegesthat deCODE and the Individual Defendants had numerous interactions andcontacts with the Underwriters from which deCODE and the Individual Defendantseither knew of, or recklessly disregarded, the Underwriters’ purported wrongfulacts. The suit seeks unspecified monetary and recissionary damages andcertification of a plaintiff class consisting of all persons who purchasedshares of our common stock from July 17, 2000 to December 6, 2000.

 

deCODE is aware that similar allegations havebeen made in hundreds of other lawsuits filed (many by some of the sameplaintiff law firms) against numerous underwriter defendants and issuercompanies (and certain of their current and former officers) in connection withvarious public offerings conducted in recent years. All of the lawsuits thathave been filed in the Southern District of New York have been consolidated forpretrial purposes before Honorable Judge Shira Scheindlin. Pursuant to theunderwriting agreement executed in connection with our IPO, deCODE has demandedindemnification from the Underwriter Defendants. The Underwriter Defendantshave asserted that our request for indemnification is premature.

 

Pursuant to an agreement the IndividualDefendants have been dismissed from the case without prejudice. Along withnumerous other issuers, deCODE moved to dismiss the complaint for failure tostate a claim. On February 19, 2003, Judge Scheindlin granted our motion withrespect to the Section 10(b) claims and denied the motion with respect to theSection 11 claims.

 

On July 31, 2003, our Board of Directors(other than Dr. Stefansson, who recused himself because he was an IndividualDefendant) conditionally approved a proposed partial settlement with theplaintiffs in this matter.  Thesettlement would provide, among other things, a release of deCODE and of theIndividual Defendants for the conduct alleged in the amended complaint to bewrongful.  deCODE would agree toundertake other responsibilities under the partial settlement, includingagreeing to assign away, and not assert or release, certain potential claims wemay have against our underwriters.  Anydirect financial impact of the proposed settlement is expected to be borne bydeCODE’s insurers.   The Board agreed toapprove the settlement subject to a number of conditions, including theparticipation of a substantial number of other issuer defendants in theproposed settlement, the consent of deCODE’s insurers to the settlement, andthe completion of acceptable final settlement documentation.  Furthermore, the settlement is subject to a hearingon fairness and approval by the Court overseeing the litigation.

 

Due to the inherent uncertainties oflitigation and the fact that the settlement is in its early stages, theultimate outcome of this matter cannot be predicted.  If the settlement is not consummated, deCODE expects to contestthe allegations against deCODE and deCODE’s officers vigorously.   If deCODE was required to pay significantmonetary damages as a result of such litigation (or any other lawsuits allegingsimilar claims filed against deCODE and deCODE’s officers in the future),deCODE’s business could be significantly harmed. Even if such suit concludes indeCODE’s favor, deCODE may be required to expend significant funds to defendagainst the allegations. deCODE is unable to estimate the range of possibleloss from the litigation and no amounts have been provided for such matters indeCODE’s financial statements.

 

***Recent Accounting Pronouncements***

 

In January 2003, the FinancialAccounting Standards Board (FASB) issued FASB Interpretation No. 46,“Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51”,(FIN 46).  FIN 46 requires that if anentity has a controlling financial interest in a variable interest entity, theassets, liabilities and results of activities of the variable interest entityshould be included in the consolidated financial statements of the entity. FIN46 requires that its provisions are effective immediately for all arrangementsentered into after January 31, 2003. For those arrangements entered into priorto January 31, 2003, FIN 46, as amended by FIN 46R, provisions are required tobe adopted in the first quarter of 2004. deCODE does not have any financialinterests in variable interest entities created after January 31, 2003. Theadoption of FIN 46R did not impact deCODE’s financial position or its resultsof operations for the quarter ended March 31, 2004.

 

**ITEM2.****MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF****OPERATIONS. (tabular amountsin thousands, except share and per share amounts)**

 

This Management’s Discussion and Analysis of Financial Condition andResults of Operations as of March 31, 2004 and for the three-month periodsended March 31, 2004 and 2003 should be read in conjunction with the unauditedcondensed consolidated financial statements and notes thereto set forth in Item1 of this report.

 

13

----

 

# **Overview**

 

We are apopulation genetics company developing drugs and DNA-based diagnostics basedupon our discoveries in the inherited causes of common diseases.  Our population approach and resources haveenabled us to identify genes and targets directly involved in the developmentof many of the most common diseases.  Weare focused on turning these findings into a growing pipeline of products and serviceswhich we believe will be able to combat the causes of disease, not just thesigns and symptoms.  Our approach toresearch and development brings together three key types of non-personallyidentifiable data derived from our population research in Iceland: genotypicand disease data from more than 100,000 volunteer participants in some 50disease-gene research programs and information that can be analyzed in tandemwith genealogical data linking together the entire present-day population ofIceland and going back to the settlement of the country in the ninth century.

 

Our primary focusis on the discovery and commercialization of novel therapeutics based ongenetic information identified in our population-based gene discoverywork.  Through our acquisition in March2002 of MediChem Life Sciences and its subsidiary, Emerald Biostructures, nowour pharmaceuticals and biostructures groups, we have integrated capabilitiesfor applying genetic findings to the development of drugs, both through our ownprograms and in alliance with corporate partners.  We are also applying the links we have identified between geneticfactors and disease to create DNA-based tests which can be used to identifypatients with increased risk of developing a disease or to predict whichpatients will respond well to a given drug therapy.  We believe that such tests will become a standard part ofhealthcare within the coming decade; making it possible to gauge individualpredisposition to a particular illness and to design effective preventivestrategies; to complement traditional clinical diagnoses; and to identifypatients who are likely to respond or not respond to particular drugs.  We are also marketing software systems wehave developed, making correlations between genetic variation and disease anddrug response.

 

We currentlyderive revenues primarily from research funding and other service fees from ourcollaborative partners; milestone payments, and upfront, exclusivity,technology-access and technology-development fees under our collaborationagreements comprise most of the rest of our revenues.  Our expenses consist primarily of research and developmentexpenses.  While we are entitled toroyalties or profit-sharing under the terms of our agreements, due to theextended time period for the development and commercialization of a saleableproduct or therapy, we have not yet received royalties or profit sharing underany of our contracts and do not expect to do so for several years, if atall.  In addition to conducting work onour targets in our collaborative and internal programs, our pharmaceuticalsgroup provides drug discovery work for our fee-for-service customers.  Our other service offerings include proteincrystallization products and protein structure analysis contract servicesthrough our Seattle-based biostructures group; pharmacogenomics and clinicaltrials services though our wholly owned subsidiary Encode; and DNA analysisservices through our genotyping laboratory in Reykjavik, Iceland.

 

As we continue ourdiscovery in common diseases, we aim to conserve ample resources to bring ourproducts forward to the market, and we are constantly evaluating the optimalbalance between several factors crucial to our strategy.  These include the level of our investment inresearch and development, the preservation of cash resources and theirdeployment for product development, and the financing environment.  Our goal is to bring products to the marketand, in that, make the company profitable. We believe the best means to achieve that objective is to operate thecompany on a sustainable basis such that it will have the staying power to turnour discoveries into products in the marketplace.  As a means to this end, in late 2002 and in the face of anuncertain environment in the capital markets, we undertook measures aimed atimproving our operational efficiency and at lowering our operating costs.  As a benchmark, we set ourselves the goal ofrunning our base research and development activities on a cash-neutralbasis.  However, this objective was notan end unto itself but rather a means to ensure that we continued to have onhand the resources to advance our key drug and diagnostic programs.

 

While we achievedpositive cash flow from operations for the third quarter of 2003 and the firstquarter of 2004, we believe that the initiation of substantial new activities,such as the conduct of clinical trials on our proprietary compounds, willrequire significant additional expenditures. For example, in our target discovery work on our findings in myocardialinfarction, we have in-licensed a compound that was developed for a differentindication but which acts upon our principal target and for which we areconducting a Phase II clinical trial in Iceland.  We expect to seek similar in-licensing opportunities for othercompounds in other diseases and any success may increase our cashrequirements.  We anticipate incurringadditional net losses at least through the next several years, due to, inaddition to the above-mentioned factors, depreciation and amortization, as wellas stock-based compensation and other non-cash charges.  We expect that our revenues and losses willfluctuate from quarter to quarter and that such fluctuations may besubstantial, especially because progress in our scientific work and milestonepayments that are related to progress can fluctuate between quarters.  We do not believe that comparisons of ourquarter-to-quarter performance are a good indication of future performance.

 

Following our sale of $150,000,000 of our 3.5% Senior Convertible Notesin April, 2004, we believe that we have sufficient cash resources to continueto fund our current research and operations for several years.  However, we will require significantadditional capital in the future for our product development programs and sowill continue to investigate additional avenues of financing.  Our ability to obtain capital will beaffected by conditions in the global financial markets and in thepharmaceutical industry.  We expect thatdownturns in the market valuations of biotechnology companies and of the equitymarkets more generally will restrict our ability to raise additional capital onfavorable terms while positive movement in those markets will poseopportunities for us.

 

14

----

 

The pharmaceuticalindustry, which is the principal customer base for our gene-discovery andcontract chemistry businesses, is experiencing difficulties in maintaininghistorical rates of growth.  Thispresents near-term challenges and significant longer-term opportunities.  One of the main challenges facing thepharmaceutical industry is developing pipelines of effective new drugs to treatmajor indications.  As many leadingbrand-name drugs come off patent and face generic competition, developingsuccessful new medicines will become critical for filling the gap.  In the short term, the financial pressureson pharmaceutical companies may be reflected in their research and developmentspending, making it more difficult for us to sign corporate alliances withsignificant upfront funding, or lengthening the time required to negotiate suchdeals.  We believe that in the medium tolonger term, however, companies such as ours may be well positioned to play animportant role in filling the gap in the pipeline of new drugs, either on theirown or as partners of pharmaceutical companies.  Our gene discovery programs are aimed at identifying novel drugtargets that are involved in the basic biology of common diseases and we arefocused on discovering new drugs against these targets, both on our own andwith major pharmaceutical partners.  Ourpartnerships with Roche and Merck demonstrate that the industry is alreadyinvesting in the development of new therapeutics based on our approach.  Our recent in-licensing of a developmentalcompound from Bayer demonstrates that the industry may be prepared to providecompanies such as ours with rights to shelved compounds that may be broughtforward in clinical development in indications other than those for which thecompounds were originally designed.

 

**Collaborationsand Alliances**

 

Collaborations andfurther growth in our medicinal chemistry, pharmacogenomics, clinical trialservices and informatics services will remain an important element of ourbusiness strategy and future revenues. Our ability to generate revenue growth and become profitable isdependent, in part, on our ability to enter into additional collaborativearrangements, and on our ability and our collaborative partners’ ability tosuccessfully commercialize products incorporating, or based on, our work.  It is also dependent on our ability tomaintain and grow our service lines of business.  There can be no assurance that we will be able to maintain orexpand our existing collaborations, enter into future collaborations to developapplications based on existing or future research agreements, sign additionalsubscribers to our database services, or successfully expand our medicinalchemistry or pharamacogenomics businesses. Our failure to successfully develop and market products over the nextseveral years, or to realize product revenues, would have a material (ormaterially) adverse effect on our business, financial condition and results ofoperations.  We do not expect to receiveroyalties or other revenues from commercial sales of products developed usingour technologies in the near term.  Itmay be several years before product revenues materialize, if they do at all.

 

**CriticalAccounting Policies**

 

The preparation of financialstatements in conformity with generally accepted accounting principles requiresus to make certain estimates and assumptions that affect the reported amountsof assets and liabilities, the disclosure of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenuesand expenses during the reported period. On an ongoing basis we evaluate ourestimates, which include, among others, those related to collaborativearrangements, long-lived assets, materials and supplies, foreign exchangetransactions, income taxes and litigation and other commitments andcontingencies. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form our basis for making judgments about carrying values ofassets and liabilities that are not readily apparent from other sources. Theimpact and any associated risks related to these and our other accountingpolicies on our business or operations is discussed throughout Management’sDiscussion and Analysis of Financial Condition and Results of Operations wheresuch policies affect our reported and expected financial results. For adetailed discussion on the application of these and other accounting policies,please refer to our notes to the Condensed Consolidated Financial Statements inthis quarterly report on Form 10Q and the Consolidated Financial Statements inthe Annual Report on Form 10-K. There can be no assurance that actual resultsmay not differ from the estimates referred to above.

 

**Resultsof Operations for the Three-Month Periods Ended March 31, 2004 and 2003**

 

Our results of operations havefluctuated from period to period and may continue to fluctuate in the futurebased upon, among other things, the timing and composition of funding under ourvarious collaborative agreements, as well as the progress of our own researchand development efforts.  Results ofoperations for any period may be unrelated to results of operations for anyother period.  In addition, historicalresults should not be viewed as indicative of future operating results.  We are subject to risks common to companiesin our industry and at our stage of development, including risks inherent inour research and development efforts, reliance upon collaborative partners,development by us or our competitors of new technological innovations, abilityto market products or services, dependence on key personnel, dependence on keysuppliers, protection of proprietary technology, ability to obtain additionalfinancing, ability to negotiate collaborative arrangements, and compliance withgovernmental and other regulations.  Inorder for a product to be commercialized based on our research, we and ourcollaborators must conduct preclinical tests and clinical trials,

 

15

----

 

demonstrate the efficacy andsafety of our product candidates, obtain regulatory approvals or clearances andenter into manufacturing, distribution and marketing arrangements, as well asobtain market acceptance.  We do notexpect to receive revenues or royalties based on therapeutic or diagnosticproducts for a period of years, if at all.

 

Company highlights include:

 

•                  Ourrevenue was $10.3 million for the three-month period ended March 31,2004 as compared to $11.8 million for the three-month period endedMarch 31, 2003.  These revenues reflects the long-term, productdevelopment focus of our business strategy and our corporate partnerships, aswell as the timing of milestone payments. At the close of the quarter thecompany had $18.9 million in deferred research revenue, compared to $12.8million at the close of the first quarter 2003. This increase reflects cashreceived related to the company’s new alliance with Merck, and will berecognized, along with other deferred revenue, over future reporting periods.

 

•                  Wedecreased our research and development expenses to $15.4 million for thethree-month period ended March 31, 2004 as compared to $19.7 millionfor the three-month period ended March 31, 2003.  The 22% decrease in 2004 as compared to 2003 reflects the successful streamlining andautomation of the company’s core genetics research operations together withincreased expenditures on product development.

 

•                  InApril 2004, we initiated a ten-week, information-rich Phase IIa clinical trialin Iceland that will examine the effect of various dose levels of ourdevelopmental compound DG031 on the production of leukotrienes and otherbiomarkers associated with vascular inflammation. We plan to employ the datagenerated in this trial to optimize the design of an information-rich,multicenter Phase III trial to test DG031 for the prevention of heart attackthat may commence before the end of 2004.

 

•                  AtMarch 31, 2004, we had $97.0 million in cash and cash equivalents,including $6 million in restricted cash. This is approximately $22 million morethan at the close of the fourth quarter of 2003. The increase reflects paymentsrelated to the signing of a new drug development alliance with Merck and theliquidation of our two currency swaps, offset in part by costs associated withthe advancement of our drug development programs.

 

•                  In April 2004,we completed an offering of 3.5% Senior Convertible Notes due 2011 to qualifiedinstitutional buyers pursuant to Rule 144A and raised gross proceeds of $150million.  The Notes are convertible intoshares of our common stock, at the option of the holder, at a price of $14.00per share, equivalent to an initial conversion rate of approximately 71.43shares per $1,000 principal amount of the Notes.  We may redeem the Notes beginning April 20, 2009. We expect to use the proceeds of theoffering principally for advancing our drug development programs, as well asfor general corporate purposes.

 

*Revenue.*  Our business strategy is focused on turningour discoveries and assets into a broad range of products for the market, as weleverage our capabilities to generate near-term service revenue.  In some instances, we are pursuing productdevelopment on our own.  In others, wehave formed alliances with pharmaceutical and biotechnology firms through whichwe can cover some of the cost of conducting basic research and spread the riskand investment involved in product development.  We have entered into research, development and commercializationalliances and collaborations with major pharmaceutical and biotechnologycompanies across our business. Depending on the nature of each prospective business opportunity, thekey components of the commercial terms of such alliance arrangements typicallyinclude one or more of the following: research funding; up-front, exclusivity,technology access, and technology development fees; milestone payments; licenseor commercialization fees; and royalties or profit sharing from thecommercialization of products.

 

Significant elements ofour revenue are summarized as follows:

 
|                                                                       |   | **For the  Three Month Periods Ended March 31,** |   |
|----------------------------------------------------------------------------|--------|-------------------------------------------------------|--------|
|                                                                       |   | **2004**                                              |   | **2003** |   |
|                                                                       |   | **(In  thousands)**                                   |   |
| Research funding and service fees                                          |   | $                                                     | 7,897  |   | $ | 8,601 |   |
| Milestone payments                                                         |   | 165                                                   |   | 1,365 |   |
| Up-front, exclusivity, technology access,  and technology development fees |   | 1,000                                                 |   | 1,000 |   |
| Other                                                                      |   | 1,220                                                 |   | 876 |   |
|                                                                       |   | $                                                     | 10,282 |   | $ | 11,842 |   |

 

Collaborations with our mostsignificant partners include:

 

*F. Hoffmann-La Roche (Roche)*

 

*Therapeutics.* In 1998 we entered into a research collaboration and cross-licenseagreement with Roche, which terminated in 2002, under which we identified keygenetic factors involved in ten common diseases: osteoarthritis, Alzheimer’sdisease, schizophrenia, PAOD, stroke, osteoporosis, obesity, anxiety,non-insulin-dependent diabetes and rheumatoid arthritis.  In January 2002, we entered into a newthree-year agreement with Roche focused on turning the achievements of our 1998gene discovery collaboration into novel

 

16

----

 

therapeutics.  The 2002 agreement provided that we wouldcollaborate with respect to four diseases that had been the subject of the 1998agreement.  We are currently collaboratingon two of those diseases.  Under the2002 agreement, we have received $17,000,000 in research funding and mayreceive an additional $3,000,000 in research funding during the remainder ofthe term of the agreement.  Theagreement provides that upon the development of specified compounds during theterm of the agreement and for a specified period thereafter we may receivemilestone payments, the amount of which will depend on the type of compounddeveloped.  In addition, we will be entitledto receive royalties on the sales of drugs that are developed.  We expect that we will not receive researchfunding under the 2002 agreement after February 1, 2005, when the researchterm ends, unless we and Roche decide to extend the collaboration beyond thattime.

 

*Diagnostics.*  In June 2001, we signed a five-yearalliance with Roche’s diagnostics division to develop and market DNA-baseddiagnostics for major diseases.  Morerecently we have added research programs aimed at developing diagnostics to predictdrug response for major therapeutics used to treat those diseases, in order tohelp select the most effective treatment of those available.  Under the agreement, we have received$30,187,500 in research funding, up-front fees and milestone payments.  We may receive $14,062,500 in additionalresearch funding over the remainder of the term of the agreement as well asmilestone payments upon the achievement of research and development milestonesand royalties on the sales of diagnostic products developed.

 

Revenues from thesealliances with Roche amounted to $3.4 million and $5.3 million for thethree-month periods ended March 31, 2004 and 2003, respectively.

 

*Merck & Co., Inc. (Merck)*

 

*Obesity.*  In September 2002, we entered into analliance with Merck aimed at developing new treatments for obesity.  Under the alliance, we are combining ourresearch efforts in the genetics of obesity to identify, validate andprioritize a series of drug targets to take into development.  Under the terms of the three-year agreement,which can be extended on a year-to-year basis upon the consent of the parties,we have received research funding, technology access fees and milestonepayments in the aggregate amount of $14,875,000 and may receive researchfunding and technology access in the future of $9,625,000.  In addition, we may receive further researchmilestone payments and we may receive milestone payments as compounds developedunder the alliance advance in the development process and royalties onsuccessfully marketed drugs.  Merck mayterminate the agreement at any time upon 90 days’ notice or afterSeptember 26, 2004 upon 30 days’ notice in the event that theresearch program fails to achieve certain specified goals.

 

*Information-RichClinical Trials.*  InFebruary 2004, we entered into an agreement with Merck under which we willconduct information-rich clinical trials on a range of Merck’s developmentalcompounds. The term of the alliance is seven years, subject to termination byMerck after five years.  We will, at anygiven point over the course of the alliance, be conducting concurrent trials onas many as five Merck compounds.  Thecollaboration involved three agreements: (a) License and Research CollaborationAgreement; (b) a Stock and Warrant Purchase Agreement; and (c) a WarrantAgreement.   Under the terms of theLicense and Research Collaboration Agreement, deCODE will receive royalties onsales of drugs and diagnostics developed as part of the alliance, will receivemilestone payments as compounds or pharmacogenomic tests reach the market, willreceive research funding for the clinical development of compounds andpharmacogenomic analysis, and received a one-time technology access fee of$10,000,000. There is a contingency clause on the technology access fee if wereject the first two non-exclusive development compounds that Merck presents tothe collaboration, then Merck has the right to request a refund of $2.5 millionof the technology access fee.  Under theterms of the Stock and Warrant Purchase Agreement, Merck has purchased 689,703shares of our common stock at a price of $14.50 per share or $10 million,which represents a premium of $2.7 million to the fair market value of thestock on the effective date of the agreements ($10.60).  Accordingly, of the $10 million cashreceived, we have ascribed $7.3 million to the common stock and $2.7 millionpremium to deferred revenue.  Under theterms of the Warrant Agreement, we have issued Merck a warrant to purchase upto 1,724,257 of additional shares of our common stock at an exercise price of$29.00 per share over the next five years. The warrant shall be exercisable atthe option of Merck as to 344,851 shares for a period of 30 days commencing onthe first, second, third, fourth and fifth anniversaries of the WarrantAgreement with the final portion of warrants expiring in March 2009.  Any portion of this warrant that is notexercised during an applicable exercise period shall expire and be of nofurther force or effect. The warrant was valued at $6.3 million using a BlackScholes model with the following assumptions: lives of one to five years, riskfree interest rates of 1.24% to 3.07%, volatility of 90% and no dividendyield.  The one-time technology accessfee and the premium portion of the equity purchase together with the estimatedfair value of the warrant have been deferred and the $6.4 million netamount is included in deferred revenue at March 31, 2004 and will berecognized as revenue over the seven year development term.

 

Revenues from thetherapeutics and other alliances with Merck during the periods presentedamounted to $1.9 million and $1.8 million for the three-month periodsended March 31, 2004 and 2003, respectively.

 

Revenue for thethree-month periods ended March 31, 2004 and 2003 are as follows:

 
|    |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|---------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|    |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|    |   | **(In  thousands, except%)** |   |
| Revenue |   | $                            | 10,282 |     | $      | 11,842                        |   | $ | (1,560 | ) | (13 | )% |
|         |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

The 13% decrease in revenue in the three-month periodended March 31, 2004 from the same period in 2003 is reflective of the long-term, product developmentfocus of our business strategy and our corporate partnerships, as well as thetiming of milestone payments. At the close of the quarter the company had $18.9million in deferred revenue, compared to $12.8 million at the close of thefirst

 

17

----

 

quarter 2003. This increase is reflects cash received related to thecompany’s new alliance with Merck, and will be recognized, along with otherdeferred revenue, over future reporting periods.  We expect that our revenues will fluctuate fromquarter to quarter and that such fluctuations may be substantial especiallybecause progress in our scientific work, including milestone payments that arerelated to progress, can fluctuate between quarters.

 

*Researchand Development, including Cost of Revenue*.  Research and development expenses for thethree-month periods ended March 31, 2004 and 2003 are as follows:

 
|                                                |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|-----------------------------------------------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|                                                |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|                                                |   | **(In  thousands, except%)** |   |
| Research and Development including Cost of  Revenue |   | $                            | 15,433 |     | $      | 19,671                        |   | $ | (4,238 | ) | (22 | )% |
|                                                     |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

The 22% decrease in the quarter ended March 31, 2004as compared to the same period in 2003 reflects the successful streamlining andautomation of the company’s core genetics research operations together withincreased expenditures on product development, with notable reductionsin our salary and related expenses ($1.8 million), usage of chemicals andconsumables ($0.3 million) and our research and development facilities-relatedand other overheads ($0.9 million). Further, productivity gains have enabled acceleration in our basic geneand target discovery work while also making available the resources toundertake preparations for clinical work on our lead drug developmentprograms.  Our research and developmentexpenses for the quarter ended March 31, 2004 as compared to the same period in2003 also reflect a relative net benefit of $0.5 million resulting from(i) materials and supplies we used for which there was relatively littleor no attendant cost as a result of prior provisions we had made as slowmoving, excess or obsolete according to our accounting policy, and(ii) development funding received from International Business MachinesCorporation (IBM).

 

In April 2004, we initiated a ten-week, information-rich Phase IIa clinical trial in Iceland that willexamine the effect of various dose levels of our developmental compound DG031on the production of leukotrienes and other biomarkers associated with vascularinflammation. We plan to employ the data generated in this trial to optimizethe design of an information-rich, multicenter Phase III trial to test DG031for the prevention of heart attack that may commence before the end of 2004.

 

*Selling,General and Administrative Expenses.*  Selling, general and administrative expensesfor the three-month periods ended March 31, 2004 and 2003 are as follows:

 
|                               |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|------------------------------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|                               |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|                               |   | **(In  thousands, except%)** |   |
| Selling General and Administrative |   | $                            | 4,230  |     | $      | 4,257                         |   | $ | (27 | ) | (1 | )% |
|                                    |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

Our selling, general andadministrative expenses were virtually unchanged in the quarter ended March 31,2004 as compared to the same period in 2003. Our selling, general and administrative expenses for the quarter endedMarch 31, 2004 as compared to the same period in 2003 show an improvement inselling, general and administrative overheads ($0.5 million), an increase insalaries and employee benefits ($0.4 million) and an increase in our director’sand officer’s insurance premiums ($0.3 million).

 

*StockBased Compensation and Remuneration Expense.*  Stock based compensation and remunerationexpense for the three-month periods ended March 31, 2004 and 2004 are asfollows:

 
|                                               |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|----------------------------------------------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|                                               |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|                                               |   | **(In  thousands, except%)** |   |
| Stock Based Compensation and Remuneration  Expense |   | $                            | 261    |     | $      | 552                           |   | $ | (291 | ) | (53 | )% |
|                                                    |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

With little compensationexpense being attributed to our more recent stock option grants, stock-basedcompensation and remuneration expense has been decreasing as grants made toemployees in earlier years become fully vested.  Historical stock-based compensation and remuneration is notnecessarily representative of the effects on reported income or loss for futureyears due to, among other things, the vesting period of the stock options, thevalue of stock options that have been granted in recent times and the value ofadditional options that may be granted in future years.

 

*EmployeeTermination Charges.* Impairment, employee termination benefits and other costs for thethree-month periods ended March 31, 2004 and 2003 are as follows:

 

18

----

 
|                         |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|------------------------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|                         |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|                         |   | **(In  thousands, except%)** |   |
| Employee Termination Charges |   | $                            | 0      |     | $      | 485                           |   | $ | (485 | ) | (100 | )% |
|                              |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

Beginning in September2002, we implemented a cost reduction program aimed at achieving positiveoperating cashflow from existing operations by the end of 2003.  In this regard, we reduced total worldwideheadcount, focusing in particular on utilizing ongoing process automation andincreased productivity in the core genetics operations in Reykjavik,Iceland.  During the year ended December 31,2003, we recorded $951,000 of additional employee terminations benefits.  The following summarizes the charges,payments and unpaid termination benefits for the three month periods endingMarch 31, 2004 and 2003:

 
|                           |   | **For the  Three  Month Periods Ended  March 31,** |   |
|--------------------------------|--------|---------------------------------------------------------|--------|
|                           |   | **2004**                                                |   | **2003** |   |
|                           |   | **(In  thousands)**                                     |   |
| Balance at beginning of period |   | $                                                       | 66     |   | $ | 874 |   |
| Additions to accrual           |   | 0                                                       |   | 485 |   |
| Payments of benefits           |   | (66                                                     | )      | (1,155 | ) |
|                           |   | $                                                       | 0      |   | $ | 204 |   |

 

The charges related to termination benefits are for 0 and 27 employeesduring the three-month periods ended March 31, 2004 and 2003, respectively.

 

*InterestIncome.*  Interestincome for the three-month periods ended March 31, 2004 and 2003 are asfollows:

 
|            |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|-----------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|            |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|            |   | **(In  thousands, except%)** |   |
| Interest Income |   | $                            | 235    |     | $      | 355                           |   | $ | (120 | ) | (34 | )% |
|                 |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

In general, the decreasedreturns are attributable to the continued decline of prevailing interest ratesbut also from an overall decrease in our cash balance as we utilize theproceeds of, among other of our financing activities, our initial publicoffering.

 

In April 2004, we completed anoffering of 3.5% Senior Convertible Notes realizing gross proceeds of $150.0million.  We expect to use the proceedsof this offering principally for advancing our drug development programs.  In the meantime, we will invest the moniesreceived in accordance with our policy, having the objective of preservingprincipal while maximizing income we receive from our investments withoutsignificantly increasing risk.  Weexpect to maintain our portfolio of cash equivalents and short-term investmentsin a variety of securities, including commercial paper, money market funds andgovernment and non-government debt securities. As a result, we expect that the amount of our interest income willincrease in the future although the rate of returns on the portfolio may notincrease appreciably.

 

*Interest Expense.*  Interest expense for the three-month periods ended March 31,2004 and 2003 are as follows:

 
|             |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|------------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|             |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|             |   | **(In  thousands, except%)** |   |
| Interest Expense |   | $                            | 1,199  |     | $      | 916                           |   | $ | 283 |   | 31 | % |
|                  |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

The increase in interestexpense from 2003 reflects the cost of financings put into place during thelate part of 2001 and early part of 2002 and, from 2003, reflects an equipmentsale-leaseback financing in June, as well as short-term borrowings made in thelatter-half of 2003.

 

In April 2004, wecompleted an offering of 3.5% Senior Convertible Notes due 2011 realizing grossproceeds of $150.0 million.  We will payinterest on the notes in April and October of each year, beginning October2004.  As a result, our interest expensewill increase considerably in the future.

 

*OtherNon-Operating Income and Expense, Net.*  Other non-operating income and expense forthe three-month periods ended March 31, 2004 and 2003 are as follows:

 

19

----

 
|                                        |   |                         |   |     |   | **2004 as  Compared to 2003** |   |
|---------------------------------------------|--------|------------------------------|--------|----------|--------|-------------------------------|--------|
|                                        |   | **2004**                     |   | **2003** |   | **$ Change**                  |   | **% Change** |   |
|                                        |   | **(In  thousands, except%)** |   |
| Other Non-Operating Income And Expense, Net |   | $                            | (1,658 | )        | $      | 90                            |   | $ | (1,748 | ) | 1,942 | % |
|                                             |        |                              |        |          |        |                               |        |  |  |  |  |  |

 

Our other non-operatingincome and expense, net for the quarters ended March 31, 2004 and 2003comprises unrealized and realized swap gains and losses and the net impact offoreign exchange.  In March 2004, weliquidated our two cross-currency swaps receiving $9.7 million inproceeds.  We realized a loss on thisearly termination that, together with unrealized losses on the swaps during thequarter ended March 31, 2004, amounted to $1.5 million.  Unrealized gains on the two cross-currencyswaps in the quarter ended March 31, 2003 were $0.3 million.

 

*IncomeTaxes.*  As ofMarch 31, 2004, we had an accumulated deficit of $342.2 million and didnot owe any Icelandic or U.S. federal income taxes nor did we pay any in the three-monthperiods ended March 31, 2004 and 2003. Realization of deferred tax assets is dependent on future earnings, ifany.  As of December 31, 2003, wehad net operating losses able to be carried forward for U.S. federal income taxpurposes of approximately $31.4 million to offset future taxable income inthe United States that expire at various dates through 2023.  Also, as of December 31, 2003, ourforeign subsidiaries had net operating losses carried forward of approximately$146.3 million that expire in varying amounts beginning in 2006.

 

*NetLoss and Basic and Diluted Net Loss Per Share*. Net loss andbasic and diluted net loss per share for the three-month periods endedMarch 31, 2004 and 2003 are as follows:

 
|                                 |   |                         |    |     |   | **2003 as  Compared to 2002** |   |
|--------------------------------------|--------|------------------------------|---------|----------|--------|-------------------------------|--------|
|                                 |   | **2004**                     |    | **2003** |   | **$ Change**                  |   | **% Change** |   |
|                                 |   | **(In  thousands, except%)** |    |
| Net Loss                             |   | $                            | (12,036 | )        | $      | (13,042                       | )      | $ | (1,006 | ) | (8 | )% |
|                                 |   |                         |    |     |   |                          |   |   |   |
| Basic and Diluted Net Loss Per Share |   | $                            | (0.23   | )        | $      | (0.25                         | )      | $ | (0.02 | ) | (8 | )% |

 

Net loss and basic anddiluted net loss per share both declined 8% for the quarter ended March 31,2004 as compared to the quarter ended March 31, 2003 principally due to the successful streamlining andautomation of the company’s core genetics research operations.

 

**Liquidityand Capital Resources**

 

We have financed ouroperations primarily through funding from research and developmentcollaborative agreements and the issuance of equity securities and long-termfinancing instruments ($538 million from the beginning of 1999 to-date).  Future funding under terms of our existingagreements is approximately $53 million excluding milestone payments androyalties that we may earn under such collaborations.  In April 2004, we completed an offering of 3.5% SeniorConvertible Notes in which we received $144 million, net of expenses.

 

Although we currentlydepend upon funded research arrangements for a significant portion of ourrevenue, we continue to invest in proprietary research and we will incur thecosts of such research.  In the nearterm, this will require us to continue to make investments in our in-housecapabilities for downstream development which we believe will better positionus to capture the most value to us in our discoveries.  As we identify promising discoveries forfurther development, we may choose to continue the development ourselves intoand through clinical trials, regulatory clearances and manufacture,distribution and marketing. In other cases we are or will be working to varyingdegrees with partners.  The decisions wemake as to these matters will affect our cash requirements.

 

Based upon the range ofour current activities, and without regard to any changes we may make inadvancing our drug development programs as a result of the additional resourcesprovided by the recent offering of Senior Convertible Notes, we currentlyexpect to have an overall net use of cash in 2004 in our operating, investingand financing activities very similar to that used in 2003($18.6 million).  Debt service in2004 together with net payments on short-term borrowings and other workingcapital needs are expected to amount to $15.0 million, excluding theadditional $5.2 million annual interest on our new 3.5% Senior ConvertibleNotes.  In February 2004, wereceived total proceeds of $20.0 million from Merck for their purchase ofdeCODE common stock and an upfront technology access fee.  Of the $20.0 million received, $7.3 millionhas been ascribed to the value of the common stock and $12.7 million consideredupfront payments associated with the collaboration.  Although our capital expenditure needs and other investingactivities may in the future fluctuate significantly from period to period, wecurrently anticipate that we will largely only make replacement capitalexpenditures in 2004.  We will continueto carefully manage our basic operating costs. However, having completed our $150,000,000 Senior Convertible Notesoffering we are better positioned to advance our own programs and to makedecisions as to which programs to partner and how.  We are able and ready to deploy the necessary resources to bringour proprietary programs into the clinic and we will be re-examining ourstrategic options in advancing such programs. Our most advanced proprietarydrug discovery programs are in myocardial

 

20

----

 

infarction and peripheralarterial occlusive disease (PAOD).  Inour myocardial infarction program we in-licensed DG031 in the fourth quarter of2003, a compound that we will be testing in the clinic as a treatment forvascular inflammation and the prevention of heart attack and in April 2004 webegan our Phase II information-rich clinical trial.  In our PAOD program, during 2003 we advanced into screening oflead compounds and we anticipate filing an investigational new drug (IND)application in PAOD by the end of 2004 or early 2005 and entering into theclinic shortly thereafter.

 
|                                        |   | **For the  Three Month  Periods Ended March 31,** |   |
|---------------------------------------------|--------|--------------------------------------------------------|--------|
|                                        |   | **2004**                                               |   | **2003** |   |
|                                        |   | **(In  thousands)**                                    |   |
|                                        |   |                                                   |   |   |   |
| **Cash provided by (used in):**             |   |                                                   |   |   |   |
| Operating activities                        |   | $                                                      | 7,048  |   | $ | (12,260 | ) |
| Investing activities                        |   | (654                                                   | )      | (325 | ) |
| Financing activities                        |   | 15,893                                                 |   | (1,437 | ) |
| Cash and cash equivalents, at end of period |   | 90,956                                                 |   | 73,222 |   |
|                                             |        |                                                        |        |  |  |  |  |

 

*Cashand Cash Equivalents.* At March 31, 2004, we had $97.0 million in cash and cashequivalents, including $6 million in restricted cash. This is approximately $22million more than at the close of the fourth quarter of 2003. The increasereflects equity and technology access fee payments received related to thesigning of a new drug development alliance with Merck ($20.0 million) and theliquidation of our two currency swaps ($9.7 million), offset in part by costsassociated with the advancement of our drug development programs.  For the quarter ended March 31, 2004,capital expenditures amounted to $0.7 million and debt service was $1.9million.  Available cash is invested inaccordance with our investment policy’s primary objectives of liquidity, safetyof principal and diversity of investments. Our cash is deposited only with financial institutions in Iceland, theUnited Kingdom and the United States having a high credit standing.  This cash is largely invested in U.S. dollardenominated money market and checking accounts and also in Icelandic kronadenominated accounts.

 

*Operating Activities.*  Net cash provided by operating activitiesincreased to $7.0 million for the quarter ended March 31, 2004 as compared to ause of $12.3 million for the same period in 2003.  Together with the $12.7 million technology access fee and premiumon common stock received from Merck in the quarter ended March 31, 2004,working capital provided $14.5 million of funds as compared to a use$4.4 million in the three-month period ended March 31, 2003.  As more fully described above, the decreasein use of cash in operating activities reflects the successful streamlining and automation of the company’s coregenetics research operations together with increased expenditures on productdevelopment.

 

*InvestingActivities.*  Ourinvesting activities have consisted of capital expenditures and long-termstrategic equity investments in, and acquisitions of, technologies andbusinesses that are complementary to our business.  Purchases of property and equipment during the three-month periodended March 31, 2004 were $0.7 million as compared to $0.3 million inthe three-month period ended March 31, 2003.  We principally made replacement capital expenditures during 2003and into 2004 and did invest in certain equipment for our statistical labduring the quarter ended March 31, 2004. Although we expect to continue to make simply replacement capitalexpenditures, net cash used in investing activities may in the future fluctuatesignificantly from period to period due to the timing of our capitalexpenditures and other investments.

 

*FinancingActivities.*  Net cashof $15.9 million was provided in financing activities in the three-monthperiod ended March 31, 2004, as compared to $1.4 million used infinancing activities in the three-month period ended March 31, 2003.  Financing activities for the three-monthperiod ended March 31, 2004 largely consisted of proceeds on the issuanceof common stock to Merck ($7.7 million), proceeds in the liquidation ofour two cross-currency swap ($9.7 million) and installment payments on ourexisting debt and capital lease obligations ($1.9 million).

 

In March 2004, we entered into a $17,500,000term loan with an Icelandic financial institution (the “Lender”) to refinanceour Tier C bonds and Tier D bank loan, thereby securing a significantly lowerinterest rate and extended payment terms on this portion of our mortgageobligations.  The new term loan bearsinterest at the three-month LIBOR plus 3% (4.11% as of March 31, 2004) untilMarch 1, 2009, at which point, the Lender may adjust the interest marginunilaterally.  The term loan is payablein twenty quarterly payments starting on March 1, 2009 and the final payment isdue on December 1, 2013.  The termloan can be repaid on every anniversary of the loan starting on March 1, 2006,but for which we will pay a prepayment fee of 1% for every year that remains onthe term loan facility with a maximum fee of 6%.

 

In April 2004, we completed an offering of 3.5%Senior Convertible Notes due 2011 to qualified institutional buyers pursuant toRule 144A. In addition to the $125.0 million principal amount of Notes offered,we issued a further $25.0 million of Notes pursuant to the exercise of theover-allotment option by the initial purchasers of the Notes.  The Notes are convertible into shares of ourcommon stock, at the option of the holder, at a price of $14.00 per share,equivalent to an initial conversion rate of approximately 71.43 shares per$1,000 principal amount of the Notes. We may redeem the Notes beginning April 20, 2009. We expect to use the proceeds of the offeringprincipally for advancing our drug development programs, as well as for generalcorporate purposes.

 

21

----

 

*General*.  We believe that our existingresources will be adequate to satisfy our capital needs for several years. Ourcash requirements depend on numerous factors, including our ability to obtainnew research collaboration agreements, to obtain subscription and collaborationagreements for the database services; to obtain and maintain contract service agreementsin our chemistry services and clinical research trials groups; expenditures inconnection with alliances, license agreements and acquisitions of andinvestments in complementary technologies and businesses; competingtechnological and market developments; the cost of filing, prosecuting,defending and enforcing patent claims and other intellectual property rights;the purchase of additional capital equipment, including capital equipmentnecessary to ensure that our sequencing and genotyping operations remaincompetitive; and capital expenditures required to expand our facilities.Changes in our research and development plans, the entry into clinical trialsof a drug based on our discoveries, or other changes affecting our operatingexpenses may result in changes in the timing and amount of expenditures of ourcapital resources.

 

We will require significant additional capital in the future, which wemay seek to raise through further public or private equity offerings,additional debt financing or added collaborations and licensing arrangements.No assurance can be given that additional financing or collaborations andlicensing arrangements will be available when needed, or that if available,will be obtained on favorable terms. If adequate funds are not available whenneeded, we may have to curtail operations or attempt to raise funds onunattractive terms.

 

***Recent AccountingPronouncements***

 

In January 2003, the Financial AccountingStandards Board (FASB) issued FASB Interpretation No. 46, “Consolidation ofVariable Interest Entities, an Interpretation of ARB No. 51”, (FIN 46).  FIN 46 requires that if an entity has acontrolling financial interest in a variable interest entity, the assets,liabilities and results of activities of the variable interest entity should beincluded in the consolidated financial statements of the entity. FIN 46requires that its provisions are effective immediately for all arrangementsentered into after January 31, 2003. For those arrangements entered into priorto January 31, 2003, FIN 46, as amended by FIN 46R, provisions are required tobe adopted in the first quarter of 2004. deCODE does not have any financialinterests in variable interest entities created after January 31, 2003. Theadoption of FIN 46R did not impact on our financial position or its results ofoperations for the quarter ended March 31, 2004.

 

**RISK FACTORS, FORWARD-LOOKING STATEMENTS, ANDCAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS**

 

This report contains forward-looking statements. These statements relateto future events or our future financial performance. In some cases,forward-looking statements can be identified by terminology such as “may,”“will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,”“estimate,” “predict,” “intend,” “potential” or “continue” or the negative ofsuch terms or other comparable terminology. These statements are onlypredictions. We cannot assure our investors that our expectations andassumptions will prove to have been correct. We undertake no intention or obligationto update or revise any forward-looking statements, whether as a result offuture events, new information or otherwise. Actual events or results maydiffer materially due to a number of factors, including those set forth in this section and elsewhere in this Form10-Q. These factors include, but are not limited to, the risks set forth below.

 

# **Risks Related to Our Business**

 

***We may not successfully develop or derive revenuesfrom any products.***

 

We use ourtechnology and research capabilities primarily to identify genes or genefragments that are responsible for certain diseases, indicate the presence ofcertain diseases or cause or predispose individuals to certain complexdiseases. Although we have identified genes that we believe are likely to causecertain diseases, we may not be correct and may not be successful inidentifying any other similar genes. Many experts believe that some of thediseases we are targeting are caused by both genetic and environmental factors.Even if we identify specific genes that are partly responsible for causingdiseases, any gene-based therapeutic or diagnostic products may not detect,prevent, treat or cure a particular disease. Accordingly, even if we aresuccessful in identifying specific genes, our discoveries may not lead to thedevelopment of commercial therapeutic or diagnostic products.

 

Any pharmaceutical ordiagnostic products that we or our collaborators are able to develop will failto produce revenues unless we:

 

•                  establishthat they are safe and effective;

 

22

----

 

•                  successfullycompete with other technologies and products;

 

•                  ensurethat they do not infringe on the proprietary rights of others;

 

•                  establishthat they can be manufactured in sufficient quantities at reasonable costs; and

 

•                  canmarket them successfully.

 

We may not be ableto meet these conditions. We expect that it will be years, if ever, before wewill recognize significant revenue from the development of therapeutic ordiagnostic products.

 

Our informaticsproducts may not meet the needs of potential customers. We have generatedlittle revenue from sales or licenses of informatics products. We cannot assureyou that we can successfully develop or commercialize, or that there will be amarket for, our informatics products.

 

***If we continue to incur operating losses longer thananticipated, or in amounts greater than anticipated, we may be unable tocontinue our operations.***

*** ***

We incurred a netloss of $12.0 million for the quarter ended March 31, 2004, and had anaccumulated deficit of $342.2 million at March 31, 2004. We have nevergenerated a profit and we have not generated revenues except for paymentsreceived in connection with our research and development collaborations withRoche, Merck and other collaborations, and from contract services. Our researchand development expenditures and general and administrative costs have exceededour revenue to date, and we expect to spend significant additional amounts tofund research and development in order to enhance our core technologies andundertake product development (including drug development and related clinicaltrials) and to prepare our informatics products. We do not expect to receiveroyalties or other revenues from commercial sales of products developed usingour technology in the near term.  It maybe several years before product revenues materialize, if they do at all.  As a result, we expect to incur net lossesfor several years. If the time required to generate product revenues and achieveprofitability is longer than we currently anticipate or the level of losses isgreater than we currently anticipate, we may not be able to continue ouroperations.

 

***If our assumption about the role of genes in diseaseis wrong, we may not be able to develop useful products.***

*** ***

The products wehope to develop involve new and unproven approaches. They are based on theassumption that information about genes may help scientists to betterunderstand complex disease processes. Scientists generally have a limitedunderstanding of the role of genes in diseases, and few products based on genediscoveries have been developed. Of the products that exist, all are diagnosticproducts. To date, we know of no therapeutic products based on disease-genediscoveries. If our assumption about the role of genes in the disease processis wrong, our gene discovery programs may not result in products, the geneticdata included in our database and informatics products may not be useful to ourcustomers and those products may lose any competitive advantage.

 

***Clinical trials required for our product candidates orthe products of our customers and partners are expensive and time-consuming,and their outcome is uncertain.***

*** ***

Before obtainingregulatory approvals for the commercial sale of any of our products underdevelopment, we must demonstrate through pre-clinical studies and clinicaltrials that the product is safe and effective for use in each targetindication. Pre-clinical testing and clinical development are long, expensiveand uncertain processes. It may take several years to complete testing for aproduct and failure can occur at any stage of testing. The length of timenecessary to complete clinical trials varies significantly and may be difficultto predict. Factors that can cause delay or termination of our clinical trialsinclude:

 

•                  slowerthan expected patient enrollment due to the nature of the protocol, theproximity of patients to clinical sites, the eligibility criteria for thestudy, competition with clinical trials for other drug candidates or otherfactors;

 

•                  lowerthan expected retention rates of patients in a clinical trial;

 

•                  inadequatelytrained or insufficient personnel at the study site to assist in overseeing andmonitoring clinical trials;

 

•                  delaysin approvals or failure to obtain approval from the pertinent review board forstudies conducted at sites outside of Iceland;

 

•                  delaysin approvals or the failure to obtain approval from the National BioethicsCommittee for trials in Iceland;

 

•                  longertreatment time required to demonstrate effectiveness or determine theappropriate product dose;

 

•                  lackof sufficient supply of the product candidate;

 

•                  adversemedical events or side effects in treated patients;

 

•                  lackof effectiveness of the product candidate being tested; and

 

23

----

 

•                  regulatorychanges.

 

Even if we obtainpositive results from pre-clinical or clinical trials for a particular product,we may not achieve the same success in future trials of that product. Inaddition, some or all of the clinical trials we undertake may not demonstratesufficient safety and efficacy to obtain the requisite regulatory approvals,which could prevent the creation of marketable products. Our productdevelopment costs will increase if we have delays in testing or approvals, ifwe need to perform more or larger clinical trials than planned or if our trialsare not successful. Delays in our clinical trials may harm our financialresults and the commercial prospects for our products.  Delays or termination of clinical trialsthat we conduct for our partners or customers may also harm our financialresults as payments under these contracts may be delayed, reduced or curtailed.

 

***Because revenues are concentrated, the loss of asignificant customer would harm our business.***

*** ***

Historically, asubstantial portion of our revenue has been derived from contracts with alimited number of significant customers. Our largest customer, Roche, accountedfor approximately 43% of our consolidated revenue in 2003 and 33% ofconsolidated revenue in the three-month period ended March 31, 2004. Revenueunder our alliance with Merck accounted for approximately 19% of consolidatedrevenue in 2003 and 18% of consolidated revenue in the three-month period endedMarch 31, 2004. Revenues under the joint development and commercializationagreement with ABG, which was terminated in the fourth quarter of 2002,accounted for 15% of consolidated revenue in the year ended December 31,2002. The loss of any significant customer may significantly lower our revenuesand affect our progression to profitability.

 

***If we are not able to obtain sufficient additionalfunding to meet our capital requirements, we may be forced to reduce orterminate our research and product development programs.***

*** ***

We have spent substantialamounts of cash to fund our research and development activities and expect tocontinue to spend substantial amounts for these activities over the nextseveral years. We expect to use cash to collect, generate and analyze genotypicand disease data from volunteers in our disease-gene research programs; toconduct drug discovery and development activities; to continue to developdatabase and healthcare informatics products; and to continue other researchand development activities. Many factors will influence our future capitalneeds, including:

 

•                  thenumber, breadth and progress of our discovery and research programs;

 

•                  ourability to attract customers;

 

•                  ourability to commercialize our discoveries and the resources we devote tocommercialization;

 

•                  theamount we spend to enforce patent claims and other intellectual propertyrights; and

 

•                  thecosts and timing of regulatory approvals.

 

We intend to relyon Roche, Merck and other existing and future collaborators for significantfunding of our research efforts. In addition, we may seek additional fundingthrough public or private equity offerings and debt financings. We may not beable to obtain additional financing when we need it or the financing may not beon terms favorable to us or our stockholders. Stockholders’ ownership will bediluted if we raise additional capital by issuing equity securities.

 

If we raiseadditional funds through collaborations and licensing arrangements, we may haveto relinquish rights to some of our technologies or product candidates, orgrant licenses on unfavorable terms. If adequate funds are not available, wewould have to scale back or terminate our discovery and research programs andproduct development.

 

The Icelandic parliament enactedlegislation in 2002, authorizing the Minister of Finance to provide anIcelandic government guarantee of a convertible bond offering of up to $200million by us for the purpose of financing our new activities in the area ofdrug development.  To become effective,this legislation must be approved by the European Free Trade AssociationSurveillance Authority, or ESA, following a notification to ESA by the Ministerof Finance. ESA’s task is to ensure compatibility with the state aidstipulations of the agreement on the European Economic Area, to which Icelandis a signatory. The ESA began a formal investigation procedure with regard tothe proposed state guarantee in 2003. Following completion of the sale of our 3.5% Senior Convertible Notesdue 2011 in April, 2004, we advised the Minister of Finance that we did notintend to seek government guaranteed financing pursuant to thislegislation.  As a result, the Ministerof Finance withdrew its notification of the proposed state aid to ESA, whichsubsequently terminated its review. At this time no action is being take tomake the 2002 legislation effective, nor is it likely that such action will betaken in the future.

 

***If we cannot successfully develop a marketing andsales force or maintain suitable arrangements with third parties to market andsell our products, our ability to deliver products may be impaired.***

*** ***

We currently have noexperience in marketing or selling pharmaceutical products. In order to achievecommercial success for any approved product, we must either develop a marketingand sales force, which will require substantial additional funds and personnel,or, where appropriate or permissible, enter into arrangements with thirdparties to market and sell our products. We might not be

 

24

----

 

successful in developingmarketing and sales capabilities. Further, we may not be able to enter intomarketing and sales agreements with others on acceptable terms, and any sucharrangements, if entered into, may be terminated. If we develop our ownmarketing and sales capability, it will compete with other companies thatcurrently have experienced, well-funded and larger marketing and salesoperations. To the extent that we enter into co-promotion or other sales andmarketing arrangements with other companies, revenues will depend on theefforts of others, which may not be successful.

 

***If we cannot successfully form and maintain suitablearrangements with third parties for the manufacturing of the products we may develop,our ability to develop or deliver products may be impaired.***

*** ***

We have noexperience in manufacturing products for commercial purposes and do not havemanufacturing facilities. We must either develop such facilities, which willrequire substantial additional funds, or rely on contract manufacturers for theproduction of products for development and commercial purposes. The manufactureof our products for clinical trials and commercial purposes is subject to cGMPregulations promulgated by the FDA. In the event that we are unable to developsatisfactory manufacturing facilities or obtain or retain third-partymanufacturing for our products, we will not be able to commercialize suchproducts as planned. We may not be able to enter into agreements for themanufacture of future products with manufacturers whose facilities andprocedures comply with cGMP and other regulatory requirements. Our currentdependence upon others for the manufacture of our products may adversely affectour profit margin, if any, on the sale of future products and our ability todevelop and deliver such products on a timely and competitive basis.

 

***Our reliance on the Icelandic population may limit theapplicability of our discoveries to certain populations.***

*** ***

The geneticmake-up and prevalence of disease generally varies across populations aroundthe world. Common complex diseases generally occur with a similar frequency inIceland and other European populations. However, the populations of othernations may be genetically predisposed to certain diseases because of mutationsnot present in the Icelandic population. As a result, we and our partners maybe unable to develop diagnostic and therapeutic products that are effective onall or a portion of people with such diseases. Any difference between theIcelandic population and other populations may have an effect on the usefulnessof the Clinical Genome Miner in studying populations outside of Iceland. Forour business to succeed, we must be able to apply discoveries that we make onthe basis of the Icelandic population to other markets.

 

***If we fail to protect confidential data adequately, wecould incur a liability or lose the Icelandic Health Sector Database license.***

*** ***

Under laws andregulations in force in Iceland, including applicable European laws, directivesand regulations, all information on individuals that is used in our populationresearch is anonymized under the protocols and supervision of the DataProtection Authority of Iceland. If any of this data held or generated by us wereto become personally identifiable, we would risk losing public support forparticipation in its research, and could be liable to legal action. Any failureto comply fully with all confidentiality requirements could lead to liabilityfor damages incurred by individuals whose privacy is violated, the loss of ourcustomers and reputation and the loss of the goodwill and participation of theIcelandic population, including healthcare professionals. These eventualitiescould materially adversely affect our work in Iceland.

 

The same generalprivacy and data protection laws and regulations as well as specific laws andregulations apply to our license to build and operate the Icelandic HealthSector Database, or IHD. Were any data sent to or contained in the IHD tobecome personally identifiable, we would incur the same risks above andpotentially lose our database license.

 

***Some parts of our product development services createa risk of liability from clinical trial participants and the parties with whomwe contract.***

 

Through our wholly ownedsubsidiary Encode ehf., we contract with drug companies to perform a wide rangeof services to assist them in bringing new drugs to market. Our servicesinclude:

 

•                  supervisingclinical trials;

 

•                  dataand laboratory analysis;

 

•                  patientrecruitment;

 

•                  actingas investigators in conducting clinical trials; and

 

•                  engagingin Phase I clinical trials.

 

If, in the course of these trials or activities,

 

•                  wedo not perform our services to contractual or regulatory standards;

 

•                  wefail to obtain permission to conduct trials from the National BioethicsCommittee of Iceland;

 

•                  patientsor volunteers suffer personal injury caused by or death from adverse reactionsto the test drugs or otherwise;

 

25

----

 

•                  thereare deficiencies in the professional conduct of the investigators with whom wecontract;

 

•                  ourlaboratories inaccurately report or fail to report lab results; or

 

•                  ourinformatics products violate rights of third parties,

 

then, we could be held liable for these eventualitiesby the drug companies with whom we contract or by study participants. Wemaintain insurance to cover ordinary risks, but such insurance may beinadequate and it would not cover the risk of a customer deciding not to dobusiness with us as a result of poor performance.

 

***Use of therapeutic or diagnostic products developed asa result of our programs may result in product liability claims for which wehave inadequate insurance.***

*** ***

The users of anytherapeutic or diagnostic products developed as a result of our discovery orresearch programs or the use of our database or informatics products may bringproduct liability claims against us. We currently do not carry liabilityinsurance to cover such claims. We are not certain that we, or ourcollaborators will be able to obtain such insurance or, if obtained, thatsufficient coverage can be acquired at a reasonable cost. If we cannot protectagainst potential liability claims, we or our collaborators may find it difficultor impossible to commercialize products.

 

***Increased leverage as a result of our convertible debt may harm ourfinancial condition and results of operations.***

 

In April, 2004 we issued$150,000,000 principal amount of our 3.5% Senior Convertible Notes due 2011(the “Notes”).  At March 31, 2004, wewould have had $205,108,000 of outstanding debt as reflected in our balancesheet, after giving effect to the Notes. We may incur additional indebtednessin the future and the Notes do not restrict our future issuance ofindebtedness.  Our level of indebtednesswill have several important effects on our future operations, including,without limitation:

 

•              aportion of our cash flow from operations will be dedicated to the payment ofany interest  required with respect tooutstanding indebtedness;

 

•              increasesin our outstanding indebtedness and leverage will increase our vulnerability toadverse changes in general economic and industry conditions, as well as tocompetitive pressure; and

 

•              dependingon the levels of our outstanding debt, our ability to obtain additionalfinancing for working capital, capital expenditures, general corporate andother purposes may be limited.

 

Our ability to make paymentsof principal and interest on our indebtedness depends upon our futureperformance, which will be subject to the success of our development andcommercialization of new pharmaceutical products, general economic conditions,industry cycles and financial, business and other factors affecting ouroperations, many of which are beyond our control. If we are not able togenerate sufficient cash flow from operations in the future to service ourdebt, we may be required, among other things:

 

•               toseek additional financing in the debt or equity markets;

 

•               torefinance or restructure all or a portion of our indebtedness, including theNotes;

 

•               tosell selected assets; or

 

•               toreduce or delay planned expenditures on clinical trials, and development andcommercialization activities.

 

Such measures might not besufficient to enable us to service our debt. In addition, any such financing, refinancing or sale of assets might notbe available on economically favorable terms.

 

***We may be unable to hire and retain the key personnelupon whom our success depends.***

*** ***

We depend on the principal members of ourmanagement and scientific staff, including Dr. Kari Stefansson, Chairman,President and Chief Executive Officer and Hannes Smarason, Executive VicePresident and Senior Business Officer. We have not entered into agreements withany of these people that bind them to a specific period of employment. If anyof these people leaves, our ability to conduct our operations may be negativelyaffected. Our future success also will depend in part on our ability toattract, hire and retain additional personnel. There is intense competition forsuch qualified personnel and we cannot be certain that we will be able tocontinue to attract and retain such personnel. Failure to attract and retainkey personnel could have a material adverse effect on us.

 

***Currency fluctuations may negatively affect ourfinancial condition.***

*** ***

We publish ourconsolidated financial statements in U.S. dollars. Currency fluctuations canaffect our financial results because a portion of our cash reserves and ouroperating costs are in Icelandic kronas. A fluctuation of the exchange rates ofthe Icelandic krona against the U.S. dollar can thus adversely affect the“buying power” of our cash reserves and revenues. Most of our long-termliabilities are U.S. dollar denominated. However, we may enter into hedgingtransactions if we have substantial foreign currency exposure in the future. Wemay have increased exposure as a result of investments or payments fromcollaborative partners.

 

26

----

 

***Our contracts may terminate upon short notice.***

*** ***

Many of ourcontracts for research services are terminable on short notice. This means thatour contracts could be terminated for numerous reasons, any of which may bebeyond our control such as a reduction or reallocation of a customer’s researchand development budget or a change in a customer’s overall financial condition.The loss of a large contract or multiple smaller contracts, or a significantdecrease in revenue derived from a contract, could significantly reduce ourprofitability and require us to reallocate under-utilized physical andprofessional resources.

 

# **Risks Related to Our Collaborators**

# ** **

***We may not be able to form and maintain thecollaborative relationships that our business strategy requires and therelationships may lead to disputes over technology rights.***

*** ***

Our ability togenerate revenue growth and become profitable is dependent, in part, upon ourability to enter into additional collaborative arrangements, and upon ourability and that of our collaborative partners to successfully commercializeproducts incorporating, or based upon, our work.

 

We must formresearch collaborations and licensing arrangements with several partners at thesame time in order to execute our business strategy. We currently have a numberof collaborative relationships and only three substantial collaborativerelationships, including two with Roche. To succeed, we will have to maintainor expand these relationships and establish additional collaborations. Therecan be no assurance that we will be able to maintain or expand our existingcollaborations, enter into future collaborations to develop applications basedon existing or future research agreements, sign additional subscribers to ourdatabase services, or successfully expand our medicinal chemistry orpharmacogenomics businesses.

 

If our collaborations are not successful orif we are not able to manage multiple collaborations successfully, our programswill suffer. If we increase the number of collaborations, it will become moredifficult to manage the various collaborations successfully and the potentialfor conflicts among the collaborators as to rights to the technology andproducts generated under work conducted with us will increase.

 

***Dependence on collaborative relationships may lead todelays in product development, product defects and disputes over rights totechnology.***

*** ***

We depend oncollaborators for the pre-clinical study and clinical development oftherapeutic and diagnostic products and for regulatory approval, manufacturingand marketing of any products that result from our technology. Our agreementswith collaborators typically allow them significant discretion in electingwhether to pursue such activities. We cannot control the amount and timing of resourcescollaborators will devote to our programs or potential products.

 

In addition, ourarrangements may place responsibility for key aspects of informationtechnology, product development and marketing on our collaborative partners. Ifour collaborators fail to perform their obligations, our information technologyproducts could contain erroneous data, design defects, viruses or softwaredefects that are difficult to detect and correct and may adversely affect ourrevenues and the market acceptance of our products.

 

Our collaboratorsmay stop supporting our products or providing services to us if they develop orobtain rights to competing products. Disputes may arise in the future over theownership of rights to any technology developed with collaborators. These andother possible disagreements between our collaborators and us could lead todelays in the collaborative research, development or commercialization ofproducts. Such disagreements could also result in litigation or requirearbitration to resolve.

 

# **Risks Related to Our Industry**

 

***Concerns regarding the use of genetic testing resultsmay limit the commercial viability of any products we develop.***

 

Other companieshave developed genetic predisposition tests that have raised ethical concerns.It is possible that employers or others could discriminate against people whohave a genetic predisposition to certain diseases. Concern regarding possiblediscrimination may result in governmental authorities enacting restrictions orbans on the use of all, or certain types of, genetic testing. Similarly, suchconcerns may lead individuals to refuse to use genetic tests even ifpermissible. These factors may limit the market for, and therefore thecommercial viability of, products that our collaborators and/or we may develop.

 

***We may not be able to compete successfully with othercompanies and government agencies in the development and marketing of productservices.***

 

27

----

 

A number ofcompanies are attempting to rapidly identify and patent genes that causediseases or an increased susceptibility to diseases. Competition in this fieldand our other areas of business, including drug discovery and development aswell as database services and healthcare informatics, is intense and isexpected to increase. We have numerous competitors, including majorpharmaceutical and diagnostic companies, specialized biotechnology firms,universities and other research institutions, and other government-sponsoredentities and companies providing healthcare information products. Ourcollaborators, including Roche and Merck, may also compete with us. Many of ourcompetitors, either alone or with collaborators, have considerably greatercapital resources, research and development staffs and facilities, andtechnical and other resources than we do, which may allow them to discoverimportant genes before we do. We believe that a number of our competitors aredeveloping competing products and services that may be commercially successfuland that are further advanced in development than our potential products andservices. To succeed, we, together with our collaborators, must discoverdisease-predisposing genes, characterize their functions, develop genetic testsor therapeutic products and related information services based on suchdiscoveries, obtain regulatory and other approvals, and launch such services orproducts before competitors. Even if we or our collaborators are successful indeveloping effective products or services, our products and services may notsuccessfully compete with those of our competitors. Our competitors may succeedin developing and marketing products and services that are more effective thanours or that are marketed before ours.

 

Competitors haveestablished, and in the future may establish, patent positions with respect togene sequences related to our research projects. Such patent positions or thepublic availability of gene sequences comprising substantial portions of thehuman genome could decrease the potential value of our research projects andmake it more difficult for us to compete. We may also face competition fromother entities in gaining access to DNA samples used for research anddevelopment purposes. Our competitors may also obtain patent protection or otherintellectual property rights that could limit our rights, or our customers’ability, to use our technologies or databases, or commercialize therapeutic ordiagnostics products. In addition, we face, and will continue to face, intensecompetition from other companies for collaborative arrangements withpharmaceutical and biotechnology companies, for establishing relationships withacademic and research institutions and for licenses to proprietary technology.

 

We expectcompetition to intensify as technical advances are made and become more widelyknown. Our future success will depend in large part on maintaining acompetitive position in the genomic field. Others or our rapid technologicaldevelopment may result in products or technologies becoming obsolete before werecover the expenses we incur in developing them.

 

Our ability to competesuccessfully will depend, in part, on our ability, and that of ourcollaborators, to:

 

•                  developproprietary products;

 

•                  developand maintain products that reach the market first, and are technologicallysuperior to, and more cost effective than, other products on the market;

 

•                  obtainpatent or other proprietary protection for our products and technologies;

 

•                  attractand retain scientific and product development personnel;

 

•                  obtainrequired regulatory approvals; and

 

•                  manufacture,market and sell products that we develop.

 

***Changes in outsourcing trends and economic conditionsin the pharmaceutical and biotechnology industries could adversely affect ourgrowth.***

 

Economic factorsand industry trends that affect our primary customers, pharmaceutical andbiotechnology companies, also affect our business. For example, the practice ofmany companies in these industries has been to outsource to organizations likeus the conduct of genetic research, clinical research, sales and marketingprojects and chemistry research and development projects. If these industriesreduce their present tendency to outsource those projects, our operations,financial condition and growth rate could be materially and adversely affected.These alliances and arrangements are both time consuming and complex and weface substantial competition in establishing these relationships. In addition,our ability to generate new business could be impaired by general economicdownturns in our customers’ industries. We have experienced increasing pressureon the part of our customers to reduce expenses, including the use of ourservices as a result of negative economic trends generally and in thepharmaceutical industry.  Ifpharmaceutical and biotechnology companies discontinue or decrease their usageof our services, including as a result of the slowdown in the overall U.S.economy, our revenues and earnings could be lower than we expect and ourrevenues may decrease or not grow at historical rates.

 

***If regulatory approvals for products resulting fromour gene discovery programs are not obtained, we will not be able to deriverevenues from these products.***

 

Government agencies mustapprove new drugs and diagnostic products in the countries in which they are tobe marketed. We cannot be certain that we can obtain regulatory approval forany drugs or diagnostic products resulting from our gene discovery programs.The regulatory process can take many years and require substantial resources.Because some of the products likely to result from our disease researchprograms involve the application of new technologies and may be based upon anew therapeutic approach, various

 

28

----

 

government regulatoryauthorities may subject such products to substantial additional review. As aresult, these authorities may grant regulatory approvals for these productsmore slowly than for products using more conventional technologies. Furthermore,regulatory approval may impose limitations on the use of a drug or diagnosticproduct.

 

After initialregulatory approval, a marketed product and its manufacturer must undergocontinuing review. Discovery of previously unknown problems with a product mayhave adverse effects on our business, financial condition and results ofoperations, including withdrawal of the product from the market.

 

Our success willdepend, in part, on the development and marketing of products based upon ourresearch and development. Strict regulatory controls on the clinical testing,manufacture, labeling, supply and marketing of the products will influence ourand our partners’ ability to successfully manufacture and market therapeutic ordiagnostic products. Most countries require a company to obtain and maintainregulatory approval for a product from the relevant regulatory authority toenable the product to be marketed. Obtaining regulatory approval and complyingwith appropriate statutes and regulations is time-consuming and requires theexpenditure of substantial resources.

 

Most Europeancountries and the United States have very high standards of technical appraisaland consequently, in most cases, a lengthy approval process for pharmaceuticalproducts. The regulatory approval processes, which usually include pre-clinicaland clinical studies, as well as post-marketing surveillance to establish acompound’s safety and efficacy, can take many years and require the expenditureof substantial resources. Data obtained from such studies is susceptible tovarying interpretations that could delay, limit or prevent regulatory approval.Delays or rejections may also be encountered based upon changes in drugapproval policies in applicable jurisdictions. There can be no assurance thatwe or our collaborative customers will obtain regulatory approval for any drugsor diagnostic products developed as the result of our gene discovery programs.

 

***Efforts to reduce healthcare costs may reduce marketacceptance of our products.***

*** ***

Our success will dependin part on the price and extent to which we will be paid for our products bygovernment and health administration authorities, private health insurers andother third party payors. Reimbursement for newly approved healthcare productsis uncertain. Third party payors, including Medicare in the United States, areincreasingly challenging the prices charged for medical products and services.They are increasingly attempting to contain healthcare costs by limiting bothcoverage and the level of reimbursement for new therapeutic products. We cannotbe certain that any third party insurance coverage will be available topatients for any products we discover or develop. If third party payors do notprovide adequate coverage and reimbursement levels for our products, the marketacceptance of these products may be materially reduced.

 

Numerousgovernments have undertaken efforts to control growing healthcare costs throughlegislation, regulation and voluntary agreements with medical care providersand pharmaceutical companies. If cost containment efforts limit the profitsthat can be derived from new drugs, our customers may reduce their research anddevelopment spending which could reduce the business they outsource to us.

 

***Our operations involve a risk of injury or damage fromhazardous materials, and if an accident were to occur, we could be subject tocostly and damaging liability claims, which could have a material adverseeffect on our business, financial condition and results of operations.***

*** ***

Our research anddevelopment activities involve the controlled use of hazardous materials andchemicals. Although we believe that our safety procedures for handling anddisposing of hazardous materials comply with the standards prescribed byapplicable governmental regulations, the risk of accidental contamination orinjury from these materials cannot be completely eliminated. In the event of anaccident, we could be held liable for any damages or fines that result. Suchliability could have a material adverse effect on our business, financialcondition, results of operations and liquidity.

 

# **Risks Related to Our Intellectual Property**

 

***We may not be able to protect the proprietary rightsthat are critical to our success.***

 

Our success will dependin part on our ability to protect our genealogy database and genotypic data andany other proprietary databases that we develop and our proprietary softwareand other proprietary methods and technologies. Despite our efforts to protectour proprietary rights, unauthorized parties may be able to obtain and useinformation that we regard as proprietary. Our commercial success will dependin part on obtaining patent protection. The patent positions of pharmaceutical,biopharmaceutical and biotechnology companies, including deCODE, are generallyuncertain and involve complex legal and factual considerations. We cannot besure that:

 

•                  anyof our pending patent applications will result in issued patents;

 

•                  thatwe will develop additional proprietary technologies that are patentable;

 

29

----

 

•                  thatany patents issued to us or our partners will provide a basis for commerciallyviable products, will provide us with any competitive advantages or will not bechallenged by third parties; or

 

•                  thatthe patents of others will not have an adverse effect on our ability to dobusiness.

 

If we are unable to obtain patent protectionfor our technology or discoveries, the value of our proprietary resources willbe adversely affected.

 

In addition,patent law relating to the scope of claims in the area of genetics and genediscovery is still evolving. There is substantial uncertainty regarding thepatentability of genes or gene fragments without known functions. The laws ofsome European countries provide that genes and gene fragments may not bepatented. The European Commission has passed a directive that prevents thepatenting of genes in their natural state. The U.S. Patent and Trademark Officeinitially rejected a patent application by the National Institutes of Health onpartial genes. Accordingly, the degree of future protection for our proprietaryrights is uncertain and, we cannot predict the breadth of claims allowed in anypatents issued to us or others. We could also incur substantial costs in litigationif we are required to defend ourselves in patent suits brought by third partiesor if we initiate such suits.

 

Others may havefiled and in the future are likely to file patent applications covering genesor gene products that are similar or identical to our products. We cannot becertain that our patent applications will have priority over any patentapplications of others. The mere issuance of a patent does not guarantee thatit is valid or enforceable; thus even if we are holding or are granted patents,we cannot be sure that they would be valid and enforceable against thirdparties. Further, a patent does not provide the patent holder with freedom tooperate in a way that infringes the patent rights of others. Any legal actionagainst us or our partners claiming damages and seeking to enjoin commercialactivities relating to the affected products and processes could, in additionto subjecting us to potential liability for damages, require us or our partnersto obtain a license in order to continue to manufacture or market the affectedproducts and processes. There can be no assurance that we or our partners wouldprevail in any action or that any license required under any patent would bemade available on commercially acceptable terms, if at all. If licenses are notavailable, we or our partners may be required to cease marketing our productsor practicing our methods.

 

If expressedsequence tags, single nucleotide polymorphisms, or SNPs, or other sequenceinformation become publicly available before we apply for patent protection ona corresponding full-length or partial gene, our ability to obtain patentprotection for those genes or gene sequences could be adversely affected. Inaddition, other parties are attempting to rapidly identify and characterizegenes through the use of gene expression analysis and other technologies. Ifany patents are issued to other parties on these partial or full-length genesor gene products or uses for such genes or gene products, the risk increasesthat the sale of our or our collaborators’ potential products or processes maygive rise to claims of patent infringement. The amount of supportive data required for issuance of patents for humantherapeutics is highly uncertain. If more data than we have available isrequired, our ability to obtain patent protection could be delayed or otherwiseadversely affected. Even with supportive data, the ability to obtain patents isuncertain in view of evolving examination guidelines, such as the utility andwritten description guidelines that the U.S. Patent and Trademark Office hasadopted.

 

While we requireemployees, academic collaborators and consultants to enter into confidentialityagreements, there can be no assurance that proprietary information will not bedisclosed, that others will not independently develop substantially equivalentproprietary information and techniques, otherwise gain access to our tradesecrets or disclose such technology, or that we can meaningfully protect ourtrade secrets.

 

***Our patent protection for DG031 may provide protectionfor only a limited term.***

*** ***

The patents we licensedfrom Bayer for DG031 expire in 2009 and 2012. While we will seek to obtain oneor more use patents protecting our proprietary rights to this compound for alonger period, we cannot be certain that we will obtain such patents or thatthey will adequately protect us. In addition, although we may seek to extendthe term of one of the patents we licensed from Bayer and to obtain marketingexclusivity under the Hatch-Waxman Act, we cannot be certain that we will besuccessful. If we cannot obtain new patents or extend the term of patentprotection under one of the patents we licensed from Bayer, the amount ofrevenues that we will be able to derive from an approved product based on thesepatents may be adversely affected.

 

**ITEM 3.****QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

The primary objective of ourinvestment activities is to preserve principal while maximizing income wereceive from our investments without significantly increasing risk. Some of thesecurities in our investment portfolio may be subject to market risk. Thismeans that a change in prevailing interest rates may cause the market value ofthe investment to fluctuate. For example, if we hold a security that was issuedwith a fixed interest rate at the then-prevailing rate and the prevailinginterest rate later rises, the market value of our investment will probablydecline. To minimize this risk in the future, we intend to maintain ourportfolio of cash equivalents and short-term investments in a variety ofsecurities, including commercial paper, money market funds and government andnon-government debt securities. In general, money market funds and bankdeposits are not subject to market risk because the interest paid

 

30

----

 

on such  funds fluctuates with the prevailinginterest rate. As of March 31, 2004, all of our cash and cash equivalents werein money market, bank deposit and checking accounts.

 

We are exposed to market risks from changes in foreign currencyexchange rates, interest rates and investment prices. These changes mayadversely affect our operating results and financial condition. We seek tomanage these risks through regular operating and financing activities and, whendeemed appropriate, through the use of derivative financial instruments. Wecontrol and manage foreign exchange risk, interest rate risk, and investmentprice risk by continually monitoring changes in key economic indicators and marketinformation.

 

As a consequence of the nature our business and operations our reportedfinancial results and cash flows are exposed to the risks associated withfluctuations in the exchange rates of the U.S. dollar, the Icelandic krona andother world currencies. We continue to monitor our exposure to currency riskbut have not yet purchased instruments to hedge these general risks through theuse of derivative financial instruments.

 

We hold various interest rate sensitive assets and liabilities tomanage the liquidity and cash needs of our day-to-day operations. As a result,we are exposed to risks due to changes in interest rates. In order to mitigaterisks associated with interest rate sensitive liabilities we use interest ratederivative instruments, such as cross currency interest rate swaps, and may infuture use other instruments to achieve the desired interest rate maturitiesand asset/liability structures.

 

We are exposed to credit (or repayment) risk, as well as market riskfrom the use of derivative instruments. If the counterparty fails to fulfillits performance obligations under a derivative contract, our credit risk willequal the positive market value in a derivative. Consequently, when the fairmarket value of a derivative contract is positive, this indicates that thecounterparty owes us, thus creating a repayment risk for us. When the fairmarket value of a derivative contract is negative, we owe the counterparty andtherefore, assume no repayment risk.

 

In order to minimize the credit risk in derivative instruments, weenter into transactions with high quality counterparties such as financialinstitutions that satisfy our established credit approval criteria. We reviewthe credit ratings of such counterparties on a regular basis.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

(a) Evaluation of disclosure controls and procedures.  Our Chief Executive Officer and our ChiefFinancial Officer evaluated the effectiveness of deCODE’s disclosure controlsand procedures (as defined in Rule 13a-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)), as of the end of the fiscal quartercovered by this Quarterly Report on Form 10-Q. Based upon that evaluation, the Chief Executive Officer and the ChiefFinancial Officer have concluded that as of the end of such fiscal quarter,deCODE’s current disclosure controls and procedures are adequate and effectiveto ensure that information required to be disclosed in the reports deCODE filesunder the Exchange Act is recorded, processed, summarized and reported on atimely basis.

 

(b) Changes in internal controls. There was no change in deCODE’sinternal controls over financial reporting (as defined in Rule 13a-15(f)under the Exchange Act) during fiscal quarter covered by this Quarterly Reporton Form 10-Q that has materially affected, or is reasonably likely tomaterially affect, deCODE’s internal controls over financial reporting.

 

**PART IIOTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

There has been no change in the matters reported in our annual reporton Form 10-K for the year ended December 31, 2003.

 

**ITEM 2.  CHANGES IN  SECURITIES,USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES.**

 

On February 25, 2004, we issued to Merck& Co., Inc. (i) 689,703 shares of our common stock for an aggregatepurchase price of $10,000,000 and (ii) a warrant to purchase 1,724,257 sharesof our common stock at an exercise price of $29.00 per share.  The warrant may be exercised at the optionof the holder at any time prior to its expiration on March 26, 2009.  The offer and sale of these securities wereexempt from registration under the Securities Act of 1933, as amended (the“Act”) pursuant to Section 4(2) of the Act as a transaction not involving apublic offering because of the nature of the purchaser and the circumstances ofthe offering.  Appropriate legendsrestricting transfer were affixed to the certificates representing the commonstock and the warrant.

 

On April 14, 2004, we issued $150,000,000principal amount of our 3.5% Senior Convertible Notes due 2011 (the “Notes”) toLehman Brothers Inc., J.P. Morgan Securities Inc., Piper Jaffray & Co.,Deutsche Bank Securities and ThinkEquity Partners LLC (the “InitialPurchasers”) for a price of 96.5% of the principal amount of the Notes, or$144,750,000.  The Initial Purchasersresold the Notes to certain qualified institutional buyers pursuant to Rule144A under the Securities Act of 1933, as amended (the “Act”).

 

31

----

 

The offer and sale of the Notes to the InitialPurchasers were exempt from registration under the Act pursuant to Section 4(2)of the Act as a transaction not involving a public offering because of thenature of the purchasers and the circumstances of the offering. The Notes wereresold by the Initial Purchasers in reliance on Rule 144A under the Act.  Each Initial Purchaser made representationsto us as to its compliance with Rule 144A. In addition, appropriate legendsrestricting transfer were affixed to the Notes.

 

The Notes are convertible at any time throughmaturity into shares of our common stock, at the option of the holder, at aprice of $14.00 per share, which is equivalent to an initial conversion rate ofapproximately 71.43 shares per $1,000 principal amount of the Notes.

 

**ITEM 5. OTHER INFORMATION**

 

(a) On April 28, 2004 James Beery wasappointed to our Board of Directors  toserve as a Class II Director until the Annual Meeting of the Stockholders to beheld in 2006 and until his successor has been duly elected and qualifies.  Mr. Beery is Senior of Counsel in the Londonoffice of Covington & Burlington, an international law firm.  Prior tohis present appointment he served as Senior Vice President and General Counselof GlaxoSmithKline, and prior to the merger creating that company,  SmithKlineBeecham.  Mr. Beery holds a BA from Harvard College and a JD from StanfordLaw School.

 

**ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K**

 

(a) EXHIBITS

 

The following is a list of exhibits filed as part of this QuarterlyReport on Form 10-Q.

 
| **EXHIBIT  NUMBER** |   | **DESCRIPTION  OF EXHIBIT**                                                                                                                                                                                                                                        |
|---------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                                                                                                               |
| 3.1                 |   | Amended and Restated Certificate  of Incorporation, as furtheramended (Incorporated by reference  to Exhibit 3.1 and Exhibit 3.3 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000). |
|                |   |                                                                                                                                                                                                                                                               |
| 3.2                 |   | Certificate of Amendment to  Amended and Restated Certificateof Incorporation dated August 30,  2002 (Incorporated by reference to Exhibit 3.2 to the Company’s  Quarterly Report on Form 10-Q filed on November 14, 2002).                                   |
|                |   |                                                                                                                                                                                                                                                               |
| 3.3                 |   | Bylaws, as amended (Incorporated  by reference to Exhibit 3.2 to the Company’s Registration Statement on Form  S-1 (Registration No. 333-31984) which became effective on July 17, 2000).                                                                     |
|                |   |                                                                                                                                                                                                                                                               |
| 4.1                 |   | Specimen Common Stock Certificate  (Incorporated by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became effective on  July 17, 2000).                                                     |
|                |   |                                                                                                                                                                                                                                                               |
| 4.2                 |   | Form of Warrant to Purchase Series  A Preferred Stock (Incorporated by reference to Exhibit 4.2 to the Company’s  Registration Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000).                                  |
|                |   |                                                                                                                                                                                                                                                               |
| 4.3                 |   | Form of Warrant to Purchase Series  C Preferred Stock (Incorporated by reference to Exhibit 4.3 to the Company’s  Registration Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000).                                  |
|                |   |                                                                                                                                                                                                                                                               |
| 4.4                 |   | Warrant Certificate, dated May 6,  2002 issued to Islandsbanki-FBA hf. (Incorporated by reference to Exhibit 4.1                                                                                                                                                   |

 

32

----

 
|   |   | to the Company’s Quarterly Report  on Form 10-Q filed on May 15, 2002).                                                                                                                                                                           |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                   |
| 4.5    |   | Form of Indexed Bond (Tier A)  (Incorporated by reference to Exhibit 4.2 to the Company’s Quarterly Report  on Form 10-Q filed on May 15, 2002).                                                                                                  |
|   |   |                                                                                                                                                                                                                                                   |
| 4.7    |   | Warrant dated February 25, 2004,  issued to Merck & Co., Inc. (Incorporated by reference to Exhibit 4.7 to  the Company’s Annual Report on Form 10-K filed on March 15, 2004.)                                                                |
|   |   |                                                                                                                                                                                                                                                   |
| 4.8    |   | Indenture dated as of April 14,  2004 between deCODE genetics, Inc. and The Bank of New York (including form  of 3.5% Senior Convertible Note due 2011).                                                                                               |
|   |   |                                                                                                                                                                                                                                                   |
| 4.9    |   | Registration Rights Agreement  dated as of April 14, 2004 between deCODE genetics, Inc., J.P. Morgan  Securities Inc. and Lehman Brothers Inc., as representatives of the Initial  Purchasers.                                                         |
|   |   |                                                                                                                                                                                                                                                   |
| 10.1   |   | License and Research Collaboration  Agreement dated February 25, 2004 between deCODE genetics, ehf. and Merck  & Co., Inc. (Incorporated by reference to Exhibit 10.33 to the Company’s  Annual Report on Form 10-K filed on March 15, 2004.) |
|   |   |                                                                                                                                                                                                                                                   |
| 10.2   |   | Stock and Warrant Purchase  Agreement dated February 25, 2004 between deCODE genetics, Inc. and Merck  & Co., Inc. (Incorporated by reference to Exhibit 10.36 to the Company’s  Annual Report on Form 10-K filed on March 15, 2004.)         |
|   |   |                                                                                                                                                                                                                                                   |
| 10.3   |   | Loan Agreement between  Vetrargardurinn ehf. and Islandsbanki hf. dated March 12, 2004.                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                   |
| 31.1   |   | Certification pursuant to Section  302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                   |
| 31.2   |   | Certification pursuant to Section  302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                   |
| 32.1   |   | Certification pursuant to Section  906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                              |

 

Note: Unless otherwise noted, the SEC File number of each of the abovereferenced documents is 000-30469.

 

(b)REPORTS ON FORM 8-K

 

On February 18, 2004 the Company filed a Current Report on Form 8-Kfurnishing financial information regarding its results of operations andfinancial condition for the year ended December 31, 2003.

 

33

----

 

**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
| Dated:  May 10, 2004 |                                                                                                    |
|--------------------------------|---------------------------------------------------------------------------------------------------------|
|                           |                                                                                                    |
|                           | deCODE genetics, Inc.                                                                                   |
|                           |                                                                                                    |
|                           |                                                                                                    |
|                           |                                                                                                    | /s/ Kari Stefansson |   |
|                           | Kari Stefansson                                                                                         |   |
|                           | Chairman,  President,  and Chief Executive Officer                                                      |   |
|                           |                                                                                                    |   |
|                           |                                                                                                    |   |
|                           |                                                                                                    | /s/ Lance Thibault |   |
|                           | Lance Thibault                                                                                          |   |
|                           | Chief Financial Officer  and  Treasurer (principal financial  officer and principal accounting officer) |   |

 

34

----

 

 
| **EX****HIBIT  NUMBER** |   | **DESCRIPTION  OF EXHIBIT**                                                                                                                                                                                                                                        |
|-------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |   |                                                                                                                                                                                                                                                               |
| 3.1                     |   | Amended and Restated Certificate  of Incorporation, as further amended (Incorporated by reference to Exhibit  3.1 and Exhibit 3.3 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on July 17, 2000). |
|                    |   |                                                                                                                                                                                                                                                               |
| 3.2                     |   | Certificate of Amendment to  Amended and Restated Certificate of Incorporation dated August 30, 2002  (Incorporated by reference to Exhibit 3.2 to the Company’s Quarterly Report  on Form 10-Q filed on November 14, 2002).                                  |
|                    |   |                                                                                                                                                                                                                                                               |
| 3.3                     |   | Bylaws, as amended (Incorporated  by reference to Exhibit 3.2 to the Company’s Registration Statement on Form  S-1 (Registration No. 333-31984) which became effective on July 17, 2000).                                                                     |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.1                     |   | Specimen Common Stock Certificate  (Incorporated by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became effective on  July 17, 2000).                                                     |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.2                     |   | Form of Warrant to Purchase Series  A Preferred Stock (Incorporated by reference to Exhibit 4.2 to the Company’s  Registration Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000).                                  |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.3                     |   | Form of Warrant to Purchase Series  C Preferred Stock (Incorporated by reference to Exhibit 4.3 to the Company’s  Registration Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000).                                  |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.4                     |   | Warrant Certificate, dated May 6,  2002 issued to Islandsbanki-FBA hf. (Incorporated by reference to Exhibit 4.1  to the Company’s Quarterly Report on Form 10-Q filed on May 15, 2002).                                                                      |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.5                     |   | Form of Indexed Bond (Tier A)  (Incorporated by reference to Exhibit 4.2 to the Company’s Quarterly Report  on Form 10-Q filed on May 15, 2002).                                                                                                              |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.7                     |   | Warrant dated February 25, 2004,  issued to Merck & Co., Inc. (Incorporated by reference to Exhibit 4.7 to  the Company’s Annual Report on Form 10-K filed on March 15, 2004.)                                                                            |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.8                     |   | Indenture dated as of April 14,  2004 between deCODE genetics, Inc. and The Bank of New York (including form  of 3.5% Senior Convertible Note due 2011).                                                                                                           |
|                    |   |                                                                                                                                                                                                                                                               |
| 4.9                     |   | Registration Rights Agreement  dated as of April 14, 2004 between deCODE genetics, Inc., J.P. Morgan  Securities Inc. and Lehman Brothers Inc., as representatives of the Initial  Purchasers.                                                                     |
|                    |   |                                                                                                                                                                                                                                                               |
| 10.1                    |   | License and Research Collaboration  Agreement dated February 25, 2004 between deCODE genetics, ehf. and Merck  & Co., Inc. (Incorporated by reference to Exhibit 10.33 to the Company’s                                                                   |

 

35

----

 
|   |   | Annual Report on Form 10-K filed  on March 15, 2004.)                                                                                                                                                                                          |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                           |
| 10.2   |   | Stock and Warrant Purchase  Agreement dated February 25, 2004 between deCODE genetics, Inc. and Merck  & Co., Inc. (Incorporated by reference to Exhibit 10.36 to the Company’s  Annual Report on Form 10-K filed on March 15, 2004.) |
|   |   |                                                                                                                                                                                                                                           |
| 10.3   |   | Loan Agreement between  Vetrargardurinn ehf. and Islandsbanki hf. dated March 12, 2004.                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                           |
| 31.1   |   | Certification pursuant to Section  302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                           |
| 31.2   |   | Certification pursuant to Section  302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                           |
| 32.1   |   | Certification pursuant to Section  906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                      |

 

Note: Unless otherwise noted, the SEC File number of each of the abovereferenced documents is 000-30469.

 

36

----