** **

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM10-Q**

**(MarkOne)**

**x****       ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**For theQuarterly Period Ended June 30, 2006**

**or**

**o****          ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT**

**Forthe transition period from _______________ to _______________**

**Commissionfile number 000-30469**

**deCODE genetics, Inc.**

(Exact Name of Registrantas Specified in Its Charter)
| **Delaware**                    | **04-3326704**                       |
|---------------------------------|--------------------------------------|
| (State or Other Jurisdiction of | (I.R.S. Employer Identification No.) |
| Incorporation or Organization)  |                                 |

 

**STURLUGATA 8, IS-101REYKJAVIK, ICELAND**

(Address of PrincipalExecutive Offices)

**+354-570-1900**

(Registrant’s TelephoneNumber, Including Area Code)

Indicate by check whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 x   No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):
| Large accelerated  filer  o | Accelerated  filer  x | Non-accelerated  filer  o |
|---------------------------------------|---------------------------------|-------------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

  Yes o   No  x

Theaggregate number of shares of the registrant’s common stock outstanding on July31, 2006 was 55,519,704 shares of common stock $.001 par value.

 

----

 

**deCODEgenetics, Inc.**

**INDEX**

** **
|                             | ** ** | ** **                                                                                                        | ** ** | **Page  Number** | ** ** |
|-----------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| PART  I.                    |       | FINANCIAL  INFORMATION                                                                                            |       | 3                |       |
|                        |       |                                                                                                              |       |             |       |
| Item  1.                    |       | Financial  Statements (Unaudited)                                                                                 |       | 3                |       |
|                        |       |                                                                                                              |       |             |       |
|                        |       | Condensed Consolidated Balance Sheets as of June 30,  2006 and December 31, 2005                                  |       | 3                |       |
|                        |       |                                                                                                              |       |             |       |
|                        |       | Condensed Consolidated Statements of Operations for  the three and six-month periods ended June 30, 2006 and 2005 |       | 4                |       |
|                        |       |                                                                                                              |       |             |       |
|                        |       | Condensed Consolidated Statements of Cash Flows for  the six-month periods ended June 30, 2006 and 2005           |       | 5                |       |
|                        |       |                                                                                                              |       |             |       |
|                        |       | Notes  to Condensed Consolidated Financial Statements                                                             |       | 6                |       |
|                        |       |                                                                                                              |       |             |       |
| Item 2.                     |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                       |       | 11               |       |
|                        |       |                                                                                                              |       |             |       |
| Item 3.                     |       | Quantitative and Qualitative Disclosures about Market  Risk                                                       |       | 22               |       |
|                        |       |                                                                                                              |       |             |       |
| Item 4.                     |       | Controls and Procedures                                                                                           |       | 22               |       |
|                        |       |                                                                                                              |       |             |       |
|                        |       |                                                                                                              |       |             |       |
| PART  II. OTHER INFORMATION |       | 23                                                                                                                |       |
|                        |       |                                                                                                              |       |             |       |
| Item  1.                    |       | Legal Proceedings                                                                                                 |       | 23               |       |
|                        |       |                                                                                                              |       |             |       |
| Item 1A.                    |       | Risk Factors                                                                                                      |       | 23               |       |
|                        |       |                                                                                                              |       |             |       |
| Item 4.                     |       | Submission of Matters to a Vote of Security Holders                                                               |       | 26               |       |
|                        |       |                                                                                                              |       |             |       |
| Item 6.                     |       | Exhibits                                                                                                          |       | 27               |       |
|                        |       |                                                                                                              |       |             |       |
|                        |       | (a) Exhibits                                                                                                      |       | 27               |       |
|                        |       |                                                                                                              |       |
| Signatures                  |       | 27                                                                                                                |       |
|                        |       |                                                                                                              |       |
| Index to Exhibits           |       | 28                                                                                                                |       |

 

2

----

**PART I. FINANCIAL INFORMATION**

**ITEM 1.**                    FINANCIALSTATEMENTS

**deCODEgenetics, Inc.CONDENSED CONSOLIDATED BALANCE SHEETS**

(Unaudited)
| ** **                                                                                                                                                                                                                     | ** ** | **June 30,  2006**                                      | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                     | ** ** | **(In thousands, except share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                         |       |                                                         |       |                        |       |
| Current assets:                                                                                                                                                                                                                |       |                                                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                     |       | $                                                            | 27,677     |                        | $          | 65,943 |   |
| Investments                                                                                                                                                                                                                    |       | 87,836                                                       |       | 89,611                      |       |
| Receivables                                                                                                                                                                                                                    |       | 5,796                                                        |       | 7,856                       |       |
| Other current  assets                                                                                                                                                                                                          |       | 8,218                                                        |       | 3,541                       |       |
| Total current assets                                                                                                                                                                                                           |       | 129,527                                                      |       | 166,951                     |       |
| Property and  equipment, net                                                                                                                                                                                                   |       | 22,708                                                       |       | 24,500                      |       |
| Goodwill                                                                                                                                                                                                                       |       | 10,054                                                       |       | 8,863                       |       |
| Other long-term  assets and deferred charges                                                                                                                                                                                   |       | 9,774                                                        |       | 6,444                       |       |
| Total assets                                                                                                                                                                                                                   |       | $                                                            | 172,063    |                        | $          | 206,758 |   |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                                                                                    |       |                                                         |       |                        |       |
| Current liabilities:                                                                                                                                                                                                           |       |                                                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                               |       | $                                                            | 4,201      |                        | $          | 4,732 |   |
| Accrued expenses  and other current liabilities                                                                                                                                                                                |       | 10,450                                                       |       | 12,823                      |       |
| Current portion  of capital lease obligations                                                                                                                                                                                  |       | 518                                                          |       | 1,313                       |       |
| Current portion  of long-term debt                                                                                                                                                                                             |       | 585                                                          |       | 550                         |       |
| Deferred revenue                                                                                                                                                                                                               |       | 5,525                                                        |       | 6,105                       |       |
| Total current liabilities                                                                                                                                                                                                      |       | 21,279                                                       |       | 25,523                      |       |
| Capital lease  obligations, net of current portion                                                                                                                                                                             |       | 701                                                          |       | 1,046                       |       |
| Long-term  debt, net of current portion                                                                                                                                                                                        |       | 156,126                                                      |       | 155,653                     |       |
| Deferred gain on  sale-leaseback                                                                                                                                                                                               |       | 26,685                                                       |       | 27,654                      |       |
| Deferred revenue                                                                                                                                                                                                               |       | 6,219                                                        |       | 6,219                       |       |
| Commitments and  contingencies                                                                                                                                                                                                 |       |                                                         |       |                        |       |
| Stockholders’ deficit:                                                                                                                                                                                                    |       |                                                         |       |                        |       |
| Preferred stock,  $0.001 par value; Authorized: 6,716,666 shares; Issued and outstanding: none                                                                                                                                 |       | —                                                       |       | —                      |       |
| Common stock,  $0.001 par value; Authorized: 100,000,000 shares; Issued and outstanding:  55,536,343 and 55,516,843, respectively, at June 30, 2006; and 54,762,095 and  54,742,595 shares, respectively, at December 31, 2005 |       | 56                                                           |       | 55                          |       |
| Additional paid-in  capital                                                                                                                                                                                                    |       | 452,897                                                      |       | 444,401                     |       |
| Notes receivable                                                                                                                                                                                                               |       | (2,814                                                       | )          | (2,898                      | )          |
| Deferred  compensation                                                                                                                                                                                                         |       | —                                                       |       | (418                        | )          |
| Accumulated  deficit                                                                                                                                                                                                           |       | (488,831                                                     | )          | (450,215                    | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                        |       | (132                                                         | )          | (139                        | )          |
| Treasury stock,  19,500 shares stated at cost                                                                                                                                                                                  |       | (123                                                         | )          | (123                        | )          |
| Total stockholders’ deficit                                                                                                                                                                                               |       | (38,947                                                      | )          | (9,337                      | )          |
| Total  liabilities and stockholders’ deficit                                                                                                                                                                              |       | $                                                            | 172,063    |                        | $          | 206,758 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

3

----

** deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

 (Unaudited)

 
| ** **                                                     | ** ** | **For the Three Months  Ended June 30,**    | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                           |       | **(In thousands, exept per share amounts)** |       |
| REVENUE                                                        |       | $                                           | 10,360     |                                   | $          | 11,437 |   | $ | 20,493 |   | $ | 20,960 |   |
| OPERATING EXPENSES                                             |       |                                        |       |                                   |       |   |   |   |   |
| Cost of revenue                                                |       | 10,459                                      |       | 8,597                                  |       | 20,309 |   | 17,737 |   |
| Research and  development—proprietary programs            |       | 13,207                                      |       | 11,001                                 |       | 28,724 |   | 19,276 |   |
| Selling, general  and administrative                           |       | 4,392                                       |       | 4,694                                  |       | 9,659 |   | 8,852 |   |
| Total operating expenses                                       |       | 28,058                                      |       | 24,292                                 |       | 58,692 |   | 45,865 |   |
| Operating loss                                                 |       | (17,698                                     | )          | (12,855                                | )          | (38,199 | ) | (24,905 | ) |
| Interest income                                                |       | 1,336                                       |       | 1,533                                  |       | 3,048 |   | 2,653 |   |
| Interest expense                                               |       | (1,691                                      | )          | (1,700                                 | )          | (3,407 | ) | (4,089 | ) |
| Other non-operating  income and (expense), net                 |       | (290                                        | )          | (310                                   | )          | (58 | ) | (3,927 | ) |
| Net loss                                                       |       | $                                           | (18,343    | )                                      | $          | (13,332 | ) | $ | (38,616 | ) | $ | (30,268 | ) |
| Basic and  diluted net loss per share                          |       | $                                           | (0.34      | )                                      | $          | (0.25 | ) | $ | (0.71 | ) | $ | (0.56 | ) |
| Shares used in  computing basic and diluted net loss per share |       | 54,746                                      |       | 53,664                                 |       | 54,664 |   | 53,656 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

4

----

**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

** **(Unaudited) 
| ** **                                                                   | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,  2006**                          | ** ** | **June 30,  2005** | ** ** |
| ** **                                                                   | ** ** | **(In thousands)**                               | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                    | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                                | (38,616    | ) | $ | (30,268 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                |       | 3,785                                            |       | 4,160 |   |
| Stock-based compensation                                                     |       | 2,050                                            |       | 74 |   |
| Amortization of gain on sale-leaseback                                       |       | (969                                             | )          | (425 | ) |
| Amortization of deferred financing costs                                     |       | 433                                              |       | 503 |   |
| Gain on disposal of fixed assets                                             |       | (734                                             | )          | — |   |
| Charges for debt extinguishment                                              |       | —                                           |       | 1,741 |   |
| Foreign currency exchange loss on Icelandic krona  denominated debt          |       | (4                                               | )          | 257 |   |
| Other                                                                        |       | 53                                               |       | 100 |   |
| Changes in operating  assets and liabilities net of effect of acquisitions:  |       |                                             |       |   |   |
| Receivables and other current assets                                         |       | 322                                              |       | (2,571 | ) |
| Accounts payable, accrued expenses and other current  liabilities            |       | (3,589                                           | )          | (714 | ) |
| Deferred research revenue                                                    |       | (2,792                                           | )          | 1,045 |   |
| Net cash used in operating activities                                        |       | (40,061                                          | )          | (26,098 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                       |       |                                             |       |   |   |
| Purchase of investments                                                      |       | (159,770                                         | )          | (111,925 | ) |
| Redemptions of investments                                                   |       | 161,530                                          |       | 95,530 |   |
| Purchase of property and equipment                                           |       | (1,590                                           | )          | (1,202 | ) |
| Proceeds from sale of property and equipment                                 |       | 206                                              |       | 61,241 |   |
| Purchase acquisition, net of cash acquired                                   |       | 1,270                                            |       | — |   |
| Changes in restricted cash                                                   |       | —                                           |       | 6,000 |   |
| Net cash provided by investing activities                                    |       | 1,646                                            |       | 49,644 |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                       |       |                                             |       |   |   |
| Proceeds from issuance of common stock                                       |       | 778                                              |       | 78 |   |
| Proceeds from debt financing                                                 |       | —                                           |       | 6,211 |   |
| Proceeds from equipment financing                                            |       | 798                                              |       | — |   |
| Repayment of notes receivable for common stock                               |       | 89                                               |       | 37 |   |
| Repayments of short term borrowings                                          |       | (376                                             | )          | (569 | ) |
| Payments on line of credit                                                   |       | —                                           |       | (4,500 | ) |
| Repayments of debt and capital lease obligations                             |       | (1,140                                           | )          | (47,881 | ) |
| Net cash provided by (used in) financing activities                          |       | 149                                              |       | (46,624 | ) |
| Net decrease in  cash and cash equivalents                                   |       | (38,266                                          | )          | (23,078 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 65,943                                           |       | 70,238 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                | 27,677     |   | $ | 47,160 |   |
| Supplemental cash flow  information:                                         |       |                                             |       |   |   |
| Cash paid for  interest                                                      |       | $                                                | 2,922      |   | $ | 3,744 |   |
| Supplemental schedule  of non-cash transactions:                             |       |                                             |       |   |   |
| Deferred gain on sale of property                                            |       | $                                                | —     |   | $ | 29,048 |   |
| Note receivable  for sale of property                                        |       | 884                                              |       | — |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

 

5

----

 

**deCODEgenetics, Inc.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**(tabularamounts in thousands, except share and per share amounts)

**1.   Organizationand Business**

References in thesefinancial statements to deCODE refer to deCODE genetics, Inc., a Delawarecompany, and deCODE genetics, Inc.’s wholly-owned subsidiary, Islenskerfdagreining ehf., an Icelandic company registered in Reykjavik, and itssubsidiaries, as well as deCODE genetics, Inc.’s wholly-owned subsidiary,MediChem Life Sciences, Inc., a Delaware corporation, and itssubsidiaries. 

**2.   Basisof Presentation**

In the opinion of thedeCODE’s management, the accompanying unaudited condensed consolidatedfinancial statements contain all adjustments (consisting of items of a normaland recurring nature) necessary to present fairly the financial position as ofJune 30, 2006, the results of operations for the three and six-month periodsended June 30, 2006 and 2005 and cash flows for the six-month periods endedJune 30, 2006 and 2005. The results of operations for the three and six-monthperiods ended June 30, 2006 are not necessarily indicative of the results to beexpected for the full year. These financial statements should be read inconjunction with deCODE’s Annual Report on Form 10-K for the year endedDecember 31, 2005, which includes consolidated financial statements andnotes thereto for the years ended December 31, 2005, 2004 and 2003. 

**3.   Revenue**

Significant elements ofour revenue are summarized as follows:

|                                                                            | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                           | ** ** |
| Research funding  and other service fees                                   |       | $                                                                 | 5,445      |                                                            | $          | 7,803 |   | $ | 10,913 |   | $ | 14,557 |   |
| Milestone  payments                                                        |       | 101                                                               |       | 234                                                             |       | 299 |   | 582 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | 500                                                               |       | 1,000                                                           |       | 1,000 |   | 2,038 |   |
| Grant funding                                                              |       | 3,939                                                             |       | 2,003                                                           |       | 6,926 |   | 2,891 |   |
| Other                                                                      |       | 375                                                               |       | 397                                                             |       | 1,355 |   | 892 |   |
| Total                                                                      |       | $                                                                 | 10,360     |                                                            | $          | 11,437 |   | $ | 20,493 |   | $ | 20,960 |   |

 

Significant sources of ourrevenue as a percentage of consolidated revenue are summarized as follows:

|                                      | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Roche                                |       | 27                                                                | %          | 20                                                              | %          | 26 | % | 24 | % |
| Merck                                |       | —                                                            | %          | 17                                                              | %          | — | % | 18 | % |
| National Institutes of  Health (NIH) |       | 35                                                                | %          | 15                                                              | %          | 30 | % | 10 | % |

 

**4.   Researchand Development — Proprietary Programs**

deCODE’s research and developmentexpenses consist of the costs of its own proprietary programs and consist ofthe following:

|                                                  | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                                           | ** ** |
| Salaries and  other personnel costs              |       | $                                                                 | 4,360      |                                                            | $          | 4,383 |   | $ | 9,696 |   | $ | 8,327 |   |
| Materials and  supplies                          |       | 1,170                                                             |       | 1,250                                                           |       | 2,759 |   | 2,196 |   |
| Contractor  services and other third party costs |       | 5,140                                                             |       | 3,378                                                           |       | 10,966 |   | 5,064 |   |
| Overhead  expenses                               |       | 1,251                                                             |       | 1,208                                                           |       | 2,823 |   | 2,032 |   |
| Depreciation and  amortization                   |       | 891                                                               |       | 782                                                             |       | 1,763 |   | 1,657 |   |
| Stock-based compensation                         |       | 395                                                               |       | —                                                          |       | 717 |   | — |   |
| Total                                            |       | $                                                                 | 13,207     |                                                            | $          | 11,001 |   | $ | 28,724 |   | $ | 19,276 |   |

 

6

----

 

In May 2006, deCODEentered into a strategic alliance with Illumina, Inc. (“Illumina”) to developand commercialize molecular diagnostic products. Under the terms of theagreement, deCODE and Illumina will share development costs equally and splitoperating profits from the sale of diagnostic tests. 

**5.   Stock-BasedCompensation**

On January 1, 2006,deCODE adopted Statement of Financial Accounting Standards No. 123(revised 2004), “*Share-Based Payment”*(“SFAS 123R”) using the modified prospective transition method. Accordingly,prior periods have not been restated. SFAS 123R requires companies toestimate the fair value of stock-based payment awards on the date of grantusing an option-pricing model. The value of the portion of the award that isultimately expected to vest is recognized as expense over the requisite serviceperiods in deCODE’s consolidated statements of operations.

The following table summarizes stock-based compensation expense relatedto employee stock option and nonvested share awards under SFAS 123R forthe three and six months ended June 30, 2006 which was included in theCondensed Consolidated Statements of Operations in the following captions:

|                                                      | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                           | ** ** | **(In thousands)**                                   | ** ** |
| Operating Expenses:                                  |       |                                                      |       |                                                    |       |
| Cost of revenue                                      |       | $                                                         | 143        |                                                    | $          | 259 |   |
| Research and development — proprietary programs |       | 395                                                       |       | 717                                                     |       |
| Selling, general and administrative expenses         |       | 483                                                       |       | 968                                                     |       |
| Total                                                |       | $                                                         | 1,021      |                                                    | $          | 1,944 |   |

 

The adoption of SFAS123R resulted in incremental stock-based compensation expense andincreased deCODE’s net loss by $1,021,000 and $1,944,000 in the three andsix-month periods ended June 30, 2006, respectively, resulting in a per shareexpense increase of $0.02 and $0.04 per share, respectively, for those periods.The adoption had no impact on cash flows from operating or financingactivities.

The following tableillustrates the pro forma effect on net loss and net loss per share had deCODEelected to account for all of its stock-based compensation plans using thefair-value method under SFAS No. 123 for the three and six-months endedJune 30, 2005:

|                                                                                                     | ** ** | **Three Months Ended  June 30, 2005**         | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **(In thousands, except per share  amounts)** | ** ** |
| Net loss  attributable to common stockholders — as reported                                    |       | $                                                                 | (13,332    | )                                                       | $          | (30,268 | ) |
| Add: Stock-based  compensation expense included in reported net loss                                |       | 26                                                                |       | 74                                                      |       |
| Deduct: total  stock-based compensation expense determined under fair value methods for all  awards |       | (1,133                                                            | )          | (2,372                                                  | )          |
| Net loss —  proforma                                                                           |       | $                                                                 | (14,439    | )                                                       | $          | (32,566 | ) |
|                                                                                                |       |                                                              |       |                                                    |       |
| Basic and  diluted net loss per share — as reported                                            |       | $                                                                 | (0.25      | )                                                       | $          | (0.56 | ) |
| Basic and diluted net  loss per share — proforma                                               |       | $                                                                 | (0.27      | )                                                       | $          | (0.61 | ) |

 

*Equity Incentive Plans*

In May 2006, deCODEadopted the deCODE genetics, Inc. 2006 Equity Incentive Plan (the “2006 Plan”).The 2006 Plan provides for the issuance of up to 4,000,000 shares of commonstock to employees, consultants and non-employee directors in the form ofincentive stock options, nonqualified stock options, restricted stock and stockappreciation rights (SARs).

7

----

 

deCODE also maintains thedeCODE genetics, Inc. 1996 and 2002 Equity Incentive Plans that providefor the grant for awards to employees, members of the Board of Directors,consultants and other advisors who are not employees. A total of 10,000,000shares are reserved for grants of options and restricted stock under the termsof the 1996 and 2002 Equity Incentive Plans.

The equity incentiveplans are administered by the Compensation Committee of the Board of Directors.The Compensation Committee determines the type and term of each award, theaward exercise or purchase price, if applicable, the number of sharesunderlying each award granted and the rate at which each award becomes vestedor exercisable. Incentive stock options may be granted only to employees ofdeCODE at an exercise price per share of not less than the fair market valueper share of common stock on the day before the grant and with a term not toexceed ten years from date of grant. Nonqualified stock options may be grantedto any officer, employee, director, consultant or advisor at a per shareexercise price in such amount as the Compensation Committee may determine.Generally each employee option grant vests twenty-five percent on the firstanniversary date of an employee’s commencement of employment and 1/48th of theoriginal grant each month thereafter for the following three years. Uponexercise of options, shares are issued from the pool of registered shares underthe plans.

The CompensationCommittee may also grant restricted stock and other stock-based awards on suchterms and conditions as it may determine, which may include deCODE’s right torepurchase the unvested underlying stock upon termination of the holder’semployment.

Options granted to dategenerally vest over a period of four years, generally have a maximum term of10 years, and may contain early-exercise provisions allowing forcompany-provided financing of the exercise price. As of June 30, 2006,4,460,855 shares were available for grant.

The following tablerepresents stock option activity for the six months ended June 30, 2006:

|                                 | ** ** | **Number  of Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Contractual  Life** | ** ** | **Aggregate  Intrinsic Value  (In thousands)** | ** ** |
|---------------------------------|------------|----------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| Outstanding at  January 1, 2006 |       | 4,702,702                  |       | $                                      | 8.38       |                                     |       |                                                     |       |   |
| Granted                         |       | 561,167                    |       | 8.60                                   |       |                                     |       |                                                     |       |
| Exercised                       |       | (132,857                   | )          | 5.89                                   |       |                                     |       |                                                     |       |
| Forfeited/cancelled             |       | (364,811                   | )          | 9.76                                   |       |                                     |       |                                                     |       |
| Outstanding at  June 30, 2006   |       | 4,766,201                  |       | 8.37                                   |       | 7.33                                     |       | $                                                        | (10,383    | ) |
| Exercisable at June 30,  2006   |       | 3,109,047                  |       | $                                      | 8.27       |                                     | 6.62       |                                                     | $          | (6,480 | ) |

 

The aggregate intrinsicvalue in the table above represents the total intrinsic value, based on deCODE’scommon stock closing price of $6.19 as of June 30, 2006, which would have beenreceived by the option  holders had all option holders exercised theiroptions as of that date. The total number of in-the-money options exercisableas of June 30, 2006 was 473,628.

The weighted averagegrant date fair value of options, as determined under SFAS 123R and SFAS 123,granted during the three and six-month periods ended June 30, 2006 was $4.23and $5.22, per share respectively, and $4.76 and $4.76 per share during thethree and six-month periods ended June 30, 2005, respectively. The totalintrinsic value of options exercised during the three and six-month periodsended June 30, 2006 was $72,000 and $409,000, respectively and during the threeand six-month periods ended June 30, 2005 was approximately $150,000 and$183,000, respectively. The total cash received from employees as a result ofemployee stock option exercises during the six months ended June 30, 2006 and2005 was $778,000 and $78,000, respectively. The total fair value of sharesvested during the three and six months ended June 30, 2006 was $636,000 and$1,429,000, respectively.

At June 30, 2006, deCODE’sfuture compensation cost related to nonvested stock options is $7,761,000,which will be recognized over the weighted average remaining vesting period of2.01 years.

deCODE uses the Black-Scholesoption-pricing model to value stock options. The Black-Scholes model requiresthe use of employee exercise behavior data and the use of a number ofassumptions (as noted in the table below) including volatility of deCODE’sstock price, the weighted average risk-free interest rate, and the weightedaverage expected term of the options.

deCODE estimates theexpected term of the options based on historical patterns by employees withrespect to exercise and post vesting employment termination behaviors. Expectedvolatility is based on deCODE’s historical volatility and is calculated using aweighted average of the volatility over a period equal to the expected term ofthe award and the most recent one year volatility. deCODE bases the risk-freeinterest rate used on the implied yield currently available on U.S. Treasuryzero-coupon issues with an equivalent term. As deCODE does not pay dividends,the dividend rate variable in the Black-Scholes model is zero.

8

----

 

|                           | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|---------------------------|------------|---------------------------------------------------------|------------|
| Dividend yield            |       | —                                                  |       |
| Expected  volatility      |       | 66.20%  to 68.24%                                       |       |
| Expected term  (in years) |       | 5.11                                                    |       |
| Risk-free interest rate   |       | 4.57% to 5.21%                                          |       |

 

Stock-based compensationexpense is recognized in the consolidated statement of operations on a straight-linebasis based on awards ultimately expected to vest. deCODE has calculatedstock-based compensation using an estimated forfeiture rate of 5.60%. To theextent the actual forfeiture rate differs materially from this estimate theexpense will be adjusted.

*Restricted Stock*

deCODE’s Equity IncentivePlans allow for the issuance of restricted stock awards that may not be sold orotherwise transferred until certain restrictions have lapsed. The unearnedstock-based compensation related to these awards is amortized to compensationexpense over the period the restrictions lapse. The stock-based compensationexpense for these awards is determined based on the market price of our stockat the date of the grant applied to the total numbers of shares that are anticipatedto fully vest and then amortized over the vesting period. In 2006 and 2005,deCODE granted 7,588 and 57,944 restricted shares, respectively, and recognizedstock-based compensation expense related to these restricted shares of $53,000and $106,000 during the three and six-months ended June 30, 2006, respectively,and $0 and $0 during the three and six-months ended June 30, 2005,respectively. During the three and six-month periods ended June 30, 2006 deCODEreceived $37,000 and $89,000, respectively, and during the three and six-monthsended June 30, 2005, deCODE received $37,000 and $37,000, respectively, relatedto the payment of notes receivable in connection with share-based paymentarrangements.

The following tablerepresents restricted stock activity for the six months ended June 30, 2006:

|                              | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** |
|------------------------------|------------|----------------------------|------------|-------------------------------------------------------------|------------|
| Unvested at  January 1, 2006 |       | 51,987                     |       | $                                                           | 9.31       |   |
| Granted                      |       | 7,588                      |       | 7.38                                                        |       |
| Vested                       |       | (3,884                     | )          | 7.21                                                        |       |
| Forfeited/cancelled          |       | —                     |       | —                                                      |       |
| Unvested at June 30,  2006   |       | 55,691                     |       | $                                                           | 9.19       |   |

 

At June 30, 2006, therewas $368,000 of total unrecognized compensation cost related to restrictedstock to be recognized over a weighted average remaining period of2.0 years. The total fair value of shares vested during the three andsix-months ended June 30, 2006 was $14,000 and $28,000, respectively.

**6.   NetLoss Per Share**

Basic net loss per shareis computed using net loss available to common stockholders and theweighted-average number of common shares outstanding. The weighted-averagenumber of common shares outstanding during the period is the number of sharesdetermined by relating the portion of time within a reporting period thatcommon shares have been outstanding to the total time in that period.

Diluted net loss per share does not differ from basicnet loss per share in all periods presented as potential common shares areantidilutive for all such periods and are, therefore, excluded from thecalculation. Potential common shares excluded from the calculation of dilutednet loss per share were:

|                                                                                | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Warrants to  purchase shares of common stock                                   |       | 2,385,022               |       | 2,779,873               |       |
| Options to  purchase shares of common stock                                    |       | 4,766,201               |       | 4,351,542               |       |
| Restricted  shares with an associated outstanding non-recourse promissory note |       | 746,291                 |       | 1,175,623               |       |
| Convertible shares  issuable upon conversion of 3.5% senior convertible notes  |       | 10,714,286              |       | 10,714,286              |       |
| Total                                                                          |       | 18,611,800              |       | 19,021,324              |       |

 

9

----

 

**7.   ComprehensiveLoss**

Comprehensive income(loss) generally represents all changes in stockholders’ equity except thoseresulting from investments or contributions by stockholders. Amounts reportedin other comprehensive income include foreign currency translation adjustmentsand unrealized gains and losses associated with investments. The followingtable presents the calculation of comprehensive income (loss):

|                                                    | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                                           | ** ** |
| Net loss                                           |       | $                                                                 | (18,343    | )                                                               | $          | (13,332 | ) | $ | (38,616 | ) | $ | (30,268 | ) |
| Other comprehensive  income (loss)                 |       |                                                              |       |                                                            |       |   |   |   |   |
| Foreign currency translation                       |       | 13                                                                |       | 1                                                               |       | 21 |   | 1 |   |
| Unrealized gain (loss) associated with investments |       | 6                                                                 |       | (292                                                            | )          | (15 | ) | (371 | ) |
| Total  comprehensive loss                          |       | $                                                                 | (18,324    | )                                                               | $          | (13,623 | ) | $ | (38,610 | ) | $ | (30,638 | ) |

 

**8.   Investments**

deCODE’s investmentsconsist of auction rate securities, municipal bonds, US government securitiesand a corporate bond, all of which are classified as available-for-sale.Investments are available for current operations and are classified as currentassets. Investments are carried at fair value with the unrealized holding gainor loss included in accumulated other comprehensive income. Fair value isgenerally determined with reference to quotations in active markets. Premiumand discounts associated with investments in bonds are amortized using theeffective interest rate method.

Investmentsas of June 30, 2006 are summarized as follows:

|                                | ** ** | **Amortized  Cost**     | ** ** | **Estimated  Fair Value** | ** ** |
|--------------------------------|------------|-------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **(In thousands)** | ** ** |
| Auction rate  securities       |       | $                       | 64,000     |                           | $          | 64,000 |   |
| US government  debt securities |       | 15,000                  |       | 14,836                         |       |
| Municipal bonds                |       | 4,000                   |       | 4,000                          |       |
| Corporate bonds                |       | 5,000                   |       | 5,000                          |       |
|                           |       | $                       | 88,000     |                           | $          | 87,836 |   |

 

Gross unrealized holding gains and gross unrealizedholding losses at June 30, 2006 were $0 and $164,000, respectively, and at June30, 2005 were $200,000 and $546,000, respectively, and are included inaccumulated other comprehensive income.

**9.   Acquisition of UVS**

On January 17, 2006,deCODE acquired 100% of the outstanding shares of Urdur Verandi Skuld ehf. (“UVS”),a privately-held cancer research firm, from Iceland GenomicsCorporation, Inc. (“IGC”), both companies having their principal officesin Reykjavik, Iceland. deCODE paid gross consideration of $6,137,000 including635,006 shares of deCODE common stock valued at $6,082,000 (based upon theaverage closing price of deCODE common stock two days before and after theacquisition date) and approximately $55,000 for acquisition related costs. Aspart of the transaction, deCODE acquired research rights for blood and tissuesamples and clinical data for various types of cancers which deCODE has addedto its samples for research and development purposes. deCODE has included theresults of operations of the acquired entity in deCODE’s consolidatedstatements of operations from the date of acquisition. Because the activityfrom the beginning of the period to the acquisition date was not material, no pro-formainformation is presented.

The purchase price wasallocated to the estimated fair value of the acquired tangible and intangibleassets and assumed liabilities as follows (amounts in thousands): 

| Cash                            |   | $     | 1,270  |   |
|---------------------------------|--------|-------|--------|--------|
| Net liabilities  acquired       |   | (719  | )      |
| Goodwill                        |   | 1,191 |   |
| Identifiable  intangible assets |   | 4,395 |   |
|                            |   | $     | 6,137  |   |

 

10

----

 

The purchase price wasallocated to the net assets acquired based on their estimated fair values atthe date of acquisition. The excess of the purchase price over the estimatedfair value of the net assets acquired amounted to $1,191,000, which wasallocated to goodwill. Under Icelandic tax law goodwill is not deductible fortax purposes.

The identifiable intangible assets acquired consist ofthe exclusive rights to perform research on blood and tissue samples andrelated clinical data which were valued at $4,395,000 and will be amortizedover a period of 15 years, the estimated useful life of the assets.

**10.   Long-Term Debt**

In March 2005, deCODE executed a refinancing of itsmortgage with a financial institution for its Woodridge, IL facility. Therefinanced balance of $6,211,000 carries an interest rate of three-month LIBOR+ 2.25% (7.25% at June 30, 2006), payable in monthly principal installments of$26,000 plus interest for two years and six months with a final payment of$5,378,000 due in September 2007.

**11.   Litigation**

Other than claims andlegal proceedings that arise from time to time in the ordinary course ofbusiness which are not material, there has been no change in the mattersreported in our Annual Report on Form 10-K for the year endedDecember 31, 2005.

**12.   SubsequentEvent**

InJuly 2006 deCODE completed the sale of 6,000,000 shares of common stock at apurchase price of $5.00 per share for aggregate net proceeds, after costs ofthe transaction, of $27.8 million.

# **ITEM 2. MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

This Management’s Discussion and Analysis of FinancialCondition and Results of Operations as of June 30, 2006 and for the three andsix-month periods ended June 30, 2006 and 2005 should be read in conjunctionwith the unaudited condensed consolidated financial statements and notesthereto set forth in Item 1 of this report.

This quarterly report onForm 10-Q contains forward-looking statements, including our expectationsof future industry conditions, strategic plans and forecasts of operationalresults. Various risks may cause our actual results to differ materially. Alist and description of some of the risks and uncertainties is contained belowand in the summary of risk factors set forth in Item 1A of our Annual Report onForm 10-K for the year ended December 31, 2005.

# **Overview**

deCODE is abiopharmaceutical company applying its discoveries in human genetics to developdrugs for common diseases. Our population approach and resources enable us toisolate genes and drug targets directly involved in the development of many ofthe diseases that are the biggest challenges to public health. We are turningthese discoveries into a growing pipeline of therapeutics aimed at combatingthe causes of disease, not just the signs and symptoms. As these diseases arecommon and current therapies are of limited effectiveness, we believe that ourstrategy represents a significant opportunity to create better medicine withmajor potential in the global marketplace.

We believe that deCODE’sadvantage derives from our population approach to human genetics and theability to apply this approach across the drug development process. In Iceland,we have comprehensive population resources that enable our scientists toefficiently conduct genome- and population-wide scans to identify key genes andgene variations contributing to common diseases. The proteins encoded by thesegenes, and other proteins with which they interact in the disease pathway,offer drug targets that we believe are directly involved in the onset andprogression of disease. Small-molecule drugs that target these proteins maytherefore represent a direct means of modulating the onset or progression ofthe disease. Our approach also enables us to apply our gene discoveries todevelop DNA-based diagnostic tests. We believe that such tests have significantmedical and commercial potential, offering a means of gauging individual riskof common diseases, informing more effective prevention strategies, andidentifying patients who may derive particular benefit from our drugs — whichare aimed at counteracting the biological effects of the same at-risk genevariants.

Through our medicinalchemistry and structural biology subsidiaries based in the United States, weare able to discover novel small-molecule therapeutic compounds, take candidatecompounds through pre-clinical testing, and manufacture sufficient quantitiesfor early-stage clinical trials. Our product development group designs andimplements our clinical development programs. By leveraging the capabilities ofEncode, our clinical trials subsidiary, and our expertise in genetics and drugand disease modeling, we are able to

11

----

 

make the drug developmentprocess a more efficient and sensitive means of testing and optimizing thetherapeutic and commercial potential of new drugs. In certain programs we havealso taken advantage of the fact that drug targets we have identified throughour genetics research have already been targeted by other companies to developcompounds for other indications. By licensing these compounds or entering intoco-development arrangements, we have been able to bypass over several years ofdrug discovery, entering directly into Phase II clinical trials.

Our goal is to bring tomarket new drugs for major indications, and in so doing make the companyprofitable and create value for our shareholders. To achieve this goal we mustensure that we have the capabilities and financial means to expand and advanceour pipeline through the long, risky and expensive process of drug developmentand on to the market. This requires us to constantly evaluate the optimalbalance between several factors, including the level of our investment inresearch and development, the preservation of cash resources and theirdeployment for product development, and the financing environment.

In order to support ourdrug development infrastructure, to focus the use of our cash resources on ourproprietary therapeutics programs, and to diversify risk in our overall drugdevelopment portfolio, we leverage our capabilities to form corporate alliancesand to provide services to fee-paying customers. We also receive contract andgrant funding from various governmental agencies. We have formed drug and otherproduct development alliances with Roche and Merck, among others. In additionto conducting work on our targets in our collaborative and internal programs,our medicinal chemistry subsidiary provides drug discovery services andcontract manufacturing of therapeutic compounds for human clinical trials forour fee-for-service customers. Our other service offerings include proteincrystallography products and instruments, as well as protein structure analysiscontract services through our structural biology subsidiary; clinical trialsservices through Encode; and DNA analysis services through our genotypinglaboratory in Reykjavik.

We derive revenuesprimarily from research funding and other fees from our service customers andcollaborative partners and also various research grants. Milestone payments andupfront, exclusivity, technology-access and technology-development fees underour collaboration agreements constitute much of the rest of our revenues. Whilewe are entitled to royalties or profit-sharing under the terms of some of ouragreements, due to the extended time period for the development andcommercialization of a saleable product or therapy, we have not yet receivedroyalties or profit sharing under any of our contracts and do not expect to doso for several years, if at all. Our expenses consist primarily of research anddevelopment expenses such as, salaries and related employee costs, materialsand supplies, and contractor services.

We believe that our ongoingwork in genetics and advancing our drug development programs, particularly theconduct of clinical trials on a growing number of our compounds, will requiresignificant and increasing expenditures. In the first half of 2006, we beganenrollment for a Phase III trial for DG031, our lead developmental compound forthe prevention of heart attack and stroke; completed our Phase I dose-ranging, pharmacokinetics(PK) and safety clinical program for DG041, our developmental compound forperipheral artery disease (PAD), and initiated a Phase IIa trial; and weconcluded our Phase II trial of Cephalon’s developmental compound CEP-1347 inasthma. We also advanced our pre-clinical work on our follow-on compound inheart attack, DG051, and filed an IND in late June. We expect to begin a PhaseI trial in the third quarter of this year. We are also working on several other preclinical programs for stroke,inflammation, obesity, and pain among others. We anticipate incurring additional net losses at least through the nextseveral years, due to, in addition to the above-mentioned factors, depreciationand amortization, as well as stock-based compensation and other non-cashcharges. We expect that our revenues and losses will fluctuate from quarter toquarter and that such fluctuations may be substantial, especially because progressin our scientific work and milestone payments that are related to progress canfluctuate between quarters. We do not believe that comparisons of ourquarter-to-quarter performance are a good indication of future performance.

At June 30, 2006, we had$115.5 million in cash, cash equivalents and investments and as we advance andbroaden our drug development pipeline we will require significant additionalcapital for product development and so we will continue to investigateadditional avenues of financing. In July 2006 we completed the sale of6,000,000 shares of common stock at a purchase price of $5.00 per share, for aggregatenet proceeds, after costs of the transaction, of $27.8 million. Our ability toobtain capital in the future will be affected by conditions in the globalfinancial markets and in the pharmaceutical industry. We expect that morefavorable conditions in those markets will present opportunities for us, whiledownturns in the market valuations of biotechnology companies and of the equitymarkets more generally will restrict our ability to raise additional capital onattractive terms.

The difficulties facingthe pharmaceutical industry present for us both near-term challenges andsignificant longer-term opportunities. One of the main issues confronting bigpharmaceutical companies is their lack of promising new drugs to treat majorindications. As many leading brand-name drugs come off patent and face genericcompetition, developing successful new medicines will become critical for fillingthe gap. In the short term, the pressures on pharmaceutical companies may bereflected in their research and development spending, making it more difficultfor us to sign corporate alliances with significant up-front funding, orlengthening the time required to negotiate such deals. We believe that in themedium to longer term, however, companies such as ours may be well positionedto play an important role in filling the gap in the pipeline of new drugs,either alone or as partners of pharmaceutical companies. Our partnershipsdemonstrate that the industry is already investing in the development of newtherapeutics based on our approach.

12

----

 

**Research and Development Programs**

The following is asummary of the development of our drug candidates in late pre-clinical orclinical development. Because of uncertainties involved in the drug developmentprocess, the actual timing for the events described below may differ materiallyfrom that provided in this summary.

·       Our most advanceddevelopmental compound is DG031 for the prevention of heart attack and stroke.Under a Special Protocol Assessment with the FDA, we finalized the protocol fora Phase III outcome trial (LTCAD Study) for DG031 and began the Phase IIItrial in May 2006.  The trial willexamine the long-term effects of DG031 in reducing the risk of acutecardiovascular events by its impact on the production of leukotreine B4 (LTB4),a potent modulator of inflammation, the production of which is up-regulated bygene variants we have linked to increased risk for heart attack. This is a mechanismdiscovered through our gene discovery work and validated in manypopulations.  We have enriched this trialby initially focusing on those patients who are at highest risk through thispathway—African Americans who carry an at risk variant of the gene encodingleukotreine A4 Hydrolase (LTA4H) and who have had a previous heart attack.

·       DG041 is our lead compoundfor the treatment of atherosclerosis of the extremities, or peripheral arterydisease (PAD). DG041 is a first-in-class small molecule inhibitor of the EP3receptor for prostaglandin E2, a G-protein coupled receptor (GPCR) encoded by agene we have shown to be associated with increased risk of developing thedisease. In early 2006, we concluded thePhase I clinical program for DG041. Nearly 200 healthy subjects were exposed toDG041 in these studies. The results of the Phase I program showed DG041 to bewell-tolerated across the entire dose range studied, and that DG041 caneffectively inhibit platelet aggregation in a dose-dependent manner withoutincreasing bleeding time. In the second quarter of 2006, we began a Phase IIaclinical trial that will examine the effect of DG041 on certain plasma biomarkers.

·       In asthma, we haveconducted a Phase II trial, working with Cephalon on their compound CEP-1347,which was originally developed for treatment of Parkinson’s disease. Thiscompound inhibits MAP3K9, a kinase encoded by a gene we have linked to risk ofasthma. In the Phase IIa trial we found that the compound had a dose-relatedeffect on both lung function and biomarkers associated with lung inflammationand severity of disease in patients with asthma who were already being treatedwith inhaled coriticosteriods and long-acting beta agonist (LABA).

·       As a follow-on to DG031, weare developing DG051, an inhibitor of the enzyme LTA4H, which is directlyinvolved in the synthesis of LTB4. Like DG031, DG051aims to prevent heartattack and stroke by decreasing the production of leukotriene B4 (LTB4). DG051appears to provide potent inhibition of LTB4 production, is orally bioavailable,has potential for once-daily dosing and with minimal potential fordrug-interaction. We filed an IND on DG051 during the second quarter of 2006,and expect to begin a Phase I clinical trial in the third quarter of this year.

·       Our drug discovery group is also working on pre-clinical programs inobesity, pain, inflammation and stroke, among other indications. We arepursuing a PDE4 inhibitor program for vascular disease/stroke pursuant to our2004 agreement with Roche and working on identifying and advancing a leadpre-clinical compound.

We use many of ouremployee and infrastructure resources across several programs, and many of ourresearch and development costs are indirectly attributable to an individuallynamed program or are directed broadly to applicable research programs. However,taking into account costs that are specifically attributable to individualprograms and allocations of our research and development program costs basedupon those direct costs, we have cumulatively invested $24.4 million, $13.6million, $7.3 million and $7.9 million in our heart attack (myocardialInfarction, or MI), PAD, stroke and asthma programs, respectively, from thebeginning of 2003 to date. Inception to-date costs are not available as thesecosts were not historically tracked by program.

We have not applied foror received marketing approval from the applicable regulatory authorities inany country for any of our drug candidates. In order for us to achievemarketing approval in the United States, the FDA must conclude that ourclinical data establish the safety and efficacy of our drug candidate. Othercountries have similar requirements. Historically, the results frompre-clinical testing and early clinical trials (through Phase II) haveoften not been predictive of success in later clinical trials. Many newcompounds have shown promising results in early clinical trials, butsubsequently failed to establish sufficient safety and efficacy data to obtainnecessary marketing approvals. Additional risks and uncertainties involved inthe development and commercialization of any products are described under Item1A in our reports on Form 10-K and 10-Q. We expect that it will be severalyears, if ever, before we receive revenues from the commercial sale of our therapeuticproducts.

Furthermore, our strategyincludes the option of entering into collaborative arrangements with thirdparties to participate in the development and commercialization of ourproducts. Entering into a collaboration with a partner at any point in thedevelopment or commercialization of a product is a business decision. Whenmaking this decision we do and will consider, among other matters, thecomplexity of the indication, the size, complexity and expense of necessarydevelopment and/or commercialization efforts, competition in the market andsize of the applicable market, an assessment of our own resources—financial andoperational, and an assessment of the resources of a potential partner. In theevent that we do collaborate on any of the above programs in the future, apartner will have a level of control, which may be significant, over thepre-clinical development or clinical trial process for a product. As a resultthe completion date of such a partnered program could largely be under controlof that third party rather than under our

 

13

----

control. We cannotforecast with any degree of certainty which proprietary drug candidate will besubject to future collaborative arrangements or how such arrangements wouldaffect our development plan or capital requirements.

As a result of theuncertainties discussed above, we are unable to determine the duration andcompletion costs of our research and development projects or when and to whatextent we will receive cash inflows from the commercialization and sale of aproduct.

**Acquisitions, Joint DevelopmentPrograms and In-licensing**

As part of our businessstrategy, we continue to consider joint development programs and merger andacquisition opportunities that may provide us with products in late-stage development,intellectual property or financial resources or with capabilities that willhelp accelerate our downstream drug discovery efforts.

*UVS*.  In January 2006, we acquired all of theoutstanding shares of Urdur Verdandi Skuld ehf. (“UVS”), a privately-heldcancer research firm, from Iceland Genomics Corporation, Inc. (“IGC”),both companies having their principal offices in Reykjavik, Iceland. Asconsideration for the purchase, we issued 635,006 shares of deCODE common stockvalued at $6,082,000 to IGC. This acquisition will allow us to broaden ourcancer program by applying our gene discovery and drug development efforts to alarger set of population resources.

*Illumina*.  In May 2006, we entered into a strategicalliance with Illumina, Inc. (“Illumina”) to develop and commercializemolecular diagnostic products. Under the terms of the agreement, deCODE andIllumina will share development costs equally and split operating profits fromthe sales of diagnostic tests. Our initial focus will be developing diagnosticsfor heart attack, breast cancer and Type 2 diabetes. Also as part of theagreement, we will install Illumina’s SNP genotyping platform, enabling us toexpand our contract genotyping business to offer Illumina’s platform and assaytechnologies together with our proprietary analytical services for customers.We intend to utilize the Illumina platform to carry-out high-density,whole-genome studies utilizing our comprehensive population genetics resourcesin Iceland.

In certain programs wehave taken advantage of the fact that drug targets we have identified throughour genetics research have already been employed by other companies to makedevelopmental compounds for other indications. By licensing these compounds orentering into co-development arrangements we have been able to leapfrog overseveral years of drug discovery, entering directly into Phase II clinicaltrials. We are conducting a Phase III clinical trial for DG031, our leaddevelopmental compound for the prevention of heart attack and stroke, which welicensed from Bayer HealthCare AG and which was initially developed for asthma.We also recently concluded a Phase II trial in asthma, working with Cephalon onCEP-1347, on a compound they originally developed for Parkinson’s disease. Wecontinue to investigate additional such possibilities for the in-licensing orco-development of promising existing compounds that may effectively act againsttargets we have identified through our gene discovery work.

**Critical Accounting Policies**

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires us to make certain estimates and assumptions that affectthe reported amounts of assets and liabilities, the disclosure of contingentassets and liabilities at the date of the financial statements, and thereported amounts of revenues and expenses during the reported period. On anongoing basis we evaluate our estimates, which include, among others, thoserelated to collaborative arrangements, long-lived assets, materials andsupplies, stock-based compensation, foreign exchange transactions, income taxesand litigation and other commitments and contingencies. We base our estimateson historical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form our basis formaking judgments about carrying values of assets and liabilities that are notreadily apparent from other sources. The impact and any associated risksrelated to these and our other accounting policies on our business oroperations is discussed throughout Management’s Discussion and Analysis ofFinancial Condition and Results of Operations where such policies affect ourreported and expected financial results. For a detailed discussion on theapplication of these and other accounting policies, please refer to our notesto the Condensed Consolidated Financial Statements in this quarterly report onForm 10Q and the Consolidated Financial Statements in the Annual Report onForm 10-K for the year ended December 31, 2005. There can be noassurance that actual results may not differ from the estimates referred toabove.

*Stock-based Compensation*

In December 2004,the Financial Accounting Standards Board (FASB) issued SFAS No. 123R (SFAS123R), a revision of SFAS No. 123, *Accountingfor Stock-Based Compensation*(SFAS 123), which requires that allshare-based payments to employees and directors, including grants of stockoptions be recognized in the income statement based on their fair values. SFAS123R supersedes Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(APB 25) and amends SFAS No. 95, *Statementof Cash Flows*. On January 1, 2006, we adopted SFAS123R using the modified prospective method of adoption as permitted underSFAS 123R which requires that compensation expense be recorded for allnonvested stock options and other stock-based awards as of the beginning of thefirst quarter of adoption. In accordance with the modified prospective method,no prior period amounts have been restated to reflect the provisions of SFAS123R.

14

----

 

Prior to the adoption ofSFAS 123R, in accordance with the provisions of SFAS 123, we elected to followAPB 25, and FASB Interpretation No. 44, *Accountingfor Certain Transactions Involving Stock Compensation—an Interpretation of APBOpinion No. 25*, in accounting for our employee stock-basedplans. Under APB 25, if the exercise price of deCODE’s employee stock optionswas equal to or greater than the fair value of the underlying stock on the dateof grant, no compensation expense was recognized. However, as required by SFAS123, the pro forma impact of expensing the fair value of our stock optionawards and employee stock purchase plan was disclosed in the notes to ourcondensed consolidated financial statements.

In connection with ouradoption of SFAS 123R, we refined our valuation assumptions and themethodologies used to derive those assumptions; however, we elected to continueusing the Black-Scholes option valuation model. Concurrent with our adoption ofSFAS 123R, we determined that historical volatility of deCODE’s stock would bethe best measure of market conditions and expected volatility. We estimate theweighted-average expected life of our stock-option awards based on historicalcancellation and exercise data related to our stock-based awards as well as thecontractual term and vesting terms of the awards. We allocate stock-basedcompensation expense using a straight-line expense attribution approach.Stock-based compensation expense related to stock options is recognized net ofestimated forfeitures. We estimated forfeitures based on our historicalexperience.

During the three andsix-months ended June 30, 2006, we recognized stock-based compensation expenseof $1.0 million and $1.9 million, or $0.02 and $0.04 per share, respectively.As of June 30, 2006, we had unrecognized stock-based compensation of $7.8million related to nonvested stock options awards, which is expected to berecognized over an estimated weighted average period of 2.01 years.

**Results of Operationsfor the Three and Six-Month Periods Ended June 30, 2006 and 2005**

Our results of operationshave fluctuated from period to period and may continue to fluctuate in thefuture based upon, among other things, the timing and composition of fundingunder our various collaborative agreements, as well as the progress of our ownresearch and development efforts including, those carried out under researchgrants. Results of operations for any period may be unrelated to results ofoperations for any other period. In addition, historical results should not beviewed as indicative of future operating results. We are subject to riskscommon to companies in our industry and at our stage of development, includingrisks inherent in our research and development efforts, reliance uponcollaborative partners, development by us or our competitors of newtechnological innovations, ability to market products or services, dependenceon key personnel, dependence on key suppliers, protection of proprietarytechnology, ability to obtain additional financing, ability to negotiatecollaborative arrangements, and compliance with governmental and otherregulations. In order for a product to be commercialized based on our research,we and our collaborators must conduct preclinical tests and clinical trials,demonstrate the efficacy and safety of our product candidates, obtainregulatory approvals or clearances and enter into manufacturing, distributionand marketing arrangements, as well as obtain market acceptance. We do notexpect to receive revenues or royalties based on therapeutic or diagnosticproducts for a period of years, if at all.

Financial highlights asof and for the three and six-month periods ended June 30, 2006 include:

·       At June 30, 2006, we had$115.5 million in cash and investments compared to $155.6 million atDecember 31, 2005. The net utilization of our cash and investments in thefirst half of 2006 reflects principally the costs associated with theadvancement of our drug development programs as reflected in the $40.1 millionof cash we used in operating activities.

·       In July 2006 we completedthe sale of 6,000,000 shares of common stock at a purchase price of $5.00 pershare for aggregate net proceeds, after costs of the transaction, of $27.8million.

·       Research and developmentexpense for proprietary programs was $13.2 million and $28.7 million for thethree and six-month periods ended June 30, 2006, respectively, as compared to$11.0 million and $19.3 million for the three and six-month periods ended June30, 2005. The increase in our research and development expenses for proprietaryprograms is the result of costs associated with the advancement of our leaddrug discovery and development programs. In May 2006, we began a Phase IIIclinical trial for DG031 our lead developmental compound for the prevention ofheart attack. In 2006 we also began a Phase IIa trial for DG041, ourdevelopmental compound in Peripheral Artery Disease, filed an IND on DG051, andcarried out a Phase II trial in asthma for Cephalon’s CEP-1347.

·       Our revenue was $10.4million and $20.5 million for the three and six-month periods ended June 30,2006, respectively, as compared to $11.4 million and $21.0 million for thethree and six-month periods ended June 30, 2005 respectively. Revenue for theperiods presented generally reflects our strategic focus on proprietary drugdiscovery and development.

*Revenue.*  Revenuefor the three and six-month periods ended June 30, 2006 and 2005 is asfollows:

 
| ** ** | ** ** | **For the Three Months**     | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------|------------|---------------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** ** | ** ** | **Ended June 30,**                | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** ** | ** ** | **2006**                                    | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except %)** | ** ** |
| Revenue    |       | $                                           | 10,360     |                                  | $          | 11,437                                           |       | $ | 20,493 |   | $ | 20,960 |   | $ | (1,077 | ) | (9 | )% | $ | (467 | ) | (2 | )% |
|            |            |                                             |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

15

----

 

Our business strategy isfocused on turning our discoveries into new drugs for the treatment of commondiseases. At the same time, we leverage our capabilities to generate revenuethrough corporate alliances, through service contracts and through researchgrants. In the majority of our programs we are pursuing drug development on ourown. In certain others, we have formed alliances with pharmaceutical andbiotechnology firms through which we can cover some of the cost of conductingbasic research and spread the risk and investment involved in productdevelopment. Increasingly, we have also sought and received research grantfunding. We have entered into research, development, commercialization, and feefor service alliances and contracts across our business. Depending on thenature of each prospective business opportunity, the key components of thecommercial terms of such arrangements typically include one or more of thefollowing: research funding; up-front, exclusivity, technology access, andtechnology development fees; fees for particular services; milestone payments;license or commercialization fees; and royalties or profit sharing from thecommercialization of products.

Collaborations with our most significant partnersinclude:

*F. Hoffmann-LaRoche (Roche)*

*Therapeutics.* In 2002, we entered into an agreement with Roche tocollaborate on four diseases that had been the subject of an earliercollaboration with Roche. During 2004 and through January 2005, we collaboratedwith Roche on two of those diseases. Under this agreement we discovered geneslinked to diabetes and Roche continues drug discovery based on one of thesediscoveries. Under the 2002 agreement, which expired on February 1, 2005,we received $20.0 million in research funding and we are entitled to receiveroyalties on the sales of any drugs that are developed coming out of workconducted under this agreement.

In November 2004, wesigned a new three-year agreement with Roche to co-develop inhibitors of PDE4for the prevention and treatment of vascular disease, including stroke. Thisagreement continues work advanced under the 2002 agreement, and we will focuson optimizing lead compounds identified under the previous agreement andbeginning clinical development. Under this agreement, as of the end of June 30,2006, we have received $4.0 million of research funding. We will share drugdiscovery and clinical trials costs under this new agreement, and we mayreceive an additional $2.0 million of research funding over the remaining termof the agreement as well as milestone payments and royalties based on drugsales.

*Diagnostics.* In June 2001, we signed a five-year alliance withRoche’s diagnostics division and through June 2006 we collaborated to developand market DNA-based diagnostics for major diseases.  During the term of the alliance, which hasnow expired, we received $44.3 million in research funding, up-front fees andmilestone payments under the agreement and we may receive additional milestonepayments upon the achievement of research and development milestones by Rocheand royalties on the sales of diagnostic products developed by Roche.

Revenues recognized andcosts incurred in connection with these collaborations with Roche aresummarized as follows:

|                                                  | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In millions, except %)**                        | ** ** |
| Revenue                                          |       | $                                                                 | 2.8        |                                                            | $          | 2.3 |   | $ | 5.4 |   | $ | 5.0 |   |
| Revenue as a  percentage of consolidated revenue |       | 27                                                                | %          | 20                                                              | %          | 26 | % | 24 | % |
| Cost of revenue                                  |       | $                                                                 | 3.2        |                                                            | $          | 1.3 |   | $ | 6.1 |   | $ | 5.0 |   |

 

*Merck &Co, Inc. (Merck)*

*Obesity.  *In September 2002, we entered into a three year alliancewith Merck aimed at developing new treatments for obesity. Under the alliance,we combined research efforts with Merck in the genetics of obesity to identify,validate and prioritize a series of drug targets to take into development.During the three-year research program, which has now expired, we have receivedresearch funding, technology access fees and milestone payments in theaggregate amount of $25.3 million. In addition, we may receive furthertechnology access fees in the total aggregate amount of $2.0 million. Subjectto Merck’s developing products based on collaboration discoveries, we may alsoreceive development milestones and royalties. We have discovered three geneslinked to obesity under this alliance, and Merck has generated a lead series ofcompounds against one of the targets we validated through our geneticsresearch.

Revenues recognized andcosts incurred in connection with this collaboration with Merck are summarizedas follows:

|                                                  | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In millions, except %)**                        | ** ** |
| Revenue                                          |       | $                                                                 | —     |                                                            | $          | 1.8 |   | $ | — |   | $ | 3.6 |   |
| Revenue as a  percentage of consolidated revenue |       | -                                                                 | %          | 16                                                              | %          | - | % | 17 | % |
| Cost of revenue                                  |       | $                                                                 | —     |                                                            | $          | 1.0 |   | $ | — |   | $ | 2.1 |   |

 

16

----

 

*Information-RichClinical Trials.  *In February 2004, weentered into an agreement with Merck which provides that we will conductinformation-rich clinical trials on a range of Merck’s developmental compoundsthat Merck selects for inclusion in the program. The term of the alliance isseven years, subject to termination by Merck after five years. The collaborationinvolved three agreements: (a) a License and Research CollaborationAgreement; (b) a Stock and Warrant Purchase Agreement; and (c) aWarrant Agreement. Under the terms of the License and Research CollaborationAgreement, we will receive royalties on sales of drugs and diagnosticsdeveloped as part of the alliance, will receive milestone payments as compoundsor pharmacogenomic tests reach the market, will receive research funding forthe clinical development of compounds and pharmacogenomic analysis, andreceived a one-time technology access fee of $10.0 million. A contingencyclause on the technology access fee provides that if we reject the first twonon-exclusive development compounds that Merck presents to the collaboration,then Merck has the right to request a refund of $2,500,000 of the technologyaccess fee. The remaining amount of the technology access fee isnon-refundable. To date, Merck has not selected any compounds for developmentunder the agreement.

*GrantFunding*

We have received variousresearch grants from divisions of the United States National Institutes ofHealth (NIH), the Commission of the European Communities (EC) and privatefoundations. Research grants for multiple years are based on approved budgetswith budgeted amounts subject to approval on an annual basis. NIH grantsgenerally provide for 100% reimbursement of allowable expenditures while thegrant under the EC generally provides for 50% reimbursement of allowableresearch and development related expenditures. Our significant researchcontracts include:

*NationalInstitute of Allergy and Infectious Diseases (NIAID).  *InSeptember 2004, we were awarded a five-year $23,900,000 contract by theNIAID, a division of NIH. Under the contract, we are applying our populationapproach to discover genetic factors associated with susceptibility to certaininfectious diseases and with responsiveness to vaccines targeting suchdiseases.  We may receive $16.6 millionin additional research funding over the remaining term of the agreement.

Revenues recognized andcosts incurred related to work performed under contracts and on which wereceive research grants from the NIH are summarized as follows:

|                                                  | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In millions, except %)**                        | ** ** |
| Revenue                                          |       | $                                                                 | 3.7        |                                                            | $          | 1.7 |   | $ | 6.2 |   | $ | 2.2 |   |
| Revenue as a  percentage of consolidated revenue |       | 35                                                                | %          | 15                                                              | %          | 30 | % | 10 | % |
| Cost of revenue                                  |       | $                                                                 | 3.7        |                                                            | $          | 1.7 |   | $ | 6.2 |   | $ | 2.2 |   |

 

Significant elements of ourrevenue are summarized as follows:

|                                                                            | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                           | ** ** |
| Research funding  and other service fees                                   |       | $                                                                 | 5,445      |                                                            | $          | 7,803 |   | $ | 10,913 |   | $ | 14,557 |   |
| Milestone  payments                                                        |       | 101                                                               |       | 234                                                             |       | 299 |   | 582 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | 500                                                               |       | 1,000                                                           |       | 1,000 |   | 2,038 |   |
| Grant funding                                                              |       | 3,939                                                             |       | 2,003                                                           |       | 6,926 |   | 2,891 |   |
| Other                                                                      |       | 375                                                               |       | 397                                                             |       | 1,355 |   | 892 |   |
| Total                                                                      |       | $                                                                 | 10,360     |                                                            | $          | 11,437 |   | $ | 20,493 |   | $ | 20,960 |   |

 

Revenue for the periodspresented generally reflects our strategic focus on proprietary drug discoveryand development. Specifically, the decrease in revenue for the three andsix-month periods ended June 30, 2006 as compared to the same periods in 2005,is primarily due to the completion of research funding under the 2002 agreementwith Roche and the Merck obesity research program, offset by an increase ingrant monies earned from research grants with NIH and EC, contract service feesand the addition of the Roche alliance to co-develop inhibitors of PDE4D.Further, in the six-month period ended June 30, 2006 we sold technology andrelated rights to our Drug Advice Expert (DAX) software for $0.5 million. Weexpect that our revenues will fluctuate from quarter to quarter and that suchfluctuations may be substantial especially because progress in our scientificwork, including milestone payments that are related to progress, can fluctuatebetween quarters.

 

17

----

*Cost of Revenue*.   Cost of revenue, which includes costsincurred in connection with collaborative programs and research grants, for thethree and six-month periods ended June 30, 2006 and 2005 is as follows:
| ** **      | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|-----------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **      | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **      | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)**            | ** ** |
| Cost of Revenue |       | $                                       | 10,459     |                                  | $          | 8,597                                            |       | $ | 20,309 |   | $ | 17,737 |   | $ | 1,862 |   | 22 | % | $ | 2,572 |   | 15 | % |
|                 |            |                                         |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our cost of revenueconsists of the costs of services provided to customers, collaborators andunder research contracts and grants, including the entirety of the costsincurred in connection with programs that have been partnered and on which we receiveresearch funding and that are performed under research contracts and grants. Attimes, we invested in addition to costs covered by research funding received insuch collaborative programs and in addition to monies received under researchcontracts and grants. Our cost of revenue for the three and six-month periodsended June 30, 2006 as compared to the comparative periods in 2005 increasedlargely on account of increased research contract and grant activities ($2.0million and $4.5 million, respectively), but also with the culmination of ourresponsibilities under the diagnostics collaboration with Roche.

Our cost of revenue,including costs incurred in connection with collaborative programs in the threeand six-month periods ended June 30, 2006 as compared to the three andsix-month periods ended June 30, 2005 principally reflect more chemicals andconsumables ($1.1 million, and $1.7 million, respectively) and an increase insalaries and related costs ($0.7 million and $0.5 million, respectively). Also,our cost of revenue, including costs incurred in connection with collaborativeprograms in the three and six-month periods ended June 30, 2006 now includestock-based compensation expense related to our adoption of SFAS123R ($0.1 million and $0.3 million, respectively).  Further, due to the sale-and-leaseback of ourfacilities in Reykjavik, Iceland, our rent expense has increased, which will beoffset by the deferred gain on the sale-and-leaseback that is being amortizedover the term of the lease and also resulted in a decrease in our depreciationexpense for the three and six-month periods ended June 30, 2006 as compared tothe three and six-month periods ended June 30, 2005 ($0.1 million and $0.5million, respectively).

*Research and Development—ProprietaryPrograms.  *Researchand development for proprietary programs for the three and six-month periodsended June 30, 2006 and 2005 is as follows:
| ** **                                           | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **                                           | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                           | ** ** | **(In thousands, except %)**            | ** ** |
| Research and Development — Proprietary Programs |       | $                                       | 13,207     |                                  | $          | 11,001                                           |       | $ | 28,724 |   | $ | 19,276 |   | $ | 2,206 |   | 20 | % | $ | 9,448 |   | 49 | % |
|                                                      |            |                                         |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in ourresearch and development expenses in proprietary programs results from ouremphasis on and increasing expenditures in product development, includingpre-clinical and clinical work on our lead drug discovery and developmentprograms. Importantly, in May 2006 we began a Phase III clinical trial forDG031 our lead developmental compound for the prevention of heart attack. In2006, we also initiated a Phase IIa trial for DG041, our developmental compoundin Peripheral Artery Disease and we conducted a Phase II trial in asthma for acompound developed by Cephalon.  Further,we filed an IND on our compound to inhibit the LTA4 hydrolase (DG051), and wecontinue a PDE4 inhibitor program for vascular disease/stroke pursuant to our2004 agreement with Roche as well as are working on pre-clinical programs instroke, inflammation, obesity and pain, among other indications.  Based upon the range of our current researchand development activities, we currently anticipate that our overall investmentin research and development in 2006 will be in the range of $65 to $70 million.

Our research anddevelopment expenses for the three and six-month periods ended June 30, 2006and 2005 consist of the following:

|                                                  | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                                                | ** ** |
| Salaries and  other personnel costs              |       | $                                                                 | 4,360      |                                                            | $          | 4,383 |   | $ | 9,696 |   | $ | 8,327 |   |
| Materials and  supplies                          |       | 1,170                                                             |       | 1,250                                                           |       | 2,759 |   | 2,196 |   |
| Contractor  services and other third party costs |       | 5,140                                                             |       | 3,378                                                           |       | 10,966 |   | 5,064 |   |
| Overhead  expenses.                              |       | 1,251                                                             |       | 1,208                                                           |       | 2,823 |   | 2,032 |   |
| Depreciation and amortization                    |       | 891                                                               |       | 782                                                             |       | 1,763 |   | 1,657 |   |
| Stock-based compensation                         |       | 395                                                               |       | —                                                          |       | 717 |   | — |   |
| Total                                            |       | $                                                                 | 13,207     |                                                            | $          | 11,001 |   | $ | 28,724 |   | $ | 19,276 |   |

 

18

----

 

Increases in the researchand development costs of our proprietary programs (e.g., contractor servicesand other third party costs, salaries and related costs, and usage of materialsand supplies) will likely continue, particularly as we advance our clinicaldevelopment and proprietary drug development programs. Further, in 2006, wehave granted salary increases to our personnel and during 2005 added clinicaldevelopment executives to our staff, which will contribute to future increasesin our research and development costs for proprietary programs. Our cost ofresearch and development for proprietary programs in the three and six-monthperiod ended June 30, 2006 also includes stock-based compensation expenserelated to our adoption of SFAS 123R. Our overhead expense, consistingprimarily of rent, has increased due to the sale-and-leaseback of ourfacilities in Reykjavik, Iceland. This increase in rent is offset by thedeferred gain on the sale-and-leaseback of the facilities that is beingamortized over the term of the lease.

*Selling, General and Administrative Expense.  *Selling,general and administrative expense for the three and six-month periods endedJune 30, 2006 and 2005 is as follows:
| ** **                           | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **                           | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In thousands, except %)**            | ** ** |
| Selling, General and  Administrative |       | $                                       | 4,392      |                                  | $          | 4,694                                            |       | $ | 9,659 |   | $ | 8,852 |   | $ | (302 | ) | (6 | )% | $ | 807 |   | 9 | % |
|                                      |            |                                         |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our selling, general andadministrative expenses have decreased overall for the three-month period endedJune 30, 2006 as compared to the three-month period ended June 30, 2005 whileshowing an increase for the six-month period ended June 30, 2006 as compared tothe same period last year. Salaries and related costs were approximately thesame in the three-month periods ended June 30, 2006 and 2005 but were higher inthe six-month period ended June 30, 2006 as compared to the correspondingperiod in 2005 ($0.4 million) while legal expenses were approximately the samein the six-month periods ended June 30, 2006 and 2005 but lower ($0.3 million)in the three-month period ended June 30, 2006 as compared to the same period in2005. Further, our selling, general and administrative expenses for the threeand six-month periods indeed June 30, 2006 include a $0.8 million gain on thesale of property.  Our selling, generaland administrative expense in the three and six-month periods ended June 30,2006 now also include stock-based compensation expense related to our adoptionof SFAS 123R ($0.5 million and $0.9 million, respectively).  We generally grant annual salary increases toour personnel and have added significant new members to our Board of Directorswhich will increase our selling, general and administrative expenses.

*Interest Income.  *Interest income forthe three and six-month periods ended June 30, 2006 and 2005 is asfollows:
| ** **       | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **       | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **       | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except %)**            | ** ** |
| Interest  Income |       | $                                       | 1,336      |                                  | $          | 1,533                                            |       | $ | 3,048 |   | $ | 2,653 |   | $ | (197 | ) | (13 | )% | $ | 395 |   | 15 | % |
|                  |            |                                         |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest income hasdecreased in the three-month period ended June 30, 2006 as compared to the sameperiod in 2005 and  increased in thesix-month period ended June 30, 2006 as compared to the same period in2005.  Our interest income is a functionof both the balance of our cash and investments (which have been declining asresources are deployed in operations) and the rate of return we are able togarner under our investment policy (which average rate of return has beenincreasing in 2005 and again in 2006). We expect to use our cash andinvestments principally for advancing our drug and clinical developmentprograms. In the meantime, we will invest the monies received in accordancewith our policy, having the objective of preserving principal while maximizingincome we receive from our investments without significantly increasing risk.We expect to maintain our portfolio of cash equivalents and investments in avariety of securities, including auction rate securities, commercial paper,money market funds, mutual fund investments and government and non-government debtsecurities.

*InterestExpense.  *Interest expense for the three and six-monthperiods ended June 30, 2006 and 2005 is as follows:
| ** **        | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|-------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **        | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **        | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **(In thousands, except %)**            | ** ** |
| Interest  Expense |       | $                                       | 1,691      |                                  | $          | 1,700                                            |       | $ | 3,407 |   | $ | 4,089 |   | $ | (9 | ) | (1 | )% | $ | (682 | ) | (17 | )% |
|                   |            |                                         |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest expenseprincipally reflects interest on our 3.5% Senior Convertible Notes due in 2011that we issued in April 2004.

19

----

 

*OtherNon-Operating Income and Expense, Net.  *Othernon-operating income and expense for the three and six-month periods ended June30, 2006 and 2005 is as follows:
| ** **                                     | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                     | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **                                     | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **(In thousands, except %)**            | ** ** |
| Other  Non-Operating Income and (Expense), Net |       | $                                       | (290       | )                                     | $          | (310                                             | )          | $ | (58 | ) | $ | (3,927 | ) | $ | 20 |   | 6 | % | $ | 3,869 |   | 99 | % |
|                                                |            |                                         |            |                                       |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our other non-operatingincome and expense, net, consists principally of the net impact of foreignexchange in the three and six-month periods ended June 30, 2006. In the threeand six-month periods ended June 30, 2005, these amounts also include realizedgains and losses on derivative financial instruments as well as a loss on theearly extinguishment of debt as a result of having prepaid the short andlong-term debts that were secured by mortgages on Sturlugata 8 (3.1 million).Our losses on derivative financial instruments in the three and six-month periodsended June 30, 2005 ($0.1 million and $0.2 million, respectively) result fromthree forward foreign currency exchange options we entered into as economichedges against foreign exchange rate fluctuations that we expected may occur onour ISK-denominated operating expenses but that did not qualify for hedgeaccounting.

*NetLoss and Basic and Diluted Net Loss Per Share*.   Net lossand basic and diluted net loss per share for the three and six-month periodsended June 30, 2006 and 2005 is as follows:
| ** **                            | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|--------------------------------------------------|------------|
| ** **                            | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** | **Three Months**                            | ** ** | **Six Months** | ** ** |
| ** **                            | ** ** | **2006**                                | ** ** | **2005**                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(In thousands, except %)**            | ** ** |
| Net  loss                             |       | $                                       | (18,343    | )                                     | $          | (13,332                                          | )          | $ | (38,616 | ) | $ | (30,268 | ) | $ | (5,011 | ) | (38 | )% | $ | (8,348 | ) | (28 | )% |
| Basic  and diluted net loss Per share |       | $                                       | (0.34      | )                                     | $          | (0.25                                            | )          | $ | (0.71 | ) | $ | (0.56 | ) | $ | (0.09 | ) | (36 | )% | $ | (0.15 | ) | (27 | )% |

 

Net loss and basic anddiluted net loss per share both increased in the three and six-month periodsended June 30, 2006 as compared to the three and six-month periods ended June30, 2005, principally on account of increased research and development costsrelated to the advancement of our drug discovery and development programs, but also for all the reasons more fully discussedabove, including stock-based compensation expense related to ouradoption of SFAS 123R.

**Liquidityand Capital Resources**

We have financed ouroperations primarily through funding from research and development collaborativeagreements, and the issuance of equity securities and long-term financinginstruments ($848.1 million from the beginning of 1999 to-date). Future fundingunder terms of our existing agreements is approximately $38.8 millionexcluding milestone payments and royalties that we may earn under suchcollaborations.

We make significantinvestments in proprietary research and development and we incur the costs ofsuch activities. In the near term, this requires us to devote resources to ourin-house drug and clinical development which we believe will better position usto capture the most value to us in our discoveries. As we identify promisingdiscoveries for further development, we may choose to continue the developmentourselves into and through clinical trials, regulatory approvals,manufacturing, distribution and marketing. In other cases we are or will beworking to varying degrees with partners. The decisions we make as to thesematters will affect our cash requirements.

Our cash requirementsdepend on numerous factors, including the level and timing of our research anddevelopment expenditures; our ability to access the capital markets; to obtainnew research and development collaboration agreements; to obtain and maintaincontract service agreements in our pharmaceuticals, biostructures, clinicalresearch trials and genotyping service groups; expenditures in connection withalliances, license agreements and acquisitions of and investments incomplementary technologies and businesses; competing technological and marketdevelopments; the cost of filing, prosecuting, defending and enforcing patentclaims and other intellectual property rights; the purchase of additionalcapital equipment; and capital expenditures at our facilities. Changes in ourresearch and development plans, notably the entry into clinical trials of drugsbased on our discoveries, or other changes affecting our operating expenses mayresult in changes in the timing and amount of expenditures of our capitalresources.

In December 2005, wefiled a universal shelf registration statement on Form S-3 with theSecurities and Exchange Commission (“SEC”) for the issuance and sale from timeto time of debt and equity securities either individually or in units, in oneor more offerings, with a total value of up to $100 million. In July 2006 wecompleted the sale of 6,000,000 shares of common stock at a purchase price of$5.00 per share for aggregate net proceeds, after costs of the transaction, of$27.8 million.

At June 30, 2006, we had$115.5 million of cash, cash equivalents and investments.  Based upon the range of our currentactivities, taking into account proceeds from the July 2006 equity issuance butwithout taking into account cash from any new alliances, milestone payments,significant financing or other activities, we currently anticipate that ouroverall net use of cash resources in 2006 

20

----

will be in therange of $60 to $65 million.  As weadvance and broaden our drug development pipeline we will require significantadditional capital for product development and so we will continue toinvestigate additional avenues of financing, such as further public or privateequity offerings, additional debt financing, other forms of financing or addedcollaborations and licensing arrangements. However, no assurance can be giventhat additional financing or collaborations and licensing arrangements will beavailable when needed, or that if available, will be obtained on favorableterms. If adequate funds are not available when needed, we may have to curtailoperations or attempt to raise funds on unattractive terms.

|                                              | ** ** | **For the Six Month Periods  Ended June 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                                          | ** ** |
| **Cash  provided by (used in):**             |       |                                                                        |       |   |   |
| Operating  activities                        |       | $                                                                           | (40,061    | ) | $ | (26,098 | ) |
| Investing  activities                        |       | 1,646                                                                       |       | 49,644 |   |
| Financing  activities                        |       | 149                                                                         |       | (46,624 | ) |
| Cash and cash  equivalents, at end of period |       | 27,677                                                                      |       | 47,160 |   |
|                                              |            |                                                                             |            |  |  |  |  |

 

*Cashand Cash Equivalents.*   At June 30, 2006, we had $27.7million in cash and cash equivalents. Together with our investments at June 30,2006 ($87.8 million), this balance has decreased $40.0 million from the closeof the year-ended December 31, 2005, most significantly on account of costsassociated with the advancement of our drug development programs.

Available cash isinvested in accordance with our investment policy’s primary objectives ofliquidity and safety of principal while maximizing the income we receive fromour investments without significantly increasing risk. Our cash is depositedonly with financial institutions in Iceland, the United Kingdom and the UnitedStates having a high credit standing (A-/A3 or better). We expect to maintainour portfolio of cash equivalents and investments in a variety of securities,including auction rate securities commercial paper, money market funds, mutualfund investments and government and non-government debt securities.

At June 30, 2006, ourcash is largely invested in U.S. dollar denominated money market and checkingaccounts and also in Icelandic krona denominated accounts.  At June 30, 2006, our investments are inauction rate securities, municipal bonds, US government securities and a corporatebond.

*OperatingActivities.  *Net cash used in operating activitiesincreased to $40.1 million for the six-month period ended June 30, 2006 ascompared to $26.1 million having been used in the same period in 2005.  The increase in use of cash in operatingactivities is most importantly attributable to the significant research anddevelopment investments being made in advancing our drug and clinicaldevelopment programs, as more fully described above.

*InvestingActivities.  *Our investing activities have consistedprincipally of short-term investments in marketable securities (mainly auctionrate securities and US government securities) and capital expenditures.  Additionally, in the six-months ended June30, 2006, we purchased UVS and, in doing so, we acquired $1.3 million of cashto be used to fund the acquired liabilities of UVS.  Also, in the six-month period ended June 30,2005, we completed the sale and leaseback of our Reykjavik, Iceland facilitiesat Sturlugata 8 and Krokhals 5D and 5E.

We principally madereplacement capital expenditures during the six-month periods ended June 30,2006 and 2005. In July 2006, we commenced installation of important newlaboratory equipment from Illumina that may amount to more than $4.0 millionand that we expect to finance over a period of three years.  Although we believe we will continue to makeprincipally replacement capital expenditures in the near-term, net cash used ininvesting activities may in the future fluctuate significantly from period toperiod due to the timing of our capital expenditures and other investments aswell as changing business needs.

*FinancingActivities.*   Net cash of $0.1 million was provided byfinancing activities in the six-month period ended June 30, 2006, as comparedto $46.6 million that was used in the six-month period ended June 30, 2005. Financing activities for the six-month period ended June 30, 2006 largelyconsisted of equity proceeds on the exercise of common stock options ($0.8million), financing of certain equipment ($0.8 million)  and installment payments on short termborrowings and debt and capital lease obligations ($1.5 million). Financingactivities for the six-month period ended June 30, 2005 largely consisted ofprepayments of short and long-term debts secured by mortgages on Sturlugata 8and Krokhals 5D and 5E ($40.4 million), refinancing of the mortgage on ourWoodridge, IL facility ($4.0 million) and other debt service ($1.3 million).

*ContractualCommitments and Off-Balance Sheet Arrangements.  *Thefollowing summarizes our contractual obligations (using interest and exchangerates as of June 30, 2006) at June 30, 2006, and the effects such obligationsare expected to have on our liquidity and cash flows in future periods (Inthousands):
| ** **                                         | ** ** | ** **         | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Total**          | ** ** | **Less Than  1 Year**           | ** ** | **1 – 2 Years** | ** ** | **2 – 3 Years** | ** ** | **3 – 4 Years** | ** ** | **4 – 5 Years** | ** ** | **More Than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| 3.5% Senior  convertible notes, including interest |       | $                  | 173,625    |                                      | $          | 5,250 |   | $ | 5,250 |   | $ | 5,250 |   | $ | 5,250 |   | $ | 152,625 |   | $ | — |   |
| Long-term debt,  including interest                |       | 7,402              |       | 1,078                                     |       | 5,839 |   | 272 |   | 213 |   | — |   | — |   |
| Capital lease  obligations, including interest     |       | 1,298              |       | 572                                       |       | 501 |   | 223 |   | 2 |   | — |   | — |   |
| Operating leases                                   |       | 60,910             |       | 4,813                                     |       | 4,657 |   | 4,538 |   | 4,453 |   | 4,342 |   | 38,107 |   |
| Total                                              |       | $                  | 243,235    |                                      | $          | 11,713 |   | $ | 16,247 |   | $ | 10,283 |   | $ | 9,918 |   | $ | 156,967 |   | $ | 38,107 |   |

 

21

----

 

In addition to theamounts in the table above, deCODE has committed to the purchase of equipmentfrom Illumina that may amount to over $4.0 million. We believe this equipmentwill be received in the third quarter of 2006 and we intend to finance thispurchase over three years.

Under the terms ofcertain technology licensing agreements, we are obligated to make payments uponthe achievement of established milestones leading to the discovery of definedproducts. These payments could total $5.0 million, with the timing of thepayments not determinable at the current time. These potential payments are notincluded in the above table.

All material intercompanybalances and transactions have been eliminated. We do not have any othersignificant relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. As such, we are not exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.Additionally, holders of our 3.5% senior convertible notes may elect to converttheir notes into shares of our common stock at any time at a price of $14.00per share.

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

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, and Section 21E ofthe Securities Exchange Act of 1934. These statements relate to future events or our future financialperformance. In some cases, forward-looking statements can be identified byterminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,”“estimate,” “predict,” “intend,” “potential” or “continue” or the negative ofsuch terms or other comparable terminology. These statements are onlyexpectations.  We cannot assure you thatour expectations and assumptions will prove to be correct. We do not intend toupdate or revise any forward-looking statements, whether as a result of futureevents, new information or otherwise, except to the extent that the reports weare required to file under the Securities Exchange Act of 1934, as amended,(the “Exchange Act”) contain such updates or revisions. Actual events orresults may differ materially from the forward-looking statements due to anumber of factors, including but not limited to, those set forth inItem 1A of our Annual Report on Form 10-K for the year endedDecember 31, 2005 as updated by Item A of this Quarterly Report on Form10-Q and elsewhere in this Quarterly Report on Form 10-Q and in the reports wefile under the Exchange Act.

**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

The primary objectives ofour investment activities are to preserve principal, maintain a high degree ofliquidity to meet operating needs, and obtain competitive returns subject toprevailing market conditions. Investments are made primarily in high-gradecorporate bonds, asset-backed debt securities and U.S. government agency debtsecurities. These investments are subject to risk of default, changes in creditrating and changes in market value. These investments are also subject tointerest rate risk and will decrease in value if market interest ratesincrease. A hypothetical 100 basis point increase in interest rates wouldresult in an approximate $0.4 million decrease in the fair value of ourinvestments as of June 30, 2006. Due to the conservative nature of ourinvestments and relatively short effective maturities of debt instruments,interest rate risk is mitigated. Changes in interest rates do not affectinterest expense incurred on our Convertible Notes, because they bear interestat a fixed rate. Using the price in the latest trade in March 2006, themarket value of the Convertible Notes was $115 million on June 30, 2006.

As a consequence of thenature our business and operations our reported financial results and cashflows are exposed to the risks associated with fluctuations in the exchangerates of the U.S. dollar, the Icelandic krona and other world currencies. Wecontinue to monitor our exposure to currency risk. A hypothetical 10.0%decrease in value of the US dollar against the Icelandic krona would result ina loss of approximately $0.1 million on our Icelandic krona denominatedassets and liabilities. We have historically purchased instruments to hedgethese general risks through the use of derivative financial instruments and maycontinue to do so.

**ITEM4. CONTROLS AND PROCEDURES**

a)*Evaluation ofdisclosure controls and procedures.* Our Chief Executive Officer andour Chief Financial Officer evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rule 13a-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) as of the end of thefiscal quarter covered by this Quarterly Report on Form 10-Q. Based upon thatevaluation, the Chief Executive Officer and the Chief Financial Officer haveconcluded that as of the end of such fiscal quarter our current disclosurecontrols and procedures are adequate and effective to ensure that informationrequired to be disclosed in the reports we file under the Exchange Act isrecorded, processed, summarized and reported on a timely basis.

22

----

 

In designing and evaluating our disclosure controlsand procedures, our management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurancethat the desired objectives of the control system will be met. In addition, thedesign of any control system is based in part upon certain assumptions aboutthe likelihood of future events and the application of judgment in evaluatingthe cost-benefit relationship of possible controls and procedures. Because ofthese and other inherent limitations of control systems, there is onlyreasonable assurance that our controls will succeed in achieving their goalsunder all potential future conditions.

b) *Changes inInternal Controls.* We are continuously seeking to improve theefficiency and effectiveness of our internal controls. This results in periodicrefinements to internal control processes throughout the company. However,there was no change in our internal control over financial reporting (asdefined in Rule 13a-15(f) under the Exchange Act) during the fiscalquarter covered by this Quarterly Report on Form 10-Q that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

**PART IIOTHER INFORMATION**

**ITEM1. LEGAL PROCEEDINGS**

Other than claims andlegal proceedings that arise from time to time in the ordinary course ofbusiness which are not material, there has been no change in the mattersreported in our Annual Report on Form 10-K for the year ended December 31,2005.

**ITEM1A. RISK FACTORS**

Whilethere have been no material changes from the risk factors disclosed in Item 1Aof our Annual Report on Form 10-K for the year ended December 31, 2005,  the risk factors set forth below have beenupdated to provide information and data for and as of the quarter ended June30, 2006.

**Risks Related to Our Development of DG031**

***The Phase IIIclinical trial for DG031 will require the recruitment of patients based onethnicity and haplotype status; if recruitment rates are lower than we expect,the trial may be delayed and our commercial prospects may be hurt.***

In ourPhase III clinical trial for DG031, we are testing the hypothesis whetherAfrican American patients who (a) carry the HapK haplotype in LTA4H and(b) have experienced a hospitalization and/or admission for procedures andtesting for unstable angina or myocardial infarction will experience reducedrates of acute cardiovascular events when treated with DG031, as compared toplacebo on top of concomitantly administered standard of care. In order torecruit a sufficient number of patients to obtain statistically significantevidence for the efficacy of DG031, we will require the participation of alarge number of African American patients willing to be tested for haplotypestatus and to participate in the clinical trial for at least 12 months.Many factors outside our control may reduce the willingness of patients to betested and participate in the clinical trial. If we fail to recruit asufficient number of patients in a timely manner, the trial may be delayed orwe may fail to show the efficacy of the drug. This may delay or prevent themarketing approval of DG031, which could adversely impact our financial resultsand commercial prospects.

***We have onlyindirect evidence from biomarkers studies about the effectiveness of DG031 andthis data may not be validated in the Phase III clinical trial.***

Thedata collected during the Phase I and Phase II clinical trials for DG031, whichis the basis for our continuing development of this drug, does not provideevidence of whether DG031 will prove to be an effective treatment to reduce therate of acute cardiovascular events in the prospective treatment population. Inorder to prove or disprove the validity of our assumption about the efficacy ofDG031, we must conduct the Phase III trial, which will be of at least 36 monthsduration from the recruitment of the first patient, although the time may varydue to unforeseen circumstances. Various factors that we do or do not controlmay cause the trial to be lengthier or costlier than anticipated. Until datafrom the trial can be collected and analyzed we will not know whether DG031 isan effective treatment and regulatory review by the United States Food and DrugAdministration (FDA) will ultimately determine whether the drug gains marketingapproval. The outcome of this process is uncertain and delays or failure togain market approval could adversely impact our financial results andcommercial prospects. Furthermore, even if the drug is approved for AfricanAmerican patients, there can be no assurance that it will ever be approved fora broader population.

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

Weincurred a net loss of $38.6 million and $30.3 million for the six months endedJune 30, 2006 and 2005, respectively, and $62.8 million for the year endedDecember 31, 2005, and had an accumulated deficit of $488.8 millionat June 30, 2006. We have never generated a profit and we have not generatedrevenues except for payments received in connection with our research and developmentcollaborations with Roche, Merck and others, from contract services, from salesof Emerald BioSystems products and instruments, and under grants. Our researchand development expenditures and selling, general and administrative costs haveexceeded our revenue to date, and we expect to spend significant additionalamounts to fund research and development in order to enhance our coretechnologies and undertake product development (including drug development andrelated clinical trials). We do not 

23

----

expectto receive royalties or other revenues from commercial sales of productsdeveloped using our technology in the near term. It may be several yearsbefore product revenues materialize, if they do at all. As a result, we expectto incur net losses for several years. If the time required to generate productrevenues and achieve profitability is longer than we currently anticipate, orif the level of losses is greater than we currently anticipate, we may notbe able to continue our operations.

**Risks Related to Our Business**

***If we are not ableto obtain sufficient additional funding to meet our capital requirements, wemay be forced to reduce or terminate our research and product developmentprograms.***

Wehave spent substantial amounts of cash to fund our research and developmentactivities and expect to continue to spend substantial amounts for theseactivities over the next several years. We expect to use cash to collect,generate and analyze genotypic and disease data from volunteers in ourdisease-gene research programs; to conduct drug discovery and developmentactivities (including clinical trials); and to continue other research anddevelopment activities. Many factors will influence our future capital needs,including:

·      the number, breadth andprogress of our discovery and research programs;

·      our ability to attractcustomers;

·      our ability to commercializeour discoveries and the resources we devote to commercialization;

·      the amount we spend toenforce patent claims and other intellectual property rights; and

·      the costs and timing ofregulatory approvals.

Wehave relied on, and may continue to rely on, revenues generated by ourcorporate alliances and fee-paying customers for significant funding of ourresearch efforts. Historically, a substantial portion of our revenue has beenderived from contracts with a limited number of significant customers. Ourlargest partner, Roche, accounted for approximately 27% and 20% of ourconsolidated revenue in the three-months ended June 30, 2006 and 2005,respectively, and 26% and 24% of our consolidated revenue in the six-monthperiods ended June 30, 2006 and 2005, respectively. Revenue under our allianceswith Merck accounted for approximately 0% and 17% of our consolidated revenuein the three-months ended June 30, 2006 and 2005, respectively, and 0% and 18%of our consolidated revenue in the six-months ended June 30, 2006 and 2005,respectively. During the three-months ended June 30, 2006 and 2005,divisions of the NIH represented 35% and 15% of our consolidated revenue,respectively, and 30% and 10% of our consolidated revenue in the six-monthsended June 30, 2006 and 2005, respectively. Work under our agreement with Merckaimed at developing new treatments for obesity and our 2002 agreement withRoche has been substantially completed, and this may significantly lowerour revenues and affect the resources available to support our drug discoveryprograms, which will increase our need for additional funding.

Inaddition, we may seek additional funding through public or private equityofferings and debt financings. We may not be able to obtain additionalfinancing when we need it or the financing may not be on terms favorableto us or our stockholders. Stockholders’ ownership will be diluted if we raiseadditional capital by issuing equity securities.

Ifwe raise additional funds through collaborations and licensing arrangements, wemay have to relinquish rights to some of our technologies or productcandidates, or grant licenses on unfavorable terms. If adequate funds are notavailable, we would have to scale back or terminate our discovery and researchprograms and product development.

***If we cannotsuccessfully form and maintain suitable arrangements with third parties for themanufacturing of the products we may develop, our ability to develop or deliverproducts may be impaired.***

We haveno experience in manufacturing products for commercial purposes and do not havemanufacturing facilities that can produce sufficient quantities of drugs forlarge scale clinical trials. Accordingly, we must either develop suchfacilities, which will require substantial additional funds, or rely oncontract manufacturers for the production of products for development andcommercial purposes. In order to conduct our Phase III clinical trial ofDG031, we will have to contract with third parties to manufacture a sufficientsupply of the drug for the trial and to produce tablets containing DG031 inamounts sufficient for the clinical trial. While we have signed contracts withsuppliers for the production of DG031 material and tablets for the launch ofour Phase III clinical trial and have received sufficient materials to initiatethe trial we may fail to secure sufficient supply of the drug in a timelymanner over the duration of the trial.

Themanufacture of our products for clinical trials and commercial purposes issubject to Good Manufacturing Practices (cGMP) regulations promulgated by theFDA. The manufacture of diagnostic products is subject to the FDA’s qualitysystem requirements (QSR). 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, QSR and other regulatory 

24

----

requirements.Our current dependence upon others for the manufacture of our products mayadversely affect our ability to develop and deliver such products on a timelyand competitive basis and, in the longer term, the profit margin, if any, onthe sale of future products and our ability to develop and deliver suchproducts on a timely and competitive basis.

***Increased leverageas a result of our convertible debt may harm our financial condition andresults of operations.***

On June30, 2006 we had $156.7 million of outstanding debt as reflected in our balancesheet. We may incur additional indebtedness in the future and our outstanding3.5% Senior Convertible Notes (the “Notes”) do not restrict our future issuanceof indebtedness. Our level of indebtedness will have several important effectson our future operations, including, without limitation:

·      a portion of our cash flow from operationswill be dedicated to the payment of any interest required with respect to   outstanding indebtedness;

·      increases in our outstandingindebtedness and leverage will increase our vulnerability to adverse changes ingeneral economic and industry conditions, as well as to competitive pressure;and

·      depending on the levels ofour outstanding debt, our ability to obtain additional financing for workingcapital, capital expenditures, general corporate and other purposes may belimited.

Ourability to make payments of principal and interest on our indebtedness dependsupon our future performance, which will be subject to the success of ourdevelopment and commercialization of new pharmaceutical products, generaleconomic conditions, industry cycles and financial, business and other factorsaffecting our operations, many of which are beyond our control. If we are notable to generate sufficient cash flow from operations in the future to serviceour debt, we may be required, among other things:

·      to seek additional financing in thedebt or equity markets;

·      to refinance or restructure all or aportion of our indebtedness, including the Notes;

·      to sell selected assets; or

·      to reduce or delayexpenditures on planned activities, including but not limited to clinicaltrials, and development and commercialization activities.

Suchmeasures might not be sufficient to enable us to service our debt. In addition,any such financing, refinancing or sale of assets might not be available oneconomically favorable terms.

***Currencyfluctuations may negatively affect our financial condition.***

Weprimarily expend or generate cash in U.S. dollars, our functional currency. Wealso publish our consolidated financial statements in U.S. dollars. Currencyfluctuations can affect our financial results because a portion of our cashreserves, our debt and our operating costs are in Icelandic kronas. Afluctuation of the exchange rates of the Icelandic krona against the U.S.dollar can thus adversely affect the “buying power” of our cash reserves andrevenues. Most of our long-term liabilities are U.S. dollar denominated.However, we may enter into hedging transactions if we have substantial foreigncurrency exposure in the future. We may have increased exposure as a result ofinvestments, payments from collaborative partners or the decrease in value ofIcelandic kronas.

**Risks Related to Our Collaborative Relationships**

***If we are unable toform and maintain the collaborative relationships that our business strategyrequires, our programs will suffer and we may not be able to develop products.***

Ourstrategy for developing products and deriving revenues from them is dependent,in part, upon our ability to enter into collaborative arrangements withresearch collaborators, corporate partners and others. We may rely on thesearrangements both to provide funding necessary to our product development andto obtain goods and services that we require for our product development. We donot have the capacity to conduct large scale Phase III clinical trials andwill rely on partnerships or third party contractors to conduct ourPhase III trials, including our Phase  III trial of DG031. We willrely on these third parties to provide us with clinical material for the trialand various services necessary to organize and conduct a multi-center,multinational study, as well as other goods and services. We have not enteredinto contracts for all goods and services required for the Phase III trial ofDG031 at this time. Our arrangement for this and other Phase III trials will besubject to risks described below, with respect to our collaborativerelationships.

If ourcollaborations are not successful or if we are not able to manage multiplecollaborations successfully, our programs may suffer. If we increase the numberof collaborations, it will become more difficult to manage the variouscollaborations successfully and the potential for conflicts among thecollaborators as to rights to the technology and products generated under workconducted with us will increase.

25

----

 

***Dependence oncollaborative relationships may lead to delays in product development, productdefects and disputes over rights to technology.***

We haveformed, and may in the future form additional, collaborative relationships(including relationships with clinical research organizations to conductclinical trials on our behalf) that will, in some cases, make us dependent oncollaborators for the pre-clinical studies and/or clinical trials and forregulatory approval of any products that we are developing. Failure of suchcollaborators to perform under these agreements properly in a timely manner, orat all, may lead to delays in our product development. In addition, ifparticipants in the trials conducted by our collaborators suffer personalinjury or death as a result of actions of the collaborators, we could be heldliable. In some cases, our agreements with collaborators typically allow themsignificant discretion in electing whether and how to pursue such activities. Wecannot control the amount and timing of resources collaborators will devote tothese programs or potential products. In addition, collaborative agreements maycontain exclusivity provisions that may prevent us from working in a particularfield or on a particular disease even when our collaborators elect not topursue activities under the agreements.

Ourcollaborators may stop supporting our products or providing services to us ifthey develop or obtain rights to competing products. Disputes may arise in thefuture over the ownership of rights to any technology developed withcollaborators. These and other possible disagreements between our collaboratorsand us could lead to delays in the collaborative research, development orcommercialization of products. Such disagreements could also result inlitigation or require arbitration to resolve.

**Risks Related to Our Intellectual Property**

***Our patentapplications covering DG041 and DG051 compounds that we are developing in ourpain treatment program have not issued yet as patents.***

Themost important compounds that we have currently in pre-clinical and clinicaldevelopment and which we have discovered are DG041, DG051 and compounds that weare developing in our pain treatment program. We have filed composition ofmatter type patent applications covering the compounds in the United States.However, these patent applications are in the early stages of patentprosecution before the United States Patent and Trademark Office (USPTO) and wehave no certainty or indication from the USPTO that these patent applicationswill issue as patents. The USPTO is currently facing considerable backlog forexamining pending patent applications so considerable time may elapse before wewill have more certainty as to the patentability of the compounds. Should theUSPTO ultimately reject our patent applications covering these compounds, orshould others have filed or obtained issued patent covering the same, the valueand potential of these programs for our business would be adversely affected.

**ITEM 4. SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS.**

On May 9,2006, we heldour annual meeting of stockholders. The results of the voting on the proposalssubmitted to the stockholders at this meeting were as follows:

1.  Election of two Class II Directors

| NAME               | ** ** | **FOR**    | ** ** | **WITHHELD** |
|--------------------|------------|------------|------------|--------------|
| J. Neal  Armstrong |       | 39,653,086 |       | 892,545      |
| James R. Beery     |       | 39,602,989 |       | 942,642      |

 

2.  Ratification of the appointment ofDeloitte & Touche LLP as our independent registered public accountingfirm for the fiscal year ending December 31, 2006

| FOR        | ** ** | **AGAINST** | ** ** | **ABSTAIN** |
|------------|------------|-------------|------------|-------------|
| 40,450,936 |       | 51,403      |       | 43,293      |

 

3.  Approval of 2006 Equity Incentive Plan

| FOR        | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **BROKER  NON-VOTES** |
|------------|------------|-------------|------------|-------------|------------|-----------------------|
| 16,070,727 |       | 4,608,285   |       | 101,890     |       | 19,764,730            |

 

26

----

**ITEM6. EXHIBITS AND REPORTS ON FORM 8-K**

(a) EXHIBITS

The following is alist of exhibits filed as part of this Quarterly Report on Form 10-Q.
| EXHIBIT    | ** ** | ** **                                                                                                                                                                                                                                                                        |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **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).                                                                     |
|       |       |                                                                                                                                                                                                                                                                              |
| 10.1*      |       | 2006 Equity Incentive Plan (Incorporated by  reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K filed  on May 11, 2006).                                                                                                                                  |
|       |       |                                                                                                                                                                                                                                                                              |
| 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.                                                                                                                                                                                                    |

----

*                    Constitutesa management contract or compensatory plan or arrangement.

Note: Unless otherwisenoted, the SEC File number of each of the above referenced documents is000-30469.

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

Dated: August 9, 2006
|        | 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) |

 

27

----

 
| EXHIBIT    | ** ** | ** **                                                                                                                                                                                                                                                                        |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **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).                                                                     |
|       |       |                                                                                                                                                                                                                                                                              |
| 10.1*      |       | 2006 Equity Incentive Plan (Incorporated by  reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K filed  on May 11, 2006).                                                                                                                                  |
|       |       |                                                                                                                                                                                                                                                                              |
| 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.                                                                                                                                                                                                    |

----

*                    Constitutesa management contract or compensatory plan or arrangement.

Note: Unless otherwisenoted, the SEC File number of each of the above referenced documents is000-30469.

28

----