**SECURITIESAND EXCHANGE COMMISSION**

 

**WASHINGTON,D.C. 20549**

 

**FORM10-Q**

 

**(MarkOne)**

 

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

 

**FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005**

 

**OR**

 

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

 

**FOR THE TRANSITION PERIOD FROM                       TO                      **

 

**COMMISSION FILE NUMBER 000-30469**

 

**deCODEgenetics, Inc.**

(ExactName of Registrant as Specified in Its Charter)

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

 

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

(Addressof Principal Executive Offices)

 

**+354-570-1900**

(Registrant’sTelephone Number, Including Area Code)

 

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

 

Indicate by check whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes ý No o

 

The aggregate number ofshares of the registrant’s common stock outstanding on July 29, 2005 was 54,585,901shares of common stock $.001 par value.

 

 

----

 

**deCODE genetics, Inc.**

 

**INDEX**

 
| PART I.  FINANCIAL  INFORMATION |                                                                                                               |
|-------------------------------------------|--------------------------------------------------------------------------------------------------------------------|
|                                      |                                                                                                               |   |
| Item 1.                                   | Financial Statements (Unaudited)                                                                                   |   |
|                                      |                                                                                                               |   |
|                                      | Condensed Consolidated  Balance Sheets as of June 30, 2005 and December 31, 2004                                   |   |
|                                      |                                                                                                               |   |
|                                      | Condensed Consolidated  Statements of Operations for the three and six-month periods ended June 30,  2005 and 2004 |   |
|                                      |                                                                                                               |   |
|                                      | Condensed Consolidated  Statements of Cash Flows for the three and six-month periods ended June 30,  2005 and 2004 |   |
|                                      |                                                                                                               |   |
|                                      | Notes to Condensed  Consolidated Financial Statements                                                              |   |
|                                      |                                                                                                               |   |
| Item  2.                                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        |   |
|                                      |                                                                                                               |   |
| Item 3.                                   | Quantitative and Qualitative  Disclosures about Market Risk                                                        |   |
|                                      |                                                                                                               |   |
| Item 4.                                   | Controls and Procedures                                                                                            |   |
|                                      |                                                                                                               |   |
| PART II.  OTHER  INFORMATION    |                                                                                                               |
|                                      |                                                                                                               |   |
| Item 1.                                   | Legal proceedings                                                                                                  |   |
|                                      |                                                                                                               |   |
| Item 4.                                   | Submission of Matters to a Vote of  Security Holders                                                               |   |
|                                      |                                                                                                               |   |
| Item 6.                                   | Exhibits                                                                                                           |   |
|                                      |                                                                                                               |   |
|                                      | (a) Exhibits                                                                                                       |   |
|                                      |                                                                                                               |   |
| Signatures                                |                                                                                                               |
|                                      |                                                                                                               |   |
| Index to Exhibits                         |                                                                                                               |
|                                           |                                                                                                                    |  |  |

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**deCODE genetics, Inc.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(Unaudited)

 
| ** **                                                                                                                                                                                                                            | ** ** | **JUNE 30,  2005**                        | ** ** | **DECEMBER 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                            | ** ** | **(In thousands, except  share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                |       |                                      |       |                   |       |
| Current assets:                                                                                                                                                                                                                       |       |                                      |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                                                             |       | $                                         | 47,160     |                   | $          | 70,238 |   |
| Investments                                                                                                                                                                                                                           |       | 138,096                                   |       | 122,082                |       |
| Receivables                                                                                                                                                                                                                           |       | 9,093                                     |       | 6,450                  |       |
| Other current assets                                                                                                                                                                                                                  |       | 5,379                                     |       | 4,307                  |       |
| Total current assets                                                                                                                                                                                                                  |       | 199,728                                   |       | 203,077                |       |
| Restricted cash                                                                                                                                                                                                                       |       | 0                                         |       | 6,000                  |       |
| Property and equipment, net                                                                                                                                                                                                           |       | 24,707                                    |       | 60,447                 |       |
| Goodwill                                                                                                                                                                                                                              |       | 8,863                                     |       | 8,863                  |       |
| Other long-term assets and deferred charges                                                                                                                                                                                           |       | 7,451                                     |       | 9,865                  |       |
| Total assets                                                                                                                                                                                                                          |       | $                                         | 240,749    |                   | $          | 288,252 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                             |       |                                      |       |                   |       |
| Current liabilities:                                                                                                                                                                                                                  |       |                                      |       |                   |       |
| Accounts payable                                                                                                                                                                                                                      |       | $                                         | 4,066      |                   | $          | 5,829 |   |
| Accrued expenses and other current  liabilities                                                                                                                                                                                       |       | 10,588                                    |       | 9,528                  |       |
| Short-term borrowings                                                                                                                                                                                                                 |       | 0                                         |       | 5,069                  |       |
| Current portion of capital lease  obligations                                                                                                                                                                                         |       | 1,737                                     |       | 1,745                  |       |
| Current portion of long-term debt                                                                                                                                                                                                     |       | 576                                       |       | 7,081                  |       |
| Deferred revenue                                                                                                                                                                                                                      |       | 10,855                                    |       | 8,654                  |       |
| Total current liabilities                                                                                                                                                                                                             |       | 27,822                                    |       | 37,906                 |       |
| Capital lease obligations, net of current  portion                                                                                                                                                                                    |       | 329                                       |       | 1,194                  |       |
| Long-term debt, net of current portion                                                                                                                                                                                                |       | 155,858                                   |       | 189,535                |       |
| Deferred gain on sale-leaseback                                                                                                                                                                                                       |       | 28,623                                    |       | 0                      |       |
| Deferred revenue                                                                                                                                                                                                                      |       | 6,065                                     |       | 7,221                  |       |
|                                                                                                                                                                                                                                  |       |                                      |       |                   |       |
| Commitments and contingencies                                                                                                                                                                                                         |       |                                      |       |                   |       |
|                                                                                                                                                                                                                                  |       |                                      |       |                   |       |
| Stockholders’ equity:                                                                                                                                                                                                            |       |                                      |       |                   |       |
| Preferred stock, $0.001 par value; Authorized:  6,716,666 shares Issued and outstanding: none                                                                                                                                         |       | 0                                         |       | 0                      |       |
| Common stock, $0.001 par value; Authorized:  100,000,000 shares; Issued and outstanding: 54,582,170 and 54,562,670 shares,  respectively, at June 30, 2005; and 54,539,069 and 54,522,069 shares,  respectively, at December 31, 2004 |       | 55                                        |       | 55                     |       |
| Additional paid-in capital                                                                                                                                                                                                            |       | 443,274                                   |       | 442,999                |       |
| Notes receivable                                                                                                                                                                                                                      |       | (3,089                                    | )          | (3,111                 | )          |
| Accumulated deficit                                                                                                                                                                                                                   |       | (417,733                                  | )          | (387,465               | )          |
| Accumulated other comprehensive income  (loss)                                                                                                                                                                                        |       | (331                                      | )          | 38                     |       |
| Treasury stock, 19,500 and 17,000 shares  stated at cost at June 30, 2005 and December 31, 2004, respectively                                                                                                                         |       | (124                                      | )          | (120                   | )          |
| Total stockholders’ equity                                                                                                                                                                                                       |       | 22,052                                    |       | 52,396                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                       |       | $                                         | 240,749    |                   | $          | 288,252 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

3

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** deCODE genetics, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 (Unaudited)

 
| ** **                                                     | ** ** | **FOR THE THREE MONTHS  ENDED JUNE 30,** | ** ** | **FOR THE SIX MONTHS  ENDED JUNE 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUE                                                        |       | $                                        | 11,437     |                                   | $          | 9,635 |   | $ | 20,960 |   | $ | 19,917 |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| OPERATING EXPENSES                                             |       |                                     |       |                                   |       |   |   |   |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Cost of revenue, including collaborative  programs             |       | 8,597                                    |       | 10,338                                 |       | 17,737 |   | 21,512 |   |
| Research and development - proprietary  programs               |       | 11,001                                   |       | 5,385                                  |       | 19,276 |   | 9,644 |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Selling, general and administrative                            |       | 4,694                                    |       | 5,589                                  |       | 8,852 |   | 9,852 |   |
| Total operating expenses                                       |       | 24,292                                   |       | 21,312                                 |       | 45,865 |   | 41,008 |   |
| Operating loss                                                 |       | (12,855                                  | )          | (11,677                                | )          | (24,905 | ) | (21,091 | ) |
| Interest income                                                |       | 1,533                                    |       | 746                                    |       | 2,653 |   | 981 |   |
| Interest expense                                               |       | (1,700                                   | )          | (2,113                                 | )          | (4,089 | ) | (3,312 | ) |
| Other non-operating income and (expense),  net                 |       | (310                                     | )          | (235                                   | )          | (3,927 | ) | (1,893 | ) |
| Net Loss                                                       |       | $                                        | (13,332    | )                                      | $          | (13,279 | ) | $ | (30,268 | ) | $ | (25,315 | ) |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Basic and diluted net loss per share                           |       | $                                        | (0.25      | )                                      | $          | (0.25 | ) | $ | (0.56 | ) | $ | (0.48 | ) |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Shares used in computing basic and diluted  net loss per share |       | 53,663,568                               |       | 53,543,747                             |       | 53,656,312 |   | 53,235,623 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

4

----

 

**deCODE genetics, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
|                                                                         |   | **FOR THE SIX-MONTHS ENDED JUNE 30,** |    |
|------------------------------------------------------------------------------|--------|---------------------------------------|---------|
|                                                                         |   | **2005**                              |    | **2004** |   |
|                                                                         |   | **(In thousands)**                    |    |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |   |                                  |    |   |   |
| Net loss                                                                     |   | $                                     | (30,268 | ) | $ | (25,315 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                                  |    |   |   |
| Depreciation and amortization                                                |   | 4,160                                 |    | 5,637 |   |
| Amortization of deferred stock compensation                                  |   | 74                                    |    | 813 |   |
| Amortization of deferred financing costs                                     |   | 503                                   |    | 307 |   |
| Amortization of gain in sale and leaseback of  property                      |   | (425                                  | )       | 0 |   |
| Charges for debt extinguishment                                              |   | 1,741                                 |    | 0 |   |
| Loss on derivative financial instruments                                     |   | 0                                     |    | 1,404 |   |
| Foreign currency exchange loss on Icelandic  krona denominated debt          |   | 257                                   |    | 61 |   |
| Other                                                                        |   | 100                                   |    | 58 |   |
| Changes in operating assets and  liabilities:                                |   |                                  |    |   |   |
| Receivables and other current assets                                         |   | (2,571                                | )       | 3,216 |   |
| Accounts payable, accrued expenses and  other current liabilities            |   | (714                                  | )       | 2,098 |   |
| Deferred research revenue                                                    |   | 1,045                                 |    | 2,099 |   |
| Net cash used in operating activities                                        |   | (26,098                               | )       | (9,622 | ) |
|                                                                         |   |                                  |    |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |   |                                  |    |   |   |
|                                                                         |   |                                  |    |   |   |
| Purchases of investments                                                     |   | (111,925                              | )       | (58,600 | ) |
| Redemptions of investments                                                   |   | 95,530                                |    | 0 |   |
| Purchase of property and equipment                                           |   | (1,202                                | )       | (967 | ) |
| Proceeds from sale of property and  equipment                                |   | 61,241                                |    | 39 |   |
| Changes in restricted cash                                                   |   | 6,000                                 |    | 0 |   |
| Net cash provided by (used in) investing  activities                         |   | 49,644                                |    | (59,528 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |   |                                  |    |   |   |
| Proceeds from issuance of common stock and warrants                          |   | 78                                    |    | 14,101 |   |
| Proceeds from convertible debt offering,  net                                |   | 0                                     |    | 143,770 |   |
| Proceeds from debt refinancing                                               |   | 6,211                                 |    | 0 |   |
| Proceeds from swap close-out                                                 |   | 0                                     |    | 9,720 |   |
| Repayment of notes receivable for common  stock                              |   | 37                                    |    | 901 |   |
| Debt refinancing cost                                                        |   | 0                                     |    | (478 | ) |
| Repayments from short-term borrowings                                        |   | (569                                  | )       | 0 |   |
| Payments on line of credit                                                   |   | (4,500                                | )       | (2,000 | ) |
| Repayments of debt and capital lease obligations                             |   | (47,881                               | )       | (3,867 | ) |
| Net cash (used in) provided by financing  activities                         |   | (46,624                               | )       | 162,147 |   |
| Net (decrease) increase in cash and cash  equivalents                        |   | (23,078                               | )       | 92,997 |   |
| Cash and cash equivalents at beginning of  period                            |   | 70,238                                |    | 68,669 |   |
| Cash and cash equivalents at end of period                                   |   | $                                     | 47,160  |   | $ | 161,666 |   |
| Supplemental cash flow information:                                          |   |                                  |    |   |   |
| Cash paid for interest                                                       |   | $                                     | 3,744   |   | $ | 1,526 |   |
| Supplemental schedule of non-cash  transactions:                             |   |                                  |    |   |   |
| Deferred gain on sale of property                                            |   | $                                     | 29,048  |   | $ | 0 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

5

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**deCODE genetics, Inc.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

(tabularamounts in thousands, except share and per share amounts)

 

***1.******             ******The Company***

 

References in these financial statements to deCODE referto deCODE genetics, Inc., a Delaware company, and deCODEgenetics, Inc.’s wholly-owned subsidiary, Islensk erfdagreining ehf., anIcelandic company registered in Reykjavik, and its subsidiaries, as well asdeCODE genetics, Inc.’s wholly-owned subsidiary, MediChem LifeSciences, Inc., a Delaware corporation, and its subsidiaries.

 

## ***2.***              Basis ofPresentation

 

In the opinion of theCompany’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 of June30, 2005, the results of operations for the three and six-month periods ended June30, 2005 and 2004 and cash flows for the six-month periods ended June 30, 2005and 2004.  The results of operations forthe three and six-month periods ended June 30, 2005 are not necessarilyindicative of the results to be expected for the full year.  These financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2004, which includes consolidated financial statements and notesthereto for the years ended December 31, 2004, 2003 and 2002.  Certain reclassifications have been made toprior year financial statements to conform to the 2005 presentation.

 

Beginning in 2004, deCODE began presenting cost ofrevenue in its statements of operations. To be consistent with the June 30,2005 operating expense classifications, deCODE has reclassified previouslyreported research and development expenses for the three and six-months ended June30, 2004. These reclassifications between research and development expenses andcost of revenue had no effect on reported amounts of total operating expensesor operating loss.

 

***3.******             ******Revenue***

 

Significant elements of ourrevenue are summarized as follows:

 
| ** **                                                                 | ** ** | **For the  Three Months  Ended June 30,** | ** ** | **For the  Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In  thousands)**                       | ** ** |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| Research funding and other service fees                                    |       | $                                         | 7,803      |                                    | $          | 7,606 |   | $ | 14,557 |   | $ | 15,503 |   |
| Milestone payments                                                         |       | 234                                       |       | 56                                      |       | 582 |   | 221 |   |
| Up-front, exclusivity, technology access, and  technology development fees |       | 1,000                                     |       | 1,000                                   |       | 2,038 |   | 2,000 |   |
| Grant funding                                                              |       | 2,003                                     |       | 546                                     |       | 2,891 |   | 1,426 |   |
| Other                                                                      |       | 397                                       |       | 427                                     |       | 892 |   | 767 |   |
|                                                                       |       | $                                         | 11,437     |                                    | $          | 9,635 |   | $ | 20,960 |   | $ | 19,917 |   |

 

deCODE receives contract and grant funding fromvarious governmental agencies.  Revenueis generally recognized on these contracts/grants as costs are incurred.

 

Revenue from collaborations with Merck for thethree and six-month periods ended June 30, 2005 constituted 17% and 18% ofconsolidated revenue and 17% and 18% for the three and six-month periods endedJune 30, 2004.  Revenues fromcollaborations with Roche for the three and six-month periods ended June 30,2005 constituted 20% and 24% of consolidated revenue and 32% and 33% for thethree and six-month periods ended June 30, 2004.

 

***4.******             ******Research and Development—Proprietary Programs***

 

deCODE’s research and development expenses consist of thecosts of its own proprietary programs and consist of the following:

 

6

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| ** **                                       | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                       | ** ** |
| ** **                                       | ** ** | ** **                               | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries and other personnel costs               |       | $                                        | 4,383      |                                   | $          | 2,407 |   | $ | 8,327 |   | $ | 4,360 |   |
| Materials and supplies                           |       | 1,250                                    |       | 844                                    |       | 2,196 |   | 1,363 |   |
| Contractor services and other third party  costs |       | 3,378                                    |       | 653                                    |       | 5,064 |   | 1,216 |   |
| Overhead expenses                                |       | 1,208                                    |       | 547                                    |       | 2,032 |   | 935 |   |
| Depreciation and amortization                    |       | 782                                      |       | 873                                    |       | 1,657 |   | 1,632 |   |
| Stock-based compensation and remuneration        |       | 0                                        |       | 61                                     |       | 0 |   | 138 |   |
|                                             |       | $                                        | 11,001     |                                   | $          | 5,385 |   | $ | 19,276 |   | $ | 9,644 |   |
|                                                  |            |                                          |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

## ***5.***              Stock-BasedCompensation and Remuneration

 

deCODE follows SFAS No. 123, Accounting for Stock-BasedCompensation. The provisions of SFAS No. 123 allow companies to eitherexpense the estimated fair value of stock options granted to employees or tofollow the intrinsic value method set forth in Accounting Principles BoardOpinion No. 25 (APB No. 25), Accounting for Stock Issued toEmployees, and disclose the pro forma effects on net loss and net loss pershare had the estimated fair value of the options granted to employees beenexpensed. SFAS No. 123 requires companies to expense the estimated fairvalue of stock options granted to non-employees. deCODE has elected to followthe intrinsic value method in accounting for its employee stock options and followsthe fair value method in accounting for its non-employee stock options.

 

Stock-based compensationrepresents the expense charged in the statements of operations relating toemployee stock options granted. Stock-based remuneration represents the expensecharged in the statements of operations relating to shares of stock issued tonon-employees in exchange for services provided. Stock-based compensation andremuneration are included in the statements of operations in the followingcaptions:

 
| ** **                                        | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(In  thousands)**                      | ** ** |
| Cost of revenue, including collaborative programs |       | $                                        | 0          |                                   | $          | 86 |   | $ | 0 |   | $ | 257 |   |
| Research and development - proprietary programs   |       | $                                        | 0          |                                   | $          | 61 |   | $ | 0 |   | $ | 138 |   |
| General and administrative expense                |       | 26                                       |       | 405                                    |       | 74 |   | 418 |   |
| Total                                             |       | $                                        | 26         |                                   | $          | 552 |   | $ | 74 |   | $ | 813 |   |

 

On a proforma basis, had compensation cost for all employee stockoptions been determined using the fair value method, deCODE’s net loss andbasic and diluted net loss per share would have been reported as follows:

 
| ** **                                                                                        | ** ** | **For the Three Months  Ended June 30,**     | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                                     | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                        | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                                                                              |       |                                         |       |                                   |       |   |   |   |   |
| Net loss attributable to common stockholders  — as reported                                  |       | $                                            | (13,332    | )                                      | $          | (13,279 | ) | $ | (30,268 | ) | $ | (25,315 | ) |
| Add: Stock-based compensation expense included  in reported net loss                              |       | 26                                           |       | 552                                    |       | 74 |   | 813 |   |
| Deduct: Total stock-based compensation expense  determined under fair value method for all awards |       | (1,133                                       | )          | (1,451                                 | )          | (2,372 | ) | (2,891 | ) |
| Net loss — proforma                                                                          |       | $                                            | (14,439    | )                                      | $          | (14,178 | ) | $ | (32,566 | ) | $ | (27,393 | ) |
| Basic and diluted net loss per share—as  reported                                            |       | $                                            | (0.25      | )                                      | $          | (0.25 | ) | $ | (0.56 | ) | $ | (0.48 | ) |
| Basic and diluted net loss per  share—proforma                                               |       | (0.27                                        | )          | (0.26                                  | )          | (0.61 | ) | (0.51 | ) |

 

7

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In December 2004, the FASB issued Statement ofFinancial Accounting Standard (“SFAS”) No. 123 (revised 2004), “Share-BasedPayment”. This Statement replaces FASB Statement No. 123 and supersedesAPB Opinion No. 25. SFAS No. 123(R) eliminates the ability to accountfor employee share-based compensation transactions using the intrinsic methodused by deCODE. SFAS No. 123(R) requires such transactions be accountedfor using a fair-value-based method that would result in expense beingrecognized in deCODE’s financial statements. In April 2005, the Securities and Exchange Commission (“SEC”) adopted arule that defers the required effective date of SFAS No. 123(R) to fiscal yearsbeginning after June 15, 2005 (January 1, 2006 for deCODE).  deCODE has not yet determined the impact ofadoption on its consolidated financial position or results of operations.

 

## ***6.***              Net Loss Per CommonShare

 

Basic net loss per share is computed using net lossavailable to common stockholders and the weighted-average number of commonshares outstanding. The weighted-average number of common shares outstandingduring the period is the number of shares determined by relating the portion oftime within a reporting period that common shares have been outstanding to thetotal time in that period.

 

Diluted net loss per share is computed using the weighted-averagenumber of common shares outstanding during the period, plus the dilutive effectof potential common shares. Diluted net loss per share does not differ frombasic net loss per share in all periods presented as potential common sharesare antidilutive 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,  2005** | ** ** | **June 30,  2004** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                     | ** ** | **(Shares)**       | ** ** | **(Shares)**       | ** ** |
| Warrants to purchase shares of common stock                                    |       | 2,779,873          |       | 3,124,724          |       |
| Options to purchase shares of common stock                                     |       | 4,351,542          |       | 4,728,280          |       |
| Restricted shares with an associated  outstanding non-recourse promissory note |       | 1,175,623          |       | 1,229,456          |       |
| Convertible shares issuable upon conversion  of 3.5% senior convertible notes  |       | 10,714,286         |       | 10,714,286         |       |
|                                                                           |       | 19,021,324         |       | 19,796,746         |       |

 

***7.****              Comprehensive Income*

 

Comprehensive incomegenerally represents all changes in stockholders’ equity except those resultingfrom investments or contributions by stockholders. Amounts reported in othercomprehensive income include foreign currency translation adjustments, derivativefinancial instruments designated and effective as hedges of underlying foreigncurrency denominated transactions, and unrealized gains and losses associatedwith investments.  The following tablepresents the calculation of comprehensive income (loss):

 
| ** **                                  | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                       | ** ** |
| ** **                                  | ** ** | ** **                               | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                    |       | $                                        | (13,332    | )                                      | $          | (13,279 | ) | $ | (30,268 | ) | $ | (25,315 | ) |
| Other comprehensive income (loss):          |       |                                     |       |                                   |       |   |   |   |   |
| Foreign currency translation                |       | 1                                        |       | (1                                     | )          | 1 |   | 0 |   |
| Forward foreign exchange contracts          |       | 0                                        |       | 40                                     |       | 0 |   | (2 | ) |
| Unrealized loss associated with investments |       | (292                                     | )          | 0                                      |       | (371 | ) | 0 |   |
|                                        |       |                                     |       |                                   |       |   |   |   |   |
| Total comprehensive loss                    |       | $                                        | (13,623    | )                                      | $          | (13,240 | ) | $ | (30,638 | ) | $ | (25,317 | ) |

 

8

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***8.******             ******Investments***

 

deCODE’s investments consist of auction rate securities,US government securities and an equity mutual fund investment, all of which areclassified as available-for-sale. Investments are available for currentoperations and are classified as current assets. Investments are carried atfair value with the unrealized holding gain or loss included in accumulatedother comprehensive income. Fair value is generally determined with referenceto quotations in active markets. Premium and discounts associated withinvestments in bonds are amortized using the effective interest rate method.  These investments as of June 30, 2005 aresummarized as follows:

 
| ** **                    | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|-------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **(in thousands)**  | ** ** |
| Auction rate securities       |       | $                   | 93,200     |                      | $          | 93,200 |   |
| US government debt securities |       | 15,000              |       | 14,950                    |       |
| Equity mutual fund investment |       | 30,242              |       | 29,946                    |       |
|                          |       | $                   | 138,442    |                      | $          | 138,096 |   |

 

Gross unrealized holding gains and gross unrealizedholding losses at June 30, 2005 were $200,000 and $546,000, respectively, andare included in accumulated other comprehensive income.

 

Proceeds from the sale of investments available-for-salefor the six-month period ended June 30, 2005 were $95,530,000. There wereno realized gains or realized losses from the sale of investmentsavailable-for-sale in the three and six-month periods ended June 30, 2005 and2004.

 

***9.******             ******Short-TermBorrowings***

 

In March 2005 and in connection with the sale-leasebackfinancing of Sturlugata 8 discussed in Note 10, deCODE repaid short-termborrowings of $4,500,000.   The remaining$228,000 on the short-term loan was paid off during the three months ended June30, 2005.

** **

***10.****       Debt, Property andCommitments*

 

*Sale-leasebackFinancing*

 

In March 2005, deCODEentered into a financing for the sale and leaseback of its headquartersfacility at Sturlugata 8, Reykjavik, Iceland. The sale price for the propertywas 3.4 billion Icelandic kronas ($54,767,000 after taking into account aforward foreign exchange contact entered into in connection with the sale ofthe property). As a result of the sale, the remaining net book value of theproperty ($29,278,000) has been removed from the balance sheet as of June 30,2005, and the resulting gain has deferred and is being recognized to earningsover the 15 year term of the leaseback.

 

A portion of the proceeds fromthe sale of Sturlugata 8 were used to prepay approximately $38,639,000 of shortand long-term debt that was secured by mortgages on the property.  deCODE recorded a loss on early extinguishmentof debt during the six-month period ended June 30, 2005 amounting to $3,100,000which consisted of (i) prepayment fees ($1,400,000), (ii) write-off ofremaining unamortized finance costs related to the prepaid long-term debt($1,394,000), and (iii) remaining unamortized discount on the prepaid long-termdebt ($348,000).  The loss has beenrecorded in other non-operating expense in the accompanying CondensedConsolidated Statement of Operations.

 

deCODE has leased the Sturlugata8 property back under a 15 year non-cancelable lease agreement at a rent of21.4 million Icelandic kronas per month (approximately $328,000 as of June 30,2005), subject to changes based on the Icelandic consumer price index. Thelease is an operating lease and, as a result, Icelandic krona denominated rentwill be included in operating expenses over the 15 year term of the leaseagreement.

 

In June 2005, deCODE enteredinto a financing for the sale and leaseback of its facility at Krokhals 5D and5E, Reykjavik, Iceland.  The sale pricefor the property was 502 million Icelandic kronas (approximately $7,588,000after taking into account the sales commission) of which $1,229,000 will bepaid in the third quarter of 2005.  As aresult of the sale, the remaining net book value of the property ($4,029,000)has been removed from the balance sheet as of June 30, 2005, and the resultinggain ($3,559, 000) has been deferred and will be recognized to earnings overthe 15 year term of the leaseback.

 

A portion of the proceeds fromthe sale of Krokhals were used to prepay approximately $1,836,000 of long-termdebt that was secured by a mortgage on the property.

 

9

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deCODE has leased theKrokhals 5D and 5E property back under a 15 year non-cancelable lease agreementat a rent of 4.1 million Icelandic krona per month (approximately $60,000 as ofJune 30, 2005), subject to changes based on the Icelandic consumer priceindex.  The lease is an operating leaseand, as a result, Icelandic krona denominated rent will be included inoperating expenses over the 15 year term of the lease agreement.

 

*MortgageRefinancing*

 

In connection with arefinancing of the mortgage on its Woodridge, IL facility in March 2005, deCODErepaid its $4,000,000 existing mortgage, eliminated restricted cash collateraltotaling $6,000,000 and entered into a $6,200,000 mortgage with the samefinancial institution.  The new mortgagecarries an interest rate of three-month LIBOR + 2.25% (5.37% at June 30, 2005),payable in monthly installments of $26,000 for five years and a final paymentof $5,500,000 due in June 2007.

 

*Commitments*

 

As of June 30, 2005, ourcontractual commitments are as follows:

 
| ** **                                         | ** ** | ** **         | ** ** | ** **            | ** ** | **Payments Due by period** | ** ** | ** **    | ** ** |
|----------------------------------------------------|------------|--------------------|------------|-----------------------|------------|----------------------------|------------|---------------|------------|
| ** **                                         | ** ** | **Total**          | ** ** | **Less Than  1 Year** | ** ** | **1-3 Years**              | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| 3.5% senior convertible notes, including  interest |       | $                  | 181,500    |                  | $          | 5,250                      |       | $             | 10,500     |   | $ | 10,500 |   | $ | 155,250 |   |
| Long-term debt, including interest                 |       | 7,079              |       | 910                   |       | 6,169                      |       | 0             |       | 0 |   |
| Capital lease obligations, including  interest     |       | 13,650             |       | 2,566                 |       | 1,882                      |       | 1,559         |       | 7,643 |   |
| Operating leases                                   |       | 59,480             |       | 4,602                 |       | 8,455                      |       | 7,973         |       | 38,450 |   |
|                                               |       | $                  | 261,709    |                  | $          | 13,328                     |       | $             | 27,006     |   | $ | 20,032 |   | $ | 201,343 |   |

 

Under the terms of certain technology licensingagreements, deCODE is obligated to make payments upon the achievement ofestablished milestones leading to the discovery of defined products. Thesepayments could total $6,000,000 and the year incurred cannot be determined atthe current time.

 

## ***11.***       Derivative Financial Instruments

 

deCODE recognizes all derivatives as either assets orliabilities in the consolidated balance sheet and measured those instruments atfair value.

 

In March 2004, deCODE refinanced its foreigncurrency debt, with the new instrument being a variable rate U.S dollardenominated debt. Following-on from this refinancing, deCODE reconsidered itstwo cross-currency swaps and decided to liquidate them realizing $9,720,000 inproceeds. deCODE realized a loss on this early termination that, together withunrealized losses on the swaps during the six-months ended June 30, 2004,amounted to $1,465,000. Unrealized and realized gains and losses on these twocross-currency swaps are included in other non-operating income and (expense),net in the Condensed Consolidated Statements of Operations.

 

InMarch 2004, deCODE entered into five forward foreign exchange contractswith an Icelandic financial institution for purposes of hedging a portion ofits Icelandic krona-denominated salaries. On the maturity date of each contract,deCODE sold $1,600,000 and deCODE received Icelandic krona at the contractedforward rate. These forward foreign exchange contracts were designated aseconomic hedges of the foreign currency salary cash flows and qualified forhedge accounting. The final contract matured in August 2004 and no newcontracts were entered into during the remainder of 2004. During the six-month period ended June 30,2004, a loss of $17,000 was recorded to operating expenses in the CondensedConsolidated Statements of Operations.

 

InMarch 2005, deCODE purchased three forward foreign exchange option contractsfrom an Icelandic financial institution for purposes of hedging a portion ofits Icelandic krona-denominated salaries and other operating expenses. Theforward foreign exchange option contracts, to sell $10,000,000, and $3,394,000and $3,394,000, respectively, matured/mature on June 10, June 30 and July 29,2005, and provide deCODE the right but not the obligation to sell stated amountof U.S. dollars and receive Icelandic krona at the contracted forward rates .These forward foreign exchange option contracts were designated as economichedges of the foreign currency salary and other operating cost cash flows butdid not qualify for hedge accounting. The estimated fair value of the remainingderivative financial instrument is $0. The resulting change in the fair valueof these contracts for the three and six-month periods ended June 30, 2005 of $57,000and $214,000, respectively is included in other non-operating income andexpense, net in the Condensed Consolidated Statement of Operations.

 

The fair value of derivative instruments is sensitive tomovements in the underlying market rates and variables. deCODE monitors thefair value of derivative instruments on a periodic basis. Fair values areestimated for each derivative using common market valuation methods withreference to available market data as of the balance sheet date.

 

10

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***12.******      ******Litigation***

 

Therehas been no change in the matters reported in our quarterly report on Form 10-Qfor the quarter ended March 31, 2005 except as follows.  On May 13, 2005, the court in the securitiesclass actions filed against deCODE and certain of its officers and directors inSeptember and October 2004 and consolidated in January 2005 approved the Noticeof Agreed Motion and Proposed Order of Voluntary Dismissal filed by theplaintiffs on May 4, 2005, thereby terminating the action.

 

# **ITEM 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

This Management’s Discussionand Analysis of Financial Condition and Results of Operations as of June 30,2005 and for the three and six-month periods ended June 30, 2005 and 2004should be read in conjunction with the unaudited condensed consolidatedfinancial statements and notes thereto set forth in Item 1 of this report.

 

Thisquarterly report on Form 10-Q contains forward-looking statements,including our expectations of future industry conditions, strategic plans andforecasts of operational results. Various risks may cause our actual results todiffer materially. A list and description of some of the risks anduncertainties is contained below and in the summary of risk factors thatfollow.

 

# **Overview**

 

deCODE is a biopharmaceutical company applying itsdiscoveries in human genetics to develop drugs for common diseases. Ourpopulation approach and resources enable us to isolate genes and drug targetsdirectly involved in the development of many of the biggest challenges topublic health. We are turning these discoveries into a growing pipeline oftherapeutics aimed at combating the causes of disease, not just the signs andsymptoms. As these diseases are common and current therapies are of limitedeffectiveness, we believe that our strategy represents a significantopportunity to create better medicine with major potential in the globalmarketplace.

 

We believe that deCODE’s advantage derives from ourpopulation approach to human genetics and the ability to apply this approachacross the drug development process. In Iceland, we have comprehensivepopulation resources that enable our scientists to efficiently conduct genome-and population-wide scans to identify key genes and gene variationscontributing to common diseases. The proteins encoded by these genes, and otherproteins with which they interact in the disease pathway, offer drug targetswhich we believe are directly involved in the onset and progression of disease.Small-molecule drugs that target these proteins therefore represent a directmeans of modulating the onset or progression of the disease.

 

Through our medicinal chemistry and structural biologysubsidiaries based in the United States we are able to discover novel small-moleculetherapeutic compounds, take candidate compounds through preclinical testing,and manufacture sufficient quantities for early-stage clinical trials. Encode,our wholly-owned clinical research organization in Reykjavik, conductsInformation-rich clinical trialsÔ (IRCTs) that utilize our population data andapproach to make the clinical development process a more efficient andsensitive means of testing new drugs. In certain programs we have also takenadvantage of the fact that drug targets we have identified through our geneticsresearch have already been employed by other companies to make developmentalcompounds for other indications. By licensing these compounds or entering intoco-development arrangements we have been able to leapfrog over several years ofdrug discovery, entering directly into Phase II clinical trials.

 

Our goal is to bring to market new drugs for majorindications, and in so doing make the company profitable and create value forour shareholders. To achieve this goal we must ensure that we have thecapabilities and financial means to expand and advance our pipeline through thelong, risky and expensive process of drug development and on to the market.This requires us to constantly evaluate the optimal balance between severalfactors, including the level of our investment in research and development, thepreservation of cash resources and their deployment for product development,and the financing environment.

 

In order to support our drug development infrastructure,to focus the use of our cash resources on our proprietary therapeuticsprograms, and to diversify risk in our overall drug development portfolio, weleverage our capabilities to form corporate alliances and to provide servicesto fee-paying customers. We also receive contract and grant funding from variousgovernmental agencies.  We have formeddrug and other product development alliances with Roche and Merck, amongothers. In addition to conducting work on our targets in our collaborative andinternal programs, our medicinal chemistry subsidiary provides drug discoveryservices and contract manufacturing of therapeutic compounds for human clinicaltrials for our fee-for-service customers. Our other service offerings includeprotein crystallization products; protein crystallization instruments and proteinstructure analysis contract services through our structural biology subsidiary;clinical trials services though our wholly owned subsidiary Encode; and DNAanalysis services through our genotyping laboratory in Reykjavik.

 

We currently derive revenues primarily from researchfunding and other fees from our service customers and collaborative partners;milestone payments and upfront, exclusivity, technology-access and technology-developmentfees under our collaboration agreements constitute most of the rest of ourrevenues. While we are entitled to royalties or profit-sharing under the terms ofsome of our agreements, 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.

 

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We believe that ongoing work in genetics and advancingour drug development programs, particularly the conduct of clinical trials on agrowing number of our compounds, will require significant and increasingexpenditures. In 2005 we have concluded our Phase II clinical studies for DG031,our developmental compound for the prevention of heart attack; begun our PhaseI clinical program for DG041, our developmental compound for peripheral arterydisease (PAD), which we previously referred to as peripheral arterial occlusivedisease (PAOD), and begun a Phase II trial in asthma. In the remainder of thisyear we expect to begin a Phase III trial for DG031, and to conclude our PhaseI and begin our Phase II trials for DG041, and we expect to conclude our PhaseII trial in asthma before year end. We also expect to be advancing ourpreclinical work on our follow-on compound in heart attack and in our PDE4inhibitor program for vascular disease/stroke, and expect these to be the nextprograms we bring into clinical development. We anticipate incurring additionalnet losses at least through the next several years, due to, in addition to theabove-mentioned factors, depreciation and amortization, as well as stock-basedcompensation and other non-cash charges. We expect that our revenues and losseswill fluctuate from quarter to quarter and that such fluctuations may besubstantial, especially because progress in our scientific work and milestonepayments that are related to progress can fluctuate between quarters. We do notbelieve that comparisons of our quarter-to-quarter performance are a goodindication of future performance.

 

Following our sale of $150,000,000 of our 3.5% SeniorConvertible Notes in April, 2004, we believe that we have sufficient cashresources to continue to fund our operations for several years. However, wewill require significant additional capital in the future for our productdevelopment programs and so will continue to investigate additional avenues offinancing. Our ability to obtain capital will be affected by conditions in theglobal financial markets and in the pharmaceutical industry. We expect thatdownturns in the market valuations of biotechnology companies and of the equitymarkets more generally will restrict our ability to raise additional capital onattractive terms, while more favorable conditions in those markets will presentopportunities for us.

 

The difficulties facing the pharmaceutical industrypresent for us both near-term challenges and significant longer-termopportunities. One of the main issues confronting big pharmaceutical companiesis their lack of promising new drugs to treat major indications. As manyleading brand-name drugs come off patent and face generic competition,developing successful new medicines will become critical for filling the gap. Inthe short term, the financial 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 partnerships withRoche and Merck demonstrate that the industry is already investing in thedevelopment of new therapeutics based on our approach.

 

**Research and Development Programs**

 

The following is a summary of the development of our drugcandidates in late pre-clinical or clinical development. Because ofuncertainties involved in the drug development process, the actual timing forthe events described below may differ materially from that provided in thissummary.

 

•                  Our most advanced developmentalcompound is DG031 for the prevention of heart attack. In 2004 we conducted aPhase IIa clinical trial for DG031 in Iceland, and conducted a small follow-onPhase II study in Iceland earlier this year. We have submitted an IND for DG031with the U.S. Food and Drug Administration (FDA) and expect to make similarfilings in selected European countries. We have submitted the safety summaryand results of the Phase II trials to the FDA and have conducted an end ofPhase II meeting with the FDA. Later this year we expect to begin a Phase IIIoutcome trial for DG031 in the Americas., Iceland and Europe, and are currentlyworking with the FDA to finalize the protocol under a Special ProtocolAssessment. The start of the DG-031 Phase III trial may be delayed if there aredelays in the timelines for manufacturing, packaging, labeling and shipping ofclinical supplies, delays in negotiations with CRO for clinical trialperformance, or delays in approval of the study protocol by local InstitutionalReview Boards (IRB) and/or the FDA.

 

•                  DG041is our lead compound for the treatment of atherosclerosis of the extremities,or peripheral artery disease (PAD). DG041 is a first-in-class small moleculeinhibitor of the EP3 receptor for prostaglandin E2, a G-protein coupled receptor(GPCR) encoded by a gene we have shown to be associated with increased risk ofdeveloping the disease. Our IND application for DG041 was accepted by the FDAin February 2005 and on this basis we began the first Phase 1 trial forthis compound in the U.S. in March of 2005. The Phase I single-dose escalationtrial was concluded in the second quarter 2005, and the results indicate that DG041 appears to be well tolerated at alldose levels tested. In particular, DG041 did not prolong bleeding time as comparedto the placebo. Additionally, doses were identified which appear to completelyinhibit platelet aggregation stimulated through the EP3 receptor. Themultiple-dose and food effect Phase I trials of DG041 began in the secondquarter 2005 and we expect to complete our Phase I clinical program for DG041in the fall.

 

•                  In asthma, we commenced a Phase IItrial with a third party compound during the second quarter of 2005. Thiscompound inhibits MAP3K9, a kinase encoded by a gene we have linked to risk ofasthma.  We expect to conclude our PhaseII trial before year end.

 

•                  We are developing a compound toinhibit the LTA4 hydrolase, a protein encoded by a second gene within the samepathway targeted by DG031 that we have also linked to significantly increasedrisk of heart attack.

 

12

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•                  We have begun a PDE4 inhibitorprogram for vascular disease/stroke pursuant to our 2004 agreement with Roche.

 

We use many of our employee and infrastructure resourcesacross several programs, and many of our research and development costs areindirectly attributable to an individually named program or are directedbroadly to applicable research programs. However, taking into account coststhat are specifically attributable to individual programs and allocations ofour research and development program costs based upon those direct costs , wehave cumulatively invested $8.9, $8.1, $3.7 and $5.0 million in our MI,PAD, stroke and asthma programs, respectively, from the beginning of 2003 todate. Inception to-date costs are not available as these costs were nothistorically tracked by program.

 

We have not applied for or received marketing approvalfrom the applicable regulatory authorities in any country for any of our drugcandidates. In order for us to achieve marketing approval in the U.S., the FDAmust conclude that our clinical data establish the safety and efficacy of ourdrug candidate. Other countries have similar requirements. Historically, theresults from pre-clinical testing and early clinical trials (through PhaseII) have often not been predictive of results obtained in later clinicaltrials. Many new compounds have shown promising results in early clinicaltrials, but subsequently failed to establish sufficient safety and efficacydata to obtain necessary marketing approvals. Additional risks anduncertainties involved in the development and commercialization of any productsare described below under the caption “Risk Factors, Forward-LookingStatements, and Cautionary Factors That May Affect Future Results”. We expectthat it will be several years, if ever, before we receive revenues from thecommercial sale of our therapeutic products.

 

Furthermore, our strategy includes the option of enteringinto collaborative arrangements with third parties to participate in thedevelopment and commercialization of our products, such as our collaborationagreements with Roche and Merck. Entering into a collaboration with a partnerat any point in the development or commercialization of a product is a businessdecision of ours. When making this decision we do and will consider, amongother matters, the complexity of the indication, the size, complexity andexpense of necessary development and/or commercialization efforts, competitionin the market and size of the applicable market, an assessment of our ownresources—financial and operational, and an assessment of the resources of apotential partner. In the event that we do collaborate on any of the aboveprograms in the future, a partner will have a level of control, which may besignificant, over the pre-clinical development or clinical trial process for aproduct. As a result the completion date of such a partnered program couldlargely be under control of that third party rather than under our control. Wecannot forecast with any degree of certainty which proprietary drug candidatewill be subject to future collaborative arrangements or how such arrangementswould affect our development plan or capital requirements.

 

As a result of the uncertainties discussed above, we areunable to determine the duration and completion costs of our research anddevelopment projects or when and to what extent we will receive cash inflowsfrom the commercialization and sale of a product.

 

**CriticalAccounting 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, foreign exchange transactions, income taxes and litigation and othercommitments and contingencies. We base our estimates on historical experienceand on various other assumptions that we believe to be reasonable under thecircumstances, the results of which form our basis for making judgments aboutcarrying values of assets and liabilities that are not readily apparent fromother sources. The impact and any associated risks related to these and ourother accounting policies on our business or operations is discussed throughoutManagement’s Discussion and Analysis of Financial Condition and Results ofOperations where such policies affect our reported and expected financialresults. For a detailed discussion on the application of these and otheraccounting policies, please refer to our notes to the Condensed ConsolidatedFinancial Statements in this quarterly report on Form 10Q and the ConsolidatedFinancial Statements in the Annual Report on Form 10-K. There can be noassurance that actual results may not differ from the estimates referred toabove.

 

**Resultsof Operations for the Three and Six-Month Periods Ended June 30, 2005 and 2004**

 

Our results of operations have fluctuated from period toperiod and may continue to fluctuate in the future based upon, among otherthings, the timing and composition of funding under our various collaborativeagreements, as well as the progress of our own research and developmentefforts. 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.

 

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Financial highlights as of and for the three and six-monthperiods ended June 30, 2005 include:

 

•                  At June 30, 2005, we had $185.3 million incash, cash equivalents and investments compared to $198.3 million at December31, 2004. The net utilization of just $13.1 million in the first six-months of2005 reflects costs associated with the advancement of our drug developmentprograms as reflected in the $26.1 million cash used in operations, togetherwith the net proceeds from the sale and leaseback of our Sturlugata and Krokhalsfaciltities in Reykjavik, Iceland ($20.0 million) and also the refinancing ofthe mortgage on our Woodridge, IL facility, during the six-month period ended June30, 2005.

 

•                  Research and development expense forproprietary programs was $11.0 million for the three-month period ended June 30,2005 as compared to $5.4 million for the three-month period ended June 30,2004.  Research and development expensefor proprietary programs was $19.3 million for the six-month period ended June30, 2005 as compared to $9.6 million for the six-month period ended June 30,2004.  The increase in our research anddevelopment expenses for proprietary programs is the result principally ofcosts associated with the advancement of our lead drug development programsinto clinical trials.

 

•                  In March 2005, we entered into a financingfor the sale and leaseback of our headquarters facility at Sturlugata 8,Reykjavik, Iceland. The sale price for the property was 3.4 billion Icelandickronas ($54.8 million after taking into account a forward foreign exchange contractwe entered into in connection with the sale of the property). As a result ofthe sale, we have removed the remaining net book value of the property ($29.3million) from our balance sheet as of June 30, 2005, deferred the resultinggain (remaining unamortized balance of $25.1 million) in our balance sheet asof June 30, 2005 and have begun recognizing the gain to earnings over the 15year term of the leaseback. Proceeds from the sale of Sturlugata 8 went toprepay approximately $38.6 million of short and long-term debt that was securedby mortgages on the property and, in this connection, we have recorded a losson early extinguishment debt during the six-month period ended June 30, 2005amounting to $3.1 million. We have leased the property back under a 15 yearnon-cancelable lease agreement at a rent of 21.4 million Icelandic kronas(approximately $0.3 million as of June 30, 2005) per month, subject to changesbased on the Icelandic consumer price index. We are accounting for the leasebackas an operating lease.

 

•                  In June 2005, we entered into a financing forthe sale and leaseback of our facility at Krokhals 5D and 5E, Reykjavik,Iceland.  The sale price for the propertywas 502 million Icelandic kronas (approximately $7.6 million after taking intoaccount a sales commission) of which $1.2 million will be paid in the thirdquarter of 2005.  As a result of thesale, the remaining net book value of the property ($4.0 million) has beenremoved from the balance sheet as of June 30, 2005, and the resulting gain ($3.6million) has been deferred and will be recognized to earnings over the 15 yearterm of the leaseback.  Proceeds from thesale of Krokhals were used to prepay approximately $1.8 million of long-termdebt that was secured by a mortgage on the property.  deCODE has leased the Krokhals 5D and 5Eproperty back under a 15 year non-cancelable lease agreement at a rent of 4.1million Icelandic krona (approximately $60,000 as of June 30, 2005) per month,subject to changes based on the Icelandic consumer price index.  The lease is an operating lease and, as aresult, Icelandic krona denominated rent will be included in operating expensesover the 15 year term of the lease agreement.

 

•                  Our revenue for the three-month period ended June30, 2005 was $11.4 million as compared to $9.6 million for the three-monthperiod ended June 30, 2004.  Our revenuefor the six-month period ended June 30, 2005 was $21.0 million as compared to$19.9 million for the six-month period ended June 30, 2004.  The flattening of revenue generally reflects ourincreasing focus on drug discovery and development.  Specifically, the comparison of the three andsix-month periods ended June 30, 2005 versus the same periods last year reflectthe completion of research funding under the 2002 agreement with Roche offsetsomewhat by revenues in our alliance to co-develop inhibitors of PDE4 as wellas an overall increase in grant monies received.

 

*Revenue.*  Our business strategy is focused on turningour discoveries into new drugs for the treatment of common diseases. At thesame time, we leverage our capabilities to generate revenue through corporatealliances and through service contracts. In the majority of our programs we arepursuing drug development on our own. In certain others, we have formedalliances with pharmaceutical and biotechnology firms through which we cancover some of the cost of conducting basic research and spread the risk andinvestment involved in product development. We have entered into research,development, commercialization, and fee for service alliances and contractsacross our business. Depending on the nature of each prospective businessopportunity, the key components of the commercial terms of such arrangementstypically include one or more of the following: research funding; up-front,exclusivity, technology access, and technology development fees; fees forparticular services; milestone payments; license or commercialization fees; androyalties or profit sharing from the commercialization of products.

 

Significant elements of our revenue are summarized asfollows:

 

14

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| ** **                                                                 | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                       | ** ** |
|                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Research funding and other service fees                                    |       | $                                        | 7,803      |                                   | $          | 7,606 |   | $ | 14,557 |   | $ | 15,503 |   |
| Milestone payments                                                         |       | 234                                      |       | 56                                     |       | 582 |   | 221 |   |
| Up-front, exclusivity, technology access, and  technology development fees |       | 1,000                                    |       | 1,000                                  |       | 2,038 |   | 2,000 |   |
| Grant funding                                                              |       | 2,003                                    |       | 546                                    |       | 2,891 |   | 1,426 |   |
| Other                                                                      |       | 397                                      |       | 427                                    |       | 892 |   | 767 |   |
|                                                                       |       | $                                        | 11,437     |                                   | $          | 9,635 |   | $ | 20,960 |   | $ | 19,917 |   |

 

Collaborations with our most significant partnersinclude:

 

*F. Hoffmann-LaRoche (Roche)*

 

*Therapeutics.*In 1998 we entered into a research collaborationand cross-license agreement with Roche, under which we identified key geneticfactors involved in ten common diseases: osteoarthritis, Alzheimer’s disease,schizophrenia, PAD, stroke, osteoporosis, obesity, anxiety, non-insulin-dependentdiabetes and rheumatoid arthritis. In January 2002, we entered into a newthree-year agreement with Roche focused on turning the achievements of our 1998gene discovery collaboration into novel therapeutics. The 2002 agreementprovided that we would collaborate with respect to four diseases that had beenthe subject of the 1998 agreement. During 2004 and through January 2005 wecollaborated with Roche on two of those diseases. Under the 2002 agreement,which expired on February 1, 2005, we received $20 million in research fundingand we are entitled to receive royalties on the sales of any drugs that aredeveloped coming out of work conducted under this agreement.

 

In November 2004, we signed a new three-yearagreement with Roche to co-develop inhibitors of PDE4 for the prevention andtreatment of vascular disease, including stroke. This agreement continues workadvanced under the 2002 agreement, and we will focus on optimizing lead compoundsidentified in our previous work and begin clinical development. We will sharedrug discovery and clinical trials costs with Roche under this new agreement,and we may receive milestone payments and royalties based on drug sales.

 

*Diagnostics.*  In June 2001, we signed a five-yearalliance with Roche’s diagnostics division to develop and market DNA-baseddiagnostics for major diseases. We have, as well, added research programs aimedat developing diagnostics to predict drug response for major therapeutics usedto treat those diseases, in order to help select the most effective treatmentof those available.  Under the agreementwe have received $38.0 million in research funding, up-front fees and milestonepayments. We may receive $6.3 million in additional research funding over theremainder of the term of the agreement as well as milestone payments upon theachievement of research and development milestones and royalties on the salesof diagnostic products developed.

 

Revenues from these alliances with Roche amounted to $2.3million and $3.1 million in the three-month periods ended June 30, 2005and 2004, respectively, and $5.0 million and $6.5 million in the six-monthperiods ended June 30, 2005 and 2004, respectively, representing 20% and 32%of consolidated revenue for the three-month periods ended June 30, 2005and 2004, respectively, and 24% and 33% of consolidated revenue for thesix-month periods ended June 30, 2005 and 2004, respectively.  Costs incurred with these collaborativeprograms with Roche amounted to $1.3 million and $6.0 million in thethree-month periods ended June 30, 2005 and 2004, respectively and $5.0million and $9.7 million in the six-month periods ended June 30, 2005 and2004, respectively.

 

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

 

*Obesity.*  In September 2002, we entered into threeyear alliance with Merck aimed at developing new treatments for obesity. Underthe alliance, we combined research efforts with Merck in the genetics ofobesity to identify, validate and prioritize a series of drug targets to takeinto development. Under the terms of the three-year agreement, we have receivedresearch funding, technology access fees and milestone payments in theaggregate amount of $24.3 million.  Inaddition, we may receive milestone payments as compounds developed under thealliance advance in the development process and royalties on successfullymarketed drugs. We have discovered three genes linked to obesity under thisalliance, and Merck had generated lead series of compounds against one of thetargets we validated through our genetics research.

 

Revenues from this alliance with Merck amounted to $1.8million and $1.6 million in the three-month periods ended June 30, 2005 and2004, respectively, and $3.6 million and $3.5 million in the six-month periodsended June 30, 2005 and 2004, respectively , representing 16% and 17% ofconsolidated revenue for the three-month periods ended June 30, 2005 and2004, respectively, and 17% and 18% of consolidated revenue for the six-monthperiods ended June 30, 2005 and 2004, respectively. Costs incurred withthis alliance with Merck amounted to $1.0 million and $1.3 million in thethree-month periods ended June 30, 2005 and 2004, respectively and $2.1million and $2.5 million in the six-month periods ended June 30, 2005 and2004, respectively.

 

15

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*Information Rich Clinical Trials.*  In February 2004, we entered into anagreement with Merck which provides that deCODE will conduct information-richclinical trials on a range of Merck’s developmental compounds that Merckselects for inclusion in the program. The term of the alliance is seven years,subject to termination by Merck after five years. The collaboration involvedthree agreements: (a) a License and Research Collaboration Agreement;(b) a Stock and Warrant Purchase Agreement; and (c) a WarrantAgreement. Under the terms of the License and Research Collaboration Agreement,we will receive royalties on sales of drugs and diagnostics developed as partof the alliance, will receive milestone payments as compounds orpharmacogenomic tests reach the market, will receive research funding for theclinical development of compounds and pharmacogenomic analysis, and received aone-time technology access fee of $10 million. To date, Merck has not selectedany compounds for development under the agreement.

 

Revenues from this alliance with Merck amounted to $0.0million and $0.2 million in the three and six-month periods ended June 30,2005, representing 0% and 1% of consolidated revenue for the three and six-monthperiods ended June 30, 2005. Costs incurred with this alliance with Merckamounted to $0.03 million and $0.1 million in the three and six-month periodsended June 30, 2005.

 

*National Institute of Allergy andInfectious Diseases (NIAID).*

 

On September 30, 2004, deCODE was awarded afive-year $23.9 million contract by the NIAID, a division of the U.S. NationalInstitutes of Health. Under the contract, deCODE will apply its populationapproach and resources to discover genetic factors associated withsusceptibility to certain infectious diseases and with responsiveness tovaccines targeting such diseases. Revenue under this contract will berecognized as deCODE incurs costs related to the contract and we expect that wewill expend funds generally ratably over the five-year term of the contract.  Revenues and costs attendant to this contractwith the NIAID amounted to $1.5 million and $1.5 million in the three-monthperiod ended June 30, 2005 and $2.0 million and $2.0 million in the six-monthperiod ended June 30, 2005, respectively.

 

Revenue for the three andsix-month periods ended June 30, 2005 and 2004 is as follows:

 
| ** ** | ** ** | **For the Three Months**        | ** ** | **For the Six Months** | ** ** | **2005 as Compared to 2004** | ** ** |
|------------|------------|---------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** ** | ** ** | **Ended June 30,**              | ** ** | **Ended June 30,**     | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** ** | ** ** | **2005**                        | ** ** | **2004**               | ** ** | **2005**                     | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except for%)** | ** ** |
| Revenue    |       | $                               | 11,437     |                   | $          | 9,635                        |       | $ | 20,960 |   | $ | 19,917 |   | $ | 1,802 |   | 19 | % | $ | 1,043 |   | 5 | % |
|            |            |                                 |            |                        |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenuefor the three and six-month periods ended June 30, 2005 generally reflects our strategicfocus on drug discovery and development. Specifically, the comparison of the three and six-month periods ended June30, 2005 versus the same periods last year reflect the completion of researchfunding under the 2002 agreement with Roche offset somewhat by revenues in ouralliance to co-develop inhibitors of PDE4 as well as an overall increase ingrant monies received. At June 30, 2005, we had $16.9 million in deferredrevenue, compared to $15.9 million at the close of 2004. We expect that ourrevenues will fluctuate from quarter to quarter and that such fluctuations maybe substantial especially because progress in our scientific work, includingmilestone payments that are related to progress, can fluctuate betweenquarters.

 

*Cost of Revenue, includingCollaborative Programs.*  Cost of revenue,including costs incurred in connection with collaborative programs for thethree and six-month periods ended June 30, 2005 and 2004 is as follows:

 
| ** **                                         | ** ** | **For the Three Months**         | ** ** | **For the Six Months** | ** ** | **2005 as Compared to 2004** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** **                                         | ** ** | **Ended June 30,**               | ** ** | **Ended June 30,**     | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                                         | ** ** | **2005**                         | ** ** | **2004**               | ** ** | **2005**                     | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In  thousands, except for%)** | ** ** |
| Cost of Revenue, including Collaborative  Programs |       | $                                | 8,597      |                   | $          | 10,338                       |       | $ | 17,737 |   | $ | 21,512 |   | $ | (1,741 | ) | (17 | )% | $ | (3,775 | ) | (18 | )% |
|                                                    |            |                                  |            |                        |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our cost of revenue consistsof the costs of services provided to customers, collaborators and under grants,including the entirety of costs incurred in connection with programs that havebeen partnered and on which we receive research funding. At times, we investedin addition to costs covered by research funding received in such collaborativeprograms. The decrease in our cost of revenue, including costs incurred inconnection with collaborative programs over the periods presented, in generalreflects a relative lessening of our investment in programs on which we receiveresearch funding.

 

Ourcost of revenue, including costs incurred in connection with collaborativeprograms for the three-months ended June 30, 2005 as compared to the sameperiod in 2004 includes (i) an overall decrease in salary and employee relatedexpenses ($0.4 million), and (ii) less in chemicals and consumables ($0.6million), together driving (iii) lower allocation of overheads, depreciationand amortization ($0.7 million).

 

16

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Ourcost of revenue, including costs incurred in connection with collaborativeprograms for the six-months ended June 30, 2005 as compared to the same periodin 2004 includes (i) an overall decrease in salary and employee relatedexpenses ($1.1 million), and (ii) less in chemicals and consumables ($0.9million), together driving (iii) lower allocation of overheads, depreciationand amortization ($1.7 million).

 

Therelative strengthening of the Icelandic krona versus the U.S. dollar over theperiods presented has affected the U.S. dollar reported amounts of our expensesdenominated in Icelandic krona (e.g.,increases of approximately $0.1 millionand $0.6 million for the three and six-month periods ended June 30, 2005, respectively,on a portion of our salary and employee related expenses included in cost ofrevenue). Although we have experienced this relative currency exchangereversing somewhat of late, this general trend in the currencies may continue.

 

*Research and Development—ProprietaryPrograms.*  Research and development forproprietary programs for the three and six-month periods ended June 30, 2005and 2004 is as follows:

 
| ** **                                       | ** ** | **For the Three Months**        | ** ** | **For the Six Months** | ** ** | **2005 as Compared to 2004** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Ended June 30,**              | ** ** | **Ended June 30,**     | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                                       | ** ** | **2005**                        | ** ** | **2004**               | ** ** | **2005**                     | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **(In thousands, except for%)** | ** ** |
| Research and Development - Proprietary  Programs |       | $                               | 11,001     |                   | $          | 5,385                        |       | $ | 19,276 |   | $ | 9,644 |   | $ | 5,616 |   | 104 | % | $ | 9,632 |   | 100 | % |
|                                                  |            |                                 |            |                        |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theincrease in our research and development expenses in proprietary programsresults from our emphasis on and increasing expenditures in product developmentclinical work and pre-clinical preparations on our lead drug developmentprograms. Importantly, based on the results of our Phase IIa clinical trial ofDG031and a small follow-on Phase II study in Iceland conducted in the firsthalf of 2005, we are designing an information-rich, multi-center, pivotal PhaseIII outcome trial in the Americas, Iceland and Europe to test DG031 for theprevention of heart attack, which we expect to begin later this year afterfinalizing the protocol with the FDA under a Special Protocol Assessment.  Also, our IND application for DG041 wasaccepted by the FDA in February 2005 and on this basis we began the first PhaseI trial for this compound in the U.S. in March of 2005.  The multiple-dose Phase I trial of DG041 beganin the second quarter 2005 and we expect to complete our Phase I clinicalprogram for DG041 in the fall.  Inaddition,  we commenced a Phase II trialin Iceland for asthma with a third party compound during the second quarter of 2005.  Further, among other pre-clinical programs weare developing a compound to inhibit the LTA4 hydrolase, a protein encoded by asecond gene within the same pathway targeted by DG031 that we have also linkedto significantly increased risk of heart attack, and we have begun a PDE4inhibitor program for vascular disease/stroke pursuant to our 2004 agreementwith Roche.

 

Our research and developmentexpenses for the three and six-month periods ended June 30, 2005 and 2004consist of the following:

 
| ** **                                       | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                       | ** ** |
|                                             |       |                                     |       |                                   |       |   |   |   |   |
| Salaries and other personnel costs               |       | $                                        | 4,383      |                                   | $          | 2,407 |   | $ | 8,327 |   | $ | 4,360 |   |
| Materials and supplies                           |       | 1,250                                    |       | 844                                    |       | 2,196 |   | 1,363 |   |
| Contractor services and other third party  costs |       | 3,378                                    |       | 653                                    |       | 5,064 |   | 1,216 |   |
| Overhead expenses                                |       | 1,208                                    |       | 547                                    |       | 2,032 |   | 935 |   |
| Depreciation and amortization                    |       | 782                                      |       | 873                                    |       | 1,657 |   | 1,632 |   |
| Stock-based compensation and remuneration        |       | 0                                        |       | 61                                     |       | 0 |   | 138 |   |
|                                             |       | $                                        | 11,001     |                                   | $          | 5,385 |   | $ | 19,276 |   | $ | 9,644 |   |

 

Increasesin the research and developments costs of our proprietary programs (e.g.,salaries and attendant costs, usage of chemicals and consumables, contractorservices) will likely continue, particularly as we advance our clinicaldevelopment and proprietary drug development programs. Further, we have grantedsalary increases to our personnel and have added clinical development andregulatory executives to our staff – which will contribute to future increasesin our research and development costs for proprietary programs.  Also, the relative strengthening of theIcelandic krona versus the U.S. dollar over the periods presented has affectedthe

 

17

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U.S.dollar reported amounts of our expenses denominated in Icelandic krona (e.g., increasesof approximately $0.5 million and $0.6 million for the three and six-monthperiods ended June 30, 2005, respectively, on a portion of our salary andemployee related expenses included in research and development). Although wehave experienced this relative currency exchange reversing somewhat of late,this general trend in the currencies may continue.

 

*Selling, General and AdministrativeExpense.*  Selling, generaland administrative expense for the three and six-month periods ended June 30,2005 and 2004 is as follows:

 
| ** **                           | ** ** | **For the  Three Months**        | ** ** | **For the  Six Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **Ended  June 30,**              | ** ** | **Ended  June 30,**     | ** ** | **Three  Months**             | ** ** | **Six  Months** | ** ** |
| ** **                           | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In  thousands, except for%)** | ** ** |
| Selling, General and Administrative. |       | $                                | 4,694      |                    | $          | 5,589                         |       | $ | 8,852 |   | $ | 9,852 |   | $ | (895 | ) | (16 | )% | $ | (1,000 | ) | (102 | )% |
|                                      |            |                                  |            |                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Ourselling, general and administrative expenses for the three and six-month periodsended June 30, 2005 decreased as compared to the same periods a year-ago with modestdeclines in most expense categories. Our legal expenses have increased $0.3million and $0.2 million for the three and six-month periods ended June 30,2005, respectively, as compared to the same periods in 2004 largely on accountof increased activity around our intellectual property and patentapplications.  Cost for contractorservices, however, have decreased $0.3 million and $0.4 million for the threeand six-month periods ended June 30, 2005, respectively as compared to the sameperiods in 2004 chiefly due to efficiencies gained in this second year ofimplementation of the provisions of the Sarbanes Oxley Act of 2002.  There is also a relative decrease in ourselling, general and administrative expenses for the 2005 periods as comparedto the same periods a year-ago due to severance costs ($0.6 million) and anaccrual for probable losses related to grant monies received in pre-acquisitionperiods of MediChem ($0.4 million) recorded in the 2004 periods.

 

Wehave granted salary increases to our personnel and are making efforts torecruit new members to our Board of Directors – which will increase ourselling, general and administrative expenses.  Further, the relative strengthening of theIcelandic krona versus the U.S. dollar over the periods presented has affectedthe U.S. dollar reported amounts of our expenses denominated in Icelandic krona(e.g., increases of approximately $0.2 million and $0.4 million for the threeand six-month periods ended June 30, 2005, respectively, on a portion of oursalary and employee related expenses included in selling, general andadministrative expenses).  Although wehave experienced this relative currency exchange reversing somewhat of late,this general trend in the currencies may continue.

 

*Stock Based Compensation andRemuneration Expense.* Stock based compensation and remuneration expense for the three and six-monthperiods ended June 30, 2005 and 2004 is as follows:

 
| ** **                                         | ** ** | **For the  Three Months**        | ** ** | **For the  Six Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                                         | ** ** | **Ended  June 30,**              | ** ** | **Ended  June 30,**     | ** ** | **Three  Months**             | ** ** | **Six  Months** | ** ** |
| ** **                                         | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In  thousands, except for%)** | ** ** |
| Stock Based Compensation and Remuneration  Expense |       | $                                | 26         |                    | $          | 552                           |       | $ | 74 |   | $ | 813 |   | $ | (526 | ) | (95 | )% | $ | (739 | ) | (91 | )% |
|                                                    |            |                                  |            |                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

With little compensationexpense being attributed to our more recent stock option grants, stock-basedcompensation and remuneration expense has been decreasing as grants made toemployees in earlier years become fully vested. Historical stock-basedcompensation and remuneration is not necessarily representative of the effectson reported income or loss for future years due to, among other things, thevesting period of the stock options, the value of stock options that have beengranted in recent times and the required change to the fair value method.

 

FASBNo. 123(R) replaces FASB Statement No. 123 and supersedes APB Opinion No. 25and eliminates the ability to account for employee share-based compensationtransactions using the intrinsic method. FASB No. 123(R) requires suchtransactions be accounted for using a fair-value-based method that would resultin additional expense being recognized in our financial statements. In April2005, the Securities and Exchange Commission (“SEC”) adopted a rule that defersthe required effective date of SFAS No. 123(R) to our fiscal year beginningJanuary 1, 2006. Although we have not yet determined the impact of its adoptionon our consolidated financial position or results of operations, the chargesinvolved could be significant.

 

*Interest Income.*  Interest income for the three and six-monthperiods ended June 30, 2005 and 2004 is as follows:

 

18

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| ** **      | ** ** | **For the  Three Months**        | ** ** | **For the  Six Months** | ** ** | **2004 as  Compared to 2003** | ** ** |
|-----------------|------------|----------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **      | ** ** | **Ended  June 30,**              | ** ** | **Ended  June 30,**     | ** ** | **Three  Months**             | ** ** | **Six  Months** | ** ** |
| ** **      | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In  thousands, except for%)** | ** ** |
| Interest Income |       | $                                | 1,533      |                    | $          | 746                           |       | $ | 2,653 |   | $ | 981 |   | $ | 787 |   | 105 | % | $ | 1,672 |   | 170 | % |
|                 |            |                                  |            |                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest income has increased with rising interestrates and increasing returns on a greater amount of cash and investments.  We expect to use our cash and investmentsprincipally for advancing our drug and clinical development programs. In themeantime, we will invest our monies received in accordance with our policy,having the objective of preserving principal while maximizing income we receivefrom our investments without significantly increasing risk. We expect tomaintain our portfolio of cash equivalents and investments in a variety ofsecurities, including auction rate securities, commercial paper, money marketfunds, mutual fund investments and government and non-government debtsecurities.

 

*Interest Expense.*  Interest expense for the three and six-monthperiods ended June 30, 2005 and 2004 is as follows:

 
| ** **       | ** ** | **For the  Three Months**        | ** ** | **For the  Six Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|------------------|------------|----------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **       | ** ** | **Ended  June 30,**              | ** ** | **Ended  June 30,**     | ** ** | **Three  Months**             | ** ** | **Six  Months** | ** ** |
| ** **       | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In  thousands, except for%)** | ** ** |
| Interest Expense |       | $                                | 1,700      |                    | $          | 2,113                         |       | $ | 4,089 |   | $ | 3,312 |   | $ | (413 | ) | (20 | )% | $ | 777 |   | (23 | )% |
|                  |            |                                  |            |                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

InMarch 2005, we prepaid $38.6 million of short and long-term debt that wassecured by mortgages on Sturlugata 8. Also in March 2005, we refinanced themortgage on our Woodridge, IL facility, paying-down $4.0 million on theexisting mortgage.  Further, in June 2005we prepaid $1.8 million of long-term debt that was secured by mortgages onKrokhals 5D and 5E.  As a result of theseprepayments and refinancings, our future interest expense is currently expectedto be approximately $5.6 million on an annual basis.

 

*Other Non-Operating Income andExpense, Net.*  Othernon-operating income and expense for the three and six-month periods ended June30, 2005 and 2004 is as follows:

 
| ** **                                     | ** ** | **For the  Three Months**        | ** ** | **For the  Six Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                                     | ** ** | **Ended  June 30,**              | ** ** | **Ended  June 30,**     | ** ** | **Three  Months**             | ** ** | **Six  Months** | ** ** |
| ** **                                     | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **(In  thousands, except for%)** | ** ** |
| Other Non-Operating Income and (Expense),  Net |       | $                                | (310       | )                       | $          | (235                          | )          | $ | (3,927 | ) | $ | (1,893 | ) | $ | 75 |   | 32 | % | $ | 2,034 |   | 107 | % |
|                                                |            |                                  |            |                         |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our other non-operatingincome and expense, net consists principally of the net impact of foreignexchange and unrealized and realized gains and losses on derivative financialinstruments and, in the three and six-month periods ended June 30, 2005, losson early extinguishment of debt.

 

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. Thenet impact of foreign exchange on the translated amount of our non-US dollardenominated liabilities, net together with transaction gains and losses,amounted to losses of $0.3 million and $0.2 million for the three-month periodsended June 30, 2005 and 2004, respectively, and $0.6 million and $0.4 millionfor the six-month periods ended June 30, 2005 and 2004, respectively.  The continued weakening of the U.S. dollarcompared to the Icelandic krona during 2004 and into 2005 was significant and,although we have experienced this relative currency reversing somewhat of late,this general trend in the currencies may continue to adversely affect ourfinancial results.

 

Our losses on derivativefinancial instruments in the three and six-month periods ended June 30, 2005($0.1 million and $0.2 million, respectively) result from three forward foreigncurrency exchange options we entered into as economic hedges against foreignexchange rate fluctuations that we expected may occur on our ISK-denominatedoperating expenses but that did not qualify for hedge accounting.

 

Our losses on derivativefinancial instruments in the six-month period ended June 30, 2004 stem from thetwo cross-currency swaps we entered into as economic hedges against foreignexchange rate fluctuations that may have occurred on our foreign currency debtbut that did not qualify for hedge accounting. In March 2004, we liquidated ourtwo cross-currency swaps receiving $9.7 million in

 

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proceeds. We realized a losson this early termination that, together with unrealized losses on the swapsduring the six-month period ended June 30, 2004, amounted to $1.5 million.

 

Asa result of having prepaid the short and long-term debts that were secured bymortgages on Sturlugata we have recorded a loss on early extinguishment debtduring the six-month period ended June 30, 2005 amounting to $3.1 million andconsisting of (i) prepayment fees ($1.4 million), (ii) write-off of remainingunamortized finance costs related to the prepaid long-term debt ($1.4 million),and (iii) remaining unamortized discount on the prepaid long-term debt ($0.3 million).

 

**Liquidityand Capital Resources**

 

We have financed our operations primarily through fundingfrom research and development collaborative agreements, and the issuance ofequity securities and long-term financing instruments ($807 million fromthe beginning of 1999 to-date). Future funding under terms of our existingagreements is approximately $57 million excluding milestone payments androyalties that we may earn under such collaborations.

 

Although we rely on funded research arrangements for asignificant portion of our revenue, we continue to invest in proprietaryresearch and development and we will incur the costs of such activities. In thenear term, this will require us to devote resources to our in-house drug andclinical development which we believe will better position us to capture themost value to us in our discoveries. As we identify promising discoveries forfurther development, we may choose to continue the development ourselves intoand through clinical trials, regulatory approvals, manufacture, distributionand marketing. In other cases we are or will be working to varying degrees withpartners. The decisions we make as to these matters will affect our cashrequirements.

 

Based upon the range of our current activities, we expectto have greater overall net use of cash in 2005 in our operating, investing andfinancing activities than we did in 2004. Our cash requirements depend onnumerous 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.

 

We believe that we will have sufficient cash to fund ouroperations for several years. However, under all circumstances, we will requiresignificant additional capital in the future, which we may seek to raisethrough further public or private equity offerings, additional debt financingor added collaborations and licensing arrangements. However, no assurance canbe given that additional financing or collaborations and licensing arrangementswill be available when needed, or that if available, will be obtained onfavorable terms. If adequate funds are not available when needed, we may haveto curtail operations or attempt to raise funds on unattractive terms.

 
| ** **                                  | ** ** | **For the  Six Month  Periods Ended June 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(In  thousands)**                                 | ** ** |
|                                        |       |                                                |       |   |   |
| **Cash provided by (used in):**             |       |                                                |       |   |   |
| Operating activities                        |       | $                                                   | (26,098    | ) | $ | (9,622 | ) |
| Investing activities                        |       | 49,644                                              |       | (59,528 | ) |
| Financing activities                        |       | (46,624                                             | )          | 162,147 |   |
|                                        |       |                                                |       |   |   |
| Cash and cash equivalents, at end of period |       | 47,160                                              |       | 161,666 |   |
|                                             |            |                                                     |            |  |  |  |  |

 

*Cash andCash Equivalents.*  At June 30, 2005, we had $47.2 million incash and cash equivalents. Together with our investments at June 30, 2005 ($185.3million), this balance has decreased just $13.1 million from the close of theyear-ended 2004. Significant cash flows during the six-month period ended June30, 2005 include, the net proceeds from the sale and leaseback financing of ourSturlugata 8 headquarters facility ($54.8 million), the net proceeds from thesales and leaseback financing of our Krokhals facility ($7.6 million), prepaymentsof short and long-term debts secured by mortgages on Sturlugata 8 ($38.6million), prepayments of short and long-term debts secured by mortgages on ourKrokhals facility ($1.8 million), refinancing of the mortgage on our Woodridge,IL facility ($4.0 million), debt service ($1.3 million), capital expenditures($1.2 million), and costs associated with the advancement of our drugdevelopment programs as reflected in the $26.1 million of cash we used inoperating activities during the six-month period ended June 30, 2005.

 

Available cash is investedin accordance with our investment policy’s primary objectives of liquidity and safetyof principal while maximizing the income we receive from our investmentswithout significantly increasing risk. Our cash is deposited only with

 

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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, 2005, our cashis largely invested in U.S. dollar denominated money market and checkingaccounts and also in Icelandic krona denominated accounts. At June 30, 2005,our investments are in auction rate securities, US government agency securitiesand a mutual fund.

 

*OperatingActivities.* Net cashused in operating activities increased to $26.1 million for the six-monthperiod ended June 30, 2005 as compared to $9.6 million in the same period in2004.  As more fully described above, theincrease in use of cash in operating activities is most importantlyattributable to the significant research and development investments being madein advancing our drug and clinical development programs.  Also, because of $6.4 million of the moniesreceived by us in the Information Rich Clinical Trial with Merck, workingcapital provided $7.4 million of funds in the six-month period ended June 30,2004 as compared to a use of $2.3 million in the six-month period ended June 30,2005.

 

*InvestingActivities.* Ourinvesting activities have consisted of short-term investments, capitalexpenditures and, in the six-month period ended June 30, 2005, the sale andleaseback of our headquarters facilities at Sturlugata, and Krokhals 5D and 5Ein Reykjavik, Iceland.

 

Investments made during thesix-month period ended June 30, 2005 consist mainly of auction rate securities,US government securities and a mutual fund.

 

We principally madereplacement capital expenditures during 2004 and 2005 and did invest in certainequipment for our laboratories.  Althoughwe expect we will continue to make principally replacement capital expendituresin the near-term, net cash used in investing activities may in the futurefluctuate significantly from period to period due to timing of our capitalexpenditures and other investments as well as changing business needs.

 

As more fully describedbelow, in March 2005, we entered into a financing with an Icelandic real estatecompany for the sale and leaseback of our headquarters facility at Sturlugata8, Reykjavik, Iceland. The sale price for the property was 3.4 billionIcelandic kronas ($54.8 million after taking into account a standard forwardforeign exchange contact we entered into in connection with the sale).  In June 2005, we entered into a financingwith an Icelandic real estate company for the sale and leaseback of ourfacility at Krokhals 5D and 5E, Reykjavik, Iceland.  The sale price for the property was 502million Icelandic kronas (approximately $7.6 million after taking into accountthe sales commission), of which $1.2 million will be paid in the third quarter2005.

 

*FinancingActivities.* Net cashof $46.6 million was used in financing activities in the six-month period endedJune 30, 2005, as compared to $162.1 million that was provided in the six-monthperiod ended June 30, 2004.  Financingactivities for the six-month period ended June 30, 2005 largely consisted ofprepayments of short and long-term debts secured by mortgages on Sturlugata 8($38.6 million), prepayments of long-term debts secured by mortgages onKrokhals 5D and 5E ($1.8 million) refinancing of the mortgage on our Woodridge,IL facility ($6.2 million) which freed-up $6.0 million of previously restrictedcash which is reflected above in investing activities, and other debt service($1.3 million). Financing activities for the six-month period ended June 30,2004 largely consisted of net proceeds from our convertible notes ($143.8million), equity proceeds and a portion of the up-front monies received by usin the Information Rich Clinical Trial alliance with Merck ($13.6 million),proceeds in the liquidation of our two cross-currency swap ($9.7 million) andinstallment payments on debt and capital lease obligations ($5.9 million).

 

A portion of the proceeds from the sale of ourheadquarters facility at Sturlugata 8 went to prepay approximately $34.1million of long-term debt that was secured by mortgages on the property, (ourTier A bonds, Tier B loan and March 2004 loan) and $4.5 million of short-termborrowings. We have leased the property back under a 15 year non-cancelablelease agreement at a rent of 21.4 million Icelandic kronas per month (approximately$0.3 million as of June 30, 2005), subject to changes based on the Icelandicconsumer price index. Under the terms of the lease we will continue to payproperty taxes and insurance and will be responsible for the property’smaintenance. The monthly rent will be revised as of July 1, 2010 to reflectchanges in capital markets as well as our credit quality. Under the terms ofthe lease, we have a right of first refusal on any sale of the property and apriority right to extend the term of the lease at its expiration. The leaseprovides us with the option to redenominate the rent in currencies other thanIcelandic kronas at a predetermined rate as of July 1, 2007.

 

In March 2005, werefinanced the mortgage on our Woodridge, IL facility, paying-down $4.0 millionon the existing mortgage and eliminating restricted cash collateral totaling $6.0million.  The principal amount of the newmortgage ($6.2 million) is payable in monthly installments of $26,000 for fiveyears and a final payment of $5.5 million due in June 2007.  The new mortgage carries an interest rate ofthree-month LIBOR + 2.25% (5.37% at June 30, 2005).

 

A portion ofthe proceeds from the sale of Krokhals 5D and 5E were used to prepayapproximately $1.8 million of long-term debt that was secured by a mortgage onthe property.  deCODE has leased theKrokhals 5D and 5E property back under a 15 year non-cancelable lease

 

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agreement at a rent of 4.1million Icelandic kronas (approximately $0.06 million as of June 30, 2005) permonth, subject to changes based on the Icelandic consumer price index.  The lease is an operating lease and, as aresult, Icelandic krona denominated rent will be included in operating expensesover the 15 year term of the lease agreement

 

*Contractual Commitments.*  Our major outstanding contractual commitmentsrelate to the privately placed bonds, bank loans and property and equipmentlease financings. Our contractual commitments as of June 30, 2005 were asfollows:

 
| ** **                                         | ** ** | ** **          | ** ** | ** **             | ** ** | **Payments  Due by period** | ** ** | ** **    | ** ** |
|----------------------------------------------------|------------|---------------------|------------|------------------------|------------|-----------------------------|------------|---------------|------------|
| ** **                                         | ** ** | **Total**           | ** ** | **Less  Than  1 Year** | ** ** | **1-3  Years**              | ** ** | **3-5 Years** | ** ** | **More  than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In  thousands)** | ** ** |
| 3.5% senior convertible notes, including  interest |       | $                   | 181,500    |                   | $          | 5,250                       |       | $             | 10,500     |   | $ | 10,500 |   | $ | 155,250 |   |
| Long-term debt, including interest                 |       | 7,079               |       | 910                    |       | 6,169                       |       | 0             |       | 0 |   |
| Capital lease obligations, including interest      |       | 13,650              |       | 2,566                  |       | 1,882                       |       | 1,559         |       | 7,643 |   |
| Operating leases                                   |       | 59,480              |       | 4,602                  |       | 8,455                       |       | 7,973         |       | 38,450 |   |
|                                               |       | $                   | 261,709    |                   | $          | 13,328                      |       | $             | 27,006     |   | $ | 20,032 |   | $ | 201,343 |   |

 

Under the terms of certain technology licensingagreements, we are obligated to make payments upon the achievement ofestablished milestones leading to the discovery of defined products. Thesepayments could total $6,000,000 and the year incurred cannot be determined atthe current time.

 

**RISK FACTORS, FORWARD-LOOKINGSTATEMENTS, AND CAUTIONARY FACTORS**

**THAT MAY AFFECT FUTURE RESULTS**

 

This Quarterly Report on Form 10-Q contains forward-lookingstatements. These statements relate to future events or our future financialperformance. In some cases, forward-looking statements can be identified byterminology such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,”“believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or thenegative of such terms or other comparable terminology. These statements areonly predictions. We cannot assure our investors that our expectations andassumptions will prove to have been correct. We undertake no intention orobligation to update or revise any forward-looking statements, whether as aresult of future events, new information or otherwise. Actual events or resultsmay differ materially due to a number of factors, including those set forth inthis section and elsewhere in this Form 10-Q. These factors include, butare not limited to, the risks set forth below.

 

**Risks Related to Our Business**

 

***We may notsuccessfully develop or derive revenues from any products.***

 

We use our technology and research capabilities toidentify genes and gene variations that contribute to certain diseases and thendevelop small molecule drugs that target proteins produced by these genes.  Although we have identified genes that webelieve are likely to cause certain diseases, we may not be correct and may notbe successful in identifying any other similar genes or in developing drugsbased on these discoveries. Many experts believe that some of the diseases weare targeting are caused by both genetic and environmental factors. Even if weidentify specific genes that are partly responsible for causing diseases, anytherapeutic or diagnostic products we develop as a result of our genetic workmay not detect, prevent, treat or cure a particular disease.  Any pharmaceutical or diagnostic products thatwe or our collaborators are able to develop will fail to produce revenuesunless we:

 

•      establishthat they are safe and effective;

 

•      successfullycompete with other technologies and products;

 

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

 

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

 

•      obtainand maintain regulatory approvals for them; and

 

•      canmarket them successfully.

 

We may not be able to meet these conditions. We expectthat it will be years, if ever, before we will recognize significant revenuefrom the development of therapeutic or diagnostic products.

 

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

 

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We incurred a net loss of $30.3 million for the six-monthsended June 30, 2005, and had an accumulated deficit of $417.7 million at June30, 2005. We have never generated a profit and we have not generated revenuesexcept for payments received in connection with our research and development collaborationswith Roche, Merck and other collaborations, from contract services and undergrants. Our research and development expenditures and general andadministrative costs have exceeded our revenue to date, and we expect to spendsignificant additional amounts to fund research and development in order toenhance our core technologies and undertake product development (including drugdevelopment and related clinical trials). We do not expect to receive royaltiesor other revenues from commercial sales of products developed using ourtechnology in the near term. It may be several years before product revenuesmaterialize, if they do at all. As a result, we expect to incur net losses forseveral years. If the time required to generate product revenues and achieveprofitability is longer than we currently anticipate or the level of losses isgreater than we currently anticipate, we may not be able to continue ouroperations.

 

***If ourassumption about the role of genes in disease is wrong, we may not be able todevelop useful products.***

 

The products we hope to develop involve new and unprovenapproaches. They are based on the assumption that information about genes mayhelp scientists to better understand complex disease processes. Scientistsgenerally have a limited understanding of the role of genes in diseases, andfew products based on gene discoveries have been developed. Of the productsthat exist, all are diagnostic products. To date, we know of no therapeuticproducts based on disease-gene discoveries. If our assumption about the role ofgenes in the disease process is wrong, our gene discovery programs may notresult in products.

 

***Clinical trialsrequired for our product candidates or the products of our customers andpartners are expensive and time-consuming, and their outcome is uncertain.***

 

Before obtaining regulatory approvals for the commercialsale of any of our products under development, we must demonstrate throughpre-clinical studies and clinical trials that the product is safe and effectivefor use in each target indication. Pre-clinical testing and clinicaldevelopment are long, expensive and uncertain processes. It may take severalyears to complete testing for a product and failure can occur at any stage oftesting. The length of time necessary to complete clinical trials variessignificantly and may be difficult to predict. Factors that can cause delay ortermination of our clinical trials include:

 

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

 

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

 

•      delayedapproval of study protocol and pharmacogenomic components of studies byregulatory agencies in different countries, some of which are still developingpolicies with respect to pharmacogenomic testing;

 

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

 

•      delaysin approvals or failure to obtain approval from the pertinent review boards orregulatory authorities;

 

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

 

•      lackof sufficient supply of the product candidate;

 

•      adversemedical events or side effects in treated patients;

 

•      lackof effectiveness of the product candidate being tested; and

 

•      regulatorychanges.

 

Even if we obtain positive results from pre-clinical orclinical trials for a particular product, we may not achieve the same successin future trials of that product. In addition, some or all of the clinicaltrials we undertake may not demonstrate sufficient safety and efficacy toobtain the requisite regulatory approvals, which could prevent the creation ofmarketable products. Our product development costs will increase if we havedelays in testing or approvals, if we need to perform more or larger clinicaltrials than planned or if our trials are not successful. Delays in our clinicaltrials may harm our financial results and the commercial prospects for ourproducts. Delays or termination of clinical trials that we conduct for ourpartners or customers may also harm our financial results as payments underthese contracts may be delayed, reduced or curtailed.

 

***Co-developmentof therapeutic and diagnostic products may be required, and delays in thedevelopment and approval of a commercially available diagnostic may delay drugapproval or impede market acceptance of the therapeutic product.***

 

The use of some of our therapeutic products may bedependent upon the selection of patients using both clinical and geneticmarkers. This may require co-development and clinical testing of thetherapeutic drug and a related diagnostic product. In the United States, drug

 

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approval could be delayed until we successfully obtainFDA approval of the related diagnostic product. In addition, if the diagnostictest cannot be performed on a commercially viable basis, it may impede marketacceptance of our approved therapeutic products.  To successfully co-develop and market a drugand diagnostic we may also need to establish and maintain successfulpartnerships with manufacturing and marketing partners for diagnosticproducts.  If necessary partnerships cannot be established or maintained the development of our therapeutics and/ordiagnostics may be delayed or may fail.

 

***Becauserevenues are concentrated, the loss of a significant customer would harm ourbusiness.***

 

Historically, a substantial portion of our revenue hasbeen derived from contracts with a limited number of significant customers. Ourlargest customer, Roche, accounted for approximately 20% and 32% of the company’sconsolidated revenue in the three-month periods ended June 30, 2005 and 2004,respectively, and 24% and 33% of the company’s consolidated revenue in thesix-month periods ended June 30, 2005 and 2004, respectively. Revenue under ouralliances with Merck accounted for approximately 17% and 17% of the company’sconsolidated revenue in the three-month periods ended June 30, 2005 and 2004,respectively, and 18% and 18% of the company’s consolidated revenue in thesix-month periods ended June 30, 2005 and 2004, respectively. The loss of anysignificant customer may significantly lower our revenues and affect theresources available to support our drug discovery programs.

 

***If we are notable to obtain sufficient additional funding to meet our capital requirements,we may be forced to reduce or terminate our research and product developmentprograms.***

 

We have spent substantial amounts of cash to fund ourresearch and development activities and expect to continue to spend substantialamounts for these activities over the next several years. We expect to use cashto collect, generate and analyze genotypic and disease data from volunteers inour disease-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:

 

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

 

•      ourability to attract customers;

 

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

 

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

 

•      thecosts and timing of regulatory approvals.

 

We have relied on, may continue to rely on partnershipsfor significant funding of our research efforts. In addition, we may seekadditional funding through public or private equity offerings and debtfinancings. We may not be able to obtain additional financing when we need itor the financing may not be on terms favorable to us or our stockholders.Stockholders’ ownership will be diluted if we raise additional capital byissuing equity securities.

 

If we raise additional funds through collaborations andlicensing arrangements, we may have to relinquish rights to some of ourtechnologies or product candidates, or grant licenses on unfavorable terms. Ifadequate funds are not available, we would have to scale back or terminate ourdiscovery and research programs and product development.

 

***If we cannotsuccessfully develop a marketing and sales force or maintain suitablearrangements with third parties to market and sell our products, our ability todeliver products may be impaired.***

 

We currently have no experience in marketing or sellingpharmaceutical products. In order to achieve commercial success for anyapproved product, we must either develop a marketing and sales force, whichwill require substantial additional funds and personnel, or, where appropriateor permissible, enter into arrangements with third parties to market and sellour products. We might not be successful in developing marketing and salescapabilities. Further, we may not be able to enter into marketing and salesagreements with others on acceptable terms, and any such arrangements, ifentered into, may be terminated. If we develop our own marketing and salescapability, it will compete with other companies that currently haveexperienced, well-funded and larger marketing and sales operations. To theextent that we enter into co-promotion or other sales and marketingarrangements with other companies, revenues will depend on the efforts ofothers, which may not be successful.

 

***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 have no experience in manufacturing products forcommercial purposes and do not have manufacturing facilities that can producesufficient quantities of drugs for large scale clinical trials. Accordingly, wemust either develop such facilities, which will require substantial additionalfunds, or rely on contract manufacturers for the production of products fordevelopment and commercial purposes. In order to conduct our currently plannedPhase III clinical trial of DG031, we will have to contract with third partiesto manufacture a sufficient supply of the drug for the trial and to producetablets containing DG031 in amounts sufficient for the clinical trial. While wehave signed contracts with suppliers for the production of DG031 material andtablets for the planned launch of our Phase III clinical trial,

 

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we have not received the finished drug tablets, and we mayfail to secure sufficient supply of the drug in a timely manner over theduration of the trial.

 

The manufacture of our products for clinical trials andcommercial purposes is subject to cGMP regulations promulgated by the FDA. Inthe event that we are unable to develop satisfactory manufacturing facilitiesor obtain or retain third-party manufacturing for our products, we will not beable to commercialize such products as planned. We may not be able to enterinto agreements for the manufacture of future products with manufacturers whosefacilities and procedures comply with cGMP and other regulatory 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

 

***Our reliance onthe Icelandic population may limit the applicability of our discoveries tocertain populations.***

 

The genetic make-up and prevalence of disease generallyvaries across populations around the world. Common complex diseases generallyoccur with a similar frequency in Iceland and other European populations.However, the populations of other nations may be genetically predisposed tocertain diseases because of mutations not present in the Icelandic population.As a result, we and our partners may be unable to develop diagnostic andtherapeutic products that are effective on all or a portion of people with suchdiseases. For our business to succeed, we must be able to apply discoveriesthat we make on the basis of the Icelandic population to other markets.

 

***If we fail toprotect confidential data adequately, we could incur a liability.***

 

Under laws and regulations in force in Iceland, includingapplicable European laws, directives and regulations, all information onindividuals that is used in our population research is anonymized under theprotocols and supervision of the Data Protection Authority of Iceland. If wefail to comply with these laws and regulations, we could lose public supportfor participation in our research and we could be liable to legal action. Anyfailure to comply fully with all confidentiality requirements could lead toliability for damages incurred by individuals whose privacy is violated, theloss of our customers and reputation and the loss of the goodwill andparticipation of the Icelandic population, including healthcare professionals.These eventualities could materially adversely affect our work in Iceland.

 

***Some parts ofour product development services create a risk of liability from clinical trialparticipants and the parties with whom we contract.***

 

Through our wholly owned subsidiary Encode ehf., weconduct clinical trials of products we are developing and contract with drugcompanies and clinical research organizations to perform a wide range ofservices to assist them in bringing new drugs to market. Our services include:

 

•      supervisingclinical trials;

 

•      dataand laboratory analysis;

 

•      patientrecruitment;

 

•      actingas investigators in conducting clinical trials; and

 

If, in the course of these trials or activities,

 

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

 

•      wefail to obtain permission to conduct trials from the appropriate authorities inIceland;

 

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

 

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

 

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

 

•      ourinformatics products violate rights of third parties,

 

then we could be held liable for these eventualities bythe drug companies and clinical research organizations with whom we contract orby study participants. We maintain product liability insurance for claimsarising from the use of products we are developing in clinical trials conductedby Encode and are covered by the product liability insurance of the drugcompanies and clinical research organizations for whom we provide clinicaltrial services for claims arising from the use of their products in suchtrials. Such insurance may be inadequate and in any event would not cover therisk of a customer deciding not to do business with us as a result of poorperformance or claims for a customer’s financial loss as the result of ourfailure to perform our contractual obligations properly.

 

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***Use oftherapeutic or diagnostic products developed as a result of our programs mayresult in product liability claims for which we have inadequate insurance.***

 

The users of any therapeutic or diagnostic products developedby us or our collaborators as a result of our discovery or research programs(including participants in our clinical trials) may bring product liabilityclaims against us. Except as described above with respect to clinical trialsconducted by Encode, we currently do not carry liability insurance to coversuch claims (although we expect to obtain such insurance for our Phase IIItrial of DG031). We are not certain that we or our collaborators will be ableto obtain such insurance or, if obtained, that sufficient coverage can beacquired at a reasonable cost. If we cannot protect against potential liabilityclaims, we or our collaborators may find it difficult or impossible tocommercialize products.

 

***Ourfee-for-service work bears certain risks of liability to our customers.***

 

Our subsidiaries, deCODE chemistry, Inc., deCODEbiostructures, Inc., and Emerald Biosystems, Inc., provide services andproducts for third party customers who pay us on a fee-for-service or productbasis.  In this function, we oftensynthesize compounds and provide recommendations for research direction for ourcustomers.   We also provide contract research services in X-raycrystallographic structure determination of protein-ligand complexes forcustomers, and often recommend targets to customers based on thesedeterminations.

 

We may be liable to our customers for damages if weperform such services negligently or with willful misconduct., or if we providecustomers with defective products.  Wealso may be held liable for failure to meet specifications or failure to complywith other contractual conditions.  Whileour agreements with customers limit our liability and while we carry generalcommercial liability insurance, such contractual limitations may not beeffective in the event of our material breach of the agreements, grossnegligence, or willful misconduct and such insurance may not be adequate.   We also supply compounds for clinical trialsconducted by our customers.   In doingso, we may provide materials requiring certification of compliance with GoodManufacturing Practices (cGMP) regulations applicable to production of suchmaterials.  If we are found not to havecomplied with such requirements, we may incur liabilities related to suchfailures.  If participants in thesetrials suffer personal injury or death from adverse reactions to the testdrugs, we could be held liable to our customers or the participants.  We maintain product liability insurance forclaims arising from the use of products we supply.  However, such insurance may be in adequate.  Failure to perform to customer expectationalso may limit future business from our existing customers, or could result inthe holdback of certain payments due to us.

 

Our facilities where work for customers is conducted aresubject to audits by FDA and by customers. In the event we are found in non-compliance by FDA, there is a risk thatsuch facility may be subject to corrective measures up to and including theclosure of the facility.  Such closurewould have impact on our ability to meet customer obligations as well asobligations relating to our internal programs. Customer audits may lead to disputes regarding compliance withcontractual terms, which could lead to potential disputes and/or liabilities asdescribed above.

 

In addition, we typicallyhave the obligation to maintain the confidentiality of proprietary informationof our customers. While we have systems in place to ensure that suchconfidentiality is protected, because we conduct work on our internal projectsat the same facilities where we work for our customers, there is an increasedrisk that customers may claim that we have violated our confidentialityobligations or used their proprietary information in our proprietary projects.

 

***Increasedleverage as a result of our convertible debt may harm our financial conditionand results of operations.***

 

On June 30, 2005, we have $158.5 million of outstandingdebt as reflected in our balance sheet. We may incur additional indebtedness inthe future and our outstanding 3.5% Senior Convertible Notes do not restrictour future issuance of indebtedness. Our level of indebtedness will haveseveral important effects on our future operations, including, withoutlimitation:

 

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

 

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

 

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

 

Our ability to make payments of principal and interest onour indebtedness depends upon our future performance, which will be subject tothe success of our development and commercialization of new pharmaceuticalproducts, general economic conditions, industry cycles and financial, business andother factors affecting our operations, many of which are beyond our control.If we are not able to generate sufficient cash flow from operations in thefuture to service our debt, we may be required, among other things:

 

•      toseek additional financing in the debt or equity markets;

 

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

 

•      tosell selected assets; or

 

•      toreduce or delay expenditures on planned activities, including but not limitedto clinical trials, and development and commercialization activities.

 

Such measures might not be sufficient to enable us toservice our debt. In addition, any such financing, refinancing or sale ofassets might not be available on economically favorable terms.

 

***We may beunable to hire and retain the key personnel upon whom our success depends.***

 

We depend on the principal members of our management andscientific staff, including Dr. Kari Stefansson, Chairman, President and ChiefExecutive Officer. We have not entered into agreements with any of these peoplethat bind them to a specific period of employment. If any of these peopleleave, our ability to conduct our operations may be negatively affected. Ourfuture success also will depend in part on our ability to attract, hire andretain additional personnel. There is intense competition for such qualifiedpersonnel and we cannot be certain that we will be able to continue to attractand retain such personnel. Failure to attract and retain key personnel couldhave a material adverse effect on us.

 

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

 

We publish our consolidated financial statements in U.S.dollars. Currency fluctuations can affect our financial results because aportion of our cash reserves, our debt and our operating costs are in Icelandickronas. A fluctuation of the exchange rates of the Icelandic krona against theU.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 or payments from collaborative partners.

 

***Our contractsmay terminate upon short notice.***

 

Many of our contracts for research services areterminable on short notice. This means that our contracts could be terminatedfor numerous reasons, any of which may be beyond our control such as areduction or reallocation of a customer’s research and development budget or achange in a customer’s overall financial condition. The loss of a largecontract or multiple smaller contracts, or a significant decrease in revenuederived from a contract, could significantly reduce our profitability andrequire us to reallocate under-utilized physical and professional resources.

 

**Risks Related to Our CollaborativeRelationships**

 

***If we areunable to form and maintain the collaborative relationships that our businessstrategy requires, our programs will suffer and we may not be able to develop******products.***

 

Our strategy for developing products and derivingrevenues from them is dependent, in part, upon our ability to enter intocollaborative arrangements with research collaborators, corporate partners andothers. We may rely on these arrangements both to provide funding necessary toour product development and to obtain goods and services that we require forour product development. We do not have the capacity to conduct large scalePhase III clinical trials and will rely on partnerships or third partycontractors to conduct our Phase III trials, including our currently plannedPhase III trial of DG031. We will rely on these third parties to provide uswith clinical material for the trial and various services necessary to organizeand conduct a multi-center, multinational study, as well as other goods andservices. We have not entered into contracts for all goods and servicesrequired for the Phase III trial of DG031 at this time. Our arrangement forthis and other Phase III trials will be subject to risks described below, withrespect to our collaborative relationships.

 

If our collaborations are not successful or if we are notable to manage multiple collaborations successfully, our programs may suffer.If we increase the number of collaborations, it will become more difficult tomanage the various collaborations successfully and the potential for conflictsamong the collaborators as to rights to the technology and products generatedunder work conducted with us will increase.

 

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

 

We may form collaborative relationships (including relationshipswith clinical research organizations to conduct clinical trials on our behalf) thatwill, in some cases, make us dependent on collaborators for the pre-clinicalstudies and/or clinical trials and for regulatory approval of any products thatwe are developing. Failure of such collaborators to perform under theseagreements properly in a timely manner, or at all, may lead to delays in ourproduct development. In addition, if participants in the trials conducted byour collaborators suffer personal injury or death as a result of actions of thecollaborators, we could be held liable.  Insome cases, our agreements with collaborators typically allow them significantdiscretion in electing whether and how to pursue such activities. We cannotcontrol the amount and timing of resources collaborators will devote to theseprograms or potential products.

 

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Our collaborators may stop supporting our products orproviding services to us if they develop or obtain rights to competingproducts. Disputes may arise in the future over the ownership of rights to anytechnology developed with collaborators. These and other possible disagreementsbetween our collaborators and us could lead to delays in the collaborativeresearch, development or commercialization of products. Such disagreementscould also result in litigation or require arbitration to resolve.

 

**Risks Related to Our Industry**

 

***Concernsregarding the use of genetic testing results may limit the commercial viabilityof any products we develop.***

 

Other companies have developed genetic predispositiontests that have raised ethical concerns. It is possible that employers orothers could discriminate against people who have a genetic predisposition tocertain diseases. Concern regarding possible discrimination may result ingovernmental authorities enacting restrictions or bans on the use of all, orcertain types of, genetic testing. Similarly, such concerns may leadindividuals to refuse to use genetic tests even if permissible. These factorsmay limit the market for, and therefore the commercial viability of, productsthat our collaborators and/or we may develop.

 

***We may not beable to compete successfully with other companies and government agencies inthe development and marketing of products and services.***

 

A number of companies are attempting to rapidly identifyand patent genes that cause diseases or an increased susceptibility todiseases. Competition in this field and our other areas of business, includingdrug discovery and development is intense and is expected to increase. We havenumerous competitors, including major pharmaceutical and diagnostic companies,specialized biotechnology firms, universities and other research institutions, andother government-sponsored entities and companies providing healthcareinformation products. Our collaborators, including Roche and Merck, may alsocompete with us. Many of our competitors, either alone or with collaborators,have considerably greater capital resources, research and development staffsand facilities, and technical and other resources than we do, which may allowthem to discover important genes or develop drugs based on such discoveriesbefore we do. We believe that a number of our competitors are developingcompeting products and services that may be commercially successful and thatare further advanced in development than our potential products and services.To succeed, we, together with our collaborators, must discover disease-predisposinggenes, characterize their functions, develop genetic tests or therapeuticproducts and related information services based on such discoveries, obtainregulatory and other approvals, and launch such services or products beforecompetitors. Even if we or our collaborators are successful in developingeffective products or services, our products and services may not successfullycompete with those of our competitors, including cases where the competingdrugs use the same mechanism of action as our products. Our competitors maysucceed in developing and marketing products and services that are moreeffective than ours or that are marketed before ours.

 

Competitors have established, and in the future mayestablish, patent positions with respect to gene sequences related to ourresearch projects. Such patent positions or the public availability of genesequences comprising substantial portions of the human genome could decreasethe potential value of our research projects and make it more difficult for usto compete. We may also face competition from other entities in gaining accessto DNA samples used for research and development purposes. Our competitors mayalso obtain patent protection or other intellectual property rights that couldlimit our rights, or our customers’ ability, to use our technologies ordatabases, or commercialize therapeutic or diagnostics products. In addition,we face, and will continue to face, intense competition from other companiesfor collaborative arrangements with pharmaceutical and biotechnology companies,for establishing relationships with academic and research institutions and forlicenses to proprietary technology.

 

We expect competition to intensify as technical advancesare made and become more widely known. Our future success will depend in largepart on maintaining a competitive position in the genomic field. Rapidtechnological development may result in products or technologies becomingobsolete before we recover the expenses we incur in developing them.

 

Our ability to compete successfully will depend, in part,on our ability, and that of our collaborators, to:

 

•      developproprietary products;

 

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

 

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

 

•      attractand retain scientific and product development personnel;

 

•      obtainrequired regulatory approvals; and

 

•      manufacture,market and sell products that we develop.

 

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***Changes inoutsourcing trends and economic conditions in the pharmaceutical andbiotechnology industries could adversely affect our growth.***

 

Economic factors and industry trends that affect ourprimary customers, pharmaceutical and biotechnology companies, also affect ourbusiness. For example, the practice of many companies in these industries hasbeen to outsource to organizations like us the conduct of genetic research,clinical research, sales and marketing projects and chemistry and structuralbiology research and development projects. If these industries reduce theirpresent tendency to outsource those projects, our operations, financialcondition and growth rate could be materially and adversely affected. Thesealliances and arrangements are both time consuming and complex and we facesubstantial competition in establishing these relationships. In addition, ourability to generate new business could be impaired by general economicdownturns in our customers’ industries. We have experienced increasing pressureon the part of our customers to reduce expenses, including the use of ourservices as a result of negative economic trends generally and in thepharmaceutical industry. If pharmaceutical and biotechnology companiesdiscontinue or decrease their usage of our services, including as a result ofthe slowdown in the overall U.S. economy, our revenues and earnings could belower than we expect and our revenues may decrease or not grow at historicalrates.

 

***If regulatoryapprovals for products resulting from our gene discovery programs are notobtained, we will not be able to derive revenues from these products.***

 

Government agencies must approve new drugs and diagnosticproducts in the countries in which they are to be marketed. We cannot becertain that we can obtain regulatory approval for any drugs or diagnosticproducts resulting from our gene discovery programs. The regulatory process cantake many years and require substantial resources. Because some of the productslikely to result from our disease research programs involve the application ofnew technologies and may be based upon a new therapeutic approach, variousgovernment regulatory authorities may subject such products to substantialadditional review. As a result, these authorities may grant regulatoryapprovals for these products more slowly than for products using moreconventional technologies. Furthermore, regulatory approval may imposelimitations on the use of a drug or diagnostic product.

 

Even if a product is approved for marketing, it and itsmanufacturer must undergo continuing review. Discovery of previously unknownproblems with a product may have adverse effects on our business, financialcondition and results of operations, including withdrawal of the product fromthe market.

 

***Third partyreimbursement and health care reform policies may reduce market acceptance ofour products.***

 

Our success will depend in part on the price and extentto which we will be paid for our products by government and healthadministration authorities, private health insurers and other third party payers.Reimbursement for newly approved healthcare products is uncertain. Third partypayers, including Medicare in the United States, are increasingly challengingthe prices charged for medical products and services. They are increasinglyattempting to contain healthcare costs by limiting both coverage and the levelof reimbursement for new therapeutic products. We cannot be certain that anythird party insurance coverage will be available to patients for any productswe discover or develop. If third party payers do not provide adequate coverageand reimbursement levels for our products, the market acceptance of theseproducts may be materially reduced.

 

Numerous governments have undertaken efforts to controlgrowing healthcare costs through legislation, regulation and voluntaryagreements with medical care providers and pharmaceutical companies. If costcontainment efforts limit the profits that can be derived from new drugs, ourcustomers may reduce their research and development spending which could reducethe business they outsource to us.

 

***Our operationsinvolve a risk of injury or damage from hazardous materials, and if an accidentwere to occur, we could be subject to costly and damaging liability claims.***

 

In the course of our work, we handle and producehazardous materials and chemicals as well as compounds which may have known orunknown characteristics such as toxicity and reactivity with othercompounds.  Although we have systems inplace to manage such compounds and their characteristics, the risk ofaccidental contamination or injury from these materials cannot be completelyeliminated.  Any such contamination orinjury could result in negative effects to our personnel or facilities, whichcould lead to liabilities as well as impacting our ability to meet customerobligations and conduct our internal programs.

 

**Risks Related to Our IntellectualProperty**

 

***We may not beable to protect the proprietary rights that are critical to our success.***

 

Our success will depend in part on our ability to protectour products, our genealogy database and genotypic data and any otherproprietary databases that we develop and our proprietary software and otherproprietary methods and technologies. Despite our efforts to protect ourproprietary rights, unauthorized parties may be able to obtain and useinformation that we regard as proprietary.

 

While we require employees, business partners, academiccollaborators and consultants to enter into confidentiality agreements, therecan be no assurance that proprietary information will not be disclosed, thatothers will not independently develop substantially equivalent proprietaryinformation and techniques, otherwise gain access to our trade secrets ordisclose such technology, or that we can meaningfully protect our tradesecrets.

 

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Our commercial success will depend in part on obtainingpatent protection. The patent positions of pharmaceutical, biopharmaceuticaland biotechnology companies, including deCODE, are generally uncertain andinvolve complex legal and factual considerations. We cannot be sure that:

 

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

 

•      wewill develop additional proprietary technologies that are patentable;

 

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

 

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

 

If we are unable to obtain patent protection for ourtechnology or discoveries, the value of our proprietary resources may be adverselyaffected.

 

In addition, patent law relating to the scope of claimsin the area of genetics and gene discovery is still evolving and subject touncertainty, including in areas important to us such as patenting ofdiscoveries for the development of therapeutic methods, diagnostic methods andproducts that predict inherited susceptibility to diseases and diagnosticmethods and products that predict drug response and disease progression.Accordingly, the degree of future protection for our proprietary rights isuncertain and, we cannot predict the breadth of claims allowed in any patentsissued to us or others. We could also incur substantial costs in litigation ifwe are required to defend ourselves in patent suits brought by third parties orif we initiate such suits to enforce our own patents against potentialinfringers.

 

Others may have filed and in the future are likely tofile patent applications covering products or technology that are similar oridentical to our products and technology. In addition, others may developcompetitive products outside the protection that may be afforded by the claimsof our patents. We cannot be certain that our patent applications will havepriority over any patent applications of others. The mere issuance of a patent doesnot guarantee that it is valid or enforceable; thus even if we are holding orare granted patents, we cannot be sure that they would be valid and enforceableagainst third parties. Further, a patent does not provide the patent holderwith freedom to operate in a way that infringes the patent rights of others.Any legal action against us or our partners claiming damages and seeking toenjoin commercial activities relating to the affected products and processescould, in addition to subjecting us to potential liability for damages, requireus or our partners to obtain a license in order to continue to manufacture ormarket the affected products and processes. There can be no assurance that weor our partners would prevail in any action or that any license required underany patent would be made available on commercially acceptable terms, if at all.If licenses are not available, we or our partners may be required to ceasemarketing our products or practicing our methods.

 

If expressed sequence tags, single nucleotidepolymorphisms, or SNPs, or other sequence information become publicly availablebefore we apply for patent protection on a corresponding full-length or partialgene, our ability to obtain patent protection for those genes or gene sequencescould be adversely affected. In addition, other parties are attempting torapidly identify and characterize genes through the use of gene expressionanalysis and other technologies. If any patents are issued to other parties onthese partial or full-length genes or gene products or uses for such genes orgene products, the risk increases that the sale of our or our collaborators’potential products or processes may give rise to claims of patent infringement.The amount of supportive data required for issuance of patents for humantherapeutics is highly uncertain. If more data than we have available isrequired, our ability to obtain patent protection could be delayed or otherwiseadversely affected. Even with supportive data, the ability to obtain patents isuncertain in view of evolving examination guidelines, such as the utility andwritten description guidelines that the U.S. Patent and Trademark Office haveadopted.

 

***Our patentprotection for DG031 may provide marketing exclusivity for only a limited term.***

 

The patents we licensed from Bayer for DG031 expire in2009 and 2012. While we will seek to obtain one or more use patents protectingour proprietary rights to specific uses of this compound for a longer period,we cannot be certain that we will obtain such patents or that they willadequately protect us. In addition, although we may seek to extend the term ofone of the patents we licensed from Bayer and to obtain marketing exclusivityunder the Hatch-Waxman Act and equivalent foreign statutes, we cannot be certainthat we will be successful. If we cannot obtain new patents or extend the termof patent protection under one of the patents we licensed from Bayer, theamount of revenues that we will be able to derive from an approved productbased on these patents may be adversely affected.

 

***Any patentprotection we obtain for our products may not prevent marketing of similarcompeting products.***

 

Patents on our products may not prevent our competitorsfrom designing around and developing similar compounds or compounds withsimilar modes of action that may compete successfully with our products. Suchthird party compounds may prove to be superior to our products or gain widermarket acceptance and thus adversely affect any revenue stream that we couldotherwise expect from sales of our products.

 

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***Any patents weobtain may be challenged by producers of generic drugs.***

 

Patents on new drugs, which are also commonly referred toas “branded drugs” or “pioneer drugs,” face increased scrutiny and challengesin the courts from manufacturers of generic drugs who may receive benefits suchas limited marketing co-exclusivity if the challenge is successful. Such patentchallenges typically occur when the generic manufacturer files an AbbreviatedNew Drug Application with the FDA and asserts that the patent or patentscovering the branded drug are invalid or unenforceable, forcing the owner orlicensee of the branded drug to file suit for patent infringement. If anypatents we obtain are subject to such successful patent challenges, ourmarketing exclusivity may be eliminated or reduced in time, which would thusadversely affect any revenue stream that we could otherwise expect from salesof our products.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

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 $0.7 million decrease in the fair value of ourinvestments as of June 30, 2005. Due to the nature of our investments andrelatively short effective maturities of debt instruments, interest rate riskis mitigated. Changes in interest rates do not affect interest expense incurredon the company’s Convertible Notes, because the Convertible Notes bear interestat a fixed rate. Using the price in the latest trade in June 2005, the marketvalue of the Convertible Notes was $136.8 million on June 30, 2005.

 

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% increasein value of the US dollar against the Icelandic krona would result in a loss ofapproximately $0.4 million on our Icelandic krona denominated assets andliabilities. We have historically used derivative financial instruments tohedge these general risks.

 

As of June 30, 2005 we didnot have any financing arrangements that were not reflected in our balancesheet.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

*a)Evaluation of disclosurecontrols and procedures.* Our Chief Executive Officer and our Chief Financial Officerevaluated the effectiveness of our disclosure controls and procedures (asdefined in Rule 13a-15(e) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) as of the end of the fiscal quarter covered bythis Quarterly Report on Form 10-Q. Based upon that evaluation, the ChiefExecutive Officer and the Chief Financial Officer have concluded that as of theend of such fiscal quarter our current disclosure controls and procedures areadequate and effective to ensure that information required to be disclosed inthe reports we file under the Exchange Act is recorded, processed, summarizedand reported on a timely basis.

 

In designing and evaluating our disclosurecontrols and procedures, our management recognizes that any controls and procedures,no matter 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**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

Therehas been no change in the matters reported in our quarterly report on Form 10-Qfor the quarter ended March 31, 2005 except as follows.  On May 13, 2005, the court in the securitiesclass actions filed against deCODE and certain of its officers and directors inSeptember and October 2004 and consolidated in January 2005 approved the Noticeof Agreed Motion and Proposed Order of Voluntary Dismissal filed by theplaintiffs on May 4, 2005, thereby terminating the action.

 

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

OnMay 10, 2005, we held our annual meeting of stockholders. The results of thevoting on the proposals submitted to the stockholders at this meeting were asfollows:

 

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1.

Electionof one Class I Director

 
| **NAME**   | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|------------|------------|------------|------------|--------------|------------|
| Goran Ando |       | 37,077,219 |       | 3,390,007    |       |

 

2.

Ratificationof the appointment of Deloitte & Touche LLP as our independentregistered public accounting firm for the fiscal year ending December 31,2005

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 40,400,152 |       | 53,633      |       | 13,441      |       |

 

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

 

(a)EXHIBITS

 

The following is a list ofexhibits 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).                                                                     |
|                |       |                                                                                                                                                                                                                                                                |
| 31.1                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 31.2                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 32.1                |       | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |

 

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

 

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**SIGNATURES**

 

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

 
| Dated:  August 5, 2005                |
|--------------------------------------------|
|                                       |
| 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) |   |

 

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| **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).                                                                     |
|                |       |                                                                                                                                                                                                                                                                |
| 31.1                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 31.2                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 32.1                |       | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |

 

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

 

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