**UNITEDSTATES**

**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, 2004**

 

**OR**

 

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

 

**FOR THE TRANSITION PERIOD FROM                     TO                    **

 

**COMMISSIONFILE NUMBER 000-30469**

 

**deCODE****genetics, 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 whether the registrant: (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling 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 30, 2004 was54,523,043 shares of common stock $.001 par value.

 

 

----

 

**deCODE****genetics, Inc.**

 

**INDEX**

 

 
| PART I.            | FINANCIAL  INFORMATION                                                                                                  |   |
|--------------------|-------------------------------------------------------------------------------------------------------------------------|--------|
|               |                                                                                                                    |   |
| Item 1.            | Financial Statements  (unaudited)                                                                                       |   |
|               |                                                                                                                    |   |
|               | Condensed  Consolidated Statements of Operations for the three and six-month periods  ended June 30, 2004 and 2003 |   |
|               |                                                                                                                    |   |
|               | Condensed  Consolidated Balance Sheets as of June 30, 2004 and December 31,  2003                             |   |
|               |                                                                                                                    |   |
|               | Condensed  Consolidated Statements of Cash Flows for the six-month periods ended  June 30, 2004 and 2003           |   |
|               |                                                                                                                    |   |
|               | Notes  to Condensed Consolidated Financial Statements                                                                   |   |
|               |                                                                                                                    |   |
| Item  2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             |   |
|               |                                                                                                                    |   |
| Item  3.           |  Quantitative and Qualitative Disclosures  about Market Risk ...                                                   |   |
|               |                                                                                                                    |   |
| Item 4.            | Controls  and Procedures                                                                                                |   |
|               |                                                                                                                    |   |
| PART II.           | OTHER  INFORMATION                                                                                                      |   |
|               |                                                                                                                    |   |
| Item 1.            | Legal  proceedings                                                                                                      |   |
|               |                                                                                                                    |   |
| Item 2.            | Changes in Securities, Use of  Proceeds and Issuer Purchases of Equity Securities                                       |   |
|               |                                                                                                                    |   |
| Item 6.            | Exhibits and Reports  on Form 8-K                                                                                       |   |
|               |                                                                                                                    |   |
|               | (a) Exhibits                                                                                                            |   |
|               |                                                                                                                    |   |
|               | (b)  Reports on Form 8-K                                                                                                |   |
|               |                                                                                                                    |   |
| Signatures         |                                                                                                                    |
|               |                                                                                                                    |   |
| Index  to Exhibits |                                                                                                                    |

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM 1.****FINANCIAL STATEMENTS**

 

**deCODE****genetics, Inc**.

**CONDENSED CONSOLIDATED STATEMENTS OF OPE****RATIONS**

(in thousands, except share and per share amounts)

unaudited

 

 
| ** **                                                          | ** ** | **FOR THE THREE MONTHS  ENDED JUNE 30,** | ** ** | **FOR THE SIX MONTHS  ENDED JUNE 30,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| REVENUE                                                             |       | $                                             | 9,635      |                                        | $          | 10,536 |   | $ | 19,917 |   | $ | 22,378 |   |
|                                                                |       |                                          |       |                                        |       |   |   |   |   |
| OPERATING EXPENSES                                                  |       |                                          |       |                                        |       |   |   |   |   |
|                                                                |       |                                          |       |                                        |       |   |   |   |   |
| Cost of revenue, including  collaborative programs             |       | 10,338                                        |       | 11,868                                      |       | 21,512 |   | 25,536 |   |
| Research and development –  proprietary programs          |       | 5,385                                         |       | 4,829                                       |       | 9,644 |   | 10,832 |   |
| Selling, general and administrative                                 |       | 5,589                                         |       | 3,809                                       |       | 9,852 |   | 8,066 |   |
| Employee termination costs                                          |       | 0                                             |       | 306                                         |       | 0 |   | 791 |   |
| Total operating expense                                             |       | 21,312                                        |       | 20,812                                      |       | 41,008 |   | 45,225 |   |
| Operating loss                                                      |       | (11,677                                       | )          | (10,276                                     | )          | (21,091 | ) | (22,847 | ) |
| Interest income                                                     |       | 746                                           |       | 299                                         |       | 981 |   | 654 |   |
| Interest expense                                                    |       | (2,113                                        | )          | (861                                        | )          | (3,312 | ) | (1,777 | ) |
| Other non-operating income and  (expense), net                 |       | (235                                          | )          | 606                                         |       | (1,893 | ) | 696 |   |
| Net Loss                                                            |       | $                                             | (13,279    | )                                           | $          | (10,232 | ) | $ | (25,315 | ) | $ | (23,274 | ) |
|                                                                |       |                                          |       |                                        |       |   |   |   |   |
| Basic and diluted net loss per share                                |       | $                                             | (0.25      | )                                           | $          | (0.20 | ) | $ | (0.48 | ) | $ | (0.45 | ) |
|                                                                |       |                                          |       |                                        |       |   |   |   |   |
| Shares used in computing basic and  diluted net loss per share |       | 53,543,747                                    |       | 51,282,154                                  |       | 53,235,623 |   | 51,219,783 |   |

 

Theaccompanying notes are an integral part of the condensed consolidated financialstatements.

 

3

----

 

**deCODE****genetics, Inc.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

(in thousands, except share amounts) 

unaudited

 
| ** **                                                                                                                                                                                                                                               | ** ** | **JUNE 30,   2004** | ** ** | **DECEMBER 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                                                                                   |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                                                                                          |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                |       | $                        | 161,666    |                        | $          | 68,669 |   |
| Marketable securities and short-term  investments                                                                                                                                                                                                        |       | 58,600                   |       | 0                           |       |
| Receivables                                                                                                                                                                                                                                              |       | 4,761                    |       | 6,498                       |       |
| Other current assets                                                                                                                                                                                                                                     |       | 5,285                    |       | 5,894                       |       |
| Total current assets                                                                                                                                                                                                                                     |       | 230,312                  |       | 81,061                      |       |
| Restricted cash                                                                                                                                                                                                                                          |       | 6,000                    |       | 6,000                       |       |
| Property and equipment, net                                                                                                                                                                                                                              |       | 67,380                   |       | 71,590                      |       |
| Goodwill                                                                                                                                                                                                                                                 |       | 8,863                    |       | 8,863                       |       |
| Other long-term assets and deferred charges                                                                                                                                                                                                              |       | 9,935                    |       | 15,961                      |       |
| Total assets                                                                                                                                                                                                                                             |       | $                        | 322,490    |                        | $          | 183,475 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                |       |                     |       |                        |       |
| Current liabilities:                                                                                                                                                                                                                                     |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                         |       | $                        | 4,247      |                        | $          | 5,353 |   |
| Accrued expenses and other current  liabilities                                                                                                                                                                                                          |       | 10,272                   |       | 7,189                       |       |
| Short-term borrowings                                                                                                                                                                                                                                    |       | 4,500                    |       | 6,500                       |       |
| Current portion of capital lease  obligations                                                                                                                                                                                                            |       | 3,696                    |       | 5,741                       |       |
| Current portion of long-term debt                                                                                                                                                                                                                        |       | 4,895                    |       | 4,893                       |       |
| Deferred revenue                                                                                                                                                                                                                                         |       | 8,200                    |       | 10,518                      |       |
| Total current liabilities                                                                                                                                                                                                                                |       | 35,810                   |       | 40,194                      |       |
| Capital lease obligations, net of current  portion                                                                                                                                                                                                       |       | 1,724                    |       | 2,520                       |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                   |       | 43,134                   |       | 43,854                      |       |
| 3.5% senior convertible notes                                                                                                                                                                                                                            |       | 150,000                  |       | 0                           |       |
| Deferred revenue                                                                                                                                                                                                                                         |       | 7,917                    |       | 3,500                       |       |
|                                                                                                                                                                                                                                                     |       |                     |       |                        |       |
| Commitments and contingencies                                                                                                                                                                                                                            |       |                     |       |                        |       |
|                                                                                                                                                                                                                                                     |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Preferred stock, $0.001 par value;                                                                                                                                                                                                                       |       |                     |       |                        |       |
| Authorized: 6,716,666 shares Issued and  outstanding: none                                                                                                                                                                                               |       | 0                        |       | 0                           |       |
| Common stock, $0.001 par value;                                                                                                                                                                                                                          |       |                     |       |                        |       |
| Authorized: 100,000,000 shares; Issued:  54,521,730 and 54,003,970 shares at June 30, 2004 and December 31,  2003, respectively; Outstanding: 54,521,730 and 53,735,230 shares at  June 30, 2004 and December 31, 2003, respectively |       | 55                       |       | 54                          |       |
| Additional paid-in capital                                                                                                                                                                                                                               |       | 442,864                  |       | 430,489                     |       |
| Notes receivable                                                                                                                                                                                                                                         |       | (3,339                   | )          | (4,240                      | )          |
| Deferred compensation                                                                                                                                                                                                                                    |       | (151                     | )          | (572                        | )          |
| Accumulated deficit                                                                                                                                                                                                                                      |       | (355,525                 | )          | (330,210                    | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                   |       | 1                        |       | 3                           |       |
| Treasury stock, 0 and 268,740 shares stated  at cost at June 30, 2004 and December 31, 2003, respectively                                                                                                                                      |       | 0                        |       | (2,117                      | )          |
| Total stockholders’ equity                                                                                                                                                                                                                          |       | 83,905                   |       | 93,407                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                          |       | $                        | 322,490    |                        | $          | 183,475 |   |

 

Theaccompanying notes are an integral part of the condensed consolidated financialstatements.

 

4

----

 

**deCODE****genetics, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF CAS****H FLOWS**

(in thousands)

unaudited

 
| ** **                                                                   | ** ** | **FOR THE SIX-MONTHS ENDED JUNE 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |       |                                       |       |   |   |
| Net loss                                                                     |       | $                                          | (25,315    | ) | $ | (23,274 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                       |       |   |   |
| Depreciation and amortization                                                |       | 5,637                                      |       | 7,185 |   |
| Amortization of deferred stock compensation                                  |       | 813                                        |       | 1,098 |   |
| Loss on disposal of equipment                                                |       | 24                                         |       | 51 |   |
| Charges for write-down of obsolete and  excess materials and supplies        |       | 8                                          |       | 797 |   |
| (Gain)loss on  derivative financial instruments..                            |       | 1,465                                      |       | (1,163 | ) |
| Other                                                                        |       | 355                                        |       | 220 |   |
| Changes in operating assets and  liabilities:                                |       |                                       |       |   |   |
| Receivables and other assets                                                 |       | 3,216                                      |       | (141 | ) |
| Accounts payable, accrued expenses and  other current liabilities            |       | 2,098                                      |       | (1,276 | ) |
| Deferred research revenue                                                    |       | 8,417                                      |       | (1,474 | ) |
| Other                                                                        |       | (22                                        | )          | 0 |   |
| Net cash used in operating activities                                        |       | (3,304                                     | )          | (17,977 | ) |
|                                                                         |       |                                       |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                       |       |   |   |
| Purchase of property and equipment                                           |       | (967                                       | )          | (502 | ) |
| Purchase of marketable securities and  short-term investments                |       | (58,600                                    | )          | 0 |   |
| Proceeds from sale of equipment                                              |       | 39                                         |       | 46 |   |
| Net cash used in investing activities                                        |       | (59,528                                    | )          | (456 | ) |
|                                                                         |       |                                       |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                       |       |   |   |
| Debt refinancing cost                                                        |       | (478                                       | )          | 0 |   |
| Proceeds from financing of property and  equipment                           |       | 0                                          |       | 4,750 |   |
| Proceeds from convertible debt offering  (net)                               |       | 143,770                                    |       | 0 |   |
| Issuance of common stock                                                     |       | 7,783                                      |       | 102 |   |
| Proceeds from notes receivable for common  stock                             |       | 901                                        |       | 65 |   |
| Proceeds from swap close-out                                                 |       | 9,720                                      |       | 0 |   |
| Payments on short-term borrowings                                            |       | (2,000                                     | )          | 0 |   |
| Installment payments on capital lease and  long-term debt obligations        |       | (3,867                                     | )          | (3,087 | ) |
| Net cash provided by financing activities                                    |       | 155,829                                    |       | 1,830 |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | 92,997                                     |       | (16,603 | )  |
| Cash and cash equivalents at beginning of  period                            |       | 68,669                                     |       | 87,244 |   |
| Cash and cash equivalents at end of period                                   |       | $                                          | 161,666    |   | $ | 70,641 |   |

 

Theaccompanying notes are an integral part of the condensed consolidated financialstatements.

 

5

----

 

**deCODE****genetics, Inc.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIA****L STATEMENTS**

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

 

## ***The Company***

 

References in this report todeCODE and “we” and “us” refer to deCODE genetics, Inc., a Delaware company,and deCODE genetics, Inc.’s wholly owned subsidiary, Islensk erfdagreiningehf., an Icelandic company registered in Reykjavik, and its subsidiaries Encodeehf., deCODE Cancer ehf. and Vetrargardurinn ehf. aswell as deCODE genetics, Inc.’s wholly owned subsidiary, MediChem LifeSciences, Inc., a Delaware corporation, and its subsidiaries MediChem Research,Inc., ThermoGen, Inc., Emerald BioStructures, Inc., Advanced X-Ray AnalyticalServices, Inc. and MediChem Management, Inc.

 

With its headquarters inReykjavik, Iceland, deCODE is a population genetics company developing drugsand DNA-based diagnostics based upon its discoveries in the inherited causes ofcommon diseases. deCODE’s population approach andresources have enabled it to isolate gene and targets directly involved in thedevelopment of many of the biggest challenges to public health.  deCODE is focused onturning these findings into a pipeline of products which it believes will beable to combat the cause of disease, not just the signs and symptoms. deCODE’s customers include major pharmaceutical companies,biotechnology firms, pharmacogenomics companies, universities and otherresearch institutions. deCODE’s business is global,with its principal markets in the United States and in Europe.

 

deCODE’s primary focus is on the discovery andcommercialization of novel therapeutics based on genetic information identifiedin our population-based gene discovery work. Through the acquisition inMarch 2002 of MediChem Life Sciences and its subsidiary, EmeraldBiostructures, now its pharmaceuticals and biostructures groups, deCODE hasintegrated capabilities for applying genetic findings to the development ofdrugs, both through its own programs and in alliance with corporate partners.deCODE is also applying the links it has identified between genetic factors anddisease to create DNA based tests which can also be used to identify patientswith increased risk of developing a disease or to predict which patients willrespond well to a given drug therapy. deCODE believes that such tests will become a standard part ofhealthcare within the coming decade, making it possible to gauge individualpredisposition to a particular illness and to design effective preventivestrategies; to complement traditional clinical diagnoses; and to identifypatients who are likely to respond or not respond to particular drugs.

 

In addition to conductingwork on our targets in deCODE’s collaborative and internal programs, thepharmaceuticals group provides drug discovery work for our fee-for-servicecustomers.  deCODE’s other serviceofferings include protein crystallization products and protein structure analysiscontract services through its Seattle-based biostructures group;pharmacogenomics and clinical trials services through its wholly-ownedsubsidiary Encode; and DNA analysis services through its genotyping laboratoryin Reykjavik.

 

## ***Basis of Presentation***

## *** ***

The unaudited condensedconsolidated financial statements included herein have been prepared by deCODE,pursuant to the rules and regulations of the Securities and ExchangeCommission. Certain information and disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted pursuant to suchrules and regulations. The condensed consolidated balance sheet as ofDecember 31, 2003 has been derived from the audited financial statementsas of that date, but does not include all disclosures required by accountingprinciples generally accepted in the United States of America. deCODE believes the disclosures included in the condensedconsolidated financial statements when read in conjunction with the financialstatements and the notes thereto included in deCODE’s Annual Report on Form10-K are adequate to make the information presented not misleading.

 

Certain reclassifications have been made in the three and six-monthperiods ended June 30, 2003 to be consistent with the currentpresentation.  These financial statementsare reported in United States dollars, deCODE’s functional currency, andprepared in accordance with accounting principles generally accepted in theUnited States of America.

 

The condensed consolidatedfinancial statements have been prepared on the same basis as the annualfinancial statements and, in the opinion of management, reflect alladjustments, which include only normal recurring adjustments, necessary for afair presentation of deCODE’s financial position, results of operations andcash flows for the periods presented. The results of operations for the threeand six month periods ended June 30, 2004 and 2003 are not necessarilyindicative of the results that may be expected for any other interim period orfor the full fiscal year.

 

***Revenue***

 

deCODE records revenue provided that thereis persuasive evidence that an arrangement exists, the price is fixed anddeterminable and collectibility is reasonably assured.  deCODE has enteredinto research, development and commercialization alliances and collaborationswith major pharmaceutical and biotechnology companies.  The key components of the commercial terms ofsuch

 

6

----

 

alliance arrangements typically include oneor more of the following:  researchfunding; up-front, exclusivity, technology access, and technology developmentfees; milestone payments; license or commercialization fees; and royalties orprofit sharing from the commercialization of products.

 

deCODE’s revenues fromresearch and development collaboration agreements are recorded and recognizedin accordance with the applicable performance requirements and terms of therespective contracts, generally either (i) as contract research costs areincurred, usually ratably over the period of effort, (ii) according to thelevel of efforts expended based on the ratio of contract research costsincurred to expected total costs, or (iii) upon the achievement of substantivemilestones.   deCODE’saccounting recognition policies with respect to each significant element of ourrevenue is summarized as follows:

 

*Research funding and other service fees.* Research funding is recognized as earned, typically ratably over theperiod of effort.  Funding payments arenot refundable in the event that the related efforts are not successful.  Other service revenues from negotiated ratecontracts are recognized based upon the terms of the underlying contractgenerally either (i) on a per diem basis as services are rendered; (ii) on thebasis efforts expended, generally upon the ratio of costs incurred to totalexpected costs of providing the service; or (iii) upon completion of theservice rendered.  Any losses oncontracts are provided for when they are determinable.  Included in revenue are billings to customersfor the cost of materials purchased by deCODE.

 

*Milestonepayments.*  For contracts where (i) the milestone eventis substantive, (ii) there is substantial effort involved in achieving themilestone, (iii) the milestone payment amount is commensurate with themagnitude of the related achievement, and (iv) the associated follow-on revenuestreams bear a reasonable relationship to one another deCODE recognized revenueusing the substantive milestone method. Under the substantive milestone methoddeCODE records revenue when the milestone has been achieved and payment is dueand payable under the terms of the respective agreement and deCODE recognizesrevenue when acknowledgement of having achieved applicable performancerequirements is received from the collaborator. Milestone payments without theabove characteristics are recognized on a retrospective basis over thecontractual term of the underlying agreement.

 

*Up-front,exclusivity, technology access, and technology development fees*.  deCODErecognizes revenue from non-refundable fees not specifically tied to a separateearnings process ratably over the expected customer relationship period orestimated period of performance. Changes in estimates could impact revenue inthe period the estimate is changed.  IfdeCODE’s estimate of the period of performance shortens or lengthens, theamount of revenue we recognize from such non-refundable fees not specificallytied to a separate earnings process could increase or decrease in the periodthe change in estimate becomes known; future related revenues would be adjustedaccordingly.

 

In November 2002, theEmerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21,“Accounting for Revenue Arrangements with Multiple Deliverables” (EITF No.00-21).  EITF No. 00-21 provides guidanceon how to account for arrangements that involve the delivery or performance of multipleproducts, services and/or rights to use assets. The provisions of  EITF No. 00-21were applicable to revenue arrangements entered into fiscal periods beginningafter June 15, 2003.  deCODE’sadoption of EITF No. 00-21 did not impact revenue for the year endedDecember 31, 2003 or the three and six months ended June 30, 2004;however, this pronouncement will impact the timing of revenue in the future,including the recognition of milestone payments received.

 

Significant elements of ourrevenue are summarized as follows:

 
| ** **                                                                 | ** ** | **For the Three Months   Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                                       | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                             | ** ** |
|                                                                       |       |                                           |       |                                        |       |   |   |   |   |
| Research funding and other service fees                                    |       | $                                              | 7,606      |                                        | $          | 8,756 |   | $ | 15,503 |   | $ | 17,357 |   |
| Milestone payments                                                         |       |                                           | 56         |                                        |       | 67 |   |   | 221 |   |   | 1,432 |   |
| Up-front, exclusivity, technology access,  and technology development fees |       | 1,000                                          |       | 1,000                                       |       | 2,000 |   | 2,000 |   |
| Other                                                                      |       | 973                                            |       | 713                                         |       | 2,193 |   | 1,589 |   |
|                                                                       |       | $                                              | 9,635      |                                        | $          | 10,536 |   | $ | 19,917 |   | $ | 22,378 |   |

 

In general, prerequisitesfor billings are established by contractual terms including predeterminedpayment schedules, the achievement of contract milestones, or submission ofappropriate billing detail.  Deferredrevenue represents amounts billed in accordance with contract terms but not yetrecognized according to our accounting policy. Unbilled costs and fees arisewhen revenue has been recognized but customers have not been billed.

 

7

----

 

Two of deCODE’s executiveofficers own an aggregate 37.5% of the share capital of Prokaria ehf. (Prokaria) during the six-monthperiods ended June 30, 2004 and 2003. deCODE provides Prokaria certain sequencing and advisory services inexchange for fees and recognized $0 and $7,000 in revenue in respect of suchsequencing services provided during the six month-periods ended June 30,2004 and 2003, respectfully.

 

***Collaborations***

 

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

 

*Therapeutics*.In 1998 deCODE entered into a research collaboration and cross-licenseagreement with Roche, which terminated in 2002, under which deCODE identifiedkey genetic factors involved in ten common diseases: osteoarthritis,Alzheimer’s disease, schizophrenia, PAOD, stroke, osteoporosis, obesity,anxiety, non-insulin-dependent diabetes and rheumatoid arthritis. InJanuary 2002, deCODE entered into a new three-year agreement with Rochefocused on turning the achievements of the 1998 gene discovery collaborationinto novel therapeutics. The 2002 agreement provided that deCODE wouldcollaborate with respect to four diseases that had been the subject of the 1998agreement.  deCODEis currently collaborating on two of those diseases.  Under the 2002 agreement deCODE has received$18,000,000 in research funding and may receive an additional $2,000,000 inresearch funding during the remainder of the term of the agreement.  The agreement provides that upon thedevelopment of specified compounds during the term of the agreement and for aspecified period thereafter deCODE may receive milestone payments, the amountof which will depend on the type of compound developed.  In addition, deCODE will be entitled toreceive royalties on the sales of drugs that are developed.

 

*Diagnostics.*  InJune 2001, deCODE signed a five-year alliance with Roche’s diagnosticsdivision to develop and market DNA-based diagnostics for major diseases. Morerecently deCODE has added research programs aimed at developing diagnostics topredict drug response for major therapeutics used to treat those diseases, inorder to help select the most effective treatment of those available. Under theagreement we have received $31,750,000 in research funding, up-front fees andmilestone payments. deCODE may receive $12,500,000 in additional researchfunding over the remainder of the term of the agreement as well as milestonepayments upon the achievement of research and development milestones androyalties on the sales of diagnostic products developed.

 

Revenues from these alliances with Roche amounted to $3.1 million and$4.1 million for the three-month periods ended June 30, 2004 and 2003,respectively, representing 32% and 39% of consolidated revenue for thethree-month periods ended June 30, 2004 and 2003, respectively, and $6.5million and $9.5 million for the six-month periods ended June 30, 2004 and2003, respectively, representing 33% and 43% of consolidated revenue for thesix-month periods ended June 30, 2004 and 2003, respectively.  Costs incurred in connection with thesecollaborative programs with Roche amounted to $4.4 million and $6.0 million forthe three-month periods ended June 30, 2004 and 2003, respectively, and$9.7 million and $13.1 million for the six-month periods ended June 30,2004 and 2003, respectively.

 

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

 

*Obesity*.  In September 2002, deCODE entered intoan alliance with Merck aimed at developing new treatments for obesity. Underthe alliance, deCODE is combining our research efforts in the genetics ofobesity to identify, validate and prioritize a series of drug targets to takeinto development.  Under the terms of thethree-year agreement, which can be extended on a year-to-year basis upon theconsent of the parties, deCODE has received research funding, technology accessfees and milestone payments in the aggregate amount of $16,475,000 and mayreceive research funding and technology access fees in the future of$8,500,000.  In addition, deCODE mayreceive further research milestone payments and may receive milestone paymentsas compounds developed under the alliance advance in the development processand royalties on successfully marketed drugs. Merck may terminate the agreement at any time upon 90 days’ notice orafter September 26, 2004 upon 30 days’ notice in the event that theresearch program fails to achieve certain specified goals.

 

Revenues from this alliance withMerck amounted to $1.6 million and $1.6 million for thethree-month periods ended June 30, 2004 and 2003, respectively, and $3.5million and $3.3 million for the six-month periods ended June 30, 2004 and2003, respectively.  Costs incurred inconnection with this alliance with Merck amounted to $1.3 million and $1.4million for the three-month periods ended June 30, 2004 and 2003,respectively, and $2.5 million and $3.1 million for the six-month periods endedJune 30, 2004 and 2003, respectively.

 

*Information Rich Clinical Trials*.  In February 2004, deCODE entered into anagreement with Merck under which deCODE will conduct information-rich clinicaltrials on a range of Merck’s developmental compounds. The term of the allianceis seven years, subject to termination by Merck after five years. deCODE will, at any given point over the course of thealliance, be conducting concurrent trials on as many as five Merckcompounds.  The collaboration involvedthree agreements: (a) License and Research Collaboration Agreement; (b) a Stockand Warrant Purchase Agreement; and (c) a Warrant Agreement.   Under the terms of the License and ResearchCollaboration Agreement, deCODE will receive royalties on sales of drugs anddiagnostics developed as part of the alliance, will receive milestone paymentsas compounds or pharmacogenomic tests reach the market, will receive researchfunding for the clinical development of compounds and pharmacogenomic analysis,and received a one-time technology access fee of $10,000,000. There is acontingency clause on the technology access fee if deCODE rejects the first twonon-exclusive development

 

8

----

 

compounds that Merck presents to thecollaboration, then Merck has the right to request a refund of $2.5 million ofthe technology access fee.  Under theterms of the Stock and Warrant Purchase Agreement, Merck has purchased 689,703shares of deCODE’s common stock at a price of $14.50 per share or $10 million,which represents a premium of $2.7 million to the fair market value of thestock on the effective date of the agreement ($10.60).  Accordingly, of the $10 million cashreceived, we have ascribed $7.3 million to the common stock and $2.7 millionpremium to deferred revenue.  Under theterms of the Warrant Agreement, deCODE has issued Merck a warrant to purchaseup to 1,724,257 of additional shares of our common stock at an exercise priceof $29.00 per share over the next five years. The warrant shall be exercisableat the option of Merck as to 344,851 shares for a period of 30 days commencingon the first, second, third, fourth and fifth anniversaries of the WarrantAgreement with the final portion of warrants expiring in March 2009.  Any portion of this warrant that is notexercised during an applicable exercise period shall expire and be of nofurther force or effect. The warrant was valued at $6.3 million using a BlackScholes model with the following assumptions: lives of one to five years, risk free interest rates of 1.24% to 3.07%,a volatility of 90% and no dividend yield. The one-time technology access fee and the premium portion of the equitypurchase together with the estimated fair value of the warrant have beendeferred and the $6.4 million net amount is included in deferred revenue atJune 30, 2004 and will be recognized as revenue according to level ofefforts over the seven-year development term. Merck has identified the first compound to be initiated into clinicaltrials and deCODE is working with Merck to complete the necessary protocols andworkplans and expect to have the approvals in place during the third quarter of2004.  As such, no revenue was recognizedin 2004 and costs incurred of $.1 million were deferred as of June 30,2004.

 

# ***Cost of Revenue, includingCollaborative Programs***

# ** **

deCODE’s cost of revenue iscomprised of costs of services provided to customers and collaborators,including the entirety of costs incurred in connection with programs that havebeen partnered and on which we receive research funding.  At times, deCODE may dedicate additional resourcesand incur costs in addition to costs covered by research funding received insuch collaborative programs.  Majorcomponents of deCODE’s cost of revenue include personnel costs, namelysalaries, benefits and stock-based compensation; materials and supplies;services contracted for research activities; other third-party fees and costs;depreciation of property and equipment; amortization of patents and otherintangible assets; and items of overhead, including allocations of various administrativeand facilities related costs.

 

# ***Research and Development –Proprietary Programs***

# ** **

In accordance with SFAS No. 2,“Accounting for Research and Development Costs,” research and development costsare charged to expense when incurred.  deCODE’s research and development expenses consist of thecosts of its own proprietary programs and consisting  of the following:

 
| ** **                                       | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                            | ** ** |
|                                             |       |                                          |       |                                        |       |   |   |   |   |
| Salaries and other personnel costs               |       | $                                             | 2,407      |                                        | $          | 2,139 |   | $ | 4,360 |   | $ | 4,612 |   |
| Materials and supplies                           |       | 844                                           |       | 587                                         |       | 1,363 |   | 1,509 |   |
| Contractor services and other third party  costs |       | 653                                           |       | 516                                         |       | 1,216 |   | 1,107 |   |
| Overhead expenses                                |       | 547                                           |       | 474                                         |       | 935 |   | 1,269 |   |
| Depreciation and amortization                    |       | 873                                           |       | 985                                         |       | 1,632 |   | 2,090 |   |
| Stock-based compensation and remuneration        |       | 61                                            |       | 128                                         |       | 138 |   | 245 |   |
|                                             |       | $                                             | 5,385      |                                        | $          | 4,829 |   | $ | 9,644 |   | $ | 10,832 |   |

 

## ***Stock-Based Compensation and Remuneration***

## *** ***

deCODE follows SFAS No. 123, “Accounting forStock-Based Compensation” (SFAS No. 123). The provisions of SFAS No. 123 allowcompanies to either expense the estimated fair value of stock options grantedto employees or to follow the intrinsic value method set forth in AccountingPrinciples Board Opinion 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 fair valueof stock options granted to non-employees. deCODE has elected to follow theintrinsic value method in accounting for its employee stock options and followsthe fair value method in accounting for its non-employee stock options.

 

9

----

 

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,** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                       | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(In thousands)**                             | ** ** |
| Research and development expense   |       | $                                              | 147        |                                        | $          | 314 |   | $ | 395 |   | $ | 636 |   |
| General and administrative expense |       | 405                                            |       | 232                                         |       | 418 |   | 462 |   |
| Total                              |       | $                                              | 552        |                                        | $          | 546 |   | $ | 813 |   | $ | 1,098 |   |

 

Had compensation cost forall stock options been determined based on the fair value at the grant date forawards consistent with the provisions of SFAS No. 123, as amended by SFAS No.148, “Accounting for Stock-Based Compensation — Transition and Disclosure — anamendment of FASB Statement No. 123” (SFAS 148), deCODE’s net loss and basicand diluted net loss per share would have been changed to the pro forma amountsindicated below:

 
| ** **                                                                                        | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                        | ** ** | **(In thousands, except per share amounts)**  | ** ** |
|                                                                                              |       |                                          |       |                                        |       |   |   |   |   |
| Net loss attributable to common  stockholders — as reported                                  |       | $                                             | (13,279    | )                                           | $          | (10,232 | ) | $ | (25,315 | ) | $ | (23,274 | ) |
| Add: Stock-based compensation expense  included in reported net loss                              |       | 552                                           |       | 546                                         |       | 813 |   | 1,098 |   |
| Deduct: Total stock-based compensation  expense determined under fair value method for all awards |       | (1,451                                        | )          | (1,407                                      | )          | (2,891 | ) | (2,593 | ) |
| Net loss — proforma                                                                          |       | $                                             | (14,178    | )                                           | $          | (11,093 | ) | $ | (27,393 | ) | $ | (24,769 | ) |
| Basic and diluted net loss per share-as  reported                                                 |       | $                                             | (0.25      | )                                           | $          | (0.20 | ) | $ | (0.48 | ) | $ | (0.45 | ) |
| Basic and diluted net loss per  share-proforma                                                    |       | (0.26                                         | )          | (0.22                                       | )          | (0.51 | ) | (0.48 | ) |

 

The effects of applying theprovisions of SFAS No. 123 on net loss and net loss per share as stated aboveis not necessarily representative of the effects on reported income or loss forfuture years due to, among other things, the vesting period of the stockoptions and the fair value of additional stock options that may be granted in futureyears.

 

In January andFebruary 2004, deCODE granted options to purchase 216,967 shares of commonstock to employees and a director under the 2002 Equity Incentive Plan.

 

In May and June 2004,deCODE granted options to purchase 550,267 shares of common stock to employeesand 31,500 shares to consultants under the 2002 Equity Incentive Plan.  The options granted to the consultantsqualified for variable accounting treatment under Emerging Issues Task ForceIssue No. 96-18 (“EITF 96-18”) and were valued using a Black Scholes model, 90%volatility, and a 10 year life.  The fairvalue of these grants was $294,000 and is subject to re-measurement until allthe options are vested.  The compensationcharge will be taken over the term of the consulting agreement.

 

In June 2004, inconjunction with a severance agreement with an executive officer, certain prioroption grants were modified resulting in a charge of $392,000 in the quarterending June 30, 2004.

 

## ***Computation of Net Loss PerCommon Share***

 

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

 

10

----

 

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 as their inclusion would have been antidilutive were:

 
| ** **                                                                     | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                     | ** ** | **(Shares)**            | ** ** | **(Shares)**            | ** ** |
| Warrants to purchase shares of common stock                                    |       | 3,124,724               |       | 1,851,300               |       |
| Options to purchase shares of common stock                                     |       | 4,728,280               |       | 2,288,000               |       |
| Restricted shares with an associated  outstanding non-recourse promissory note |       | 1,229,456               |       | 2,226,622               |       |
| 3.5% senior convertible notes                                                  |       | 10,714,286              |       | 0                       |       |
|                                                                           |       | 19,796,746              |       | 6,365,922               |       |

 

In February 2004, deCODE issued a warrant to purchase 1,724,257shares of common stock at $29.00 per share over five years to a collaborator inconnection with a Stock and Warrant Purchase Agreement.  The warrant shall be exercisable at theoption of Merck as to 344,851 shares for a period of 30 days commencing on thefirst, second, third, fourth and fifth anniversaries of the WarrantAgreement.  Any portion of this warrantthat is not exercised during an applicable exercise period shall expire and beof no further force or effect (See “Revenue Recognition” Note).

 

InApril 2004, deCODE completed an offering of 3.5% Senior Convertible Notesdue 2011 to qualified institutional buyers. The Notes are convertible intoshares of deCODE common stock, at the option of the holder, at a price of$14.00 per share (fair market value of $10.60 on date of issuance), which isequivalent to an initial conversion rate of approximately 71.43 shares per$1,000 principal amount of the Notes.  deCODE may redeem the Notes beginning April 20,2009.  Had noteholders decided to converttheir notes, the potential shares of common stock issuable at June 30,2004 would have been 10,714,286 shares.

 

***Comprehensive Income***

 

Comprehensive income generally represents all changes in stockholders’equity except those resulting from investments or contributions bystockholders. Amounts reported in other comprehensive income include foreigncurrency translation adjustments and standard forward foreign exchangecontracts.  The following table presentsthe calculation of comprehensive income (loss):

 
| ** **                         | ** ** | **For the Three Months   Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** **     |
|------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|----------------|
| ** **                         | ** ** | **2004**                                       | ** ** | **2003**                                    | ** **     | **2004** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(in thousands)**                             | ** ** |
| Net loss                           |       | $                                              | (13,279    | )                                           | $              | (10,232 | ) | $ | (23,274 | ) |  $(25,315 | ) |
| Other comprehensive income (loss): |       |                                           |       |                                        |           |   |   |   |   |
| Foreign currency translation       |       | (1                                             | )          | (2                                          | )              | 0 |   | 1 |   |
| Forward foreign exchange contracts |       | 40                                             |       | 0                                           |           | (2 | ) | 0 |   |
| Total comprehensive loss           |       | $                                              | (13,240    | )                                           |  $(10,234 | ) | $ | (25,317 | ) | $ | (23,273 | ) |
|                                    |            |                                                |            |                                             |                |  |  |  |  |  |  |  |  |

 

***Employee TerminationCosts***

 

Beginning in September 2002, deCODE reduced total worldwideheadcount, focusing in particular on utilizing ongoing process automation andincreased productivity in the core genetics operations in Reykjavik.  The following is a schedule of charges,payments and unpaid termination benefits for the three and six-month periodsended June 30, 2004 and 2003:

 

11

----

 
| ** **                     | ** ** | **For the Three Months   Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                     | ** ** | **2004**                                       | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                     | ** ** | **(In thousands)**                             | ** ** |
|                           |       |                                           |       |                                        |       |   |   |   |   |
| Balance at beginning of period |       | $                                              | 0          |                                        | $          | 204 |   | $ | 66 |   | $ | 874 |   |
| Additions to accrual           |       | 0                                              |       | 306                                         |       | 0 |   | 791 |   |
| Payments of benefits           |       | 0                                              |       | (219                                        | )          | (66 | ) | (1,374 | ) |
| Balance at end of period       |       | $                                              | 0          |                                        | $          | 291 |   | $ | 0 |   | $ | 291 |   |

 

The charges related totermination benefits are for 17 and 44 employees during the three and six-monthperiods ended June 30, 2003, respectively. Subsequent employee termination costs not related to the September 2002initiative are reported as research and development or selling, general andadministrative expense, as appropriate.

 

## ***Cash and CashEquivalents***

## *** ***

Cash equivalents, consisting of principally of money market funds andmunicipal notes purchased with initial maturities of 90 days or less, arevalued at market value.

 

## ***MarketableSecurities and Short-Term Investments***

## *** ***

Marketable securities have been classified as available for sale andare stated at market value based on quoted prices.  Gains and losses on sales of securities arecalculated using the specific identification method.  Marketable securities at June 30, 2004can be summarized as follows:

 
| ** **                        | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                        | ** ** | **(in thousands)**  | ** ** |
|                              |       |                |       |                      |       |
| Money market preferred securities |       | $                   | 3,600      |                      | $          | 3,600 |   |
| Total marketable securities       |       | $                   | 3,600      |                      | $          | 3,600 |   |

 

At June 30, 2004, there were no unrealized gains or lossesassociated with the marketable securities included in accumulated othercomprehensive income and equity.  Thecontractual maturity of deCODE’s available for sale securities is 91 days.  All of deCODE’s investments are classified asshort-term, which is consistent with their intended use.

 

deCODE also has two certificates of deposit with commercial banksvalued at $55,000,000, that have contractual maturities of six and sevenmonths, respectively, that are classified as short-term investments.

 

## ***Derivative Financial Instruments***

## *** ***

During the normal course ofbusiness, deCODE is exposed to foreign currency risk and interest rate risk.These risks can create volatility in earnings and cash flows from period toperiod. deCODE’s objective is to reduce volatility ofearnings and cash flows associated with market risks.

 

deCODE seeks to maintain a desired level offloating-rate debt with respect to its overall debt portfolio denominated inU.S. Dollars. To this end, deCODE uses interest rate and cross-currency swapsto manage interest rate and foreign currency risk arising from long-term debtobligations denominated in Icelandic krona. These interest rate and cross-currencyswaps with a combined notional amount of 1,730 million Icelandic krona aredesignated as economic hedges of fixed rate foreign currency debt (Tier A andTier C bonds), but do not qualify for hedge accounting under SFAS 133.  In March 2004, deCODE refinanced itsTier C bonds, with the new instrument being a variable rate U.S dollardenominated debt (See Below). Following-on from this refinancing, deCODE reconsidered its twocross-currency swaps and decided to liquidate them realizing $9,720,000 in proceeds.  deCODE realized a loss on this earlytermination that, together with unrealized losses on the swaps during thequarter ended March 31, 2004, amounted to $1,473,000.  Cumulative unrealized gains on the twocross-currency swaps through December 31, 2003 were $11,185,000.  Unrealized gains on the two cross-currencyswaps in the quarter ended March 31, 2003 were $202,000.  Unrealized and realized gains and losses onthese two cross-currency swaps are included in other non-operating income and(expense), net in the Condensed Consolidated Statements of Operations.

 

In March 2004, deCODEentered into five forward foreign exchange contracts with an Icelandicfinancial institution for purposes of hedging a portion of its Icelandickrona-denominated salaries.  At maturityof each contract, deCODE will sell $1,600,000 and deCODE will receive Icelandickrona at the contracted forward rate. The contracts mature monthly through July 2004.  These forward foreign exchange contracts aredesignated as economic hedges of the foreign currency salary cash flows andqualify for hedge

 

12

----

 

accounting under SFAS 133, “Accounting for DerivativeInstruments and Hedging Activities” (SFAS 133). Under SFAS 133 these contractswill be marked-to-market at the end of each reporting period and the estimatedfair value of these instruments at June 30, 2004 is $2,000, net.  As of June 30, 2004, an unrealized lossof $2,000 was included in accumulated other comprehensive income on the CondensedConsolidated Balance Sheet.  During thethree-month and six-month periods ended June 30, 2004, a loss of $14,000and $31,000, respectively, was recorded to operating expenses in the CondensedConsolidated Statements of Operations.

 

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

 

***Short-TermBorrowings***

 

Short-term borrowings as of June 30, 2004 consists of a $4,500,000loan with an Icelandic financial institution that is due in two traunches of$2,500,000 and $2,000,000 on August 17 and October 28, 2004 at aninterest rate of 2.08% and 2.59%, respectively.

 

***Debt***

 

*Sale-leasebackFinancing*

 

In June 2003, deCODEsold certain laboratory equipment for $4,750,000 net cash proceeds and leasedthe equipment back from the counter-party (an Icelandic leasing company) for an18-month term.  As ownership of theequipment will be transferred to deCODE at the end of the lease without anyfurther significant payment, the transaction has been recorded as a financingand the gain ($1,418,000) has been deferred and is being amortized over theremaining useful life of the leased equipment (3 years).  In January 2004, deCODE exercised itsoption to extend the loan for an additional 18 month term.

 

*MortgageRefinancing*

 

In March 2004, weentered into a $17,500,000 term loan with an Icelandic financial institution(the “Lender”) to refinance our Tier C bonds and Tier D bank loan.  The new term loan bears interest at thethree-month LIBOR plus 3% (4.33% as of June 30, 2004) until March 1,2009, at which point, the Lender may adjust the interest marginunilaterally.  The term loan is payablein twenty quarterly payments starting on March 1, 2009 and the finalpayment is due on December 1, 2013. The term loan can be repaid on every anniversary of the loan starting onMarch 1, 2006, but for which we will pay a prepayment fee of 1% for everyyear that remains on the term loan facility with a maximum fee of 6%.  The balance of the unamortized costs at June30, 2004 was $1,758,000.

 

The remaining unamortizedborrowing costs and discount associated with the Tier C bonds and Tier D bankloan, along with borrowing costs associated with the new term loan and the callpenalty associated with the prepayment of Tier C will be amortized to interest expenseover the remaining term of the new loan.

 

*Senior Convertible Notes*

 

In April 2004, deCODEcompleted an offering of 3.5% Senior Convertible Notes due 2011 to qualifiedinstitutional buyers. The Notes are convertible into shares of deCODE commonstock, at the option of the holder, at a price of $14.00 per share (fair marketvalue of $10.60 on date of issuance), which is equivalent to an initialconversion rate of approximately 71.43 shares per $1,000 principal amount ofthe Notes.  deCODEmay redeem the Notes beginning April 20, 2009.  Interest is payable semi-annually onApril 15 and October 15. During the three-month period ended June 30, 2004, interest expenseof $1,122,000, was recorded to operating expenses in the Condensed ConsolidatedStatements of Operations.

 

From this offering, deCODEreceived net proceeds of $143.8 million. deCODE recorded deferred offering costs of $6.2million.  deCODEis amortizing these costs to interest expense over the seven-year life of theconvertible notes.  Deferred offeringcosts are included in other current and long-term assets and total $6.0 millionat June 30, 2004.  During the threeand six-month period ended June 30, 2004, interest expense of $190,000,was recorded to operating expenses in the Condensed Consolidated Statements ofOperations.

 

## ***Guarantees***

## *** ***

When as part of anacquisition deCODE acquires all of the stock or all of the assets andliabilities of a company, it assumes the liability for certain events oroccurrences that took place prior to the date of acquisition. The maximumpotential amount of future payments it could be required to make for suchobligations is undeterminable at this time. deCODE hasno liabilities recorded for these liabilities as of June 30, 2004.

 

deCODE enters intoindemnification provisions under (i) its agreements with other companies in itsordinary course of business, typically with business partners, contractors,clinical sites and customers and (ii) its agreements with investors. Underthese provisions

 

13

----

 

deCODE generally indemnifies and hold harmless theindemnified party for losses suffered or incurred by the indemnified party as aresult of deCODE’s activities or, in some cases, as a result of the indemnifiedparty’s activities under the agreement. These indemnification provisionsgenerally survive termination of the underlying agreement. In addition, in somecases, deCODE has agreed to reimburse employees for certain expenses and toprovide salary continuation during short-term disability. The maximum potentialamount of future payments deCODE could be required to make under theseindemnification provisions is unlimited. deCODE hasnot incurred material costs to defend lawsuits or settle claims related tothese indemnification agreements. As a result, the estimated fair value ofthese agreements is minimal. Accordingly, deCODE has no liabilities recordedfor these agreements as of June 30, 2004.

 

## ***Litigation***

## *** ***

Other than claims and legalproceedings that arise from time to time in the ordinary course of its businesswhich are not material, deCODE has no pending legal proceedings except asfollows:

 

Onor about April 20, 2002, an amended class action complaint, captioned Inre deCODE genetics, Inc. Initial Public Offering Securities Litigation (01 Civ.11219(SAS)), alleging violations of federal securities laws was filed in theUnited States District Court for the Southern District of New York on behalf ofcertain purchasers of deCODE common stock. The complaint names deCODE, two ofdeCODE’s current executive officers (the “Individual Defendants”), and the twolead underwriters (the “Underwriter Defendants”) for our initial publicoffering in July 2000 (the “IPO”) as defendants.

 

Inthe amended pleading, the plaintiff alleges violations of Section 11 ofthe Securities Act of 1933 and violations of Section 10(b) of theSecurities Exchange Act of 1934 (and Rule 10b-5 promulgated thereunder) againstdeCODE, the Individual Defendants and the Underwriter Defendants. In addition,the amended complaint alleges violations of Section 15 of the SecuritiesAct of 1933, and Section 20(a) of the Securities Exchange Actof 1934 against the Individual Defendants.Generally, the amended complaint alleges that the Underwriter Defendants: (i)solicited and received excessive and undisclosed commissions from certaininvestors in exchange for which the Underwriter Defendants allocated to thoseinvestors material portions of the shares of our stock sold in the IPO; (ii)entered into agreements with customers whereby the Underwriter Defendantsagreed to allocate shares of our stock sold in the IPO to those customers inexchange for which the customers agreed to purchase additional shares of ourstock in the aftermarket at pre-determined prices; and (iii) improperly usedtheir analysts, who purportedly suffered from conflicts of interest, tomanipulate the market. The amended complaint further alleges that theprospectus incorporated into the registration statement for the IPO wasmaterially false and misleading in that it failed to disclose thesearrangements. The amended complaint also alleges that deCODE and the IndividualDefendants had numerous interactions and contacts with the Underwriters fromwhich deCODE and the Individual Defendants either knew of, or recklesslydisregarded, the Underwriters’ purported wrongful acts. The suit seeksunspecified monetary and recissionary damages and certification of a plaintiffclass consisting of all persons who purchased shares of our common stock fromJuly 17, 2000 to December 6, 2000.

 

deCODEis aware that similar allegations have been made in hundreds of other lawsuitsfiled (many by some of the same plaintiff law firms) against numerousunderwriter defendants and issuer companies (and certain of their current andformer officers) in connection with various public offerings conducted inrecent years. All of the lawsuits that have been filed in the Southern Districtof New York have been consolidated for pretrial purposes before Honorable JudgeShira Scheindlin. Pursuant to the underwriting agreement executed in connectionwith our IPO, deCODE has demanded indemnification from the UnderwriterDefendants. The Underwriter Defendants have asserted that our request forindemnification is premature.

 

Pursuantto an agreement the Individual Defendants have been dismissed from the casewithout prejudice. Along with numerous other issuers, deCODE moved to dismissthe complaint for failure to state a claim. On February 19, 2003, JudgeScheindlin granted our motion with respect to the Section 10(b) claims anddenied the motion with respect to the Section 11 claims.

 

OnJuly 31, 2003, our Board of Directors (other than Dr. Stefansson, whorecused himself because he was an Individual Defendant) conditionally approveda proposed partial settlement with the plaintiffs in this matter.  The settlement would provide, among otherthings, a release of deCODE and of the Individual Defendants for the conductalleged in the amended complaint to be wrongful.  deCODE would agreeto undertake other responsibilities under the partial settlement, includingagreeing to assign away, and not assert or release, certain potential claims wemay have against our underwriters.  Anydirect financial impact of the proposed settlement is expected to be borne bydeCODE’s insurers.   The Board agreed toapprove the settlement subject to a number of conditions, including theparticipation of a substantial number of other issuer defendants in theproposed settlement, the consent of deCODE’s insurers to the settlement, andthe completion of acceptable final settlement documentation.  Furthermore, the settlement is subject to ahearing on fairness and approval by the Court overseeing the litigation.  In conjunction with the plaintiffs, thesettling issuer defendants have filed a motion seeking the court’s approval ofthe settlement.  deCODEcannot currently opine as to whether or when the court may approve thesettlement.

 

Dueto the inherent uncertainties of litigation and the fact that the settlement isin its early stages, the ultimate outcome of this matter cannot bepredicted.  If the settlement is notconsummated, deCODE expects to contest the allegations against deCODE anddeCODE’s officers vigorously.   If deCODEwas required to pay significant monetary damages as a result of such litigation(or any other lawsuits alleging similar claims filed against deCODE anddeCODE’s officers in the future), deCODE’s business could be

 

14

----

 

significantly harmed. Even if such suit concludes indeCODE’s favor, deCODE may be required to expend significant funds to defendagainst the allegations. deCODE is unable to estimatethe range of possible loss from the litigation and no amounts have beenprovided for such matters in deCODE’s financial statements.

 

## ***Recent Accounting Pronouncements***

## *** ***

In January 2003, the Financial Accounting Standards Board (FASB)issued FASB Interpretation No. 46, “Consolidation of Variable InterestEntities, an Interpretation of ARB No. 51”, (FIN 46).  FIN 46 requires that if an entity has acontrolling financial interest in a variable interest entity, the assets,liabilities and results of activities of the variable interest entity should beincluded in the consolidated financial statements of the entity. FIN 46requires that its provisions are effective immediately for all arrangementsentered into after January 31, 2003. For those arrangements entered intoprior to January 31, 2003, FIN 46, as amended by FIN 46R, provisions arerequired to be adopted in the first quarter of 2004. deCODEdoes not have any financial interests in variable interest entities createdafter January 31, 2003. The adoption of FIN 46R did not impact deCODE’sfinancial position or its results of operations for the quarter endedJune 30, 2004.

 

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

 

This Management’s Discussionand Analysis of Financial Condition and Results of Operations as ofJune 30, 2004 and for the three and six month periods ended June 30,2004 and 2003 should be read in conjunction with the unaudited condensedconsolidated financial statements and notes thereto set forth in Item 1 of thisreport.

 

# **Overview**

# ** **

We are a population genetics company developing drugs and DNA-baseddiagnostics based upon our discoveries in the inherited causes of commondiseases.  Our population approach andresources have enabled us to identify genes and targets directly involved in thedevelopment of many of the most common diseases.  We are focused on turning these findings intoa growing pipeline of products and services which we believe will be able tocombat the causes of disease, not just the signs and symptoms.  Our approach to research and developmentbrings together three key types of non-personally identifiable data derivedfrom our population research in Iceland: genotypic and disease data from morethan 100,000 volunteer participants in some 50 disease-gene research programs andinformation that can be analyzed in tandem with genealogical data linkingtogether the entire present-day population of Iceland and going back to thesettlement of the country in the ninth century.

 

Our primary focus is on the discovery and commercialization of noveltherapeutics based on genetic information identified in our population-basedgene discovery work.  Through ouracquisition in March 2002 of MediChem Life Sciences and its subsidiary,Emerald Biostructures, now our pharmaceuticals and biostructures groups, wehave integrated capabilities for applying genetic findings to the developmentof drugs, both through our own programs and in alliance with corporatepartners.  We are also applying the linkswe have identified between genetic factors and disease to create DNA-basedtests which can be used to identify patients with increased risk of developinga disease or to predict which patients will respond well to a given drugtherapy.  We believe that such tests willbecome a standard part of healthcare within the coming decade; making itpossible to gauge individual predisposition to a particular illness and todesign effective preventive strategies; to complement traditional clinicaldiagnoses; and to identify patients who are likely to respond or not respond toparticular drugs.  We are also marketingsoftware systems we have developed, making correlations between geneticvariation and disease and drug response.

 

We currently derive revenues primarily from research funding and otherservice fees from our collaborative partners; milestone payments, and upfront,exclusivity, technology-access and technology-development fees under ourcollaboration agreements comprise most of the rest of our revenues.  Our expenses consist primarily of researchand development expenses.  While we areentitled to royalties or profit-sharing under the terms of our agreements, dueto the extended time period for the development and commercialization of asaleable product or therapy, we have not yet received royalties or profitsharing under any of our contracts and do not expect to do so for severalyears, if at all.  In addition toconducting work on our targets in our collaborative and internal programs, ourpharmaceuticals group provides drug discovery work for our fee-for-servicecustomers.  Our other service offeringsinclude protein crystallization products and protein structure analysiscontract services through our Seattle-based biostructures group;pharmacogenomics and clinical trials services though our wholly ownedsubsidiary Encode; and DNA analysis services through our genotyping laboratoryin Reykjavik, Iceland.

 

15

----

 

As we continue our discovery in common diseases, we aim to conserveample resources to bring our products forward to the market, and we areconstantly evaluating the optimal balance between several factors crucial toour strategy.  These include the level ofour investment in research and development, the preservation of cash resourcesand their deployment for product development, and the financingenvironment.  Our goal is to bringproducts to the market and, in that, make the company profitable.  We believe the best means to achieve thatobjective is to operate the company on a sustainable basis such that it willhave the staying power to turn our discoveries into products in themarketplace.  As a means to this end, inlate 2002 and in the face of an uncertain environment in the capital markets,we undertook measures aimed at improving our operational efficiency and atlowering our operating costs.  As abenchmark, we set ourselves the goal of running our base research anddevelopment activities on a cash-neutral basis. However, this objective was not an end unto itself but rather a means toensure that we continued to have on hand the resources to advance our key drugand diagnostic programs.

 

We believe that the initiation of substantial new activities, such asthe conduct of clinical trials on our proprietary compounds, will requiresignificant additional expenditures.  Forexample, in our target discovery work on our findings in myocardial infarction,we have in-licensed a compound that was developed for a different indicationbut which acts upon our principal target and for which we are conducting aPhase II clinical trial in Iceland. We expect to seek similar in-licensing opportunities for other compoundsin other diseases and any success may increase our cash requirements.  We anticipate incurring additional net lossesat 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 losses will fluctuate from quarter toquarter and that such fluctuations may be substantial, especially becauseprogress in our scientific work and milestone payments that are related toprogress can fluctuate between quarters. We do not believe that comparisons of our quarter-to-quarter performanceare a good indication of future performance.

 

Following our sale of$150,000,000 of our 3.5% Senior Convertible Notes in April, 2004, we believethat we have sufficient cash resources to continue to fund our current researchand operations for several years.  However,we will require significant additional capital in the future for our productdevelopment programs and so will continue to investigate additional avenues offinancing.  Our ability to obtain capitalwill be affected by conditions in the global financial markets and in thepharmaceutical industry.  We expect thatdownturns in the market valuations of biotechnology companies and of the equitymarkets more generally will restrict our ability to raise additional capital onfavorable terms while positive movement in those markets will poseopportunities for us.

 

The pharmaceutical industry, which is the principal customer base forour gene-discovery and contract chemistry businesses, is experiencingdifficulties in maintaining historical rates of growth.  This presents near-term challenges andsignificant longer-term opportunities. One of the main challenges facing the pharmaceutical industry isdeveloping pipelines of effective new drugs to treat major indications.  As many leading brand-name drugs come offpatent and face generic competition, developing successful new medicines willbecome 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 upfront funding, orlengthening the time required to negotiate such deals.  We believe that in the medium to longer term,however, companies such as ours may be well positioned to play an importantrole in filling the gap in the pipeline of new drugs, either on their own or aspartners of pharmaceutical companies. Our gene discovery programs are aimed at identifying novel drug targetsthat are involved in the basic biology of common diseases and we are focused ondiscovering new drugs against these targets, both on our own and with majorpharmaceutical partners.  Ourpartnerships with Roche and Merck demonstrate that the industry is alreadyinvesting in the development of new therapeutics based on our approach.  Our recent in-licensing of a developmentalcompound from Bayer demonstrates that the industry may be prepared to providecompanies such as ours with rights to shelved compounds that may be broughtforward in clinical development in indications other than those for which thecompounds were originally designed.

 

**Collaborations and Alliances**

 

Collaborations and further growth in our medicinal chemistry,pharmacogenomics, genotyping and clinical trial services will remain animportant element of our business strategy and future revenues.  Our ability to generate revenue growth andbecome profitable is dependent, in part, on our ability to enter intoadditional collaborative arrangements, and on our ability and our collaborativepartners’ ability to successfully commercialize products incorporating, orbased on, our work.  It is also dependenton our ability to maintain and grow our service lines of business.  There can be no assurance that we will beable to maintain or expand our existing collaborations, enter into futurecollaborations to develop applications based on existing or future researchagreements, or successfully expand our medicinal chemistry, genotyping orpharamacogenomics businesses.  Our failureto successfully develop and market products over the next several years, or torealize product revenues, would have a materially adverse effect on ourbusiness, financial condition and results of operations.  We do not expect to receive royalties or otherrevenues from commercial sales of products developed using our technologies inthe near term.  It may be several yearsbefore product revenues materialize, if they do at all.

 

# **Research andDevelopment Programs**

# ** **

The following summary of thedevelopment of our drug candidates in late  pre-clinical or clinical developmentbrings up to date the 

 

16

----

 

disclosure we made in thebusiness section of our Annual Report on Form 10-K for the year endedDecember 31, 2003 with respect to the status of our clinical andpre-clinical development pipeline and should be read in conjunction with thedisclosures made in the business section of our Annual Report on Form 10-Kfor the year ended December 31, 2003. Because of uncertainties involved in the drug development process, theactual timing for the events described below may differ materially from thatprovided in this summary..

 

•                  Our mostadvanced program is DGO31 for the prevention of myocardial infarction(MI).  We began a Phase IIa trial inIceland for DG031 in early April of 2004. We completed enrollment in June and expect to conclude the 200patient trial in September of this year.  We have filed an Investigative New DrugApplication, or IND, for this compound with the U.S. Food and DrugAdministration (FDA) and expect to make similar filings in selected Europeancountries.  (We refer to such filings asINDs although the technical name may differ from country to country.)  Based on the results of the Phase IIa trial,we expect to begin a Phase III trial in the U.S., Iceland and Europe for thiscompound in the first quarter of 2005.

 

•                  D151746, oursecond lead program is being developed for the treatment of peripheral arterialocclusive disease (PAOD), a form of atherosclerosis in the lowerextremities.  The compound is aninhibitor of a G-coupled protein receptor which we have shown in preclinicalwork to be associated with a significant increase in risk of developing thedisease.  We anticipate filing an IND bythe end of this year for D151746 and hope to begin a Phase 1 trial for thiscompound in the U.S. in the first quarter of 2005.  We expect the trial will be of 4-8 weeksduration and could be finished in the second quarter of 2005.

 

•                  In our strokeprogram, we expect to file an IND in Iceland in 2005

 

•                  In one of ourasthma programs, we expect to make a regulatory filing in Iceland to permit usto begin a Phase II trial for DG031 in 2004 and to commence this trial in early2005.

 

We use many of our employee and infrastructure resources across severalprograms, and many of our research and development costs are indirectlyattributable to an individually named program or are directed broadly toapplicable research programs.  However,taking into account costs that are specifically attributable to individualprograms and allocations of our research and development program costs basedupon those direct costs in 2003 and 2004 to-date, we have cumulatively invested$3.6, $3.3, $2.1 and $3.3 million in our MI, PAOD, stroke and asthma programs,respectively, from the beginning of 2003 to-date.  Inception to-date costs are not available asthese costs were not historically tracked by program.

 

Wehave not applied for or received marketing approval from the applicableregulatory authorities in any country for any of our drug candidates.  In order for us to achieve marketing approvalin the U.S., the FDA must conclude that our clinical data establish the safetyand efficacy of our drug candidate. Other countries have similar requirements.  Historically, the results from pre-clinicaltesting and early clinical trials (through Phase II) have often not beenpredictive of results obtained in later clinical trials. A number of new drugsand biologics have shown promising results in early clinical trials, butsubsequently failed to establish sufficient safety and efficacy data to obtainnecessary marketing approvals. Additional risks and uncertainties involved in the development andcommercialization of any products are described further at “Risk Factors,Forward-Looking Statements, and Cautionary Factors That May Affect FutureResults—”We may not successfully develop or derive revenues from any products”and “Clinical trials required for our product candidates or the products of ourcustomers and partners are expensive and time-consuming.” We expect that itwill be several years, if ever, before we receive revenues from the commercialsale of our therapeutic products.

 

Furthermore,our strategy includes the option of entering into collaborative arrangementswith third parties to participate in the development and commercialization ofour products, such as our collaboration agreement with Roche and Merck.Entering into a collaboration with a partner at anypoint in the development or commercialization of a product is a business decisionof ours.  When making this decision we doand will consider, among other matters, the complexity of the indication, thesize, complexity and expense of necessary development and/or commercializationefforts, the nature 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 wedo collaborate on any of the above programs in the future, a partner will havea level of control, which may be significant, over the pre-clinical developmentor clinical trial process for a product. 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 are unable todetermine the duration and completion costs of our research and developmentprojects or when and to what extent we will receive cash inflows from thecommercialization and sale of a product.

 

**Critical Accounting Policies**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires us to make certain estimates andassumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereported period. On an ongoing basis we evaluate our estimates, which include,among others, those related to collaborative arrangements, long-lived assets,materials 

 

17

----

 

and supplies, foreign exchangetransactions, income taxes and litigation and other commitments andcontingencies. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form our basis for making judgments about carrying values ofassets and liabilities that are not readily apparent from other sources. Theimpact and any associated risks related to these and our other accountingpolicies on our business or operations is discussed throughout Management’sDiscussion and Analysis of Financial Condition and Results of Operations wheresuch policies affect our reported and expected financial results. For adetailed discussion on the application of these and other accounting policies,please refer to our notes to the Condensed Consolidated Financial Statements inthis quarterly report on Form 10Q and the Consolidated Financial Statements inthe Annual Report on Form 10-K. There can be no assurance that actual resultsmay not differ from the estimates referred to above.

 

**Results of Operations for the Three and SixMonth Periods Ended June 30, 2004 and 2003**

 

Our results of operations have fluctuated from period to period and maycontinue to fluctuate in the future based upon, among other things, the timingand composition of funding under our various collaborative agreements, as wellas the progress of our own research and development efforts.  Results of operations for any period may beunrelated to results of operations for any other period.  In addition, historical results should not beviewed as indicative of future operating results.  We are subject to risks common to companiesin our industry and at our stage of development, including risks inherent inour research and development efforts, reliance upon collaborative partners,development by us or our competitors of new technological innovations, abilityto market products or services, dependence on key personnel, dependence on keysuppliers, protection of proprietary technology, ability to obtain additionalfinancing, ability to negotiate collaborative arrangements, and compliance withgovernmental and other regulations.  Inorder for a product to be commercialized based on our research, we and ourcollaborators must conduct preclinical tests and clinical trials, demonstratethe efficacy and safety of our product candidates, obtain regulatory approvalsor clearances and enter into manufacturing, distribution and marketingarrangements, as well as obtain market acceptance.  We do not expect to receive revenues orroyalties based on therapeutic or diagnostic products for a period of years, ifat all.

 

Company highlights include:

 

•                  Our revenue was$9.6 million for the three-month period ended June 30, 2004 as compared to$10.5 million for the three-month period ended June 30, 2003. Our revenuewas $19.9 million for the six-month period ended June 30, 2004 as comparedto $22.4 million for the six-month period ended June 30, 2003. Theserevenues reflect the long-term, product development focus of our businessstrategy and our corporate partnerships, as well as the unpredictable timing ofmilestone payments. At the close of the quarter the company had $16.1 million indeferred research revenue, compared to $14.0 million at the close of the 2003.This increase reflects cash received related to the company’s new alliance withMerck, and will be recognized, along with other deferred revenue, over futurereporting periods.

 

•      Our cost of revenue, including costsincurred in connection with collaborative programs, decreased to $10.3 millionfor the three-month period ended June 30, 2004 as compared to $11.9 million forthe three-month period ended June 30, 2003. Our cost of revenue, includingcosts incurred in connection with collaborative programs, decreased to $21.5million for the six-month period ended June 30, 2004 as compared to $25.5million for the six-month period ended June 30, 2003. Thedecreases in 2004 as compared to 2003 result mainly of the streamlining andautomation of our core genetics research and operations. Our cost ofrevenue consists of the costs of services provided to customers andcollaborators, including the entirety of costs incurred in connection withprograms that have been partnered and on which we receive research funding. Attimes, we may dedicate additional resources and incur costs in addition tocosts covered by research funding received in such collaborative programs.

 

•      Our research and development expenses inproprietary programs increased to $5.4 million for the three-month period endedJune 30, 2004 as compared to $4.8 million for the three-month period ended June30, 2003. Our research and development expenses in proprietary programs decreasedto $9.6 million for the six-month period ended June 30, 2004 as compared to$10.8 million for the six-month period ended June 30, 2003. Productivity gainshave enabled acceleration in our basic gene and target discovery work. Thechanges our research and development expenses in proprietary programs in thethree and six-month periods ended June 30, 2004 as compared to the same periodsin 2003 reflect the streamlining and automation of the our core geneticsresearch operations but also our increasing expenditures in product developmentclinical work and pre-clinical preparations on our lead development programs.

 

•                  InApril 2004, we initiated a ten-week, information-rich Phase IIa clinicaltrial in Iceland that will examine the effect of various dose levels of ourdevelopmental compound DG031 on the production of leukotrienes and otherbiomarkers associated with vascular inflammation. Based on the results of thistrial, we plan to design an information-rich, multicenter Phase III trial totest DG031 for the prevention of heart attack that may commence before the endof 2004.

 

•                  At June 30,2004, we had $226.3 million in cash and short-term investments. This includesrestricted cash, cash equivalents, short-term investments and marketablesecurities and this significant increase reflects net proceeds from ourconvertible notes issue completed in April 2004 ($143.8 million), equityand technology access fee payments received related to the signing of a newdrug development alliance with Merck ($20.0 million) and the liquidation of ourtwo currency swaps ($9.7 million) offset by capital expenditures ($1.0million), debt service ($6.3 million) and costs associated with the advancementof our drug development programs in the six-months ended June 30, 2004.

 

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

 

18

----

 

Significant elements of our revenue are summarized as follows:

 
| ** **                                                                 | ** ** | **For the Three Months   Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                                       | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                             | ** ** |
| Research funding and other service fees..                             |       | $                                              | 7,606      |                                        | $          | 8,756 |   | $ | 15,503 |   | $ | 17,357 |   |
| Milestone payments                                                         |       | 56                                             |       | 69                                          |       | 221 |   | 1,432 |   |
| Up-front, exclusivity, technology access,  and technology development fees |       | 1,000                                          |       | 1,000                                       |       | 2,000 |   | 2,000 |   |
| Other                                                                      |       | 973                                            |       | 713                                         |       | 2,193 |   | 1,589 |   |
|                                                                       |       | $                                              | 9,635      |                                        | $          | 10,536 |   | $ | 19,917 |   | $ | 22,378 |   |

 

Collaborations with our most significant partners include:

 

*F. Hoffmann-La Roche (Roche)*

 

*Therapeutics.*  In 1998 we entered into a researchcollaboration and cross-license agreement with Roche, which terminated in 2002,under which we identified key genetic factors involved in ten common diseases:osteoarthritis, Alzheimer’s disease, schizophrenia, PAOD, stroke, osteoporosis,obesity, anxiety, non-insulin-dependent diabetes and rheumatoid arthritis.  In January 2002, we entered into a newthree-year agreement with Roche focused on turning the achievements of our 1998gene discovery collaboration into novel therapeutics.  The 2002 agreement provided that we wouldcollaborate with respect to four diseases that had been the subject of the 1998agreement.  We are currentlycollaborating on two of those diseases. Under the 2002 agreement, we have received $18,000,000 in researchfunding and may receive an additional $2,000,000 in research funding during theremainder of the term of the agreement. The agreement provides that upon the development of specified compoundsduring the term of the agreement and for a specified period thereafter we mayreceive milestone payments, the amount of which will depend on the type ofcompound developed.  In addition, we willbe entitled to receive royalties on the sales of drugs that are developed.  We expect that we will not receive researchfunding under the 2002 agreement after February 1, 2005, when the researchterm ends, unless we and Roche decide to extend the collaboration beyond thattime.

 

*Diagnostics.*  In June 2001, we signed a five-yearalliance with Roche’s diagnostics division to develop and market DNA-baseddiagnostics for major diseases.  Morerecently we have added research programs aimed at developing diagnostics topredict drug response for major therapeutics used to treat those diseases, inorder to help select the most effective treatment of those available.  Under the agreement, we have received$31,750,500 in research funding, up-front fees and milestone payments.  We may receive $12,500,000 in additionalresearch funding over the remainder of the term of the agreement as well as milestonepayments upon the achievement of research and development milestones androyalties on the sales of diagnostic products developed.

 

Revenues from these alliances with Roche amounted to $3.1 million and$4.1 million for the three-month periods ended June 30, 2004 and 2003,respectively, and $6.5 million and $9.5 million for the six-month periods endedJune 30, 2004 and 2003, respectively. Costs incurred in connection with these collaborative programs withRoche amounted to $4.4 million and $6.0 million for the three-month periodsended June 30, 2004 and 2003, respectively, and $9.7 million and $13.1million for the six-month periods ended June 30, 2004 and 2003,respectively.

 

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

 

*Obesity.*  In September 2002, we entered into analliance with Merck aimed at developing new treatments for obesity.  Under the alliance, we are combining ourresearch efforts in the genetics of obesity to identify, validate andprioritize a series of drug targets to take into development.  Under the terms of the three-year agreement,which can be extended on a year-to-year basis upon the consent of the parties,we have received research funding, technology access fees and milestonepayments in the aggregate amount of $16,495,000 and may receive researchfunding and technology access fees in the future of $8,500,000.  In addition, we may receive further researchmilestone payments and we may receive milestone payments as compounds developedunder the alliance advance in the development process and royalties onsuccessfully marketed drugs.  Merck mayterminate the agreement at any time upon 90 days’ notice or afterSeptember 26, 2004 upon 30 days’ notice in the event that theresearch program fails to achieve certain specified goals.

 

Revenues from this alliance withMerck amounted to $1.6 million and $1.6 million for thethree-month periods ended June 30, 2004 and 2003, respectively, and $3.5million and $3.3 million for the six-month periods ended June 30, 2004 and2003, respectively.  Costs incurred inconnection with this alliance with Merck amounted to $1.3 million and $1.4million for the three-month periods ended June 30, 2004 and 2003,respectively, and $2.5 million and $3.1 million for the six-month periods endedJune 30, 2004 and 2003, respectively.

 

19

----

 

*Information-Rich Clinical Trials.*  In February 2004, we entered into anagreement with Merck under which we will conduct information-rich clinicaltrials on a range of Merck’s developmental compounds. The term of the allianceis seven years, subject to termination by Merck after five years.  We will, at any given point over the courseof the alliance, be conducting concurrent trials on as many as five Merckcompounds.  The collaboration involvedthree agreements: (a) License and Research Collaboration Agreement; (b) a Stockand Warrant Purchase Agreement; and (c) a Warrant Agreement.   Under the terms of the License and ResearchCollaboration Agreement, deCODE will receive royalties on sales of drugs and diagnosticsdeveloped as part of the alliance, will receive milestone payments as compoundsor pharmacogenomic tests reach the market, will receive research funding forthe clinical development of compounds and pharmacogenomic analysis, andreceived a one-time technology access fee of $10,000,000. There is acontingency clause on the technology access fee if we reject the first twonon-exclusive development compounds that Merck presents to the collaboration, then Merck has the right to request a refund of $2.5 millionof the technology access fee.  Under theterms of the Stock and Warrant Purchase Agreement, Merck has purchased 689,703shares of our common stock at a price of $14.50 per share or $10 million, whichrepresents a premium of $2.7 million to the fair market value of the stock onthe effective date of the agreements ($10.60). Accordingly, of the $10 million cash received, we have ascribed $7.3million to the common stock and $2.7 million premium to deferred revenue.  Under the terms of the Warrant Agreement, wehave issued Merck a warrant to purchase up to 1,724,257 of additional shares ofour common stock at an exercise price of $29.00 per share over the next fiveyears. The warrant shall be exercisable at the option of Merck as to 344,851shares for a period of 30 days commencing on the first, second, third, fourthand fifth anniversaries of the Warrant Agreement with the final portion ofwarrants expiring in March 2009. Any portion of this warrant that is not exercised during an applicable exerciseperiod shall expire and be of no further force or effect. The warrant wasvalued at $6.3 million using a Black Scholes model Withthe following assumptions:  lives of oneto five years, risk free interest rates of 1.24% to 3.07%, volatility of 90%and no dividend yield.  The one-timetechnology access fee and the premium portion of the equity purchase togetherwith the estimated fair value of the warrant have been deferred and the $6.4million net amount is included in deferred revenue at June 30, 2004 andwill be recognized as revenue according to level of efforts over the seven-yeardevelopment term.  Merck has identifiedthe first compound to be initiated into clinical trials and we are working withMerck to complete the necessary protocols and workplans and expect to haveapprovals in place during the third quarter of 2004.  As such, no revenue was recognized in 2004and costs incurred of $.1 million were deferred as of June 30, 2004.

 

Revenue for the three-month and six-month periods ended June 30,2004 and 2003 is as follows:

 
| ** ** | ** ** | **For the Three Months**        | ** ** | **For the Six Months**  | ** ** | **2004 as Compared to 2003** | ** ** |
|------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** ** | ** ** | **Ended June 30,**         | ** ** | **Ended June 30,** | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** ** | ** ** | **2004**                        | ** ** | **2003**                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except for%)** | ** ** |
| Revenue    |       | $                               | 9,635      |                    | $          | 10,536                       |       | $ | 19,917 |   | $ | 22,378 |   | $ | (901 | ) | (9 | )% | $ | (2,461 | ) | (11 | )% |
|            |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decreases in revenue in the three and six-month periods endedJune 30, 2004 as compared to the same periods in 2003 are reflective ofthe long-term, product development focus of our business strategy and ourcorporate partnerships, as well as the unpredictable timing of milestonepayments. At the close of the quarter the company had $16.1 million in deferredrevenue, compared to $14.0 million at the close of the 2003. This increase isreflects cash received related to our new alliance with Merck, and will berecognized, along with other deferred revenue, over future reporting periods.We expect that our revenues will fluctuate from quarter to quarter and thatsuch fluctuations may be substantial especially because progress in ourscientific work, including milestone payments that are related to progress, canand do fluctuate between quarters.

 

*Cost of Revenue, including Collaborative Programs*.  Costof revenue, including costs incurred in connection with collaborative programsfor the three-month and six-month periods ended June 30, 2004 and 2003 areas follows:

 
| ** **                                         | ** ** | **For the Three Months**        | ** ** | **For the Six Months**  | ** ** | **2004 as Compared to 2003** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                         | ** ** | **Ended June 30,**         | ** ** | **Ended June 30,** | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                                         | ** ** | **2004**                        | ** ** | **2003**                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In thousands, except for%)** | ** ** |
| Cost of Revenue, including Collaborative  Programs | ** ** | $                               | 10,338     |                    | $          | 11,868                       | ** ** | $ | 21,512 | ** ** | $ | 25,536 |   | $ | (1,530 | ) | (13 | )% | $ | (4,024 | ) | (16 | )% |
|                                                    |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Productivity gains have enabled acceleration in our basic gene andtarget discovery work. The decreases in our cost of revenue, including costsincurred in connection with collaborative programs for the three and six-monthperiods ended June 30, 2004 as compared to the same periods in 2003 generallyreflect the streamlining and automation of our core genetics research and other

 

20

----

 

operations. Our cost of revenue comprisesthe costs of services provided to customers and collaborators, including theentirety of costs incurred in connection with programs that have been partneredand on which we receive research funding. At times, we may invest in additionto costs covered by research funding received in such collaborative programs.

 

Ourcost of revenue, including costs incurred in connection with collaborativeprograms in the three-months ended June 30, 2004 as compared to the sameperiod in 2003 notably reflect (i) $1.0 million lower salary and relatedexpenses, (ii) $0.6 million lower depreciation and amortization charge, and(iii) a relative net benefit of $0.2 million resulting from chemicals andconsumables we used for which there was relatively little or no attendant costas a result of prior provisions we had made as slow moving, excess or obsoleteaccording to our accounting policy.

 

Ourcost of revenue, including costs incurred in connection with collaborativeprograms in the six-months ended June 30, 2004 as compared to the sameperiod in 2003 include (i) $2.1 million lower salary and related expenses, (ii)$1.0 million lower depreciation and amortization charge, and (iii) a relativenet benefit of $0.8 million resulting from chemicals and consumables we usedfor which there was relatively little or no attendant cost as a result of priorprovisions we had made as slow moving, excess or obsolete according to ouraccounting policy.

 

*Research and Development – Proprietary Programs*.  Research and developmentexpenses for proprietary programs for the three-month and six-month periodsended June 30, 2004 and 2003 are as follows:

 
| ** **                                       | ** ** | **For the Three Months**        | ** ** | **For the Six Months**  | ** ** | **2004 as Compared to 2003** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Ended June 30,**         | ** ** | **Ended June 30,** | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                                       | ** ** | **2004**                        | ** ** | **2003**                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **(In thousands, except for%)** | ** ** |
| Research and Development - Proprietary  Programs |       | $                               | 5,385      |                    | $          | 4,829                        |       | $ | 9,644 |   | $ | 10,832 |   | $ | 556 |   | 12 | % | $ | (1,188 | ) | (11 | )% |
|                                                  |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Productivity gains haveenabled acceleration in our basic gene and target discovery work. The changesour research and development expenses in proprietary programs in the three andsix-month periods ended June 30, 2004 as compared to the same periods in2003 reflect the streamlining and automation of the our core genetics researchoperations but also our increasing expenditures in product development clinicalwork and pre-clinical preparations on our lead development programs.Importantly, in April 2004, we initiated a ten-week, information-richPhase IIa clinical trial in Iceland that will examine the effect of various doselevels of our developmental compound DG031 on the production of leukotrienesand other biomarkers associated with vascular inflammation. Based on theresults of this trial, we plan to design an information-rich, multicenter PhaseIII trial to test DG031 for the prevention of heart attack.

 

Our research and developmentcosts for proprietary programs in the three-months ended June 30, 2004 ascompared to the same period in 2003 notably reflect (i) a relative net benefitof $0.1 million resulting from chemicals and consumables we used for whichthere was relatively little or no attendant cost as a result of priorprovisions we had made as slow moving, excess or obsolete according to ouraccounting policy, (ii) $0.4 million related to increased usage of other chemicalsand consumables, (iii) $0.1 million for additional employee incentives.

 

Our research and development costs for proprietary programs in thesix-months ended June 30, 2004 as compared to the same period in 2003include (i) $0.6 million lower salary and related expenses, (ii) a relative netbenefit of $0.5 million resulting from chemicals and consumables we used forwhich there was relatively little or no attendant cost as a result of priorprovisions we had made as slow moving, excess or obsolete according to ouraccounting policy, (iii) $0.3 million related to increased usage of otherchemicals and consumables, and (iv) a $0.4 million lower depreciation andamortization charge.

 

Several of the above-noted increases and decreases to the research anddevelopments costs of our proprietary programs are likely non-recurring orirregular in their occurrence. Other of the experienced increases in theresearch and developments costs of our proprietary programs (e.g., usage ofchemicals and consumables, salary rises) may likely continue, particularly aswe advance our own drug development programs

 

*Selling, General and Administrative Expenses.* Selling, general and administrative expenses for the three-month andsix-month periods ended June 30, 2004 and 2003 are as follows:

 
| ** **                          | ** ** | **For the Three Months**        | ** ** | **For the Six Months**  | ** ** | **2004 as Compared to 2003** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                          | ** ** | **Ended June 30,**         | ** ** | **Ended June 30,** | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                          | ** ** | **2004**                        | ** ** | **2003**                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$** | ** Change** | ** ** | **% Change** | ** ** | **$** | ** Change** | ** ** | **% Change** | ** ** |
| ** **                          | ** ** | **(In thousands, except for%)** | ** ** |
| Selling, General and Administrative | ** ** | $                               | 5,589      |                    | $          | 3,809                        |       | $ | 9,852 |   | $ | 8,066 | ** ** | $ | 1,780 |   | 47 | % | $ | 1,786 |   | 22 | % |
|                                     |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

21

----

 

The increases in selling, general and administrative expenses for thethree and six-month periods ended June 30, 2004 as compared to the sameperiods in 2003 mainly arise as a result of an increase in our director’s andofficer’s insurance premium (increases of $0.3 million and $0.7million,respectively, for the three and six-month periods ended June 30, 2004 as comparedto the same periods in 2003), severance costs recorded in the quarter endedJune 30, 2004 ($0.6 million), employee incentives provided for in thequarter ended June 30, 2004 ($0.6 million), and an accrual for probablelosses related to grant monies received in pre-acquisition periods of Medichem($0.4 million). Several of the above items are likely non-recurring orirregular in their occurrence. Other of the experienced increases in ourselling, general and administrative expenses (e.g., the direct and indirectcosts of compliance with the Sarbanes Oxley legislation, salary rises) maylikely continue.

 

*Stock Based Compensation and RemunerationExpense.*  Stockbased compensation and remuneration expense for the three-month and six-monthperiods ended June 30, 2004 and 2003 are as follows:

 
| ** **                                         | ** ** | **For the Three Months**        | ** ** | **For the Six Months**  | ** ** | **2004 as Compared to 2003** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                         | ** ** | **Ended June 30,**         | ** ** | **Ended June 30,** | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                                         | ** ** | **2004**                        | ** ** | **2003**                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In thousands, except for%)** | ** ** |
| Stock Based Compensation and Remuneration  Expense | ** ** | $                               | 552        |                    | $          | 546                          |       | $ | 813 |   | $ | 1,098 |   | $ | 6 |   | 1 | % | $ | (285 | ) | (26 | )% |
|                                                    |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in stock based compensation for the three-month periodended June 30, 2004 is due to the modification of an option grant to anemployee and the associated expense ($0.4 million), otherwise there has beenlittle compensation expense being attributed to our more recent stock optiongrants, stock-based compensation and remuneration expense has been decreasingas grants made to employees in earlier years become fully vested.  Historical stock-based compensation andremuneration is not necessarily representative of the effects on reportedincome or loss for future years due to, among other things, the vesting periodof the stock options, the value of stock options that have been granted inrecent times and the value of additional options that may be granted in futureyears.

 

*Employee Termination Charges.*  Impairment, employee termination benefits andother costs for the three-month and six-month periods ended June 30, 2004and 2003 are as follows:

 
| ** **                   | ** ** | **For the Three Months**        | ** ** | **For the Six Months**  | ** ** | **2004 as Compared to 2003** | ** ** |
|------------------------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                   | ** ** | **Ended June 30,**         | ** ** | **Ended June 30,** | ** ** | **Three Months**             | ** ** | **Six Months** | ** ** |
| ** **                   | ** ** | **2004**                        | ** ** | **2003**                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                   | ** ** | **(In thousands, except for%)** | ** ** |
| Employee Termination Charges | ** ** | $                               | 0          |                    | $          | 306                          |       | $ | 0 |   | $ | 791 |   | $ | (306 | ) | (100 | )% | $ | (791 | ) | (100 | )% |
|                              |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Beginning in September 2002, we implemented a cost reductionprogram aimed at achieving positive operating cashflow from existing operationsby the end of 2003.  In this regard, wereduced total worldwide headcount, focusing in particular on utilizing ongoingprocess automation and increased productivity in the core genetics operationsin Reykjavik, Iceland.  During the yearended December 31, 2003, we recorded $951,000 of additional employeeterminations benefits.  The followingsummarizes the charges, payments and unpaid termination benefits for the threeand six-month periods ended June 30, 2004 and 2003 related to theSeptember 2002 initiative:

 
| ** **                     | ** ** | **For the Three Months   Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------|------------|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                     | ** ** | **2004**                                       | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                     | ** ** | **(In thousands)**                             | ** ** |
| Balance at beginning of period |       | $                                              | 0          |                                        | $          | 204 |   | $ | 66 |   | $ | 874 |   |
| Additions to accrual           |       | 0                                              |       | 306                                         |       | 0 |   | 791 |   |
| Payments of benefits           |       | 0                                              |       | (219                                        | )          | (66 | ) | (1,374 | ) |
| Balance at June 30        |       | $                                              | 0          |                                        | $          | 291 |   | $ | 0 |   | $ | 291 |   |

 

22

----

 

The charges related totermination benefits are for 17 and 44 employees during the three and six-monthperiods ended June 30, 2003.  Costof severances subsequent to and not related to the September 2002 initiative are reported as research and development orselling, general and administrative expenses, as appropriate.

 

*Interest Income.*  Interest income for the three-month andsix-month periods ended June 30, 2004 and 2003 is as follows:

 
| ** **       | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** | **2004 as Compared to 2003** | ** ** |
|------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|
| **Three Months** | ** ** | **Six Months**                                |
| ** **       | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except for%)**               | ** ** | ** **                                  |
| Interest Income  |       | $                                             | 746        |                                        | $          | 299                          |       | $ | 981 |   | $ | 654 |   | $ | 447 |   | 149 | % | $ | 327 |   | 50 | % |
|                  |            |                                               |            |                                             |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increases in interest income for the three and six-month periodsended June 30, 2004 as compared to the same periods in 2003 mainly ariseas a result of the completion of the offering of 3.5% Senior Convertible Notesrealizing net proceeds of $143.8 million. We expect to use the proceeds of this offering principally for advancingour drug development programs.  In themeantime, we will invest the 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 to maintain our portfolio of cashequivalents and short-term investments in a variety of securities, includingcommercial paper, money market funds and government and non-government debtsecurities.  As a result, we expect thatthe amount of our interest income will increase in the future although the rateof returns on the portfolio may not increase appreciably.

 

*Interest Expense.*  Interest expense for the three-month andsix-month periods ended June 30, 2004 and 2003 is as follows:

 
| ** **       | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** | **2004 as Compared to 2003** | ** ** |
|------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|
| **Three Months** | ** ** | **Six Months**                                |
| ** **       | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except for%)**               | ** ** |
| Interest Expense | ** ** | $                                             | 2,113      |                                        | $          | 861                          |       | $ | 3,312 |   | $ | 1,777 |   | $ | 1,252 |   | 145 | % | $ | 1,535 |   | 86 | % |
|                  |            |                                               |            |                                             |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increases in interest expense for the three and six-month periodsended June 30, 2004 as compared to the same period in 2003 principallyreflect interest on our 3.5% Senior Convertible Notes due 2011 that we issuedin April 2004.  We will pay intereston the Senior Convertible Notes in April and October of each year,beginning October 2004.  As aresult, our interest expense will increase $5.3 million annually.

 

*Other Non-Operating Income and Expense, Net.*  Other non-operating income and expense forthe three-month and six-month periods ended June 30, 2004 and 2003 is asfollows:

 
| ** **                                     | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** | **2004 as Compared to 2003** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|
| **Three Months**                               | ** ** | **Six Months**                                |
| ** **                                     | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **(In thousands, except for%)**               | ** ** |
| Other Non-Operating Income and (Expense),  Net | ** ** | $                                             | (235       | )                                           | $          | 606                          | ** ** | $ | (1,893 | ) | $ | 696 |   | $ | (841 | ) | (139 | )% | $ | (2,589 | ) | (372 | )% |
|                                                |            |                                               |            |                                             |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our other non-operating income and expense, net for the three andsix-month periods ended June 30, 2004 and 2003 comprises unrealized andrealized swap gains and losses and the net impact of foreign exchange.  In March 2004, we liquidated our two cross-

 

23

----

 

currency swaps receiving $9.7 million inproceeds.  We realized a loss on thisearly termination that, together with unrealized losses on the swaps during thequarter ended March 31, 2004, amounted to $1.5 million.

 

Unrealized (losses)/gains on the two cross-currency swaps for thethree-month periods ended June 30, 2004 and 2003 were $0 and $1.0 million,respectively, and for the six-month periods ended June 30, 2004 and 2003were $(1.5) and $1.2 million, respectively.

 

Net foreign exchange losses for the three-month periods endedJune 30, 2004 and 2003 were $0.2 and $0.4 million, respectively, and forthe six-month periods ended June 30, 2004 and 2003 were $0.4 and $0.5million, respectively.

 

*Income Taxes.*  As of June 30, 2004, we had anaccumulated deficit of $355.5 million and did not owe any Icelandic or U.S.federal income taxes nor did we pay any in the three-month and six-monthperiods ended June 30, 2004 and 2003. Realization of deferred tax assets is dependent on future earnings, ifany.  As of December 31, 2003, wehad net operating losses able to be carried forward for U.S. federal income taxpurposes of approximately $31.4 million to offset future taxable income inthe United States that expire at various dates through 2023.  Also, as of December 31, 2003, ourforeign subsidiaries had net operating losses carried forward of approximately$146.3 million that expire in varying amounts beginning in 2006.

 

*Net Loss and Basic and Diluted Net Loss PerShare*. Net loss and basic and diluted net loss pershare for the three-month and six-month periods ended June 30, 2004 and2003 are as follows:

 
| ** **                           | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** | **2004 as Compared to 2003** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|
| **Three Months**                     | ** ** | **Six Months**                                |
| ** **                           | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004**                     | ** ** | **2003** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In thousands, except for%)**               | ** ** |
| Net Loss                             | ** ** | $                                             | 13,279     |                                        | $          | 10,232                       |       | $ | 25,315 |   |  $23,274 |   | $ | 3,047 |   | 30 | % | $ | 2,041 |   | 9 | % |
|                                 | ** ** |                                          |       |                                        |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic and Diluted Net Loss Per Share | ** ** | $                                             | (0.25      | )                                           | $          | (0.20                        | )          | $ | (0.48 | ) | $ | (0.45 | ) | $ | (0.05 | ) | 25 | % | $ | 0.03 |   | 7 | % |
|                                      |            |                                               |            |                                             |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Net loss and basic and diluted net loss per share both increasedprincipally due to lower revenues, higher interest expense related to our convertible debtand general and administrative expenses, offset in part by the efficiencies gainedin streamlining and automation of our core genetics research operations.

 

**Liquidity and Capital Resources**

 

We have financed our operations primarily through funding from researchand development collaborative agreements and the issuance of equity securitiesand long-term financing instruments ($691 million from the beginning of1999 to-date).  Future funding underterms of our existing agreements is approximately $58 million excludingmilestone payments and royalties that we may earn under such collaborations.  In April 2004, we completed an offeringof 3.5% Senior Convertible Notes in which we received $144 million, net ofexpenses.

 

Although we currently depend upon funded research arrangements for asignificant portion of our revenue, we continue to invest in proprietaryresearch and we will incur the costs of such research.  In the near term, this will require us tocontinue to make investments in our in-house capabilities for downstreamdevelopment which we believe will better position us to capture the most valueto us in our discoveries.  As we identifypromising discoveries for further development, we may choose to continue thedevelopment ourselves into and through clinical trials, regulatory clearances andmanufacture, distribution and marketing. In other cases we are or will beworking to varying degrees with partners. The decisions we make as to these matters will affect our cashrequirements.

 

Based upon the range of our current activities, and without regard tothe proceeds from our recent offering of Senior Convertible Notes and anychanges we may make in advancing our drug development programs as a result ofthe additional resources provided by the offering, we currently expect to havean overall net use of cash in 2004 in our operating, investing and financingactivities very similar to that used in 2003 ($18.6 million).  Debt service in 2004 together with netpayments on short-term borrowings are expected to amount to $15.0 million,excluding the additional $5.2 million annual interest on our new 3.5% SeniorConvertible Notes.

 

In February 2004, we received total proceeds of $20.0 millionfrom Merck for their purchase of deCODE common stock and an upfront technologyaccess fee.  Of the $20.0 millionreceived, $7.3 million has been ascribed to the value of the common stock and$12.7 million considered upfront payments associated with thecollaboration.  Although our capitalexpenditure needs and other investing activities may in the future fluctuate significantlyfrom period to period, we currently anticipate that we will largely only makereplacement capital expenditures in 2004. We will continue to carefully manage our basic operating costs.  However, having completed our $150,000,000Senior Convertible Notes offering we are better positioned to advance our ownprograms and to make decisions as to which programs to partner and how.  We are able and ready to deploy the necessaryresources to bring our proprietary programs into the clinic and we will bere-examining our strategic options in advancing such programs. Our mostadvanced proprietary drug discovery programs are in myocardial infarction andperipheral arterial occlusive disease (PAOD). In our myocardial

 

24

----

 

infarction program we in-licensed DG031 in the fourth quarter of 2003,a compound that we will be testing in the clinic as a treatment for vascularinflammation and the prevention of heart attack and in April 2004 we beganour Phase II information-rich clinical trial. In our PAOD program, during 2003 we advanced into screening of leadcompounds and we anticipate filing an investigational new drug (IND)application in PAOD by the end of 2004 and aims to begin Phase I clinicaltrials in the first quarter of 2005.

 
| ** **                                  | ** ** | **For the Six Month  Periods Ended June 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                           | ** ** | **2003** | ** ** |
| ** **                                  | ** ** | **(In thousands)**                                 | ** ** |
|                                        |       |                                               |       |   |   |
| **Cash provided by  (used in):**            |       |                                               |       |   |   |
| Operating activities                        |       | $                                                  | (3,304     | ) | $ | (17,977 | ) |
| Investing activities                        |       | (59,528                                            | )          | (456 | ) |
| Financing activities                        |       | 161,666                                            |       | (1,830 | ) |
|                                        |       |                                               |       |   |   |
| Cash and cash equivalents, at end of period |       | $                                                  | 161,666    |   | $ | 70,641 |   |

 

*Cash and Cash Equivalents.*  At June 30, 2004, we had $161.7 millionin cash and cash equivalents as compared to $68.7 million at December 31,2003. Together with our restricted cash and resources put into short-terminvestments and marketable securities at June 30, 2004, this balance isapproximately $151.6 million more than at the close of the fourth quarter of2003. The increase reflects net proceeds from our convertible notes issuecompleted in April 2004 ($143.8 million), equity and technology access feepayments received related to the signing of a new drug development alliancewith Merck ($20.0 million) and the liquidation of our two currency swaps ($9.7million) offset with capital expenditures ($1.0 million), debt service ($6.3million) and costs associated with the advancement of our drug developmentprograms.

 

Our resources are invested in accordance with our investment policy’sprimary objectives of liquidity, safety of principal and diversity ofinvestments. Our cash and short-term investments are only deposited in orinvested with financial institutions in Iceland, the United Kingdom and theUnited States having a high credit standing. At June 30, 2004, our cash islargely invested in U.S. dollar denominated money market and checking accountsand also in Icelandic krona denominated accounts. At June 30, 2004, ourcash equivalents and our marketable securities are principally investments inauction-rate preferred securities, and our short-term investments consist ofcertificates of deposit with maturities up to seven months.

 

*Operating Activities.*  Net cash used in operating activitiesdecreased to $3.3 million for the six-months ended June 30, 2004 ascompared to $18.0 million for the same period in 2003. Together with the $12.7million technology access fee and premium on common stock received from Merckin the six-months ended June 30, 2004, working capital provided $13.7million of funds as compared to a use $2.9 million in the six-month periodended June 30, 2003. As more fully described above, the decrease in use ofcash in operating activities reflects both the successful streamlining andautomation of the company’s core genetics research operations and research anddevelopment investments being made in advancing our drug development programs.

 

*Investing Activities.*  Our investing activities have consisted ofcapital expenditures and long-term strategic equity investments in, andacquisitions of, technologies and businesses that are complementary to ourbusiness. Purchases of property and equipment during the six-month period endedJune 30, 2004 were $1.0 million as compared to $0.5 million in thesix-month period ended June 30, 2003. We principally made replacementcapital expenditures during 2003 and into 2004 and did invest in certainequipment for our statistical lab during the six-months ended June 30,2004. Although we expect to continue to make simply replacement capitalexpenditures, net cash used in investing activities may in the future fluctuatesignificantly from period to period due to the timing of our capitalexpenditures and other investments.

 

Investments in marketable securities and short-term investments duringthe six-month period ended June 30, 2004 consist of money market preferredsecurities and certificates of deposit with maturities of up to seven months.

 

*Financing Activities.*  Net cash of $155.8 million was provided infinancing activities in the six-month period ended June 30, 2004, ascompared to $1.8 million used in financing activities in the six-month periodended June 30, 2003. Financing activities for the six-month period endedJune 30, 2004 largely consisted of net proceeds from our convertible notesissue completed in April 2004 ($143.8 million), proceeds on the issuanceof common stock to Merck ($7.7 million), proceeds in the liquidation of our twocross-currency swap ($9.7 million) and installment payments on our existingdebt and capital lease obligations ($6.3 million).

 

In April 2004, we completed an offering of 3.5% Senior ConvertibleNotes due 2011 to qualified institutional buyers. In addition to the $125.0million principal amount of Notes offered, we issued a further $25.0 million ofNotes pursuant to the exercise of the over-allotment option by the initialpurchasers of the Notes. The Notes are convertible into shares of our commonstock, at the option of the holder, at a price of $14.00 per share, equivalentto an initial conversion rate of approximately 71.43 shares per $1,000principal amount of the Notes. We may redeem the Notes beginning April 20,2009. We expect to use the proceeds of the offering principally for advancingour drug development programs, as well as for general corporate purposes.

 

25

----

 

InMarch 2004, we entered into a $17,500,000 term loan with an Icelandicfinancial institution (the “Lender”) to refinance our Tier C bonds and Tier Dbank loan, thereby securing a significantly lower interest rate and extendedpayment terms on this portion of our mortgage obligations. The new term loanbears interest at the three-month LIBOR plus 3% (4.33% as of June 30,2004) until March 1, 2009, at which point, the Lender may adjust theinterest margin unilaterally. The term loan is payable in twenty quarterlypayments starting on March 1, 2009 and the final payment is due onDecember 1, 2013. The term loan can be repaid on every anniversary of theloan starting on March 1, 2006, but for which we will pay a prepayment feeof 1% for every year that remains on the term loan facility with a maximum feeof 6%.

 

*ContractualCommitments*. Our major outstanding contractualcommitments relate to the privately placed bonds and bank loans and equipmentlease financings. Our contractual commitments as of June 30, 2004 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                  |       | $                          | 150,000    |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 150,000 |   |
| Long-term debt                                 |       |                       | 48,292     |   |   | 4,819 |   |   | 19,169 |   |   | 8,534 |   |   | 15,770 |   |
| Capital lease obligations, including  interest |       | 5,584                      |       | 3,834 |   | 1,688 |   | 62 |   | 0 |   |
| Operating leases                               |       | 1,776                      |       | 1,178 |   | 597 |   | 1 |   | 0 |   |
|                                           |       | $                          | 205,652    |   | $ | 9,831 |   | $ | 21,454 |   | $ | 8,597 |   | $ | 165,770 |   |

 

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

 

We will require significantadditional capital in the future, which we may seek to raise through furtherpublic or private equity offerings, additional debt financing or addedcollaborations and licensing arrangements. No assurance can be given thatadditional financing or collaborations and licensing arrangements will beavailable when needed, or that if available, will be obtained on favorableterms. If adequate funds are not available when needed, we may have to curtailoperations or attempt to raise funds on unattractive terms.

 

## ***Recent Accounting Pronouncements***

## *** ***

In January 2003, the Financial Accounting Standards Board (FASB)issued FASB Interpretation No. 46, “Consolidation of Variable InterestEntities, an Interpretation of ARB No. 51”, (FIN 46).  FIN 46 requires that if an entity has acontrolling financial interest in a variable interest entity, the assets,liabilities and results of activities of the variable interest entity should beincluded in the consolidated financial statements of the entity. FIN 46requires that its provisions are effective immediately for all arrangementsentered into after January 31, 2003. For those arrangements entered intoprior to January 31, 2003, FIN 46, as amended by FIN 46R, provisions arerequired to be adopted in the first quarter of 2004. We do not have anyfinancial interests in variable interest entities created afterJanuary 31, 2003. The adoption of FIN 46R did not impact on our financialposition or its results of operations.

 

**RISKFACTORS, FORWARD-LOOKING STATEMENTS, AND CAUTIONARY FACTORS THAT MAY AFFECTFUTURE RESULTS**

 

This report containsforward-looking statements. These statements relate to future events or ourfuture financial performance. In some

 

26

----

 

cases, forward-lookingstatements can be identified by terminology such as “may,” “will,” “should,”“could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,”“intend,” “potential” or “continue” or the negative of such terms or othercomparable terminology. These statements are only predictions. We cannot assureour investors that our expectations and assumptions will prove to have beencorrect. We undertake no intention or obligation to update or revise anyforward-looking statements, whether as a

 

result of future events, new information orotherwise. Actual events or results may differ materially due to a number offactors,  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 toOur Business**

# ** **

We may not successfully develop or derive revenues from any products.

 

We use our technology and research capabilities primarily to identifygenes or gene fragments that are responsible for certain diseases,indicate the presence of certain diseases or cause or predispose individuals tocertain complex diseases. Although we have identified genes that we believe arelikely to cause certain diseases, we may not be correct and may not besuccessful in identifying any other similar genes. Many experts believe thatsome of the diseases we are targeting are caused by both genetic and environmentalfactors. Even if we identify specific genes that are partly responsible forcausing diseases, any gene-based therapeutic or diagnostic products may notdetect, prevent, treat or cure a particular disease. Accordingly, even if weare successful in identifying specific genes, our discoveries may not lead tothe development of commercial therapeutic or diagnostic products.

 

Any pharmaceutical or diagnostic products that we or our collaboratorsare able to develop will fail to produce revenues unless we:

 

•                  establish thatthey are safe and effective;

 

•                  successfully compete with other technologies and products;

 

•                  ensure that theydo not infringe on the proprietary rights of others;

 

•                  establish thatthey can be manufactured in sufficient quantities at reasonable costs; and

 

•                  can market themsuccessfully.

 

We may not be able to meet these conditions. We expect that it will beyears, if ever, before we will recognize significant revenue from thedevelopment of therapeutic or diagnostic products.

 

Our informatics products may not meet the needs of potential customers.We have generated little revenue from sales or licenses of informaticsproducts. We cannot assure you that we can successfully develop orcommercialize, or that there will be a market for, our informatics products.

 

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

 

We incurred a net loss of $25.3 million for the six-month period endedJune 30, 2004, and had an accumulated deficit of $355.5 million atJune 30, 2004. We have never generated a profit and we have not generatedrevenues except for payments received in connection with our research anddevelopment collaborations with Roche, Merck and other collaborations, and fromcontract services. 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) and to prepare our informaticsproducts. We do not expect to receive royalties or other revenues fromcommercial sales of products developed using our technology in the nearterm.  It may be several years beforeproduct revenues materialize, if they do at all.  As a result, we expect to incur net lossesfor several years. If the time required to generate product revenues and achieveprofitability is longer than we currently anticipate or the level of losses isgreater than we currently anticipate, we may not be able to continue ouroperations.

 

***If our assumptionabout the role of genes in disease is wrong, we may not be able to developuseful products.***

 

The products we hope to develop involve new and unproven approaches.They are based on the assumption that information about genes may helpscientists to better understand complex disease processes. Scientists generallyhave a limited understanding of the role of genes in diseases, and few productsbased on gene discoveries have been developed. Of the products that exist, allare diagnostic products. To date, we know of no therapeutic products based ondisease-gene discoveries. If our assumption about the role of genes in thedisease process is wrong, our gene discovery programs may not result inproducts, the genetic data included in our database and informatics productsmay not be useful to our customers and those products may lose any competitiveadvantage.

 

27

----

 

***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 commercial sale of any ofour products under development, we must demonstrate through pre-clinicalstudies and clinical trials that the product is safe and effective for use ineach target indication. Pre-clinical testing and clinical development are long,expensive and uncertain processes. It may take several years to completetesting for a product and failure can occur at any stage of testing. The lengthof time necessary to complete clinical trials varies significantly and may bedifficult to predict. Factors that can cause delay or termination of ourclinical trials include:

 

•                  slower thanexpected patient enrollment due to the nature of the protocol, the proximity ofpatients to clinical sites, the eligibility criteria for the study, competitionwith clinical trials for other drug candidates or other factors;

 

•                  lower than expected retention rates of patients in aclinical trial;

 

•                  inadequately trained or insufficient personnel at the studysite to assist in overseeing and monitoring clinical trials;

 

•                  delays in approvals or failure to obtain approval from thepertinent review board for studies conducted at sites outside of Iceland;

 

•                  delays in approvals or the failure to obtain approval fromthe National Bioethics Committee for trials in Iceland;

 

•                  longer treatment time required to demonstrate effectivenessor determine the appropriate product dose;

 

•                  lack of sufficient supply of the product candidate;

 

•                  adverse medical events or side effects in treated patients;

 

•                  lack of effectiveness of the product candidate being tested;and

 

•                  regulatory changes.

 

Even if we obtain positive results from pre-clinical or clinical trialsfor a particular product, we may not achieve the same success in future trialsof that product. In addition, some or all of the clinical trials we undertakemay not demonstrate sufficient safety and efficacy to obtain the requisiteregulatory approvals, which could prevent the creation of marketable products.Our product development costs will increase if we have delays in testing orapprovals, if we need to perform more or larger clinical trials than planned orif our trials are not successful. Delays in our clinical trials may harm ourfinancial results and the commercial prospects for our products.  Delays or termination of clinical trials thatwe conduct for our partners or customers may also harm our financial results aspayments under these contracts may be delayed, reduced or curtailed.

 

***Because revenues areconcentrated, the loss of a significant customer would harm our business.***

 

Historically, a substantial portion of our revenue has been derivedfrom contracts with a limited number of significant customers. Our largestcustomer, Roche, accounted for approximately 43% of our consolidated revenue in2003 and 32% and 33% of consolidated revenue in the three and six-month periodsended June 30, 2004, respectively. Revenue under our alliance with Merckaccounted for approximately 19% of consolidated revenue in 2003 and 17% and 18%of consolidated revenue in the three and six-month periods ended June 30,2004. Revenues under the joint development and commercialization agreement withABG, which was terminated in the fourth quarter of 2002, accounted for 15% ofconsolidated revenue in the year ended December 31, 2002. The loss of anysignificant customer may significantly lower our revenues and affect ourprogression to profitability.

 

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

 

We have spent substantial amounts of cash to fund our research anddevelopment activities and expect to continue to spend substantial amounts forthese activities over the next several years. We expect to use cash to collect,generate and analyze genotypic and disease data from volunteers in ourdisease-gene research programs; to conduct drug discovery and developmentactivities; to continue to develop database and healthcare informatics products;and to continue other research and development activities. Many factors willinfluence our future capital needs, including:

 

•                  the number, breadth and progress of our discovery andresearch programs;

 

•                  our ability to attract customers;

 

•                  our ability to commercialize our discoveries and theresources we devote to commercialization;

 

•                  the amount we spend to enforce patent claims and otherintellectual property rights; and

 

•                    the costsand timing of regulatory approvals.

 

We intend to rely on Roche, Merck and other existing and futurecollaborators for significant funding of our research efforts. In addition, wemay seek additional funding through public or private equity offerings and debtfinancings. We may not be able to obtain

 

28

----

 

additional financing when we need it or thefinancing 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 and licensingarrangements, we may have to relinquish rights to some of our technologies orproduct candidates, or grant licenses on unfavorable terms. If adequate fundsare not available, we would have to scale back or terminate our discovery andresearch programs and product development.

 

The Icelandic parliament enacted legislation in 2002, authorizing theMinister of Finance to provide an Icelandic government guarantee of aconvertible bond offering of up to $200 million by us for the purpose offinancing our new activities in the area of drug development.  To become effective, this legislation must beapproved by the European Free Trade Association Surveillance Authority, or ESA,following a notification to ESA by the Minister of Finance. ESA’s task is toensure compatibility with the state aid stipulations of the agreement on theEuropean Economic Area, to which Iceland is a signatory. The ESA began a formalinvestigation procedure with regard to the proposed state guarantee in2003.  Following completion of the saleof our 3.5% Senior Convertible Notes due 2011 in April, 2004, we advised theMinister of Finance that we did not intend to seek government guaranteedfinancing pursuant to this legislation. As a result, the Minister of Finance withdrew its notification of theproposed state aid to ESA, which subsequently terminated its review. At thistime no action is being take to make the 2002legislation effective, nor is it likely that such action will be taken in thefuture.

 

***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 selling pharmaceuticalproducts. In order to achieve commercial success for any approved product, wemust either develop a marketing and sales force, which will require substantialadditional funds and personnel, or, where appropriate or permissible, enterinto arrangements with third parties to market and sell our products. We mightnot be successful in developing marketing and sales capabilities. Further, wemay not be able to enter into marketing and sales agreements with others onacceptable terms, and any such arrangements, if entered into, may beterminated. If we develop our own marketing and sales capability, it willcompete with other companies that currently have experienced, well-funded andlarger marketing and sales operations. To the extent that we enter intoco-promotion or other sales and marketing arrangements with other companies,revenues will depend on the efforts of others, 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 for commercial purposesand do not have manufacturing facilities. We must either develop suchfacilities, which will require substantial additional funds, or rely oncontract manufacturers for the production of products for development andcommercial purposes. 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 profit margin, if any, on the sale of future products andour ability to develop and deliver such products on a timely and competitivebasis.

 

***Our reliance on theIcelandic population may limit the applicability of our discoveries to certainpopulations.***

 

The genetic make-up and prevalence of disease generally varies acrosspopulations around the world. Common complex diseases generally occur with asimilar frequency in Iceland and other European populations. However, thepopulations of other nations may be genetically predisposed to certain diseasesbecause of mutations not present in the Icelandic population. As a result, weand our partners may be unable to develop diagnostic and therapeutic productsthat are effective on all or a portion of people with such diseases. Anydifference between the Icelandic population and other populations may have aneffect on the usefulness of the Clinical Genome Miner in studying populationsoutside of Iceland. For our business to succeed, we must be able to applydiscoveries that we make on the basis of the Icelandic population to othermarkets.

 

***If we fail toprotect confidential data adequately, we could incur a liability or lose theIcelandic Health Sector Database license.***

 

Under laws and regulations in force in Iceland, including applicableEuropean laws, directives and regulations, all information on individuals thatis used in our population research is anonymized under the protocols andsupervision of the Data Protection Authority of Iceland. If any of this dataheld or generated by us were to become personally identifiable, we would risklosing public support for participation in its research, and could be liable tolegal action. Any failure to comply fully with all confidentiality requirementscould lead to liability for damages incurred by individuals whose privacy isviolated, the loss of our customers and reputation and the loss of 

 

29

----

 

the goodwill and participation of theIcelandic population, including healthcare professionals. These eventualitiescould materially adversely affect our work in Iceland.

 

The same general privacy and data protection laws and regulations aswell as specific laws and regulations apply to our license to build and operatethe Icelandic Health Sector Database, or IHD. Were any data sent to orcontained in the IHD to become personally identifiable, we would incur the samerisks above and potentially lose our database license.

 

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

 

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

 

•                  supervisingclinical trials;

 

•                  data and laboratory analysis;

 

•                  patient recruitment;

 

•                  acting asinvestigators in conducting clinical trials; and

 

•                  engaging inPhase I clinical trials.

 

If, in the course of these trials or activities,

 

•                  we do not perform our services to contractual or regulatorystandards;

 

•                  we fail to obtain permission to conduct trials from theNational Bioethics Committee of Iceland;

 

•                  patients or volunteers suffer personal injury caused by ordeath from adverse reactions to the test drugs or otherwise;

 

•                  there are deficiencies in the professional conduct of theinvestigators with whom we contract;

 

•                  our laboratories inaccurately report or fail to report labresults; or

 

•                  our informatics products violate rights of third parties,

 

then we could be held liable for theseeventualities by the drug companies with whom we contract or by studyparticipants. We maintain product liability insurance for claims arising fromthe use of products we are developing in clinical trials conducted by Encodeand are covered by the product liability insurance of the drug companies forwhom we provide clinical trial services for claims arising from the use oftheir products in such trials.  Suchinsurance may be inadequate and in any event would not cover the risk of acustomer deciding not to do business with us as a result of poor performance orclaims for a customer’s financial loss as the result of our failure to performour contractual obligations properly.

 

***Use of therapeuticor diagnostic products developed as a result of our programs may result inproduct liability claims for which we have inadequate insurance.***

 

The users of any therapeutic or diagnostic products developed by us orour collaborators as a result of our discovery or research programs or the useof our database or informatics products may bring product liability claimsagainst us. Except as described above with respect to clinical trials conductedby Encode, we currently do not carry liability insurance to cover such claims.We are not certain that we, or our collaborators willbe able to obtain such insurance or, if obtained, that sufficient coverage canbe acquired at a reasonable cost. If we cannot protect against potentialliability claims, we or our collaborators may find it difficult or impossibleto commercialize products.

 

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

 

AtJune 30, 2004, we have $207,949,000 of outstanding debt as reflected inour balance sheet.  We may incuradditional indebtedness in the future and the Notes do not restrict our futureissuance of indebtedness.  Our level ofindebtedness will have several important effects on our future operations,including, without limitation:

 

•                                          a portion of our cash flow from operationswill be dedicated to the payment of any interest  required with respect to outstandingindebtedness;

 

•                                          increases in our outstanding indebtedness andleverage will increase our vulnerability to adverse changes in general economicand industry conditions, as well as to competitive pressure; and

 

•                                          depending on the levels of our outstandingdebt, our ability to obtain additional financing for working capital, capitalexpenditures, general corporate and other purposes may be limited.

 

Ourability to make payments of principal and interest on our indebtedness dependsupon our future performance, which will be subject to the success of ourdevelopment and commercialization of new pharmaceutical products, generaleconomic conditions,

 

30

----

 

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:

 

•                                            to seek additional financing in the debt orequity markets;

 

•                                            to refinance or restructure all or a portion ofour indebtedness, including the Notes;

 

•                                            to sell selected assets; or

 

•                                            to reduce or delay planned expenditures onclinical trials, and development and commercialization activities.

 

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

 

***We may be unable tohire and retain the key personnel upon whom our success depends.***

 

Wedepend on the principal members of our management and scientific staff,including Dr. Kari Stefansson, Chairman, President and Chief ExecutiveOfficer.  We have not entered intoagreements with any of these people that bind them to a specific period ofemployment. If any of these people leaves, our ability to conduct ouroperations may be negatively affected. Our future success also will depend inpart on our ability to attract, hire and retain additional personnel. There isintense competition for such qualified personnel and we cannot be certain thatwe will be able to continue to attract and retain such personnel. Failure toattract and retain key personnel could have 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 a portion of ourcash reserves and our operating costs are in Icelandic kronas. A fluctuation ofthe exchange rates of the Icelandic krona against the U.S. dollar can thusadversely affect the “buying power” of our cash reserves and revenues. Most ofour long-term liabilities are U.S. dollar denominated. However, we may enterinto hedging transactions if we have substantial foreign currency exposure inthe future. We may have increased exposure as a result of investments orpayments from collaborative partners.

 

***Our contracts mayterminate upon short notice.***

 

Many of our contracts for research services are terminable on shortnotice. This means that our contracts could be terminated for numerous reasons,any of which may be beyond our control such as a reduction or reallocation of acustomer’s research and development budget or a change in a customer’s overallfinancial condition. The loss of a large contract or multiple smallercontracts, or a significant decrease in revenue derived from a contract, couldsignificantly reduce our profitability and require us to reallocateunder-utilized physical and professional resources.

 

# **Risks Related toOur Collaborators**

# ** **

***We may not be ableto form and maintain the collaborative relationships that our business strategyrequires and the relationships may lead to disputes over technology rights.***

 

Our ability to generate revenue growth and become profitable isdependent, in part, upon our ability to enter into additional collaborativearrangements, and upon our ability and that of our collaborative partners tosuccessfully commercialize products incorporating, or based upon, our work.

 

We must form research collaborations and licensing arrangements withseveral partners at the same time in order to execute our business strategy. Wecurrently have a number of collaborative relationships and only threesubstantial collaborative relationships, including two with Roche. To succeed,we will have to maintain or expand these relationships and establish additionalcollaborations. There can be no assurance that we will be able to maintain orexpand our existing collaborations, enter into future collaborations to developapplications based on existing or future research agreements, sign additionalsubscribers to our database services, or successfully expand our medicinalchemistry or pharmacogenomics businesses.

 

Ifour collaborations are not successful or if we are not able to manage multiplecollaborations successfully, our programs will suffer. If we increase thenumber of collaborations, it will become more difficult to manage the variouscollaborations successfully and the potential for conflicts among the collaboratorsas to rights to the technology and products generated under work conducted withus will increase.

 

31

----

 

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

 

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

 

In addition, our arrangements may place responsibility for key aspectsof information technology, product development and marketing on ourcollaborative partners. If our collaborators fail to perform their obligations,our information technology products could contain erroneous data, designdefects, viruses or software defects that are difficult to detect and correctand may adversely affect our revenues and the market acceptance of ourproducts.

 

Our collaborators may stop supporting our products or providingservices to us if they develop or obtain rights to competing products. Disputesmay arise in the future over the ownership of rights to any technologydeveloped with collaborators. These and other possible disagreements betweenour collaborators and us could lead to delays in the collaborative research,development or commercialization of products. Such disagreements could alsoresult in litigation or require arbitration to resolve.

 

# **Risks Related toOur Industry**

# ** **

***Concerns regardingthe use of genetic testing results may limit the commercial viability of anyproducts we develop.***

 

Other companies have developed genetic predisposition tests that haveraised ethical concerns. It is possible that employers or others coulddiscriminate against people who have a genetic predisposition to certaindiseases. Concern regarding possible discrimination may result in governmentalauthorities enacting restrictions or bans on the use of all, or certain typesof, genetic testing. Similarly, such concerns may lead individuals to refuse touse genetic tests even if permissible. These factors may limit the market for,and therefore the commercial viability of, products that our collaboratorsand/or we may develop.

 

***We may not be ableto compete successfully with other companies and government agencies in thedevelopment and marketing of product services.***

 

A number of companies are attempting to rapidly identify and patentgenes that cause diseases or an increased susceptibility to diseases.Competition in this field and our other areas of business, including drugdiscovery and development as well as database services and healthcareinformatics, is intense and is expected to increase. We have numerouscompetitors, including major pharmaceutical and diagnostic companies, specializedbiotechnology firms, universities and other research institutions, and othergovernment-sponsored entities and companies providing healthcare informationproducts. Our collaborators, including Roche and Merck, may also compete withus. Many of our competitors, either alone or with collaborators, haveconsiderably greater capital resources, research and development staffs andfacilities, and technical and other resources than we do, which may allow themto discover important genes before we do. We believe that a number of ourcompetitors are developing competing products and services that may becommercially successful and that are further advanced in development than ourpotential products and services. To succeed, we, together with ourcollaborators, must discover disease-predisposing genes, characterize theirfunctions, develop genetic tests or therapeutic products and relatedinformation services based on such discoveries, obtain regulatory and otherapprovals, and launch such services or products before competitors. Even if weor our collaborators are successful in developing effective products orservices, our products and services may not successfully compete with those ofour competitors. Our competitors may succeed in developing and marketing productsand services that are more effective than ours or that are marketed beforeours.

 

Competitors have established, and in the future may establish, patentpositions with respect to gene sequences related to our research projects. Suchpatent positions or the public availability of gene sequences comprisingsubstantial portions of the human genome could decrease the potential value ofour research projects and make it more difficult for us to compete. We may alsoface competition from other entities in gaining access to DNA samples used forresearch and development purposes. Our competitors may also obtain patentprotection or other intellectual property rights that could limit our rights,or our customers’ ability, to use our technologies or databases, or commercializetherapeutic or diagnostics products. In addition, we face, and will continue toface, intense competition from other companies for collaborative arrangementswith pharmaceutical and biotechnology companies, for establishing relationshipswith academic and research institutions and for licenses to proprietarytechnology.

 

We expect competition to intensify as technical advances are made andbecome more widely known. Our future success will depend in large part onmaintaining a competitive position in the genomic field. Others or our 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;

 

•                  develop andmaintain products that reach the market first, and are technologically superiorto, and more cost effective than, other products on the market;

 

•                  obtain patent orother proprietary protection for our products and technologies;

 

32

----

 

•                  attract andretain scientific and product development personnel;

 

•                  obtain requiredregulatory approvals; and

 

•                  manufacture,market and sell products that we develop.

 

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

 

Economic factors and industry trends that affect our primary customers,pharmaceutical and biotechnology companies, also affect our business. Forexample, the practice of many companies in these industries has been tooutsource to organizations like us the conduct of genetic research, clinicalresearch, sales and marketing projects and chemistry research and developmentprojects. If these industries reduce their present tendency to outsource thoseprojects, our operations, financial condition and growth rate could bematerially and adversely affected. These alliances and arrangements are bothtime consuming and complex and we face substantial competition in establishingthese relationships. In addition, our ability to generate new business could beimpaired by general economic downturns in our customers’ industries. We haveexperienced increasing pressure on the part of our customers to reduceexpenses, including the use of our services as a result of negative economictrends generally and in the pharmaceutical 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 diagnostic products inthe countries in which they are to be marketed. We cannot be certain that wecan obtain regulatory approval for any drugs or diagnostic products resultingfrom our gene discovery programs. The regulatory process can take many yearsand require substantial resources. Because some of the products likely toresult from our disease research programs involve the application of newtechnologies 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.

 

After initial regulatory approval, a marketed product 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 from themarket.

 

Our success will depend, in part, on the development and marketing ofproducts based upon our research and development. Strict regulatory controls onthe clinical testing, manufacture, labeling, supply and marketing of theproducts will influence our and our partners’ ability to successfullymanufacture and market therapeutic or diagnostic products. Most countriesrequire a company to obtain and maintain regulatory approval for a product fromthe relevant regulatory authority to enable the product to be marketed.Obtaining regulatory approval and complying with appropriate statutes andregulations is time-consuming and requires the expenditure of substantialresources.

 

Most European countries and the United States have very high standardsof technical appraisal and consequently, in most cases, a lengthy approvalprocess for pharmaceutical products. The regulatory approval processes, whichusually include pre-clinical and clinical studies, as well as post-marketingsurveillance to establish a compound’s safety and efficacy, can take many yearsand require the expenditure of substantial resources. Data obtained from suchstudies is susceptible to varying interpretations that could delay, limit orprevent regulatory approval. Delays or rejections may also be encountered basedupon changes in drug approval policies in applicable jurisdictions. There canbe no assurance that we or our collaborative customers will obtain regulatoryapproval for any drugs or diagnostic products developed as the result of ourgene discovery programs.

 

***Efforts to reducehealthcare costs may reduce market acceptance of our products.***

 

Our success will depend in part on the price and extent to which wewill be paid for our products by government and health administration authorities,private health insurers and other third party payors. Reimbursement for newlyapproved healthcare products is uncertain. Third party payors, includingMedicare in the United States, are increasingly challenging the prices chargedfor medical products and services. They are increasingly attempting to containhealthcare costs by limiting both coverage and the level of reimbursement fornew therapeutic products. We cannot be certain that any third party insurancecoverage will be available to patients for any products we discover or develop.If third party payors do not provide adequate coverage and reimbursement levelsfor our products, the market acceptance of these products may be materiallyreduced.

 

33

----

 

Numerous governments have undertaken efforts to control growinghealthcare costs through legislation, regulation and voluntary agreements withmedical care providers and pharmaceutical companies. If cost containmentefforts limit the profits that can be derived from new drugs, our customers mayreduce their research and development spending which could reduce the businessthey 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,which could have a material adverse effect on our business, financial conditionand results of operations.***

 

Our research and development activities involve the controlled use ofhazardous materials and chemicals. Although we believe that our safetyprocedures for handling and disposing of hazardous materials comply with thestandards prescribed by applicable governmental regulations, the risk ofaccidental contamination or injury from these materials cannot be completelyeliminated. In the event of an accident, we could be held liable for anydamages or fines that result. Such liability could have a material adverseeffect on our business, financial condition, results of operations andliquidity.

 

# **Risks Related toOur Intellectual Property**

# ** **

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

 

Our success will depend in part on our ability to protect our genealogydatabase and genotypic data and any other proprietary databases that we developand our proprietary software and other proprietary methods and technologies.Despite our efforts to protect our proprietary rights, unauthorized parties maybe able to obtain and use information that we regard as proprietary. Our commercialsuccess will depend in part on obtaining patent protection. The patentpositions of pharmaceutical, biopharmaceutical and biotechnology companies,including deCODE, are generally uncertain and involve complex legal and factualconsiderations. We cannot be sure that:

 

•                  any of our pending patent applications will result in issuedpatents;

 

•                  that we will develop additional proprietary technologiesthat are patentable;

 

•                  that any patents issued to us or our partners will provide abasis for commercially viable products, will provide us with any competitiveadvantages or will not be challenged by third parties; or

 

•                  that the patents of others will not have an adverse effecton our ability to do business.

 

Ifwe are unable to obtain patent protection for our technology or discoveries,the value of our proprietary resources will be adversely affected.

 

In addition, patent law relating to the scope of claims in the area ofgenetics and gene discovery is still evolving. There is substantial uncertaintyregarding the patentability of genes or gene fragments without known functions.The laws of some European countries provide that genes and gene fragments maynot be patented. The European Commission has passed a directive that preventsthe patenting of genes in their natural state. The U.S. Patent and TrademarkOffice initially rejected a patent application by the National Institutes ofHealth on partial genes. Accordingly, the degree of future protection for ourproprietary rights is uncertain and, we cannot predict the breadth of claimsallowed in any patents issued to us or others. We could also incur substantialcosts in litigation if we are required to defend ourselves in patent suitsbrought by third parties or if we initiate such suits.

 

Others may have filed and in the future are likely to file patentapplications covering genes or gene products that are similar or identical toour products. We cannot be certain that our patent applications will havepriority over any patent applications of others. The mere issuance of a patentdoes not guarantee that it is valid or enforceable; thus even if we are holdingor are granted patents, we cannot be sure that they would be valid andenforceable against third parties. Further, a patent does not provide the patentholder with freedom to operate in a way that infringes the patent rights ofothers. Any legal action against us or our partners claiming damages andseeking to enjoin commercial activities relating to the affected products andprocesses could, in addition to subjecting us to potential liability fordamages, require us or our partners to obtain a license in order to continue tomanufacture or market the affected products and processes. There can be noassurance that we or our partners would prevail in any action or that anylicense required under any patent would be made available on commerciallyacceptable terms, if at all. If licenses are not available, we or our partnersmay be required to cease marketing our products or practicing our methods.

 

If expressed sequence tags, single nucleotide polymorphisms, or SNPs,or other sequence information become publicly available before we apply forpatent protection on a corresponding full-length or partial gene, our abilityto obtain patent protection for those genes or gene sequences could beadversely affected. In addition, other parties are attempting to rapidlyidentify and characterize genes through the use of gene expression analysis andother technologies. If any patents are issued to other parties on these partialor full-length genes or gene products or uses for such genes or gene products,the risk increases that the sale of our or our collaborators’ potentialproducts or processes may give rise to claims of patent infringement.  The amount of supportive data required forissuance of 

 

34

----

 

patents for human therapeutics is highlyuncertain. If more data than we have available is required, our ability toobtain patent protection could be delayed or otherwise adversely affected. Evenwith supportive data, the ability to obtain patents is uncertain in view ofevolving examination guidelines, such as the utility and written descriptionguidelines that the U.S. Patent and Trademark Office hasadopted.

 

While we require employees, academic collaborators and consultants toenter into confidentiality agreements, there can be no assurance thatproprietary information will not be disclosed, that others will notindependently develop substantially equivalent proprietary information andtechniques, otherwise gain access to our trade secrets or disclose suchtechnology, or that we can meaningfully protect our trade secrets.

 

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

 

The patents we licensed from Bayer for DG031 expire in 2009 and 2012.While we will seek to obtain one or more use patents protecting our proprietaryrights to this compound for a longer period, we cannot be certain that we willobtain such patents or that they will adequately protect us. In addition,although we may seek to extend the term of one of the patents we licensed fromBayer and to obtain marketing exclusivity under the Hatch-Waxman Act, we cannotbe certain that we will be successful. If we cannot obtain new patents orextend the term of patent protection under one of the patents we licensed fromBayer, the amount of revenues that we will be able to derive from an approvedproduct based on these patents may be adversely affected.

 

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

 

The primary objective of our investment activities is to preserveprincipal while maximizing income we receive from our investments withoutsignificantly increasing risk. Some of the securities in our investmentportfolio may be subject to market risk. This means that a change in prevailinginterest rates may cause the market value of the investment to fluctuate. Forexample, if we hold a security that was issued with a fixed interest rate atthe then-prevailing rate and the prevailing interest rate later rises, themarket value of our investment will probably decline. To minimize this risk inthe future, we intend to maintain our portfolio of cash equivalents andshort-term investments in a variety of securities, including commercial paper,money market funds and government and non-government debt securities. Ingeneral, money market funds and bank deposits are not subject to market riskbecause the interest paid on such  funds fluctuates with the prevailinginterest rate. As of June 30, 2004, all of our cash and cash equivalentswere money market preferred securities, money market, bank deposit and checkingaccounts.

 

We are exposed to marketrisks from changes in foreign currency exchange rates, interest rates andinvestment prices. These changes may adversely affect our operating results andfinancial condition. We seek to manage these risks through regular operatingand financing activities and, when deemed appropriate, through the use ofderivative financial instruments. We control and manage foreign exchange risk,interest rate risk, and investment price risk by continually monitoring changesin key economic indicators and market information.

 

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 but have not yet purchasedinstruments to hedge these general risks through the use of derivativefinancial instruments.

 

We hold various interestrate sensitive assets and liabilities to manage the liquidity and cash needs ofour day-to-day operations. As a result, we are exposed to risks due to changesin interest rates. In order to mitigate risks associated with interest ratesensitive liabilities we use interest rate derivative instruments, such ascross currency interest rate swaps, and may in future use other instruments toachieve the desired interest rate maturities and asset/liability structures.

 

We are exposed to credit (orrepayment) risk, as well as market risk from the use of derivative instruments.If the counterparty fails to fulfill its performance obligations under a derivativecontract, our credit risk will equal the positive market value in a derivative.Consequently, when the fair market value of a derivative contract is positive,this indicates that the counterparty owes us, thus creating a repayment riskfor us. When the fair market value of a derivative contract is negative, we owethe counterparty and therefore, assume no repayment risk.

 

In order to minimize thecredit risk in derivative instruments, we enter into transactions with highquality counterparties such as financial institutions that satisfy ourestablished credit approval criteria. We review the credit ratings of suchcounterparties on a regular basis.

 

**ITEM 4.****CONTROLS AND PROCEDURES**

 

(a) Evaluation of disclosurecontrols and procedures. Our Chief Executive Officer and our Chief FinancialOfficer evaluated the effectiveness of deCODE’s disclosure controls andprocedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 

 

35

----

 

1934, as amended (the“Exchange Act”)) as of the end of the fiscal quarter covered by this QuarterlyReport on Form 10-Q. Based upon that evaluation, the Chief Executive Officerand the Chief Financial Officer have concluded that as of the end of suchfiscal quarter, deCODE’s current disclosure controls and procedures areadequate and effective to ensure that information required to be disclosed inthe reports deCODE files under the Exchange Act is recorded, processed,summarized and reported on a timely basis.

 

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

 

**PART II OTHER INFORMATION**

 

**ITEM 1.****LEGAL PROCEEDINGS**

 

There has been no change inthe matters reported in our annual report on Form 10-K for the year endedDecember 31, 2003.

 

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

 

OnApril 14, 2004, we issued $150,000,000 principal amount of our 3.5% SeniorConvertible Notes due 2011 (the “Notes”) to Lehman Brothers Inc., J.P. MorganSecurities Inc., Piper Jaffray & Co., Deutsche Bank Securities andThinkEquity Partners LLC (the “Initial Purchasers”) for a price of 96.5% of theprincipal amount of the Notes, or $144,750,000. The Initial Purchasers resold a portion of the Notes to certainqualified institutional buyers pursuant to Rule 144A under the Securities Actof 1933, as amended (the “Act”).

 

Theoffer and sale of the Notes to the Initial Purchasers were exempt fromregistration under the Act pursuant to Section 4(2) of the Act as atransaction not involving a public offering because of the nature of thepurchasers and the circumstances of the offering. The Initial Purchasers resolda portion of the Notes in reliance on Rule 144A under the Act.  Each Initial Purchaser made representationsto us as to its compliance with Rule 144A. In addition, appropriate legendsrestricting transfer were affixed to the Notes.

 

TheNotes are convertible at any time through maturity into shares of our commonstock, at the option of the holder, at a price of $14.00 per share, which isequivalent to an initial conversion rate of approximately 71.43 shares per$1,000 principal amount of the Notes.

 

**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).                                                                     |

 

36

----

 
| 4.1    |   | Indenture  dated as of April 14, 2004 between deCODE genetics, Inc. and The Bank of  New York (including form of 3.5% Senior Convertible Note due 2011).  (Incorporated by reference to Exhibit 4.2  to the Company’s Registration Statement on Form S-3 (Registration No.  333-116543) which was filed on June 16, 2004). |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                      |
| 4.2    |   | Registration  Rights Agreement dated as of April 14, 2004 between deCODE  genetics, Inc., J.P. Morgan Securities Inc. and Lehman Brothers Inc., as  representatives of the Initial Purchasers.   (Incorporated by reference to Exhibit 4.9 to the Company’s Quarterly  Report on Form 10-Q filed on May 10, 2004).         |
|   |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.1*  |   | Agreement  on Termination of Employment between deCODE  genetics, Inc. and Hannes Smarason dated June 18, 2004.                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                      |
| 31.1   |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                      |
| 31.2   |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                      |
| 32.1   |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            |

 

----

* Constitutes a managementcontract or compensatory plan or arrangement.

 

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

 

(b)REPORTS ON FORM 8-K

 

 On May 5, 2004, deCODE filed a Current Reporton Form 8-K furnishing financial information regarding the results ofoperations and financial condition for the quarter ended March 31, 2004.

 

OnJune 29, 2004, deCODE filed a Current Report on Form 8-K reporting  (i) that Hannes Smarason, Executive VicePresident and Senior Business Officer, would be leaving deCODE and (ii) thecompletion of enrollment for its Phase IIa clinical trial of DG031.

 

37

----

 

**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 6, 2004

 

deCODEgenetics, 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) |                |
|                                            |                     |        |  |

 

 

38

----

 
| **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).                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                      |
| 4.1                 |       | Indenture  dated as of April 14, 2004 between deCODE genetics, Inc. and The Bank of  New York (including form of 3.5% Senior Convertible Note due 2011).  (Incorporated by reference to Exhibit 4.2  to the Company’s Registration Statement on Form S-3 (Registration No.  333-116543) which was filed on June 16, 2004). |
|                |       |                                                                                                                                                                                                                                                                                                                                      |
| 4.2                 |       | Registration  Rights Agreement dated as of April 14, 2004 between deCODE  genetics, Inc., J.P. Morgan Securities Inc. and Lehman Brothers Inc., as  representatives of the Initial Purchasers.   (Incorporated by reference to Exhibit 4.9 to the Company’s Quarterly  Report on Form 10-Q filed on May 10, 2004).         |
|                |       |                                                                                                                                                                                                                                                                                                                                      |
| 10.1*               |       | Agreement  on Termination of Employment between deCODE  genetics, Inc. and Hannes Smarason dated June 18, 2004.                                                                                                                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                      |
| 31.1                |       | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                      |
| 31.2                |       | Certification  pursuant to Section 302 of the Sarbanes-Oxley                                                                                                                                                                                                                                                                         |

 

39

----

 
|   |   | Act  of 2002.                                                                  |
|--------|--------|--------------------------------------------------------------------------------|
|   |   |                                                                           |
| 32.1   |   | Certification  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

* Constitutes a managementcontract or compensatory plan or arrangement.

 

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

 

 

40

----