**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 

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

 

**FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005**

 

**OR**

 

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

 

**FOR THE TRANSITION PERIOD FROM            TO            **

 

**COMMISSION FILE NUMBER 000-30469**

 

**deCODEgenetics, Inc.**(Exact Name ofRegistrant as Specified in Its Charter)

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

 

**STURLUGATA 8, IS-101 REYKJAVIK, ICELAND**(Address of PrincipalExecutive Offices)

 

**+354-570-1900**(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check whetherthe registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe 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 April 29, 2005 was54,546,337 shares of common stock $.001 par value.

 

 

----

 

**deCODE genetics, Inc.**

**INDEX**

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

 

2

----

 

**PART I.FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL S****TATEMENTS**

 

**deCODE genetics, Inc.CONDENSED CONSOLIDATED BALANCE SHEETS**

(Unaudited)

 
| ** **                                                                                                                                                                                                                                       | ** ** | **MARCH 31,**         | ** ** | **DECEMBER 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                       | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                                                                                       | ** ** | **(In  thousands, except** | ** ** |
| ** **                                                                                                                                                                                                                                       | ** ** | **share  amounts)**        | ** ** |
| ASSETS                                                                                                                                                                                                                                           |       |                       |       |                  |       |
| Current assets:                                                                                                                                                                                                                                  |       |                       |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                        |       | $                          | 55,394     |                  | $          | 70,238 |   |
| Investments                                                                                                                                                                                                                                      |       | 142,236                    |       | 122,082               |       |
| Receivables                                                                                                                                                                                                                                      |       | 6,426                      |       | 6,450                 |       |
| Other current assets                                                                                                                                                                                                                             |       | 4,303                      |       | 4,307                 |       |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Total current assets                                                                                                                                                                                                                             |       | 208,359                    |       | 203,077               |       |
| Restricted cash                                                                                                                                                                                                                                  |       | 0                          |       | 6,000                 |       |
| Property and equipment, net                                                                                                                                                                                                                      |       | 29,739                     |       | 60,447                |       |
| Goodwill                                                                                                                                                                                                                                         |       | 8,863                      |       | 8,863                 |       |
| Other long-term assets and deferred charges                                                                                                                                                                                                      |       | 7,974                      |       | 9,865                 |       |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Total assets                                                                                                                                                                                                                                     |       | $                          | 254,935    |                  | $          | 288,252 |   |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                        |       |                       |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                 |       | $                          | 3,647      |                  | $          | 5,829 |   |
| Accrued expenses and other current  liabilities                                                                                                                                                                                                  |       | 11,409                     |       | 9,528                 |       |
| Short-term borrowings                                                                                                                                                                                                                            |       | 228                        |       | 5,069                 |       |
| Current portion of capital lease  obligations                                                                                                                                                                                                    |       | 1,766                      |       | 1,745                 |       |
| Current portion of long-term debt                                                                                                                                                                                                                |       | 2,565                      |       | 7,081                 |       |
| Deferred revenue                                                                                                                                                                                                                                 |       | 10,900                     |       | 8,654                 |       |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Total current liabilities                                                                                                                                                                                                                        |       | 30,515                     |       | 37,906                |       |
| Capital lease obligations, net of current  portion                                                                                                                                                                                               |       | 739                        |       | 1,194                 |       |
| Long-term debt, net of current portion                                                                                                                                                                                                           |       | 156,036                    |       | 189,535               |       |
| Deferred gain on sale-leaseback                                                                                                                                                                                                                  |       | 25,489                     |       | 0                     |       |
| Deferred revenue                                                                                                                                                                                                                                 |       | 6,604                      |       | 7,221                 |       |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Commitments and contingencies                                                                                                                                                                                                                    |       |                       |       |                  |       |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                                       |       |                       |       |                  |       |
| Preferred stock, $0.001 par value; Authorized:  6,716,666 shares Issued and outstanding: none                                                                                                                                                    |       | 0                          |       | 0                     |       |
| Common stock, $0.001 par value; Authorized:  100,000,000 shares; Issued and outstanding: 54,561,468 and 54,541,968 shares,  respectively, at March 31, 2005; and 54,539,069 and 54,522,069 shares,  respectively, at December 31, 2004 |       | 55                         |       | 55                    |       |
| Additional paid-in capital                                                                                                                                                                                                                       |       | 443,171                    |       | 442,999               |       |
| Notes receivable                                                                                                                                                                                                                                 |       | (3,108                     | )          | (3,111                | )          |
| Accumulated deficit                                                                                                                                                                                                                              |       | (404,401                   | )          | (387,465              | )          |
| Accumulated other comprehensive income  (loss)                                                                                                                                                                                                   |       | (41                        | )          | 38                    |       |
| Treasury stock, 19,500 and 17,000 shares  stated at cost at March 31, 2005 and December 31, 2004,  respectively                                                                                                                        |       | (124                       | )          | (120                  | )          |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Total stockholders’ equity                                                                                                                                                                                                                  |       | 35,552                     |       | 52,396                |       |
|                                                                                                                                                                                                                                             |       |                       |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                  |       | $                          | 254,935    |                  | $          | 288,252 |   |

 

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

 

3

----

 

**deCODE genetics, Inc.CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**(Unaudited)

 
| ** **                                                     | ** ** | **FOR THE THREE-MONTHS ENDED MARCH 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except**                     | ** ** |
| ** **                                                     | ** ** | **per share amounts)**                        | ** ** |
|                                                           |       |                                          |       |   |   |
| REVENUE                                                        |       | $                                             | 9,523      |   | $ | 10,282 |   |
|                                                           |       |                                          |       |   |   |
| OPERATING EXPENSES                                             |       |                                          |       |   |   |
|                                                           |       |                                          |       |   |   |
| Cost of revenue, including collaborative  programs             |       | 9,140                                         |       | 11,174 |   |
| Research and development – proprietary  programs          |       | 8,275                                         |       | 4,259 |   |
| Selling, general and administrative                            |       | 4,158                                         |       | 4,263 |   |
|                                                           |       |                                          |       |   |   |
| Total operating expenses                                       |       | 21,573                                        |       | 19,696 |   |
|                                                           |       |                                          |       |   |   |
| Operating loss                                                 |       | (12,050                                       | )          | (9,414 | ) |
| Interest income                                                |       | 1,120                                         |       | 235 |   |
| Interest expense                                               |       | (2,389                                        | )          | (1,199 | ) |
| Other non-operating income and (expense),  net                 |       | (3,617                                        | )          | (1,658 | ) |
|                                                           |       |                                          |       |   |   |
| Net Loss                                                       |       | $                                             | (16,936    | ) | $ | (12,036 | ) |
|                                                           |       |                                          |       |   |   |
| Basic and diluted net loss per share                           |       | $                                             | (0.32      | ) | $ | (0.23 | ) |
|                                                           |       |                                          |       |   |   |
| Shares used in computing basic and diluted net  loss per share |       | 53,649                                        |       | 52,927 |   |

 

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

 

4

----

 

**deCODE genetics, Inc.CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**(Unaudited)

 
| ** **                                                                                 | ** ** | **FOR THE THREE-MONTHS ENDED MARCH 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                                                                                 | ** ** | **(In thousands)**                            | ** ** |
|                                                                                       |       |                                          |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |       |                                          |       |   |   |
| Net loss                                                                                   |       | $                                             | (16,936    | ) | $ | (12,036 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                                          |       |   |   |
| Depreciation and amortization                                                              |       | 2,229                                         |       | 2,921 |   |
| Amortization of deferred stock compensation                                                |       | 48                                            |       | 261 |   |
| Loss on disposal of equipment                                                              |       | 0                                             |       | 23 |   |
| Charges for write-down of obsolete and  excess materials and supplies                      |       | 0                                             |       | 8 |   |
| Loss(gain)on derivative financial  instruments                                             |       | 0                                             |       | 1,465 |   |
| Charges for debt extinguishment                                                            |       | 1,741                                         |       | 0 |   |
| Foreign currency exchange loss on Icelandic  krona denominated debt                        |       | 263                                           |       | (42 | ) |
| Amortization of deferred financing costs                                                   |       | 283                                           |       | 201 |   |
| Other                                                                                      |       | (16                                           | )          | (179 | ) |
| Changes in operating assets and  liabilities:                                              |       |                                          |       |   |   |
| Receivables and other assets                                                               |       | 18                                            |       | 1,204 |   |
| Accounts payable, accrued expenses and  other current liabilities                          |       | (197                                          | )          | 2,220 |   |
| Deferred research revenue                                                                  |       | 1,629                                         |       | 4,858 |   |
| Other                                                                                      |       | 0                                             |       | (174 | ) |
|                                                                                       |       |                                          |       |   |   |
| Net cash provided by (used in) operating  activities                                       |       | (10,938                                       | )          | 730 |   |
|                                                                                       |       |                                          |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |       |                                          |       |   |   |
| Purchase of property and equipment                                                         |       | (538                                          | )          | (693 | ) |
| Purchases of investments                                                                   |       | (85,053                                       | )          | 0 |   |
| Redemptions of investments                                                                 |       | 64,810                                        |       | 0 |   |
| Proceeds from sale of property and  equipment                                              |       | 54,767                                        |       | 39 |   |
|                                                                                       |       |                                          |       |   |   |
| Net cash provided by (used in) investing  activities                                       |       | 33,986                                        |       | (654 | ) |
|                                                                                       |       |                                          |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |       |                                          |       |   |   |
| Issuance of common stock and warrants                                                      |       | 19                                            |       | 14,006 |   |
| Repayment of notes receivable for common  stock                                            |       | 0                                             |       | 841 |   |
| Repayments from short-term borrowings                                                      |       | (341                                          | )          | 0 |   |
| Payments on line of credit                                                                 |       | (4,500                                        | )          | 0 |   |
| Changes in restricted cash                                                                 |       | 6,000                                         |       | 0 |   |
| Debt refinancing cost                                                                      |       | 0                                             |       | (478 | ) |
| Proceeds from swap close-out                                                               |       | 0                                             |       | 9,720 |   |
| Proceeds from debt refinancing                                                             |       | 6,211                                         |       | 0 |   |
| Repayments of debt and capital lease obligations                                           |       | (45,281                                       | )          | (1,878 | ) |
|                                                                                       |       |                                          |       |   |   |
| Net cash provided by (used in) financing  activities                                       |       | (37,892                                       | )          | 22,211 |   |
|                                                                                       |       |                                          |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                      |       | (14,844                                       | )          | 22,287 |   |
| Cash and cash equivalents at beginning of  period                                          |       | 70,238                                        |       | 68,669 |   |
|                                                                                       |       |                                          |       |   |   |
| Cash and cash equivalents at end of period                                                 |       | $                                             | 55,394     |   | $ | 90,956 |   |
|                                                                                       |       |                                          |       |   |   |
| Supplemental schedule of non-cash  transactions:                                      |       |                                          |       |   |   |
| Deferred gain on sale of property                                                          |       | 25,489                                        |       | 0 |   |

 

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

 

5

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**deCODE genetics, Inc.NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (UNAUDITED)**(tabular amounts inthousands, except share and per share amounts)

 

***1.******    ******TheCompany***

 

Referencesin these financial statements to deCODE refer to deCODE genetics, Inc., aDelaware company, and deCODE genetics, Inc.’s wholly-owned subsidiary,Islensk erfdagreining ehf., an Icelandic company registered in Reykjavik, andits subsidiaries, as well as deCODE genetics, Inc.’s wholly-ownedsubsidiary, MediChem Life Sciences, Inc., a Delaware corporation, and itssubsidiaries.

 

## ***2.***     Basisof Presentation

## *** ***

In the opinion of theCompany’s management, the accompanying unaudited condensed consolidatedfinancial statements contain all adjustments (consisting of items of a normaland recurring nature) necessary to present fairly the financial position as of March 31,2005, the results of operations for the three-month periods ended March 31,2005 and 2004 and cash flows for the three-month periods ended March 31,2005 and 2004.  The results of operationsfor the three-month period ended March 31, 2005 are not necessarilyindicative of the results to be expected for the full year.  These financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the yearended December 31, 2004, which includes consolidated financial statementsand notes thereto for the years ended December 31, 2004, 2003 and2002.  Certain reclassifications havebeen made to prior year financial statements to conform to the 2005presentation.

 

Beginningin 2004, deCODE began presenting cost of revenue in its statements ofoperations. To be consistent with the March 31, 2005 operating expenseclassifications, deCODE has reclassified previously reported research anddevelopment expenses for the three-months ended March 31, 2004. Thesereclassifications between research and development expenses and cost of revenuehad no effect on reported amounts of total operating expenses or operatingloss.

 

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

 

Significant elements of ourrevenue are summarized as follows:

 
| ** **                                                                 | ** ** | **For the Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                            | ** ** |
|                                                                       |       |                                          |       |   |   |
| Research funding and other service fees                                    |       | $                                             | 6,754      |   | $ | 7,897 |   |
| Milestone payments                                                         |       | 348                                           |       | 165 |   |
| Up-front, exclusivity, technology access, and  technology development fees |       | 1,038                                         |       | 1,000 |   |
| Other                                                                      |       | 1,383                                         |       | 1,220 |   |
|                                                                       |       | $                                             | 9,523      |   | $ | 10,282 |   |

 

Forthe three months ended March 2005 and 2004, revenue from collaborationswith Merck constituted 21% and 18% of consolidated revenue and revenue fromcollaborations with Roche constituted 29% and 33% of consolidated revenue,respectively.

 

***4.******    ******Researchand Development—Proprietary Programs***

 

deCODE’sresearch and development expenses consist of the costs of its own proprietaryprograms and consist of the following:

 
| ** **                                       | ** ** | **For the Three Months** | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|
| ** **                                       | ** ** | **Ended March 31,** | ** ** |
| ** **                                       | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In thousands)**       | ** ** |
| Salaries and other personnel costs               |       | $                        | 3,945      |   | $ | 1,952 |   |
| Materials and supplies                           |       | 947                      |       | 519 |   |
| Contractor services and other third party  costs |       | 1,703                    |       | 563 |   |
| Overhead expenses                                |       | 805                      |       | 389 |   |
| Depreciation and amortization                    |       | 875                      |       | 759 |   |
| Stock-based compensation and remuneration        |       | 0                        |       | 77 |   |
| Total                                            |       | $                        | 8,275      |   | $ | 4,259 |   |

 

6

----

 

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

## *** ***

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

 

Stock-based 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 March 31,** | ** ** |
| ** **                                            | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **(In thousands)**       | ** ** |
| Cost of revenue, including collaborative  programs    |       | $                        | 0          |   | $ | 171 |   |
| Research and development – proprietary  programs |       | 0                        |       | 77 |   |
| General and administrative expense                    |       | 48                       |       | 13 |   |
| Total                                                 |       | $                        | 48         |   | $ | 261 |   |

 

Ona proforma basis, had compensation cost for all employee stock options beendetermined using the fair value method, deCODE’s net loss and basic and dilutednet loss per share would have been reported as follows:

 
| ** **                                                                                        | ** ** | **For the Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                                                                                        | ** ** | **(In thousands, except per share amounts)**  | ** ** |
|                                                                                              |       |                                          |       |   |   |
| Net loss attributable to common  stockholders — as reported                                  |       | $                                             | (16,936    | ) | $ | (12,036 | ) |
| Add: Stock-based compensation and  remuneration expense included in reported net loss             |       | 48                                            |       | 261 |   |
| Deduct: Total stock-based compensation expense  determined under fair value method for all awards |       | (1,131                                        | )          | (1,441 | ) |
|                                                                                              |       |                                          |       |   |   |
| Net loss — proforma                                                                          |       | $                                             | (18,019    | ) | $ | (13,216 | ) |
|                                                                                              |       |                                          |       |   |   |
| Basic and diluted net loss per share – as  reported                                          |       | $                                             | (0.32      | ) | $ | (0.23 | ) |
| Basic and diluted net loss per share —  proforma                                             |       | (0.34                                         | )          | (0.25 | ) |

 

InDecember 2004, the FASB issued Statement of Financial Accounting Standard(“SFAS”) No. 123 (revised 2004), “Share-Based Payment”. This Statementreplaces FASB Statement No. 123 and supersedes APB Opinion No. 25.SFAS No. 123(R) eliminates the ability to account for employee share-basedcompensation transactions using the intrinsic method currently used by deCODE.SFAS No. 123(R) requires such transactions be accounted for using afair-value-based method that would result in expense being recognized in deCODE’sfinancial statements.  In April 2005,the Securities and Exchange Commission (“SEC”) adopted a rule that defersthe required

 

7

----

 

effectivedate of SFAS No. 123(R) to fiscal years beginning after June 15, 2005(January 1, 2006 for deCODE). deCODE has not yet determined the impact of adoption on its consolidatedfinancial position or results of operations.

 

## ***6.***     NetLoss Per Common Share

## *** ***

Basicnet loss per share is computed using net loss available to common stockholdersand the weighted-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.

 

Dilutednet loss per share is computed using the weighted-average number of commonshares outstanding during the period, plus the dilutive effect of potentialcommon shares. Diluted net loss per share does not differ from basic net lossper share in all periods presented as potential common shares are antidilutivefor all such periods and are, therefore, excluded from the calculation.Potential common shares excluded from the calculation of diluted net loss pershare were:

 
| ** **                                                                     | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                     | ** ** | **2005**           | ** ** | **2004**           | ** ** |
| ** **                                                                     | ** ** | **(Shares)**       | ** ** | **(Shares)**       | ** ** |
| Warrants to purchase shares of common stock                                    |       | 2,779,873          |       | 3,124,724          |       |
| Options to purchase shares of common stock                                     |       | 4,583,632          |       | 4,181,341          |       |
| Restricted shares with an associated  outstanding non-recourse promissory note |       | 1,182,623          |       | 1,267,756          |       |
| Convertible shares issuable upon conversion  of 3.5% senior convertible notes  |       | 10,714,286         |       | 0                  |       |
|                                                                           |       | 19,260,414         |       | 8,573,821          |       |

** **

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

** **

Comprehensive incomegenerally represents all changes in stockholders’ equity except those resultingfrom investments or contributions by stockholders. Amounts reported in othercomprehensive income include foreign currency translation adjustments,derivative financial instruments designated and effective as hedges ofunderlying foreign currency denominated transactions, and unrealized gains andlosses associated with investments.  Thefollowing table presents the calculation of comprehensive income (loss):

 
| ** **                                          | ** ** | **For the Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                            | ** ** |
|                                                |       |                                          |       |   |   |
| Net loss                                            |       | $                                             | (16,936    | ) | $ | (12,036 | ) |
| Other comprehensive income (loss):                  |       |                                          |       |   |   |
| Foreign currency translation                        |       | 0                                             |       | 1 |   |
| Derivative financial instruments                    |       | 0                                             |       | (42 | ) |
| Unrealized gain (loss) associated with  investments |       | (79                                           | )          | 0 |   |
|                                                |       |                                          |       |   |   |
| Total comprehensive loss                            |       | $                                             | (17,015    | ) | $ | (13,039 | ) |

 

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

 

deCODE’sinvestments consist of auction rate securities, US government securities and anequity mutual fund investment, all of which are classified as available-for-sale.Investments are available for current operations and are classified as currentassets. Investments are carried at fair value with the unrealized holding gainor loss included in accumulated other comprehensive income. Fair value isgenerally determined with reference to quotations in active markets. Premiumand discounts associated with investments in bonds are amortized using theeffective interest rate method.  Therewere no investments as of March 31, 2004. These investments as of March 31, 2005 are summarized as follows:

 

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| ** **                    | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|-------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **(in thousands)**  | ** ** |
| Auction rate securities       |       | $                   | 97,290     |                      | $          | 97,290 |   |
| US government debt securities |       | 15,000              |       | 14,892                    |       |
| Equity mutual fund investment |       | 30,000              |       | 30,054                    |       |
|                          |       | $                   | 142,290    |                      | $          | 142,236 |   |

 

Grossunrealized holding gains and gross unrealized holding losses at March 31,2005 were $54,000 and $108,000, respectively, and are included in accumulatedother comprehensive income.

 

Proceedsfrom the sale of investments available-for-sale for the three-month periodended March 31, 2005 were $64,810,000. There were no realized gains orrealized losses from the sale of investments available-for-sale in thethree-month period ended March 31, 2005.

 

Investmentsas of December 31, 2004 are classified in current assets and aresummarized as follows:

 
| ** **                                      | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|-------------------------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                                      | ** ** | **(in thousands)**  | ** ** |
| Auction rate securities                         |       | $                   | 85,050     |                      | $          | 85,050 |   |
| Equity mutual fund investment                   |       | 30,000              |       | 30,027                    |       |
| Certificate of deposit (due  January 2005) |       | 5,000               |       | 5,000                     |       |
| Corporate bond (due January 2005)          |       | 2,007               |       | 2,005                     |       |
|                                            |       | $                   | 122,057    |                      | $          | 122,082 |   |

 

Gross unrealized holding gains and gross unrealizedholding losses at December 31, 2004 were $27,000 and $2,000, respectively,and are included in accumulated other comprehensive income.

 

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

 

Duringthe three months ended March 31, 2005 and in connection with thesale-leaseback financing discussed in Note 10, deCODE repaid short-termborrowings of $4,500,000 leaving the balance of a short-term loan for $1,100,000which was entered into in August 2004 at an interest rate of 3.79% due inten monthly principal installments   Theremaining balance on the loan as of March 31, 2005 was $228,000.

 

***10.****  Debt, Property and Commitments*

** **

*Sale-leasebackFinancing*

 

In March 2005, deCODEentered into a financing for the sale and leaseback of its headquartersfacility at Sturlugata 8, Reykjavik, Iceland. The sale price for the propertywas 3.4 billion Icelandic kronas ($54,767,000 after taking into account astandard forward foreign exchange contact entered into in connection with thesale of the property). As a result of the sale, the remaining undepreciated netbook value of the property ($29,278,000) has been removed from the balancesheet as of March 31, 2005, and the resulting gain ($25,489,000) has beendeferred and will be recognized to earnings over the 15 year term of theleaseback.

 

Proceeds from the sale ofSturlugata 8 were used to prepay approximately $38,639,000 of short andlong-term debt that was secured by mortgages on the property and, in thisconnection, deCODE recorded a loss on early extinguishment of debt during thethree-month period ended March 31, 2005 amounting to $3,100,000 whichconsisted of (i) prepayment fees ($1,400,000), (ii) write-off ofremaining unamortized finance costs related to the prepaid long-term debt($1,394,000), and (iii) remaining unamortized discount on the prepaidlong-term debt ($348,000).  The loss hasbeen recorded in other non-operating expense in the accompanying CondensedConsolidated Statement of Operations.

 

deCODE has leased the Sturlugata8 property back under a 15 year non-cancelable lease agreement at a rent of21.4 million Icelandic kronas (approximately $353,000 as of March 31,2005) per month, subject to changes based on the Icelandic consumer priceindex. The lease is an operating lease and, as a result, Icelandic kronadenominated rent will be included in operating expenses over the 15 year termof the lease agreement.

 

*MortgageRefinancing*

 

In connection with arefinancing of the mortgage on its Woodridge, IL facility in March 2005,deCODE repaid its $4,000,000 existing mortgage, eliminated restricted cashcollateral totaling $6,000,000 and entered into a $6,200,000 mortgage with thesame financial institution.  The newmortgage carries an interest rate of three-month LIBOR + 2.25% (4.43% at March 31,2005), payable in monthly installments of $26,000 for five years and a finalpayment of $5,500,000 due in June 2007.

 

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*Commitments*

 

As of March 31, 2005, our contractual commitments are as follows:

 
| ** **                                         | ** ** | ** **         | ** ** | **Payments Due by period** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|----------------------------|------------|
| ** **                                         | ** ** | **Total**          | ** ** | **Less Than  1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| 3.5% senior convertible notes, including  interest |       | $                  | 184,125    |                       | $          | 5,250 |   | $ | 10,500 |   | $ | 10,500 |   | $ | 157,875 |   |
| Long-term debt                                     |       | 8,693              |       | 2,664                      |       | 6,029 |   | 0 |   | 0 |   |
| Capital lease obligations, including  interest     |       | 2,558              |       | 1,841                      |       | 691 |   | 26 |   | 0 |   |
| Operating leases                                   |       | 64,770             |       | 4,964                      |       | 9,008 |   | 8,466 |   | 42,332 |   |
|                                               |       | $                  | 260,146    |                       | $          | 14,719 |   | $ | 26,228 |   | $ | 18,992 |   | $ | 200,207 |   |

 

Underthe terms of certain technology licensing agreements, deCODE is obligated tomake payments upon the achievement of established milestones leading to thediscovery of defined products. These payments could total $6,000,000 and theyear incurred cannot be determined at the current time.

 

## ***11.***  DerivativeFinancial Instruments

## *** ***

deCODErecognizes all derivatives as either assets or liabilities in the consolidatedbalance sheet and measure those instruments at fair value.

 

InMarch 2004, deCODE refinanced its foreign currency debt, with the newinstrument being a variable rate U.S dollar denominated debt. Following-on fromthis refinancing, deCODE reconsidered its two cross-currency swaps and decidedto liquidate them realizing $9,720,000 in proceeds. deCODE realized a loss onthis early termination that, together with unrealized losses on the swapsduring the quarter ended March 31, 2004, amounted to $1,465,000. Unrealizedand realized gains and losses on these two cross-currency swaps are included inother non-operating income and (expense), net in the Condensed ConsolidatedStatements of Operations.

 

In March 2004, deCODEentered into five forward foreign exchange contracts with an Icelandicfinancial institution for purposes of hedging a portion of its Icelandic krona-denominatedsalaries. On the maturity date of each contract, deCODE sold $1,600,000 anddeCODE received Icelandic krona at the contracted forward rate. These forwardforeign exchange contracts were designated as economic hedges of the foreigncurrency salary cash flows and qualified for hedge accounting. The finalcontract matured in August 2004 and no new contracts were entered intoduring the remainder of 2004. As of March 31, 2004, an unrealized loss of$42,000 was included in accumulated other comprehensive income on the CondensedConsolidated Balance Sheet.  During thethree-month period ended March 31, 2004, a loss of $17,000 was recorded tooperating expenses in the Condensed Consolidated Statements of Operations.

 

InMarch 2005, deCODE purchased three forward foreign exchange optioncontracts from an Icelandic financial institution for purposes of hedging aportion of its Icelandic krona-denominated salaries and other operatingexpenses. The forward foreign exchange option contracts, to sell $10,000,000,and $3,394,000 and $3,394,000, respectively, mature on June 10, June 30and July 29, 2005, and provide deCODE the right but not the obligation tosell stated amount of U.S.dollars and receive Icelandic krona at the contractedforward rates . These forward foreign exchange option contracts were designatedas economic hedges of the foreign currency salary and other operating cost cashflows but did not qualify for hedge accounting. The estimated fair value ofthese derivative financial instruments ($57,000) is included in other currentassets in the Condensed Consolidated Balance Sheet at March 31, 2005. Theresulting change in the unrealized loss for the three-months ended March 31,2005 of $157,000 is included in other non-operating income and expense, net inthe Condensed Consolidated Statement of Operations.

 

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

 

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

 

Onor about April 20, 2002, an amended class action complaint, captioned Inre deCODE genetics, Inc. Initial Public Offering Securities Litigation (01Civ. 11219(SAS)), alleging violations of federal securities laws in connectionwith deCODE’s initial public offering was filed in the United States DistrictCourt for the Southern District of New York on behalf of certain purchasers ofdeCODE common stock.  The complaint namesdeCODE, two individuals who were executive officers of deCODE at the time ofits initial public offering (the “Individual Defendants”), and the two leadunderwriters (the “Underwriter Defendants”) for deCODE’s initial publicoffering in July 2000 (the “IPO”) as defendants.

 

deCODEis aware that similar allegations have been made in hundreds of other lawsuitsnot involving deCODE filed (many by some of the same plaintiff law firms)against numerous underwriter defendants and issuer companies (and certain oftheir current and former officers) in connection with various public offeringsconducted in recent years.  All of thelawsuits that have been filed in the Southern

 

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Districtof New York have been consolidated for pretrial purposes before United StatesDistrict Judge Shira Scheindlin. Pursuant to the underwriting agreement executed in connection with ourIPO, deCODE has demanded indemnification from the Underwriter Defendants.  The Underwriter Defendants have asserted thatdeCODE’s request for indemnification is premature.

 

Pursuantto an agreement, the Individual Defendants have been dismissed from the casewithout prejudice.

 

OnJuly 31, 2003, deCODE’s Board of Directors (other than deCODE’s Chairmanand Chief Executive Officer, who recused himself because he was an IndividualDefendant) approved a proposed partial settlement with the plaintiffs in thismatter, subject to a number of conditions, including the participation of asubstantial number of other issuer defendants in the proposed settlement, theconsent of deCODE’s insurers to the settlement and the completion of acceptablefinal settlement documentation.  Anydirect financial impact of the proposed settlement is expected to be borne bydeCODE’s insurers.

 

Inconjunction with the plaintiffs, the settling issuer defendants filed a motionseeking the court’s preliminary approval of the settlement.  On February 15, 2005, the court grantedthe motion, subject to certain modifications. If the parties are able to agree upon the required modifications, andsuch modifications are acceptable to the court, notice will be given to allclass members of the settlement and a “fairness” hearing will be held.  If the court determines that the settlementis fair to the class members, the settlement will be approved.  There can be no assurance that this proposedsettlement will be approved and implemented in its current form, if atall.  If the settlement of the IPOlitigation is not consummated, deCODE expects to contest the allegations in theaction vigorously.  Due to the inherentuncertainties of the litigation and because the settlement approval process isat a preliminary stage, deCODE cannot predict the ultimate outcome of thismatter.

 

Inan unrelated matter, subsequent to deCODE’s Form 8-K filing on August 26,2004 relating to deCODE’s change in auditors, five complaints were filed in September andOctober 2004 in the United States District Court for the Southern Districtof New York against deCODE and deCODE’s Chief Executive Officer and ChiefFinancial Officer alleging violations of federal securities laws arising fromcertain of deCODE’s public statements. The complaints were brought by plaintiffs seeking to represent apurported class consisting of all persons who purchased deCODE’s common stockduring the period from October 29, 2003 through August 26, 2004 andcontend that deCODE made misleading statements, misrepresentations andomissions regarding deCODE’s financial performance, compliance with generallyaccepted accounting principles and deCODE’s internal controls.  The complaints all arise out of the samealleged statements, and have been consolidated before a single Judge.  The plaintiffs seek unspecified monetarydamages and other relief.  The plaintiffshave agreed to withdraw their consolidated amended complaint; this withdrawalwas not conditioned upon any payment or fees to the plaintiffs.  On May 4, 2005, the plaintiffs filed aNotice of Agreed Motion and Proposed Order of Voluntary Dismissal (the “Notice”)in order to terminate the action.  TheNotice is subject to approval by the Court, and there can be no assurance thatit will be approved.  deCODE believesthat this action is without merit, and, should the Court not approve thevoluntary dismissal of the litigation, intends to defend against it vigorously.

 

OnSeptember 14, 2004, a complaint was filed in the United States DistrictCourt for the Southern District of New York in a derivative action againstdeCODE, its directors and specified officers. Based upon the same misstatements and omissions alleged in the above-describedsecurities complaints, the complaint alleged violations of state law by thedefendants including breaches of fiduciary duty, abuse of control, grossmismanagement, waste of corporate assets and unjust enrichment, and soughtunspecified monetary damages and other relief. On April 27, 2005, the plaintiff in the derivative action filed aNotice of Voluntary Dismissal withdrawing its complaint.  The voluntary dismissal of this action wasnot conditioned upon any payment or fees to the plaintiff.

 

Dueto the inherent uncertainties of litigation and the fact that voluntarydismissal of the securities litigation and the settlement of the litigationrelating to deCODE’s IPO remain subject to court approval, the ultimate outcomeof these matters cannot be predicted.  IfdeCODE were required to pay significant monetary damages in the event that theIPO settlement is unconsummated or as a result of an adverse determination inthe other actions described above (or any other lawsuits alleging similarclaims filed against deCODE and deCODE’s directors and officers in the future),deCODE’s business could be significantly harmed.  Even if such litigations conclude in deCODE’sfavor, deCODE may be required to expend significant funds to defend against theallegations.  deCODE is unable toestimate the range of possible loss from the above litigations and no amountshave been provided for such matters in deCODE’s financial statements.

 

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

 

This Management’s Discussionand Analysis of Financial Condition and Results of Operations as of March 31,2005 and for the three-month periods ended March 31, 2005 and 2004 shouldbe read in conjunction with the unaudited condensed consolidated financialstatements and notes thereto set forth in Item 1 of this report.

 

This quarterly report on Form 10-Qcontains forward-looking statements, including our expectations of futureindustry conditions, strategic plans and forecasts of operational results.Various risks may cause our actual results to differ materially. A list anddescription of some of the risks and uncertainties is contained below and inthe summary of risk factors that follow.

 

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# **Overview**

# ** **

deCODEis a biopharmaceutical company applying its discoveries in human genetics todevelop drugs for common diseases. Our population approach and resources enableus to isolate genes and drug targets directly involved in the development ofmany of the biggest challenges to public health. We are turning thesediscoveries into a growing pipeline of therapeutics aimed at combating thecauses of disease, not just the signs and symptoms. As these diseases arecommon and current therapies are of limited effectiveness, we believe that ourstrategy represents a significant opportunity to create better medicine withmajor potential in the global marketplace.

 

Webelieve that deCODE’s advantage derives from our population approach to humangenetics and the ability to apply this approach across the drug developmentprocess. In Iceland, we have comprehensive population resources that enable ourscientists to efficiently conduct genome- and population-wide scans to identifykey genes and gene variations contributing to common diseases. The proteinsencoded by these genes, and other proteins with which they interact in thedisease pathway, we believe we offer drug targets that are directly involved inthe onset and progression of disease. Small-molecule drugs that target theseproteins therefore represent a direct means of modulating the onset orprogression of the disease.

 

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

 

Ourgoal is to bring to market new drugs for major indications, and in so doingmake the company profitable and create value for our shareholders. To achievethis goal we must ensure that we have the capabilities and financial means toexpand and advance our pipeline through the long, risky and expensive processof drug development and on to the market. This requires us to constantlyevaluate the optimal balance between several factors, including the level ofour investment in research and development, the preservation of cash resourcesand their deployment for product development, and the financing environment.

 

Inorder to support our drug development infrastructure, to focus the use of ourcash resources on our proprietary therapeutics programs, and to diversify riskin our overall drug development portfolio, we leverage our capabilities to formcorporate alliances and to provide services to fee-paying customers. We haveformed drug and other product development alliances with Roche and Merck, amongothers. In addition to conducting work on our targets in our collaborative andinternal programs, our medicinal chemistry subsidiary provides drug discoveryservices and contract manufacturing of therapeutic compounds for human clinicaltrials for our fee-for-service customers. Our other service offerings includeprotein crystallization products, protein crystallization instruments andprotein structure analysis contract services through our structural biologysubsidiary; clinical trials services though our wholly owned subsidiary Encode;and DNA analysis services through our genotyping laboratory in Reykjavik.

 

Wecurrently derive revenues primarily from research funding and other fees fromour service customers and collaborative partners; milestone payments andupfront, exclusivity, technology-access and technology-development fees underour collaboration agreements constitute most of the rest of our revenues. Whilewe are entitled to royalties or profit-sharing under the terms of ouragreements, due to the extended time period for the development andcommercialization of a saleable product or therapy, we have not yet receivedroyalties or profit sharing under any of our contracts and do not expect to doso for several years, if at all. Our expenses consist primarily of research anddevelopment expenses.

 

Webelieve that ongoing work in genetics and advancing our drug developmentprograms, particularly the conduct of clinical trials on a growing number ofour compounds, will require significant and increasing expenditures. In 2005 weanticipate that we will be conducting clinical trials for DG031, DG041, and inasthma. We also expect to be advancing our preclinical work on our follow-oncompound in heart attack and in our PDE4 inhibitor program for vasculardisease/stroke, and expect to bring these programs into clinical developmentfollowing the submission of IND applications. We anticipate incurringadditional net losses at least through the next several years, due to, inaddition to the above-mentioned factors, depreciation and amortization, as wellas stock-based compensation and other non-cash charges. We expect that ourrevenues and losses will fluctuate from quarter to quarter and that such fluctuationsmay be substantial, especially because progress in our scientific work andmilestone payments that are related to progress can fluctuate between quarters.We do not believe that comparisons of our quarter-to-quarter performance are agood indication of future performance.

 

Followingour sale of $150,000,000 of our 3.5% Senior Convertible Notes in April, 2004,we believe that we have sufficient cash resources to continue to fund ouroperations for several years. However, we will require significant additionalcapital in the future for our product development programs and so will continueto investigate additional avenues of financing. Our ability to obtain capitalwill be affected by conditions in the global financial markets and in thepharmaceutical industry. We expect that downturns in the market valuations ofbiotechnology companies and of the equity markets more generally will restrictour ability to raise additional capital on attractive terms, while morefavorable conditions in those markets will present opportunities for us.

 

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Thedifficulties facing the pharmaceutical industry present for us both near-termchallenges and significant longer-term opportunities. One of the main issuesconfronting big pharmaceutical companies is their lack of promising new drugsto treat major indications. As many leading brand-name drugs come off patentand face generic competition, developing successful new medicines will becomecritical for filling the gap. In the short term, the financial pressures onpharmaceutical companies may be reflected in their research and developmentspending, making it more difficult for us to sign corporate alliances withsignificant up-front funding, or lengthening the time required to negotiatesuch deals. We believe that in the medium to longer term, however, companiessuch as ours may be well positioned to play an important role in filling thegap in the pipeline of new drugs, either alone or as partners of pharmaceuticalcompanies. Our partnerships with Roche and Merck demonstrate that the industryis already investing in the development of new therapeutics based on ourapproach.

 

**Research and Development Programs**

 

Thefollowing is a summary of the development of our drug candidates in latepre-clinical or clinical development. Because of uncertainties involved in thedrug development process, the actual timing for the events described below maydiffer materially from that provided in this summary.

 

•      Our mostadvanced developmental compound is DG031 for the prevention of heart attack. In2004 we conducted a Phase IIa clinical trial for DG031 in Iceland. We havesubmitted an IND for DG031 with the U.S. Food and Drug Administration (FDA) andexpect to make similar filings in selected European countries. We havesubmitted the safety summary and results of the Phase IIa trial to the FDA andhave conducted an end of Phase II meeting with the FDA. As a result of thismeeting, there is sufficient safety experience with DG-031 to plan a Phase IIIoutcome trial in the U.S., Iceland and Europe for DG031 to be initiated in the fallof 2005. The start of the DG-031 Phase III trial may be delayed if there aredelays in the time lines for manufacturing, packaging, labeling and shipping ofclinical supplies, delays in negotiations with CRO for clinical trialperformance, or delays in approval of the study protocol by local InstitutionalReview Boards (IRB).

 

•      DG041 is ourlead compound for the treatment of atherosclerosis of the legs, or peripheral arterialocclusive disease (PAOD). DG041 is an inhibitor of a G-protein coupled receptor(GPCR), the EP3 receptor for prostaglandin E2, which our genetics work hasshown to be associated with a significantly increased risk of developing thedisease. Our IND application for DG041 was accepted by the FDA in February 2005and on this basis we began the first Phase 1 trial for this compound in theU.S. in March of 2005.  AdditionalPhase I studies are being initiated that will continue to characterize the doseresponse during multiple dose administration and for specializedpopulations.  The multiple clinicalstudies that comprise the Phase I program are scheduled for completion in the thirdquarter of 2005.

 

•      In asthma, we anticipatecommencement of a Phase II trial with a third party compound during the secondquarter of 2005. This compound acts against a target our genetics work hasshown to be involved in the development of asthma.

 

•      We aredeveloping a follow-on compound for DG031 that is designed to inhibit the LTA4hydrolase, a protein encoded by a second gene within the same pathway targetedby DG031 that we have also linked to significantly increased risk of heartattack.

 

•      We have begun aPDE4 inhibitor program for vascular disease/stroke pursuant to our 2004agreement with Roche.

 

Weuse many of our employee and infrastructure resources across several programs,and many of our research and development costs are indirectly attributable toan individually named program or are directed broadly to applicable researchprograms. However, taking into account costs that are specifically attributableto individual programs and allocations of our research and development programcosts based upon those direct costs , we have cumulatively invested $7.2, $7.2,$3.5 and $4.5 million in our MI, PAOD, stroke and asthma programs,respectively, from the beginning of 2003 to date. Inception to-date costs arenot available as these 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 orderfor us to achieve marketing approval in the U.S., the FDA must conclude thatour clinical data establish the safety and efficacy of our drug candidate.Other countries have similar requirements. Historically, the results frompre-clinical testing and early clinical trials (through Phase II) haveoften not been predictive of results obtained in later clinical trials. Manynew compounds have shown promising results in early clinical trials, butsubsequently failed to establish sufficient safety and efficacy data to obtainnecessary marketing approvals. Additional risks and uncertainties involved inthe development and commercialization of any products are described below underthe caption “Risk Factors, Forward-Looking Statements, and Cautionary FactorsThat May Affect Future Results”. We expect that it will be several years,if ever, before we receive revenues from the commercial sale of our therapeuticproducts.

 

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 agreements with Roche and Merck. Enteringinto a collaboration with a partner at any point in the development orcommercialization of a product is a business decision of ours. When making thisdecision we do and will consider, among other matters, the complexity of theindication, the size, complexity and expense of necessary development and/orcommercialization efforts, competition in the market and size of the applicablemarket, an assessment of

 

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ourown resources—financial and operational, and an assessment of the resources ofa potential partner. In the event that we do collaborate on any of the aboveprograms in the future, a partner will have a level of control, which may besignificant, over the pre-clinical development or clinical trial process for aproduct. As a result the completion date of such a partnered program couldlargely be under control of that third party rather than under our control. Wecannot forecast with any degree of certainty which proprietary drug candidatewill be subject to future collaborative arrangements or how such arrangementswould affect our development plan or capital requirements.

 

Asa result of the uncertainties discussed above, we are unable to determine theduration and completion costs of our research and development projects or whenand to what extent we will receive cash inflows from the commercialization andsale of a product.

 

**Critical Accounting Policies**

** **

The preparation offinancial statements in conformity with generally accepted accounting principlesrequires us to make certain estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingent assets andliabilities at the date of the financial statements, and the reported amountsof revenues and expenses during the reported period. On an ongoing basis weevaluate our estimates, which include, among others, those related tocollaborative arrangements, long-lived assets, materials and supplies, foreignexchange transactions, 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 FinancialStatements in the Annual Report on Form 10-K. There can be no assurancethat actual results may not differ from the estimates referred to above.

 

**Results of Operations for the Three-Month Periods Ended March 31,2005 and 2004**

** **

Ourresults of operations have fluctuated from period to period and may continue tofluctuate in the future based upon, among other things, the timing andcomposition of funding under our various collaborative agreements, as well asthe progress of our own research and development efforts. Results of operationsfor any period may be unrelated to results of operations for any other period.In addition, historical results should not be viewed as indicative of futureoperating results. We are subject to risks common to companies in our industryand at our stage of development, including risks inherent in our research anddevelopment efforts, reliance upon collaborative partners, development by us orour competitors of new technological innovations, ability to market products orservices, dependence on key personnel, dependence on key suppliers, protectionof proprietary technology, ability to obtain additional financing, ability tonegotiate collaborative arrangements, and compliance with governmental andother regulations. In order for a product to be commercialized based on ourresearch, we and our collaborators must conduct preclinical tests and clinicaltrials, demonstrate the efficacy and safety of our product candidates, obtainregulatory approvals or clearances and enter into manufacturing, distributionand marketing arrangements, as well as obtain market acceptance. We do notexpect to receive revenues or royalties based on therapeutic or diagnosticproducts for a period of years, if at all.

 

Financial highlights as of and for the three-monthperiod ended March 31, 2005 include:

 

•      At March 31, 2005, we had $197.6 millionin cash, cash equivalents and investments compared to $198.3 million at December 31,2004. The net utilization of just $0.7 million in the first quarter reflectscosts associated with the advancement of our drug development programs duringthe three months as reflected in the $10.9 million cash used in operations,together with the net proceeds from the sale and leaseback of our headquartersfacility at Sturlugata 8, Reykjavik, Iceland ($14.2 million) and also therefinancing of the mortgage on our Woodridge, IL facility during thethree-month period ended March 31, 2005.

 

•      Research and development expense forproprietary programs was $8.3 million for the three-month period ended March 31,2005 as compared to $4.3 million for the three-month period ended March 31,2004. The increase in our research and development expenses for proprietaryprograms is the result principally of costs associated with the advancement ofour lead drug development programs into clinical trials.

 

•      In March 2005, we entered into afinancing for the sale and leaseback of our headquarters facility at Sturlugata8, Reykjavik, Iceland. The sale price for the property was 3.4 billionIcelandic kronas ($54.8 million after taking into account a standard forwardforeign exchange contact we entered into in connection with the sale of theproperty). As a result of the sale, we have removed the remaining undepreciatednet book value of the property ($29.3 million) from our balance sheet as of March 31,2005, deferred the resulting gain ($25.5 million) in our balance sheet as of March 31,2005 and will recognize the gain to earnings over the 15 year term of theleaseback. Proceeds from the sale of Sturlugata 8 went to prepay approximately$38.6 million of short and long-term debt that was secured by mortgages on theproperty and, in this connection, we have recorded a loss on earlyextinguishment debt during the three-month period ended March 31, 2005amounting to $3.1 million. We have

 

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leased the property backunder a 15 year non-cancelable lease agreement at a rent of 21.4 millionIcelandic kronas (approximately $0.4 million as of March 31, 2005) permonth, subject to changes based on the Icelandic consumer price index. We areaccounting for the leaseback as an operating lease.

 

•      Our revenue for the three-month period ended March 31,2005 was $9.5 million as compared to $10.3 million for the three-month periodended March 31, 2004. The decrease in revenue generally reflects ourincreasing focus on drug discovery and development and, for the quarter ended March 31,2005 as compared to the same quarter last year, is specifically accountable tothe completion of research funding under the 2002 agreement with Roche offsetsomewhat by revenues in our alliance to co-develop inhibitors of PDE4.

 

*Revenue.*  Our business strategy isfocused on turning our discoveries into new drugs for the treatment of commondiseases. At the same time, we leverage our capabilities to generate revenuethrough corporate alliances and through service contracts. In the majority ofour programs we are pursuing drug development on our own. In certain 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, commercialization, and fee for service alliances and contractsacross our business. Depending on the nature of each prospective businessopportunity, the key components of the commercial terms of such arrangementstypically include one or more of the following: research funding; up-front,exclusivity, technology access, and technology development fees; fees forparticular services; milestone payments; license or commercialization fees; androyalties or profit sharing from the commercialization of products.

 

Significantelements of our revenue are summarized as follows:

 
| ** **                                                                 | ** ** | **For the Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                            | ** ** |
|                                                                       |       |                                          |       |   |   |
| Research funding and other service fees                                    |       | $                                             | 6,754      |   | $ | 7,897 |   |
| Milestone payments                                                         |       | 348                                           |       | 165 |   |
| Up-front, exclusivity, technology access, and  technology development fees |       | 1,038                                         |       | 1,000 |   |
| Other                                                                      |       | 1,383                                         |       | 1,220 |   |
|                                                                       |       | $                                             | 9,523      |   | $ | 10,282 |   |

 

Collaborations with our most significant partnersinclude:

 

*F. Hoffmann-La Roche (Roche)*

 

*Therapeutics.* In 1998 we entered into a researchcollaboration and cross-license agreement with Roche, under which we identifiedkey genetic factors involved in ten common diseases: osteoarthritis, Alzheimer’sdisease, schizophrenia, PAOD, stroke, osteoporosis, obesity, anxiety,non-insulin-dependent diabetes and rheumatoid arthritis. In January 2002, weentered into a new three-year agreement with Roche focused on turning theachievements of our 1998 gene discovery collaboration into novel therapeutics.The 2002 agreement provided that we would collaborate with respect to fourdiseases that had been the subject of the 1998 agreement. During 2004 andthrough January 2005 we collaborated with Roche on two of those diseases.Under the 2002 agreement, which expired on February 1, 2005, we received$20 million in research funding and we are entitled to receive royalties on thesales of any drugs that are developed coming out of work conducted under thisagreement.

 

InNovember 2004, we signed a new three-year agreement with Roche toco-develop inhibitors of PDE4 for the prevention and treatment of vasculardisease, including stroke. This agreement continues work advanced under the2002 agreement, and we will focus on optimizing lead compounds identified inour previous work and begin clinical development. We will share drug discoveryand clinical trials costs with Roche under this new agreement, and we mayreceive milestone payments and royalties based on drug sales.

 

*Diagnostics.*  In June 2001, we signed afive-year alliance with Roche’s diagnostics division to develop and marketDNA-based diagnostics for major diseases. More recently we have added researchprograms aimed at developing diagnostics to predict drug response for majortherapeutics used to treat those diseases, in order to help select the mosteffective treatment of those available.  Underthe agreement we have received $36.4 million in research funding, up-front feesand milestone payments. We may receive $7.8 million 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.

 

15

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Revenuesfrom these alliances with Roche amounted to $2.7 million and $3.4 million inthe three-month periods ended March 31, 2005 and 2004, respectively,representing 29% and 33% of consolidated revenue for the three-month periods endedMarch 31, 2005 and 2004, respectively. Costs incurred with thesecollaborative programs with Roche amounted to $3.7 million and $5.3 million inthe three-month periods ended March 31, 2005 and 2004, respectively.

 

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

 

*Obesity.*  In September 2002, weentered into an alliance with Merck aimed at developing new treatments for obesity.Under the alliance, we are combining research efforts with Merck in thegenetics of obesity to identify, validate and prioritize a series of drug targetsto take into development. Under the terms of the three-year agreement, whichcan be extended on a year-to-year basis upon the consent of the parties, wehave received research funding, technology access fees and milestone paymentsin the aggregate amount of $23.2 million and may receive research funding andtechnology access fees in the future of $1.4 million. In addition, we mayreceive further research funding, access fees, and research milestone paymentsand may receive milestone payments as compounds developed under the allianceadvance in the development process and royalties on successfully marketeddrugs. Merck may terminate the agreement at any time upon 30 days’ noticein the event that the research program fails to achieve certain specified goals.  We have discovered three genes linked toobesity under this alliance, and Merck had generated lead series of compoundsagainst one of the targets we validated through our genetics research.

 

Revenuesfrom this alliance with Merck amounted to $1.8 million and $1.9 million in thethree-month periods ended March 31, 2005 and 2004, respectively,representing 19% and 18% of consolidated revenue for the three-month periodsended March 31, 2005 and 2004, respectively. Costs incurred with thisalliance with Merck amounted to $1.1 million and $1.2 million in thethree-month periods ended March 31, 2005 and 2004, respectively.

 

*Information Rich Clinical Trials.*  In February 2004,we entered into an agreement with Merck which provides that deCODE will conductinformation-rich clinical trials on a range of Merck’s developmental compoundsthat Merck selects for inclusion in the program. The term of the alliance isseven years, subject to termination by Merck after five years. Thecollaboration involved three agreements: (a) a License and ResearchCollaboration Agreement; (b) a Stock and Warrant Purchase Agreement; and (c) aWarrant Agreement. Under the terms of the License and Research CollaborationAgreement, we will receive royalties on sales of drugs and diagnosticsdeveloped as part of the alliance, will receive milestone payments as compoundsor pharmacogenomic tests reach the market, will receive research funding forthe clinical development of compounds and pharmacogenomic analysis, andreceived a one-time technology access fee of $10 million. A contingency clauseon the technology access fee provides that if we reject the first twonon-exclusive development compounds that Merck presents to the collaboration,then Merck has the right to request a refund of $2.5 million of the technologyaccess fee. The remaining amount of the technology access fee isnon-refundable. To date, Merck has not selected any compounds for developmentunder the agreement. Under the terms of the Stock and Warrant PurchaseAgreement, Merck purchased 689,703 shares of deCODE’s common stock at a priceof $14.50 per share or $10 million, which represents a premium of $2.7 millionto the fair market value of the stock on the effective date of the agreement($10.60 per share). Accordingly, of the $10 million cash received, deCODEascribed $7.3 million to the common stock and $2.7 million to deferred revenue.Under the terms of the Warrant Agreement, deCODE has issued Merck a warrant topurchase up to 1,724,257 of additional shares of our common stock at anexercise price of $29.00 per share over the five year term of the warrant. Thewarrant is exercisable at Merck’s option as to 344,851 shares for a period of30 days commencing on the first, second, third, fourth and fifthanniversaries of the Warrant Agreement with the final portion of warrantsexpiring in March 2009. Any portion of this warrant that is not exercisedduring an applicable exercise period shall expire and be of no further force oreffect. The warrant was valued at $6.3 million using a Black Scholes model withthe following assumptions: lives of one to five years, risk free interest ratesof 1.24% to 3.07%, volatility of 90% and no dividend yield. The one-timetechnology access fee of $10 million and the $2.7 million premium received onthe sale of common stock less the estimated fair value of the warrant of $6.3million, together netting to $6.4 million, has been recorded as deferredrevenue. This amount less the refundable amount of $2.5 million ($3.9 million)is being recognized as revenue according to level of efforts over theseven-year development term. The $2.5 million refundable amount will berecognized as revenue according to level of efforts retrospectively over theseven-year development term commencing upon satisfaction of the contingency.

 

Revenuesfrom this alliance with Merck amounted to $0.2 million and $0 in thethree-month periods ended March 31, 2005 and 2004, respectively,representing 2% and 0% of consolidated revenue for the three-month periodsended March 31, 2005 and 2004, respectively. Costs incurred with thisalliance with Merck amounted to $0.1 million and $0 in the three-month periodsended March 31, 2005 and 2004, respectively.

 

*National Institute of Allergy and Infectious Diseases(NIAID).*

 

OnSeptember 30, 2004, deCODE was awarded a five-year $23.9 million contractby the NIAID, a division of the U.S. National Institutes of Health. Under thecontract, deCODE will apply its population approach and resources to discovergenetic factors associated with susceptibility to certain infectious diseasesand with responsiveness to vaccines targeting such diseases. Revenue under thiscontract will be recognized as deCODE incurs costs related to the contract andwe expect that we will expend funds generally ratably over the five-year termof the contract.  Revenues and costsattendant to this contract with the NIAID amounted to $0.5 million and $0.5million in the three-month period ended March 31, 2005.

 

16

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Revenue for the three-monthperiods ended March 31, 2005 and 2004 is as follows:

 
| ** ** | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** ** | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except %)** | ** ** |
| Revenue    |       | $                            | 9,523      |       | $          | 10,282                        |       | $ | (759 | ) | (7 | )% |
|            |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

The decrease in revenue in the three-month periodended March 31, 2005 from the same period in 2004 generally reflects ourincreasing focus on drug discovery and development and, for the quarter ended March 31,2005 as compared to the same quarter last year, is specifically attributable tothe completion of research funding under the 2002 agreement with Roche offsetsomewhat by revenues in our alliance to co-develop inhibitors of PDE4. At March 31,2005, we had $17.5 million in deferred revenue, compared to $15.9 million atthe close of 2004. We expect that our revenues will fluctuate from quarter toquarter and that such fluctuations may be substantial especially becauseprogress in our scientific work, including milestone payments that are relatedto progress, can fluctuate between quarters.

 

*Cost of Revenue, including Collaborative Programs.*  Costof revenue, including costs incurred in connection with collaborative programsfor the three-month periods ended March 31, 2005 and 2004 is as follows:

 
| ** **                                         | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **                                         | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In thousands, except %)** | ** ** |
| Cost of revenue, including collaborative  programs |       | $                            | 9,140      |       | $          | 11,174                        |       | $ | (2,034 | ) | (18 | )% |
|                                                    |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

Our cost of revenue consistsof the 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.The decrease in our cost of revenue, including costs incurred in connectionwith collaborative programs in general reflects the continued streamlining ofour core genetics research and other operations as well as a relative lesseningof investment in programs on which we receive research funding.

 

Ourcost of revenue, including costs incurred in connection with collaborativeprograms for the three-months ended March 31, 2005 as compared to the sameperiod in 2004 includes (i) an overall decrease in salary and employeerelated expenses ($0.3 million), and (ii) less in chemicals andconsumables ($0.4 million), together driving (iii) lower allocation ofoverheads, depreciation and amortization ($1.0 million). The relativestrengthening of the Icelandic krona versus the U.S. dollar over the periodspresented has affected the U.S. dollar reported amounts of our expensesdenominated in Icelandic krona (e.g., an increase of approximately $0.2 millionon a portion of our salary and employee related expenses. Although we haveexperienced this relative currency exchange reversing somewhat of late, thisgeneral trend in the currencies may continue.

 

*Research and Development—Proprietary Programs.* Research and development for proprietary programs for the three-monthperiods ended March 31, 2005 and 2004 is as follows:

 
| ** **                                            | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **                                            | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **                                            | ** ** | **(In thousands, except %)** | ** ** |
| Research and development – proprietary  programs |       | $                            | 8,275      |       | $          | 4,259                         |       | $ | 4,016 |   | 94 | % |
|                                                       |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

Theincrease in our research and development expenses in proprietary programsresults from our emphasis on and increasing expenditures in product developmentclinical work and pre-clinical preparations on our lead development programs.Importantly, based on the results of our Phase IIa clinical trial of DG031, weare designing an information-rich, multi-center, pivotal Phase III outcometrial in the U.S., Iceland and Europe to test DG031 for the prevention of heartattack, which we expect to begin in the fall of 2005. Also, our IND applicationfor DG041 was accepted by the FDA in February 2005 and on this basis webegan the first Phase 1 trial for this compound in the U.S. in March of2005. Further, we anticipate commencement of a Phase II trial in Iceland forasthma with a third party compound during the second quarter of 2005.

 

Our research and developmentexpenses for the three-month periods ended March 31, 2005 and 2004 consistof the following:

 

17

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| ** **                                       | ** ** | **For the Three Months** | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|
| ** **                                       | ** ** | **Ended March 31,** | ** ** |
| ** **                                       | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In  thousands)**      | ** ** |
| Salaries and other personnel costs               |       | $                        | 3,945      |   | $ | 1,952 |   |
| Materials and supplies                           |       | 947                      |       | 519 |   |
| Contractor services and other third party  costs |       | 1,703                    |       | 563 |   |
| Overhead expenses                                |       | 805                      |       | 389 |   |
| Depreciation and amortization                    |       | 875                      |       | 759 |   |
| Stock-based compensation and remuneration        |       | 0                        |       | 77 |   |
| Total                                            |       | $                        | 8,275      |   | $ | 4,259 |   |

 

Experiencedincreases in the research and developments costs of our proprietary programs(e.g., salaries and attendant costs, usage of chemicals and consumables,contractor services) will likely continue, particularly as we advance ourclinical development and proprietary drug development programs. Further, therelative strengthening of the Icelandic krona versus the U.S. dollar over theperiods presented has affected the U.S. dollar reported amounts of our expensesdenominated in Icelandic krona (e.g., an increase of approximately $0.2 millionon a portion of our salary and employee related expenses). Although we haveexperienced this relative currency exchange reversing somewhat of late, thisgeneral trend in the currencies may continue.

 

*Selling, General and AdministrativeExpense.*  Selling, generaland administrative expense for the three-month periods ended March 31,2005 and 2004 is as follows:

 
| ** **                                 | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **                                 | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **                                 | ** ** | **(In thousands, except %)** | ** ** |
| Selling general and administrative expense |       | $                            | 4,158      |       | $          | 4,263                         |       | $ | (105 | ) | (2 | )% |
|                                            |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

Ourselling, general and administrative expenses for the three-month period ended March 31,2005 were largely the same as the comparable period a year-ago with generallyslight declines in all expense categories. The increase in salaries andemployee related costs for the three-month period ended March 31, 2005 ascompared to the same period in 2004 ($0.1 million) is generally attributable tothe continued relative strengthening of the Icelandic krona versus the U.S.dollar. Although we have experienced this relative currency exchange reversingsomewhat of late, this general trend in the currencies may continue. Further,we have granted salary increases to our personnel and are actively seeking toadd clinical development and regulatory executives to our staff, as well asmaking efforts to recruit new members to our Board of Directors – all of whichwill likely contribute to future increases in our selling, general andadministrative expenses.

 

*Stock Based Compensation andRemuneration Expense.* Stock based compensation and remuneration expense for the three-monthperiods ended March 31, 2005 and 2004 is as follows:

 
| ** **                                         | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **                                         | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In thousands, except %)** | ** ** |
| Stock based compensation and remuneration  expense |       | $                            | 48         |       | $          | 261                           |       | $ | (213 | ) | (82 | )% |
|                                                    |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

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

 

FASBNo. 123(R) replaces FASB Statement No. 123 and supersedes APB OpinionNo. 25 and eliminates the ability to account for employee share-basedcompensation transactions using the intrinsic method. FASB No. 123(R)requires such transactions be accounted for using a fair-value-based methodthat would result in additional expense being recognized in our financialstatements. In April 2005, the Securities and Exchange Commission (“SEC”)adopted a rule that defers the required effective date of SFAS No. 123(R)to our fiscal year beginning January 1, 2006. Although we have not yetdetermined the impact of its adoption on our consolidated financial position orresults of operations, the charges involved could be significant.

 

18

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*Interest Income.*  Interest income for the three-month periodsended March 31, 2005 and 2004 is as follows:

 
| ** **      | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|-----------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **      | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)** | ** ** |
| Interest income |       | $                            | 1,120      |       | $          | 235                           |       | $ | 885 |   | 377 | % |
|                 |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

Ourinterest income has increased as a result of the completion of the offering of3.5% Senior Convertible Notes in April 2004, realizing net proceeds of$143.8 million and rising interest rates. We expect to use the proceeds ofthis offering principally for advancing our drug and clinical developmentprograms. In the meantime, we will invest the monies received in accordancewith our policy, having the objective of preserving principal while maximizingincome we receive from our investments without significantly increasing risk.We expect to maintain our portfolio of cash equivalents and investments in avariety of securities, including auction rate securities, commercial paper,money market funds, mutual fund investments and government and non-governmentdebt securities

 

*Interest Expense.*  Interest expense for the three-month periodsended March 31, 2005 and 2004 is as follows:

 
| ** **       | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **       | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest expense |       | $                            | 2,389      |       | $          | 1,199                         |       | $ | 1,190 |   | 99 | % |
|                  |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

The increase in our interestexpense principally reflects interest on our 3.5% Senior Convertible Notes due2011 that we issued in April 2004. We began making the necessarysemi-annual interest payments on the Senior Convertible Notes in October 2004.As a result of the Senior Convertible Notes, our interest expense has increased$5.3 million on an annualized basis.

 

InMarch 2005, we prepaid $38.6 million of short and long-term debt that wassecured by mortgages on Sturlugata 8. Also in March 2005, we refinancedthe mortgage on our Woodridge, IL facility, paying-down $4.0 million on theexisting mortgage. The principal amount of the new mortgage ($6.2 million)carries an interest rate of three-month LIBOR + 2.25% (5.37% at March 31,2005). As a result of these prepayments and refinancings, our interest expensewill decrease approximately $2.8 million on an annual basis.

 

*Other Non-Operating Income andExpense, Net.*  Othernon-operating income and expense for the three-month periods ended March 31,2005 and 2004 is as follows:

 
| ** **                                               | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **                                               | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **                                               | ** ** | **(In thousands, except %)** | ** ** |
| Other non-operating income and  expense,   net |       | $                            | (3,617     | )          | $          | (1,658                        | )          | $ | 1,959 |   | 118 | % |
|                                                          |            |                              |            |            |            |                               |            |  |  |  |  |  |

 

Our other non-operatingincome and expense, net consists principally of the net impact of foreignexchange and unrealized and realized gains and losses on derivative financialinstruments and, in the three-month period ended March 31, 2005, loss onearly extinguishment of debt.

 

As a consequence of thenature our business and operations our reported financial results and cashflows are exposed to the risks associated with fluctuations in the exchangerates of the U.S. dollar, the Icelandic krona and other world currencies. Thenet impact of foreign exchange on the translated amount of our non-US dollardenominated liabilities, net together with transaction gains and losses,amounted to losses of $0.3 million and $0.2 million for the three-month periodsended March 31, 2005 and 2004, respectively. The continued weakening ofthe U.S. dollar compared to the Icelandic krona during 2004 and 2005 has beensignificant and these currency fluctuations may continue to adversely affectour financial results.

 

Our losses on derivativefinancial instruments in the three-month period ended March 31, 2005 ($0.2million) result from three forward foreign currency exchange options we enteredinto as economic hedges against foreign exchange rate fluctuations that mayoccur on our ISK-denominated operating expenses but that did not qualify forhedge accounting.

 

Our losses on derivativefinancial instruments in the three-month period ended March 31, 2004 stemfrom the two cross-currency swaps we entered into as economic hedges againstforeign exchange rate fluctuations that may have occurred on our foreigncurrency debt but that did not qualify for hedge accounting. In March 2004,we liquidated our two cross-currency swaps receiving $9.7 million in proceeds.We realized a loss on this early termination that, together with unrealizedlosses on the swaps during the quarter ended March 31, 2004, amounted to$1.5 million.

 

19

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Asa result of having prepaid the short and long-term debts that were secured bymortgages on Sturlugata we have recorded a loss on early extinguishment debtduring the three-month period ended March 31, 2005 amounting to $3.1million and consisting of (i) prepayment fees ($1.4 million), (ii) write-offof remaining unamortized finance costs related to the prepaid long-term debt($1.4 million), and (iii) remaining unamortized discount on the prepaidlong-term debt ($0.3 million).

 

*Net Loss and Basic and Diluted NetLoss Per Share*. Net loss and basic and diluted net loss pershare for the three-month periods ended March 31, 2005 and 2004 is asfollows:

 
| ** **                           | ** ** | ** **                   | ** ** | ** ** | ** ** | **2005 as  Compared to 2004** | ** ** |
|--------------------------------------|------------|------------------------------|------------|------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **2005**                     | ** ** | **2004**   | ** ** | **$ Change**             | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In thousands, except %)** | ** ** |
| Net Loss                             |       | $                            | (16,936    | )          | $          | (12,036                       | )          | $ | 4,900 |   | 41 | % |
|                                 |       |                         |       |       |       |                          |       |   |   |
| Basic and Diluted Net Loss Per Share |       | $                            | (0.32      | )          | $          | (0.23                         | )          | $ | 0.09 |   | 39 | % |

 

Netloss and basic and diluted net loss per share both increased in the three-monthperiod ended March 31, 2005, principally on account of higher research anddevelopment related to the advancement of our drug development programs, higherinterest expense related to our convertible notes issued in April 2004,lower revenues and costs related to the early extinguishment of debt.

 

**Liquidity and Capital Resources**

** **

Wehave financed our operations primarily through funding from research and developmentcollaborative agreements, and the issuance of equity securities and long-termfinancing instruments ($789 million from the beginning of 1999 to-date).Future funding under terms of our existing agreements is approximately $62 millionexcluding milestone payments and royalties that we may earn under suchcollaborations.

 

Althoughwe rely on funded research arrangements for a significant portion of ourrevenue, we continue to invest in proprietary research and development and wewill incur the costs of such activities. In the near term, this will require usto devote resources to our in-house drug and clinical development which webelieve will better position us to capture the most value to us in ourdiscoveries. As we identify promising discoveries for further development, wemay choose to continue the development ourselves into and through clinicaltrials, regulatory approvals, manufacture, distribution and marketing. In othercases we are or will be working to varying degrees with partners. The decisionswe make as to these matters will affect our cash requirements.

 

Basedupon the range of our current activities, we expect to have greater overall netuse of cash in 2005 in our operating, investing and financing activities thanwe did in 2004. Our cash requirements depend on numerous factors, including thelevel and timing of our research and development expenditures; our ability to accessthe capital markets; to obtain new research and development collaborationagreements; to obtain and maintain contract service agreements in ourpharmaceuticals, biostructures, clinical research trials and genotyping servicegroups; expenditures in connection with alliances, license agreements andacquisitions of and investments in complementary technologies and businesses;competing technological and market developments; the cost of filing,prosecuting, defending and enforcing patent claims and other intellectualproperty rights; the purchase of additional capital equipment; and capitalexpenditures at our facilities. Changes in our research and development plans,notably the entry into clinical trials of drugs based on our discoveries, orother changes affecting our operating expenses may result in changes in thetiming and amount of expenditures of our capital resources.

 

Webelieve that we will have sufficient cash to fund our operations for severalyears. However, under all circumstances, we will require significant additionalcapital in the future, which we may seek to raise through further public orprivate equity offerings, additional debt financing or added collaborations andlicensing arrangements. However, no assurance can be given that additionalfinancing or collaborations and licensing arrangements will be available whenneeded, or that if available, will be obtained on favorable terms. If adequatefunds are not available when needed, we may have to curtail operations orattempt to raise funds on unattractive terms.

 
| ** **                                  | ** ** | **For the Three Month  Periods Ended March 31,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                              | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(In thousands)**                                    | ** ** |
|                                        |       |                                                  |       |   |   |
| **Cash provided by (used in):**             |       |                                                  |       |   |   |
| Operating activities                        |       | $                                                     | (10,938    | ) | $ | 730 |   |
| Investing activities                        |       | 33,986                                                |       | (654 | ) |
| Financing activities                        |       | (37,892                                               | )          | 22,211 |   |
| Cash and cash equivalents, at end of period |       | 55,394                                                |       | 90,956 |   |
|                                             |            |                                                       |            |  |  |  |  |

 

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*Cash andCash Equivalents.*  At March 31, 2005, we had $55.4 millionin cash and cash equivalents. Together with our investments at March 31,2005 ($142.2 million), this balance has decreased just $0.7 million from theclose of the year-ended 2004. Significant cash flows during the three-monthperiod ended March 31, 2005 include, the net proceeds from the sale andleaseback financing of our Sturlugata 8 headquarters facility ($54.8 million),prepayments of short and long-term debts secured by mortgages on Sturlugata 8($38.6 million), refinancing of the mortgage on our Woodridge, IL facility($4.0 million), debt service ($1.3 million), capital expenditures ($0.5million), and costs associated with the advancement of our drug developmentprograms as reflected in the $10.9 million of cash we used in operatingactivities during the three-month period ended March 31, 2005..

 

Available cash is investedin accordance with our investment policy’s primary objectives of liquidity andsafety of principal while maximizing the income we receive from our investmentswithout significantly increasing risk. Our cash is deposited only withfinancial institutions in Iceland, the United Kingdom and the United Stateshaving a high credit standing (A-/A3 or better). We expect to maintain ourportfolio of cash equivalents and investments in a variety of securities,including auction rate securities commercial paper, money market funds, mutualfund investments and government and non-government debt securities.

 

At March 31, 2005, ourcash is largely invested in U.S. dollar denominated money market and checkingaccounts and also in Icelandic krona denominated accounts. At March 31,2005, our investments are in auction rate securities, US government agencysecurities and a mutual fund.

 

*OperatingActivities.* Net cashused in operating activities increased to $10.9 million for the three-monthperiod ended March 31, 2005 as compared to $0.7 million having beenprovided in the same period in 2004.  Becauseof $6.4 million of the monies received by us in the Information Rich ClinicalTrial with Merck, working capital provided $5.9 million of funds in thethree-month period ended March 31, 2004 as compared to $1.5 millionprovided in the three-month period ended March 31, 2005. As more fully describedabove, the increase in use of cash in operating activities primarily derivesfrom research and development investments being made in advancing our drug andclinical development programs.

 

*InvestingActivities.*

 

Our investing activitieshave consisted of short-term investments, capital expenditures and, in thethree-month period ended March 31, 2005, the sale and leaseback of ourheadquarters facility at Sturlugata 8, Reykjavik, Iceland.

 

As more fully describedbelow, in March 2005, we entered into a financing with an Icelandic realestate company for the sale and leaseback of our headquarters facility atSturlugata 8, Reykjavik, Iceland. The sale price for the property was 3.4billion Icelandic kronas ($54.8 million after taking into account a standardforward foreign exchange contact we entered into in connection with the sale).

 

Investments during thethree-month period ended March 31, 2005 consist mainly of continuedinvestments in auction rate securities, US government securities and a mutualfund. We principally made replacement capital expenditures during 2004 and 2005and did invest in certain equipment for our laboratories. Although we expect wewill continue to make principally replacement capital expenditures in thenear-term, 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 as well as changing business needs.

 

*FinancingActivities.* Net cashof $37.9 million was used in financing activities in the three-month periodended March 31, 2005, as compared to $22.2 million that was provided inthe three-month period ended March 31, 2004.  Financing activities for the three-monthperiod ended March 31, 2005 largely consisted of prepayments of short andlong-term debts secured by mortgages on Sturlugata 8 ($38.6 million),refinancing of the mortgage on our Woodridge, IL facility ($4.0 million) whichfreed-up $6.0 million of previously restricted cash, and other debt service($1.3 million). Financing activities for the three-month period ended March 31,2004 largely consisted of equity proceeds and a portion of the up-front moniesreceived by us in the Information Rich Clinical Trial alliance with Merck($13.6 million), proceeds in the liquidation of our two cross-currency swap($9.7 million) and installment payments on debt and capital lease obligations($1.9 million).

 

Proceeds from the sale of our headquarters facility atSturlugata 8 went to prepay approximately $34.1 million of long-term debt thatwas secured by mortgages on the property, (our Tier A bonds, Tier B loan and March 2004loan) and $4.5 million of short-term borrowings. We have leased the propertyback under a 15 year non-cancelable lease agreement at a rent of 21.4 millionIcelandic kronas (approximately $0.4 million as of March 31, 2005) permonth, subject to changes based on the Icelandic consumer price index. Underthe terms of the lease we will continue to pay property taxes and insurance andwill be responsible for the property’s maintenance. The monthly rent will berevised as of July 1, 2010 to reflect changes in capital markets as wellas our credit quality. Under the terms of the lease, we have a right of firstrefusal on any sale of the property and a priority right to extend the term ofthe lease at its expiration. The lease provides us with the option toredenominate the rent in other currencies than Icelandic kronas at a

 

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In March 2005, we refinanced the mortgage on our Woodridge, ILfacility, paying-down $4.0 million on the existing mortgage and eliminatingrestricted cash collateral totaling $6.0 million.  The principal amount of the new mortgage ($6.2million) is payable in monthly installments of $26,000 for five years and afinal payment of $5.5 million due in June 2007.  The new mortgage carries an interest rate ofthree-month LIBOR + 2.25% (4.43% at March 31, 2005).

 

*Contractual Commitments.*  Ourmajor outstanding contractual commitments relate to the privately placed bondsand bank loans and equipment lease financings. Our contractual commitments asof March 31, 2005 were as follows:

 
| ** **                                         | ** ** | ** **         | ** ** | **Payments Due by period** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|----------------------------|------------|
| ** **                                         | ** ** | **Total**          | ** ** | **Less Than  1 Year**      | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| 3.5% senior convertible notes, including  interest |       | $                  | 184,125    |                       | $          | 5,250 |   | $ | 10,500 |   | $ | 10,500 |   | $ | 157,875 |   |
| Long-term debt                                     |       | 8,693              |       | 2,664                      |       | 6,029 |   | 0 |   | 0 |   |
| Capital lease obligations, including  interest     |       | 2,558              |       | 1,841                      |       | 691 |   | 26 |   | 0 |   |
| Operating leases                                   |       | 64,770             |       | 4,964                      |       | 9,008 |   | 8,466 |   | 42,332 |   |
|                                               |       | $                  | 260,146    |                       | $          | 14,719 |   | $ | 26,228 |   | $ | 18,992 |   | $ | 200,207 |   |

 

Underthe terms of certain technology licensing agreements, we are obligated to makepayments upon the achievement of established milestones leading to thediscovery of defined products. These payments could total $6,000,000 and theyear incurred cannot be determined at the current time.

 

**RISKFACTORS, FORWARD-LOOKING STATEMENTS, AND CAUTIONARY FACTORSTHAT MAY AFFECT FUTURE RESULTS**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements. Thesestatements relate to future events or our future financial performance. In somecases, forward-looking statements can be identified by terminology such as “may,”“will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“predict,” “intend,” “potential” or “continue” or the negative of such terms orother comparable terminology. These statements are only predictions. We cannotassure our investors that our expectations and assumptions will prove to havebeen correct. We undertake no intention or obligation to update or revise anyforward-looking statements, whether as a result of future events, newinformation or otherwise. Actual events or results may differ materially due toa number of factors, including those set forth in this section andelsewhere in this Form 10-Q. These factors include, but are not limitedto, the risks set forth below.

 

**Risks Related to Our Business**

 

***We may not successfully develop orderive revenues from any products.***

 

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

 

•                  establish that they are safe and effective;

 

•                  successfully compete with other technologies and products;

 

•                  ensure that they do not infringe on the proprietaryrights of others;

 

•                  establish that they can be manufactured insufficient quantities at reasonable costs;

 

•                  obtain and maintain regulatory approvals for them;and

 

•                  can market them successfully.

 

Wemay not be able to meet these conditions. We expect that it will be years, ifever, before we will recognize significant revenue from the development oftherapeutic or diagnostic products.

 

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***If we continue to incur operatinglosses longer than anticipated, or in amounts greater than anticipated, we maybe unable to continue our operations.***

 

Weincurred a net loss of $16.9 million for the three-months ended March 31,2005, and had an accumulated deficit of $404.4 million at March 31,2005. We have never generated a profit and we have not generated revenuesexcept for payments received in connection with our research and developmentcollaborations with Roche, Merck and other collaborations, and from contractservices. Our research and development expenditures and general andadministrative costs have exceeded our revenue to date, and we expect to spendsignificant additional amounts to fund research and development in order toenhance our core technologies and undertake product development (including drugdevelopment and related clinical trials). We do not expect to receive royaltiesor other revenues from commercial sales of products developed using ourtechnology in the near term. It may be several years before product revenuesmaterialize, if they do at all. As a result, we expect to incur net losses forseveral years. If the time required to generate product revenues and achieveprofitability is longer than we currently anticipate or the level of losses isgreater than we currently anticipate, we may not be able to continue ouroperations.

 

***If our assumption about the role ofgenes in disease is wrong, we may not be able to develop useful products.***

 

Theproducts we hope to develop involve new and unproven approaches. They are basedon the assumption that information about genes may help scientists to betterunderstand complex disease processes. Scientists generally have a limitedunderstanding of the role of genes in diseases, and few products based on genediscoveries have been developed. Of the products that exist, all are diagnosticproducts. To date, we know of no therapeutic products based on disease-genediscoveries. If our assumption about the role of genes in the disease processis wrong, our gene discovery programs may not result in products.

 

***Clinical trials required for ourproduct candidates or the products of our customers and partners are expensiveand time-consuming, and their outcome is uncertain.***

 

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

 

•                  slower than expected patient enrollment due to thenature of the protocol, the proximity of patients to clinical sites, theeligibility criteria for the study, competition with clinical trials for otherdrug candidates or other factors;

 

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

 

•                  delayed approval of study protocol andpharmacogenomic components of studies by regulatory agencies in different countries,some of which are still developing policies with respect to pharmacogenomictesting;

 

•                  inadequately trained or insufficient personnel atthe study site to assist in overseeing and monitoring clinical trials;

 

•                  delays in approvals or failure to obtain approvalfrom the pertinent review boards or regulatory authorities;

 

•                  longer treatment time required to demonstrateeffectiveness or determine the appropriate product dose;

 

•                  lack of sufficient supply of the product candidate;

 

•                  adverse medical events or side effects in treatedpatients;

 

•                  lack of effectiveness of the product candidate beingtested; and

 

•                  regulatory changes.

 

Evenif we obtain positive results from pre-clinical or clinical trials for aparticular product, we may not achieve the same success in future trials ofthat product. In addition, some or all of the clinical trials we undertake maynot 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 ortermination of clinical trials that we conduct for our partners or customersmay also harm our financial results as payments under these contracts may bedelayed, reduced or curtailed.

 

***Co-development of therapeutic anddiagnostic products may be required, and delays in the development and approvalof a commercially available diagnostic may delay drug approval or impede marketacceptance of the therapeutic product.***

 

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Theuse of some of our therapeutic products may be dependent upon the selection ofpatients using both clinical and genetic markers. This may requireco-development and clinical testing of the therapeutic drug and a relateddiagnostic product. In the United States, drug approval could be delayed untilwe successfully obtain FDA approval of the related diagnostic product. Inaddition, if the diagnostic test cannot be performed on a commercially viablebasis, it may impede market acceptance of our approved therapeutic products.  To successfully co-develop and market a drugand diagnostic we may also need to establish and maintain successfulpartnerships with manufacturing and marketing partners for diagnostic products.  If necessary partnerships can not beestablished or maintained the development of our therapeutics and/ordiagnostics may be delayed or may fail.

 

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

 

Historically,a substantial portion of our revenue has been derived from contracts with alimited number of significant customers. Our largest customer, Roche, accountedfor approximately 29% and 33% of the company’s consolidated revenue in thethree-month periods ended March 31, 2005 and 2004, respectively. Revenueunder our alliances with Merck accounted for approximately 21% and 18% of thecompany’s consolidated revenue in the three-month periods ended March 31,2005 and 2004, respectively. The loss of any significant customer may significantlylower our revenues and affect the resources available to support our drugdiscovery programs.

 

***If we are not able to obtainsufficient additional funding to meet our capital requirements, we may beforced to reduce or terminate our research and product development programs.***

 

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

 

•                  the number, breadth and progress of our discoveryand research 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 andother intellectual property rights; and

 

•                  the costs and timing of regulatory approvals.

 

Wehave relied on, may continue to rely on partnerships for significant funding ofour research efforts. In addition, we may seek additional funding throughpublic or private equity offerings and debt financings. We may not be able toobtain additional financing when we need it or the financing may not be onterms favorable to us or our stockholders. Stockholders’ ownership will bediluted if we raise additional capital by issuing equity securities.

 

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

 

***If we cannot successfully develop amarketing and sales force or maintain suitable arrangements with third partiesto market and sell our products, our ability to deliver products may beimpaired.***

 

Wecurrently have no experience in marketing or selling pharmaceutical products.In order to achieve commercial success for any approved product, we must eitherdevelop a marketing and sales force, which will require substantial additionalfunds and personnel, or, where appropriate or permissible, enter intoarrangements with third parties to market and sell our products. We might notbe successful in developing marketing and sales capabilities. Further, we maynot 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 cannot successfully form andmaintain suitable arrangements with third parties for the manufacturing of theproducts we may develop, our ability to develop or deliver products may beimpaired.***

 

Wehave no experience in manufacturing products for commercial purposes and do nothave manufacturing facilities that can produce sufficient quantities of drugsfor large scale clinical trials. Accordingly, we must either develop suchfacilities, which will require substantial additional funds, or rely oncontract manufacturers for the production of products for development andcommercial purposes. In order to conduct our currently planned Phase IIIclinical trial of DG031, we will have to contract with third parties tomanufacture a

 

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sufficientsupply of the drug for the trial and to produce tablets containing DG031 inamounts sufficient for the clinical trial. While we have signed contracts withsuppliers for the production of DG031 material and tablets for the plannedlaunch of our Phase III clinical trial, we have not received the finished drugtablets, and we may fail to secure sufficient supply of the drug in a timelymanner over the duration of the trial.

 

Themanufacture of our products for clinical trials and commercial purposes issubject to cGMP regulations promulgated by the FDA. In the event that we areunable to develop satisfactory manufacturing facilities or obtain or retainthird-party manufacturing for our products, we will not be able tocommercialize such products as planned. We may not be able to enter intoagreements for the manufacture of future products with manufacturers whosefacilities and procedures comply with cGMP and other regulatory requirements.Our current dependence upon others for the manufacture of our products mayadversely affect our ability to develop and deliver such products on a timelyand competitive basis and, in the longer term, the profit margin, if any, onthe sale of future products and our ability to develop and deliver suchproducts on a timely and competitive basis

 

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

 

Thegenetic make-up and prevalence of disease generally varies across populationsaround the world. Common complex diseases generally occur with a similarfrequency in Iceland and other European populations. However, the populationsof other nations may be genetically predisposed to certain diseases because ofmutations not present in the Icelandic population. As a result, we and ourpartners may be unable to develop diagnostic and therapeutic products that areeffective on all or a portion of people with such diseases. For our business tosucceed, we must be able to apply discoveries that we make on the basis of theIcelandic population to other markets.

 

***If we fail to protect confidentialdata adequately, we could incur a liability.***

 

Underlaws and regulations in force in Iceland, including applicable European laws,directives and regulations, all information on individuals that is used in ourpopulation research is anonymized under the protocols and supervision of theData Protection Authority of Iceland. If we fail to comply with these laws andregulations, we could lose public support for participation in our research andwe could be liable to legal action. Any failure to comply fully with allconfidentiality requirements could lead to liability for damages incurred byindividuals whose privacy is violated, the loss of our customers and reputationand the loss of the goodwill and participation of the Icelandic population,including healthcare professionals. These eventualities could materiallyadversely affect our work in Iceland.

 

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

 

Throughour wholly owned subsidiary Encode ehf., we conduct clinical trials of productswe are developing and contract with drug companies and clinical researchorganizations to perform a wide range of services to assist them in bringingnew drugs to market. Our services include:

 

•                  supervising clinical trials;

 

•                  data and laboratory analysis;

 

•                  patient recruitment;

 

•                  acting as investigators in conducting clinicaltrials; and

 

If, in the course of these trials or activities,

 

•                  we do not perform our services to contractual orregulatory standards;

 

•                  we fail to obtain permission to conduct trials fromthe appropriate authorities in Iceland;

 

•                  patients or volunteers suffer personal injury causedby or death from adverse reactions to the test drugs or otherwise;

 

•                  there are deficiencies in the professional conductof the investigators with whom we contract;

 

•                  our laboratories inaccurately report or fail toreport lab results; or

 

•                  our informatics products violate rights of thirdparties,

 

thenwe could be held liable for these eventualities by the drug companies andclinical research organizations with whom we contract or by study participants.We maintain product liability insurance for claims arising from the use ofproducts we are developing in clinical trials conducted by Encode and arecovered by the product liability insurance of the drug companies and clinicalresearch organizations for whom we provide clinical trial services for claimsarising from the use of their products in such trials. Such insurance may be

 

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inadequateand in any event would not cover the risk of a customer deciding not to dobusiness with us as a result of poor performance or claims for a customer’sfinancial loss as the result of our failure to perform our contractualobligations properly.

 

***Use of therapeutic or diagnosticproducts developed as a result of our programs may result in product liabilityclaims for which we have inadequate insurance.***

 

Theusers of any therapeutic or diagnostic products developed by us or ourcollaborators as a result of our discovery or research programs (includingparticipants in our clinical trials) may bring product liability claims againstus. Except as described above with respect to clinical trials conducted byEncode, we currently do not carry liability insurance to cover such claims(although we expect to obtain such insurance for our Phase III trial of DG031).We are not certain that we or our collaborators will be able to obtain suchinsurance or, if obtained, that sufficient coverage can be acquired at areasonable cost. If we cannot protect against potential liability claims, we orour collaborators may find it difficult or impossible to commercializeproducts.

 

***Our fee-for-service work bearscertain risks of liability to our customers.***

 

Inour work for fee-for-service customers, we often synthesize compounds andprovide recommendations for research direction for our customers. We may beliable to our customers for damages if we perform such services negligently orwith willful misconduct. Failure to perform to customer expectation also maylimit future business from our existing customers, or could result in theholdback of certain payments due to us. We also supply compounds for clinical trials conducted by ourcustomers.  If participants in thesetrials suffer personal injury or death from adverse reactions to the testdrugs, we could be held liable to our customers or the participants.  We maintain product liability insurance forclaims arising from the use of products we supply.  However, such insurance may be inadequate andin any event would not cover the risk of the customer deciding not to dobusiness with us as a result of poor performance or claims for a customer’sfinancial loss as the result of our failure to perform our contractualobligations properly.

 

Inaddition, we typically have the obligation to maintain the confidentiality ofproprietary information of our customers. While we have systems in place toensure that such confidentiality is protected, because we conduct work on ourinternal projects at the same facilities where we work for our customers, thereis an increased risk that customers may claim that we have violated ourconfidentiality obligations or used their proprietary information in ourproprietary projects.

 

***Increased leverage as a result ofour convertible debt may harm our financial condition and results ofoperations.***

 

OnMarch 31, 2005, we have $161.3 million of outstanding debt as reflected inour balance sheet. We may incur additional indebtedness in the future and ouroutstanding 3.5% Senior Convertible Notes do not restrict our future issuanceof indebtedness. Our level of indebtedness will have several important effectson our future operations, including, without limitation:

 

•                  a portion of our cash flow from operations will bededicated 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 outstanding debt, ourability 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, industry cycles and financial, business and other factorsaffecting our operations, many of which are beyond our control. If we are notable to generate sufficient cash flow from operations in the future to serviceour debt, we may be required, among other things:

 

•                  to seek additional financing in the debt or equitymarkets;

 

•                  to refinance or restructure all or a portion of ourindebtedness, including the Notes;

 

•                  to sell selected assets; or

 

•                  to reduce or delay expenditures on plannedactivities, including but not limited to clinical trials, and development andcommercialization activities.

 

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

 

***We may be unable to hire and retainthe key personnel upon whom our success depends.***

 

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Wedepend on the principal members of our management and scientific staff,including Dr. Kari Stefansson, Chairman, President and Chief ExecutiveOfficer. We have not entered into agreements with any of these people that bindthem to a specific period of employment. If any of these people leave, ourability to conduct our operations may be negatively affected. Our futuresuccess also will depend in part on our ability to attract, hire and retainadditional personnel. There is intense competition for such qualified personneland we cannot be certain that we will be able to continue to attract and retainsuch personnel. Failure to attract and retain key personnel could have amaterial adverse effect on us.

 

***Currency fluctuations may negativelyaffect our financial condition.***

 

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

 

***Our contracts may terminate uponshort notice.***

 

Manyof our contracts for research services are terminable on short notice. Thismeans that our contracts could be terminated for numerous reasons, any of whichmay be beyond our control such as a reduction or reallocation of a customer’sresearch and development budget or a change in a customer’s overall financialcondition. The loss of a large contract or multiple smaller contracts, or asignificant decrease in revenue derived from a contract, could significantlyreduce our profitability and require us to reallocate under-utilized physicaland professional resources.

 

**Risks Related to Our Collaborative Relationships**

 

***If we are unable to form andmaintain the collaborative relationships that our business strategy requires,our programs will suffer and we may not be able to develop*****products.**

 

Ourstrategy for developing products and deriving revenues from them is dependent,in part, upon our ability to enter into collaborative arrangements withresearch collaborators, corporate partners and others. We may rely on thesearrangements both to provide funding necessary to our product development andto obtain goods and services that we require for our product development. We donot have the capacity to conduct large scale Phase III clinical trials and willrely on partnerships or third party contractors to conduct our Phase IIItrials, including our currently planned Phase III trial of DG031. We will relyon these third parties to provide us with clinical material for the trial andvarious services necessary to organize and conduct a multi-center,multinational study, as well as other goods and services. We have not enteredinto contracts for all goods and services required for the Phase III trial of DG031at this time. Our arrangement for this and other Phase III trials will besubject to risks described below, with respect to our collaborativerelationships.

 

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

 

***Dependence on collaborativerelationships may lead to delays in product development, product defects anddisputes over rights to technology.***

 

Wemay form collaborative relationships (including relationships with clinicalresearch organizations to conduct clinical trials on our behalf) that will, insome cases, make us dependent on collaborators for the pre-clinical studiesand/or clinical trials and for regulatory approval of any products that we aredeveloping. Failure of such collaborators to perform under these agreements properlyin a timely manner, or at all, may lead to delays in our product development. Inaddition, if participants in the trials conducted by our collaborators suffer personalinjury or death as a result of actions of the collaborators, we could be heldliable.  In some cases, our agreementswith collaborators typically allow them significant discretion in electingwhether and how to pursue such activities. We cannot control the amount andtiming of resources collaborators will devote to these programs or potentialproducts.

 

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

 

**Risks Related to Our Industry**

 

***Concerns regarding the use ofgenetic testing results may limit the commercial viability of any products wedevelop.***

 

Othercompanies have developed genetic predisposition tests that have raised ethicalconcerns. It is possible that employers or others could discriminate againstpeople who have a genetic predisposition to certain diseases. Concern regardingpossible discrimination may

 

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resultin governmental authorities enacting restrictions or bans on the use of all, orcertain types of, genetic testing. Similarly, such concerns may leadindividuals to refuse to use genetic tests even if permissible. These factorsmay limit the market for, and therefore the commercial viability of, productsthat our collaborators and/or we may develop.

 

***We may not be able to competesuccessfully with other companies and government agencies in the developmentand marketing of products and services.***

 

Anumber of companies are attempting to rapidly identify and patent genes thatcause diseases or an increased susceptibility to diseases. Competition in thisfield and our other areas of business, including drug discovery and developmentis intense and is expected to increase. We have numerous competitors, includingmajor pharmaceutical and diagnostic companies, specialized biotechnology firms,universities and other research institutions, and other government-sponsoredentities and companies providing healthcare information products. Ourcollaborators, including Roche and Merck, may also compete with us. Many of ourcompetitors, either alone or with collaborators, have considerably greatercapital resources, research and development staffs and facilities, andtechnical and other resources than we do, which may allow them to discoverimportant genes or develop drugs based on such discoveries before we do. Webelieve that a number of our competitors are developing competing products andservices that may be commercially successful and that are further advanced indevelopment than our potential products and services. To succeed, we, togetherwith our collaborators, must discover disease-predisposing genes, characterizetheir functions, 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, including cases where the competing drugs use the samemechanism of action as our products. Our competitors may succeed in developingand marketing products and services that are more effective than ours or thatare marketed before ours.

 

Competitorshave established, and in the future may establish, patent positions withrespect to gene sequences related to our research projects. Such patentpositions or the public availability of gene sequences comprising substantialportions of the human genome could decrease the potential value of our researchprojects and make it more difficult for us to compete. We may also facecompetition 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, orcommercialize therapeutic or diagnostics products. In addition, we face, andwill continue to face, intense competition from other companies forcollaborative arrangements with pharmaceutical and biotechnology companies, forestablishing relationships with academic and research institutions and forlicenses to proprietary technology.

 

Weexpect competition to intensify as technical advances are made and become morewidely known. Our future success will depend in large part on maintaining acompetitive position in the genomic field. Rapid technological development mayresult in products or technologies becoming obsolete before we recover theexpenses we incur in developing them.

 

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

 

•                  develop proprietary products;

 

•                  develop and maintain products that reach the marketfirst, and are technologically superior to, and more cost effective than, otherproducts on the market;

 

•                  obtain patent or other proprietary protection forour products and technologies;

 

•                  attract and retain scientific and productdevelopment personnel;

 

•                  obtain required regulatory approvals; and

 

•                  manufacture, market and sell products that wedevelop.

 

***Changes in outsourcing trends andeconomic conditions in the pharmaceutical and biotechnology industries couldadversely affect our growth.***

 

Economicfactors and industry trends that affect our primary customers, pharmaceuticaland biotechnology companies, also affect our business. For example, thepractice of many companies in these industries has been to outsource toorganizations like us the conduct of genetic research, clinical research, salesand marketing projects and chemistry and structural biology research anddevelopment projects. If these industries reduce their present tendency tooutsource those projects, our operations, financial condition and growth ratecould be materially and adversely affected. These alliances and arrangements areboth time consuming and complex and we face substantial competition inestablishing these relationships. In addition, our ability to generate newbusiness could be impaired by general economic downturns in our customers’industries. We have experienced increasing pressure on the part of ourcustomers to reduce expenses, including the use of our services as a result ofnegative economic trends generally and in the pharmaceutical industry. Ifpharmaceutical and biotechnology companies discontinue or decrease their usageof our services, including as a result of the slowdown in the overall U.S.economy, our revenues and earnings could be lower than we expect and ourrevenues may decrease or not grow at historical rates.

 

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***If regulatory approvals for productsresulting from our gene discovery programs are not obtained, we will not beable to derive revenues from these products.***

 

Governmentagencies must approve new drugs and diagnostic products in the countries inwhich they are to be marketed. We cannot be certain that we can obtainregulatory approval for any drugs or diagnostic products resulting from ourgene discovery programs. The regulatory process can take many years and requiresubstantial resources. Because some of the products likely to result from ourdisease research programs involve the application of new technologies and maybe based upon a new therapeutic approach, various government regulatoryauthorities may subject such products to substantial additional review. As aresult, these authorities may grant regulatory approvals for these productsmore slowly than for products using more conventional technologies.Furthermore, regulatory approval may impose limitations on the use of a drug ordiagnostic product.

 

Evenif a product is approved for marketing, it and its manufacturer must undergocontinuing review. Discovery of previously unknown problems with a product mayhave adverse effects on our business, financial condition and results ofoperations, including withdrawal of the product from the market.

 

***Third party reimbursement and healthcare reform policies may reduce market acceptance of our products.***

 

Oursuccess will depend in part on the price and extent to which we will be paidfor our products by government and health administration authorities, privatehealth insurers and other third party payers. Reimbursement for newly approvedhealthcare products is uncertain. Third party payers, including Medicare in theUnited States, are increasingly challenging the prices charged for medicalproducts and services. They are increasingly attempting to contain healthcarecosts by limiting both coverage and the level of reimbursement for newtherapeutic 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 payers do not provide adequate coverage and reimbursement levelsfor our products, the market acceptance of these products may be materiallyreduced.

 

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

 

***Our operations involve a risk ofinjury or damage from hazardous materials, and if an accident were to occur, wecould be subject to costly and damaging liability claims, which could have amaterial adverse effect on our business, financial condition and results ofoperations.***

 

Ourresearch and development activities involve the controlled use of hazardousmaterials and chemicals. Although we believe that our safety procedures forhandling and disposing of hazardous materials comply with the standardsprescribed by applicable governmental regulations, the risk of accidentalcontamination or injury from these materials cannot be completely eliminated.In the event of an accident, we could be held liable for any damages or finesthat result. Such liability could have a material adverse effect on ourbusiness, financial condition, results of operations and liquidity.

 

**Risks Related to Our Intellectual Property**

 

***We may not be able to protect theproprietary rights that are critical to our success.***

 

Oursuccess will depend in part on our ability to protect our products, ourgenealogy database and genotypic data and any other proprietary databases thatwe develop and our proprietary software and other proprietary methods andtechnologies. Despite our efforts to protect our proprietary rights,unauthorized parties may be able to obtain and use information that we regardas proprietary.

 

Whilewe require employees, business partners, academic collaborators and consultantsto enter 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.

 

Ourcommercial success will depend in part on obtaining patent protection. Thepatent positions of pharmaceutical, biopharmaceutical and biotechnologycompanies, including deCODE, are generally uncertain and involve complex legaland factual considerations. We cannot be sure that:

 

•                  any of our pending patent applications will resultin issued patents;

 

•                  we will develop additional proprietary technologiesthat are patentable;

 

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•                  any patents issued to us or our partners willprovide a basis for commercially viable products, will provide us with anycompetitive advantages or will not be challenged by third parties; or

 

•                  the patents of others will not have an adverseeffect on our ability to do business.

 

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

 

Inaddition, patent law relating to the scope of claims in the area of geneticsand gene discovery is still evolving and subject to uncertainty, including inareas important to us such as patenting of discoveries for the development oftherapeutic methods, diagnostic methods and products that predict inheritedsusceptibility to diseases and diagnostic methods and products that predictdrug response and disease progression. Accordingly, the degree of futureprotection for our proprietary rights is uncertain and, we cannot predict thebreadth of claims allowed in any patents issued to us or others. We could alsoincur substantial costs in litigation if we are required to defend ourselves inpatent suits brought by third parties or if we initiate such suits to enforceour own patents against potential infringers.

 

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

 

Ifexpressed sequence tags, single nucleotide polymorphisms, or SNPs, or othersequence information become publicly available before we apply for patentprotection on a corresponding full-length or partial gene, our ability toobtain patent protection for those genes or gene sequences could be adverselyaffected. In addition, other parties are attempting to rapidly identify andcharacterize genes through the use of gene expression analysis and othertechnologies. If any patents are issued to other parties on these partial orfull-length genes or gene products or uses for such genes or gene products, therisk increases that the sale of our or our collaborators’ potential products orprocesses may give rise to claims of patent infringement. The amount ofsupportive data required for issuance of patents for human therapeutics ishighly uncertain. If more data than we have available is required, our abilityto obtain patent protection could be delayed or otherwise adversely affected.Even with supportive data, the ability to obtain patents is uncertain in viewof evolving examination guidelines, such as the utility and written descriptionguidelines that the U.S. Patent and Trademark Office have adopted.

 

***Our patent protection for DG031 mayprovide marketing exclusivity for only a limited term.***

 

Thepatents we licensed from Bayer for DG031 expire in 2009 and 2012. While we willseek to obtain one or more use patents protecting our proprietary rights tospecific uses of this compound for a longer period, we cannot be certain thatwe will obtain such patents or that they will adequately protect us. Inaddition, although we may seek to extend the term of one of the patents welicensed from Bayer and to obtain marketing exclusivity under the Hatch-WaxmanAct and equivalent foreign statutes, we cannot be certain that we will besuccessful. If we cannot obtain new patents or extend the term of patentprotection under one of the patents we licensed from Bayer, the amount ofrevenues that we will be able to derive from an approved product based on thesepatents may be adversely affected.

 

***Any patent protection we obtain forour products may not prevent marketing of similar competing products.***

 

Patentson our products may not prevent our competitors from designing around anddeveloping similar compounds or compounds with similar modes of action that maycompete successfully with our products. Such third party compounds may prove tobe superior to our products or gain wider market acceptance and thus adverselyaffect any revenue stream that we could otherwise expect from sales of ourproducts.

 

***Any patents we obtain may bechallenged by producers of generic drugs.***

 

Patentson new drugs, which are also commonly referred to as “branded drugs” or “pioneerdrugs,” face increased scrutiny and challenges in the courts from manufacturersof generic drugs who may receive benefits such as limited marketingco-exclusivity if the challenge is successful. Such patent challenges typicallyoccur when the generic manufacturer files an Abbreviated New Drug Applicationwith the FDA and asserts that the patent or patents covering the branded drugare invalid or unenforceable, forcing the owner or licensee of the branded drugto file suit for patent infringement. If any patents we obtain are subject tosuch successful patent challenges, our marketing exclusivity may be eliminatedor reduced in time, which would thus adversely affect any revenue stream thatwe could otherwise expect from sales of our products.

 

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**ITEM 3. QUAN****TITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Theprimary objectives of our investment activities are to preserve principal,maintain a high degree of liquidity to meet operating needs, and obtaincompetitive returns subject to prevailing market conditions. Investments aremade primarily in high-grade corporate bonds, asset-backed debt securities andU.S. government agency debt securities. These investments are subject to riskof default, changes in credit rating and changes in market value. Theseinvestments are also subject to interest rate risk and will decrease in valueif market interest rates increase. A hypothetical 100 basis point increase ininterest rates would result in an approximate $0.8 million decrease in thefair value of our investments as of March 31, 2005. Due to theconservative nature of our investments and relatively short effectivematurities of debt instruments, interest rate risk is mitigated. Changes ininterest rates do not affect interest expense incurred on the Company’sConvertible Notes, because they bear interest at a fixed rate. Using the pricein the latest trade in March 2005, the market value of the ConvertibleNotes was $121.9 million on March 31, 2005.

 

Asa consequence of the nature our business and operations our reported financialresults and cash flows are exposed to the risks associated with fluctuations inthe exchange rates of the U.S. dollar, the Icelandic krona and other worldcurrencies. We continue to monitor our exposure to currency risk. Ahypothetical 10.0% decrease in value of the US dollar against the Icelandickrona would result in a loss of approximately $0.2 million on ourIcelandic krona denominated non U.S. dollar assets and liabilities. We havehistorically purchased instruments to hedge these general risks through the useof derivative financial instruments.

 

**ITEM 4. CON****TROLS AND PROCEDURES**

 

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

 

Indesigning and evaluating our disclosure controls and procedures, our managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance that the desired objectives ofthe control system will be met. In addition, the design of any control systemis based in part upon certain assumptions about the likelihood of future eventsand the application of judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Because of these and other inherentlimitations of control systems, there is only reasonable assurance that ourcontrols will succeed in achieving their goals under all potential futureconditions.

 

(b)*Changes in Internal Controls.* We arecontinuously seeking to improve the efficiency and effectiveness of ourinternal controls. This results in periodic refinements to internal controlprocesses throughout the company. However, there was no significant change inour internal control over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act) during the fiscal quarter covered by this Quarterly Report onForm 10-Q that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

**PART IIOT****HER INFORMATION**

 

**ITEM 1. L****EGAL PROCEEDINGS**

 

 On or about April 20, 2002, an amendedclass action complaint, captioned In re deCODE genetics, Inc. InitialPublic Offering Securities Litigation (01 Civ. 11219(SAS)), alleging violationsof federal securities laws in connection with deCODE’s initial public offeringwas filed in the United States District Court for the Southern District of NewYork on behalf of certain purchasers of deCODE common stock.  The complaint names deCODE, two individualswho were executive officers of deCODE at the time of its initial publicoffering (the “Individual Defendants”), and the two lead underwriters (the “UnderwriterDefendants”) for deCODE’s initial public offering in July 2000 (the “IPO”)as defendants.

 

deCODEis aware that similar allegations have been made in hundreds of other lawsuitsnot involving deCODE filed (many by some of the same plaintiff law firms)against numerous underwriter defendants and issuer companies (and certain oftheir current and former officers) in connection with various public offeringsconducted in recent years.  All of thelawsuits that have been filed in the Southern District of New York have beenconsolidated for pretrial purposes before United States District Judge ShiraScheindlin.  Pursuant to the underwritingagreement executed in connection with our IPO, deCODE has demandedindemnification from the Underwriter Defendants.  The Underwriter Defendants have asserted thatdeCODE’s request for indemnification is premature.

 

Pursuantto an agreement, the Individual Defendants have been dismissed from the casewithout prejudice.

 

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OnJuly 31, 2003, deCODE’s Board of Directors (other than deCODE’s Chairmanand Chief Executive Officer, who recused himself because he was an IndividualDefendant) approved a proposed partial settlement with the plaintiffs in thismatter, subject to a number of conditions, including the participation of asubstantial number of other issuer defendants in the proposed settlement, theconsent of deCODE’s insurers to the settlement and the completion of acceptablefinal settlement documentation.  Anydirect financial impact of the proposed settlement is expected to be borne bydeCODE’s insurers.

 

Inconjunction with the plaintiffs, the settling issuer defendants filed a motionseeking the court’s preliminary approval of the settlement.  On February 15, 2005, the court grantedthe motion, subject to certain modifications. If the parties are able to agree upon the required modifications, andsuch modifications are acceptable to the court, notice will be given to allclass members of the settlement and a “fairness” hearing will be held.  If the court determines that the settlementis fair to the class members, the settlement will be approved.  There can be no assurance that this proposedsettlement will be approved and implemented in its current form, if atall.  If the settlement of the IPOlitigation is not consummated, deCODE expects to contest the allegations in theaction vigorously.  Due to the inherent uncertaintiesof the litigation and because the settlement approval process is at apreliminary stage, deCODE cannot predict the ultimate outcome of this matter.

 

Inan unrelated matter, subsequent to deCODE’s Form 8-K filing on August 26,2004 relating to deCODE’s change in auditors, five complaints were filed in September andOctober 2004 in the United States District Court for the Southern Districtof New York against deCODE and deCODE’s Chief Executive Officer and ChiefFinancial Officer alleging violations of federal securities laws arising fromcertain of deCODE’s public statements. The complaints were brought by plaintiffs seeking to represent apurported class consisting of all persons who purchased deCODE’s common stockduring the period from October 29, 2003 through August 26, 2004 andcontend that deCODE made misleading statements, misrepresentations andomissions regarding deCODE’s financial performance, compliance with generallyaccepted accounting principles and deCODE’s internal controls.  The complaints all arise out of the samealleged statements, and have been consolidated before a single Judge.  The plaintiffs seek unspecified monetarydamages and other relief.  The plaintiffshave agreed to withdraw their consolidated amended complaint; this withdrawalwas not conditioned upon any payment or fees to the plaintiffs.  On May 4, 2005, the plaintiffs filed aNotice of Agreed Motion and Proposed Order of Voluntary Dismissal (the “Notice”)in order to terminate the action.  TheNotice is subject to approval by the Court, and there can be no assurance thatit will be approved.  deCODE believesthat this action is without merit, and, should the Court not approve thevoluntary dismissal of the litigation, intends to defend against it vigorously.

 

OnSeptember 14, 2004, a complaint was filed in the United States DistrictCourt for the Southern District of New York in a derivative action againstdeCODE, its directors and specified officers. Based upon the same misstatements and omissions alleged in the above-describedsecurities complaints, the complaint alleged violations of state law by thedefendants including breaches of fiduciary duty, abuse of control, grossmismanagement, waste of corporate assets and unjust enrichment, and soughtunspecified monetary damages and other relief. On April 27, 2005, the plaintiff in the derivative action filed aNotice of Voluntary Dismissal withdrawing its complaint.  The voluntary dismissal of this action wasnot conditioned upon any payment or fees to the plaintiff.

 

Dueto the inherent uncertainties of litigation and the fact that voluntarydismissal of the securities litigation and the settlement of the litigationrelating to deCODE’s IPO remain subject to court approval, the ultimate outcomeof these matters cannot be predicted.  IfdeCODE were required to pay significant monetary damages in the event that theIPO settlement is unconsummated or as a result of an adverse determination inthe other actions described above (or any other lawsuits alleging similarclaims filed against deCODE and deCODE’s directors and officers in the future),deCODE’s business could be significantly harmed.  Even if such litigations conclude in deCODE’sfavor, deCODE may be required to expend significant funds to defend against theallegations.  deCODE is unable toestimate the range of possible loss from the above litigations and no amountshave been provided for such matters in deCODE’s financial statements.

 

**ITEM 6. EX****HIBITS 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).                              |

 

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| 3.3    |   | Bylaws, as amended  (Incorporated by reference to Exhibit 3.2 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000). |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                           |
| 10.1   |   | Purchase Agreement between  Vetrargardurinn ehf. and Festing ehf. dated March 29, 2005.                                                                                                                   |
|   |   |                                                                                                                                                                                                           |
| 10.2   |   | Lease Agreement between  Festing ehf. and Islensk erfdagreining, ehf dated March 29, 2005.                                                                                                                |
|   |   |                                                                                                                                                                                                           |
| 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.                                                                                                                                 |

 

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

 

 

Note: Unless otherwisenoted, the SEC File number of each of the above referenced documents is 000-30469.

 

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**SIGNATUR****ES**

 

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

 

Dated:  May 10, 2005

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

 

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| **EXHIBIT** | ** ** | ** **                                                                                                                                                                                                                                                                         |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **NUMBER**  | ** ** | **DESCRIPTION OF EXHIBIT**                                                                                                                                                                                                                                                         |
|        |       |                                                                                                                                                                                                                                                                               |
| 3.1         |       | Amended and Restated  Certificate of Incorporation, as further amended (Incorporated by reference  to Exhibit 3.1 and Exhibit 3.3 to the Company’s Registration Statement  on Form S-1 (Registration No. 333-31984) which became effective on  July 17, 2000). |
|        |       |                                                                                                                                                                                                                                                                               |
| 3.2         |       | Certificate of Amendment  to Amended and Restated Certificate of Incorporation dated August 30,  2002 (Incorporated by reference to Exhibit 3.2 to the Company’s  Quarterly Report on Form 10-Q filed on November 14, 2002).                              |
|        |       |                                                                                                                                                                                                                                                                               |
| 3.3         |       | Bylaws, as amended  (Incorporated by reference to Exhibit 3.2 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became  effective on July 17, 2000).                                                                     |

 

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| 10.1   |   | Purchase Agreement between  Vetrargardurinn ehf. and Festing ehf. dated March 29, 2005.    |
|--------|--------|-------------------------------------------------------------------------------------------------|
|   |   |                                                                                            |
| 10.2   |   | Lease Agreement between  Festing ehf. and Islensk erfdagreining, ehf dated March 29, 2005. |
|   |   |                                                                                            |
| 31.1   |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                  |
|   |   |                                                                                            |
| 31.2   |   | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                  |
|   |   |                                                                                            |
| 32.1   |   | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                  |

 

 

Note: Unless otherwisenoted, the SEC File number of each of the above referenced documents is 000-30469.

 

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