**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-Q**

**(Mark One)**

** **

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.

** **

**FOR THE QUARTERLY PERIODENDED MARCH 31, 2006**

** **

**OR**

** **

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT

** **

**FOR THE TRANSITION PERIODFROM           TO      **

** **

**COMMISSION FILE NUMBER 000-30469**

** **

**deCODE genetics, Inc.**

(Exact Name of Registrant 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-101REYKJAVIK, ICELAND**

(Address of Principal Executive Offices)

** **

**+354-570-1900**

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes  x   No  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check One):

Large acceleratedfiler  o                    Acceleratedfiler  x                   Non-acceleratedfiler  o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  o   No  x

The aggregate number of shares of the registrant’scommon stock outstanding on April 28, 2006 was 55,492,235 shares of commonstock $.001 par value.

----

**deCODE genetics, Inc.**

**INDEX**
| PART I.   FINANCIAL  INFORMATION |
|-------------------------------------------------|
|                                            |   |   |
| Item  1.                                        |   | Financial  Statements (Unaudited) |
|                                            |   |   |
|                                            |   | Condensed Consolidated Balance Sheets as of  March 31, 2006 and December 31, 2005 |
|                                            |   |   |
|                                            |   | Condensed Consolidated Statements of Operations for  the three-months ended March 31, 2006 and 2005 |
|                                            |   |   |
|                                            |   | Condensed Consolidated Statements of Cash Flows for  the three-months ended March 31, 2006 and 2005 |
|                                            |   |   |
|                                            |   | 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                               |

 

1

----

**PART I.FINANCIAL INFORMATION**

**ITEM 1. FINANCIALSTATEMENTS**

**deCODE genetics, Inc.CONDENSED CONSOLIDATED BALANCE SHEETS**(Unaudited)
| ** **                                                                                                                                                                                                                                       | ** ** | **MARCH 31,**                  | ** ** | **DECEMBER 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                       | ** ** | **2006**                            | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                                                       | ** ** | **(In thousands, except** | ** ** |
| ** **                                                                                                                                                                                                                                       | ** ** | **share amounts)**             | ** ** |
| ASSETS                                                                                                                                                                                                                                           |       |                                |       |                  |       |
| Current assets:                                                                                                                                                                                                                                  |       |                                |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                                       |       | $                                   | 12,436     |                  | $          | 65,943 |   |
| Investments                                                                                                                                                                                                                                      |       | 127,860                             |       | 89,611                |       |
| Receivables                                                                                                                                                                                                                                      |       | 7,478                               |       | 7,856                 |       |
| Other current  assets                                                                                                                                                                                                                            |       | 6,677                               |       | 3,541                 |       |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Total current  assets                                                                                                                                                                                                                            |       | 154,451                             |       | 166,951               |       |
| Property and  equipment, net                                                                                                                                                                                                                     |       | 23,827                              |       | 24,500                |       |
| Goodwill                                                                                                                                                                                                                                         |       | 10,109                              |       | 8,863                 |       |
| Other long-term  assets and deferred charges                                                                                                                                                                                                     |       | 10,275                              |       | 6,444                 |       |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Total assets                                                                                                                                                                                                                                     |       | $                                   | 198,662    |                  | $          | 206,758 |   |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                                                                                                      |       |                                |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                 |       | $                                   | 6,879      |                  | $          | 4,732 |   |
| Accrued expenses  and other current liabilities                                                                                                                                                                                                  |       | 12,420                              |       | 12,823                |       |
| Current portion  of capital lease obligations                                                                                                                                                                                                    |       | 915                                 |       | 1,313                 |       |
| Current portion  of long-term debt                                                                                                                                                                                                               |       | 489                                 |       | 550                   |       |
| Deferred revenue                                                                                                                                                                                                                                 |       | 9,703                               |       | 6,105                 |       |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Total current  liabilities                                                                                                                                                                                                                       |       | 30,406                              |       | 25,523                |       |
| Capital lease  obligations, net of current portion                                                                                                                                                                                               |       | 904                                 |       | 1,046                 |       |
| Long-term debt,  net of current portion                                                                                                                                                                                                          |       | 155,773                             |       | 155,653               |       |
| Deferred gain on  sale-leaseback                                                                                                                                                                                                                 |       | 27,169                              |       | 27,654                |       |
| Deferred revenue                                                                                                                                                                                                                                 |       | 6,219                               |       | 6,219                 |       |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Commitments and  contingencies                                                                                                                                                                                                                   |       |                                |       |                  |       |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Stockholders’ deficit:                                                                                                                                                                                                                      |       |                                |       |                  |       |
| Preferred stock,  $0.001 par value; Authorized: 6,716,666 shares; Issued and outstanding: none                                                                                                                                                   |       | —                              |       | —                |       |
| Common stock,  $0.001 par value; Authorized: 100,000,000 shares; Issued and outstanding:  55,508,016 and 55,488,516 shares, respectively, at March 31, 2006; and  54,762,095 and 54,742,595 shares, respectively, at December 31, 2005 |       | 56                                  |       | 55                    |       |
| Additional  paid-in capital                                                                                                                                                                                                                      |       | 451,758                             |       | 444,401               |       |
| Notes receivable                                                                                                                                                                                                                                 |       | (2,860                              | )          | (2,898                | )          |
| Deferred  compensation                                                                                                                                                                                                                           |       | —                              |       | (418                  | )          |
| Accumulated  deficit                                                                                                                                                                                                                             |       | (470,488                            | )          | (450,215              | )          |
| Accumulated  other comprehensive loss                                                                                                                                                                                                            |       | (152                                | )          | (139                  | )          |
| Treasury stock,  19,500 shares stated at cost                                                                                                                                                                                                    |       | (123                                | )          | (123                  | )          |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Total  stockholders’ deficit                                                                                                                                                                                                                |       | (21,809                             | )          | (9,337                | )          |
|                                                                                                                                                                                                                                             |       |                                |       |                  |       |
| Total liabilities and  stockholders’ deficit                                                                                                                                                                                                |       | $                                   | 198,662    |                  | $          | 206,758 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

2

----

**deCODE genetics, Inc.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**(Unaudited)
| ** **                                                     | ** ** | **FOR THE THREE-MONTHS ENDED MARCH 31,** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except**                               | ** ** |
| ** **                                                     | ** ** | **per share amounts)**                                  | ** ** |
|                                                           |       |                                                              |       |   |   |
| REVENUE                                                        |       | $                                                                 | 10,133     |   | $ | 9,523 |   |
|                                                           |       |                                                              |       |   |   |
| OPERATING EXPENSES                                             |       |                                                              |       |   |   |
|                                                           |       |                                                              |       |   |   |
| Cost of revenue,  including collaborative programs             |       | 10,477                                                            |       | 9,140 |   |
| Research and  development — proprietary programs          |       | 14,890                                                            |       | 8,275 |   |
| Selling, general  and administrative                           |       | 5,267                                                             |       | 4,158 |   |
|                                                           |       |                                                              |       |   |   |
| Total operating  expenses                                      |       | 30,634                                                            |       | 21,573 |   |
|                                                           |       |                                                              |       |   |   |
| Operating loss                                                 |       | (20,501                                                           | )          | (12,050 | ) |
| Interest income                                                |       | 1,712                                                             |       | 1,120 |   |
| Interest expense                                               |       | (1,716                                                            | )          | (2,389 | ) |
| Other  non-operating income and (expense), net                 |       | 232                                                               |       | (3,617 | ) |
|                                                           |       |                                                              |       |   |   |
| Net Loss                                                       |       | $                                                                 | (20,273    | ) | $ | (16,936 | ) |
|                                                           |       |                                                              |       |   |   |
| Basic and  diluted net loss per share                          |       | $                                                                 | (0.37      | ) | $ | (0.32 | ) |
|                                                           |       |                                                              |       |   |   |
| Shares used in  computing basic and diluted net loss per share |       | 54,601                                                            |       | 53,649 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

3

----

**deCODEgenetics, Inc.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                   | ** ** | **FOR THE THREE-MONTHS ENDED MARCH 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(In thousands)**                                           | ** ** |
|                                                                         |       |                                                              |       |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                       |       |                                                              |       |   |   |
| Net loss                                                                     |       | $                                                                 | (20,273    | ) | $ | (16,936 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                                              |       |   |   |
| Depreciation and  amortization                                               |       | 1,874                                                             |       | 2,229 |   |
| Stock-based  compensation                                                    |       | 971                                                               |       | 48 |   |
| Amortization of  deferred gain on sale-leaseback                             |       | (485                                                              | )          | — |   |
| Amortization of  deferred financing costs                                    |       | 212                                                               |       | 283 |   |
| Loss on disposal  of equipment                                               |       | 48                                                                |       | — |   |
| Charges for debt  extinguishment                                             |       | —                                                            |       | 1,741 |   |
| Foreign currency  exchange loss on Icelandic krona denominated debt          |       | (4                                                                | )          | 263 |   |
| Other                                                                        |       | 25                                                                |       | (16 | ) |
| Changes in operating  assets and liabilities:                                |       |                                                              |       |   |   |
| Receivables and other assets                                                 |       | (785                                                              | )          | 18 |   |
| Accounts payable, accrued expenses and other current  liabilities            |       | 1,059                                                             |       | (197 | ) |
| Deferred research revenue                                                    |       | 1,386                                                             |       | 1,629 |   |
|                                                                         |       |                                                              |       |   |   |
| Net cash used in  operating activities                                       |       | (15,972                                                           | )          | (10,938 | ) |
|                                                                         |       |                                                              |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                       |       |                                                              |       |   |   |
| Purchase of  property and equipment                                          |       | (819                                                              | )          | (538 | ) |
| Purchases of  investments                                                    |       | (88,095                                                           | )          | (85,053 | ) |
| Redemptions of  investments                                                  |       | 49,825                                                            |       | 64,810 |   |
| Proceeds from  sale of property and equipment                                |       | —                                                            |       | 54,767 |   |
| Purchase  acquisition, net of cash acquired                                  |       | 1,270                                                             |       | — |   |
| Changes in  restricted cash                                                  |       | —                                                            |       | 6,000 |   |
|                                                                         |       |                                                              |       |   |   |
| Net cash used in  investing activities                                       |       | (37,819                                                           | )          | 39,986 |   |
|                                                                         |       |                                                              |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                       |       |                                                              |       |   |   |
| Issuance of  common stock and warrants                                       |       | 709                                                               |       | 19 |   |
| Repayment of  notes receivable for common stock                              |       | 52                                                                |       | — |   |
| Repayments from  short-term borrowings                                       |       | —                                                            |       | (341 | ) |
| Payments on line  of credit                                                  |       | —                                                            |       | (4,500 | ) |
| Proceeds from  equipment financing                                           |       | 288                                                               |       | — |   |
| Proceeds from  debt refinancing                                              |       | —                                                            |       | 6,211 |   |
| Repayments of  debt and capital lease obligations                            |       | (765                                                              | )          | (45,281 | ) |
|                                                                         |       |                                                              |       |   |   |
| Net cash  provided by (used in) financing activities                         |       | 284                                                               |       | (43,892 | ) |
|                                                                         |       |                                                              |       |   |   |
| Net decrease in  cash and cash equivalents                                   |       | (53,507                                                           | )          | (14,844 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 65,943                                                            |       | 70,238 |   |
|                                                                         |       |                                                              |       |   |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                                 | 12,436     |   | $ | 55,394 |   |
|                                                                         |       |                                                              |       |   |   |
| Supplemental  schedule of non-cash transactions:                        |       |                                                              |       |   |   |
| Deferred gain on  sale of property                                           |       | —                                                            |       | 25,489 |   |
| Common stock issued for  acquisition                                         |       | 6,082                                                             |       | — |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

4

----

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

**1.**   Organizationand Business

References in these financial statements to deCODErefer to deCODE genetics, Inc., a Delaware company, and deCODE genetics, Inc.’swholly-owned subsidiary, Islensk erfdagreining ehf., an Icelandic companyregistered in Reykjavik, and its subsidiaries, as well as deCODE genetics, Inc.’swholly-owned subsidiary, MediChem Life Sciences, Inc., a Delawarecorporation, and its subsidiaries. 

**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 31,2006 and, the results of operations and cash flows for the three-month periodsended March 31, 2006 and 2005. The results of operations for thethree-month period ended March 31, 2006 are not necessarily indicative ofthe results to be expected for the full year. These financial statements shouldbe read in conjunction with the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005, which includes consolidatedfinancial statements and notes thereto for the years ended December 31,2005, 2004 and 2003.

**3.**   Revenue

Significant elements of deCODE’s revenue aresummarized as follows:
| ** **                                                                 | ** ** | **For the Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                                | ** ** |
|                                                                       |       |                                                                   |       |   |   |
| Research funding  and other service fees                                   |       | $                                                                      | 5,468      |   | $ | 6,754 |   |
| Milestone  payments                                                        |       | 198                                                                    |       | 348 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | 500                                                                    |       | 1,038 |   |
| Grant funding                                                              |       | 2,987                                                                  |       | 888 |   |
| Other                                                                      |       | 980                                                                    |       | 495 |   |
| Total                                                                      |       | $                                                                      | 10,133     |   | $ | 9,523 |   |

 

For the three months ended March 31, 2006 and2005, revenue from collaborations with Merck constituted 0% and 21% ofconsolidated revenue, revenue from collaborations with Roche constituted 26%and 29% of consolidated revenue and revenues from NIH grants constituted 22%and 9%, respectively.

**4.**   Researchand Development—Proprietary Programs

deCODE’s research and development expenses consist ofthe costs of its own proprietary programs and consist of the following:
| ** **                                      | ** ** | **For the Three Months** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                      | ** ** | **Ended March 31,**           | ** ** |
| ** **                                      | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(In thousands)**                 | ** ** |
| Salaries and  other personnel costs             |       | $                                       | 5,336      |   | $ | 3,945 |   |
| Materials and supplies                          |       | 1,590                                   |       | 947 |   |
| Contractor services and other third party costs |       | 5,200                                   |       | 1,703 |   |
| Overhead expenses                               |       | 1,570                                   |       | 805 |   |
| Depreciation and amortization                   |       | 872                                     |       | 875 |   |
| Stock-based compensation                        |       | 322                                     |       | — |   |
| Total                                           |       | $                                       | 14,890     |   | $ | 8,275 |   |

 

5

----

**5.**   Stock-BasedCompensation

On January 1, 2006, deCODE adopted Statement ofFinancial Accounting Standards No. 123 (revised 2004), “*Share-Based Payment”* (“SFAS 123(R)”) usingthe modified prospective transition method. Accordingly, prior periods have notbeen restated. SFAS 123(R) requires companies to estimate the fair valueof stock-based payment awards on the date of grant using an option-pricingmodel. The value of the portion of the award that is ultimately expected tovest is recognized as expense over the requisite service periods in deCODE’sconsolidated statements of operations.

The following table summarizes stock-based compensation expense relatedto employee stock option and nonvested share awards under SFAS No. 123(R) forthe three months ended March 31, 2006 which was included in the CondensedStatement of Operations in the following captions:

|                                                      | ** ** | **2006**                | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **(in thousands)** | ** ** |
| Operating  Expenses:                                 |       |                    |       |
| Cost of revenue, including collaborative programs    |       | $                       | 116        |   |
| Research and development — proprietary programs |       | 322                     |       |
| General and administrative                           |       | 485                     |       |
| Total                                                |       | $                       | 923        |   |

 

The adoption of SFAS No. 123(R) resulted inincremental stock-based compensation expense of $923,000, which caused deCODE’snet loss to increase by $923,000 and its net loss per share to increase by$0.02 per share for that period. The adoption had no impact on cash flows fromoperating or financing activities.

The following table illustrates the pro forma effecton net loss and net loss per share had deCODE elected to account for all of itsstock-based compensation plans using the fair-value method under SFAS No. 123for the three months ended March 31, 2005:
| ** **                                                                                         | ** ** | **Three Months  Ended  March 31, 2005**        | ** ** |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **(In thousands,  except per share  amounts)** | ** ** |
|                                                                                               |       |                                                          |       |
| Net loss  attributable to common stockholders — as reported                                   |       | $                                                             | (16,936    | ) |
| Add: Stock-based  compensation expense included in reported net loss                               |       | 48                                                            |       |
| Deduct: Total  stock-based compensation expense determined under fair value method for all  awards |       | (1,131                                                        | )          |
|                                                                                               |       |                                                          |       |
| Net loss —  proforma                                                                          |       | $                                                             | (18,019    | ) |
|                                                                                               |       |                                                          |       |
| Basic and  diluted net loss per share — as reported                                           |       | $                                                             | (0.32      | ) |
| Basic and diluted net  loss per share — proforma                                              |       | (0.34                                                         | )          |

 

*Equity IncentivePlans*

deCODE maintains the deCODE genetics, Inc. 1996and 2002 Equity Incentive Plans (the “Plans”). A total of 10,000,000 shares arereserved for grants of options and restricted stock under the terms of thePlans. The Plans provide for awards to employees, members of the Board ofDirectors, consultants and other advisors who are not employees.

The equity incentive plans are administered by theCompensation Committee of the Board of Directors. The Compensation Committeedetermines the type and term of each award, the award exercise or purchaseprice, if applicable, the number of shares underlying each award granted andthe rate at which each award becomes vested or exercisable. Incentive stockoptions may be granted only to employees of deCODE at an exercise price pershare of not less than the fair market value per share of common stock on theday before the grant and with a term not to exceed ten years from date ofgrant. Nonqualified stock options may be granted to any officer, employee,director, consultant or advisor at a per share exercise price in such amount asthe Compensation Committee may determine. Generally each employee option grantvests twenty-five percent on the first anniversary date of an employee’scommencement of employment and 1/48th of the original grant each monththereafter for the following three years. Upon exercise of options, shares areissued from the pool of registered shares under the Plans.

The Compensation Committee may also grant restrictedstock and other stock-based awards on such terms and conditions as it maydetermine, which may include deCODE’s right to repurchase the unvestedunderlying stock upon termination of the holder’s employment.

6

----

Options granted to date generally vest over a periodof four years, generally have a maximum term of 10 years, and may containearly-exercise provisions allowing for company-provided financing of theexercise price. As of March 31, 2006, 444,575 shares were available forgrant under the Plans.

The following table represents stock option activityfor the three months ended March 31, 2006:
| ** **                          | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Contractual  Life** | ** ** | **Aggregate  Intrinsic Value  (in thousands)** | ** ** |
|-------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| Outstanding at January 1, 2006      |       | 4,702,702                  |       | $                                      | 8.38       |                                     |       |                                                     |       |   |
| Granted                             |       | 403,500                    |       | 9.21                                   |       |                                     |       |                                                     |       |
| Exercised                           |       | (113,280                   | )          | 6.38                                   |       |                                     |       |                                                     |       |
| Forfeited/cancelled                 |       | (190,864                   | )          | 10.01                                  |       |                                     |       |                                                     |       |
| Outstanding at  March 31, 2006 |       | 4,802,058                  |       | $                                      | 8.43       |                                     | 7.45       |                                                     | $          | 1,152 |   |
|                                |       |                       |       |                                   |       |                                     |       |                                                     |       |
| Exercisable at March 31, 2006  |       | 3,039,743                  |       | $                                      | 8.33       |                                     | 6.79       |                                                     | $          | 1,037 |   |

 

The aggregate intrinsic value in the table aboverepresents the total intrinsic value, based on deCODE’s common stock closingprice of $8.67 as of March 31, 2006, which would have been received by theoption  holders had all option holdersexercised their options as of that date. The total number of in-the-moneyoptions exercisable as of March 31, 2006 was 1,478,479.

The weighted average grant date fair value of options,as determined under SFAS 123(R) and SFAS 123, granted during the three monthsended March 31, 2006 and 2005 was $5.61 and $0, per share respectively.The total intrinsic value of options exercised during the three month periodsended March 31, 2006 and 2005 was approximately $334,000 and $33,000,respectively. The total cash received from employees as a result of employeestock option exercises during the three months ended March 31, 2006 and2005 was $709,000 and $19,000, respectively. The total fair value of sharesvested during the quarter ended March 31, 2006 was $793,000.

At March 31, 2006, deCODE’s future compensationcost related to nonvested stock options is $8,266,000, which will be recognizedover the weighted average period of 2.24 years.

deCODE uses the Black-Scholes option-pricing model tovalue stock options. The Black-Scholes model requires the use of employeeexercise behavior data and the use of a number of assumptions (as noted in thetable below) including volatility of deCODE’s stock price, the weighted averagerisk-free interest rate, and the weighted average expected term of the options.

deCODE estimates the expected term of the optionsbased on historical patterns by employees with respect to exercise and postvesting employment termination behaviors. Expected volatility is based on deCODE’shistorical volatility and is calculated using a weighted average of thevolatility over a period equal to the expected term of the award and the mostrecent one year volatility. deCODE bases the risk-free interest rate used onthe implied yield currently available on U.S. Treasury zero-coupon issues withan equivalent term. As deCODE does not pay dividends, the dividend ratevariable in the Black-Scholes model is zero.

|                           | ** ** | **Three Months  Ended  March 31, 2006** | ** ** |
|---------------------------|------------|--------------------------------------------------------|------------|
| Dividend yield            |       | —                                                 |       |
| Expected  volatility      |       | 68.24%                                                 |       |
| Expected term  (in years) |       | 5.11                                                   |       |
| Risk-free interest rate   |       | 4.57%                                                  |       |

 

Stock-based compensation expense is recognized in the consolidatedstatement of operations on a straight-line basis based on awards ultimatelyexpected to vest. deCODE has calculated stock-based compensation using anestimated forfeiture rate of 5.60%. To the extent the actual forfeiture ratediffers materially from this estimate the expense will be adjusted.

*Restricted Stock*

deCODE’s Equity Incentive Plans allow for the issuanceof restricted stock awards that may not be sold or otherwise transferred untilcertain restrictions have lapsed. The unearned stock-based compensation relatedto these awards is amortized to compensation expense over the period therestrictions lapse. The stock-based compensation expense for these awards isdetermined based on the market price of our stock at the date of the grantapplied to the total numbers of shares that are anticipated to fully vest andthen amortized over the vesting period. In 2005, deCODE granted 57,944restricted shares and recognized stock-based compensation expense related tothese restricted shares of $53,000 and $0 during the three-months ended March 31,2006 and 2005, respectively. During the three month periods ended March 31,2006 and 2005, deCODE received $52,000 and $0, respectively, related to thepayment of notes receivable related to share-based payment arrangements.

The following table represents restricted stockactivity for the three months ended March 31, 2006:

|                                   | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** |
|-----------------------------------|------------|----------------------------|------------|-------------------------------------------------------------|------------|
| Unvested at January 1,  2006 |       | 51,987                     |       | $                                                           | 9.31       |   |
| Granted                           |       | —                     |       | —                                                      |       |
| Vested                            |       | (1,987                     | )          | 7.05                                                        |       |
| Forfeited                         |       | —                     |       | —                                                      |       |
| Unvested at  March 31, 2006  |       | 50,000                     |       | $                                                           | 9.40       |   |

 

At March 31, 2006, there was $365,000 of totalunrecognized compensation cost related to restricted stock to be recognizedover a weighted average period of 3 years. The total fair value of sharesvested during the three months ended March 31, 2006 was $14,000.

7

----

 

**6.**   NetLoss Per Share

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

Diluted net loss per share does not differ from basicnet loss per share in all periods presented as potential common shares areantidilutive for all such periods and are, therefore, excluded from thecalculation. Potential common shares excluded from the calculation of dilutednet loss per share were:
| ** **                                                                                            | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                            | ** ** | **2006**           | ** ** | **2005**           | ** ** |
| ** **                                                                                            | ** ** | **(shares)**       | ** ** | **(shares)**       | ** ** |
| Warrants to  purchase shares of common stock                                                          |       | 2,385,022          |       | 2,779,873          |       |
| Options to  purchase shares of common stock                                                           |       | 4,802,058          |       | 4,583,632          |       |
| Restricted  shares subject to vesting or with an associated outstanding non-recourse  promissory note |       | 762,800            |       | 1,182,623          |       |
| Convertible  shares issuable upon conversion of 3.5% senior convertible notes                         |       | 10,714,286         |       | 10,714,286         |       |
|                                                                                                  |       | 18,664,166         |       | 19,260,414         |       |

 

**7.**   ComprehensiveIncome (Loss)

Comprehensive income (loss) generally represents allchanges in stockholders’ equity except those resulting from investments orcontributions by stockholders. Amounts reported in other comprehensive incomeinclude foreign currency translation adjustments, derivative financialinstruments designated and effective as hedges of underlying foreign currencydenominated transactions, and unrealized gains and losses associated withinvestments. The following table presents the calculation of comprehensiveincome (loss):

|                                              | ** ** | **For the Three Months Ended March 31,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                                                | ** ** |
|                                         |       |                                                                   |       |   |   |
| Net loss                                     |       | (20,273                                                                | )          | $ | (16,936 | ) |
| Other  comprehensive income (loss):          |       |                                                                   |       |   |   |
| Foreign currency  translation                |       | 8                                                                      |       | — |   |
| Unrealized loss  associated with investments |       | (21                                                                    | )          | (79 | ) |
|                                         |       |                                                                   |       |   |   |
| Total comprehensive  loss                    |       | $                                                                      | (20,286    | ) | $ | (17,015 | ) |
|                                              |            |                                                                        |            |  |  |  |  |

 

**8.**   Investments

deCODE’s investments consist of auction ratesecurities, municipal bonds, US government securities and a corporate bond, allof which are classified as available-for-sale. Investments are available forcurrent operations and are classified as current assets. Investments arecarried at fair value with the unrealized holding gain or loss included inaccumulated other comprehensive income. Fair value is generally determined withreference to quotations in active markets. Premium and discounts associatedwith investments in bonds are amortized using the effective interest ratemethod.

Investments as of March 31, 2006 are summarizedas follows:
| ** **                  | ** ** | **Amortized  Cost**     | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------|------------|-------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **(in thousands)** | ** ** |
| Auction rate  securities    |       | $                       | 78,030     |                           | $          | 78,030 |   |
| Municipal bonds             |       | 30,000                  |       | 30,00                          |       |
| Government debt  securities |       | 15,000                  |       | 14,830                         |       |
| Corporate bond              |       | 5,000                   |       | 5,000                          |       |
|                        |       | $                       | 128,030    |                           | $          | 127,860 |   |

 

8

----

Gross unrealized holding losses at March 31, 2006were $170,000.

**9.**   Acquisitionof UVS

On January 17, 2006, deCODE acquired 100% of theoutstanding shares of Urdur Verandi Skuld ehf. (“UVS”), a privately-held cancerresearch firm, from Iceland Genomics Corporation, Inc. (“IGC”), bothcompanies having their principal offices in Reykjavik, Iceland. deCODE paidgross consideration of $6,157,000 including 635,006 shares of deCODE commonstock valued at $6,082,000 (based upon the average closing price of deCODEcommon stock two days before and after the acquisition date) and approximately$75,000 for acquisition related costs. As part of the transaction, deCODEacquired research rights for blood and tissue samples and clinical data forvarious types of cancers which deCODE has added to its samples for research anddevelopment purposes. deCODE has included the results of operations of theacquired entity in deCODE’s consolidated statements of operations from the dateof acquisition. Because the activity from the beginning of the period to theacquisition date was not material, no pro-forma information is presented.

The purchase price was allocated to the estimated fairvalue of the acquired tangible and intangible assets and assumed liabilities asfollows (amounts in thousands): 
| Cash                            |   | $     | 1,270  |   |
|---------------------------------|--------|-------|--------|--------|
| Net liabilities acquired        |   | (754  | )      |
| Goodwill                        |   | 1,246 |   |
| Identifiable  intangible assets |   | 4,395 |   |
|                            |   | $     | 6,157  |   |

 

The purchase price was allocated to the net assetsacquired based on their estimated fair values at the date of acquisition. Theexcess of the purchase price over the estimated fair value of the net assetsacquired amounted to $1,246,000, which was allocated to goodwill. UnderIcelandic tax law goodwill is not deductable for tax purposes.

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

**10.**   Litigation

Other than claims and legal proceedings that arisefrom time to time in the ordinary course of business which are not material,there has been no change in the matters reported in our Annual Report on Form 10-Kfor the year ended December 31, 2005.

9

----

 

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

This Management’s Discussion and Analysis of FinancialCondition and Results of Operations as of March 31, 2006 and for thethree-month periods ended March 31, 2006 and 2005 should be read inconjunction with the unaudited condensed consolidated financial statements andnotes thereto set forth in Item 1 of this report.

This quarterly report on Form 10-Q containsforward-looking statements, including our expectations of future industryconditions, strategic plans and forecasts of operational results. Various risksmay cause our actual results to differ materially. A list and description ofsome of the risks and uncertainties is contained below and in the summary ofrisk factors that follow in Part II, Item 1A.

**Overview**

deCODE is a biopharmaceutical company applying itsdiscoveries in human genetics to develop drugs for common diseases. Ourpopulation approach and resources enable us to isolate genes and drug targetsdirectly involved in the development of many of the diseases that are thebiggest challenges to public health. We are turning these discoveries into agrowing pipeline of therapeutics aimed at combating the causes of disease, notjust the signs and symptoms. As these diseases are common and current therapiesare of limited effectiveness, we believe that our strategy represents asignificant opportunity to create better medicine with major potential in theglobal marketplace.

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

Through our medicinal chemistry and structural biologysubsidiaries based in the United States, we are able to discover novelsmall-molecule therapeutic compounds, take candidate compounds throughpre-clinical testing, and manufacture sufficient quantities for early-stageclinical trials. Our product development group designs and implements ourclinical development programs. By leveraging the capabilities of Encode, ourclinical trials subsidiary, and our expertise in genetics and drug and diseasemodeling, we are able to make the drug development process a more efficient andsensitive means of testing and optimizing the therapeutic and commercialpotential of new drugs. In certain programs we have also taken advantage of thefact that drug targets we have identified through our genetics research havealready been targeted by other companies to develop compounds for otherindications. By licensing these compounds or entering into co-developmentarrangements, we have been able to bypass over several years of drug discovery,entering directly into Phase II clinical trials.

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

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

We derive revenues primarily from research funding andother fees from our service customers and collaborative partners; milestonepayments and upfront, exclusivity, technology-access and technology-developmentfees under our collaboration agreements constitute most of the rest of ourrevenues. While we are entitled to royalties or profit-sharing under the termsof some of our agreements, due to the extended time period for the developmentand commercialization of a saleable product or therapy, we have not yetreceived royalties or profit sharing under any of our contracts and do notexpect to do so for several years, if at all. Our expenses consist primarily ofresearch and development expenses such as, salaries and related employee costs,materials and supplies, and contractor services.

We believe that ongoing work in genetics and advancingour drug development programs, particularly the conduct of clinical trials on

10

----

a growing number of our compounds, will requiresignificant and increasing expenditures. In 2005, we concluded the Phase IIclinical studies for DG031, our developmental compound for the prevention ofheart attack; initiated our Phase I clinical program for DG041, ourdevelopmental compound for peripheral artery disease (PAD); and initiated aPhase II trial in asthma. In the first half of 2006, we have finalized ourprotocol and expect to begin enrollment for a Phase III trial for DG031; wehave concluded our Phase I program for DG041and expect to begin Phase II; andwe have concluded our Phase II trial in asthma. We are also advancing ourpre-clinical work on our follow-on compound in heart attack, DG051, and on DG061for pain, and expect these to be the next programs we bring into clinicaldevelopment. We anticipate incurring additional net losses at least through thenext several years, due to, in addition to the above-mentioned factors,depreciation and amortization, as well as stock-based compensation and othernon-cash charges. We expect that our revenues and losses will fluctuate fromquarter to quarter and that such fluctuations may be substantial, especiallybecause progress in our scientific work and milestone payments that are relatedto progress can fluctuate between quarters. We do not believe that comparisonsof our quarter-to-quarter performance are a good indication of futureperformance.

At March 31, 2006, we had $140.3 million in cash,cash equivalents and investments and as we advance and broaden our drugdevelopment pipeline we will require significant additional capital for productdevelopment and so we will continue to investigate additional avenues offinancing. Our ability to obtain capital will be affected by conditions in theglobal financial markets and in the pharmaceutical industry. We expect that morefavorable conditions in those markets will present opportunities for us, while downturnsin the market valuations of biotechnology companies and of the equity marketsmore generally will restrict our ability to raise additional capital onattractive terms, while more favorable conditions in those markets will presentopportunities for us.

The difficulties facingthe pharmaceutical industry present for us both near-term challenges andsignificant longer-term opportunities. One of the main issues confronting bigpharmaceutical companies is their lack of promising new drugs to treat majorindications. As many leading brand-name drugs come off patent and face genericcompetition, developing successful new medicines will become critical forfilling the gap. In the short term, the financial pressures on pharmaceuticalcompanies may be reflected in their research and development spending, makingit more difficult for us to sign corporate alliances with significant up-frontfunding, or lengthening the time required to negotiate such deals. We believethat in the medium to longer term, however, companies such as ours may be wellpositioned to play an important role in filling the gap in the pipeline of newdrugs, either alone or as partners of pharmaceutical companies. Ourpartnerships demonstrate that the industry is already investing in thedevelopment of new therapeutics based on our approach.

**Research andDevelopment Programs**

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

·       Our most advanceddevelopmental compound is DG031 for the prevention of heart attack. In 2005, weconcluded the Phase II clinical trials for DG031. Under a Special Protocol Assessmentwith the FDA, we have finalized the protocol for a Phase III outcome trialfor DG031. The trial will focus on those patients at highest identifiable riskthrough the pathway targeted by DG031, namely African-American patients whocarry the HapK variant of the gene encoding leukotriene A4 hydrolase (LTA4H).We expect to begin enrolling patients for the Phase III trial in the secondquarter of this year.

·       DG041 is our lead compoundfor the treatment of atherosclerosis of the extremities, or peripheral arterydisease (PAD). DG041 is a first-in-class small molecule inhibitor of the EP3receptor for prostaglandin E2, a G-protein coupled receptor (GPCR) encoded by agene we have shown to be associated with increased risk of developing thedisease. In early 2006 we concluded thePhase I clinical program for DG041. Nearly 200 healthy subjects were exposed toDG041 in these studies at doses up to 1600mg/day for seven days. The results ofthe Phase I program showed DG041 to be well-tolerated, without any drug-relatedsignificant adverse events noted, and that DG041 can effectively inhibitplatelet aggregation in a dose-dependent manner without increasing bleedingtime. We expect to begin a Phase II clinical trial in the second quarter ofthis year.

·       In asthma, we haveconducted a Phase II trial of another company’s compound. This compoundinhibits MAP3K9, a kinase encoded by a gene we have linked to risk of asthma.We have concluded this study and expect to present the results in mid-2006.

·       As a follow-on to DG031, weare developing an inhibitor of LTA4H, a compound which is likewise aimed atpreventing heart attack by decreasing the production of leukotriene B4 (LTB4).Our pre-clinical compound, DG051, appears to provide potent inhibition of LTB4production, is orally bioavailable, and with minimal potential for drug-druginteraction. We anticipate filing an IND on DG051 by mid-year 2006.

11

----

 

·       Utilizing compoundsdiscovered in our program on peripheral artery disease, our drug discoverygroup is bringing forward a lead pre-clinical candidate, DG061, for thetreatment of pain. Pre-clinical studies of DG061 demonstrate that it is efficaciousin a mouse model for pain. Moreover, by targeting the EP3 receptor forprostaglandins E2, it may be possible to avert the risk of cardiovascularevents and gastric ulceration that accompany the long-term use of selective Cox-2inhibitors and other NSAIDs.

·       We are pursuing a PDE4inhibitor program for vascular disease/stroke pursuant to our 2004 agreementwith Roche and working on identifying and advancing a lead pre-clinicalcompound.

We use many of our employee and infrastructureresources across several programs, and many of our research and developmentcosts are indirectly attributable to an individually named program or aredirected broadly to applicable research programs. However, taking into accountcosts that are specifically attributable to individual programs and allocationsof our research and development program costs based upon those direct costs, wehave cumulatively invested $14.8 million, $12.0 million, $4.1 million and$6.5 million in our Myocardial Infarction (MI), PAD, stroke and asthmaprograms, respectively, from the beginning of 2003 to date. Inception to-datecosts are not available as these costs were not historically tracked byprogram.

We have not applied for or received marketing approvalfrom the applicable regulatory authorities in any country for any of our drugcandidates. In order for us to achieve marketing approval in the United States,the FDA must conclude that our clinical data establish the safety and efficacyof our drug candidate. Other countries have similar requirements. Historically,the results from pre-clinical testing and early clinical trials (through PhaseII) have often not been predictive of success in later clinical trials.Many new 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 under Item1A in our reports on Form 10-K and 10-Q. We expect that itwill be several years, if ever, before we receive revenues from the commercialsale of our therapeutic products.

Furthermore, our strategy includes the option ofentering into collaborative arrangements with third parties to participate inthe development and commercialization of our products. Entering into acollaboration with a partner at any point in the development orcommercialization of a product is a business decision. 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 our own resources—financial and operational, and anassessment of the resources of a potential partner. In the event that we docollaborate on any of the above programs in the future, a partner will have alevel of control, which may be significant, over the pre-clinical developmentor clinical trial process for a product. As a result the completion date ofsuch a partnered program could largely be under control of that third partyrather than under our control. We cannot forecast with any degree of certaintywhich proprietary drug candidate will be subject to future collaborativearrangements or how such arrangements would affect our development plan orcapital requirements.

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

**Acquisitions andin-licensing**

As part of our business strategy, we continue toconsider joint development programs and merger and acquisition opportunitiesthat may provide us with products in late-stage development, intellectualproperty or financial resources, or with capabilities that will help accelerateour downstream drug discovery efforts.

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

In certain programs we have taken advantage of thefact that drug targets we have identified through our genetics research havealready been employed by other companies to make developmental compounds forother indications. By licensing these compounds or entering into co-developmentarrangements we have been able to leapfrog over several years of drugdiscovery, entering directly into Phase II clinical trials. We are currentlypreparing a Phase III clinical trial for DG031, our lead developmental compoundfor the prevention of heart attack, which we licensed from Bayer HealthCare AG.We are also conducting a Phase II trial in asthma on behalf of a third party.We continue to investigate additional such possibilities for the in-licensingor co-development of promising existing compounds that may effectively actagainst targets we have identified through our gene discovery work.

12

----

**CriticalAccounting Policies**

The preparation of financial statements in conformitywith generally accepted accounting principles requires us to make certainestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reported period. On an ongoing basis we evaluate our estimates,which include, among others, those related to collaborative arrangements,long-lived assets, materials and supplies, stock-based compensation, 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’s Discussionand Analysis of Financial Condition and Results of Operations where suchpolicies affect our reported and expected financial results. For a detaileddiscussion on the application of these and other accounting policies, pleaserefer to our notes to the Condensed Consolidated Financial Statements in thisquarterly report on Form 10Q and the Consolidated Financial Statements inthe Annual Report on Form 10-K for the year ended December 31,2005. There can be no assurance that actual results may not differ from theestimates referred to above.

*Stock-basedCompensation*

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS 123(R), a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*(SFAS123), which requires that all share-based payments to employees and directors,including grants of stock options be recognized in the income statement basedon their fair values. SFAS 123(R) supersedes Accounting Principles BoardOpinion No. 25, *Accounting for StockIssued to Employees* (APB 25) and amends SFAS No. 95, *Statement of Cash Flows*. On January 1,2006, we adopted SFAS 123(R) using the modified prospective method ofadoption as permitted under SFAS 123(R) which requires that compensationexpense be recorded for all nonvested stock options and other stock-basedawards as of the beginning of the first quarter of adoption. In accordance withthe modified prospective method, no prior period amounts have been restated toreflect the provisions of SFAS 123(R).

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

In connection with our adoption of SFAS 123(R), werefined our valuation assumptions and the methodologies used to derive thoseassumptions; however, we elected to continue using the Black-Scholes optionvaluation model. Concurrent with our adoption of SFAS 123(R), we determinedthat historical volatility of deCODE’s stock would be the best measure ofmarket conditions and expected volatility. We estimate the weighted-averageexpected life of our stock-option awards based on historical cancellation andexercise data related to our stock-based awards as well as the contractual termand vesting terms of the awards. We allocate stock-based compensation expenseusing a straight-line expense attribution approach. Stock-based compensationexpense related to stock options is recognized net of estimated forfeitures. Weestimated forfeitures based on our historical experience.

During the quarter ended March 31, 2006, werecognized stock-based compensation expense of $0.9 million, or $0.02 pershare. As of March 31, 2006, we had unrecognized stock-based compensationof $8.3 million related to nonvested stock options awards, which is expected tobe recognized over an estimated weighted average period of 2.24 years.

**Results ofOperations for the Three-Month Periods Ended March 31, 2006 and 2005**

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

Financial highlights as of and for the three-monthperiod ended March 31, 2006 include:

13

----

 

·              At March 31, 2006, we had$140.3 million in cash, cash equivalents and investments compared to $155.6million at December 31, 2005. The net utilization of $15.3 million in thefirst quarter reflects costs associated with the advancement of our drugdevelopment programs during the three months as reflected in the $16.0 millioncash we used in operating activities.

·              Research and development expensefor proprietary programs was $14.9 million for the three-month period ended March 31,2006 as compared to $8.3 million for the three-month period ended March 31,2005. The increase in our research and development expenses for proprietaryprograms is the result of costs associated with the advancement of our leaddrug discovery and development programs.

·              Our revenue for the three-monthperiod ended March 31, 2006 was $10.1 million as compared to $9.5 millionfor the three-month period ended March 31, 2005. Revenue for the periodspresented generally reflects our strategic focus on drug discovery anddevelopment. Specifically, the increase in revenue for the quarter ended March 31,2006 as compared to the same quarter in 2005, is primarily due to increasedservice grant monies earned related to research grants from divisions of theU.S. National Institutes of Health and the Commission of the EuropeanCommunities, contract service fees and the addition of the Roche alliance toco-develop inhibitors of PDE4D, offset by the completion of research fundingunder the 2002 agreement with Roche and the Merck obesity research program.

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

Elements of our revenue are summarized as follows:
| ** **                                                                 | ** ** | **For the Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                            | ** ** |
|                                                                       |       |                                                               |       |   |   |
| Research funding  and other service fees                                   |       | $                                                                  | 5,468      |   | $ | 6,754 |   |
| Milestone  payments                                                        |       | 198                                                                |       | 348 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | 500                                                                |       | 1,038 |   |
| Grant funding                                                              |       | 2,987                                                              |       | 888 |   |
| Other                                                                      |       | 980                                                                |       | 495 |   |
|                                                                       |       | $                                                                  | 10,133     |   | $ | 9,523 |   |

 

Collaborations with our most significant partnersinclude:

*F. Hoffmann-LaRoche (Roche)*

*Therapeutics.* In 2002, we entered into an agreement withRoche to collaborate on four diseases that had been the subject of an earliercollaboration with Roche. During 2004 and through January 2005, wecollaborated with Roche on two of those diseases. Under this agreement wediscovered genes linked to diabetes and Roche continues drug discovery based onone of these discoveries. Under the 2002 agreement, which expired on February 1,2005, we received $20.0 million in research funding and we are entitled toreceive royalties on the sales of any drugs that are developed coming out ofwork conducted under this agreement.

In November 2004, we signed a new three-yearagreement with Roche to co-develop inhibitors of PDE4 for the prevention andtreatment of vascular disease, including stroke. This agreement continues workadvanced under the 2002 agreement, and we will focus on optimizing leadcompounds identified under the previous agreement and beginning clinicaldevelopment. Under this agreement, as of the end of 2005, we received $2.0million of research funding. We will share drug discovery and clinical trialscosts under this new agreement, and we may receive an additional $4.0 millionof research funding over the remaining term of the agreement as well asmilestone payments and royalties based on drug sales.

*Diagnostics.* In June 2001, we signed a five-yearalliance with Roche’s diagnostics division to develop and market DNA-baseddiagnostics for major diseases. More recently we have added research programsaimed at developing diagnostics to predict drug response for major therapeuticsused to treat those diseases, in order to help select the most effectivetreatment of those available. Under the agreement we have received $41.1million in research funding, up-front fees and milestone payments. We mayreceive $3.1 million in additional research funding over the remainder of theterm of the agreement as well as milestone payments upon the achievement ofresearch and development milestones and royalties on the sales of diagnosticproducts developed.

14

----

 

Revenues from these alliances with Roche amounted to$2.6 million and $2.7 million in the three-month periods ended March 31,2006 and 2005, respectively, representing 26% and 29% of consolidated revenuefor the three-month periods ended March 31, 2006 and 2005, respectively.Costs incurred with these collaborative programs with Roche amounted to $2.2million and $3.7 million in the three-month periods ended March 31, 2006and 2005, respectively.

*Merck &Co, Inc. (Merck)*

*Obesity.  *In September 2002,we entered into a three year alliance with Merck aimed at developing newtreatments for obesity. Under the alliance, we combined research efforts withMerck in the genetics of obesity to identify, validate and prioritize a seriesof drug targets to take into development. During the three-year researchprogram, which has now expired, we have received research funding, technologyaccess fees and milestone payments in the aggregate amount of $25.3 million. Inaddition, we may receive further technology access fees in the total aggregateamount of $2.0 million. Subject to Merck’s developing products based oncollaboration discoveries, we may also receive development milestones androyalties. We have discovered three genes linked to obesity under thisalliance, and Merck has generated a lead series of compounds against one of thetargets we validated through our genetics research.

Revenues from this alliance with Merck amounted to $0and $1.8 million in the three-month periods ended March 31, 2006 and 2005,respectively, representing 0% and 19% of consolidated revenue for thethree-month periods ended March 31, 2006 and 2005, respectively. Costsincurred with this alliance with Merck amounted to $0 and $1.1 million in thethree-month periods ended March 31, 2006 and 2005, respectively.

*Information-Rich Clinical Trials.**  *In February 2004, we entered into anagreement with Merck which provides that deCODE will conduct information-richclinical trials on a range of Merck’s developmental compounds that Merckselects for inclusion in the program. The term of the alliance is seven years,subject to termination by Merck after five years. The collaboration involvedthree agreements: (a) a License and Research Collaboration Agreement; (b) aStock and Warrant Purchase Agreement; and (c) a Warrant Agreement. Underthe terms of the License and Research Collaboration Agreement, we will receiveroyalties on sales of drugs and diagnostics developed as part of the alliance,will receive milestone payments as compounds or pharmacogenomic tests reach themarket, will receive research funding for the clinical development of compoundsand pharmacogenomic analysis, and received a one-time technology access fee of$10.0 million. A contingency clause on the technology access fee provides thatif deCODE rejects the first two non-exclusive development compounds that Merckpresents to the collaboration, then Merck has the right to request a refund of$2,500,000 of the technology access fee. The remaining amount of the technologyaccess fee is non-refundable. To date, Merck has not selected any compounds fordevelopment under the agreement.

Revenues from this alliance with Merck amounted to $0and $0.2 million in the three-month periods ended March 31, 2006 and 2005,respectively, representing 0% and 2% of consolidated revenue for thethree-month periods ended March 31, 2006 and 2005, respectively. Costsincurred with this alliance with Merck amounted to $0 and $0.1 million in thethree-month periods ended March 31, 2006 and 2005, respectively.

*Grant Funding*

We have received various research grants fromdivisions of the United States National Institutes of Health (NIH), theCommission of the European Communities (EC) and private foundations. Researchgrants for multiple years are based on approved budgets with budgeted amountssubject to approval on an annual basis. NIH grants generally provide for 100%reimbursement of allowable expenditures while the grant under the EC generallyprovides for 50% reimbursement of allowable research and development relatedexpenditures. Our significant research contracts include:

*National Institute of Allergy andInfectious Diseases (NIAID).**  *InSeptember 2004, deCODE was awarded a five-year $23,900,000 contract by theNIAID, a division of NIH. Under the contract, deCODE will apply its populationapproach and resources to discover genetic factors associated withsusceptibility to certain infectious diseases and with responsiveness tovaccines targeting such diseases. deCODE may receive $17.4 million inadditional research funding over the remaining term of the agreement.

Revenues from NIH research grants amounted to $2.3million and $0.9 million in the three-month periods ended March 31, 2006and 2005, respectively, representing 22% and 9% of consolidated revenue for thethree-month periods ended March 31, 2006 and 2005, respectively. Costsincurred with NIH research grants amounted to $2.3 million and $0.9 million inthe three-month periods ended March 31, 2006 and 2005, respectively.

Revenue for the three-monthperiods ended March 31, 2006 and 2005 is as follows:

|            | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** ** | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except %)** | ** ** |
| Revenue    |       | $                                      | 10,133     |       | $          | 9,523                                        |       | $ | 610 |   | 6 | % |
|            |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

15

----

 

Revenue for the periods presented generally reflectsour strategic focus on drug discovery and development. Specifically, theincrease in revenue for the quarter ended March 31, 2006 as compared tothe same quarter in 2005, is primarily due to an increase in grant moniesearned from research grants with NIH and EC, contract service fees and theaddition of the Roche alliance to co-develop inhibitors of PDE4D, offset by thecompletion of research funding under the 2002 agreement with Roche and theMerck obesity research program. Further, in the three-month period ended March 31,2006, we sold technology and related rights to our Drug Advice Expert (DAX)software for $0.5 million. We expect that our revenues will fluctuate fromquarter to quarter and that such fluctuations may be substantial especiallybecause progress in our scientific work, including milestone payments that arerelated to progress, can fluctuate between quarters.

*Cost of Revenue, includingCollaborative Programs.*Cost of revenue, including costsincurred in connection with collaborative programs for the three-month periodsended March 31, 2006 and 2005 is as follows:

|                                                    | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In thousands, except %)** | ** ** |
| Cost of revenue,  including collaborative programs |       | $                                      | 10,477     |       | $          | 9,140                                        |       | $ | 1,337 |   | 15 | % |
|                                                    |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

Our cost of revenue consists of the costs of servicesprovided to customers, collaborators and under grants, including the entiretyof the costs incurred in connection with programs that have been partnered andon which we receive research funding, including research grants. At times, weinvested in addition to costs covered by research funding received in suchcollaborative programs. In general, we have decreased our cost of revenue,including costs incurred in connection with collaborative programs, reflectinga relative lessening of our investment in collaborative programs on which wereceive research funding. Our cost of revenue for the three month period ended March 31,2006 as compared to the prior period increased $2.1 million due to workconducted under research grants.

Our cost of revenue, including costs incurred inconnection with collaborative programs in the three-month period ended March 31,2006 as compared to the three-month period ended March 31, 2005 includes (i) morechemicals and consumables ($0.5 million), (ii) an increase in contractorservices ($0.8 million), and (iii) lower depreciation and amortization($0.3 million) due to the sale-leaseback of our facilities in Iceland during 2005.Our rent expense has increased due to this sale-and-leaseback of our facilities.This will be offset by the deferred gain on the sale-and-leaseback which isbeing amortized over the term of the lease. Our cost of revenue, includingcosts incurred in connection with collaborative programs in the three-monthperiod ended March 31, 2006 also includes stock-based compensation expenserelated to our adoption of SFAS No. 123(R) ($0.1 million).

*Research and Development—ProprietaryPrograms.*Research and development for proprietary programsfor the three-month periods ended March 31, 2006 and 2005 is as follows:

|                                                       | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **                                            | ** ** | **(In thousands, except %)** | ** ** |
| Research and  development — proprietary programs |       | $                                      | 14,890     |       | $          | 8,275                                        |       | $ | 6,615 |   | 80 | % |
|                                                       |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

The increase in our research and development expensesin proprietary programs results from our emphasis on and increasingexpenditures in product development, including pre-clinical and clinical workon our lead drug discovery and development programs. Importantly, in 2006 weare preparing a Phase III clinical for DG031 our lead developmental compoundfor the prevention of heart attack. We are also preparing for Phase II trialsfor DG041, our developmental compound in Peripheral Artery Disease and areco-funding a Phase II trial in asthma for a compound developed by anothercompany. Further, among other pre-clinical programs we are developing acompound to inhibit the LTA4 hydrolase, a protein encoded by a second genewithin the same pathway targeted by DG031 that we have also linked tosignificantly increased risk of heart attack, and we have begun a PDE4inhibitor program for vascular disease/stroke pursuant to our 2004 agreementwith Roche. We also maintain an ongoing program to develop inhibitors to theEP3 receptor for prostaglandins E2 for the management of pain. Based upon therange of our current research and development activities, we currentlyanticipate that our overall investment in research and development in 2006 willbe in the range of $60 to $65 million.

Our research and development expenses for thethree-month periods ended March 31, 2006 and 2005 consist of thefollowing:

|                                                  | ** ** | **For the Three Months** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **Ended March 31,**           | ** ** |
| ** **                                       | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                 | ** ** |
| Salaries and  other personnel costs              |       | $                                       | 5,336      |   | $ | 3,945 |   |
| Materials and  supplies                          |       | 1,590                                   |       | 947 |   |
| Contractor  services and other third party costs |       | 5,200                                   |       | 1,703 |   |
| Overhead  expenses                               |       | 1,570                                   |       | 805 |   |
| Depreciation and  amortization                   |       | 872                                     |       | 875 |   |
| Stock-based  compensation                        |       | 322                                     |       | — |   |
| Total                                            |       | $                                       | 14,890     |   | $ | 8,275 |   |

 

16

----

 

Increases in the research and development costs of ourproprietary programs (e.g., salaries and attendant costs, usage of chemicalsand consumables, contractor services and other third party costs) will likelycontinue, particularly as we advance our clinical development and proprietarydrug development programs. Further, we have granted salary increases to ourpersonnel and have added clinical development executives to our staff, whichwill contribute to future increases in our research and development costs forproprietary programs. Our cost of research and development for proprietaryprograms in the three-month period ended March 31, 2006 also includesstock-based compensation expense related to our adoption of SFAS No. 123(R).Our overhead expense, consisting primarily of rent, has increased due to thissale-and-leaseback of our facilities. This increase in rent will be offset bythe deferred gain on the sale-and-leaseback which is being amortized over theterm of the lease.

*Selling, General and AdministrativeExpense.*Selling, general and administrative expense for thethree-month periods ended March 31, 2006 and 2005 is as follows:

|                                             | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **                                  | ** ** | **(In thousands, except %)** | ** ** |
| Selling general  and administrative expense |       | $                                      | 5,267      |       | $          | 4,158                                        |       | $ | 1,109 |   | 27 | % |
|                                             |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

Our selling, general and administrative expenses forthe three-month period ended March 31, 2006 have increased as compared tothe three-month period ended March 31, 2005. Salaries and employee relatedcosts increased ($0.1 million) as did our legal expenses with activity aroundour intellectual property and patent applications ($0.2 million) and our travelexpenses ($0.2 million).Our selling,general and administrative expense in the three-month period ended March 31,2006 also includes stock-based compensation expense related to our adoption ofSFAS No. 123(R) ($0.5 million). We also grant annual salary increasesto our personnel and are making efforts to recruit new members to our Board ofDirectors — which will increase our selling, general and administrativeexpenses.

*InterestIncome.*Interest income for the three-month periods ended March 31,2006 and 2005 is as follows:

|                 | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|-----------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **      | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)** | ** ** |
| Interest income |       | $                                      | 1,712      |       | $          | 1,120                                        |       | $ | 592 |   | 53 | % |
|                 |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

Our interest income has increased with rising interestrates and increasing returns on a greater amount of cash and investments. Weexpect to use our cash and investments principally for advancing our drug andclinical development programs. In the meantime, we will invest the moniesreceived in accordance with our policy, having the objective of preservingprincipal while maximizing income we receive from our investments withoutsignificantly increasing risk. We expect to maintain our portfolio of cashequivalents and investments in a variety of securities, including auction ratesecurities, commercial paper, money market funds, mutual fund investments andgovernment and non-government debt securities

*Interest Expense.*Interestexpense for the three-month periods ended March 31, 2006 and 2005 is asfollows:

|                  | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **       | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest expense |       | $                                      | 1,716      |       | $          | 2,389                                        |       | $ | (673 | ) | (28 | )% |
|                  |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

Our interest expense principally reflects interest onour 3.5% Senior Convertible Notes due in 2011 that we issued in April 2004.

In March 2005, we prepaid $38.6 million of shortand long-term debt that was secured by mortgages on Sturlugata 8. Also in March 2005,we refinanced the mortgage on our Woodridge, IL facility, paying-down $4.0million on the existing mortgage. Further, in June 2005, we prepaid $1.8million of long-term debt that was secured by mortgages on Krokhals 5D and 5E. Asa result of these prepayments and refinancing, our future interest expense isexpected to be approximately $5.6 million on an annual basis.

*Other Non-Operating Income andExpense, Net.*Other non-operating income and expense for thethree-month periods ended March 31, 2006 and 2005 is as follows:

17

----

 

|                                                     | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **                                          | ** ** | **(In thousands, except %)** | ** ** |
| Other  non-operating income and (expense), net |       | $                                      | 232        |       | $          | (3,617                                       | )          | $ | 3,849 |   | 106 | % |
|                                                     |            |                                        |            |            |            |                                              |            |  |  |  |  |  |

 

Our other non-operating income and expense, netconsists principally of the net impact of foreign exchange and, in thethree-month period ended March 31, 2005, unrealized and realized gains and losses on derivative financialinstruments as well as a loss on the early extinguishment of debt.

As a consequence of the nature of our business andoperations, our reported financial results and cash flows are exposed to therisks associated with fluctuations in the exchange rates of the U.S. dollar,the Icelandic krona and other world currencies. The net impact of foreignexchange on the translated amount of our non-US dollar denominated liabilities,net together with transaction gains and losses, amounted to a gain of $0.3million, and a loss of $0.3 million in the three-month periods ended March 31,2006 and 2005, respectively.

Our losses on derivative financial instruments in thethree-month period ended March 31, 2005 ($0.2 million) resulted from threeforward foreign currency exchange options we entered into as economic hedgesagainst foreign exchange rate fluctuations on our ISK-denominated operatingexpenses but that did not qualify for hedge accounting.

As a result of having prepaid the short and long-termdebts that were secured by mortgages on Sturlugata 8 we have recorded a loss onearly extinguishment debt during the three-months ended March 31, 2005amounting to $3.1 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, 2006 and 2005 is asfollows:

|                                       | ** ** | ** **                             | ** ** | ** ** | ** ** | **2006 as  Compared to 2005** | ** ** |
|---------------------------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                            | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change**                            | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(In thousands, except %)** | ** ** |
| Net Loss                              |       | $                                      | (20,273    | )          | $          | (16,936                                      | )          | $ | (3,337 | ) | (20 | )% |
|                                  |       |                                   |       |       |       |                                         |       |   |   |
| Basic and Diluted Net  Loss Per Share |       | $                                      | (0.37      | )          | $          | (0.32                                        | )          | $ | (0.05 | ) | (16 | )% |

 

Net loss and basic and diluted net loss per share bothincreased in the three-month period ended March 31, 2006 as compared tothe three-month period ended March 31, 2005, principally on account ofhigher research and development related to the advancement of our drugdiscovery and development programs, but alsofor all the reasons more fully discussed above, including stock-basedcompensation expense related to our adoption of SFAS No. 123(R).

**Liquidity andCapital Resources**

We have financed our operations primarily throughfunding from research and development collaborative agreements, and the issuanceof equity securities and long-term financing instruments ($841 million from thebeginning of 1999 to-date). Future funding under terms of our existingagreements is approximately $42.9 million excluding milestone payments androyalties that we may earn under such collaborations.

We make significant investments in proprietaryresearch and development and we incur the costs of such activities. In the nearterm, this requires us to devote resources to our in-house drug and clinicaldevelopment which we believe will better position us to capture the most valueto us in our discoveries. As we identify promising discoveries for furtherdevelopment, we may choose to continue the development ourselves into andthrough clinical trials, regulatory approvals, manufacturing, distribution andmarketing. In other cases we are or will be working to varying degrees withpartners. The decisions we make as to these matters will affect our cashrequirements.

Our cash requirements depend on numerous factors,including the level and timing of our research and development expenditures;our ability to access the capital markets; to obtain new research anddevelopment collaboration agreements; to obtain and maintain contract serviceagreements in our pharmaceuticals, biostructures, clinical research trials andgenotyping service groups; expenditures in connection with alliances, licenseagreements and acquisitions of and investments in complementary technologiesand businesses; competing technological and market developments; the cost offiling, prosecuting, defending and enforcing patent claims and otherintellectual property rights; the purchase of additional capital equipment; andcapital expenditures at our facilities. Changes in our research and developmentplans, notably the entry into clinical trials of drugs based on ourdiscoveries, or other changes affecting our operating expenses may result inchanges in the timing and amount of expenditures of our capital resources.

18

----

 

In December 2005, we filed a universal shelfregistration statement on Form S-3 with the Securities and ExchangeCommission (“SEC”) for the issuance and sale from time to time of debt andequity securities either individually or in units, in one or more offerings,with a total value of up to $100 million. As of March 31, 2006, we had notconsummated any sales under this registration statement.

At March 31, 2006, we had $140.3 million of cash,cash equivalents and investments. Based upon the range of our currentactivities, and without taking into account cash from any new alliances,milestone payments, significant financing or other activities, we currentlyanticipate that our overall net use of cash resources in 2006 will be in therange of $75 to $80 million.  As weadvance and broaden our drug development pipeline we will require significantadditional capital for product development and so we will continue toinvestigate additional avenues of financing, such as further public or privateequity offerings, additional debt financing, other forms of financing or addedcollaborations and licensing arrangements. However, no assurance can be giventhat additional financing or collaborations and licensing arrangements will beavailable when needed, or that if available, will be obtained on favorableterms. If adequate funds are not available when needed, we may have to curtailoperations or attempt to raise funds on unattractive terms.
| ** **                                   | ** ** | **For the Three Month  Periods Ended March 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                                       | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                                        | ** ** |
|                                         |       |                                                                           |       |   |   |
| **Cash provided by (used in):**              | ** ** | ** **                                                                     | ** ** | ** ** | ** ** |
| Operating  activities                        |       | $                                                                              | (15,972    | ) | $ | (10,938 | ) |
| Investing  activities                        |       | (37,819                                                                        | )          | 39,986 |   |
| Financing  activities                        |       | 284                                                                            |       | (43,892 | ) |
| Cash and cash  equivalents, at end of period |       | 12,436                                                                         |       | 55,394 |   |
|                                              |            |                                                                                |            |  |  |  |  |

 

*Cash and Cash Equivalents.*AtMarch 31, 2006, we had $12.4 million in cash and cash equivalents.Together with our investments at March 31, 2006 ($127.9 million), thisbalance has decreased $15.3 million from the close of the year-ended December 31,2005, most significantly on account of costs associated with the advancement ofour drug development programs as reflected in the $16.0 million of cash we usedin operating activities.

Available cash is invested in accordance with ourinvestment policy’s primary objectives of liquidity and safety of principalwhile maximizing the income we receive from our investments withoutsignificantly increasing risk. Our cash is deposited only with financialinstitutions in Iceland, the United Kingdom and the United States having a highcredit standing (A-/A3 or better). We expect to maintain our portfolio of cashequivalents and investments in a variety of securities, including auction ratesecurities commercial paper, money market funds, mutual fund investments andgovernment and non-government debt securities.

At March 31, 2006, our cash is largely investedin U.S. dollar denominated money market and checking accounts and also inIcelandic krona denominated accounts. At March 31, 2006, our investmentsare in auction rate securities, municipal bonds, US government securities and acorporate bond.

*Operating Activities.*Net cash used in operating activities increased to $16.0 million for thethree-month period ended March 31, 2006 as compared to $10.9 millionhaving been used in the same period in 2005. The increase in use of cash inoperating activities is most importantly attributable to the significantresearch and development investments being made in advancing our drug andclinical development programs, as more fully described above.

*Investing Activities.*Ourinvesting activities have consisted of short-term investments in marketablesecurities (consisting mainly of auction rate securities and US governmentsecurities), capital expenditures and, in the three-month period ended March 31,2005, the sale and leaseback of our headquarters facility at Sturlugata 8,Reykjavik, Iceland. Further, in our purchase of UVS during the three-monthsended March 31, 2006 we acquired $1.3 million of cash used to fund theacquired liabilities of UVS.

We principally made replacement capital expenditures duringthe three-month periods ended March 31, 2006 and 2005. Although we expectwe will 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.

*Financing Activities.*Net cash of $0.3 million was provided by financing activities in thethree-month period ended March 31, 2006, as compared to $43.9 million thatwas used in the three-month period ended March 31, 2005. Financingactivities for the three-month period ended March 31, 2006 largelyconsisted of equity proceeds on the exercise of common stock options ($0.7million), financing of certain equipment ($0.3 million)  and installment payments on debt and capitallease obligations ($0.8 million). 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) andother debt service ($1.3 million).

19

----

 

*Contractual Commitments and Off-BalanceSheet Arrangements.* The following summarizes our contractualobligations (using interest and exchange rates as of March 31, 2006) at March 31,2006,and the effects such obligations are expected to have on our liquidity andcash flows in future periods:
| ** **                                         | ** ** | ** **              | ** ** | **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 |       | $                       | 178,875    |                                      | $          | 5,250 |   | $ | 10,500 |   | $ | 10,500 |   | $ | 152,625 |   |
| Long-term debt,  including interest                |       | 6,798                   |       | 907                                       |       | 5,826 |   | 66 |   | — |   |
| Capital lease  obligations, including interest     |       | 1,919                   |       | 978                                       |       | 936 |   | 5 |   | — |   |
| Operating leases                                   |       | 64,588                  |       | 5,084                                     |       | 9,552 |   | 9,143 |   | 40,808 |   |
|                                               |       | $                       | 252,180    |                                      | $          | 12,219 |   | $ | 26,813 |   | $ | 19,714 |   | $ | 193,433 |   |

 

Under the terms of certain technology licensingagreements, we are obligated to make payments upon the achievement ofestablished milestones leading to the discovery of defined products. Thesepayments could total $6,000,000, of which we believe $1.0 million may beincurred in the second quarter of 2006, with the timing of the payments for theremainder not determinable at the current time. These potential payments arenot included in the above table.

All material intercompany balances and transactionshave been eliminated. We do not have any other significant relationships withunconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance or special purpose entities, which would havebeen established for the purpose of facilitating off-balance sheet arrangementsor other contractually narrow or limited purposes. As such, we are not exposedto any financing, liquidity, market or credit risk that could arise if we hadengaged in such relationships. Additionally, holders of our 3.5% seniorconvertible notes may elect to convert their notes into shares of our commonstock at any time at a price of $14.00 per share.

**FORWARD-LOOKINGSTATEMENTS AND CAUTIONARY FACTORSTHAT MAY AFFECT FUTURE RESULTS**

This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934. These statements relate to future events or our futurefinancial performance. In some cases, forward-looking statements can beidentified by terminology such as “may,” “should,” “could,” “expect,” “plan,” “anticipate,”“believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or thenegative of such terms or other comparable terminology. These statements areonly expectations. We cannot assure you that our expectations and assumptionswill prove to be correct. We do not intend to update or revise anyforward-looking statements, whether as a result of future events, newinformation or otherwise, except to the extent that the reports we are requiredto file under the Securities Exchange Act of 1934, as amended, (the “ExchangeAct”) contain such updates or revisions. Actual events or results may differmaterially from the forward-looking statements due to a number of factors,including. but not limited to, those set forth in Item 1A of our AnnualReport on Form 10-K for the year ended December 31, 2005 asupdated by Item A of this Quarterly Report on Form 10-Q andelsewhere in this Quarterly Report on Form 10-Q and in the reportswe file under the Exchange Act.

**ITEM 3.**   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objectives ofour investment activities are to preserve principal, maintain a high degree ofliquidity to meet operating needs, and obtain competitive returns subject toprevailing market conditions. Investments are made primarily in high-gradecorporate bonds, asset-backed debt securities and U.S. government agency debtsecurities. These investments are subject to risk of default, changes in creditrating and changes in market value. These investments are also subject tointerest rate risk and will decrease in value if market interest ratesincrease. A hypothetical 100 basis point increase in interest rates wouldresult in an approximate $0.4 million decrease in the fair value of ourinvestments as of March 31, 2006. Due to the conservative nature of ourinvestments and relatively short effective maturities of debt instruments,interest rate risk is mitigated. Changes in interest rates do not affectinterest expense incurred on our Convertible Notes, because they bear interestat a fixed rate. Using the price in the latest trade in March 2006, themarket value of the Convertible Notes was $129.2 million on March 31,2006.

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

20

----

 

**ITEM 4.**   CONTROLSAND PROCEDURES

a)*Evaluation ofdisclosure controls and procedures.* Our Chief Executive Officer andour Chief Financial Officer evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rule 13a-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the endof the fiscal quarter covered by this Quarterly Report on Form 10-Q.Based upon that evaluation, the Chief Executive Officer and the Chief FinancialOfficer have concluded that as of the end of such fiscal quarter our currentdisclosure controls and procedures are adequate and effective to ensure thatinformation required to be disclosed in the reports we file under the ExchangeAct is recorded, processed, summarized and reported on a timely basis.

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

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

**PART II OTHERINFORMATION**

**ITEM 1.**   LEGALPROCEEDINGS

Other than claims and legal proceedings that arisefrom time to time in the ordinary course of business which are not material,there has been no change in the matters reported in our Annual Report on Form 10-Kfor the year ended December 31, 2005.

**ITEM 1A.**   RISKFACTORS

Other than with respect to the risk factors set forthbelow, there have been no material changes from the risk factors disclosed inItem 1A of our Annual Report on Form 10-K for the year ended December 31,2005. The risk factors set forth below have been updated to provide data forand as of the quarter ended March 31, 2006.

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

We incurred a net loss of $20.3 million and $16.9million for the three months ended March 31, 2006 and 2005, respectively,and $62.8 million for the year ended December 31, 2005, and had anaccumulated deficit of $470.5 million at March 31, 2006. We have nevergenerated a profit and we have not generated revenues except for paymentsreceived in connection with our research and development collaborations withRoche, Merck and others, from contract services, Emerald BioSystems productsand instruments, and under grants. Our research and development expendituresand general and administrative costs have exceeded our revenue to date, and weexpect to spend significant additional amounts to fund research and developmentin order to enhance our core technologies and undertake product development(including drug development and related clinical trials). We do not expect toreceive royalties or other revenues from commercial sales of products developedusing our technology in the near term. It may be several years beforeproduct revenues materialize, if they do at all. As a result, we expect toincur net losses for several years. If the time required to generate productrevenues and achieve profitability is longer than we currently anticipate orthe level of losses is greater than we currently anticipate, we may not beable to continue our operations.

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

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

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

·                                       ourability to attract customers;

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

21

----

 

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

·                                       thecosts and timing of regulatory approvals.

We have relied on, and may continue to rely on,revenues generated by our corporate alliances and fee-paying customers forsignificant funding of our research efforts. Historically, a substantialportion of our revenue has been derived from contracts with a limited number ofsignificant customers. Our largest partner, Roche, accounted for approximately26% and 29% of our consolidated revenue in the three months ended March 31,2006 and 2005, respectively. Revenue under our alliances with Merck accountedfor approximately 0% and 21% of our consolidated revenue in the three monthsended March 31, 2006 and 2005, respectively. During the three months endedMarch 31, 2006 and 2005, divisions of the NIH represented 22% and 9% ofour consolidated revenue, respectively. Work under the Merck obesity agreementand the Roche 2002 agreement has been substantially completed, and thismay significantly lower our revenues and affect the resources available tosupport our drug discovery programs, which will increase our need foradditional funding.

In addition, we may seek additional fundingthrough public or private equity offerings and debt financings. We may notbe able to obtain additional financing when we need it or the financingmay not be on terms favorable to us or our stockholders. Stockholders’ownership will be diluted if we raise additional capital by issuing equitysecurities.

If we raise additional funds through collaborationsand licensing arrangements, we may have to relinquish rights to some ofour technologies or product candidates, or grant licenses on unfavorable terms.If adequate funds are not available, we would have to scale back or terminateour discovery and research programs and product development.

**ITEM 6.**   EXHIBITSAND REPORTS ON FORM 8-K

(a) EXHIBITS

The following is a list of exhibits filed as part ofthis Quarterly Report on Form 10-Q.
| EXHIBIT    | ** ** | ** **                                                                                                                                                                                                                                                                                   |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **NUMBER** | ** ** | **DESCRIPTION OF EXHIBIT**                                                                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                                         |
| 3.1        |       | Amended and Restated Certificate of Incorporation,  as further amended (Incorporated by reference to Exhibit 3.1 and  Exhibit 3.3 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on  July 17, 2000). |
|       |       |                                                                                                                                                                                                                                                                                         |
| 3.2        |       | Certificate of Amendment to Amended and Restated  Certificate of Incorporation dated August 30, 2002 (Incorporated by  reference to Exhibit 3.2 to the Company’s Quarterly Report on  Form 10-Q filed on November 14, 2002).                                        |
|       |       |                                                                                                                                                                                                                                                                                         |
| 3.3        |       | Bylaws, as amended (Incorporated by reference to  Exhibit 3.2 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on  July 17, 2000).                                                                          |
|       |       |                                                                                                                                                                                                                                                                                         |
| 31.1       |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                                                                                                         |
| 31.2       |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                                                                                                         |
| 32.1       |       | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |

 

Note: Unless otherwise noted, the SEC File number ofeach of the above referenced documents is 000-30469.

22

----

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
| Dated:  May 10, 2006 |   |                                      |
|--------------------------------|--------|-------------------------------------------|
|                           |   | deCODE genetics, Inc.                |
|                           |   |                                      |
|                           |   | /s/ Kari Stefansson                       |
|                           |   | Kari Stefansson                           |
|                           |   | Chairman, President,                      |
|                           |   | and Chief Executive Officer               |
|                           |   |                                      |
|                           |   | /s/ Lance Thibault                        |
|                           |   | Lance Thibault                            |
|                           |   | Chief Financial Officer and               |
|                           |   | Treasurer (principal financial            |
|                           |   | officer and principal accounting officer) |

 

23

----

 
| EXHIBIT    | ** ** | ** **                                                                                                                                                                                                                                                                                   |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **NUMBER** | ** ** | **DESCRIPTION OF EXHIBIT**                                                                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                                         |
| 3.1        |       | Amended and Restated Certificate of Incorporation,  as further amended (Incorporated by reference to Exhibit 3.1 and  Exhibit 3.3 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on  July 17, 2000). |
|       |       |                                                                                                                                                                                                                                                                                         |
| 3.2        |       | Certificate of Amendment to Amended and Restated  Certificate of Incorporation dated August 30, 2002 (Incorporated by  reference to Exhibit 3.2 to the Company’s Quarterly Report on  Form 10-Q filed on November 14, 2002).                                        |
|       |       |                                                                                                                                                                                                                                                                                         |
| 3.3        |       | Bylaws, as amended (Incorporated by reference to  Exhibit 3.2 to the Company’s Registration Statement on Form S-1  (Registration No. 333-31984) which became effective on  July 17, 2000).                                                                          |
|       |       |                                                                                                                                                                                                                                                                                         |
| 31.1       |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                                                                                                         |
| 31.2       |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                                                                                                         |
| 32.1       |       | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                               |

 

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

 

24

----