**SECURITIESAND EXCHANGE COMMISSION**

 

**WASHINGTON,D.C. 20549**

 

**FORM10-Q**

 

**(MarkOne)**

 

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

 

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

 

**OR**

 

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

 

**FOR THE TRANSITION PERIOD FROM                       TO                      **

 

**COMMISSION FILE NUMBER 000-30469**

 

**deCODEgenetics, Inc.**

(ExactName of Registrant as Specified in Its Charter)

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

 

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

(Addressof Principal Executive Offices)

 

**+354-570-1900**

(Registrant’sTelephone Number, Including Area Code)

 

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

 

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes oNo ý

 

The aggregate number ofshares of the registrant’s common stock outstanding on October 31, 2005 was 54,702,801shares of common stock $.001 par value.

 

 

----

 

**deCODE genetics, Inc.**

 

**INDEX**

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

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**deCODE genetics, Inc.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(Unaudited)

 
| ** **                                                                                                                                                                                                                                 | ** ** | **SEPTEMBER 30,  2005**                   | ** ** | **DECEMBER 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                 | ** ** | **(In thousands, except  share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                     |       |                                      |       |                   |       |
| Current assets:                                                                                                                                                                                                                            |       |                                      |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                                                                  |       | $                                         | 31,760     |                   | $          | 70,238 |   |
| Investments                                                                                                                                                                                                                                |       | 139,252                                   |       | 122,082                |       |
| Receivables                                                                                                                                                                                                                                |       | 9,437                                     |       | 6,450                  |       |
| Other current assets                                                                                                                                                                                                                       |       | 4,320                                     |       | 4,307                  |       |
| Total current assets                                                                                                                                                                                                                       |       | 184,769                                   |       | 203,077                |       |
| Restricted cash                                                                                                                                                                                                                            |       | 0                                         |       | 6,000                  |       |
| Property and equipment, net                                                                                                                                                                                                                |       | 24,538                                    |       | 60,447                 |       |
| Goodwill                                                                                                                                                                                                                                   |       | 8,863                                     |       | 8,863                  |       |
| Other long-term assets and deferred charges                                                                                                                                                                                                |       | 6,968                                     |       | 9,865                  |       |
| Total assets                                                                                                                                                                                                                               |       | $                                         | 225,138    |                   | $          | 288,252 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                  |       |                                      |       |                   |       |
| Current liabilities:                                                                                                                                                                                                                       |       |                                      |       |                   |       |
| Accounts payable                                                                                                                                                                                                                           |       | $                                         | 3,575      |                   | $          | 5,829 |   |
| Accrued expenses and other current  liabilities                                                                                                                                                                                            |       | 11,510                                    |       | 9,528                  |       |
| Short-term borrowings                                                                                                                                                                                                                      |       | 0                                         |       | 5,069                  |       |
| Current portion of capital lease  obligations                                                                                                                                                                                              |       | 1,344                                     |       | 1,745                  |       |
| Current portion of long-term debt                                                                                                                                                                                                          |       | 572                                       |       | 7,081                  |       |
| Deferred revenue                                                                                                                                                                                                                           |       | 6,901                                     |       | 8,654                  |       |
| Total current liabilities                                                                                                                                                                                                                  |       | 23,902                                    |       | 37,906                 |       |
| Capital lease obligations, net of current  portion                                                                                                                                                                                         |       | 291                                       |       | 1,194                  |       |
| Long-term debt, net of current portion                                                                                                                                                                                                     |       | 155,738                                   |       | 189,535                |       |
| Deferred gain on sale-leaseback                                                                                                                                                                                                            |       | 28,138                                    |       | 0                      |       |
| Deferred revenue                                                                                                                                                                                                                           |       | 6,218                                     |       | 7,221                  |       |
|                                                                                                                                                                                                                                       |       |                                      |       |                   |       |
| Commitments and contingencies                                                                                                                                                                                                              |       |                                      |       |                   |       |
|                                                                                                                                                                                                                                       |       |                                      |       |                   |       |
| Stockholders’ equity:                                                                                                                                                                                                                 |       |                                      |       |                   |       |
| Preferred stock, $0.001 par value; Authorized:  6,716,666 shares Issued and outstanding: none                                                                                                                                              |       | 0                                         |       | 0                      |       |
| Common stock, $0.001 par value; Authorized:  100,000,000 shares; Issued and outstanding: 54,720,988 and 54,701,488 shares,  respectively, at September 30, 2005; and 54,539,069 and 54,522,069 shares,  respectively, at December 31, 2004 |       | 55                                        |       | 55                     |       |
| Additional paid-in capital                                                                                                                                                                                                                 |       | 443,924                                   |       | 442,999                |       |
| Notes receivable                                                                                                                                                                                                                           |       | (2,936                                    | )          | (3,111                 | )          |
| Deferred compensation                                                                                                                                                                                                                      |       | (471                                      | )          | 0                      |       |
| Accumulated deficit                                                                                                                                                                                                                        |       | (429,103                                  | )          | (387,465               | )          |
| Accumulated other comprehensive (loss) income                                                                                                                                                                                              |       | (494                                      | )          | 38                     |       |
| Treasury stock, 19,500 and 17,000 shares  stated at cost at September 30, 2005 and December 31, 2004, respectively                                                                                                                         |       | (124                                      | )          | (120                   | )          |
| Total stockholders’ equity                                                                                                                                                                                                            |       | 10,851                                    |       | 52,396                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                            |       | $                                         | 225,138    |                   | $          | 288,252 |   |

 

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

 

3

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**deCODE genetics, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 (Unaudited)

 
| ** **                                                     | ** ** | **FOR THE THREE MONTHS  ENDED SEPTEMBER 30,** | ** ** | **FOR THE NINE MONTHS  ENDED SEPTEMBER 30,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except per share amounts)**  | ** ** |
| REVENUE                                                        |       | $                                             | 13,197     |                                         | $          | 11,022 |   | $ | 34,157 |   | $ | 30,939 |   |
|                                                           |       |                                          |       |                                         |       |   |   |   |   |
| OPERATING EXPENSES                                             |       |                                          |       |                                         |       |   |   |   |   |
|                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Cost of revenue, including collaborative  programs             |       | 9,149                                         |       | 10,451                                       |       | 27,082 |   | 32,104 |   |
| Research and development - proprietary  programs               |       | 10,989                                        |       | 6,507                                        |       | 30,069 |   | 16,010 |   |
|                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Selling, general and administrative                            |       | 4,840                                         |       | 4,339                                        |       | 13,692 |   | 14,191 |   |
| Total operating expenses                                       |       | 24,978                                        |       | 21,297                                       |       | 70,843 |   | 62,305 |   |
| Operating loss                                                 |       | (11,781                                       | )          | (10,275                                      | )          | (36,686 | ) | (31,366 | ) |
| Interest income                                                |       | 1,631                                         |       | 925                                          |       | 4,284 |   | 1,906 |   |
| Interest expense                                               |       | (1,686                                        | )          | (2,716                                       | )          | (5,775 | ) | (6,028 | ) |
| Other non-operating income and (expense),  net                 |       | 466                                           |       | (436                                         | )          | (3,461 | ) | (2,329 | ) |
| Net Loss                                                       |       | $                                             | (11,370    | )                                            | $          | (12,502 | ) | $ | (41,638 | ) | $ | (37,817 | ) |
|                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Basic and diluted net loss per share                           |       | $                                             | (0.21      | )                                            | $          | (0.23 | ) | $ | (0.78 | ) | $ | (0.71 | ) |
|                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Shares used in computing basic and diluted  net loss per share |       | 53,741,436                                    |       | 53,613,120                                   |       | 53,685,015 |   | 53,368,377 |   |

 

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

 

4

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**deCODE genetics, Inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
|                                                                         |   | **FOR THE NINE-MONTHS ENDED SEPTEMBER 30,** |    |
|------------------------------------------------------------------------------|--------|---------------------------------------------|---------|
|                                                                         |   | **2005**                                    |    | **2004** |   |
|                                                                         |   | **(In thousands)**                          |    |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |   |                                        |    |   |   |
| Net loss                                                                     |   | $                                           | (41,638 | ) | $ | (37,817 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                                        |    |   |   |
| Depreciation and amortization                                                |   | 5,894                                       |    | 8,871 |   |
| Amortization of deferred compensation                                        |   | 129                                         |    | 949 |   |
| Amortization of deferred financing costs                                     |   | 726                                         |    | 578 |   |
| Amortization of deferred gain on sale of  property                           |   | (910                                        | )       | 0 |   |
| Charges for debt extinguishment                                              |   | 1,741                                       |    | 0 |   |
| (Gain) loss on disposal of equipment                                         |   | (3                                          | )       | 883 |   |
| Loss on derivative financial instruments                                     |   | 0                                           |    | 1,465 |   |
| Foreign currency exchange loss on Icelandic  krona denominated debt          |   | 263                                         |    | 435 |   |
| Other                                                                        |   | 11                                          |    | 132 |   |
| Changes in operating assets and  liabilities:                                |   |                                        |    |   |   |
| Receivables and other current assets                                         |   | (3,085                                      | )       | 688 |   |
| Accounts payable, accrued expenses and  other current liabilities            |   | (167                                        | )       | 2,347 |   |
| Deferred revenue                                                             |   | (2,756                                      | )  | 2,082 |   |
| Net cash used in operating activities                                        |   | (39,795                                     | )       | (19,387 | ) |
|                                                                         |   |                                        |    |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |   |                                        |    |   |   |
|                                                                         |   |                                        |    |   |   |
| Purchases of investments                                                     |   | (183,140                                    | )       | (99,488 | ) |
| Sales and redemptions of investments                                         |   | 165,430                                     |    | 0 |   |
| Purchase of property and equipment                                           |   | (2,516                                      | )       | (1468 | ) |
| Proceeds from sale of property and  equipment                                |   | 62,452                                      |    | 39 |   |
| Changes in restricted cash                                                   |   | 6,000                                       |    | 0 |   |
| Net cash provided by (used in) investing  activities                         |   | 48,226                                      |    | (100,917 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |   |                                        |    |   |   |
| Proceeds from issuance of common stock and warrants                          |   | 220                                         |    | 14,109 |   |
| Proceeds from convertible debt offering,  net                                |   | 0                                           |    | 143,830 |   |
| Proceeds from debt refinancing                                               |   | 6,211                                       |    | 0 |   |
| Proceeds from swap close-out                                                 |   | 0                                           |    | 9,720 |   |
| Repayment of notes receivable for common  stock                              |   | 172                                         |    | 981 |   |
| Debt refinancing cost                                                        |   | 0                                           |    | (478 | ) |
| Repayments from short-term borrowings                                        |   | (569                                        | )       | 911 |   |
| Payments on line of credit                                                   |   | (4,500                                      | )       | (2,000 | ) |
| Repayments of debt and capital lease obligations                             |   | (48,443                                     | )       | (5,687 | ) |
| Net cash (used in) provided by financing  activities                         |   | (46,909                                     | )       | 161,386 |   |
| Net (decrease) increase in cash and cash  equivalents                        |   | (38,478                                     | )       | 41,082 |   |
| Cash and cash equivalents at beginning of  period                            |   | 70,238                                      |    | 68,669 |   |
| Cash and cash equivalents at end of period                                   |   | $                                           | 31,760  |   | $ | 109,751 |   |
| Supplemental cash flow information:                                          |   |                                        |    |   |   |
| Cash paid for interest                                                       |   | $                                           | 3,876   |   | $ | 4,556 |   |
| Supplemental schedule of non-cash  transactions:                             |   |                                        |    |   |   |
| Deferred gain on sale of property                                            |   | $                                           | 29,048  |   | $ | 0 |   |

 

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

 

5

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**deCODE genetics, Inc.**

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

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

 

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

 

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

 

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

 

In the opinion of theCompany’s management, the accompanying unaudited condensed consolidatedfinancial statements contain all adjustments (consisting of items of a normaland recurring nature) necessary to present fairly the financial position as of September30, 2005, the results of operations for the three and nine-month periods ended September30, 2005 and 2004 and cash flows for the nine-month periods ended September 30,2005 and 2004.  The results of operationsfor the three and nine-month periods ended September 30, 2005 are notnecessarily indicative of the results to be expected for the full year.  These financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2004, which includes consolidated financial statements and notesthereto for the years ended December 31, 2004, 2003 and 2002.  Certain reclassifications have been made to prioryear financial statements to conform to the 2005 presentation.

 

Beginning in 2004, deCODE began presenting cost ofrevenue in its statements of operations. To be consistent with the September 30,2005 operating expense classifications, deCODE has reclassified previouslyreported research and development expenses for the three and nine-months ended September30, 2004. These reclassifications between research and development expenses andcost of revenue had no effect on reported amounts of total operating expensesor operating loss.

 

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

 

Significant elements of ourrevenue are summarized as follows:

 
| ** **                                                                 | ** ** | **For the  Three Months  Ended September 30,** | ** ** | **For the  Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                       | ** ** | **2004**                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In  thousands)**                            | ** ** |
|                                                                       |       |                                           |       |                                          |       |   |   |   |   |
| Research funding and other service fees                                    |       | $                                              | 8,226      |                                          | $          | 8,080 |   | $ | 23,265 |   | $ | 23,583 |   |
| Milestone payments                                                         |       | 434                                            |       | 628                                           |       | 932 |   | 849 |   |
| Up-front, exclusivity, technology access, and  technology development fees |       | 2,000                                          |       | 1,079                                         |       | 4,038 |   | 3,079 |   |
| Grant funding                                                              |       | 1,908                                          |       | 271                                           |       | 4,799 |   | 1,697 |   |
| Other                                                                      |       | 629                                            |       | 964                                           |       | 1,123 |   | 1,731 |   |
|                                                                       |       | $                                              | 13,197     |                                          | $          | 11,022 |   | $ | 34,157 |   | $ | 30,939 |   |

 

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

 

Revenue from collaborations with Merck for thethree and nine-month periods ended September 30, 2005 constituted 21% and 19% ofconsolidated revenue and 28% and 21% for the three and nine-month periods endedSeptember 30, 2004.  Revenues fromcollaborations with Roche for the three and nine-month periods ended September30, 2005 constituted 17% and 21% of consolidated revenue and 28% and 31% forthe three and nine-month periods ended September 30, 2004.

 

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

 

deCODE’s research and development expenses are comprised ofthe costs of its own proprietary programs and consist of the following:

 

6

----

 
| ** **                                       | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                            | ** ** |
| ** **                                       | ** ** | ** **                                    | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries and other personnel costs               |       | $                                             | 4,139      |                                         | $          | 2,631 |   | $ | 12,269 |   | $ | 6,850 |   |
| Materials and supplies                           |       | 970                                           |       | 1,135                                        |       | 3,167 |   | 2,498 |   |
| Contractor services and other third party  costs |       | 4,009                                         |       | 828                                          |       | 9,073 |   | 2,044 |   |
| Overhead expenses                                |       | 1,153                                         |       | 339                                          |       | 3,185 |   | 1,274 |   |
| Depreciation and amortization                    |       | 685                                           |       | 1,471                                        |       | 2,342 |   | 3,103 |   |
| Stock-based compensation and remuneration        |       | 33                                            |       | 103                                          |       | 33 |   | 241 |   |
|                                             |       | $                                             | 10,989     |                                         | $          | 6,507 |   | $ | 30,069 |   | $ | 16,010 |   |
|                                                  |            |                                               |            |                                              |            |  |  |  |  |  |  |  |  |  |

 

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

 

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

 

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

 
| ** **                                        | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(In  thousands)**                           | ** ** |
| Cost of revenue, including collaborative programs |       | $                                             | 0          |                                         | $          | 31 |   | $ | 0 |   | $ | 288 |   |
| Research and development - proprietary programs   |       |                                          | 33         |                                         |       | 103 |   |   | 33 |   |   | 241 |   |
| General and administrative expense                |       | 22                                            |       | 2                                            |       | 138 |   | 29 |   |
| Total                                             |       | $                                             | 55         |                                         | $          | 136 |   | $ | 171 |   | $ | 558 |   |

 

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

 
| ** **                                                                                        | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                        | ** ** | **(In thousands, except per share amounts)**  | ** ** |
|                                                                                              |       |                                          |       |                                         |       |   |   |   |   |
| Net loss attributable to common  stockholders — as reported                                  |       | $                                             | (11,370    | )                                            | $          | (12,502 | ) | $ | (41,638 | ) | $ | (37,817 | ) |
| Add: Stock-based compensation expense included  in reported net loss                              |       | 55                                            |       | 134                                          |       | 171 |   | 529 |   |
| Deduct: Total stock-based compensation expense  determined under fair value method for all awards |       | (1,128                                        | )          | (1,723                                       | )          | (3,500 | ) | (4,615 | ) |
| Net loss — proforma                                                                          |       | $                                             | (12,443    | )                                            | $          | (14,091 | ) | $ | (44,967 | ) | $ | (41,903 | ) |
| Basic and diluted net loss per share—as  reported                                            |       | $                                             | (0.21      | )                                            | $          | (0.23 | ) | $ | (0.78 | ) | $ | (0.71 | ) |
| Basic and diluted net loss per  share—proforma                                               |       | (0.23                                         | )          | (0.26                                        | )          | (0.84 | ) | (0.79 | ) |

 

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

 

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

 

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

 

7

----

 

Diluted net loss per share is computed using the weighted-averagenumber of common shares outstanding during the period, plus the dilutive effectof potential common shares. Diluted net loss per share does not differ frombasic net loss per share in all periods presented as potential common sharesare antidilutive for all such periods and are, therefore, excluded from thecalculation. Potential common shares excluded from the calculation of dilutednet loss per share were:

 
| ** **                                                                                           | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                           | ** ** | **(Shares)**            | ** ** | **(Shares)**            | ** ** |
| Warrants to purchase shares of common stock                                                          |       | 2,729,873               |       | 3,124,724               |       |
| Options to purchase shares of common stock                                                           |       | 4,721,010               |       | 4,706,032               |       |
| Restricted shares subject to vesting or  with an associated outstanding non-recourse promissory note |       | 879,126                 |       | 885,084                 |       |
| Convertible shares issuable upon conversion  of 3.5% senior convertible notes                        |       | 10,714,286              |       | 10,714,286              |       |
|                                                                                                 |       | 19,044,295              |       | 19,430,126              |       |

 

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

 

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

 
| ** **                                  | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(in thousands)**                            | ** ** |
| ** **                                  | ** ** | ** **                                    | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                    |       | $                                             | (11,370    | )                                            | $          | (12,502 | ) | $ | (41,638 | ) | $ | (37,817 | ) |
| Other comprehensive income (loss):          |       |                                          |       |                                         |       |   |   |   |   |
| Foreign currency translation                |       | (4)                                           |       | 2                                            |       | (3 | ) | 2 |   |
| Forward foreign exchange contracts          |       | 0                                             |       | 2                                            |       | 0 |   | 0 |   |
| Unrealized loss associated with investments |       | (158                                          | )          | (2                                           | )          | (529 | ) | (2 | ) |
|                                        |       |                                          |       |                                         |       |   |   |   |   |
| Total comprehensive loss                    |       | $                                             | (11,532    | )                                            | $          | (12,500 | ) | $ | (42,170 | ) | $ | (37,817 | ) |

 

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

 

deCODE’s investments consist of auction rate securities, acorporate bond, US government securities and an intermediate term bond fundinvestment, all of which are classified as available-for-sale. Investments areavailable for current operations and are classified as current assets.Investments are carried at fair value with the unrealized holding gain or lossincluded in accumulated other comprehensive income. Fair value is generallydetermined with reference to quotations in active markets. Premium anddiscounts associated with investments in bonds are amortized using theeffective interest rate method.  Theseinvestments as of September 30, 2005 are summarized as follows:

 
| ** **                    | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|-------------------------------|------------|---------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **(in thousands)**  | ** ** |
| Auction rate securities       |       | $                   | 92,190     |                      | $          | 92,190 |   |
| Corporate bond                |       | 2,000               |       | 1,950                     |       |
| US government debt securities |       | 15,000              |       | 14,893                    |       |
| Intermediate term bond fund   |       | 30,567              |       | 30,219                    |       |
|                          |       | $                   | 139,757    |                      | $          | 139,252 |   |

 

Gross unrealized holding gains and gross unrealized holdinglosses at September 30, 2005 were $437,000 and $942,000, respectively, and atDecember 31, 2004 were $27,000 and $2,000, respectively and are included inaccumulated other comprehensive income.

 

Proceeds from the sale of investments available-for-sale forthe nine-month period ended September 30, 2005 were $69,900,000 and nonefor the nine month period ending September 30, 2004. There were no realizedgains or realized losses from the sale of investments available-for-sale in thethree and nine-month periods ended September 30, 2005 and 2004.

 

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

 

In March 2005 and in connection with the sale-leasebackfinancing of Sturlugata 8 discussed in Note 10, deCODE repaid short-termborrowings of $4,500,000.  The remaining $228,000on the short-term loan was paid off during the three months ended June 30, 2005.

 

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

 

*Sale-leasebackFinancing*

 

In March 2005, deCODEentered into a financing for the sale and leaseback of its headquartersfacility at Sturlugata 8, Reykjavik, Iceland. The sale price for the propertywas 3.4 billion Icelandic kronas ($54,767,000 after taking into account aforward foreign exchange contact entered into in connection with the sale ofthe property). As a result of the sale, the remaining net book value of theproperty ($29,278,000) has been removed from the balance sheet as of September30, 2005, and the resulting gain has been deferred and is being recognized inearnings over the 15 year term of the leaseback.

 

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

 

deCODE has leased the Sturlugata8 property back under a 15 year non-cancelable lease agreement at a rent of21.4 million Icelandic kronas per month (approximately $347,000 as of September30, 2005), subject to changes based on the Icelandic consumer price index. Thelease is an operating lease and, as a result, Icelandic krona denominated rentwill be included in operating expenses over the 15 year term of the leaseagreement.

 

In June 2005, deCODE enteredinto a financing for the sale and leaseback of its facility at Krokhals 5D and5E, Reykjavik, Iceland.  The sale pricefor the property was 502 million Icelandic kronas (approximately $7,672,000after taking into account the sales commission) of which $1,229,000 was paid inthe third quarter of 2005.  As a resultof the sale, the remaining net book value of the property ($4,029,000) has beenremoved from the balance sheet as of September 30, 2005, and the resulting gain($3,559,000) has been deferred and will be recognized to earnings over the 15year term of the leaseback.

 

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

 

deCODE has leased theKrokhals 5D and 5E property back under a 15 year non-cancelable lease agreementat a rent of 4.1 million Icelandic krona per month (approximately $66,000 as ofSeptember 30, 2005), subject to changes based on the Icelandic consumer priceindex.  The lease is an operating leaseand, as a result, Icelandic krona denominated rent will be included inoperating expenses over the 15 year term of the lease agreement.

 

*MortgageRefinancing*

 

In connection with arefinancing of the mortgage on its Woodridge, IL facility in March 2005, deCODErepaid its $4,000,000 existing mortgage, eliminated restricted cash collateraltotaling $6,000,000 and entered into a $6,211,000 mortgage with the samefinancial institution.  The new mortgagecarries an interest rate of three-month LIBOR + 2.25% (5.77% at September 30,2005), payable in monthly installments of $26,000 for five years and a finalpayment of $5,500,000 due in June 2007.

 

*Commitments*

 

As of September 30, 2005,our contractual commitments are as follows:

 
| ** **                                         | ** ** | ** **         | ** ** | **Less Than  1 Year** | ** **    | **Payments Due by period** | ** **    | **More than  5 Years** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|-----------------------|---------------|----------------------------|---------------|------------------------|------------|
| ** **                                         | ** ** | **Total**          | ** ** | ** **            | **1-3 Years** | ** **                 | **3-5 Years** | ** **             | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| 3.5% senior convertible notes, including  interest |       | $                  | 181,500    |                  | $             | 5,250                      |          | $                      | 10,500     |   | $ | 10,500 |   | $ | 155,250 |   |
| Long-term debt, including interest                 |       | 6,869              |       | 899                   |          | 5,970                      |          | 0                      |       | 0 |   |
| Capital lease obligations, including  interest     |       | 1,728              |       | 1,385                 |          | 314                        |          | 29                     |       | 0 |   |
| Operating leases                                   |       | 73,935             |       | 5,692                 |          | 10,558                     |          | 10,096                 |       | 47,589 |   |
|                                               |       | $                  | 264,032    |                  | $             | 13,226                     |          | $                      | 27,342     |   | $ | 20,625 |   | $ | 202,839 |   |

 

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

 

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determined at the current time.

 

## ***11.***       Derivative FinancialInstruments

 

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

 

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

 

InMarch 2004, deCODE entered into five forward foreign exchange contractswith an Icelandic financial institution for purposes of hedging a portion ofits Icelandic krona-denominated salaries. On the maturity date of eachcontract, deCODE sold $1,600,000 and deCODE received Icelandic krona at thecontracted forward rate. These forward foreign exchange contracts weredesignated as economic hedges of the foreign currency salary cash flows andqualified for hedge accounting. The final contract matured in August 2004and no new contracts were entered into during the remainder of 2004. During the nine-month period ended September30, 2004, a loss of $11,000 was recorded to operating expenses in the CondensedConsolidated Statements of Operations.

 

InMarch 2005, deCODE purchased for $214,000 three forward foreign exchange optioncontracts from an Icelandic financial institution for purposes of hedging aportion of its Icelandic krona-denominated salaries and other operatingexpenses. The forward foreign exchange option contracts provided deCODE theright but not the obligation to sell stated amount of U.S. dollars and receiveIcelandic krona at the contracted forward rates. The forward foreign exchangeoption contracts to sell $10,000,000, $3,394,000 and $3,394,000, expired onJune 10, June 30 and July 29, 2005, respectively.

 

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

 

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

 

Therehas been no change in the matters reported in deCODE’s quarterly report on Form10-Q for the quarter ended June 30, 2005.

 

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

 

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

 

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

 

# **Overview**

 

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

 

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

 

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means of modulating the onset or progression of thedisease.

 

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

 

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

 

In order to support our drug development infrastructure,to focus the use of our cash resources on our proprietary therapeuticsprograms, and to diversify risk in our overall drug development portfolio, weleverage our capabilities to form corporate alliances and to provide servicesto fee-paying customers. We also receive contract and grant funding fromvarious governmental agencies.  We haveformed drug and other product development alliances with Roche and Merck, amongothers. In addition to conducting work on our targets in our collaborative andinternal programs, our medicinal chemistry subsidiary provides drug discoveryservices and contract manufacturing of therapeutic compounds for human clinicaltrials for our fee-for-service customers. Our other service offerings includeprotein crystallography products and instruments, as well as protein structureanalysis contract services through our structural biology subsidiary; clinicaltrials services though our wholly owned subsidiary Encode; and DNA analysisservices through our genotyping laboratory 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 terms ofsome of our agreements, due to the extended time period for the development andcommercialization of a saleable product or therapy, we have not yet receivedroyalties or profit sharing under any of our contracts and do not expect to doso for several years, if at all. Our expenses consist primarily of research anddevelopment expenses.

 

We believe that ongoing work in genetics and advancingour drug development programs, particularly the conduct of clinical trials on agrowing number of our compounds, will require significant and increasingexpenditures. In 2005, we have conducted our Phase II clinical studies forDG031, our developmental compound for the prevention of heart attack; initiatedour Phase I clinical program for DG041, our developmental compound forperipheral artery disease (PAD), which we previously referred to as peripheralarterial occlusive disease (PAOD), and initiated a Phase II trial in asthma. Inlate 2005 and the first half of 2006 we expect to finalize our protocol and beginenrollment for a Phase III trial for DG031; to conclude our Phase I program forDG041; and to conclude our Phase II trial in asthma. We are also advancing ourpreclinical work on our follow-on compound in heart attack and in our PDE4inhibitor program for vascular disease/stroke, and expect these to be the nextprograms we bring into clinical development. We anticipate incurring additionalnet losses at least through the next several years, due to, in addition to theabove-mentioned factors, depreciation and amortization, as well as stock-basedcompensation and other non-cash charges. We expect that our revenues and losseswill fluctuate from quarter to quarter and that such fluctuations may besubstantial, especially because progress in our scientific work and milestonepayments that are related to progress can fluctuate between quarters. We do notbelieve that comparisons of our quarter-to-quarter performance are a goodindication of future performance.

 

Following our sale of $150,000,000 of our 3.5% SeniorConvertible Notes in April, 2004, we believe that we have sufficient cashresources to continue to fund our operations for several years and to advanceour lead therapeutic programs through the next stages of clinical development.However, as we advance and broaden our drug development pipeline we willrequire significant additional capital for product development and so willcontinue to investigate additional avenues of financing. Our ability to obtaincapital will be affected by conditions in the global financial markets and inthe pharmaceutical industry. We expect that downturns in the market valuationsof biotechnology companies and of the equity markets more generally willrestrict our ability to raise additional capital on attractive terms, whilemore favorable conditions in those markets will present opportunities for us.

 

The difficulties facing the pharmaceutical industrypresent for us both near-term challenges and significant longer-termopportunities. One of the main issues confronting big pharmaceutical companiesis their lack of promising new drugs to treat major indications. As manyleading brand-name drugs come off patent and face generic competition,developing successful new medicines will become critical for filling the gap.In the short term, the financial pressures on pharmaceutical companies may bereflected in their research and development spending, making it more difficultfor us to sign corporate alliances with significant up-front funding, orlengthening the time required to negotiate such deals. We believe that in themedium to longer term, however, companies such as ours may be well 

 

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positioned to play an important role in filling the gapin the pipeline of new drugs, either alone or as partners of pharmaceutical companies.Our partnerships demonstrate that the industry is already investing in thedevelopment of new therapeutics based on our approach.

 

**Research and Development Programs**

 

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

 

•                  Our most advanced developmentalcompound is DG031 for the prevention of heart attack. In 2004 we conducted aPhase IIa clinical trial for DG031 in Iceland, and have conducted follow-onPhase II studies in Iceland this year. We have submitted an investigational newdrug (IND) application for DG031 with the U.S. Food and Drug Administration(FDA) and expect to make similar filings in selected European countries. Wehave submitted the safety summary and results of the Phase II trials to the FDAand have conducted an end of Phase II meeting with the FDA. We are working withthe FDA under a Special Protocol Assessment to finalize the protocol for aPhase III outcome trial for DG031 in the Americas, Iceland and Europe. The initiationof the DG-031 Phase III trial may be affected by timelines for manufacturing,packaging, labeling and shipping of clinical supplies, negotiating with CROsfor clinical trial performance, and the approval process for the study protocolby local Institutional Review Boards (IRB) and/or the FDA.  We expect to begin enrolling patients for thePhase III trial in the first half of 2006.

 

•                  DG041is our lead compound for the treatment of atherosclerosis of the extremities,or peripheral artery disease (PAD). DG041 is a first-in-class small moleculeinhibitor of the EP3 receptor for prostaglandin E2, a G-protein coupledreceptor (GPCR) encoded by a gene we have shown to be associated with increasedrisk of developing the disease. Our IND application for DG041 was accepted bythe FDA in February 2005 and on this basis we began the first Phase 1trial for this compound in the U.S. in March of 2005. The Phase I single-doseescalation trial was concluded in the second quarter 2005, and the results indicate that DG041 appears tobe well tolerated at all dose levels tested. In particular, DG041 did notprolong bleeding time as compared to the placebo. Additionally, doses wereidentified which appear to completely inhibit platelet aggregation stimulatedthrough the EP3 receptor. The multiple-dose and food effect Phase I trials of DG041began in the second quarter 2005 and we expect to announce preliminary resultsfrom the Phase I program in the first half of 2006.

 

•                  In asthma, we are conducting a PhaseII trial with a third party compound. This compound inhibits MAP3K9, a kinaseencoded by a gene we have linked to risk of asthma.  We expect to announce preliminary resultsfrom this study in the first half of2006.

 

•                  We are developing a compound toinhibit the LTA4 hydrolase, a protein encoded by a second gene within the samepathway targeted by DG031 that we have also linked to significantly increasedrisk of heart attack.  We expect to filean IND on an LTA4H inhibitor next year.

 

•                  We have begun a PDE4 inhibitorprogram for vascular disease/stroke pursuant to our 2004 agreement with Rocheand working towards filing an IND on such a compound in 2006.

 

We use many of our employee and infrastructure resourcesacross several programs, and many of our research and development costs areindirectly attributable to an individually named program or are directedbroadly to applicable research programs. However, taking into account coststhat are specifically attributable to individual programs and allocations ofour research and development program costs based upon those direct costs, wehave cumulatively invested $10.6, $9.5, $3.9 and $5.4 million in our MyocardialInfarction (MI), PAD, stroke and asthma programs, respectively, from thebeginning of 2003 to date. Inception to-date costs are not available as thesecosts were not historically tracked by program.

 

We have not applied for or received marketing approvalfrom the applicable regulatory authorities in any country for any of our drugcandidates. In order for us to achieve marketing approval in the U.S., the FDAmust conclude that our clinical data establish the safety and efficacy of ourdrug candidate. Other countries have similar requirements. Historically, theresults from pre-clinical testing and early clinical trials (through PhaseII) have often not been predictive of 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 below underthe caption “Risk Factors, Forward-Looking Statements, and Cautionary FactorsThat May Affect Future Results”. We expect that it will be several years, ifever, before we receive revenues from the commercial sale of our therapeuticproducts.

 

Furthermore, our strategy includes the option of enteringinto collaborative arrangements with third parties to participate in thedevelopment and commercialization of our products. Entering into a collaborationwith a partner at any point in the development or 

 

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commercialization of a product is a business decision.When making this decision we do and will consider, among other matters, thecomplexity of the indication, the size, complexity and expense of necessarydevelopment and/or commercialization efforts, competition in the market andsize of the applicable market, an assessment of our own resources—financial andoperational, and an assessment of the resources of a potential partner. In theevent that we do collaborate on any of the above programs in the future, apartner will have a level of control, which may be significant, over thepre-clinical development or clinical trial process for a product. As a resultthe completion date of such a partnered program could largely be under controlof that third party rather than under our control. We cannot forecast with anydegree of certainty which proprietary drug candidate will be subject to futurecollaborative arrangements or how such arrangements would affect ourdevelopment plan or capital requirements.

 

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

 

**CriticalAccounting Policies**

 

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires us to make certain estimates and assumptions that affectthe reported amounts of assets and liabilities, the disclosure of contingentassets and liabilities at the date of the financial statements, and thereported amounts of revenues and expenses during the reported period. On anongoing basis we evaluate our estimates, which include, among others, thoserelated to collaborative arrangements, long-lived assets, materials andsupplies, foreign exchange transactions, income taxes and litigation and othercommitments and contingencies. We base our estimates on historical experienceand on various other assumptions that we believe to be reasonable under thecircumstances, the results of which form our basis for making judgments aboutcarrying values of assets and liabilities that are not readily apparent fromother sources. The impact and any associated risks related to these and ourother accounting policies on our business or operations is discussed throughoutManagement’s Discussion and Analysis of Financial Condition and Results ofOperations where such policies affect our reported and expected financialresults. For a detailed discussion on the application of these and otheraccounting policies, please refer to our notes to the Condensed ConsolidatedFinancial Statements in this quarterly report on Form 10Q and the ConsolidatedFinancial Statements in the Annual Report on Form 10-K. There can be noassurance that actual results may not differ from the estimates referred toabove.

 

**Resultsof Operations for the Three and Nine-Month Periods Ended September 30, 2005 and2004**

 

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

 

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

 

•                  At September 30, 2005, we had $171.0 millionin cash, cash equivalents and investments compared to $198.3 million atDecember 31, 2004. The net utilization of just $27.3 million in the first nine-monthsof 2005 reflects costs associated with the advancement of our drug developmentprograms as reflected in the $39.8 million cash used in operations, togetherwith the net proceeds from the sale and leaseback of our Sturlugata and Krokhalsfaciltities in Reykjavik, Iceland ($22.0 million) and also the refinancing ofthe mortgage on our Woodridge, IL facility, during the nine-month period ended September30, 2005.

 

•                  Research and development expense forproprietary programs was $11.0 million for the three-month period ended September30, 2005 as compared to $6.5 million for the three-month period ended September30, 2004.  Research and developmentexpense for proprietary programs was $30.1 million for the nine-month periodended September 30, 2005 as compared to $16.0 million for the nine-month periodended September 30, 2004.  The increasein our research and development expenses for proprietary programs is the resultprincipally of costs associated with the advancement of our lead drug developmentprograms in clinical trials.

 

•                  In March 2005, we entered into a financingfor the sale and leaseback of our headquarters facility at Sturlugata 8,Reykjavik, Iceland. The sale price for the property was 3.4 billion Icelandickronas ($54.8 million after taking into account a forward foreign exchange contractwe entered into in connection with the sale of the property). As a result ofthe sale, we have removed the remaining net book value of the property ($29.3million) from our balance sheet, deferred the resulting gain 

 

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andhave begun recognizing the gain to earnings over the 15 year term of theleaseback (remaining unamortized balance of $25.1 million as of September 30,2005). Proceeds from the sale of Sturlugata 8 went to prepay approximately$38.6 million of short and long-term debt that was secured by mortgages on theproperty and, in this connection, we have recorded a loss on earlyextinguishment debt during the nine-month period ended September 30, 2005amounting to $3.1 million. We have leased the property back under a 15 yearnon-cancelable lease agreement at a rent of 21.4 million Icelandic kronas(approximately $0.3 million as of September 30, 2005) per month, subject tochanges based on the Icelandic consumer price index. We are accounting for theleaseback as an operating lease.

 

•                  In June 2005, we entered into a financing forthe sale and leaseback of our facility at Krokhals 5D and 5E, Reykjavik,Iceland.  The sale price for the propertywas 502 million Icelandic kronas (approximately $7.6 million after taking intoaccount a sales commission).  As a resultof the sale, the remaining net book value of the property ($4.0 million) hasbeen removed from the balance sheet, and we have begun recognizing the deferredgain to earnings over the 15 year term of the leaseback ( remaining unamortizedbalance of $3.0 million as of September 30, 2005).  Proceeds from the sale of Krokhals were usedto prepay approximately $1.8 million of long-term debt that was secured by amortgage on the property.  deCODE hasleased the Krokhals 5D and 5E property back under a 15 year non-cancelablelease agreement at a rent of 4.1 million Icelandic krona (approximately $0.07million as of September 30, 2005) per month, subject to changes based on theIcelandic consumer price index.  Thelease is an operating lease and, as a result, Icelandic krona denominated rentwill be included in operating expenses over the 15 year term of the leaseagreement.

 

•                  Our revenue for the three-month period ended September30, 2005 was $13.2 million as compared to $11.0 million for the three-monthperiod ended September 30, 2004.  Ourrevenue for the nine-month period ended September 30, 2005 was $34.2 million ascompared to $30.9 million for the nine-month period ended September 30,2004.  Revenue for the three andnine-month periods ended September 30, 2005 generally reflects our strategicfocus on drug discovery and development. Specifically, the increase in revenue for the three and nine-month periodsended September 30, 2005 as compared to the same periods last year is onaccount of grant monies received, service contract fees, a technology accessfee installment received from Merck, and also reflects the completion ofresearch funding under the 2002 agreement with Roche offset somewhat byrevenues in our alliance to co-develop inhibitors of PDE4.

 

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

 

Significant elements of our revenue are summarized asfollows:

 
| ** **                                                                 | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                            | ** ** |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| Research funding and other service fees                                    |       | $                                             | 8,226      |                                         | $          | 8,080 |   | $ | 23,265 |   | $ | 23,583 |   |
| Milestone payments                                                         |       | 434                                           |       | 628                                          |       | 932 |   | 849 |   |
| Up-front, exclusivity, technology access, and  technology development fees |       | 2,000                                         |       | 1,079                                        |       | 4,038 |   | 3,079 |   |
| Grant funding                                                              |       | 1,908                                         |       | 271                                          |       | 4,799 |   | 1,697 |   |
| Other                                                                      |       | 629                                           |       | 964                                          |       | 1,123 |   | 1,731 |   |
|                                                                       |       | $                                             | 13,197     |                                         | $          | 11,022 |   | $ | 34,157 |   | $ | 30,939 |   |

 

Collaborations with our most significant partnersinclude:

 

*F. Hoffmann-LaRoche (Roche)*

 

*Therapeutics.*In 1998 we entered into a research collaborationand cross-license agreement with Roche, under which we identified key geneticfactors involved in ten common diseases: osteoarthritis, Alzheimer’s disease,schizophrenia, PAD, stroke, osteoporosis, obesity, anxiety, non-insulin-dependentdiabetes and rheumatoid arthritis. In January 2002, we entered into a newthree-year agreement with Roche focused on turning the achievements of our 1998gene discovery collaboration into novel therapeutics. The 2002 agreementprovided that we would collaborate with respect to four diseases that had beenthe subject of the 1998 agreement. During 2004 and 

 

14

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through January 2005 we collaborated with Roche on two ofthose diseases. Under the 2002 agreement, which expired on February 1,2005, we received $20 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 lead compoundsidentified in our previous work and begin clinical development. We will sharedrug discovery and clinical trials costs with Roche under this new agreement,and we may receive milestone payments and royalties based on drug sales.

 

*Diagnostics.*  In June 2001, we signed a five-yearalliance with Roche’s diagnostics division to develop and market DNA-baseddiagnostics for major diseases. We have added research programs aimed atdeveloping diagnostics to predict drug response for major therapeutics used totreat those diseases in order to help select the most effective treatment ofthose available.  Under the agreement wehave received $39.6 million in research funding, up-front fees and milestonepayments. We may receive $4.7 million in additional research funding over theremainder of the term of the agreement as well as milestone payments upon theachievement of research and development milestones and royalties on the salesof diagnostic products developed.

 

Revenues from these alliances with Roche amounted to $2.3million and $3.1 million in the three-month periods ended September 30,2005 and 2004, respectively, and $7.3 million and $9.5 million in thenine-month periods ended September 30, 2005 and 2004, respectively, representing17% and 28% of consolidated revenue for the three-month periods ended September 30,2005 and 2004, respectively, and 21% and 31% of consolidated revenue for thenine-month periods ended September 30, 2005 and 2004, respectively.  Costs incurred with these collaborativeprograms with Roche amounted to $1.5 million and $3.3 million in the three-monthperiods ended September 30, 2005 and 2004, respectively and $6.5 millionand $13.0 million in the nine-month periods ended September 30, 2005 and2004, respectively.

 

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

 

*Obesity.*  In September 2002, we entered into a threeyear alliance with Merck aimed at developing new treatments for obesity. Underthe alliance, we combined research efforts with Merck in the genetics ofobesity to identify, validate and prioritize a series of drug targets to takeinto development. During the three-year research program, that has now expired,we have received research funding, technology access fees and milestonepayments in the aggregate amount of $25.3 million.  In addition, we may receive further technologyaccess fees in the total aggregate amount of $2.0 million. Subject to Merck’sdeveloping products based on collaboration discoveries, we may also receivedevelopment milestones and royalties. We have discovered three genes linked toobesity under this alliance, and Merck has generated a lead series of compoundsagainst one of the targets we validated through our genetics research.

 

Revenues from this alliance with Merck amounted to $2.8million and $2.2 million in the three-month periods ended September 30, 2005and 2004, respectively, and $6.3 million and $5.6 million in the nine-monthperiods ended September 30, 2005 and 2004, respectively, representing 21% and 20%of consolidated revenue for the three-month periods ended September 30,2005 and 2004, respectively, and 19% and 18% of consolidated revenue for thenine-month periods ended September 30, 2005 and 2004, respectively. Costsincurred with this alliance with Merck amounted to $0.8 million and $1.1million in the three-month periods ended September 30, 2005 and 2004,respectively and $2.9 million and $3.5 million in the nine-month periods endedSeptember 30, 2005 and 2004, 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) a Stock and Warrant Purchase Agreement; and (c) a WarrantAgreement. Under the terms of the License and Research Collaboration Agreement,we will receive royalties on sales of drugs and diagnostics developed as partof the alliance, will receive milestone payments as compounds orpharmacogenomic tests reach the market, will receive research funding for theclinical development of compounds and pharmacogenomic analysis, and received aone-time technology access fee of $10 million. To date, Merck has not selectedany compounds for development under the agreement that has advanced to patients.

 

Revenues from this alliance with Merck amounted to $0.0million and $0.5 million in the three-month periods ended September 30,2005 and 2004, respectively, and $0.2 million and $0.5 million in thenine-month periods ended September 30, 2005 and 2004, respectively, representing0% and 5% of consolidated revenue for the three-month periods ended September30, 2005 and 2004, respectively, and 1% and 2% of consolidated revenue for thenine-month periods ended September 30, 2005 and 2004, respectively. Costsincurred with this alliance with Merck amounted to $0.0 million and $0.8million in the three-month periods ended September 30, 2005 and 2004,respectively, and $0.1 and $0.8 million in the nine-month periods endedSeptember 30, 2005 and 2004, respectivley.

 

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

 

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

 

15

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term of the contract. Revenues and costs attendant to this contract with the NIAID amounted to$1.2 million and $1.2 million in the three-month period ended September 30,2005 and $3.2 million and $3.2 million in the nine-month period ended September30, 2005, respectively.

 

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

 
| ** ** | ** ** | **For the Three Months**        | ** ** | **For the Nine Months** | ** ** | **2005 as Compared to 2004** | ** ** |
|------------|------------|---------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** ** | ** ** | **Ended September 30,**         | ** ** | **Ended September 30,** | ** ** | **Three Months**             | ** ** | **Nine Months** | ** ** |
| ** ** | ** ** | **2005**                        | ** ** | **2004**                | ** ** | **2005**                     | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except for%)** | ** ** |
| Revenue    |       | $                               | 13,197     |                    | $          | 11,022                       |       | $ | 34,157 |   | $ | 30,939 |   | $ | 2,175 |   | 20 | % | $ | 3,218 |   | 10 | % |
|            |            |                                 |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Specifically,the increase in revenue for the three and nine-month periods ended September30, 2005 as compared to the same periods last year is on account of grantmonies received, service contract fees, a technology access fee installmentreceived from Merck, and also reflects the completion of research funding underthe 2002 agreement with Roche offset somewhat by revenues in our alliance toco-develop inhibitors of PDE4.

 

AtSeptember 30, 2005, we had $13.1 million in deferred revenue, compared to $15.9million at the close of 2004. 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 costs incurred in connection with collaborative programs for thethree and nine-month periods ended September 30, 2005 and 2004 is asfollows:

 
| ** **                                         | ** ** | **For the Three Months**         | ** ** | **For the Nine Months** | ** ** | **2005 as Compared to 2004** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                         | ** ** | **Ended September 30,**          | ** ** | **Ended September 30,** | ** ** | **Three Months**             | ** ** | **Nine Months** | ** ** |
| ** **                                         | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                     | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In  thousands, except for%)** | ** ** |
| Cost of Revenue, including Collaborative  Programs |       | $                                | 9,149      |                    | $          | 10,451                       |       | $ | 27,082 |   | $ | 32,104 |   | $ | (1,302 | ) | (12 | )% | $ | (5,022 | ) | (16 | )% |
|                                                    |            |                                  |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

Ourcost of revenue, including costs incurred in connection with collaborativeprograms for the three-months ended September 30, 2005 as compared to the sameperiod in 2004 includes (ii) less in chemicals and consumables ($0.7 million),(iii) lower allocation of overheads, depreciation and amortization ($1.4million), and (iv) an increase in contractor services ($0.5 million).

 

Ourcost of revenue, including costs incurred in connection with collaborativeprograms for the nine-months ended September 30, 2005 as compared to the sameperiod in 2004 includes (i) an overall decrease in salary and employee relatedexpenses ($0.8 million), and (ii) less in chemicals and consumables ($1.8million), together driving (iii) lower allocation of overheads, depreciationand amortization ($3.0 million).

 

Therelative strengthening of the Icelandic krona versus the U.S. dollar over theperiods presented has affected the U.S. dollar reported amounts of our expensespaid in Icelandic krona (e.g.,increases of approximately $0.4 million and $1.2million for the three and nine-month periods ended September 30, 2005, respectively,on a portion of our salary and employee related expenses included in cost ofrevenue). Although we have experienced this relative currency exchangereversing somewhat of late, this general trend in the currencies may continue.

 

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

 
| ** **                                       | ** ** | **For the Three Months**         | ** ** | **For the Nine Months** | ** ** | **2005 as Compared to 2004** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Ended September 30,**          | ** ** | **Ended September 30,** | ** ** | **Three Months**             | ** ** | **Nine Months** | ** ** |
| ** **                                       | ** ** | **2005**                         | ** ** | **2004**                | ** ** | **2005**                     | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **(In thousands, except for %)** | ** ** |
| Research and  Development - Proprietary Programs |       | $                                | 10,989     |                    | $          | 6,507                        |       | $ | 30,069 |   | $ | 16,010 |   | $ | 4,482 |   | 69 | % | $ | 14,059 |   | 88 | % |
|                                                  |            |                                  |            |                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theincrease in our research and development expenses in proprietary programsresults from our emphasis on and increasing expenditures in product developmentclinical work and pre-clinical preparations on our lead drug development programs.Importantly, 

 

16

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basedon the results of our Phase IIa clinical trial of DG031and follow-on Phase IIstudies in Iceland, we are designing an information-rich, multi-center, pivotalPhase III outcome trial in the Americas, Iceland and Europe to test DG031 forthe prevention of heart attack, which we expect to begin after finalizing theprotocol with the FDA under a Special Protocol Assessment.  Also, our IND application for DG041 wasaccepted by the FDA in February 2005 and on this basis we began the Phase I programfor this compound in the U.S. in March of 2005. The multiple-dose and food effect Phase I trial of DG041 began in thesecond quarter 2005 and we expect to announce preliminary results from thePhase I program in the first half of 2006. In addition, we commenced a Phase II trial in Iceland for asthma with athird party compound during the second quarter of 2005.  Further, among other pre-clinical programs weare developing a compound to inhibit the LTA4 hydrolase, a protein encoded by asecond gene within the same pathway targeted by DG031 that we have also linkedto significantly increased risk of heart attack, and we have begun a PDE4inhibitor program for vascular disease/stroke pursuant to our 2004 agreementwith Roche.

 

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

 
| ** **                                       | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                            | ** ** |
|                                             |       |                                          |       |                                         |       |   |   |   |   |
| Salaries and other personnel costs               |       | $                                             | 4,139      |                                         | $          | 2,631 |   | $ | 12,269 |   | $ | 6,850 |   |
| Materials and supplies                           |       | 970                                           |       | 1,135                                        |       | 3,167 |   | 2,498 |   |
| Contractor services and other third party  costs |       | 4,009                                         |       | 828                                          |       | 9,073 |   | 2,044 |   |
| Overhead expenses                                |       | 1,153                                         |       | 339                                          |       | 3,185 |   | 1,274 |   |
| Depreciation and amortization                    |       | 685                                           |       | 1,471                                        |       | 2,342 |   | 3,103 |   |
| Stock-based compensation and remuneration        |       | 33                                            |       | 103                                          |       | 33 |   | 241 |   |
|                                             |       | $                                             | 10,989     |                                         | $          | 6,507 |   | $ | 30,069 |   | $ | 16,010 |   |

 

Increasesin the research and developments costs of our proprietary programs (e.g.,salaries and attendant costs, contractor services) will likely continue,particularly as we advance our clinical development and proprietary drugdevelopment 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.  Also, the relativestrengthening of the Icelandic krona versus the U.S. dollar over the periodspresented has affected the U.S. dollar reported amounts of our expenses paid inIcelandic krona (e.g., increases of approximately $0.3 million and $0.9 millionfor the three and nine-month periods ended September 30, 2005, respectively, ona portion of our salary and employee related expenses included in research anddevelopment). Although we have experienced this relative currency exchangereversing somewhat of late, this general trend in the currencies may continue.

 

*Selling, General and AdministrativeExpense.*  Selling,general and administrative expense for the three and nine-month periods endedSeptember 30, 2005 and 2004 is as follows:

 
| ** **                           | ** ** | **For the  Three Months**         | ** ** | **For the  Nine Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **Ended  September 30,**          | ** ** | **Ended  September 30,** | ** ** | **Three  Months**             | ** ** | **Nine  Months** | ** ** |
| ** **                           | ** ** | **2005**                          | ** ** | **2004**                 | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In  thousands, except for %)** | ** ** |
| Selling, General and Administrative. |       | $                                 | 4,840      |                     | $          | 4,339                         |       | $ | 13,692 |   | $ | 14,191 |   | $ | 501 |   | 12 | % | $ | (499 | ) | (4 | )% |
|                                      |            |                                   |            |                          |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Ourselling, general and administrative expenses for the three-month period endedSeptember 30, 2005 increased as compared to the same period a year-ago withmodest increases in most expense categories. Our selling, general and administrativeexpenses for the nine-month period ended September 30, 2005 decreased ascompared to the same period a year-ago. Legal expenses have increased $0.4 million for the nine-month periodended September 30, 2005 as compared to the same period in 2004 largely onaccount of increased activity around our intellectual property and patentapplications.  Cost for contractorservices, however, have decreased $0.4 chiefly due to efficiencies gained inthis second year of implementation of the provisions of the Sarbanes Oxley Actof 2002.  There is also a relativedecrease in our selling, general and administrative expenses for the nine-monthperiod ended September 30, 2005 periods as compared to the same period ayear-ago due to severance costs ($0.6 million) and an accrual for probablelosses related to grant monies received in pre-acquisition periods of MediChem($0.4 million) recorded in the 2004 periods.

 

Wehave granted salary increases to our personnel and are making efforts torecruit new members to our Board of Directors – which will increase ourselling, general and administrative expenses. Further, the relative strengthening of the Icelandic krona versus theU.S. dollar over the periods presented has affected the U.S. dollar reportedamounts of our expenses paid in Icelandic krona (e.g., increases ofapproximately $0.1 million and $0.5 million for the three and nine-monthperiods ended September 30, 2005, respectively, on a portion of our salary andemployee related expenses included in selling, general and administrativeexpenses).  

 

17

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Althoughwe have experienced this relative currency exchange reversing somewhat of late,this general trend in the currencies may continue.

 

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

 
| ** **                                         | ** ** | **For the  Three Months**         | ** ** | **For the  Nine Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|----------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **                                         | ** ** | **Ended  September 30,**          | ** ** | **Ended  September 30,** | ** ** | **Three  Months**             | ** ** | **Nine  Months** | ** ** |
| ** **                                         | ** ** | **2005**                          | ** ** | **2004**                 | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(In  thousands, except for %)** | ** ** |
| Stock Based Compensation and Remuneration  Expense |       | $                                 | 55         |                     | $          | 136                           |       | $ | 171 |   | $ | 558 |   | $ | (81 | ) | (60 | )% | $ | (387 | ) | (69 | )% |
|                                                    |            |                                   |            |                          |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

 

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

 
| ** **      | ** ** | **For the  Three Months**         | ** ** | **For the  Nine Months** | ** ** | **2004 as  Compared to 2003** | ** ** |
|-----------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **      | ** ** | **Ended  September 30,**          | ** ** | **Ended  September 30,** | ** ** | **Three  Months**             | ** ** | **Nine  Months** | ** ** |
| ** **      | ** ** | **2005**                          | ** ** | **2004**                 | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In  thousands, except for %)** | ** ** |
| Interest Income |       | $                                 | 1,631      |                     | $          | 925                           |       | $ | 4,284 |   | $ | 1,906 |   | $ | 706 |   | 76 | % | $ | 2,378 |   | 125 | % |
|                 |            |                                   |            |                          |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

 
| ** **       | ** ** | **For the  Three Months**         | ** ** | **For the  Nine Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **       | ** ** | **Ended  September 30,**          | ** ** | **Ended  September 30,** | ** ** | **Three  Months**             | ** ** | **Nine  Months** | ** ** |
| ** **       | ** ** | **2005**                          | ** ** | **2004**                 | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In  thousands, except for %)** | ** ** |
| Interest Expense |       | $                                 | 1,686      |                     | $          | 2,716                         |       | $ | 5,775 |   | $ | 6,028 |   | $ | (1,030 | ) | (38 | )% | $ | (253) |   | (4 | )% |
|                  |            |                                   |            |                          |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

 

*Other Non-Operating Income andExpense, Net.*  Othernon-operating income and expense for the three and nine-month periods endedSeptember 30, 2005 and 2004 is as follows:

 
| ** **                                     | ** ** | **For the  Three Months**         | ** ** | **For the  Nine Months** | ** ** | **2005 as  Compared to 2004** | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-------------------------------|------------|
| ** **                                     | ** ** | **Ended  September 30,**          | ** ** | **Ended  September 30,** | ** ** | **Three  Months**             | ** ** | **Nine  Months** | ** ** |
| ** **                                     | ** ** | **2005**                          | ** ** | **2004**                 | ** ** | **2005**                      | ** ** | **2004** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **(In  thousands, except for %)** | ** ** |
| Other Non-Operating Income and (Expense),  Net |       | $                                 | 466        |                     |       | (436                          | )          | $ | (3,461 | ) | $ | (2,329 | ) | $ | (902 | ) | (207) | % | $ | 1,132 |   | 49 | % |
|                                                |            |                                   |            |                          |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

18

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Our other non-operatingincome and expense, net consists principally of the net impact of foreignexchange and unrealized and realized gains and losses on derivative financialinstruments and, in the nine-month period ended September 30, 2005, loss on earlyextinguishment of debt.

 

As a consequence of thenature of our business and operations, our reported financial results and cashflows are exposed to the risks associated with fluctuations in the exchangerates of the U.S. dollar, the Icelandic krona and other world currencies. Thenet impact of foreign exchange on the translated amount of our non-US dollardenominated liabilities, net together with transaction gains and losses,amounted to a gain of of $0.5 million and a loss of $0.4 million for the three-monthperiods ended September 30, 2005 and 2004, respectively, and losses of $0.1million and $0.9 million for the nine-month periods ended September 30, 2005and 2004, respectively.  The continuedweakening of the U.S. dollar compared to the Icelandic krona during 2004 and2005 was significant and, although we have experienced this relative currencyreversing somewhat of late, this general trend in the currencies may continueto adversely affect our financial results.

 

Our losses on derivativefinancial instruments in the nine-month period ended September 30, 2005 ($0.2million) resulted from three forward foreign currency exchange options weentered into as economic hedges against foreign exchange rate fluctuations thatwe expected may occur on our ISK-denominated operating expenses but that didnot qualify for hedge accounting.

 

Our losses on derivativefinancial instruments in the nine-month period ended September 30, 2004 stemfrom the two cross-currency swaps we entered into as economic hedges againstforeign exchange rate fluctuations that may have occurred on our foreigncurrency debt but that did not qualify for hedge accounting. In March 2004, weliquidated our two cross-currency swaps receiving $9.7 million in proceeds. Werealized a loss on this early termination that, together with unrealized losseson the swaps during the nine-month period ended September 30, 2004, amounted to$1.5 million.

 

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

 

**Liquidity and CapitalResources**

 

We have financed our operations primarily through fundingfrom research and development collaborative agreements, and the issuance ofequity securities and long-term financing instruments ($817 million fromthe beginning of 1999 to-date). Future funding under terms of our existingagreements is approximately $75 million excluding milestone payments androyalties that we may earn under such collaborations.

 

Although we rely on funded research arrangements for aportion of our revenue, we continue to invest in proprietary research anddevelopment and we will incur the costs of such activities. In the near term,this will require 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, manufacture, 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.

 

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

 

19

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| ** **                                  | ** ** | **For the  Nine Month  Periods Ended September 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **(In  thousands)**                                       | ** ** |
|                                        |       |                                                      |       |   |   |
| **Cash provided by (used in):**             |       |                                                      |       |   |   |
| Operating activities                        |       |                                                      | (39,795    | ) |   | (19,387 | ) |
| Investing activities                        |       | 48,226                                                    |       | (100,917 | ) |
| Financing activities                        |       | (46,909                                                   | )          | 161,386 |   |
|                                        |       |                                                      |       |   |   |
| Cash and cash equivalents, at end of period |       | 31,760                                                    |       | 109,751 |   |
|                                             |            |                                                           |            |  |  |  |  |

 

*Cash andCash Equivalents.*  At September 30, 2005, we had $31.8 millionin cash and cash equivalents. Together with our investments at September 30,2005 ($139.3 million), this balance has decreased just $27.3 million from theclose of the year-ended 2004. Significant cash flows during the nine-monthperiod ended September 30, 2005 include, the net proceeds from the sale andleaseback financing of our Sturlugata 8 headquarters facility ($54.8 million),the net proceeds from the sale and leaseback financing of our Krokhals facility($7.6 million), prepayments of short and long-term debts secured by mortgageson Sturlugata 8 ($38.6 million), prepayments of short and long-term debtssecured by mortgages on our Krokhals facility ($1.8 million), refinancing ofthe mortgage on our Woodridge, IL facility ($4.0 million), other debt service($2.3 million), capital expenditures ($2.5 million), and costs associated withthe advancement of our drug development programs as reflected in the $39.8million of cash we used in operating activities during the nine-month periodended September 30, 2005.

 

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

financial institutions in Iceland, the United Kingdom and the UnitedStates having a high credit standing (A-/A3 or better). We expect to maintainour portfolio of cash equivalents and investments in a variety of securities,including auction rate securities commercial paper, money market funds, mutualfund investments and government and non-government debt securities.

 

At September 30, 2005, ourcash is largely invested in U.S. dollar denominated money market and checkingaccounts and also in Icelandic krona denominated accounts. At September 30,2005, our investments are in auction rate securities, US government agencysecurities and a mutual fund.

 

*OperatingActivities.* Net cashused in operating activities increased to $39.8 million for the nine-monthperiod ended September 30, 2005 as compared to $19.4 million in the same periodin 2004.  As more fully described above,the increase in use of cash in operating activities is most importantlyattributable to the significant research and development investments being madein advancing our drug and clinical development programs.  The balance of our deferred revenue hasdecreased during 2005 as we recognize revenue as work progresses undercollaborative contracts with significant up-front monies paid.  Also, during 2005, we have experienced loweraverage turnover of our receivables largely on account of monies due undergrants.

 

*InvestingActivities.* Ourinvesting activities have consisted of short-term investments, capitalexpenditures and, in the nine-month period ended September 30, 2005, the saleand leaseback of our headquarters facilities at Sturlugata, and Krokhals 5D and5E in Reykjavik, Iceland.

 

Investments made during thenine-month period ended September 30, 2005 consist mainly of auction ratesecurities, US government securities and in an intermediate term bond mutualfund.

 

We principally madereplacement capital expenditures during 2004 and 2005 and did invest in certainequipment for our laboratories.  We haveexperienced the pace of necessary capital expenditures increase somewhat oflate and this trend may continue. Although we expect we will continue to make principally replacementcapital expenditures in the near-term, net cash used in investing activitiesmay in the future fluctuate significantly from period to period due to timingof our capital expenditures and other investments as well as changing businessneeds.

 

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

 

*FinancingActivities.* Net cashof $46.9 million was used in financing activities in the nine-month periodended September 30, 2005, as compared to $161.4 million that was provided inthe nine-month period ended September 30, 2004. Financing activities for the 

 

20

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nine-month period endedSeptember 30, 2005 largely consisted of prepayments of short and long-termdebts secured by mortgages on Sturlugata 8 ($38.6 million), prepayments oflong-term debts secured by mortgages on Krokhals 5D and 5E ($1.8 million)refinancing of the mortgage on our Woodridge, IL facility ($4.0 million) whichfreed-up $6.0 million of previously restricted cash which is reflected above ininvesting activities, and other debt service ($2.3 million). Financingactivities for the nine-month period ended September 30, 2004 largely consistedof net proceeds from our convertible notes ($143.8 million), equity proceedsand a portion of the up-front monies received by us in the Information RichClinical Trial alliance with Merck ($13.6 million), proceeds in the liquidationof our two cross-currency swap ($9.7 million) and installment payments on debtand capital lease obligations ($6.8 million).

 

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

 

In March 2005, werefinanced the mortgage on our Woodridge, IL facility, paying-down the $10.2million then existing mortgage and eliminating restricted cash collateraltotaling $6.0 million.  The principalamount of the new mortgage ($6.2 million) is payable in monthly installments of$26,000 for five years and a final payment of $5.5 million due in June2007.  The new mortgage carries aninterest rate of three-month LIBOR + 2.25% (5.77% atSeptember 30, 2005).

 

A portion ofthe proceeds from the sale of Krokhals 5D and 5E were used to prepayapproximately $1.8 million of long-term debt that was secured by a mortgage onthe property.  deCODE has leased theKrokhals 5D and 5E property back under a 15 year non-cancelable lease agreementat a rent of 4.1 million Icelandic kronas (approximately $0.07 million as ofSeptember 30, 2005) per month, subject to changes based on the Icelandicconsumer price index.  The lease is anoperating lease and, as a result, Icelandic krona denominated rent will beincluded in operating expenses over the 15 year term of the lease agreement

 

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

 
| ** **                                         | ** ** | ** **          | ** ** | **Less  Than  1 Year** | ** **     | **Payments  Due by period** | ** **     | **More  than  5 Years** | ** ** |
|----------------------------------------------------|------------|---------------------|------------|------------------------|----------------|-----------------------------|----------------|-------------------------|------------|
| ** **                                         | ** ** | **Total**           | ** ** | ** **             | **1-3  Years** | ** **                  | **3-5  Years** | ** **              | ** ** |
| ** **                                         | ** ** | **(In  thousands)** | ** ** |
| 3.5% senior convertible notes, including  interest |       | $                   | 181,500    |                   | $              | 5,250                       |           | $                       | 10,500     |   | $ | 10,500 |   | $ | 155,250 |   |
| Long-term debt, including interest                 |       | 6,869               |       | 899                    |           | 5,970                       |           | 0                       |       | 0 |   |
| Capital lease obligations, including  interest     |       | 1,728               |       | 1,385                  |           | 314                         |           | 29                      |       | 0 |   |
| Operating leases                                   |       | 73,935              |       | 5,692                  |           | 10,558                      |           | 10,096                  |       | 47,589 |   |
|                                               |       | $                   | 264,032    |                   | $              | 13,226                      |           | $                       | 27,342     |   | $ | 20,625 |   | $ | 202,839 |   |

 

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

 

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

**THAT MAY AFFECT FUTURE RESULTS**

 

This Quarterly Report on Form 10-Q containsforward-looking statements. These statements relate to future events or ourfuture financial performance. In some cases, forward-looking statements can beidentified by terminology such as “may,” “will,” “should,” “could,” “expect,”“plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential”or “continue” or the negative of such terms or other comparable terminology.These statements are only predictions. We cannot assure our investors that ourexpectations and assumptions will prove to have been correct. We undertake no intentionor obligation to update or revise any forward-looking statements, whether as aresult of future events, new information or otherwise. Actual events or resultsmay differ materially due to a number of factors, including those set forth inthis section and elsewhere in this Form 10-Q. These factors include, butare not limited to, the risks set forth below.

 

**RisksRelated to Our Business**

 

***We may not successfully developor derive revenues from any products.***

 

21

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

 

•                  establish thatthey are safe and effective;

 

•                  successfully competewith other technologies and products;

 

•                  ensure that they do notinfringe on the proprietary rights of others;

 

•                  establish that they canbe manufactured in sufficient quantities at reasonable costs;

 

•                  obtain and maintainregulatory approvals for them; and

 

•                  can market them successfully.

 

We may not be able tomeet these conditions.  We expect that itwill be years, if ever, before we will recognize significant revenue from thedevelopment of therapeutic or diagnostic products.

 

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

 

We incurred a net loss of$41.6 million for the nine-months ended September 30, 2005 and $57.3million for the year ended December 31, 2004, and had an accumulated deficit of$429.1 million at September 30, 2005. We have never generated a profit and we have not generated revenuesexcept for payments received in connection with our research and developmentcollaborations with Roche, Merck and others, from contract services and undergrants.  Our research and developmentexpenditures and general and administrative costs have exceeded our revenue todate, and we expect to spend significant additional amounts to fund researchand development in order to enhance our core technologies and undertake productdevelopment (including drug development and related clinical trials).  We do not expect to receive royalties orother revenues from commercial sales of products developed using our technologyin the near term.  It may be severalyears before product revenues materialize, if they do at all.  As a result, we expect to incur net lossesfor several years.  If the time requiredto generate product revenues and achieve profitability is longer than wecurrently anticipate or the level of losses is greater than we currentlyanticipate, we may not be able to continue our operations.

 

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

 

The products we hope todevelop involve new and unproven approaches. They are based on the assumption that information about genes may helpscientists to better understand complex disease processes.  Scientists generally have a limitedunderstanding of the role of genes in diseases, and few products based on genediscoveries have been developed. Of the products that exist, all are diagnosticproducts.  To date, we know of notherapeutic products based on disease-gene discoveries.  If our assumption about the role of genes inthe disease process is wrong, our gene discovery programs may not result inproducts.

 

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

 

Before obtaining regulatoryapprovals for the commercial sale of any of our products under development, wemust demonstrate through pre-clinical studies and clinical trials that theproduct is safe and effective for use in each target indication.  Pre-clinical testing and clinical developmentare long, expensive and uncertain processes. It may take several years to complete testing for a product and failurecan occur at any stage of testing.  Thelength of time necessary to complete clinical trials varies significantly andmay be difficult to predict.  Factorsthat can cause delay or termination of our clinical trials include:

 

•                  slower than expectedpatient enrollment due to the nature of the protocol, the proximity of patientsto clinical sites, the eligibility criteria for the study, competition withclinical trials for other drug candidates or other factors;

 

•                  lower than expectedretention rates of patients in a clinical trial;

 

•                  delayed approval of studyprotocol and pharmacogenomic components of studies by regulatory agencies indifferent 

 

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countries, some of which are still developing policieswith respect to pharmacogenomic testing;

 

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

 

•                  delays inapprovals or failure to obtain approval from the pertinent review boards orregulatory authorities;

 

•                  longer treatment timerequired to demonstrate effectiveness or determine the appropriate product dose;

 

•                  lack of sufficient supplyof the product candidate;

 

•                  adverse medical events orside effects in treated patients;

 

•                  lack of effectiveness ofthe product candidate being tested; and

 

•                  regulatorychanges.

 

Even if we obtainpositive results from pre-clinical or clinical trials for a particular product,we may not achieve the same success in future trials of that product.  In addition, some or all of the clinicaltrials we undertake may not demonstrate sufficient safety and efficacy toobtain the requisite regulatory approvals, which could prevent the creation ofmarketable products.  Our productdevelopment costs will increase if we have delays in testing or approvals, ifwe need to perform more or larger clinical trials than planned or if our trialsare not successful.  Delays in ourclinical trials may harm our financial results and the commercial prospects forour products.  Delays or termination ofclinical trials that we conduct for our partners or customers may also harm ourfinancial results as payments under these contracts may be delayed, reduced orcurtailed.

 

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

 

The use of some of ourtherapeutic products may be dependent upon the selection of patients using bothclinical and genetic markers.  This mayrequire co-development and clinical testing of the therapeutic drug and arelated diagnostic product.  In theUnited States, drug approval could be delayed until we successfully obtain FDAapproval of the related diagnostic product. In addition, if the diagnostic test cannot be performed on acommercially viable basis, it may impede market acceptance of our approvedtherapeutic products.  To successfullyco-develop and market a drug and diagnostic we may also need to establish andmaintain successful partnerships with manufacturing and marketing partners fordiagnostic products.  If necessarypartnerships can not be established or maintained, the development of ourtherapeutics and/or diagnostics may be delayed or may fail.

 

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

 

Historically, asubstantial portion of our revenue has been derived from contracts with alimited number of significant customers. Our largest customer, Roche, accounted for approximately 17% and 28% ofour consolidated revenue in the three-month periods ended September 30,2005 and 2004, respectively, and 21% and 31% of our consolidated revenue in thenine-month periods ended September 30, 2005 and 2004, respectively.  Revenue under our alliances with Merckaccounted for approximately 21% and 28% of our consolidated revenue in thethree-month periods ended September 30, 2005 and 2004, respectively, and19% and 21% of our consolidated revenue in the nine-month periods endedSeptember 30, 2005 and 2004, respectively. The loss of any significant customer may significantly lower ourrevenues and affect the resources available to support our drug discoveryprograms.

 

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

 

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

 

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

 

•                  our ability toattract customers;

 

•                  our ability tocommercialize our discoveries and the resources we devote to commercialization;

 

23

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•                  the amount wespend to enforce patent claims and other intellectual property rights; and

 

•                  the costs andtiming of regulatory approvals.

 

We have relied on, maycontinue to rely on partnerships for significant funding of our researchefforts. In addition, we may seek additional funding through public or privateequity offerings and debt financings.  Wemay not be 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 weraise additional capital by issuing equity securities.

 

If we raise additionalfunds through collaborations and licensing arrangements, we may have torelinquish rights to some of our technologies or product candidates, or grantlicenses on unfavorable terms.  Ifadequate funds are not available, we would have to scale back or terminate ourdiscovery and research programs and product development.

 

***If we cannot successfully developa marketing and sales force or maintain suitable arrangements with thirdparties to market and sell our products, our ability to deliver products may beimpaired.***

 

We currently have noexperience in marketing or selling pharmaceutical products.  In order to achieve commercial success forany approved product, we must either develop a marketing and sales force, whichwill require substantial additional funds and personnel, or, where appropriateor permissible, enter into arrangements with third parties to market and sellour products.  We might not be successfulin developing marketing and sales capabilities. Further, we may not be able to enter into marketing and sales agreementswith others on acceptable terms, and any such arrangements, if entered into,may be terminated.  If we develop our ownmarketing and sales capability, it will compete with other companies thatcurrently have experienced, well-funded and larger marketing and salesoperations.  To the extent that we enterinto co-promotion or other sales and marketing arrangements with othercompanies, revenues will depend on the efforts of others, which may not besuccessful.

 

***If we cannot successfully formand maintain suitable arrangements with third parties for the manufacturing ofthe products we may develop, our ability to develop or deliver products may beimpaired.***

 

We have no experience inmanufacturing products for commercial purposes and do not have manufacturingfacilities that can produce sufficient quantities of drugs for large scaleclinical trials.  Accordingly, we musteither develop such facilities, which will require substantial additionalfunds, or rely on contract manufacturers for the production of products fordevelopment and commercial purposes.  Inorder to conduct our currently planned Phase III clinical trial of DG031,we will have to contract with third parties to manufacture a sufficient supplyof the drug for the trial and to produce tablets containing DG031 in amountssufficient for the clinical trial.  Whilewe have signed contracts with suppliers for the production of DG031 materialand tablets for the planned launch of our Phase III clinical trial, wehave not received the finished drug tablets, and we may fail to securesufficient supply of the drug in a timely manner over the duration of thetrial.

 

The manufacture of ourproducts for clinical trials and commercial purposes is subject to GoodManufacturing Practices (cGMP) regulations promulgated by the FDA.  In the event that we are unable to develop satisfactorymanufacturing facilities or obtain or retain third-party manufacturing for ourproducts, we will not be able to commercialize such products as planned.  We may not be able to enter into agreementsfor the manufacture of future products with manufacturers whose facilities andprocedures comply with cGMP and other regulatory requirements.  Our current dependence upon others for themanufacture of our products may adversely affect our ability to develop and deliversuch products on a timely and competitive basis and, in the longer term, theprofit margin, if any, on the sale of future products and our ability todevelop and deliver such products on a timely and competitive basis.

 

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

 

The genetic make-up andprevalence of disease generally varies across populations around theworld.  Common complex diseases generallyoccur with a similar frequency in Iceland and other European populations.  However, the populations of other nations maybe genetically predisposed to certain diseases because of mutations not presentin the Icelandic population.  As aresult, we and our partners may be unable to develop diagnostic and therapeuticproducts that are effective on all or a portion of people with suchdiseases.  For our business to succeed,we must be able to apply discoveries that we make on the basis of the Icelandicpopulation to other markets.

 

***If we fail to protectconfidential data adequately, we could incur a liability.***

 

Under laws andregulations in force in Iceland, including applicable European laws, directivesand regulations, all information on individuals that is used in our populationresearch is anonym zed under the protocols and supervision of the DataProtection Authority of Iceland.  If wefail to comply with these laws and regulations, we could lose public supportfor participation in our research and we could be liable to legal action.  Any failure to comply fully with allconfidentiality requirements could lead to liability for damages incurred byindividuals whose privacy is violated, the loss of our customers and reputationand the loss of the 

 

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goodwill andparticipation of the Icelandic population, including healthcareprofessionals.  These eventualities couldmaterially adversely affect our work in Iceland.

 

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

 

Through our wholly ownedsubsidiary Encode ehf., we conduct clinical trials of products we aredeveloping and contract with drug companies and clinical research organizationsto perform a wide range of services to assist them in bringing new drugs tomarket.  Our services include:

 

•                  supervisingclinical trials;

 

•                  data andlaboratory analysis;

 

•                  patientrecruitment; and

 

•                  acting asinvestigators in conducting clinical trials.

 

If, in the courseof these trials or activities,

 

•                  we do notperform our services to contractual or regulatory standards;

 

•                  we fail toobtain permission to conduct trials from the appropriate authorities inIceland;

 

•                  patients orvolunteers suffer personal injury caused by or death from adverse reactions tothe test drugs or otherwise;

 

•                  there aredeficiencies in the professional conduct of the investigators with whom wecontract;

 

•                  our laboratoriesinaccurately report or fail to report lab results; or

 

•                  our informaticsproducts violate rights of third parties,

 

then we could beheld liable for these eventualities by the drug companies and clinical researchorganizations with whom we contract or by study participants.  We maintain product liability insurance forclaims arising from the use of products we are developing in clinical trialsconducted by Encode and are covered by the product liability insurance of thedrug companies and clinical research organizations for whom we provide clinicaltrial services for claims arising from the use of their products in suchtrials.  Such insurance may be inadequateand in any event would not cover the risk of a customer deciding not to dobusiness with us as a result of poor performance or claims for a customer’sfinancial loss as the result of our failure to perform our contractualobligations properly.

 

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

 

The users of anytherapeutic or diagnostic products developed by us or our collaborators as aresult of our discovery or research programs (including participants in ourclinical trials) may bring product liability claims against us.  Except as described above with respect toclinical trials conducted by Encode, we currently do not carry liabilityinsurance to cover such claims (although we expect to obtain such insurance forour Phase III trial of DG031).  Weare not certain that we or our collaborators will be able to obtain suchinsurance or, if obtained, that sufficient coverage can be acquired at areasonable cost.  If we cannot protectagainst potential liability claims, we or our collaborators may find itdifficult or impossible to commercialize products.

 

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

 

Our subsidiaries, deCODEchemistry, Inc., deCODE biostructures, Inc., and Emerald Biosystems, Inc.,provide services and products for third party customers who pay us on afee-for-service or product basis.  Inthis function, we often synthesize compounds and provide recommendations forresearch direction for our customers.  Wealso provide contract research services in X-ray crystallographicstructure determination of protein-ligand complexes for customers, and oftenrecommend targets to customers based on these determinations.

 

We may be liable to ourcustomers for damages if we perform such services negligently or with willfulmisconduct, or if we provide customers with defective products.  We also may be held liable for failure tomeet specifications or failure to comply with other contractualconditions.  While our agreements withcustomers limit our liability and while we carry general 

 

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commercial liabilityinsurance, such contractual limitations may not be effective in the event ofour material breach of the agreements, gross negligence, or willful misconductand such insurance may not be adequate. We also supply compounds for clinical trials conducted by ourcustomers.  In doing so, we may providematerials requiring certification of compliance with cGMP regulationsapplicable to production of such materials. If we are found not to have complied with such requirements, we mayincur liabilities related to such failures. If participants in these trials suffer personal injury or death fromadverse reactions to the test drugs, we could be held liable to our customersor the participants.  We maintain productliability insurance for claims arising from the use of products we supply.  However, such insurance may beinadequate.  Failure to perform tocustomer expectation also may limit future business from our existingcustomers, or could result in the holdback of certain payments due to us.

 

Our facilities where workfor customers is conducted are subject to audits by FDA and by customers.  In the event we are found in non-complianceby FDA, there is a risk that such facility may be subject to correctivemeasures up to and including the closure of the facility.  Such closure would have impact on our abilityto meet customer obligations as well as obligations relating to our internalprograms.  Customer audits may lead todisputes regarding compliance with contractual terms, which could lead topotential disputes and/or liabilities as described above.

 

In addition, we typicallyhave the obligation to maintain the confidentiality of proprietary informationof our customers.  While we have systemsin place to ensure that such confidentiality is protected, we do conduct workon our internal projects at the same facilities where we work for ourcustomers; therefore, there is an increased risk that customers may claim thatwe have violated our confidentiality obligations or used their proprietaryinformation in our proprietary projects.

 

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

 

On September 30,2005, we had $157.9 million of outstanding debt as reflected in our balancesheet.  We may incur additionalindebtedness in the future and our outstanding 3.5% Senior Convertible Notes(the “Notes”) do not restrict our future issuance of indebtedness.  Our level of indebtedness will have severalimportant effects on our future operations, including, without limitation:

 

•                  a portion of ourcash flow from operations will be dedicated to the payment of any interestrequired with respect to outstanding indebtedness;

 

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

 

•                  depending on thelevels of our outstanding debt, our ability to obtain additional financing forworking capital, capital expenditures, general corporate and other purposes maybe limited.

 

Our ability to makepayments of principal and interest on our indebtedness depends upon our futureperformance, which will be subject to the success of our development andcommercialization of new pharmaceutical products, general economic conditions,industry cycles and financial, business and other factors affecting ouroperations, many of which are beyond our control.  If we are not able to generate sufficientcash flow from operations in the future to service our debt, we may berequired, among other things:

 

•                  to seekadditional financing in the debt or equity markets;

 

•                  to refinance orrestructure all or a portion of our indebtedness, including the Notes;

 

•                  to sell selectedassets; or

 

•                  to reduce ordelay expenditures on planned activities, including but not limited to clinicaltrials, and development and commercialization activities.

 

Such measuresmight not be sufficient to enable us to service our debt. In addition, any suchfinancing, refinancing or sale of assets might not be available on economicallyfavorable terms.

 

***We may be unable to hire andretain the key personnel upon whom our success depends.***

 

We depend on theprincipal members of our management and scientific staff, includingDr. Kari Stefansson, Chairman, President and Chief Executive Officer.  We have not entered into agreements with anyof these people that bind them to a specific period of employment.  If any of these people leave, our ability toconduct our operations may be negatively affected. Our future success also willdepend in part on our ability to attract, hire and retain additionalpersonnel.  There is intense competitionfor such qualified personnel and we cannot be certain that we will be able tocontinue to attract and retain such personnel. Failure to attract and 

 

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retain key personnelcould have a material adverse effect on us.

 

***Currency fluctuations maynegatively affect our financial condition.***

 

We primarily expend orgenerate cash in U.S. dollars, our functional currency. We also publish ourconsolidated financial statements in U.S. dollars.  Currency fluctuations can affect ourfinancial results because a portion of our cash reserves, our debt and ouroperating costs are in Icelandic kronas. A fluctuation of the exchange rates of the Icelandic krona against theU.S. dollar can thus adversely affect the “buying power” of our cash reservesand revenues.  Most of our long-termliabilities are U.S. dollar denominated. However, we may enter into hedging transactions if we have substantialforeign currency exposure in the future. We may have increased exposure as a result of investments or paymentsfrom collaborative partners.

 

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

 

Many of our contracts forresearch services are terminable on short notice.  This means that our contracts could beterminated for numerous reasons, any of which may be beyond our control such asa reduction or reallocation of a customer’s research and development budget ora change in a customer’s overall financial condition.  The loss of a large contract or multiplesmaller contracts, or a significant decrease in revenue derived from acontract, could significantly reduce our profitability and require us toreallocate under-utilized physical and professional resources.

 

**Risks Related to OurCollaborative Relationships**

 

***If weare unable to form and maintain the collaborative relationships that ourbusiness strategy requires, our programs will suffer and we may not be able todevelop products.***

 

Our strategy fordeveloping products and deriving revenues from them is dependent, in part, uponour ability to enter into collaborative arrangements with researchcollaborators, corporate partners and others. We may rely on these arrangements both to provide funding necessary toour product development and to obtain goods and services that we require forour product development.  We do not havethe capacity to conduct large scale Phase III clinical trials and willrely on partnerships or third party contractors to conduct our Phase IIItrials, including our currently planned Phase III trial of DG031.  We will rely on these third parties toprovide us with clinical material for the trial and various services necessaryto organize and conduct a multi-center, multinational study, as well as othergoods and services.  We have not enteredinto contracts for all goods and services required for the Phase III trialof DG031 at this time.  Our arrangementfor this and other Phase III trials will be subject to risks describedbelow, with respect to our collaborative relationships.

 

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

 

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

 

We may form collaborativerelationships (including relationships with clinical research organizations toconduct clinical trials on our behalf) that will, in some cases, make usdependent on collaborators for the pre-clinical studies and/or clinical trialsand for regulatory approval of any products that we are developing. Failure ofsuch collaborators to perform under these agreements properly in a timelymanner, or at all, may lead to delays in our product development. In addition,if participants in the trials conducted by our collaborators suffer personalinjury or death as a result of actions of the collaborators, we could be heldliable.  In some cases, our agreements with collaborators typically allowthem significant discretion in electing whether and how to pursue suchactivities. We cannot control the amount and timing of resources collaboratorswill devote to these programs or potential products.

 

Our collaborators maystop supporting our products or providing services to us if they develop orobtain rights to competing products. Disputes may arise in the future over theownership of rights to any technology developed with collaborators. These andother possible disagreements between our collaborators and us could lead todelays in the collaborative research, development or commercialization ofproducts. Such disagreements could also result in litigation or requirearbitration to resolve.

 

**Risks Related to OurIndustry**

 

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

 

Other companies havedeveloped genetic predisposition tests that have raised ethical concerns.  It is possible that employers or others coulddiscriminate against people who have a genetic predisposition to certaindiseases.  Concern regarding possiblediscrimination may result in governmental authorities enacting restrictions orbans on the use of all, or certain types of, genetic 

 

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testing.  Similarly, such concerns may lead individualsto refuse to use genetic tests even if permissible.  These factors may limit the market for, andtherefore the commercial viability of, products that our collaborators and/orwe may develop.

 

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

 

A number of companies areattempting to rapidly identify and patent genes that cause diseases or anincreased susceptibility to diseases. Competition in this field and our other areas of business, includingdrug discovery and development is intense and is expected to increase.  We have numerous competitors, including majorpharmaceutical and diagnostic companies, specialized biotechnology firms,universities and other research institutions, and other government-sponsoredentities and companies providing healthcare information products.  Our collaborators, including Roche and Merck,may also compete with us.  Many of ourcompetitors, either alone or with collaborators, have considerably greatercapital resources, research and development staffs and facilities, andtechnical and other resources than we do, which may allow them to discoverimportant genes or develop drugs based on such discoveries before we do.  We believe that a number of our competitorsare developing competing products and services that may be commerciallysuccessful and that are further advanced in development than our potentialproducts and services.  To succeed, we,together with our collaborators, must discover disease-predisposing genes,characterize their functions, develop genetic tests or therapeutic products andrelated information services based on such discoveries, obtain regulatory andother approvals, and launch such services or products before competitors.  Even if we or our collaborators aresuccessful in developing effective products or services, our products andservices may not successfully compete with those of our competitors, includingcases where the competing drugs use the same mechanism of action as ourproducts.  Our competitors may succeed indeveloping and marketing products and services that are more effective thanours or that are marketed before ours.

 

Competitors haveestablished, and in the future may establish, patent positions with respect togene sequences related to our research projects.  Such patent positions or the publicavailability of gene sequences comprising substantial portions of the humangenome could decrease the potential value of our research projects and make itmore difficult for us to compete.  We mayalso face competition from other entities in gaining access to DNA samples usedfor research and development purposes. Our competitors may also obtain patent protection or other intellectualproperty rights that could limit our rights, or our customers’ ability, to useour technologies or databases, or commercialize therapeutic or diagnosticsproducts.  In addition, we face, and willcontinue to face, intense competition from other companies for collaborativearrangements with pharmaceutical and biotechnology companies, for establishingrelationships with academic and research institutions and for licenses toproprietary technology.

 

We expect competition to intensify as technical advances are made andbecome more widely known.  Our futuresuccess will depend in large part on maintaining a competitive position in thegenomic field.  Rapid technologicaldevelopment may result in products or technologies becoming obsolete before werecover the expenses we incur in developing them.

 

Our ability to competesuccessfully will depend, in part, on our ability, and that of ourcollaborators, to:

 

•              develop proprietaryproducts;

 

•              develop and maintainproducts that reach the market first, and are technologically superior to, andmore cost effective than, other products on the market;

 

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

 

•              attract and retainscientific and product development personnel;

 

•              obtain requiredregulatory approvals; and

 

•              manufacture, marketand sell products that we develop.

 

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

 

Economic factors andindustry trends that affect our primary customers, pharmaceutical andbiotechnology companies, also affect our business.  For example, the practice of many companiesin these industries has been to outsource to organizations like us the conductof genetic research, clinical research, sales and marketing projects andchemistry and structural biology research and development projects.  If these industries reduce their presenttendency to outsource those projects, our operations, financial condition andgrowth rate could be materially and adversely affected.  These alliances and arrangements are bothtime consuming and complex and we face substantial competition in establishingthese relationships.  In addition, ourability to generate new business could be impaired by general economicdownturns in our customers’ industries. We have experienced increasing pressure on the part of our 

 

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customers to reduceexpenses, including the use of our services as a result of negative economictrends generally and in the pharmaceutical industry.  If pharmaceutical and biotechnology companiesdiscontinue or decrease their usage of our services, including as a result ofthe slowdown in the overall U.S. economy, our revenues and earnings could belower than we expect and our revenues may decrease or not grow at historicalrates.

 

***If regulatory approvals forproducts resulting from our gene discovery programs are not obtained, we willnot be able to derive revenues from these products.***

 

Government agencies mustapprove new drugs and diagnostic products in the countries in which they are tobe marketed.  We cannot be certain thatwe can obtain regulatory approval for any drugs or diagnostic productsresulting from our gene discovery programs. The regulatory process can take many years and require substantialresources.  Because some of the productslikely to result from our disease research programs involve the application ofnew technologies and may be based upon a new therapeutic approach, variousgovernment regulatory authorities may subject such products to substantialadditional review.  As a result, theseauthorities may grant regulatory approvals for these products more slowly thanfor products using more conventional technologies.  Furthermore, regulatory approval may imposelimitations on the use of a drug or diagnostic product.

 

Even if a product isapproved for marketing, it and its manufacturer must undergo continuing review.Discovery of previously unknown problems with a product may have adverseeffects on our business, financial condition and results of operations,including withdrawal of the product from the market.

 

***Third party reimbursement andhealth care reform policies may reduce market acceptance of our products.***

 

Our success will dependin part on the price and extent to which we will be paid for our products bygovernment and health administration authorities, private health insurers andother third party payers.  Reimbursementfor newly approved healthcare products is uncertain.  Third party payers, including Medicare in theUnited States, are increasingly challenging the prices charged for medicalproducts and services.  They areincreasingly attempting to contain healthcare costs by limiting both coverageand the level of reimbursement for new therapeutic products.  We cannot be certain that any third partyinsurance coverage will be available to patients for any products we discoveror develop.  If third party payers do notprovide adequate coverage and reimbursement levels for our products, the marketacceptance of these products may be materially reduced.

 

Numerous governments haveundertaken efforts to control growing healthcare costs through legislation,regulation and voluntary agreements with medical care providers andpharmaceutical companies.  If costcontainment efforts limit the profits that can be derived from new drugs, ourcustomers may reduce their research and development spending which could reducethe business they outsource to us.

 

***Our operations involve a risk ofinjury or damage from hazardous materials, and if an accident were to occur, wecould be subject to costly and damaging liability claims.***

 

In the course of ourwork, we handle and produce hazardous materials and chemicals as well ascompounds which may have known or unknown characteristics such as toxicity andreactivity with other compounds. Although we have systems in place to manage such compounds and theircharacteristics, the risk of accidental contamination or injury from thesematerials cannot be completely eliminated. Any such contamination or injury could result in negative effects to ourpersonnel or facilities, which could lead to liabilities as well as impactingour ability to meet customer obligations and conduct our internal programs.

 

**Risks Related to OurIntellectual Property**

 

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

 

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

 

While we requireemployees, business partners, academic collaborators and consultants to enterinto confidentiality agreements, there can be no assurance that proprietaryinformation will not be disclosed, that others will not independently developsubstantially equivalent proprietary information and techniques, otherwise gainaccess to our trade secrets or disclose such technology, or that we canmeaningfully protect our trade secrets.

 

Our commercial successwill depend in part on obtaining patent protection.  The patent positions of pharmaceutical,biopharmaceutical and biotechnology companies, including deCODE, are generallyuncertain and involve complex legal and factual considerations. We cannot besure that:

 

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•                  any of ourpending patent applications will result in issued patents;

 

•                  we will developadditional proprietary technologies that are patentable;

 

•                  any patentsissued to us or our partners will provide a basis for commercially viableproducts, will provide us with any competitive advantages or will not bechallenged by third parties; or

 

•                  the patents ofothers will not have an adverse effect on our ability to do business.

 

If we are unableto obtain patent protection for our technology or discoveries, the value of ourproprietary resources may be adversely affected.

 

In addition, patent lawrelating to the scope of claims in the area of genetics and gene discovery isstill evolving and subject to uncertainty, including in areas important to ussuch as patenting of discoveries for the development of therapeutic methods,diagnostic methods and products that predict inherited susceptibility todiseases and diagnostic methods and products that predict drug response anddisease progression.  Accordingly, thedegree of future protection for our proprietary rights is uncertain and, we cannotpredict the breadth of claims allowed in any patents issued to us orothers.  We could also incur substantialcosts in litigation if we are required to defend ourselves in patent suitsbrought by third parties or if we initiate such suits to enforce our ownpatents against potential infringers.

 

Others may have filed andin the future are likely to file patent applications covering products ortechnology that are similar or identical to our products and technology.  In addition, others may develop competitiveproducts outside the protection that may be afforded by the claims of ourpatents.  We cannot be certain that ourpatent applications will have priority over any patent applications ofothers.  The mere issuance of a patentdoes not guarantee that it is valid or enforceable; thus even if we are holdingor are granted patents, we cannot be sure that they would be valid andenforceable against third parties. Further, a patent does not provide the patent holder with freedom tooperate in a way that infringes the patent rights of others.  Any legal action against us or our partnersclaiming damages and seeking to enjoin commercial activities relating to theaffected products and processes could, in addition to subjecting us topotential liability for damages, require us or our partners to obtain a licensein order to continue to manufacture or market the affected products andprocesses.  There can be no assurancethat we or our partners would prevail in any action or that any licenserequired under any patent would be made available on commercially acceptableterms, if at all.  If licenses are notavailable, we or our partners may be required to cease marketing our productsor practicing our methods.

 

If expressed sequencetags, single nucleotide polymorphisms, or SNPs, or other sequence informationbecome publicly available before we apply for patent protection on acorresponding full-length or partial gene, our ability to obtain patentprotection for those genes or gene sequences could be adversely affected.  In addition, other parties are attempting torapidly identify and characterize genes through the use of gene expressionanalysis and other technologies.  If anypatents are issued to other parties on these partial or full-length genes orgene products or uses for such genes or gene products, the risk increases thatthe sale of our or our collaborators’ potential products or processes may giverise to claims of patent infringement. The amount of supportive data required for issuance of patents for humantherapeutics is highly uncertain.  Ifmore data than we have available is required, our ability to obtain patentprotection could be delayed or otherwise adversely affected.  Even with supportive data, the ability toobtain patents is uncertain in view of evolving examination guidelines, such asthe utility and written description guidelines that the U.S. Patent andTrademark Office have adopted.

 

***Our patent protection for DG031may provide marketing exclusivity for only a limited term.***

 

The patents we licensedfrom Bayer for DG031 expire in 2009 and 2012. While we will seek to obtain one or more use patents protecting ourproprietary rights to specific uses of this compound for a longer period, wecannot be certain that we will obtain such patents or that they will adequatelyprotect us.  In addition, although we mayseek to extend the term of one of the patents we licensed from Bayer and toobtain marketing exclusivity under the Hatch-Waxman Act and equivalent foreignstatutes, we cannot be certain that we will be successful.  Expiration of patent(s) prior to regulatoryapproval may affect our ability to gain the full benefit of such possible termextension/marketing exclusivity. Further, even if regulatory approval is received before patentexpiration, the U.S. Patent and Trademark Office and/or FDA may not rule on ourapplication for term extension in a timely manner.  If we cannot obtain new patents or fullyextend the term of patent protection under one of the patents we licensed fromBayer, the amount of revenues that we will be able to derive from an approvedproduct based on these patents may be adversely affected.

 

***Any patent protection we obtainfor our products may not prevent marketing of similar competing products.***

 

Patents on our productsmay not prevent our competitors from designing around and developing similarcompounds or compounds with similar modes of action that may competesuccessfully with our products.  Suchthird party compounds may prove to be superior to our products or gain widermarket acceptance and thus adversely affect any revenue stream that we couldotherwise 

 

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expect from sales of ourproducts.

 

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

 

Patents on new drugs,which are also commonly referred to as “branded drugs” or “pioneer drugs”, faceincreased scrutiny and challenges in the courts from manufacturers of genericdrugs who may receive benefits such as limited marketing co-exclusivity if thechallenge is successful.  Such patent challengestypically occur when the generic manufacturer files an Abbreviated New DrugApplication with the FDA and asserts that the patent or patents covering thebranded drug are invalid or unenforceable, forcing the owner or licensee of thebranded drug to file suit for patent infringement.  If any patents we obtain are subject to suchsuccessful patent challenges, our marketing exclusivity may be eliminated orreduced in time, which would thus adversely affect any revenue stream that wecould otherwise expect from sales of our products.

 

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

 

The primary objectives ofour investment activities are to preserve principal, maintain a high degree ofliquidity to meet operating needs, provide for prudent diversification of ourinvestments, and obtain competitive returns subject to prevailing marketconditions. Investments are made primarily in high-grade corporate bonds,asset-backed debt securities, U.S. government agency debt securities and an intermediate term bond fund investment.These investments are subject to risk of default, changes in credit rating andchanges in market value. These investments are also subject to interest raterisk and will decrease in value if market interest rates increase. Ahypothetical 100 basis point increase in interest rates would result in anapproximate $0.6 million decrease in the fair value of our investments as ofSeptember 30, 2005. Due to the nature of our investments and relatively shorteffective maturities of debt instruments, interest rate risk is mitigated.Changes in interest rates do not affect interest expense incurred on thecompany’s Convertible Notes, because the Convertible Notes bear interest at afixed rate. Using the price in the latest trade in June 2005, the market valueof the Convertible Notes was $128.3 million on September 30, 2005.

 

As a consequence of thenature of our business and operations our reported financial results and cashflows are exposed to the risks associated with fluctuations in the exchangerates of the U.S. dollar, the Icelandic krona and other world currencies. Wecontinue to monitor our exposure to currency risk. A hypothetical 10.0%decrease in value of the US dollar against the Icelandic krona would result ina loss of approximately $0.2 million on our Icelandic krona denominated assetsand liabilities. We have historically used derivative financial instruments tohedge these general risks.

 

As of September 30, 2005 wedid not have any financing arrangements that were not reflected in our balancesheet.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

 

In designing and evaluating our disclosurecontrols and procedures, our management recognizes that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance that the desired objectives of the control system will bemet. In addition, the design of any control system is based in part uponcertain assumptions about the likelihood of future events and the applicationof judgment in evaluating the cost-benefit relationship of possible controlsand procedures. Because of these and other inherent limitations of controlsystems, there is only reasonable assurance that our controls will succeed inachieving their goals under all potential future conditions.

 

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

 

**PART IIOTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

Therehas been no change in the matters reported in our quarterly report on Form 10-Qfor the quarter ended June 30, 2005.

 

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

 

(a)EXHIBITS

 

The following is a list ofexhibits filed as part of this Quarterly Report on Form 10-Q.

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION  OF EXHIBIT**                                                                                                                                                                                                                                         |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                |
| 3.1                 |       | Amended and Restated  Certificate of Incorporation, as further amended (Incorporated by reference  to Exhibit 3.1 and Exhibit 3.3 to the Company’s Registration Statement on  Form S-1 (Registration No. 333-31984) which became effective on July 17,  2000). |
|                |       |                                                                                                                                                                                                                                                                |
| 3.2                 |       | Certificate of Amendment  to Amended and Restated Certificate of Incorporation dated August 30, 2002  (Incorporated by reference to Exhibit 3.2 to the Company’s Quarterly Report  on Form 10-Q filed on November 14, 2002).                                   |
|                |       |                                                                                                                                                                                                                                                                |
| 3.3                 |       | Bylaws, as amended  (Incorporated by reference to Exhibit 3.2 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became effective on  July 17, 2000).                                                                     |
|                |       |                                                                                                                                                                                                                                                                |
| 10.1                |       | Employment  Agreement between deCODE genetics, Inc. and Daniel L. Hartman, effective as  of July 15, 2005.                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                |
| 10.2                |       | Form of  Restricted Stock Agreement (Incorporated by reference to Exhibit 99.1 to the  Company's Current Report on Form 8-K filed August 1, 2005).                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                |
| 31.1                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 31.2                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 32.1                |       | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |

 

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

 

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**SIGNATURES**

 

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

 
| Dated:  November 9, 2005         |
|--------------------------------------------|
|                                       |
| deCODE  genetics, Inc.                     |
|                                       |
|                                       |
|                                       | /s/ Kari Stefansson |   |
| Kari  Stefansson                           |   |
| Chairman,  President,                      |   |
| and  Chief Executive Officer               |   |
|                                       |   |
|                                       |   |
|                                       | /s/ Lance Thibault |   |
| Lance  Thibault                            |   |
| Chief  Financial Officer and               |   |
| Treasurer  (principal financial            |   |
| officer  and principal accounting officer) |   |

 

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| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION  OF EXHIBIT**                                                                                                                                                                                                                                         |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                |
| 3.1                 |       | Amended and Restated  Certificate of Incorporation, as further amended (Incorporated by reference  to Exhibit 3.1 and Exhibit 3.3 to the Company’s Registration Statement on  Form S-1 (Registration No. 333-31984) which became effective on July 17,  2000). |
|                |       |                                                                                                                                                                                                                                                                |
| 3.2                 |       | Certificate of Amendment  to Amended and Restated Certificate of Incorporation dated August 30, 2002  (Incorporated by reference to Exhibit 3.2 to the Company’s Quarterly Report  on Form 10-Q filed on November 14, 2002).                                   |
|                |       |                                                                                                                                                                                                                                                                |
| 3.3                 |       | Bylaws, as amended  (Incorporated by reference to Exhibit 3.2 to the Company’s Registration  Statement on Form S-1 (Registration No. 333-31984) which became effective on  July 17, 2000).                                                                     |
|                |       |                                                                                                                                                                                                                                                                |
| 10.1                |       | Employment  Agreement between deCODE genetics, Inc. and Daniel L. Hartman, effective as  of July 15, 2005.                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                |
| 10.2                |       | Form of  Restricted Stock Agreement (Incorporated by reference to Exhibit 99.1 to the  Company's Current Report on Form 8-K filed August 1, 2005).                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                |
| 31.1                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 31.2                |       | Certification pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
| 32.1                |       | Certification pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                |
|                     |            |                                                                                                                                                                                                                                                                     |  |  |

 

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

 

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