**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM10-Q**

**(MarkOne)**

**x****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**FORTHE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006**

**OR**

**o****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT**

**FORTHE TRANSITION PERIOD FROM                           TO                           **

**COMMISSION FILE NUMBER****000-30469**

**deCODEgenetics, Inc.**

(Exact Name ofRegistrant as Specified in Its Charter)

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

 

**STURLUGATA8, IS-101 REYKJAVIK, ICELAND**

(Address ofPrincipal Executive Offices)

**+354-570-1900**

(Registrant’s TelephoneNumber, Including Area Code)

Indicate by check whetherthe registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  xNo  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (CheckOne):
|  | Large accelerated filer  o | Accelerated filer  x | Non-accelerated filer  o |
|--|---------------------------------|--------------------------------|------------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).    Yes  o    No  x

The aggregate number of shares of the registrant’scommon stock outstanding on October 31, 2006 was 61,535,584 shares of commonstock $.001 par value.

 

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**deCODEgenetics, Inc.**

**INDEX**
| PART I.           | FINANCIAL INFORMATION                                                                                                    |
|-------------------|--------------------------------------------------------------------------------------------------------------------------|
|              |                                                                                                                     |
| Item 1.           | Financial Statements (Unaudited)                                                                                         |
|              |                                                                                                                     |
|              | Condensed Consolidated  Balance Sheets as of September 30, 2006 and December 31, 2005                                    |
|              |                                                                                                                     |
|              | Condensed Consolidated  Statements of Operations for the three and nine-month periods ended September  30, 2006 and 2005 |
|              |                                                                                                                     |
|              | Condensed Consolidated  Statements of Cash Flows for the nine-month periods ended September 30, 2006  and 2005           |
|              |                                                                                                                     |
|              | Notes to Condensed  Consolidated Financial Statements                                                                    |
|              |                                                                                                                     |
| Item 2.      | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                              |
|              |                                                                                                                     |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                                              |
|              |                                                                                                                     |
| Item 4.           | Controls and  Procedures                                                                                                 |
|              |                                                                                                                     |
| PART II.          |   OTHER  INFORMATION                                                                                           |
|              |                                                                                                                     |
| Item 1.           | Legal Proceedings                                                                                                        |
|              |                                                                                                                     |
| Item 1A.          |   Risk Factors                                                                                                 |
|              |                                                                                                                     |
| Item 6.           | Exhibits                                                                                                                 |
|              |                                                                                                                     |
|              | (a) Exhibits                                                                                                             |
|              |                                                                                                                     |
| Signatures        |
|              |                                                                                                                     |
| Index to Exhibits |
|                   |                                                                                                                          |  |

 

2

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**PART I. FINANCIAL INFORMATION**

**ITEM 1.FINANCIAL STATEMENTS**

**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

(Unaudited)
| ** **                                                                                                                                                                                            | ** ** | **September 30,    2006**                     | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **(In thousands, except share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                |       |                                                         |       |                        |       |
| Current assets:                                                                                                                                                                                       |       |                                                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                            |       | $                                                            | 26,849     |                        | $          | 65,943 |   |
| Investments                                                                                                                                                                                           |       | 99,982                                                       |       | 89,611                      |       |
| Receivables                                                                                                                                                                                           |       | 7,271                                                        |       | 7,856                       |       |
| Other current  assets                                                                                                                                                                                 |       | 10,791                                                       |       | 3,541                       |       |
| Total current assets                                                                                                                                                                                  |       | 144,893                                                      |       | 166,951                     |       |
| Property and  equipment, net                                                                                                                                                                          |       | 25,546                                                       |       | 24,500                      |       |
| Goodwill                                                                                                                                                                                              |       | 10,055                                                       |       | 8,863                       |       |
| Other long-term  assets and deferred charges                                                                                                                                                          |       | 9,057                                                        |       | 6,444                       |       |
| Total assets                                                                                                                                                                                          |       | $                                                            | 189,551    |                        | $          | 206,758 |   |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                                                                                                                                                           |       |                                                         |       |                        |       |
| Current  liabilities:                                                                                                                                                                                 |       |                                                         |       |                        |       |
| Accounts payable                                                                                                                                                                                      |       | $                                                            | 9,231      |                        | $          | 4,732 |   |
| Accrued expenses  and other current liabilities                                                                                                                                                       |       | 12,918                                                       |       | 12,823                      |       |
| Current portion  of capital lease obligations                                                                                                                                                         |       | 2,063                                                        |       | 1,313                       |       |
| Current portion  of long-term debt                                                                                                                                                                    |       | 1,052                                                        |       | 550                         |       |
| Deferred revenue                                                                                                                                                                                      |       | 5,542                                                        |       | 6,105                       |       |
| Total current liabilities                                                                                                                                                                             |       | 30,806                                                       |       | 25,523                      |       |
| Capital lease  obligations, net of current portion                                                                                                                                                    |       | 4,033                                                        |       | 1,046                       |       |
| Long-term  debt, net of current portion                                                                                                                                                               |       | 155,987                                                      |       | 155,653                     |       |
| Deferred gain on  sale-leaseback                                                                                                                                                                      |       | 26,200                                                       |       | 27,654                      |       |
| Deferred revenue                                                                                                                                                                                      |       | 6,219                                                        |       | 6,219                       |       |
| Commitments and  contingencies                                                                                                                                                                        |       |                                                         |       |                        |       |
| Stockholders’  deficit:                                                                                                                                                                          |       |                                                         |       |                        |       |
| Preferred stock,  $0.001 par value; Authorized: 6,716,666 shares; Issued and outstanding: none                                                                                                        |       | —                                                       |       | —                      |       |
| Common stock,  $0.001 par value; Authorized: 100,000,000 shares; Issued and outstanding:  61,528,063 at September 30, 2006; and 54,762,095 and 54,742,595 shares,  respectively, at December 31, 2005 |       | 62                                                           |       | 55                          |       |
| Additional paid-in  capital                                                                                                                                                                           |       | 481,599                                                      |       | 444,401                     |       |
| Notes receivable                                                                                                                                                                                      |       | (2,832                                                       | )          | (2,898                      | )          |
| Deferred  compensation                                                                                                                                                                                |       | —                                                       |       | (418                        | )          |
| Accumulated  deficit                                                                                                                                                                                  |       | (512,463                                                     | )          | (450,215                    | )          |
| Accumulated  other comprehensive income                                                                                                                                                               |       | (60                                                          | )          | (139                        | )          |
| Treasury stock,  0 and 19,500 shares stated at cost at September 30, 2006 and December 31,  2005, respectively                                                                                        |       | —                                                       |       | (123                        | )          |
| Total stockholders’ deficit                                                                                                                                                                      |       | (33,694                                                      | )          | (9,337                      | )          |
| Total  liabilities and stockholders’ deficit                                                                                                                                                     |       | $                                                            | 189,551    |                        | $          | 206,758 |   |

 

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

3

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**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)
| ** **                                                     | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except per share amounts)**        | ** ** |
| ** **                                                     | ** ** | ** **                                                                   | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| REVENUE                                                        |       | $                                                                            | 8,566      |                                                                        | $          | 13,197 |   | $ | 29,059 |   | $ | 34,157 |   |
|                                                           |       |                                                                         |       |                                                                        |       |   |   |   |   |
| OPERATING  EXPENSES                                            |       |                                                                         |       |                                                                        |       |   |   |   |   |
| Cost of revenue                                                |       | 11,357                                                                       |       | 9,149                                                                       |       | 31,666 |   | 27,082 |   |
| Research and  development—proprietary programs            |       | 14,178                                                                       |       | 10,989                                                                      |       | 42,902 |   | 30,069 |   |
| Selling, general  and administrative                           |       | 6,938                                                                        |       | 4,840                                                                       |       | 16,597 |   | 13,692 |   |
| Total operating expenses                                       |       | 32,473                                                                       |       | 24,978                                                                      |       | 91,165 |   | 70,843 |   |
| Operating loss                                                 |       | (23,907                                                                      | )          | (11,781                                                                     | )          | (62,106 | ) | (36,686 | ) |
| Interest income                                                |       | 1,834                                                                        |       | 1,631                                                                       |       | 4,882 |   | 4,284 |   |
| Interest expense                                               |       | (1,728                                                                       | )          | (1,686                                                                      | )          | (5,135 | ) | (5,775 | ) |
| Other non-operating  income and (expense), net                 |       | 169                                                                          |       | 466                                                                         |       | 111 |   | (3,461 | ) |
| Net loss                                                       |       | $                                                                            | (23,632    | )                                                                           | $          | (11,370 | ) | $ | (62,248 | ) | $ | (41,638 | ) |
| Basic and  diluted net loss per share                          |       | $                                                                            | (0.40      | )                                                                           | $          | (0.21 | ) | $ | (1.11 | ) | $ | (0.78 | ) |
| Shares used in  computing basic and diluted net loss per share |       | 59,616                                                                       |       | 53,741                                                                      |       | 56,333 |   | 53,685 |   |

 

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

4

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**deCODEgenetics, Inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)
| ** **                                                                   | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(In thousands)**                                                     | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                       |       |                                                                        |       |   |   |
| Net loss                                                                     |       | $                                                                           | (62,248    | ) | $ | (41,638 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                                                                        |       |   |   |
| Depreciation and amortization                                                |       | 5,580                                                                       |       | 5,894 |   |
| Stock-based compensation                                                     |       | 3,138                                                                       |       | 129 |   |
| Amortization of gain on sale-leaseback                                       |       | (1,454                                                                      | )          | (910 | ) |
| Amortization of deferred financing costs                                     |       | 656                                                                         |       | 726 |   |
| Gain on disposal of fixed assets                                             |       | (739                                                                        | )          | (3 | ) |
| Charges for debt extinguishment                                              |       | —                                                                      |       | 1,741 |   |
| Other                                                                        |       | —                                                                      |       | 11 |   |
| Changes in  operating assets and liabilities net of effect of acquisitions:  |       |                                                                        |       |   |   |
| Receivables and other current assets                                         |       | (4,144                                                                      | )          | (3,085 | ) |
| Accounts payable, accrued expenses and other current  liabilities            |       | 3,909                                                                       |       | (167 | ) |
| Deferred revenue                                                             |       | (2,775                                                                      | )          | (2,756 | ) |
| Net cash used in operating activities                                        |       | (58,077                                                                     | )          | (40,058 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                       |       |                                                                        |       |   |   |
| Purchase of investments                                                      |       | (236,870                                                                    | )          | (183,140 | ) |
| Sale of investments                                                          |       | 226,570                                                                     |       | 165,430 |   |
| Purchase of property and equipment                                           |       | (5,919                                                                      | )          | (2,516 | ) |
| Proceeds from sale of property and equipment                                 |       | 623                                                                         |       | 62,452 |   |
| Acquisition of UVS (Note 9), net of cash acquired                            |       | 1,270                                                                       |       | — |   |
| Changes in restricted cash                                                   |       | —                                                                      |       | 6,000 |   |
| Net cash (used in) provided by investing activities                          |       | (14,326                                                                     | )          | 48,226 |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                       |       |                                                                        |       |   |   |
| Net proceeds from issuance of common stock                                   |       | 28,596                                                                      |       | 220 |   |
| Repayment of notes receivable for common stock                               |       | 99                                                                          |       | 172 |   |
| Proceeds from equipment financing and debt  refinancing                      |       | 5,927                                                                       |       | 6,211 |   |
| Proceeds from (repayments of) short term borrowings                          |       | 493                                                                         |       | (569 | ) |
| Payments on line of credit                                                   |       | —                                                                      |       | (4,500 | ) |
| Repayments of debt and capital lease obligations                             |       | (1,842                                                                      | )          | (48,443 | ) |
| Net cash provided by (used in) financing activities                          |       | 33,273                                                                      |       | (46,909 | ) |
| Effect of changes in exchange rate on Icelandic  krona denominated debt      |       | 36                                                                          |       | 263 |   |
| Net decrease in  cash and cash equivalents                                   |       | (39,094                                                                     | )          | (38,478 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 65,943                                                                      |       | 70,238 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                                           | 26,849     |   | $ | 31,760 |   |
| Supplemental  cash flow information:                                         |       |                                                                        |       |   |   |
| Cash paid for interest                                                       |       | $                                                                           | 3,085      |   | $ | 3,876 |   |
| Supplemental  schedule of non-cash transactions:                             |       |                                                                        |       |   |   |
| Deferred gain on sale of property                                            |       | $                                                                           | 336        |   | $ | 29,048 |   |
| Note receivable  for sale of property                                        |       | 884                                                                         |       | — |   |

 

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

5

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**deCODEgenetics, Inc.**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

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

**1.       Organization and Business**

References in thesefinancial statements to deCODE refer to deCODE genetics, Inc., a Delawarecompany, and deCODE genetics, Inc.’s wholly-owned subsidiary, Islenskerfdagreining ehf., an Icelandic company registered in Reykjavik, and itssubsidiaries, as well as deCODE genetics, Inc.’s wholly-owned subsidiary,MediChem Life Sciences, Inc., a Delaware corporation, and itssubsidiaries. 

**2.       Basis of Presentation**

In the opinion of thedeCODE’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 ofSeptember 30, 2006, the results of operations for the three and nine-monthperiods ended September 30, 2006 and 2005 and cash flows for the nine-monthperiods ended September 30, 2006 and 2005. The results of operations for thethree and nine-month periods ended September 30, 2006 are not necessarilyindicative of the results to be expected for the full year. Thesefinancial statements should be read in conjunction with deCODE’s Annual Reporton Form 10-K for the year ended December 31, 2005, which includesconsolidated financial statements and notes thereto for the years endedDecember 31, 2005, 2004 and 2003. 

**3.       Revenue**

Significant elements of our revenue are summarized asfollows:
|                                                                            | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                                      | ** ** |
| Research funding  and other service fees                                   |       | $                                                                            | 4,096      |                                                                        | $          | 8,226 |   | $ | 15,009 |   | $ | 23,265 |   |
| Milestone  payments                                                        |       | 215                                                                          |       | 434                                                                         |       | 514 |   | 932 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | —                                                                       |       | 2,000                                                                       |       | 1,000 |   | 4,038 |   |
| Grant funding                                                              |       | 3,878                                                                        |       | 1,908                                                                       |       | 10,804 |   | 4,799 |   |
| Other                                                                      |       | 377                                                                          |       | 629                                                                         |       | 1,732 |   | 1,123 |   |
| Total revenue                                                              |       | $                                                                            | 8,566      |                                                                        | $          | 13,197 |   | $ | 29,059 |   | $ | 34,157 |   |

 

Significant sources of our revenue as a percentage ofconsolidated revenue are summarized as follows:
|                                      | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months    Ended September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                               | ** ** | **2005**                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| F. Hoffmann-La  Roche (Roche)   |       | 10                                                                     | %          | 17                                                                                | %          | 21 | % | 21 | % |
| Merck and Co.,  Inc. (Merk)          |       | —                                                                 | %          | 21                                                                                | %          | — | % | 19 | % |
| National Institutes of  Health (NIH) |       | 40                                                                     | %          | 11                                                                                | %          | 32 | % | 10 | % |

 

**4.       Research and Development – ProprietaryPrograms**

deCODE’s research and development expenses consist of thecosts of its own proprietary programs and consist of the following:
|                                                  | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                                                      | ** ** |
| Salaries and  other personnel costs              |       | $                                                                            | 4,044      |                                                                        | $          | 4,139 |   | $ | 13,740 |   | $ | 12,269 |   |
| Materials and  supplies                          |       | 2,006                                                                        |       | 970                                                                         |       | 4,765 |   | 3,167 |   |
| Contractor  services and other third party costs |       | 5,758                                                                        |       | 4,009                                                                       |       | 16,724 |   | 9,073 |   |
| Overhead  expenses                               |       | 1,086                                                                        |       | 1,153                                                                       |       | 3,909 |   | 3,185 |   |
| Depreciation and  amortization                   |       | 885                                                                          |       | 685                                                                         |       | 2,648 |   | 2,342 |   |
| Stock-based compensation                         |       | 399                                                                          |       | 33                                                                          |       | 1,116 |   | 33 |   |
| Total                                            |       | $                                                                            | 14,178     |                                                                        | $          | 10,989 |   | $ | 42,902 |   | $ | 30,069 |   |

 

6

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In May 2006, deCODEentered into a strategic alliance with Illumina, Inc. (“Illumina”) to developand commercialize molecular diagnostic products. Under the terms of theagreement, deCODE and Illumina will share development costs equally and splitoperating profits from the sale of diagnostic tests.  

**5.      Stock-Based Compensation**

On January 1, 2006,deCODE adopted Statement of Financial Accounting Standards No. 123(revised 2004), *Share-Based Payment*(“SFAS 123R”) using the modified prospective transition method. Accordingly,prior periods have not been restated. SFAS 123R requires companies toestimate the fair value of stock-based payment awards on the date of grantusing an option-pricing model. The value of the portion of the award that isultimately expected to vest is recognized as expense over the requisite serviceperiods in deCODE’s consolidated statements of operations.

The following table summarizes stock-based compensation expense relatedto employee stock option and nonvested share awards under SFAS 123R forthe three and nine months ended September 30, 2006 which was included in theCondensed Consolidated Statements of Operations in the following captions:
|                                                      | ** ** | **Three Months   Ended  September 30,   2006** | ** ** | **Nine Months   Ended   September 30,   2006** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **(In thousands)**                                            | ** ** |
| Operating  Expenses:                                 |       |                                                               |       |                                                                    |       |
| Cost of revenue                                      |       | $                                                                  | 179        |                                                                    | $          | 438 |   |
| Research and development – proprietary programs |       | 399                                                                |       | 1,116                                                                   |       |
| Selling, general and administrative                  |       | 457                                                                |       | 1,425                                                                   |       |
| Total                                                |       | $                                                                  | 1,035      |                                                                    | $          | 2,979 |   |

 

The adoption of SFAS123R resulted in incremental stock-based compensation expense andincreased deCODE’s net loss by $1,035,000 and $2,979,000 in the three andnine-month periods ended September 30, 2006, respectively, resulting in a pershare expense increase of $0.02 and $0.05 per share, respectively, for thoseperiods. The adoption had no impact on cash flows from operating or financingactivities.

The following tableillustrates the pro forma effect on net loss and net loss per share had deCODEelected to account for all of its stock-based compensation plans using thefair-value method under SFAS No. 123 for the three and nine-months endedSeptember 30, 2005:
|                                                                                                          | ** ** | **Three Months   Ended  September 30,   2005**      | ** ** | **Nine Months   Ended   September 30,   2005** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                                                                               | ** ** | **(In thousands, except per share   amounts)** | ** ** |
| Net loss  attributable to common stockholders – as reported                                         |       | $                                                                       | (11,370    | )                                                                       | $          | (41,638 | ) |
| Add: Stock-based  compensation expense included in reported net loss                                     |       | 55                                                                      |       | 171                                                                     |       |
|  Deduct: total stock-based compensation  expense determined under fair value methods for all awards |       | (1,128                                                                  | )          | (3,500                                                                  | )          |
| Net loss –  proforma                                                                                |       | $                                                                       | (12,443    | )                                                                       | $          | (44,967 | ) |
|                                                                                                     |       |                                                                    |       |                                                                    |       |
| Basic and  diluted net loss per share – as reported                                                 |       | $                                                                       | (0.21      | )                                                                       | $          | (0.78 | ) |
| Basic and diluted net  loss per share – proforma                                                    |       | $                                                                       | (0.23      | )                                                                       | $          | (0.84 | ) |

 

*Equity Incentive Plans*

In May 2006, deCODEadopted the deCODE genetics, Inc. 2006 Equity Incentive Plan (the “2006 Plan”).The 2006 Plan provides for the issuance of up to 4,000,000 shares of commonstock to employees, consultants and non-employee directors in the form ofincentive stock options, nonqualified stock options, restricted stock and stockappreciation rights (SARs).

7

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deCODE also maintains thedeCODE genetics, Inc. 1996 and 2002 Equity Incentive Plans that providefor the grant for awards to employees, members of the Board of Directors,consultants and other advisors who are not employees.  The 1996 Equity Incentive Plan expired inJuly 2006.  A total of 10,000,000 shareswere originally reserved for grants of options and restricted stock under theterms of the 1996 and 2002 Equity Incentive Plans.

The equity incentiveplans are administered by the Compensation Committee of the Board of Directors.The Compensation Committee determines the type and term of each award, theaward exercise or purchase price, if applicable, the number of sharesunderlying each award granted and the rate at which each award becomes vestedor exercisable. Incentive stock options may be granted only to employees ofdeCODE at an exercise price per share of not less than the fair market valueper share of common stock on the day before the grant and with a term not toexceed ten years from date of grant. Nonqualified stock options may be grantedto any officer, employee, director, consultant or advisor at a per shareexercise price in such amount as the Compensation Committee may determine.Generally each employee option grant vests twenty-five percent on the firstanniversary date of an employee’s commencement of employment and 1/48th of theoriginal grant each month thereafter for the following three years. Uponexercise of options, shares are issued from the pool of registered shares underthe plans.

The Compensation Committeemay also grant restricted stock and other stock-based awards on such terms andconditions as it may determine, which may include deCODE’s right to repurchasethe unvested underlying stock upon termination of the holder’s employment.

Options granted to dategenerally vest over a period of four years, generally have a maximum term of10 years, and may contain early-exercise provisions allowing forcompany-provided financing of the exercise price. As of September 30, 2006,4,455,145 shares were available for grant.

The following tablerepresents stock option activity for the nine months ended September 30, 2006:
|                                    | ** ** | **Number of   Shares** | ** ** | **Weighted   Average   Exercise   Price** | ** ** | **Weighted   Average   Contractual   Life** | ** ** | **Aggregate   Intrinsic Value** | ** ** |
|------------------------------------|------------|----------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                         | ** ** | ** **                       | ** ** | ** **                                               | ** ** | ** **                                                 | ** ** | **(In thousands)**                   | ** ** |
| Outstanding at  January 1, 2006    |       | 4,702,702                        |       | $                                                        | 8.38       |                                                       |       |                                      |       |   |
| Granted                            |       | 631,194                          |       | 8.22                                                     |       |                                                       |       |                                      |       |
| Exercised                          |       | (142,874                         | )          | 5.64                                                     |       |                                                       |       |                                      |       |
| Forfeited/cancelled                |       | (436,716                         | )          | 9.62                                                     |       |                                                       |       |                                      |       |
| Outstanding at  September 30, 2006 |       | 4,754,306                        |       | 8.33                                                     |       | 7.10                                                       |       | $                                         | (13,440    | ) |
| Exercisable at  September 30, 2006 |       | 3,285,306                        |       | $                                                        | 8.30       |                                                       | 6.48       |                                      | $          | (9,200 | ) |

 

The aggregate intrinsicvalue in the table above represents the total intrinsic value, based on deCODE’scommon stock closing price of $5.50 as of September 30, 2006, which would havebeen received by the option holders had all option holders exercised theiroptions as of that date. The total number of in-the-money options exercisableas of September 30, 2006 was 474,298.

The weighted averagegrant date fair value of options granted during the three and nine-monthperiods ended September 30, 2006 was $3.05 and $4.98, per share respectively,and $6.36 and $5.93 per share during the three and nine-month periods endedSeptember 30, 2005, respectively. The total intrinsic value of options exercisedduring the three and nine-month periods ended September 30, 2006 was $29,000and $438,000, respectively and during the three and nine-month periods endedSeptember 30, 2005 was approximately $118,000 and $301,000, respectively. Thetotal cash received from employees as a result of employee stock optionexercises during the nine months ended September 30, 2006 and 2005 was $806,000and $220,000, respectively. The total fair value of shares vested during thethree and nine-months ended September 30, 2006 was $1,176,000 and $2,951,000,respectively.

At September 30, 2006,deCODE’s future compensation cost related to non-vested stock options is$6,945,000, which will be recognized over the weighted average remainingvesting period of 1.77 years.

deCODE uses theBlack-Scholes option-pricing model to value stock options. The Black-Scholesmodel requires the use of employee exercise behavior data and the use of anumber of assumptions (as noted in the table below) including volatility ofdeCODE’s stock price, the weighted average risk-free interest rate, and theweighted average expected term of the options.

deCODE estimates theexpected term of the options based on historical patterns by employees withrespect to exercise and post vesting employment termination behaviors. Expectedvolatility is based on deCODE’s historical volatility and is calculated using aweighted average of the volatility over a period equal to the expected term ofthe award and the most recent one year volatility. deCODE bases the risk-freeinterest rate used on the implied yield currently available on U.S. Treasuryzero-coupon issues with an equivalent term. As deCODE does not pay dividends,the dividend rate variable in the Black-Scholes model is zero.

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|                           | ** ** | **Nine Months Ended   September 30, 2006** | ** ** |
|---------------------------|------------|---------------------------------------------------------------------|------------|
| Dividend yield            |       | —                                                              |       |
| Expected  volatility      |       | 63.09%  to 68.24%                                                   |       |
| Expected term  (in years) |       | 5.11                                                                |       |
| Risk-free interest rate   |       | 4.57% to 5.21%                                                      |       |

 

Stock-based compensationexpense is recognized in the consolidated statement of operations on astraight-line basis based on awards ultimately expected to vest. deCODE hascalculated stock-based compensation using an estimated forfeiture rate of5.60%. To the extent the actual forfeiture rate differs materially from thisestimate the expense will be adjusted.

*Restricted Stock*

deCODE’s Equity IncentivePlans allow for the issuance of restricted stock awards that may not be sold orotherwise transferred until certain restrictions have lapsed. The unearnedstock-based compensation related to these awards is amortized to compensationexpense over the period the restrictions lapse. The stock-based compensationexpense for these awards is determined based on the market price of our stockat the date of the grant applied to the total numbers of shares that areanticipated to fully vest and then amortized over the vesting period. In 2006and 2005, deCODE granted 7,588 and 57,944 restricted shares, respectively, andrecognized stock-based compensation expense related to these restricted sharesof $54,000 and $159,000 during the three and nine-months ended September 30,2006, respectively, and $47,000 and $55,000 during the three and nine-monthsended September 30, 2005, respectively. During the three and nine-month periodsended September 30, 2006 deCODE received $10,000 and $99,000, respectively, andduring the three and nine-months ended September 30, 2005, deCODE received$135,000 and $172,000, respectively, related to the payment of notes receivablein connection with share-based payment arrangements.

The following tablerepresents restricted stock activity for the nine months ended September 30,2006:
|                                 | ** ** | **Number   of Shares** | ** ** | **Weighted   Average Grant   Date Fair Value** | ** ** |
|---------------------------------|------------|----------------------------------|------------|-------------------------------------------------------------------------|------------|
| Unvested at  January 1, 2006    |       | 51,987                           |       | $                                                                       | 9.31       |   |
| Granted                         |       | 7,588                            |       | 7.38                                                                    |       |
| Vested                          |       | (5,781                           | )          | 7.27                                                                    |       |
| Unvested at September  30, 2006 |       | 53,794                           |       | $                                                                       | 9.26       |   |

 

At September 30, 2006, there was $315,000 of totalunrecognized compensation cost related to restricted stock to be recognizedover a weighted average remaining period of 1.75 years. The total fairvalue of shares vested during the three and nine-months ended September 30,2006 was $14,000 and $42,000, respectively. 

**6.      Net Loss Per Share**

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

Dilutednet loss per share does not differ from basic net loss per share in all periodspresented as potential common shares are antidilutive for all such periods andare, therefore, excluded from the calculation. Potential common shares excludedfrom the calculation of diluted net loss per share were: 
|                                                                                                               | ** ** | **September 30,    2006** | ** ** | **September 30,    2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| Warrants to  purchase shares of common stock                                                                  |       | 2,385,022                                |       | 2,729,873                                |       |
| Options to  purchase shares of common stock                                                                   |       | 4,754,306                                |       | 4,721,010                                |       |
| Restricted  shares subject to vesting and shares with an associated outstanding  non-recourse promissory note |       | 724,394                                  |       | 879,126                                  |       |
| Common shares  issuable upon conversion of 3.5% senior convertible notes                                      |       | 10,714,286                               |       | 10,714,286                               |       |
| Total                                                                                                         |       | 18,578,008                               |       | 19,044,295                               |       |

 

**7.      Comprehensive Loss**

Comprehensive loss generally represents all changes instockholders’ equity except those resulting from investments or contributionsby stockholders. Amounts reported in other comprehensive income (loss) includeforeign currency translation adjustments and 

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unrealized gains and losses associated withinvestments. The following table presents the calculation of comprehensiveloss:
|                                                    | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                                                      | ** ** |
| Net loss                                           |       | $                                                                            | (23,632    | )                                                                           | $          | (11,370 | ) | $ | (62,248 | ) | $ | (41,638 | ) |
| Other  comprehensive income (loss):                |       |                                                                         |       |                                                                        |       |   |   |   |   |
| Foreign currency translation                       |       | (14                                                                          | )          | (4                                                                          | )          | 7 |   | (3 | ) |
| Unrealized gain (loss) associated with investments |       | 86                                                                           |       | (158                                                                        | )          | 71 |   | (529 | ) |
| Total comprehensive  loss                          |       | $                                                                            | (23,560    | )                                                                           | $          | (11,532 | ) | $ | (62,170 | ) | $ | (42,170 | ) |

 

**8.      Investments**

deCODE’s investmentsconsist of auction rate securities, municipal bonds, US government securitiesand a corporate bond, all of which are classified as available-for-sale.Investments are available for current operations and are classified as currentassets. Investments are carried at fair value with the unrealized holding gainor loss included in accumulated other comprehensive income. Fair value isgenerally determined with reference to quotations in active markets. Premiumand discounts associated with investments in bonds are amortized using theeffective interest rate method.

Investmentsas of September 30, 2006 are summarized as follows:
|                                | ** ** | **Amortized  Cost**     | ** ** | **Estimated  Fair Value** | ** ** |
|--------------------------------|------------|-------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **(In thousands)** | ** ** |
| Auction rate  securities       |       | $                       | 75,060     |                           | $          | 75,060 |   |
| US government  debt securities |       | 15,000                  |       | 14,922                         |       |
| Municipal bond                 |       | 5,000                   |       | 5,000                          |       |
| Corporate bond                 |       | 5,000                   |       | 5,000                          |       |
|                           |       | $                       | 100,060    |                           | $          | 99,982 |   |

 

Gross unrealized holding gains and gross unrealizedholding losses at September 30, 2006 were $0 and $78,000, respectively, and atSeptember 30, 2005 were $437,000 and $942,000, respectively, and are includedin accumulated other comprehensive income.

**9.      Acquisition of UVS**

On January 17, 2006,deCODE acquired 100% of the outstanding shares of Urdur Verandi Skuld ehf. (“UVS”),a privately-held cancer research firm, from Iceland GenomicsCorporation, Inc. (“IGC”), both companies having their principal officesin Reykjavik, Iceland. To acquire UVS, deCODE paid $6,137,000 including 635,006shares of deCODE common stock valued at $6,082,000 (based upon the averageclosing price of deCODE common stock two days before and after the acquisitiondate) and approximately $55,000 for acquisition related costs. As part of thetransaction, deCODE acquired research rights for blood and tissue samples andclinical data for various types of cancers which deCODE has added to itssamples for research and development purposes. deCODE has included the resultsof operations of the acquired entity in deCODE’s consolidated statements ofoperations from the date of acquisition. Because the activity from thebeginning of the period to the acquisition date was not material, no pro-formainformation is presented.

The purchase price wasallocated to the estimated fair value of the acquired tangible and intangibleassets and assumed liabilities as follows (amounts in thousands): 
| Cash                            |   | $     | 1,270  |   |
|---------------------------------|--------|-------|--------|--------|
| Net liabilities  acquired       |   | (719  | )      |
| Goodwill                        |   | 1,191 |   |
| Identifiable  intangible assets |   | 4,395 |   |
|                            |   | $     | 6,137  |   |

 

The purchase price wasallocated to the net assets acquired based on their estimated fair values atthe date of acquisition. The excess of the purchase price over the estimatedfair value of the net assets acquired amounted to $1,191,000, which wasallocated to goodwill. Under Icelandic tax law goodwill is not deductible fortax purposes.

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

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**10.    Long-Term Debt**

In March 2005, deCODE executed a refinancing of itsmortgage with a financial institution for its Woodridge, IL facility. Theunpaid principal balance of $5,688,000 at September 30, 2006, carries aninterest rate of three-month LIBOR + 2.25% (7.73% at September 30, 2006),payable in monthly principal installments of $26,000 plus interest with a finalpayment of $5,300,000 due in December 2007. 

**11.    Sale-Leaseback Financing**

In August 2006, deCODEpurchased certain laboratory equipment from Illumina for $4,071,000 and thensold the equipment for net cash proceeds of $4,325,000 and leased the equipmentback from the counter-party (an Icelandic leasing company) for a 37-month term.As ownership of the equipment will be transferred to deCODE at the end of thelease without any further significant payment, the transaction has beenrecorded as a financing and the gain ($254,000) has been deferred and is beingamortized over the remaining useful life of the leased equipment.

Also during the threemonth period ended September 30, 2006, deCODE sold certain laboratory equipmentfor $713,000 net cash proceeds and leased the equipment back from thecounter-party (an Icelandic leasing company) for 37-month term. As ownership ofthe equipment will be transferred to deCODE at the end of the lease without anyfurther significant payment, the transaction has been recorded as a financingand the gain ($82,000) has been deferred and is being amortized over theremaining useful life of the leased equipment.

**12.    Sale of Common Stock**

InJuly 2006 deCODE completed the sale of 6,000,000 shares of common stock at apurchase price of $5.00 per share for aggregate net proceeds, after costs ofthe transaction, of $27.8 million.

**13.    Litigation**

Other than claims andlegal proceedings that arise from time to time in the ordinary course ofbusiness which are not material, there has been no change in the mattersreported in our Annual Report on Form 10-K for the year endedDecember 31, 2005 except as follows:

 On August 4, 2006 we commenced an action inthe U.S. District Court for the Eastern District of Pennsylvania against fiveformer employees for misappropriation of our trade secrets and intellectualproperty, related breach of non-competition, non-solicitation, andnon-disclosure provisions of their employment agreements, and violation of thefederal Computer Fraud and Abuse Act. The suit alleges that the defendants, including Hákon Hákonarson,formerly our Vice President, Business Development, were recruited, and at leastfour are currently employed, by the Center for Applied Genomics, a businessunit of the Children’s Hospital of Philadelphia (CHOP).  Also, the suit alleges that while stilldeCODE employees and with the knowledge of senior CHOP staff, these defendantscopied or sent directly to CHOP deCODE proprietary methods, tools, businessplans and research results.  At therequest of CHOP, CHOP has intervened as a defendant in the case.

We are seeking preliminary and permanent injunctionsrestraining, among other things, the individual defendants from working at CHOPin any capacity competitive with deCODE for two years, and the individualdefendants and CHOP from soliciting our employees for a period of one year andfrom using or disclosing our confidential information.

On August 11, 2006 the court issued a temporaryrestraining order prohibiting the individual defendants from using, altering,destroying or transferring possession of any information taken from deCODE, andfrom destroying, using, altering, copying or transferring possession of one ormore 250 gigabyte hard drives or any other removable storage devices thatcontained any deCODE information.  OnAugust 22, 2006, the court entered an order extending the temporary restrainingorder until the court rules on deCODE’s motion for a preliminaryinjunction.  The hearing on plaintiffs’motion for a preliminary injunction is scheduled to conclude on November 22,2006.  A ruling is expected afterpost-hearing briefs are submitted and argued. No dates have been scheduled for submission of briefs or argument.  Accordingly, the temporary restraining orderis expected to remain in place at least through November, 2006.

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

This Management’s Discussion and Analysis of FinancialCondition and Results of Operations as of September 30, 2006 and for the threeand nine-month periods ended September 30, 2006 and 2005 should be read inconjunction with the unaudited condensed consolidated financial statements andnotes thereto set forth in Item 1 of this report.

This quarterly report onForm 10-Q contains forward-looking statements, including our expectationsof future industry conditions, strategic plans and forecasts of operationalresults. Various risks may cause our actual results to differ materially. Alist and 

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description of some ofthe risks and uncertainties is contained below and in the summary of riskfactors set forth in Item 1A of our Annual Report on Form 10-K for the yearended December 31, 2005.

# **Overview**

deCODE is abiopharmaceutical company applying its discoveries in human genetics to developproducts to better diagnose, treat and prevent common diseases. Our populationapproach and resources enable us to isolate genes and drug targets directlyinvolved in the development of many of the diseases that pose the biggestchallenges to public health. We are turning these discoveries into a growingpipeline of therapeutics and diagnostics that address the causes of disease,not just the signs and symptoms. As these diseases are common and representareas of major unmet medical need, we believe that our strategy represents asignificant opportunity to create better medicine with major potential in theglobal marketplace.

We believe that deCODE’sadvantage derives from our unique capabilities in human genetics and theability to apply our discoveries across the drug and diagnostic developmentprocess. In Iceland, we have comprehensive population resources that enable ourscientists to efficiently conduct genome- and population-wide scans to identifykey genes and gene variations contributing to common diseases. The proteinsencoded by these genes, and other proteins with which they interact in thedisease pathway, offer drug targets that we believe are directly involved inthe onset and progression of disease. Small-molecule drugs that target theseproteins may therefore represent a direct means of modulating the onset orprogression of the disease. Our approach also enables us to apply our gene discoveriesto develop DNA-based diagnostic tests. We believe that such tests havesignificant medical and commercial potential, offering a means of gaugingindividual risk of common diseases, informing more effective preventionstrategies, and identifying patients who may derive particular benefit from ourdrugs – which are aimed at counteracting the biological effects of the sameat-risk gene variants.

Through our U.S.-basedmedicinal chemistry and structural biology subsidiaries we are able to discovernovel small-molecule therapeutic compounds; take candidate compounds throughpre-clinical testing; and manufacture sufficient quantities for early-stageclinical trials. Leveraging our expertise in genetics and drug and diseasemodeling, our clinical development groups is able to make our clinical trials amore efficient and sensitive means of testing and optimizing the therapeuticand commercial potential of new drugs. In certain programs we have also takenadvantage of the fact that drug targets we have identified through our geneticsresearch have already been targeted by other companies to develop compounds forother indications. By licensing these compounds or entering into co-developmentarrangements, we have been able to bypass years of drug discovery and enterdirectly into Phase II clinical trials.

The goal of our businessstrategy is to maximize the creation of value from our human genetics work andto capture that value for the company and its shareholders. Our productdevelopment pipeline now includes drug development programs in heart attack, andthrombosis and embolism, we are collaborating on the clinical development ofCEP-1347 in asthma, and are advancing our diagnostics programs in type 2diabetes, heart attack and prostate and breast cancer. Executing on ourstrategy – advancing these programs swiftly while continuing our discovery workin a broad range of common diseases – requires us to spread risk and managecost. We are constantly evaluating the optimal balance between proprietary andpartnered product development, the level of our investment in research anddevelopment, the deployment of cash resources for product development, and thefinancing environment. As we invest in proprietary programs, we leverage ourcapabilities to form corporate alliances and to provide services to fee-payingcustomers. We also receive contract and grant funding from various governmentalagencies. We have formed drug and other product development alliances with Roche,Merck, and Illumina, among others. Our medicinal chemistry subsidiary providesdrug discovery and contract manufacturing services to fee-for-servicecustomers, and our other service offerings include protein crystallographyproducts and instruments as well as protein structure analysis contractservices through our structural biology subsidiary; clinical trials servicesthrough our Encode CRO; and DNA analysis services through our genotypinglaboratory in Reykjavik.

We derive revenuesprimarily from research funding and other fees from our service customers andcollaborative partners, as well as from research grants. Milestone payments andupfront, exclusivity, technology-access and technology-development fees underour collaboration agreements constitute another principal source of ourrevenues. While we are entitled to royalties or profit-sharing under the termsof some of our agreements, due to the extended time period for the developmentand commercialization of a saleable product or therapy, we have not yetreceived royalties or profit sharing under any of our contracts and do notexpect to do so for several years, if at all. Our expenses consist primarily ofresearch and development expenses such as, salaries and related employee costs,materials and supplies, and contractor services.

We believe that ourongoing work in genetics, the advancement of our drug and diagnostic programs,and in particular the conduct of clinical trials, will require significantongoing expenditures. In 2006, we completed our Phase I dose-ranging,pharmacokinetic and safety clinical program for DG041, our developmentalanti-platelet compound for thrombosis and embolism and initiated a Phase IIatrial; filed an IND and began a single-dose ranging Phase I study for DG051 forthe prevention of heart attack; concluded our Phase II trial of Cephalon’sdevelopmental compound CEP-1347 in asthma; designed and initiated a Phase IIItrial for DG031 for the prevention of heart attack, a trial that we voluntarilysuspended in October in order to address a formulation problem with thetablets. We are also developing reference-laboratory diagnostic testingservices.  We anticipate incurringadditional net losses at least through the next several years, due to, inaddition to the above-mentioned factors, depreciation and amortization, as wellas stock-based compensation and other non-cash charges. We expect that ourrevenues and losses will fluctuate from quarter to quarter and that suchfluctuations may be substantial, especially because

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progress in ourscientific work and milestone payments that are related to progress canfluctuate between quarters. We do not believe that comparisons of ourquarter-to-quarter performance are a good indication of future performance.

At September 30, 2006, wehad $126.8 million in cash, cash equivalents and investments. As we advance andbroaden our drug and diagnostic pipelines we will require significantadditional capital for product development and so we will continue toinvestigate additional avenues of financing. In July 2006 we completed the saleof 6,000,000 shares of common stock at a purchase price of $5.00 per share, foraggregate net proceeds, after costs of the transaction, of $27.8 million. Ourability to obtain capital in the future will be affected by conditions in theglobal financial markets and in the pharmaceutical industry. We expect thatmore favorable conditions in those markets will present opportunities for us,while downturns in the market valuations of biotechnology companies and of theequity markets more generally will restrict our ability to raise additionalcapital on attractive terms.

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

**Drug Development Programs**

The following is asummary of our drug development programs in late pre-clinical or clinicaldevelopment. Because of uncertainties involved in the drug development process,the actual timing for the events described below may differ materially fromthat provided in this summary.

·       We have two compounds in development for theprevention of heart attack. These programs come out of our discovery of majorrisk variants in two genes encoding proteins in the leukotriene pathway. Thesevariants – in the genes that code for 5-lipoxygenase activating protein (FLAP)and leukotriene A4 Hydrolase (LTA4H) – appear to confer risk in the same way:by causing an upregulation in the production of leukotriene B4, a potentpro-inflammatory molecule that is the end product of one branch of the pathway.  The therapeutical goal of both compounds isto inhibit the activity of the pathway, lowering the production of LTB4 andthereby decreasing the inflammatory activity in atherosclerotic plaques andreducing the risk of heart attack. DG051, discovered by deCODE’s chemistryunit, is a small-molecule inhibitor of LTA4H, which is directly involved in thesynthesis of LTB4. DG051 appears to provide potent inhibition of LTB4production, is orally bioavailable, has potential for once-daily dosing andappears to have minimal potential for drug-interaction. We began Phase Iclinical testing of DG051 in the third quarter of this year and expect tocomplete this program near the end of 2006. In May we began a Phase IIIclinical trial for DG031, an inhibitor of FLAP which we licensed from Bayer AG,but temporarily suspended this trial in October due to an unexpectedformulation problem with the tablets. In routine testing of clinical supplieswe discovered that, over time, the drug tablets appeared to dissolve moreslowly, potentially providing lessening amounts of active drug the longer theywere stored and leading to the possibility that as the trial progressedpatients would be receiving too little drug, undermining the trial’s chances ofsuccess. The company is currently examining alternative manufacturingprocesses.

·       DG041 is our lead anti-platelet compound for theprevention of thrombosis and embolism. 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 arterial disease. We believe that PGE2 may have additive stimulatoryeffects on platelet aggregation beyond those of other potent agonists such asADP or thromboxane A2, targeted by clopidogrel and aspirin, respectively. Inearly 2006, we concluded the Phase Iclinical program for DG041. Nearly 200 healthy subjects were exposed to DG041in these studies. The results of the Phase I program showed DG041 to bewell-tolerated across the entire dose range studied, and that DG041 caneffectively inhibit platelet aggregation in a dose-dependent manner withoutincreasing bleeding time. In the second quarter of 2006, we began a Phase IIaclinical trial that will examine the effect of DG041 on certain plasmabiomarkers.  We expect to conclude thistrial by the end of 2006 and to present the data during the first half of 2007.

·       In asthma, we have conducted a Phase IIa trialof Cephalon’s compound CEP-1347, originally developed for treatment ofParkinson’s disease. This compound inhibits MAP3K9, a kinase encoded by a genewe have linked to risk of asthma. In the Phase IIa trial we found that thecompound had a dose-related effect on both lung function and biomarkersassociated with lung inflammation and severity of disease in patients withasthma who were already being treated with inhaled corticosteroids andlong-acting beta agonist (LABA). Cephalon is currently reviewing the clinicaldevelopment plan for this compound.

·       Our drugdiscovery group has also worked on pre-clinical programs in pain, obesity andstroke, among other indications. We are pursuing a PDE4 inhibitorprogram for vascular disease/stroke pursuant to our 2004 agreement with Rocheand are working on identifying and advancing a lead pre-clinical compound.

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We use many of ouremployee and infrastructure resources across several programs, and many of ourresearch and development costs are indirectly attributable to an individuallynamed program or are directed broadly to applicable research programs. However,taking into account costs that are specifically attributable to individualprograms and allocations of our research and development program costs basedupon those direct costs, we have cumulatively invested $30.1 million, $14.8million, $8.5 million and $8.4 million in our heart attack (MyocardialInfarction, or 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 foror received marketing approval from the applicable regulatory authorities inany country for any of our drug candidates. In order for us to achievemarketing approval in the United States, the FDA must conclude that ourclinical data establish the safety and efficacy of our drug candidate. Othercountries have similar requirements. Historically, the results frompre-clinical testing and early clinical trials (through Phase II) haveoften not been predictive of success in later clinical trials. Many newcompounds have shown promising results in early clinical trials, butsubsequently failed to establish sufficient safety and efficacy data to obtainnecessary marketing approvals. Additional risks and uncertainties involved inthe development and commercialization of any products are described under Item1A in our reports on Form 10-K and 10-Q. We expect that it will be severalyears, if ever, before we receive revenues from the commercial sale of ourtherapeutic products.

Furthermore, our strategyincludes the option of entering into collaborative arrangements with thirdparties to participate in the development and commercialization of ourproducts. Entering into a collaboration with a partner at any point in thedevelopment or commercialization of a product is a business decision. Whenmaking this decision we do and will consider, among other matters, thecomplexity of the indication, the size, complexity and expense of necessary developmentand/or commercialization efforts, competition in the market and size of theapplicable 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 our developmentplan or capital requirements.

As a result of theuncertainties discussed above, we are unable to determine the duration andcompletion costs of our research and development projects or when and to whatextent we will receive cash inflows from the commercialization and sale of aproduct.

**Acquisitions, Joint DevelopmentPrograms and In-licensing**

As part of our businessstrategy, we continue to consider joint development programs and merger andacquisition opportunities that may provide us with products in late-stagedevelopment, intellectual property or financial resources or with capabilitiesthat will help accelerate our downstream drug discovery efforts.

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

*Illumina*.  In May 2006, we entered into a strategicalliance with Illumina, Inc. (“Illumina”) to develop and commercializemolecular diagnostic products. Under the terms of the agreement, deCODE andIllumina will share development costs equally and split operating profits fromthe sales of diagnostic tests. Our initial focus will be developing diagnosticsfor heart attack, breast cancer and Type 2 diabetes. Also as part of theagreement, we will install Illumina’s SNP genotyping platform, enabling us toexpand our contract genotyping business to offer Illumina’s platform and assaytechnologies together with our proprietary analytical services for customers.We intend to utilize the Illumina platform to carry-out high-density,whole-genome studies utilizing our comprehensive population genetics resourcesin Iceland.

In certain programs wehave taken advantage of the fact that drug targets we have identified throughour genetics research have already been employed by other companies to makedevelopmental compounds for other indications. By licensing these compounds orentering into co-development arrangements we have been able to leapfrog overseveral years of drug discovery, entering directly into Phase II clinicaltrials. DG031, our most advanced compound for the prevention of heart attack,was licensed from Bayer HealthCare AG, which was initially developing it forasthma. We also recently concluded a Phase II trial in asthma, working withCephalon on their compound CEP-1347, originally developed for Parkinson’sdisease. We continue to investigate additional such possibilities for thein-licensing or co-development of promising existing compounds that mayeffectively act against targets we have identified through our gene discoverywork.

**Critical Accounting 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 

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the date of the financialstatements, and the reported amounts of revenues and expenses during thereported period. On an ongoing basis we evaluate our estimates, which include,among others, those related to collaborative arrangements, long-lived assets,materials and supplies, stock-based compensation, foreign exchangetransactions, income taxes and litigation and other commitments andcontingencies. We base our estimates on historical experience and on variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form our basis for making judgments about carrying values ofassets and liabilities that are not readily apparent from other sources. Theimpact and any associated risks related to these and our other accountingpolicies on our business or operations is discussed throughout Management’sDiscussion and Analysis of Financial Condition and Results of Operations wheresuch policies affect our reported and expected financial results. For adetailed discussion on the application of these and other accounting policies,please refer to our notes to the Condensed Consolidated Financial Statements inthis quarterly report on Form 10-Q and the Consolidated FinancialStatements in the Annual Report on Form 10-K for the year endedDecember 31, 2005. There can be no assurance that actual results may notdiffer from the estimates referred to above.

In addition to thecritical accounting policies we have included in the Annual Report on Form 10-Kfor the year ended December 31, 2005, we believe the following policy which iseffective January 1, 2006 is also critical to an understanding of our financialcondition and results of operations because it requires us to make estimates,assumptions and judgments about matters that are inherently uncertain.

*Stock-based Compensation*

In December 2004,the Financial Accounting Standards Board (FASB) issued SFAS No. 123R (SFAS123R), a revision of SFAS No. 123, *Accountingfor Stock-Based Compensation*(SFAS 123), which requires that allshare-based payments to employees and directors, including grants of stockoptions be recognized in the income statement based on their fair values. SFAS123R supersedes Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(APB 25) and amends SFAS No. 95, *Statementof Cash Flows*. On January 1, 2006, we adopted SFAS123R using the modified prospective method of adoption as permitted underSFAS 123R which requires that compensation expense be recorded for allnonvested stock options and other stock-based awards as of the beginning of thefirst quarter of adoption. In accordance with the modified prospective method,no prior period amounts have been restated to reflect the provisions of SFAS123R.

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

In connection with ouradoption of SFAS 123R, we refined our valuation assumptions and themethodologies used to derive those assumptions; however, we elected to continueusing the Black-Scholes option valuation model. Concurrent with our adoption ofSFAS 123R, we determined that historical volatility of deCODE’s stock would bethe best measure of market conditions and expected volatility. We estimate theweighted-average expected life of our stock-option awards based on historicalcancellation and exercise data related to our stock-based awards as well as thecontractual term and vesting terms of the awards. We allocate stock-basedcompensation expense using a straight-line expense attribution approach.Stock-based compensation expense related to stock options is recognized net ofestimated forfeitures. We estimated forfeitures based on our historicalexperience.

During the three andnine-months ended September 30, 2006, we recognized stock-based compensationexpense of $1.0 million and $3.0 million, or $0.02 and $0.05 per share,respectively. As of September 30, 2006, we had unrecognized stock-basedcompensation of $6.9 million related to nonvested stock options awards, whichis expected to be recognized over an estimated weighted average period of 1.77years.

**Results of Operationsfor the Three and Nine-Month Periods Ended September 30, 2006 and 2005**

Our results of operationshave fluctuated from period to period and may continue to fluctuate in thefuture based upon, among other things, the timing and composition of fundingunder our various collaborative agreements, as well as the progress of our ownresearch and development efforts including, those carried out under researchgrants. 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, obtain regulatoryapprovals or clearances and enter into manufacturing, distribution andmarketing arrangements, as well as obtain market acceptance. We do not expectto receive revenues or royalties based on therapeutic or diagnostic productsfor a period of years, if at all.

Financial highlights asof and for the three and nine-month periods ended September 30, 2006 include:

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·       At September 30, 2006, we had $126.8 million incash and investments compared to $155.6 million at December 31, 2005. Thenet utilization of our cash and investments in 2006 reflects principally thecosts associated with the advancement of our drug development programs asreflected in the $58.0 million of cash we used in operating activities.

·       In July 2006 we completed the sale of 6,000,000shares of common stock at a purchase price of $5.00 per share for aggregate netproceeds, after costs of the transaction, of $27.8 million.

·       Research and development expense for proprietaryprograms was $14.2 million and $42.9 million for the three and nine-monthperiods ended September 30, 2006, respectively, as compared to $11.0 millionand $30.1 million for the three and nine-month periods ended September 30,2005. These increases are principally the result of costs associated with theadvancement of our product development programs. In May 2006, we began a PhaseIII clinical trial for DG031 our lead developmental compound for the preventionof heart attack, and then in October 2006 we voluntarily suspended the trial inorder to address an unexpected formulation problem with the tablets. In August2006 we began enrolling patients in a Phase I clinical trial for DG051, ourfollow-on development compound for the prevention of heart-attack.  Earlier in 2006, we initiated a Phase IIatrial for DG041, our developmental compound in Peripheral Artery Disease.  Additionally, we have progressed proprietarypre-clinical programs in stroke, obesity, and pain, among otherindications.  More recently, we haveinstalled the Illumina SNP genotyping platform and have begun our high-density,whole-genome studies utilizing the platform together with our comprehensivepopulation genetics resources in Iceland.

·       Our revenue was $8.6 million and $29.1 millionfor the three and nine-month periods ended September 30, 2006, respectively, ascompared to $13.2 million and $34.2 million for the three and nine-monthperiods ended September 30, 2005 respectively. The decline of our revenue isdue principally to lower alliance revenues in 2006,  chiefly on account of the completion of theMerck obesity research program in September 2005 and the more recent completionof research funding under the 2002 agreement with Roche (June 2006).

*Revenue.*  Revenuefor the three and nine-month periods ended September 30, 2006 and 2005 isas follows:
| ** ** | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** ** | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** ** | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** ** | ** ** | **(In thousands, except %)** | ** ** |
| Revenue    |       | $                                           | 8,566      |                                   | $          | 13,197                                           |       | $ | 29,059 |   | $ | 34,157 |   | $ | (4,631 | ) | (35 | )% | $ | (5,098 | ) | (15 | )% |
|            |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our business strategy isfocused on turning our discoveries into new drugs and diagnostics for thetreatment of common diseases. At the same time, we leverage our capabilities togenerate revenue through corporate alliances, through service contracts andincreasingly through research grants. 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. Increasingly, we have also soughtand received research grant funding. 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.

Collaborations with our most significant partnersinclude:

*F. Hoffmann-LaRoche (Roche)*

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

In November 2004, wesigned a new three-year agreement with Roche to co-develop inhibitors of PDE4for the prevention and treatment of vascular disease, including stroke. Thisagreement continues work advanced under the 2002 agreement, and we will focuson optimizing lead compounds identified under the previous agreement andbeginning clinical development. Under this agreement, as of September 30, 2006,we have received $4.0 million of research funding. We will share drug discoveryand clinical trials costs under this new agreement, and we may receive anadditional $2.0 million of research funding over the remaining term of theagreement as well as milestone payments and royalties based on drug sales.

*Diagnostics.* In June 2001, we signed a five-year alliance withRoche’s diagnostics division and through June 2006 we collaborated to developand market DNA-based diagnostics for major diseases.  During the term of the alliance, which hasnow expired, we received $44.3 million in research funding, up-front fees andmilestone payments under the agreement and we may receive additional milestone 

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payments upon theachievement of research and development milestones by Roche and royalties onthe sales of diagnostic products developed by Roche.

Revenues recognized andcosts incurred in connection with these collaborations with Roche aresummarized as follows:
|                                                  | ** ** | **  For the Three Months  Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                           | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In millions, except %)**                                         | ** ** |
| Revenue                                          |       | $                                                                                  | 0.8        |                                                                        | $          | 2.3 |   | $ | 6.2 |   | $ | 7.3 |   |
| Revenue as a  percentage of consolidated revenue |       | 10                                                                                 | %          | 17                                                                          | %          | 21 | % | 21 | % |
| Cost of revenue                                  |       | $                                                                                  | 1.2        |                                                                        | $          | 1.5 |   | $ | 5.2 |   | $ | 6.5 |   |

 

*Merck &Co, Inc. (Merck)*

*Obesity.  *In September 2002, we entered into a three year alliancewith Merck aimed at developing new treatments for obesity. Under the alliance,we combined research efforts with Merck in the genetics of obesity to identify,validate and prioritize a series of drug targets to take into development.During the three-year research program, which has now expired, we have receivedresearch funding, technology access fees and milestone payments in theaggregate amount of $25.3 million. In addition, we may receive furthertechnology access fees in the total aggregate amount of $2.0 million. Subjectto Merck’s developing products based on collaboration discoveries, we may alsoreceive development milestones and royalties. We have discovered three geneslinked to obesity under this alliance, and Merck has generated a lead series ofcompounds against one of the targets we validated through our geneticsresearch.

Revenues recognized andcosts incurred in connection with this collaboration with Merck are summarizedas follows:
|                                                  | ** ** | **  For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                                 | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In millions, except %)**                                               | ** ** |
| Revenue                                          |       | $                                                                                        | —     |                                                                        | $          | 2.8 |   | $ | — |   | $ | 6.3 |   |
| Revenue as a  percentage of consolidated revenue |       | —                                                                                   | %          | 21                                                                          | %          | — | % | 19 | % |
| Cost of revenue                                  |       | $                                                                                        | —     |                                                                        | $          | 0.8 |   | $ | — |   | $ | 2.9 |   |

 

*Information-RichClinical Trials.  *In February 2004, weentered into an agreement with Merck which provides that we will conductinformation-rich clinical trials on a range of Merck’s developmental compoundsthat Merck selects for inclusion in the program. The term of the alliance is sevenyears, subject to termination by Merck after five years. The collaborationinvolved three agreements: (a) a License and Research CollaborationAgreement; (b) a Stock and Warrant Purchase Agreement; and (c) aWarrant Agreement. Under the terms of the License and Research CollaborationAgreement, we will receive royalties on sales of drugs and diagnosticsdeveloped as part of the alliance, will receive milestone payments as compoundsor pharmacogenomic tests reach the market, will receive research funding forthe clinical development of compounds and pharmacogenomic analysis, andreceived a one-time technology access fee of $10.0 million. A contingencyclause on the technology access fee provides that if we reject the first twonon-exclusive development compounds that Merck presents to the collaboration,then Merck has the right to request a refund of $2,500,000 of the technologyaccess fee. The remaining amount of the technology access fee isnon-refundable. To date, Merck has not selected any compounds for developmentunder the agreement.

*GovernmentResearch Contracts and Grant Funding*

We have received variousresearch grants from divisions of the United States National Institutes ofHealth (NIH), the Commission of the European Communities (EC) and privatefoundations. Research grants for multiple years are based on approved budgetswith budgeted amounts subject to approval on an annual basis. NIH grantsgenerally provide for 100% reimbursement of allowable expenditures while thegrant under the EC generally provides for 50% reimbursement of allowableresearch and development related expenditures. Our significant researchcontracts include:

*NationalInstitute of Allergy and Infectious Diseases (NIAID).  *InSeptember 2004, we were awarded a five-year $23,900,000 contract by theNIAID, a division of NIH. Under the contract, we are applying our populationapproach to discover genetic factors associated with susceptibility to certaininfectious diseases and with responsiveness to vaccines targeting such diseases.  We may receive $15.4 million in additionalresearch funding over the remaining term of the agreement.

Revenues recognized andcosts incurred related to work performed under contracts and on which wereceive research grants from the NIH are summarized as follows:

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|                                                  | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In millions, except %)**                                   | ** ** |
| Revenue                                          |       | $                                                                            | 3.4        |                                                                        | $          | 1.4 |   | $ | 9.2 |   | $ | 3.5 |   |
| Revenue as a  percentage of consolidated revenue |       | 40                                                                           | %          | 11                                                                          | %          | 32 | % | 10 | % |
| Cost of revenue                                  |       | $                                                                            | 5.2        |                                                                        | $          | 1.4 |   | $ | 11.7 |   | $ | 3.5 |   |

 

Significant elements of our revenue are summarized asfollows:
|                                                                            | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                                                      | ** ** |
| Research funding  and other service fees                                   |       | $                                                                            | 4,096      |                                                                        | $          | 8,226 |   | $ | 15,009 |   | $ | 23,265 |   |
| Milestone  payments                                                        |       | 215                                                                          |       | 434                                                                         |       | 514 |   | 932 |   |
| Up-front,  exclusivity, technology access, and technology development fees |       | —                                                                       |       | 2,000                                                                       |       | 1,000 |   | 4,038 |   |
| Grant funding                                                              |       | 3,878                                                                        |       | 1,908                                                                       |       | 10,804 |   | 4,799 |   |
| Other                                                                      |       | 377                                                                          |       | 629                                                                         |       | 1,732 |   | 1,123 |   |
| Total                                                                      |       | $                                                                            | 8,566      |                                                                        | $          | 13,197 |   | $ | 29,059 |   | $ | 34,157 |   |

 

Our revenue for three andnine-month periods ended September 30, 2006 as compared to the same periods in2005 generally reflects our strategic focus on proprietary drug discovery anddevelopment, including that performed under grants with the NIH and EC, andalso a shift away from research funding broadly.  Specifically, the decrease in revenue for thethree and nine-month periods ended September 30, 2006 as compared to the sameperiods in 2005, is principally on account of the completion of the Merckobesity research program in September 2005 and the more recent completion ofresearch funding under the 2002 agreement with Roche (June 2006).  In making the comparison between these samereporting periods, we have earned more grant monies under research contractsand grants with NIH and EC, and also have the addition of the Roche alliance toco-develop inhibitors of PDE4. Additionally, in the nine-month period endedSeptember 30, 2006 we sold technology and related rights to our Drug AdviceExpert (DAX) software for $0.5 million.

*Cost of Revenue*.   Cost ofrevenue, which includes costs incurred in connection with collaborative programsand research contracts and grants, for the three and nine-month periods endedSeptember 30, 2006 and 2005 is as follows:
| ** **      | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|-----------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **      | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **      | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)** | ** ** |
| Cost of Revenue |       | $                                           | 11,357     |                                   | $          | 9,149                                            |       | $ | 31,666 |   | $ | 27,082 |   | $ | 2,208 |   | 24 | % | $ | 4,584 |   | 17 | % |
|                 |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our cost of revenueconsists of the costs of services provided to customers and collaborators andthe costs of programs under research contracts and grants, including (i) theentirety of the costs incurred in connection with programs that have beenpartnered and on which we receive research funding, and also (ii) the whole ofthose costs incurred in connection with discovery and development workperformed under research contracts and grants. At times, we invested inaddition to costs covered by research funding received in such collaborativeprograms and in addition to monies received under research contracts andgrants; increasingly so with regard to the latter.

Increases in our cost ofrevenue for the three and nine-month periods ended September 30, 2006 relativeto the same periods in 2005 are largely on account of (i) the shift away fromresearch funding broadly, but specifically the completion of the Merck obesityresearch program and more recently the completion of research funding under the2002 agreement with Roche, and also (ii) the growing amount of discovery anddevelopment work performed under ongoing contracts and grants with the NIH andEC, including those obtained in connection with the acquisition of UVS inJanuary 2006. Of late, much of the acceleration in the growth cost of discoveryand development work performed under contracts and grants with the NIH and ECis due to the beginnings of our high-density, whole-genome studies utilizingthe Illumina SNP genotyping platform and our comprehensive population geneticsresources in Iceland.  Further, in 2006we conducted a Phase II trial in asthma for a compound developed by Cephalonand we have stepped-up our continuing efforts in the PDE4 inhibitor program forvascular disease/stroke pursuant to our 2004 agreement with Roche.

Our cost of revenue inthe three and nine-month periods ended September 30, 2006 as compared to thethree and nine-month periods ended September 30, 2005 have increasedprincipally due to the greater usage of chemicals and consumables ($2.0million, and $3.6 million, respectively) and greater salaries and related costs($0.6 million and $1.1 million, respectively). Also, our cost of revenue in

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the three and nine-monthperiods ended September 30, 2006 now includes stock-based compensation expenseunder SFAS 123R ($0.2 million and $0.4 million, respectively).

*Research and Development—ProprietaryPrograms.*  Research and development for proprietaryprograms for the three and nine-month periods ended September 30, 2006 and 2005is as follows:
| ** **                                            | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                            | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **                                            | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change  ** | ** ** | **$ Change** | ** ** | **% Change  ** | ** ** |
| ** **                                            | ** ** | **(In thousands, except %)** | ** ** |
| Research and  Development – Proprietary Programs |       | $                                           | 14,178     |                                   | $          | 10,989                                           |       | $ | 42,902 |   | $ | 30,069 |   | $ | 3,189 |   | 29 | % | $ | 12,833 |   | 43 | % |
|                                                       |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in ourresearch and development expenses in proprietary programs results from ouremphasis on and increasing expenditures in product development, includingpre-clinical and clinical work on our lead drug discovery and developmentprograms and DNA diagnostics. In May 2006, we began a Phase III clinical trialfor DG031, our lead developmental compound for the prevention of heart attack,and then in October 2006 voluntarily suspended the trial in order to address anunexpected formulation problem with the tablets. In August 2006 we beganenrolling patients in a Phase I clinical trial for DG051, our follow-ondevelopment compound for the prevention of heart-attack. Earlier in 2006, we initiateda Phase IIa clinical trial for DG041, our lead anti-platelet compound for theprevention of thrombosis and embolism. Additionally, we have progressedproprietary pre-clinical programs in stroke, inflammation, obesity and pain,among other indications. More recently, we have installed the Illumina SNPgenotyping platform and have begun our high-density, whole-genome studiesutilizing the platform together with our comprehensive population geneticsresources in Iceland.  Based upon therange of our current research and development activities, we currentlyanticipate that our overall investment in research and development for the fullfinancial year 2006 will be in the range of $60 to $65 million.

Our research and development expenses for proprietaryprograms for the three and nine-month periods ended September 30, 2006 and 2005consist of the following:
|                                                  | ** ** | **For the Three Months   Ended September 30,** | ** ** | **For the Nine Months   Ended September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                                                     | ** ** | **2005**                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                                                      | ** ** |
| Salaries and  other personnel costs              |       | $                                                                            | 4,044      |                                                                        | $          | 4,139 |   | $ | 13,740 |   | $ | 12,269 |   |
| Materials and  supplies                          |       | 2,006                                                                        |       | 970                                                                         |       | 4,765 |   | 3,167 |   |
| Contractor  services and other third party costs |       | 5,758                                                                        |       | 4,009                                                                       |       | 16,724 |   | 9,073 |   |
| Overhead  expenses                               |       | 1,086                                                                        |       | 1,153                                                                       |       | 3,909 |   | 3,185 |   |
| Depreciation and  amortization                   |       | 885                                                                          |       | 685                                                                         |       | 2,648 |   | 2,342 |   |
| Stock-based compensation                         |       | 399                                                                          |       | 33                                                                          |       | 1,116 |   | 33 |   |
| Total                                            |       | $                                                                            | 14,178     |                                                                        | $          | 10,989 |   | $ | 42,902 |   | $ | 30,069 |   |

 

Increases in research anddevelopment costs of our proprietary programs (e.g., contractor services andother third party costs, salaries and related costs, and usage of materials andsupplies) may continue, particularly as we advance our clinical development andproprietary drug development programs. However, we have voluntarily suspendedour Phase III clinical trial for DG031 and are beginning re-formulationwork.  This suspension may serve toreduce the rate of acceleration of the increases in our research anddevelopment costs, and even reduce the overall cost of our research anddevelopment expenses as we enter into 2007. Additionally, in 2006 we began our high-density, whole-genome studiesutilizing the Illumina SNP genotyping platform, we granted salary increases toour personnel and during 2005 added clinical development executives to ourstaff, actions which would generally contribute to future increases in ourresearch and development costs.  Further,our cost of research and development for proprietary programs in the three andnine-month period ended September 30, 2006 now also includes stock-basedcompensation expense under SFAS 123R.

*Selling,General and Administrative Expense.*  Selling, general and administrative expensefor the three and nine-month periods ended September 30, 2006 and 2005 isas follows:
| ** **                           | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **                           | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                           | ** ** | **(In thousands, except %)** | ** ** |
| Selling, General  and Administrative |       | $                                           | 6,938      |                                   | $          | 4,840                                            |       | $ | 16,597 |   | $ | 13,692 |   | $ | 2,098 |   | 43 | % | $ | 2,905 |   | 21 | % |
|                                      |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Increases in our selling,general and administrative expenses for the three and nine-month periods endedSeptember 30, 2006 as compared to the corresponding periods in 2005 is theresult principally of legal fees incurred in relation to our lawsuit to protectintellectual property ($2.3 million).  Inaddition, our selling, general and administrative expenses for the nine-monthperiod ended September 30, 2006 include a $0.8 million gain on the sale ofproperty.  Further, our selling, generaland administrative expense in the three and nine-month periods ended September30, 2006 now also include stock-based compensation expense under SFAS123R ($0.5 million and $1.4 million, respectively).

*Interest Income.*  Interest income for the three and nine-monthperiods ended September 30, 2006 and 2005 is as follows:
| ** **      | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|-----------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **      | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **      | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **      | ** ** | **(In thousands, except %)** | ** ** |
| Interest Income |       | $                                           | 1,834      |                                   | $          | 1,631                                            |       | $ | 4,882 |   | $ | 4,284 |   | $ | 203 |   | 12 | % | $ | 598 |   | 14 | % |
|                 |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest income hasincreased in the three and nine-month periods ended September 30, 2006 ascompared to the same periods in 2005. Our interest income is a function of boththe balance of our cash and investments (which have been declining as resourcesare deployed in operations) and the rate of return we are able to garner underour investment policy (which average rate of return has been increasing in2006). We expect to use our cash and investments principally for advancing ourdiscovery and development programs. In the meantime, we will invest the moniesreceived in accordance with our policy, having the objective of preservingprincipal and maintaining a high degree of liquidity to meet operating needsand obtaining competitive returns subject to prevailing market conditions. Weexpect to maintain our portfolio of cash equivalents and investments in avariety of securities, including auction rate securities, commercial paper,money market funds, mutual fund investments and government and non-governmentdebt securities.

*InterestExpense.*  Interestexpense for the three and nine-month periods ended September 30, 2006 and2005 is as follows:
| ** **       | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **       | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **       | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **       | ** ** | **(In thousands, except %)** | ** ** |
| Interest Expense |       | $                                           | 1,728      |                                   | $          | 1,686                                            |       | $ | 5,135 |   | $ | 5,775 |   | $ | 42 |   | 2 | % | $ | (640 | ) | (11 | )% |
|                  |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our interest expense isprimarily attributable to interest on our 3.5% Senior Convertible Notes due in2011 that we issued in April 2004. We also have interest on mortgage loans and equipment notes and leases.

*OtherNon-Operating Income and Expense, Net.*  Other non-operating income and expense forthe three and nine-month periods ended September 30, 2006 and 2005 is asfollows:
| ** **                                     | ** ** | **For the Three Months**     | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                     | ** ** | **Ended September 30,**           | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **                                     | ** ** | **2006**                                    | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **(In thousands, except %)** | ** ** |
| Other  Non-Operating Income and (Expense), Net |       | $                                           | 169        |                                   | $          | 466                                              |       | $ | 111 |   | $ | (3,461 | ) | $ | (297 | ) | (64 | )% | $ | 3,572 |   | 103 | % |
|                                                |            |                                             |            |                                        |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our other non-operatingincome and expense, net, consists principally of the net impact of foreign exchangein the three and nine-month periods ended September 30, 2006. In the three andnine-month periods ended September 30, 2005, our other non-operating income andexpense, net also included realized gains and losses on derivative financialinstruments as well as a loss on the early extinguishment of debt as a resultof having prepaid the short and long-term debts that were secured by mortgageson Sturlugata 8 ($3.1 million). Our losses on derivative financial instrumentsin the nine-month period ended September 30, 2005 ($0.2 million) result fromthree forward foreign currency exchange options we entered into as economichedges against foreign exchange rate fluctuations that we expected may occur onour ISK-denominated operating expenses but that did not qualify for hedgeaccounting.

*NetLoss and Basic and Diluted Net Loss Per Share*. Net loss andbasic and diluted net loss per share for the three and nine-month periods endedSeptember 30, 2006 and 2005 is as follows:
| ** **                            | ** ** | **For the Three Months**                                               | ** ** | **For the Nine Months** | ** ** | **2006 as Compared to 2005** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                            | ** ** | **Ended September 30,**                                                     | ** ** | **Ended September 30,**      | ** ** | **Three Months**                            | ** ** | **Nine Months** | ** ** |
| ** **                            | ** ** | **2006**                                                                              | ** ** | **2005**                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(In thousands, except % and per share amounts)** | ** ** |
| Net loss                              |       | $                                                                                     | (23,632    | )                                      | $          | (11,370                                          | )          | $ | (62,248 | ) | $ | (41,638 | ) | $ | (12,262 | ) | (108 | )% | $ | (20,610 | ) | (49 | )% |
| Basic and diluted net  loss Per share |       | $                                                                                     | (0.40      | )                                      | $          | (0.21                                            | )          | $ | (1.11 | ) | $ | (0.78 | ) | $ | (0.19 | ) | (90 | )% | $ | (0.33 | ) | (42 | )% |

 

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Net loss and basic anddiluted net loss per share both increased in the three and nine-month periodsended September 30, 2006 as compared to the three and nine-month periods endedSeptember 30, 2005, principally on account of increased research anddevelopment costs related to the advancement of our discovery and development programs,but also for all the reasons more fullydiscussed above, including stock-based compensation expense underSFAS 123R.

**Liquidityand Capital Resources**

We have financed ouroperations primarily through funding from research and development collaborativeagreements, and the issuance of equity securities and long-term financinginstruments ($891 million from the beginning of 1999 to-date). Future fundingunder terms of our existing agreements is approximately $44.3 millionexcluding milestone payments and royalties that we may earn under suchcollaborations.

We make significantinvestments in proprietary research and development and we incur the costs ofsuch activities. In the near term, this requires us to devote resources to ourin-house discovery and development which we believe will better position us tocapture the most value to us in our discoveries. As we identify promisingdiscoveries for further development, we may choose to continue the developmentourselves into and through clinical trials, regulatory approvals,manufacturing, distribution and marketing. In other cases we are or will beworking to varying degrees with partners. The decisions we make as to thesematters will affect our cash requirements.

Our cash requirementsdepend on numerous factors, including the level and timing of our research anddevelopment expenditures; our ability to access the capital markets; to obtainnew research and development collaboration agreements; to obtain and maintaincontract service agreements in our pharmaceuticals, biostructures, clinicalresearch trials and genotyping service groups; expenditures in connection withalliances, license agreements and acquisitions of and investments incomplementary technologies and businesses; competing technological and marketdevelopments; the cost of filing, prosecuting, defending and enforcing patentclaims and other intellectual property rights; the purchase of additionalcapital equipment; and capital expenditures at our facilities. Changes in ourresearch and development plans, notably the entry into clinical trials of drugsbased on our discoveries, or other changes affecting our operating expenses mayresult in changes in the timing and amount of expenditures of our capitalresources.

In December 2005, wefiled a universal shelf registration statement on Form S-3 with theSecurities and Exchange Commission (“SEC”) for the issuance and sale from timeto time of debt and equity securities either individually or in units, in oneor more offerings, with a total value of up to $100 million. In July 2006 wecompleted the sale of 6,000,000 shares of common stock at a purchase price of$5.00 per share for aggregate net proceeds, after costs of the transaction, of$27.8 million.

At September 30, 2006, wehad $126.8 million of cash, cash equivalents and investments.  Based upon the range of our currentactivities, taking into account proceeds from the July 2006 equity issuance butwithout taking into account cash from any new alliances, milestone payments,significant financing or other activities, we currently anticipate that ouroverall net use of cash resources for the full financial year 2006 will be inthe range of $55 to $60 million. As we advance and broaden our drug developmentpipeline we will require significant additional capital for product developmentand so we will continue to investigate additional avenues of financing, such asfurther public or private equity offerings, additional debt financing, otherforms of financing or added collaborations and licensing arrangements. However,no assurance can be given that additional financing or collaborations andlicensing arrangements will be available when needed, or that if available,will be obtained on favorable terms. If adequate funds are not available whenneeded, we may have to curtail operations or attempt to raise funds onunattractive terms.
|                                              | ** ** | **For the Nine Month Periods   Ended September 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                                                | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                                                 | ** ** |
| **Cash  provided by (used in):**             |       |                                                                                    |       |   |   |
| Operating  activities                        |       | $                                                                                       | (58,077    | ) | $ | (40,058 | ) |
| Investing  activities                        |       | (14,326                                                                                 | )          | 48,226 |   |
| Financing  activities                        |       | 33,273                                                                                  |       | (46,909 | ) |
| Cash and cash  equivalents, at end of period |       | 26,849                                                                                  |       | 31,760 |   |
|                                              |            |                                                                                         |            |  |  |  |  |

 

*Cashand Cash Equivalents.*  At September 30, 2006, we had$26.8 million in cash and cash equivalents. Together with our investments atSeptember 30, 2006 ($100.0 million), this balance has decreased $28.7 millionfrom the close of the year-ended December 31, 2005, most significantly onaccount of costs associated with the advancement of our drug and clinicaldevelopment programs.

Available cash isinvested in accordance with our investment policy’s primary objectives ofliquidity and safety of principal while maximizing the income we receive fromour investments without significantly increasing risk. Our cash is depositedonly with financial institutions in Iceland, the United Kingdom and the UnitedStates having a high credit standing (A-/A3 or better). We expect 

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to maintain our portfolioof cash equivalents and investments in a variety of securities, includingauction rate securities commercial paper, money market funds, mutual fundinvestments and government and non-government debt securities.

At September 30, 2006,our cash is largely invested in U.S. dollar denominated money market andchecking accounts and also in Icelandic krona denominated accounts.  At September 30, 2006, our investments are inauction rate securities, municipal bonds, US government securities and acorporate bond.

*OperatingActivities.* Net cash used in operating activities increasedto $58.0 million for the nine-month period ended September 30, 2006 as comparedto $40.1 million having been used in the same period in 2005.  The increase in use of cash in operatingactivities is most importantly attributable to the significant research anddevelopment investments being made in advancing our drug and clinicaldevelopment programs, as more fully described above.

*InvestingActivities.*Our investing activities have consistedprincipally of short-term investments in marketable securities (mainly auctionrate securities and US government securities) and capital expenditures.  Additionally, in the nine-months endedSeptember 30, 2006, we purchased UVS and, in doing so, we acquired $1.3 millionof cash to be used to fund the acquired liabilities of UVS.  Also, in the nine-month period endedSeptember 30, 2005, we completed the sale and leaseback of our Reykjavik,Iceland facilities at Sturlugata 8 and Krokhals 5D and 5E.

In July 2006, wecommenced installation of Illumina SNP genotyping platform and financed theequipment purchased thereunder ($4.1 million) with a three-year capital leasewith an Icelandic financial institution. With the exception of the Illumina equipment purchase, we principally madereplacement capital expenditures during the nine-month periods ended September30, 2006 and 2005. Although we believe we will 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 thetiming of our capital expenditures and other investments as well as changingbusiness needs.

*FinancingActivities.* Net cash of $33.3 million was provided byfinancing activities in the nine-month period ended September 30, 2006, ascompared to $46.9 million that was used in the nine-month period endedSeptember 30, 2005.  More significant financing activities for thenine-month period ended September 30, 2006, include our sale of 6,000,000shares of common stock (netting $27.8 million), the sale-and-leaseback ofIllumina and other equipment ($5.9 million) and debt service ($1.8million).  Financing activities for thenine-month period ended September 30, 2005 largely consisted of prepayments ofshort and long-term debts secured by mortgages on Sturlugata 8 and Krokhals 5Dand 5E ($40.4 million), refinancing of the mortgage on our Woodridge, ILfacility ($4.0 million) and other debt service ($2.3 million).

*ContractualCommitments and Off-Balance Sheet Arrangements.  *The following summarizes our contractual obligations (using interest andexchange rates as of September 30, 2006) at September 30, 2006, and the effectssuch obligations are expected to have on our liquidity and cash flows in futureperiods (In thousands):
| ** **                                         | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Total**                                 | ** ** | **Less Than  1 Year** | ** ** | **1 – 2 Years** | ** ** | **2 – 3 Years** | ** ** | **3 – 4 Years** | ** ** | **4 – 5 Years** | ** ** | **More Than  5 Years** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                   | ** ** |
| 3.5% Senior  convertible notes, including interest |       | $                                         | 173,625    |   | $ | 5,250 |   | $ | 5,250 |   | $ | 5,250 |   | $ | 5,250 |   | $ | 152,625 |   | $ | — |   |
| Long-term debt,  including interest                |       | 7,260                                     |       | 1,066 |   | 5,755 |   | 272 |   | 167 |   | — |   | — |   |
| Capital lease  obligations, including interest     |       | 6,708                                     |       | 2,418 |   | 2,319 |   | 1,971 |   | — |   | — |   | — |   |
| Operating leases                                   |       | 66,015                                    |       | 5,316 |   | 5,075 |   | 4,969 |   | 4,831 |   | 4,810 |   | 41,014 |   |
| Total                                              |       | $                                         | 253,608    |   | $ | 14,050 |   | $ | 18,399 |   | $ | 12,462 |   | $ | 10,248 |   | $ | 157,435 |   | $ | 41,014 |   |

 

Under the terms ofcertain technology licensing agreements, we are obligated to make payments uponthe achievement of established milestones leading to the discovery of definedproducts. These payments could total $5.0 million, with the timing of thepayments not determinable at the current time. These potential payments are notincluded in the above table.

All material intercompanybalances and transactions have been eliminated. We do not have any othersignificant relationships with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance orspecial purpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. As such, we are not exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.Additionally, holders of our 3.5% senior convertible notes may elect to converttheir notes into shares of our common stock at any time at a price of $14.00per share.

**FORWARD-LOOKINGSTATEMENTS AND CAUTIONARY FACTORS**

**THATMAY AFFECT FUTURE RESULTS**

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, and Section 21E ofthe Securities Exchange Act of 1934. These statements relate to future events or our future financialperformance. In some cases, forward-looking statements can be identified byterminology such as “may,” “should,” “could,”

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“expect,” “plan,” “anticipate,”“believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or thenegative of such terms or other comparable terminology. These statements areonly expectations.  We cannot assure youthat our expectations and assumptions will prove to be correct. We do notintend to update or revise any forward-looking statements, whether as a resultof future events, new information or otherwise, except to the extent that thereports we are required to file under the Securities Exchange Act of 1934, asamended, (the “Exchange Act”) contain such updates or revisions. Actual eventsor results may differ materially from the forward-looking statements due to anumber of factors, including but not limited to, those set forth inItem 1A of our Annual Report on Form 10-K for the year endedDecember 31, 2005 as updated by Item A of this Quarterly Report on Form10-Q and elsewhere in this Quarterly Report on Form 10-Q and in the reports we fileunder the Exchange Act.

**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

The primary objectives ofour investment activities are to preserve principal, maintain a high degree ofliquidity to meet operating needs, and obtain competitive returns subject toprevailing market conditions. Investments are made primarily in high-gradecorporate bonds, asset-backed debt securities and U.S. government agency debtsecurities. These investments are subject to risk of default, changes in creditrating and changes in market value. These investments are also subject tointerest rate risk and will decrease in value if market interest ratesincrease. A hypothetical 100 basis point increase in interest rates wouldresult in an approximate $0.2 million decrease in the fair value of ourinvestments as of September 30, 2006. Due to the nature of our investments andrelatively short effective maturities of debt instruments, interest rate riskis mitigated. Changes in interest rates do not affect interest expense incurredon our Convertible Notes, because they bear interest at a fixed rate. Using theprice in the latest trade in September 2006, the market value of theConvertible Notes was $118 million on September 30, 2006.

As a consequence of thenature our business and operations our reported financial results and cashflows are exposed to the risks associated with fluctuations in the exchangerates of the U.S. dollar, the Icelandic krona and other world currencies. Wecontinue to monitor our exposure to currency risk. A hypothetical 10.0%decrease in value of the US dollar against the Icelandic krona would result ina loss of approximately $0.3 million on our Icelandic krona denominatedassets and liabilities. Although we have none currently, we have historicallypurchased derivative financial instruments to hedge these general risks and maycontinue to do so.

**ITEM4. CONTROLS AND PROCEDURES**

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

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

b) *Changes inInternal Controls.* We are continuously seeking to improve theefficiency and effectiveness of our internal controls. This results in periodicrefinements to internal control processes throughout the company. However,there was no change in our internal control over financial reporting (asdefined in Rule 13a-15(f) under the Exchange Act) during 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**

**ITEM1. LEGAL PROCEEDINGS**

Other than claims andlegal proceedings that arise from time to time in the ordinary course ofbusiness which are not material, there has been no change in the mattersreported in our Annual Report on Form 10-K for the year ended December 31, 2005except as follows:

On August 4, 2006 wecommenced an action in the U.S. District Court for the Eastern District ofPennsylvania against five former employees for misappropriation of our tradesecrets and intellectual property, related breach of non-competition,non-solicitation, and non-disclosure provisions of their employment agreements,and violation of the federal Computer Fraud and Abuse Act.  The suit alleges that the defendants,including Hákon Hákonarson, formerly our Vice President, Business Development,were recruited, and at least four are currently employed, by the Center forApplied Genomics, a business unit of the Children’s Hospital of Philadelphia(CHOP).  Also, the suit alleges thatwhile still deCODE employees and with the knowledge of senior CHOP staff, thesedefendants

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copied or sent directlyto CHOP deCODE proprietary methods, tools, business plans and researchresults.  At the request of CHOP, CHOPhas intervened as a defendant in the case.

We are seeking preliminary and permanent injunctionsrestraining, among other things, the individual defendants from working at CHOPin any capacity competitive with deCODE for two years, and the individualdefendants and CHOP from soliciting our employees for a period of one year andfrom using or disclosing our confidential information.

On August 11, 2006 the court issued a temporaryrestraining order prohibiting the individual defendants from using, altering,destroying or transferring possession of any information taken from deCODE, andfrom destroying, using, altering, copying or transferring possession of one ormore 250 gigabyte hard drives or any other removable storage devices thatcontained any deCODE information.  OnAugust 22, 2006, the court entered an order extending the temporary restrainingorder until the court rules on deCODE’s motion for a preliminaryinjunction.  The hearing on plaintiffs’motion for a preliminary injunction is scheduled to conclude on November 22,2006.  A ruling is expected afterpost-hearing briefs are submitted and argued. No dates have been scheduled for submission of briefs or argument.  Accordingly, the temporary restraining orderis expected to remain in place at least through November, 2006.

**ITEM1A. RISK FACTORS**

Whilethere have been no material changes from the risk factors disclosed in Item 1Aof our Annual Report on Form 10-K for the year ended December 31, 2005 (whichpre-dated the commencement of our Phase III clinical trial of DG031), the riskfactors set forth below have been updated to provide information and data forand as of the quarter ended September 30, 2006 and to reflect the commencementand suspension of the Phase III clinical trial.

**Risks Related to Our Development of DG031**

***Suspension of our Phase III trial for DG031 will delay the completionof the trial and possible commercialization of the drug, which may hurt ourfuture financial results.***

OnOctober 5, 2006, we announced that we were voluntarily suspending our Phase IIIclinical trial for DG031 in order to address an unexpected formulation problemwith the tablets being used in the trial. We cannot guarantee that we will be able to reformulate the tabletssuccessfully.  Because the resumption ofthe trial is dependent on successful reformulation, we cannot currently predictwhen, if at all, the trial will resume; however, the suspension will cause thetrial to exceed the minimum 36 months duration from the recruitment of thefirst patient that we previously estimated. This delay in the development of this drug could adversely impact ourfinancial results and commercial prospects.

***The Phase IIIclinical trial for DG031 will require the recruitment of patients based onethnicity and haplotype status; upon re-initiation of the study, recruitmentrates could still be lower than we expect, the trial may be delayed and ourcommercial prospects may be hurt.***

In ourPhase III clinical trial for DG031, we were originally testing the hypothesiswhether African American patients who (a) carry the HapK haplotype inLTA4H and (b) have experienced a hospitalization and/or admission for proceduresand testing for unstable angina or myocardial infarction will experiencereduced rates of acute cardiovascular events when treated with DG031, ascompared to placebo on top of concomitantly administered standard of care. Inorder to recruit a sufficient number of patients to obtain statisticallysignificant evidence for the efficacy of DG031, we require the participation ofa large number of African American patients willing to be tested for haplotypestatus and to participate in the clinical trial for at least 12 months.Many factors outside our control may reduce the willingness of patients to betested and participate in the clinical trial.  Based on experience gathered to date, we are evaluating the strategy forpatient recruitment and will consider alternative enrollment strategies basedon haplotype status that would accelerate the overall enrolment plan.  This will require discussions with the UnitedStates Food and Drug Administration (FDA) and agreement on strategy through theSpecial Protocol Assessment process. However, upon re-initiation of the study,we may fail to recruit a sufficient number of patients in a timely manner, thetrial may be delayed or we may fail to show the efficacy of the drug. This maydelay or prevent the marketing approval of DG031, which could adversely impactour financial results and commercial prospects.

***We have onlyindirect evidence from biomarkers studies about the effectiveness of DG031 andthis data may not be validated in the Phase III clinical trial.***

The datacollected during the Phase I and Phase II clinical trials for DG031, which isthe basis for our continuing development of this drug, does not provideevidence of whether DG031 will prove to be an effective treatment to reduce therate of acute cardiovascular events in the prospective treatment population. Inorder to prove or disprove the validity of our assumption about the efficacy ofDG031, we must conduct the Phase III trial. We temporarily suspended the trialin early October, 2006 due to formulation stability issues.  We will need to re-initiate the study afterresolution of the formulation issues. There are delays in the program as a result, with resulting delays of validationof the hypothesis being tested.  Variousfactors that we do or do not control may cause the trial to be lengthier orcostlier than anticipated. Until data from the trial can be collected andanalyzed we will not know whether DG031 is an effective treatment, andregulatory review by the FDA will ultimately determine whether the drug gainsmarketing approval. The

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outcomeof this process is uncertain and delays or failure to gain market approvalcould adversely impact our financial results and commercial prospects.Furthermore, even if the drug is approved for African American patients, therecan be no assurance that it will ever be approved for a broader population.

**Risks Related to Our Business**

***If we are not successful in ourpending litigation regarding misappropriation of trade secrets and breach ofrelated non-competition, non-solicitation and non-disclosure agreements, ourability to protect our confidential information and to enforce non-competionand non-solicitation agreements against former employees may be impaired, whichcould adversely affect our business and prospects.***

It is possible that a judgment against us with respectto our allegations of trade secret misappropriation may negatively affect ourability to protect some of what we consider to be our confidential informationunder the law of trade secrets.  Also, itis possible that a judgment against us with respect to the non-competition,non-solicitation, or non-disclosure agreements with the individual defendants(1) would allow the defendants to engage in competition with us, (2) may causeother current or former employees to test the validity of theirnon-competition, non-solicitation, and non-disclosure agreements when theymight otherwise have refrained from doing so, or (3) may cause otherinstitutions besides CHOP to hire our current or former employees when theymight otherwise have refrained from doing so. Any of these events could impair our ability to compete forcollaborative arrangements, for access to DNA samples or for product ortechnology licensing arrangements and ultimately could adversely affect ourability to develop and market products.

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

Weincurred a net loss of $62.2 million and $41.6 million for the nine monthsended September 30, 2006 and 2005, respectively, and $62.8 million for theyear ended December 31, 2005, and had an accumulated deficit of $512.5million at September 30, 2006. We have never generated a profit and we have notgenerated revenues except for payments received in connection with our researchand development collaborations with Roche, Merck and others, from contractservices, from sales of Emerald BioSystems products and instruments, and grantfunding. Our research and development expenditures and selling, general andadministrative costs have exceeded our revenue to date, and we expect to spendsignificant additional amounts to fund research and development in order toenhance our core technologies and undertake product development (including drugdevelopment and related clinical trials). We do not expect to receive royaltiesor other revenues from commercial sales of products developed using ourtechnology in the near term. It may be several years before product revenuesmaterialize, if they do at all. As a result, we expect to incur net losses forseveral years. If the time required to generate product revenues and achieveprofitability is longer than we currently anticipate, or if the level of lossesis greater than we currently anticipate, we may not be able to continueour operations.

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

Wehave spent substantial amounts of cash to fund our research and developmentactivities and expect to continue to spend substantial amounts for theseactivities over the next several years. We expect to use cash to collect,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 ofour discovery and research programs;

·                     our ability to attract customers;

·                     our ability to commercialize ourdiscoveries and the resources we devote to commercialization;

·                     the amount we spend to enforce patentclaims and other intellectual property rights; and

·                     the costs and timing of regulatoryapprovals.

Wehave relied on, and may continue to rely on, revenues generated by ourcorporate alliances and fee-paying customers for significant funding of ourresearch efforts. Historically, a substantial portion of our revenue has beenderived from contracts with a limited number of significant customers. Ourlargest partner, Roche, accounted for approximately 10% and 17% of ourconsolidated revenue in the three-months ended September 30, 2006 and 2005,respectively, and 21% and 21% of our consolidated revenue in the nine-monthperiods ended September 30, 2006 and 2005, respectively. Revenue under ouralliances with Merck accounted for approximately 0% and 21% of our consolidatedrevenue in the three-months ended September 30, 2006 and 2005, respectively,and 0% and 19% of our consolidated revenue in the nine-months ended September30, 2006 and 2005, respectively. During the three-months endedSeptember 30, 2006 and 2005, divisions of the NIH represented 40% and 11%of our consolidated revenue, respectively, and 32% and 10% of our consolidatedrevenue in the nine-months ended September 30, 2006 and 2005, respectively.Work under our agreement with Merck aimed at developing new treatments forobesity and our 2002 agreement with Roche has been completed, and thismay significantly lower our revenues and affect the resources available tosupport our drug discovery programs, which will increase our need for additionalfunding.

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Inaddition, we may seek additional funding through public or private equityofferings and debt financings. We may not be able to obtain additionalfinancing when we need it or the financing may not be on terms favorableto us or our stockholders. Stockholders’ ownership will be diluted if we raiseadditional capital by issuing equity securities.

Ifwe raise additional funds through collaborations and licensing arrangements, wemay have to relinquish rights to some of our technologies or product candidates,or grant licenses on unfavorable terms. If adequate funds are not available, wewould have to scale back or terminate our discovery and research programs andproduct development.

***If we cannotsuccessfully form and maintain suitable arrangements with third parties for themanufacturing of the products we may develop, our ability to develop or deliverproducts may be impaired.***

We haveno experience in manufacturing products for commercial purposes and do not havemanufacturing facilities that can produce sufficient quantities of drugs forlarge scale clinical trials. Accordingly, we must either develop suchfacilities, which will require substantial additional funds, or rely oncontract manufacturers for the production of products for development and commercialpurposes. In order to conduct our Phase III clinical trial of DG031, wewill have to contract with third parties to manufacture a sufficient supply ofthe drug for the trial and to produce tablets containing DG031 in amountssufficient for the clinical trial. While we signed contracts with suppliers forthe production of DG031 material and tablets for the launch of our Phase IIIclinical trial and received sufficient materials to initiate the trial,following the reformulation and resumption of the trial, we may fail to securesufficient supply of the drug in a timely manner over the duration of thetrial.  Reformulation work may requirecontracting for new quantities of tablets, and the timing of the manufacturingof such new quantities of tablets may affect the timing of the resumption ofthe clinical trial.

Themanufacture of our products for clinical trials and commercial purposes issubject to Good Manufacturing Practices (cGMP) regulations promulgated by theFDA. The manufacture of diagnostic products is subject to the FDA’s qualitysystem requirements (QSR). In the event that we are unable to developsatisfactory manufacturing facilities or obtain or retain third partymanufacturing for our products, we will not be able to commercialize such productsas planned. We may not be able to enter into agreements for the manufacture offuture products with manufacturers whose facilities and procedures comply withcGMP, QSR and other regulatory requirements. Our current dependence upon othersfor the manufacture of our products may adversely affect our ability to developand deliver such products on a timely and competitive basis and, in the longerterm, the profit margin, if any, on the sale of future products and our abilityto develop and deliver such products on a timely and competitive basis.

***Increased leverageas a result of our convertible debt may harm our financial condition andresults of operations.***

OnSeptember 30, 2006 we had $157 million of outstanding debt as reflected in ourbalance sheet. We may incur additional indebtedness in the future and ouroutstanding 3.5% Senior Convertible Notes (the “Notes”) do not restrict ourfuture issuance of indebtedness. Our level of indebtedness will have severalimportant effects on our future operations, including, without limitation:

·      a portion of our cash flow fromoperations will be dedicated to the payment of any interest required withrespect to outstanding indebtedness;

·      increases in our outstandingindebtedness and leverage will increase our vulnerability to adverse changes ingeneral economic and industry conditions, as well as to competitive pressure;and

·      depending on the levels ofour outstanding debt, our ability to obtain additional financing for workingcapital, capital expenditures, general corporate and other purposes may belimited.

Ourability to make payments of principal and interest on our indebtedness dependsupon our future performance, which will be subject to the success of ourdevelopment and commercialization of new pharmaceutical products, generaleconomic conditions, industry cycles and financial, business and other factorsaffecting our operations, many of which are beyond our control. If we are notable to generate sufficient cash flow from operations in the future to serviceour debt, we may be required, among other things:

·      to seek additional financing in thedebt or equity markets;

·      to refinance or restructure all or aportion of our indebtedness, including the Notes;

·      to sell selected assets; or

·      to reduce or delay expenditureson planned activities, including but not limited to clinical trials, anddevelopment and commercialization activities.

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

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

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

**Risks Related to Our Collaborative Relationships**

***If we are unable toform and maintain the collaborative relationships that our business strategyrequires, our programs will suffer and we may not be able to develop products.***

Ourstrategy for developing products and deriving revenues from them is dependent,in part, upon our ability to enter into collaborative arrangements withresearch collaborators, corporate partners and others. We may rely on thesearrangements both to provide funding necessary to our product development andto obtain goods and services that we require for our product development. We donot have the capacity to conduct large scale Phase III clinical trials andwill rely on partnerships or third party contractors to conduct our Phase IIItrials, including our Phase III trial of DG031. We will rely on these thirdparties to provide us with clinical material for the trial and various servicesnecessary to organize and conduct a multi-center, multinational study, as wellas other goods and services.  We have notentered into contracts for all goods and services required for the Phase IIItrial of DG031 at this time.  Ourarrangement for this and other Phase III trials will be subject to risksdescribed below, with respect to our collaborative relationships.

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

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

We haveformed, and may in the future form additional, collaborative relationships(including relationships with clinical research organizations to conductclinical trials on our behalf) that will, in some cases, make us dependent oncollaborators for the pre-clinical studies and/or clinical trials and forregulatory approval of any products that we are developing. Failure of suchcollaborators to perform under these agreements properly in a timely manner, orat all, may lead to delays in our product development. In addition, ifparticipants 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 allow themsignificant discretion in electing whether and how to pursue such activities.We cannot control the amount and timing of resources collaborators will devoteto these programs or potential products. In addition, collaborative agreementsmay contain exclusivity provisions that may prevent us from working in aparticular field or on a particular disease even when our collaborators electnot to pursue activities under the agreements. Upon resumption of our Phase III clinical trial of DG031, we expect tocontinue relationships with clinical research organizations and otherorganizations providing services, but there is no guarantee that the partieswill come to an agreement, or that reaching such agreements will not result inadditional delays.

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

**Risks Related to Our Intellectual Property**

***Our patentapplications covering DG041, DG051 and compounds that we are developing in ourpain treatment program have not issued yet as patents.***

Themost important compounds that we have currently in pre-clinical and clinicaldevelopment and which we have discovered are DG041, DG051and compounds that weare developing in our pain treatment program. We have filed composition ofmatter type patent applications covering the compounds in the United States aswell as international applications through the Patent Cooperation Treaty.However, these patent applications are in the early stages of patentprosecution before the United States Patent and Trademark Office (USPTO) and wehave no certainty or indication from the USPTO that these patent applicationswill issue as patents. The USPTO is currently facing considerable backlog forexamining pending patent applications so considerable time may elapse before wewill have more certainty as to the patentability of the compounds. Should theUSPTO ultimately reject our patent applications covering these compounds, orshould others have filed or obtained issued patent covering the same, the valueand potential of these programs for our business would be adversely affected.

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**ITEM6. EXHIBITS AND REPORTS ON FORM 8-K**

(a) EXHIBITS

The following is a listof exhibits filed as part of this Quarterly Report on Form 10-Q.
| EXHIBIT    | ** ** | ** **                                                                                                                                                                                                                                                                        |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **NUMBER** | ** ** | ** **                                                                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                              |
| 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       |       | Placement Agency Agreement by and among the Company,  Lehman Brothers Inc. and Thomas Weisel Partners LLC, dated as of  July 13, 2006 (Incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed July 14, 2006).                     |
|       |       |                                                                                                                                                                                                                                                                              |
| 10.2       |       | Form of Purchase Agreement between the Company and  Certain Purchasers of Common Stock (Incorporated by reference to Exhibit 10.2  to the Company’s Current Report on Form 8-K filed July 14, 2006).                                                                         |
|       |       |                                                                                                                                                                                                                                                                              |
| 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.

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

Dated:  November 8,2006
|        | deCODE genetics, Inc. |
|--------|----------------------------|
|   |                       |
|   |                       |   |
|   |                       | /s/ Kari Stefansson |   |
|   |                       | Kari Stefansson |   |
|   |                       | Chairman,  President, |   |
|   |                       | and Chief  Executive Officer |   |
|   |                       |   |
|   |                       |   |
|   |                       | /s/ Lance Thibault |   |
|   |                       | Lance Thibault |   |
|   |                       | Chief Financial  Officer and |   |
|   |                       | Treasurer  (principal financial |   |
|   |                       | officer and  principal accounting officer) |   |

 

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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       |       | Placement Agency Agreement by and among the Company,  Lehman Brothers Inc. and Thomas Weisel Partners LLC, dated as of  July 13, 2006 (Incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed July 14, 2006).                     |
|       |       |                                                                                                                                                                                                                                                                              |
| 10.2       |       | Form of Purchase Agreement between the Company and  Certain Purchasers of Common Stock (Incorporated by reference to Exhibit 10.2  to the Company’s Current Report on Form 8-K filed July 14, 2006).                                                                         |
|       |       |                                                                                                                                                                                                                                                                              |
| 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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