###### FORM 10-Q

** **

**UNITED STATES**

###### SECURITIES ANDEXCHANGE COMMISSION

**Washington, DC  20549**

** **

(MarkOne)

[X]**  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACTOF 1934**

or

[  ]  **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACTOF 1934**

 

###### For the quarterlyperiod ended June 30, 2006

** **

###### Commission FileNumber 0-23666

 

**TRIPOS, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

** **

| **Utah**                         | ** ** | **43-1454986**      |
|----------------------------------|------------|---------------------|
| (State or Other  Jurisdiction of | ** ** | (I.R.S. Employer    |
| Incorporation or  Organization)  | ** ** | Identification No.) |
| ** **                       | ** ** | ** **          |

**1699 South Hanley Road**

**St. Louis, Missouri 63144**

(Address of PrincipalExecutive Offices and Zip Code)

** **

**(314) 647-1099**

(Registrant's TelephoneNumber, Including Area Code)

** **

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirement for the past 90 days.

 

Yes    X          No         

 

Indicate by check mark whether the registrant isa large accelerated filer, an accelerated filer, or a non-accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).

|  

Large accelerated  filer  ___ |  

Accelerated filer  ___ |  

Non-accelerated filer   _X |
|--------------------------------------------|-------------------------------------|-----------------------------------------|

 

Indicate by check mark whether the registrant isa shell company (as defined in Rule 12b-2 of the Exchange Act).            Yes              No            _X__

           

 

Number of shares outstanding of the issuer'sCommon Stock, par value $.01 per share, as of August 11, 2006:****10,276,262shares.

 

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**TRIPOS,INC.**

###### TABLE OF CONTENTS

 

 

|                                                                                                                                                       | **Page**    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
| **PART  I  FINANCIAL INFORMATION**                                                                                                                    |        |
| **Item  1.  Financial Statements**                                                                                                                    |        |
|   Consolidated  Balance Sheets at June 30, 2006 (Unaudited) and December 31, 2005                                                                | 3           |
|   Consolidated  Statements of Operations for the Three- and Six-Months Ended  June  30, 2006 (Unaudited) and June 30, 2005 (Unaudited) |  

4   |
|   Consolidated  Statements of Cash Flows for the Six-Months Ended June  30, 2006 (Unaudited) and June 30, 2005   (Unaudited)      |  

5-6 |
|   Notes  to Consolidated Financial Statements (Unaudited)                                                                                        | 7-26        |
|                                                                                                                                                       |        |
| **Item  2. Management's Discussion and Analysis of Financial Condition and  Results of Operations**                                                        | 27-37       |
| **Item  3. Quantitative and Qualitative Disclosures about Market Risk**                                                                                    | 38          |
| **Item  4. Controls and Procedures**                                                                                                                       | 38          |
|                                                                                                                                                       |        |
| **PART  II  OTHER INFORMATION**                                                                                                                       | 39-40       |
| **SIGNATURES**                                                                                                                                             | 40          |

 

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**PART I**

##### FINANCIALINFORMATION

** **

**Item1.  Financial Statements.**

**TRIPOS, INC.**

**CONSOLIDATED BALANCESHEETS**

| (In  thousands)                                                                                                                             | **06-30-2006**              |  12-31-2005    |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------|---------------------|
| ASSETS                                                                                                                                                                                        | **(Unaudited) **       |                |
| Current  assets:                                                                                                                                                                              |                        |                |
|      Cash  and cash equivalents                                                                                                                                      | **$ 2,895 **      | $ 6,241   |
|      Restricted  cash                                                                                                                                                | **297 **               | --             |
|      Accounts  receivable, less allowance for doubtful accounts of $191                                                                                              | **4,007 **             | 11,219         |
|      Inventory                                                                                                                                                       | **7,270 **             | 5,155          |
|      Prepaid  expenses                                                                                                                                               | **4,881 **             | 4,386          |
| Total current assets                                                                                                                                                                          | **19,350 **            | 27,001         |
|                                                                                                                                                                                          | ** **                  |                |
|    Property  and equipment, less accumulated depreciation                                                                                                                      | **25,204 **            | 26,789         |
|    Capitalized  development costs, less accumulated amortization                                                                                                               | **2,378 **             | 2,291          |
|    Goodwill                                                                                                                                                                    | **5,322 **             | 5,255          |
|    Intangible  assets, less accumulated amortization                                                                                                                           | **3,311 **             | 3,554          |
|    Investments  recorded at cost                                                                                                                                               | **1,711 **             | 1,695          |
|    Deferred  income taxes                                                                                                                                                      | **232 **               | 231            |
|    Other  assets                                                                                                                                                               | **553 **               | --             |
| Total assets                                                                                                                                                                                  | **$ 58,061 **     | $ 66,816  |
|                                                                                                                                                                                          | ** **                  |                |
| LIABILITIES  AND SHAREHOLDERS' EQUITY                                                                                                                                                         |
| Current  liabilities:                                                                                                                                                                         | ** **                  |                |
|      Current  portion of long-term debt                                                                                                                              | **$ 1,177 **      | $ 5,241   |
|      Current  portion of capital leases                                                                                                                              | **3,159 **             | 2,741          |
|      Accounts  payable                                                                                                                                               | **984 **               | 1,219          |
|      Accrued  expenses                                                                                                                                               | **3,353 **             | 4,970          |
|      Deferred  revenue                                                                                                                                               | **11,799 **            | 15,898         |
| Total current liabilities                                                                                                                                                                     | **20,472 **            | 30,069         |
|                                                                                                                                                                                          | ** **                  |                |
|    Long-term  portion of capital leases                                                                                                                                        | **2,991 **             | 1,343          |
|    Long-term  debt                                                                                                                                                             | **5,572 **             | 5,891          |
|    Common  stock warrants                                                                                                                                                      | **682 **               | --             |
| Total liabilities                                                                                                                                                                             | **29,717 **            | 37,303              |
|                                                                                                                                                                                          | ** **                  |                |
|    Redeemable  convertible preferred stock, $0.01 par value, authorized    1,833  shares, issued      1,833 shares as of June 30, 2006 | ** **

**3,519 ** |  

--     |
| Shareholders'  equity :                                                                                                                                                                       | ** **                  |                |
|      Common  stock, $0.01 par value; authorized 20,000 shares,  issued  10,276 shares as of June 30, 2006 and 10,190 shares as of  December  31, 2005.     | ** **

**103 **   |  

102    |
|      Additional  paid-in capital                                                                                                                                     | **43,299 **            | 41,846         |
|      Retained  deficit                                                                                                                                               | **(17,668)**                | (12,377)            |
|      Accumulated  other comprehensive loss                                                                                                                           | **(909)**                   | (58)                |
| Total shareholders' equity                                                                                                                                                                    | **24,825 **            | 29,513         |
|                                                                                                                                                                                          | ** **                  |                |
| Total liabilities and shareholders' equity                                                                                                                                                    | **$ 58,061 **     | $ 66,816  |
|                                                                                                                                                                                          |                        |                |

*Seeaccompanying notes.*

| 3 |
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**Item1.  Financial Statements (continued)**

 

**TRIPOS, INC.**

**CONSOLIDATED STATEMENTSOF OPERATIONS**

**(In thousands, exceptper share data)**

**(Unaudited)**

|                                                            | **Three Months Ended**         |                          | **Six Months Ended** |
|-----------------------------------------------------------------|--------------------------------|--------------------------|----------------------|
|                                                            | **06-30-2006**                 | 06-30-2005               |                      | **06-30-2006** | 06-30-2005 |
| Net  sales:                                                     | ** **                     | ** **               | ** **           | ** ** |   |
|    Discovery  informatics products & support | **$ 6,210 **         | $ 5,849        | ** **           | **$ 12,093 ** | $ 12,112  |
|    Discovery  informatics services               | **1,728 **                | 580                 | ** **           | **2,517 ** | 1,248  |
|    Discovery  research products & services   | **961 **                  | 6,919               | ** **           | **2,742 ** | 15,021  |
|    Hardware                                      | **8 **                    | 11                  | ** **           | **25 ** | 21  |
| Total net sales                                                 | **8,907 **                | 13,359              | ** **           | **17,377 ** | 28,402  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Cost  of sales                                                  | **3,394 **                | 6,886               | ** **           | **6,961 ** | 14,793  |
| Gross profit                                                    | **5,513 **                | 6,473               | ** **           | **10,416 ** | 13,609  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Operating  expenses:                                            | ** **                     |                     | ** **           | ** ** |   |
|    Sales  and marketing                          | **2,776 **                | 2,685               | ** **           | **5,786 ** | 5,630  |
|    Research  and development                     | **2,631 **                | 1,991               | ** **           | **5,453 ** | 3,912  |
|    General  and administrative                   | **1,646 **                | 1,922               | ** **           | **3,484 ** | 3,887  |
|    Restructuring  charge                              | **--  **             | --             | ** **           | **927  ** | --   |
| Total operating expenses                                        | **7,053 **                | 6,598               | ** **           | **15,650 ** | 13,429  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Income (loss) from operations                                   | **(1,540)**                    | (125)                    | ** **           | **(5,234)** | 180  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Interest  expense                                               | **(527)**                      | (393)                    | ** **           | **(1,028)** | (781) |
| Other  income (loss), net                                       | **881 **                  | (650)                    | ** **           | **1,172 ** | (657) |
| Loss before income taxes                                        | **(1,186)**                    | (1,168)                  | ** **           | **(5,090)** | (1,258) |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Income  tax expense (benefit)                                   | **202 **                  | (1,979)                  | ** **           | **(16)** | (2,050) |
| Net income (loss)                                               | **(1,388)**                    | 811                 | ** **           | **(5,074)** | 792  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Preferred dividends                                             | **217**                        | --                  | ** **           | **217 ** | --  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Net income (loss) available to common shareholder               | ** **

**$ (1,605)** |  

$ 811  | ** **           | ** **

**$ (5,291)** |  

$ 792  |
|                                                            | ** **                     |                     | ** **           | ** ** |   |
| Basic  income (loss) per share                                  | **$ (0.16)**              | $ 0.08         | ** **           | **$ (0.52) ** | $ 0.08  |
| Basic  weighted average number of shares                        | **10,194 **               | 10,091              | ** **           | **10,192 ** | 10,075  |
| Diluted  income (loss) per share                                | **$ (0.16)**              | $ 0.08         | ** **           | **$ (0.52) ** | $ 0.08  |
| Diluted  weighted average number of shares                      | **10,194 **               | 10,107              | ** **           | **10,192 ** |  10,125  |

 

*See accompanying notes.*

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**Item1.  Financial Statements (continued)**

** **

**TRIPOS, INC.**

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(In Thousands)**

| **(Unaudited)                            ** | **Six Months Ended**   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------|
|                                                                                                                                                                                    | **06-30-2006**         | 06-30-2005 |
| **Operating  activities:**                                                                                                                                                              | ** **             |   |
| Net  income (loss)                                                                                                                                                                      | **$ (5,074)**     | $ 792  |
| Adjustments  to reconcile net loss to net cash provided by operating activities:                                                                                                        | ** **             |   |
|    Depreciation  of property and equipment                                                                                                                               | **2,059 **        | 1,999  |
|    Amortization  of capitalized development costs & intangibles                                                                                                      | **611 **          | 308  |
|    Amortization  of debt discount                                                                                                                                        | **126 **          | 28  |
|    Amortization  of deferred issuance costs                                                                                                                              | **36 **           | --  |
|    Gain  on revaluation of common stock warrants                                                                                                                         | **(358)**              | --  |
|    Appreciation  (depreciation) in foreign currency hedge instruments                                                                                                    | **-- **           | (85) |
|    Deferred  tax benefit                                                                                                                                                 | **4 **            | (1,177) |
|    Gain  from sale of marketable securities                                                                                                                              | **-- **           | (240) |
|    Write-down  (carrying value adjustment) of long-term investment                                                                                                       | **(16)**               | 88  |
|    Loss  on retirement of assets                                                                                                                                         | **7 **            | --  |
|    Stock-based  compensation expense                                                                                                                                     | **218 **          | --  |
|    Non  employee and director stock compensation expense                                                                                                                 | **20 **           | --  |
| Change  in operating assets and liabilities (excluding acquired business):                                                                                                              | ** **             |   |
|       Restricted  cash                                                                                                                                    | **(298)**              | --  |
|       Accounts  receivable                                                                                                                                | **7,930 **        | 5,427  |
|       Inventories                                                                                                                                         | **(1,769)**            | 2,157  |
|       Prepaid  expenses and other current assets                                                                                                          | **653 **          | (736) |
|       Accounts  payable and accrued expenses                                                                                                              | **(3,219)**            | (4,878) |
|       Deferred  revenue                                                                                                                                   | **(4,995)**            | (2,716) |
| Net cash provided by (used in) operating activities                                                                                                                                     | **(4,065)**            | 967  |
| **Investing  activities:**                                                                                                                                                              | ** **             |   |
| Purchases  of property and equipment                                                                                                                                                    | **(314)**              | (537) |
| Capitalized  development costs                                                                                                                                                          | **(455)**              | (1,157) |
| Acquisition  of business, net of cash received                                                                                                                                          | **-- **           | (4,753) |
| Proceeds  from the sale of marketable securities                                                                                                                                        | **-- **           | 426  |
| Proceeds  from the sale of equipment                                                                                                                                                    | **3,799 **        | 1,995  |
| Investment  in unconsolidated affiliates                                                                                                                                                | **-- **           | (125) |
| Net cash provided by (used in) investing activities                                                                                                                                     | **3,030 **        | (4,151) |
| **Financing  activities:**                                                                                                                                                              | ** **             |   |
| Proceeds  from stock issuance pursuant to stock purchase and option plans                                                                                                               | **172 **          | 29  |
| Proceeds  from issuance of common stock                                                                                                                                                 | **-- **           | 500  |
| Proceeds  from issuance of preferred stock                                                                                                                                              | **4,891 **        | --  |
| Payments  of cash dividends on preferred stock                                                                                                                                          | **(93)**               | --  |
| Borrowings  under revolving line of credit                                                                                                                                              | **2,300 **        | 9,580  |
| Proceeds  from issuance of long-term debt and capital leases                                                                                                                            | **-- **           | 3,500  |
| Payments  on long-term debt and capital lease obligations                                                                                                                               | **(8,967)**            | (8,850) |
| Net cash provided by (used in) financing activities                                                                                                                                     | **(1,697)**            | 4,759  |
|                                                                                                                                                                                    | ** **             |   |
| Effect of foreign exchange rate changes on cash and cash  equivalents                                                                                                                   | **(614)**              | 423  |
|                                                                                                                                                                                    | ** **             |   |
| Net increase (decrease) in cash and cash equivalents                                                                                                                                    | **(3,346)**            | 1,998  |
| Cash and cash equivalents at beginning of period                                                                                                                                        | **6,241 **        | 4,171  |
| Cash and cash equivalents at end of period                                                                                                                                              | **$ 2,895 ** | $ 6,169  |

*See accompanying notes.*

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**Item1.  Financial Statements (continued)**

** **

**SupplementalDisclosure of Cash Flow Information (amounts in thousands)**

 

Information about noncash investing activitiesnot reflected in the Consolidated Statement of Cash Flows follows:

 

|                                                                                          | Three Months Ended      |
|-----------------------------------------------------------------------------------------------|-------------------------|
| ** **                                                                                    | 06/30/2006              | 06/30/2005 |
| **Noncash investing activities**                                                              |                    |   |
|   Increase in fair value of  marketable securities, 

  net of tax effect |  

$ --  |  

$ 42 |
|   Purchase of new equipment through  capital lease financing                        | 3,966              | 1,995 |
|   Issuance of common stock warrants  with PIPE financing                            | 1,069              | -- |
|   Beneficial conversion feature of  preferred stock and other                       |                    |   |
|     preferred stock discounts                                             | (2,055)                 | -- |
|   Accretion of preferred stock  discount                                            | 124                | -- |

 

 

In January 2005, the Company acquired OptiveResearch, Inc. for $4,770 in cash, 600 shares of the Company's common stockvalued at $3,200 and direct costs of the acquisition.  The related assets andliabilities at the acquisition date were as follows:

 

|   Cash                              | $ 647    |
|-----------------------------------------------|--------------------|
|   Accounts receivable               | 809           |
|   Prepaids & other              | 30            |
|   Equipment, net                    | 40            |
|   Intangible assets                 | 3,940         |
|   Goodwill                          | 4,308         |
|     Total assets acquired | 9,774         |
|                                          |               |
|   Accounts payable                  | (422)              |
|   Accrued expenses                  | (97)               |
| **  **Deferred revenue              | (655)              |
|   Common stock issued to sellers    | (3,200)            |
|                                          |               |
|   Cash paid                         | $ 5,400  |

 

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**Item 1.  Financial Statements (continued)**

 

**TRIPOS, INC.**

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

 **(In thousands, exceptper share data)**

 

**(1)     Summaryof Significant Accounting Policies**

 

#### Organization

 

Our discovery informatics and discovery researchproducts and services enable life science companies to better perform theirdrug discovery.  We combine our resources in computer-aided molecular design,cheminformatics, chemistry research and production, with the expertise of scientistson our staff to address the challenges facing pharmaceutical researchorganizations. We deliver products and services internationally recognized fortheir innovation and quality.  By creating new chemical compounds and aidingour partners' design of new chemical compounds in ways that we believe are morelikely to result in drug discoveries, we offer our customers advantages interms of research cycle time, cost, and efficiency of research activities.

 

We have formed commercial relationships withmost major pharmaceutical companies and with many emerging biotechnologycompanies based on their use of some or all of our products and services.  Representativepharmaceutical clients include: Abbott, Bayer, Bristol-Myers Squibb, GlaxoSmithKline,Pfizer, Sanofi-Aventis, Schering AG, Schering-Plough, Servier and Wyeth. Representative biotechnology clients include: Biovitrum, BioTie, CeNeS,Chronogen and GeminX.  

 

Tripos was formed in 1979 to commercializesoftware for molecular visualization, analysis and design.  In building ourdiscovery informatics solutions, we have focused on developing an integratedsuite of offerings at the leading edge of scientific research.  In addition to ourdiscovery informatics product and service offerings, we engage in chemistryresearch enhanced by informatics capabilities to produce high-value productsand services that directly impact our customers' discovery programs.  Incertain cases with customers, these capabilities have created opportunities forus to participate in research collaborations, in which we have the potentialfor milestones and/or royalty interests in early-stage new drug candidates.

 

Our business model is based primarily onderiving revenues from our discovery informatics and discovery researchbusinesses as follows:

 

> 
•     	*Discovery  Informatics Products and Services.*  The SYBYL® and UNITY®  software suites are the foundation of our discovery informatics      product (software) offerings.  These suites provide integrated tools for  computer-aided molecular modeling and visualization, virtual screening,  combinatorial library design, data storage and analysis, and  structure-activity relationships to customers in pharmaceutical,  biotechnology and related life science fields of research.  We offer over  fifty (50) software products for these research areas.  Key components of these products are being packaged  as web services as part of Tripos' Service-Oriented Informatics strategy,  designed to make the company's valuable discovery tools adaptable to each  scientist's workflow in the new rapidly evolving informatics environment.  In  2005, we launched the Windows®-based BenchwareTM suite,  used by laboratory researchers to support synthesis and testing decisions;  digitally store, search and retrieve research information; and share  experimental results with project team members, including computational  scientists.  These products and technologies are provided to our  customers through a license arrangement, while certain of the enterprise-wide  technologies also involve systems integration and other services to  facilitate a smooth 

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**Item1.  Financial Statements (continued)**

 

implementation. Customized software development projects can also be an avenue to assistcustomers to resolve specific research issues that require new scientificmethods, techniques and analytical tools.

 

•        *DiscoveryResearch Products and Services.*Tripos Discovery Research Centre, based in theUnited Kingdom, offers compound design and synthesis, molecular analysis, acomplete suite of lead discovery and lead optimization capabilities and newlyintroduced target-specific chemical libraries on which Tripos has applied forpatent protection (LeadDiscovery libraries). Triposoffers off-the-shelf libraries of compounds sold for pharmaceutical screeningpurposes.  We also participate with our customers in strategic chemistryresearch projects, primarily on a fee for service basis.  In a few cases, thetransfer of intellectual property rights for these therapeutic collaborationsmay include royalty or milestone payments associated with advancement of thecompounds through various stages of drug development.  In addition, Tripos'newly introduced target-specific libraries are intended to be a platform forour further collaborative development with clients.

 

We have a geographically diverse customer base,with approximately 50% of our 2006 year-to-date revenues derived from customersoutside of North America.  Our worldwide sales force operates from offices inthe United States, Canada, England, France, and Germany.  We also sell ourproducts through representatives in Brazil and around the Pacific Rim.  Ourheadquarters is in St. Louis, Missouri and our chemistry laboratory is in Bude, England.

** **

**Basisof Presentation**

 

The accompanying unaudited consolidatedfinancial statements have been prepared in accordance with generally acceptedaccounting principles for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, theydo not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  In the opinion of management, all normal recurring adjustmentsnecessary for a fair presentation of such financial statements have beenincluded.  For a further description of accounting policies, please refer tothe "Description of Business and Summary of Significant AccountingPolicies" section in the Company's annual report on Form 10-K for the yearended December 31, 2005.  Operating results for the six-month period ended June30, 2006 are not necessarily indicative of the results that may be expected forthe year ending December 31, 2006.

** **

**Revenue Recognition **

**     **

**Discovery Informatics Products and Support**

** **

We recognize revenues in accordance with theAmerican Institute of Certified Public Accountants (AICPA) Statement ofPosition (SOP) 97-2, "Software Revenue Recognition," as amended. Revenues from software license agreements are recognized when all of thefollowing criteria are met as set forth in paragraph 8 of SOP 97-2: (1)persuasive evidence of an arrangement exists, (2) delivery has occurred, (3)the fee is fixed or determinable, and (4) collectibility is probable.  

 

Our  largest sources of software license revenue are from Term and Bundled  licenses.  These are time-based arrangements for one or multiple software  products that are sold together with maintenance and support for the term of  the license arrangement.  We do not have Vendor Specific Objective Evidence  ("VSOE") to determine fair value of the maintenance and support in term  arrangements and therefore

|  8 |
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**Item 1.  Financial Statements (continued)**

 

recognize revenues from these bundled time-basedlicenses ratably over the license term, which typically range from 1 to 3years.

 

We allocate revenues from perpetual softwarearrangements involving multiple elements to each element based on the relativefair values as determined by the VSOE for each element.  We limit ourassessment of VSOE for each element to the price charged when the same elementis sold separately.  We have analyzed all of the elements included in ourmultiple-element arrangements and determined that we have sufficient VSOE toallocate revenues to maintenance and support services, and training.  We selltraining separately and have established VSOE on this basis.  VSOE formaintenance and support is determined based upon the renewal rates in contractsthemselves, which is based on a fixed percentage of the current perpetuallicense list price.  Accordingly, assuming all other revenue recognitioncriteria are met, revenues from perpetual licenses are recognized upon deliveryof the software using the residual method in accordance with SOP 98-9,"Modification of SOP 97-2, Software Revenue Recognition, with Respect toCertain Transactions." 

 

Software maintenance agreements providetechnical support and the right to unspecified enhancements and upgrades on a"when-and-if-available" basis.  Post-contract support revenues onperpetual agreements are recognized ratably over the term of the support period(generally one year), and training and other service revenues are recognized asthe related services are provided.  Any unrecognized portion of amounts paid inadvance for licenses and services is recorded as deferred revenue.

 

**Discovery Informatics Services**

 

Discovery Informatics Services (DIS) includes contractsfor the development of packaged Tripos software and/or for the development anddelivery of enterprise-wide customized software (such as laboratory informationsystems or database integration projects).  Technological feasibility exists onthese software arrangements as they normally leverage our existing products ortechniques.  These arrangements typically include installation at thecustomer's site.  We account for these arrangements in accordance with SOP81-1, as required by SOP 97-2 since the contract to deliver software andinstallation requires significant production, modification or customization ofsoftware.

 

In applying the provisions of SOP 81-1 thepercentage of completion method of accounting for long-term contracts isutilized.  Percentage of completion accounting provides for two methods torecord long-term contract activity:  1) For contracts where customer approvalof contractually required tasks must occur at each distinct milestone, andwhere amounts billable are indicative of progress-to-completion, we recordrevenues when a milestone has been met and accepted by the customer.  2) Forcontracts without distinct milestones, we measure progress using thecost-to-cost method (cumulative costs as a percentage of total expected coststo complete), which approximates progress towards completion.  In addition, whencurrent estimates of total contract revenue and contract cost indicate a loss,a provision for the entire loss on the contract is made in the period that theloss becomes evident.

 

DIS also includes software development("SD") projects that are contractual arrangements with customers toleverage our expertise in developing a scientific software tool for use in drugdiscovery.  Billings may be on a time and materials basis; accordingly, werecord the related revenue when the time and costs are incurred at the statedcontractual rates.  Other contracts may be accounted for under milestone orcompleted contract basis depending on the negotiated terms.  For thesearrangements, cost and revenues are deferred until achievement of the milestoneor completion of the contract. 

 

** **

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**Item 1.  Financial Statements (continued)**

** **

**Discovery Research Products and Services**

 

Discovery research sales include:  (1) sales ofchemical compounds from inventory, (2) sales of compounds with associatedexclusive intellectual property, (3) long-term contracts to design and producechemical compounds to customer specifications, (4) contracts to performhigh-throughput analytical and/or purification, of (5) contracts to performdiscovery research activities. 

 

We recognize revenue from the sale of chemicalcompounds upon shipment of the products, FOB shipping point to the customer. This practice is consistent with the four criteria required for revenuerecognition listed in paragraph 1 of Staff Accounting Bulletin ("SAB") 104 issuedby the U.S. Securities and Exchange Commission ("SEC").  For chemical compoundtransactions, persuasive evidence of an agreement exists upon the receipt of acontract outlining the purchase and usage terms of the compounds.  A purchaseorder may also be received as confirmation.  As stated above, revenue is notrecognized until the compounds have been shipped to the customer.  The sellingprice for compounds is fixed according to the terms of the contract orcustomer's purchase order.  Payment terms for chemical compound transactionsare Net 30 days.  We have experienced very few bad debts arising from theseproduct transactions; as a result, collectibility is reasonably assured.

 

In accordance with SOP 81-1, sales derived fromlong-term contracts to design and produce chemical compounds to customerspecifications are recorded using the percentage of completion method as the finishedgoods are delivered (under the units of delivery method).  The contract costsrelated to delivered compounds are recorded to cost of sales as the compoundsare delivered and revenue is recognized.

 

Discovery research activities involve leadcompound optimization projects, custom synthesis, and compound design. Thesecontracts generally call for non-refundable contractual fees tied to time andmaterials.  Accordingly, revenues under contracts of this type are recorded ona time and material basis.  When contracts to perform discovery researchactivities require a specific deliverable, the direct and incremental contractcosts are deferred.  Revenue and the contract costs are then recognized upondelivery and acceptance.

 

An access fee for our LeadDiscovery programs isrecognized upon completion of a materials transfer agreement and shipment ofselected compounds to the customer for screening purposes.  Customers decidingto retain exclusive rights to promising compounds in the selection are requiredto pay an additional fee.  Certain customers may engage Tripos for follow-ondiscovery research services to further refine the lead compound at additional cost.

 

**Hardware Sales**

 

Hardware sales are recorded upon shipment of theproduct to the customer.

 

**Stock-Based Compensation**

 

Prior to January 1, 2006, we accounted forstock-based compensation plans under the intrinsic value method as permittedunder Accounting Principles Board Opinion No. 25 ("APB 25"), "*Accountingfor Stock Issued to Employees*", and related Interpretations.  UnderAPB 25, generally no compensation expense was recognized because the exerciseprice of the options equaled the fair value of the stock at the grant date.

 

 

| 10 |
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----

**Item 1.  Financial Statements (continued)**

 

**Stock-Based Compensation (continued)**

 

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions of SFASNo. 123R ("FAS 123R"), "Share-Based Payment," using themodified-prospective transition method.  Under this transition method,compensation expense was recognized beginning January 1, 2006 and includes(a) compensation expense for all share-based employee compensationarrangements granted prior to, but not yet vested as of January 1, 2006,based on the grant date fair value estimated in accordance with the originalprovisions of FAS 123, and (b) compensation expense for all share-basedemployee compensation arrangements granted subsequent to January 1, 2006,based on the grant date fair value estimated in accordance with the provisionsof FAS 123R.  Results for prior periods have not been restated.  See Note 14 ofthe Notes to Consolidated Financial Statements in this Form 10-Q for furtherdiscussion of stock-based compensation.

** **

**IncomeTaxes**

** **

We account for income taxes in accordance withStatement of Financial Accounting Standards No. 109 ("FAS 109"), *Accountingfor Income Taxes,* which prescribes the use of the asset and liabilitymethod whereby deferred tax assets or liabilities are calculated at the balancesheet date using current tax laws and rates in effect.  Valuation allowancesare established when necessary to reduce deferred tax assets when it is morelikely than not thata portion or all of the deferred tax assets will not be realized.  Inaccordance with FAS 109, income tax expense includes 1) deferred tax expense,which generally represents the net change in the deferred tax asset orliability balance during the period plus any change in valuation allowances,and 2) current tax expense, which represents the amount of tax currentlypayable to or receivable from ataxing authority.  The primary difference between financial statement incomeand taxable income results from the use of different methods of computingdepreciation, capitalized development cost, certain revenue recognitionactivities, other timing differences and the valuation of net operating losscarryforwards.  Deferred taxes do not reflect temporary differences relating toour investment in foreign subsidiaries as these amounts have been deemed to bepermanently invested.  Estimating the deferred tax position on these amounts isnot practical.****

 

The effective tax rate reflectsmanagement's current estimate of the distribution of earnings among thestatutory jurisdictions in which we operate and the valuation of certain taxcredits and net operating losses in the U.S. and U.K. from prior tax years(each ending December 31).  Valuation allowances established for deferred tax assetsrelated to net operating losses does not impair our ability to use thosedeferred tax assets upon achieving profitability in the related jurisdictions. Upon the recognition of income in future periods in the jurisdictions where thedeferred tax assets were created, release of the corresponding valuationallowances may result in a lower effective tax rate.

 

**Inventory**

 

We account for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage) ascurrent-period charges and not included in overhead as required by Statement ofFinancial Accounting Standards ("SFAS") No. 151 "InventoryCosts-an amendment of ARB No. 43, Chapter 4" ("FAS 151").  Inaddition, FAS 151 requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities.  We have adopted FAS 151 effective January 1, 2006.  The adoptionof FAS 151 coincided with the completion of our four-year $90 million fileenrichment project with Pfizer.  As a result, there are more current periodcharges of approximately $197 and $472 in the second quarter and first sixmonths of 2006, respectively, and we are estimating a total of approximately $935for fiscal year 2006 based upon decreased production.

| 11 |
|----|

                                                                                                                                               

----

 

 

 

 

 

**Item 1.  Financial Statements (continued)**

 

 

**(2)     ComprehensiveIncome (Loss)**

 

The components of comprehensive income, net ofrelated tax, for the three- and six-month periods ended June 30, 2006 and 2005were as follows:

|                                                                              | **Three-month Period**         |                          | **Six-month Period** |
|-----------------------------------------------------------------------------------|--------------------------------|--------------------------|----------------------|
|                                                                              | **06-30-2006**                 | 06-30-2005               |                      | **06-30-2006** | 06-30-2005 |
| Net income (loss) available to common	

   shareholder             | ** **

**$ (1,605)** |  

$ 811  |                 | ** **

**$ (5,291)** |  

$ 792  |
| Unrealized gain (loss)on marketable securities                                    | **-- **                   | 11                  |                 | **-- ** | 53  |
| Less: reclassification for (gain) loss  included in     net income | **-- **                   | (36)                     |                 | **-- ** | (149) |
| Foreign currency translation adjustments                                          | **(553)**                      | 806                 |                 | **(851)** | 1,315  |
| Comprehensive income                                                              | **$ (2,158)**             | $ 1,592        |                 | **$ (6,142)** | $ 2,011  |

 

The components ofaccumulated other comprehensive income, net of related tax, at June 30, 2006and December 31, 2005 were as follows:

|                                     | **06-30-2006**   | 12-31-2005  |
|------------------------------------------|------------------|-------------|
| Foreign currency translation adjustments | **$ (909)** | $ (58) |
| Accumulated other comprehensive  loss    | **$ (909)** | $ (58) |

 

 

 

**(3)     ContingentLiabilities**

 

*Securities Class Action Litigation*

On or about July 24, 2003, the Company and twoof its executive officers, Dr. John P. McAlister and Mr. B. James Rubin, weresued in federal district court in St. Louis, Missouri on behalf of purchasersof the Company's common stock during the first half of 2002.  The consolidatedclass action complaint alleged that statements made by the Company in pressreleases and other public disclosures contained materially false and misleadinginformation in violation of the federal securities laws.  On or about May 5,2004, plaintiffs filed a second amended complaint on behalf of a purportedclass of purchasers of the Company's common stock between February 9, 2000 andJuly 1, 2002 (the "Class Period").  The second amended complaintgenerally alleges that, during the Class Period, defendants made false ormisleading statements of material fact about the Company's prospects and failedto follow generally accepted accounting principles in violation of the federalsecurities laws.  The second amended complaint also named Ernst & YoungLLP, the Company's former independent registered public accounting firm, as aco-defendant.  In August 2004, the Company and the individual defendants andErnst & Young filed motions to dismiss the second amended complaint.  On September30, 2005, the Company was informed that its motion to dismiss was denied;however, the motion to dismiss filed by Ernst & Young was granted.

 

On March 21, 2006, the parties reached a tentativeagreement to settle the class action litigation.  The total amount of thesettlement is $3,150 which is to be paid by our insurers.  The settlement wassubject to court approval after notice and an opportunity to object wasprovided to the putative shareholder class.  On August 4, 2006, the Courtentered an order approving the settlement and dismissing with prejudice allclaims against the defendants.  

| 12 |
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* *

* *

**Item 1.  Financial Statements (continued)**

* *

**(3)     ContingentLiabilities (continued)**

* *

*Shareholder Derivative Litigation*

On or about February 10, 2006, a shareholderderivative action was filed in the Circuit Court of the County of St. Louis.  The complaint names certain of the Company's officers and directors as defendantsand names the Company as a nominal defendant.  The complaint alleges thatcertain of the Company's officers and directors breached their fiduciary dutiesto the Company by engaging in alleged wrongful conduct including conductcomplained of in the securities class action litigation described above.  

 

On March 21, 2006, theparties reached a tentative agreement to settle this litigation, subject tofinal documentation and court approval, involving the implementation of certainpolicies and procedures by the Company and the payment of attorneys' fees of$200 to plaintiffs' counsel.  All fees are to be paid by our insurers.  A courtdate has not yet been established for review of the terms of settlement.  Therecan be no assurance that the settlement will be approved, in which case we willcontinue to vigorously defend ourselves against these claims.  

 

*Grant Programs*

In 2002, Tripos, Inc.and its U.K. subsidiary, Tripos Discovery Research Ltd. ("TDR") was awarded aGBP2400 grant by the U.K Department of Trade and Industry ("DTI") based on thecreation of jobs in the region and capital investment.  In 2002 and 2004 we metall criteria for the first and second installments and received GBP550 andGBP990, respectively.  We are obligated to repay portions or all of the grantmoney received for a period of up to 24 months after our last draw under the DTIgrant programs if we eliminate jobs or exit the property.  On January 24, 2006we reduced headcount as described in Note 11 by seventy-six positions. Calculation of any amounts repayable to the U.K. government will be based onemployee staffing levels at December 31, 2006.  Actual staffing levels at thatdate will be compared to staffing levels previously funded by the grant.  Anyshortfall in actual staffing could require repayment to the DTI calculated at arate of GBP17 per employee up to a maximum amount of GBP1,540 (approximately$2,800).  The Company has initiated preliminary discussions with the DTI withthe goal of negotiating a reduced repayment obligation.  The Company has yet toreceive an indication from the DTI as to the amount to be repaid nor as to thetiming of the repayments, if any.

 

 

**(4)     SignificantCustomer **

** **

During the second quarter and six months endedJune 2006, Wyeth represented 17% and 12%, respectively, of total net sales.  Welicense our discovery software products to Wyeth and also have contracts withWyeth for two collaborative software development projects.  No other customerrepresented over 10% of total net sales in either the three or six-monthperiods in 2006.  During the second quarter and six months ended June 2005,Pfizer, Inc. represented 51% and 48%, respectively, of total net sales.  We providedproducts and services to Pfizer under three separate contracts: multi-yearworldwide licenses to our discovery software products, multi-year collaborativesoftware development project and a $90 million four-year discovery researchproject to design and synthesize exclusive compound libraries which wascompleted in the fourth quarter 2005.  We continue to provide multi-yearworldwide licenses to our discovery software products to Pfizer during 2006;however revenues from Pfizer have dropped below 10% of second quarter and sixmonths ended June 2006 total revenues.  

** **

** **

| 13 |
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----

**Item 1.  FinancialStatements (continued)**

** **

**(5)     Earnings(Loss) Per Share** 

 

The following table setsforth the computation of basic and diluted earnings per share for the three-and six-month periods ended June 30, 2006 and 2005.

|                                                                                                                                                                        | **Three-months Ended**   |              | **Six-months Ended** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------|--------------|----------------------|
|                                                                                                                                                                        | **06-30-2006**           | 06-30-2005   |                      | **06-30-2006** | 06-30-2005 |
| **Numerator:**                                                                                                                                                              | ** **               |         |                 | ** ** |   |
| Numerator for basic earnings per share--

     net income  (loss) allocable to common         shareholders | **$ (1,605)**       | $811         |                 | **$ (5,291)** | $ 792 |
| **     **dividends accruing to  preferred shareholders

        (Note  C)                                  | ** **

**-- ** |  

--   |                 | ** **

**-- ** |  

-- |
| Numerator for diluted earnings per  share                                                                                                                                   | **$ (1,605)**       | $811         |                 | **$ (5,291)** | $792 |
| **Denominator:**                                                                                                                                                            | ** **               |         |                 | ** ** |   |
| Denominator for basic earnings per share--     Weighted average shares                                                                                       | **10,194 **         | 10,091       |                 | **10,192 ** | 10,075 |
| Effect of dilutive securities:                                                                                                                                              | ** **               | ** **   | ** **           | ** ** | ** ** |
|    Warrants  (Note A)                                                                                                                                   | **-- **             | --           |                 | **-- ** | -- |
|    Employee stock options (Note  B)                                                                                                                     | **-- **             | 16           |                 | **-- ** | 50 |
|    Assumed conversion of  Series C preferred 

      Shares  (Note C)                                                          | ** **

**-- ** |  

--   |                 | ** **

**-- ** |  

-- |
| Denominator for diluted earnings  per share--     Adjusted weighted average shares                                                                           | **10,194 **         |  10,107 |                 | **10,192 ** | 10,125 |
| ** **                                                                                                                                                                  | ** **               |         |                 | ** ** |   |
| **Basic** and diluted earnings (loss) per share                                                                                                                             | **$ (0.16)**        | $ 0.08  |                 | **$ (0.52)** | $ 0.08 |

 

Note A: For the threeand six-months periods in 2006 and 2005, the dilutive effect of the 156outstanding warrants to purchase shares of common stock issued to Horizon hasbeen excluded as the average market price of Tripos common stock was below theprice of the warrants and therefore the warrants could not be deemed to havebeen converted into common stock.  The 550 warrants and 16 warrants issued toMidwood Capital and Seven Hills, respectively, have also been excluded for thethree and six-months periods in 2006 as the average market price of Triposcommon stock was below the price of the warrants and therefore the warrantscould not be deemed to have been converted into common stock.

 

Note B:  For the threeand six-months periods in 2006, weighted average shares outstanding did notinclude shares related to the effect of employee stock options as none wereexercisable due to the market price of the Company's common stock during theperiods. 

 

Note C:   For the threeand six-months periods ending June 30, 2006, weighted average sharesoutstanding were not adjusted for the conversion of the Series C PreferredStock as their inclusion would have been anti-dilutive.  Accordingly, therelated preferred dividends were not added back to the numerator for dilutedearnings per share.

 

For additionaldisclosures regarding earnings per share, see the notes to the Company's 2005consolidated financial statements in its Form 10-K.

 

| 14 |
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**Item1.  Financial Statements (continued)**

** **

**(6)     Inventory**

 

We maintain a physical inventory of chemicalcompound libraries in various states of completion for LeadQuest, LeadDiscoveryand customer-specific chemistry research projects.  Costs associated with themanufacture of compounds are calculated using the standard cost method and arecarried at the lower of cost (standard cost method approximating FIFO) ormarket.  In calculating the reserve for obsolescence, collections of compoundsare reviewed for their age, possible chemical degradation and cumulative salestrends, and if necessary, a reserve provision is made so that the carryingvalue is at or below the respective net realizable values.  If there is, in ouropinion, a significant adverse deviation in sales trends for a specificcompound collection or library, an additional reserve provision is taken.  Aportion of the LeadQuest inventory is used in discovery research projects.  Amortizationof this inventory is recorded in the reserve for obsolescence over its 10-yearexpected useful life.  Similarly, LeadDiscovery libraries containing patentedcompound series are amortized over the anticipated patent life.  The remainingLeadDiscovery libraries are amortized over a 10-year period.  Amortizationrelated to these inventory components was $66 during the second quarter and $134for the six-month period of 2006.  In all cases, customers may purchase any orall remaining quantities of LeadQuest or LeadDiscovery libraries.  Work inprocess and finished goods inventory includes the accumulated cost of compoundsin production or awaiting shipment to customers under discovery research orcustom synthesis contracts.  

 

Inventory balances at June 30, 2006 and December31, 2005 were:

|                                                                                                         | **06-30-2006**         | 12-31-2005         |
|--------------------------------------------------------------------------------------------------------------|------------------------|--------------------|
|      Raw materials                                                                  | **$ 1,900 ** | $ 1,763  |
|      Work in process                                                                | **5,629 **        | 3,339         |
|      Finished goods                                                                 | **3,214 **        | 3,217         |
|      Reserve for  obsolescence                                                      | **(3,473)**            | (3,164)            |
|          Total  inventory                                       | **$ 7,270 ** | $ 5,155  |
| Costs of discovery research customer projects  included in Work in Process and 

  Finished Goods above | **$ 882 **   | $ 534    |

 

 

**(7)     Time-basedSoftware License Arrangements**

 

Certain time-basedsoftware license arrangements are covered by non-cancelable agreements whoseterms generally range from one to five years.  The typical term of the contractsis three years.  Revenue from these time-based software license arrangements isrecognized ratably over the agreed term.  The following table shows the amountof revenues to be recognized from these non-cancelable arrangements after June30, 2006:

 

|   | Revenues to be  recognized in:                 | Amount        |
|--------|------------------------------------------------|---------------|
|   |    2006  (remaining 2 quarters) | $ 9,279  |
|   |    2007                         | 7,140         |
|   |    2008                         | 1,568         |
|   |    2009  and later              | 188           |
|   | Total                                          | $ 18,175 |

 

| 15 |
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----

 

 

**Item 1.  Financial Statements (continued)**

** **

**(7)     Time-basedSoftware License Arrangements (continued)**

 

Tripos is typically paid annually under thesecontracts.  Shown below are the amounts to be billed under these contractssubsequent to June 30, 2006 (amounts not included in the accompanying balancesheets at June 30, 2006).

 

|   | Amounts to be billed  in: | Amount       |
|--------|---------------------------|--------------|
|   |    2006    | $ 6,003 |
|   |    2007    | 3,045        |
|   |    2008    | 442          |
|   | Total                     | $ 9,490 |

** **

** **

**(8)     Debt Facilities**

** **

As of June 30, 2006 we have existing creditfacilities provided by LaSalle Bank in the form of a revolving line of creditand a mortgage loan for our corporate headquarters building, due to expire onJanuary 1, 2007 and April 18, 2008, respectively.  The line of credit andmortgage loan were both amended in April 2006.  The credit facilities arecollateralized by substantially all of our U.S. assets and stock pledges foreach of the U.S. and U.K. subsidiaries.

 

The revolving line of credit borrowing capacitywas amended to $6,000 and has a borrowing base of 80% of domestic and insuredforeign accounts receivable plus an allowance of $1,800 against excess equityin U.S. real estate.  Covenants under the amended credit facility include arevised minimum shareholders' equity covenant tested quarterly and a minimumconsolidated cash balance covenant tested monthly.  The annual clean-downrequirement was eliminated.  Borrowings under the revolving line of credit bearinterest at variable rates tied to LIBOR or the bank's prime rate.  The line of creditcarries a commitment fee of 3/8% of the unused portion of the line.  All other terms of therevolving line of credit remain the same.  Due to the short term commitment of the amendedcredit facility, draws on the line of credit are classified as short-term debt.Borrowingbase availability was $4,728 and we had no borrowings outstanding at June 30,2006.  The mortgage note calls for even quarterly principal payments based on atwenty-year amortization schedule.  Interest on the mortgage loan was modifiedto LIBOR plus 3.0%.  Interest rates paid by the Company on the mortgageaveraged 7.2% and 7.0% during the second quarter of 2006 and first six monthsof 2006, respectively.  As of June 30, 2006, $3,589 was remaining on themortgage.

 

Inconnection with the Optive acquisition, the Company issued a subordinatedpromissory note to Horizon Technology Finance with a face value of $3,500 and astated interest rate of 11.42%.  The repayment terms of the promissory noterequire monthly interest only payments of $33 for the first 18 months, followedby 30 monthly principal and interest payments of $135 beginning on August 1,2006.  Each payment of principal will be accompanied by payment of accrued butunpaid interest to the date of the payment.  The subordinated promissory notecontains prepayment penalties.  In addition, as part of the financingtransaction, 112 shares of common stock were issued to Horizon and Sand HillCapital at a discounted price of $4.48 per share.  Warrants to purchase 156 commonshares were issued to Horizon at a negotiated price of $4.48.  Thesetransactions resulted in original issuance debt discount of $89 related to thecommon stock issued at a discount and $432 related to the warrants, calculatedbased upon relative fair values.  The debt discounts are being amortized tointerest expense over the life of the loan using the effective interest ratemethod.  

 

| 16 |
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**Item 1.  Financial Statements (continued)**

** **

**(9)     CapitalLease Financing**

** **

InMarch 2006, we sold certain equipment at our research laboratory and leased theequipment back under a three-year capital financing lease.  The proceedsreceived of $2,941 were equal to the net book value of the equipment, resultingin no gain or loss on the transaction, and were recorded as a capital leaseliability.  The equipment is still actively utilized in our operations, remainson our books and continues to be depreciated.  Quarterly payments go to reducethe capital lease liability.  Computer equipment valued at $167 was acquiredwith capital lease financing at our U.S. headquarters.

 

InApril 2006, we extended the financing of certain equipment at our researchlaboratory for which capital leases were expiring.  The replacement capitalleases generated proceeds of $858 which was equal to the net book value of theequipment.  This equipment remains active and in service for our operations.

** **

** **

**(10)     Goodwilland Other Intangible Assets**

** **

At June 30, 2006 andDecember 31, 2005, the Company had the following intangible asset balances:

|                   |   | June 30, 2006 |   | December 31, 2005 |
|------------------------|--------|---------------|--------|-------------------|
|                   |   | Gross         |   |              |   | Gross |   |   |
|                   |   | Carrying      |   | Accumulated       |   | Carrying |   | Accumulated |
|                   |   | Amount        |   | Amortization      |   | Amount |   | Amortization |
| Acquired software      |   | $ 3,590  |   | $ 573        |   | $ 3,590 |   | $ 382 |
| Noncompete agreements  |   | 350           |   | 139               |   | 350 |   | 92 |
| Patents and trademarks |   | 192           |   | 109               |   | 192 |   | 104 |
| Total                  |   | $ 4,132  |   | $ 821        |   | $ 4,132 |   | $ 578 |

 

Amortized intangible assets have the followingweighted average useful lives as of June 30, 2006:  acquired software -- 14.4years; non-compete agreements -- 3.9 years; patents and trademarks -- 16.7years; and intangible assets in total -- 13.6 years.

 

Amortization expense was approximately $122 and$95 for the three-month periods ended June 30, 2006 and 2005, and $243 and $242for the six-month periods respectively.  Estimated annual amortization expensefor the next 5 years is: 2006 - $486; 2007 - $476; 2008 - $475; 2009 - $391 and2010 - $9.

 

The changes in the carrying amount of goodwill forthe three months ended June 30, 2006 are as follows:

|                                      |   | Discovery    |   | Discovery    |   |         |
|-------------------------------------------|--------|--------------|--------|--------------|--------|--------------|
|                                      |   | Informatics  |   | Research     |   | Total        |
| Balance at December  31, 2005             |   | $ 4,308 |   | $ 947   |   | $ 5,255 |
| Foreign currency  translation adjustments |   | --      |   | 67           |   | 67           |
| Balance at June 30,  2006                 |   | $ 4,308 |   | $ 1,014 |   | $ 5,322 |

The goodwill related toDiscovery Informatics is not tax deductible.

** **

| 17 |
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**Item1.  Financial Statements (continued)**

** **

**(11)**    **Restructuring Charge**

** **

OnJanuary 24, 2006 we completed a reduction in force for our Discovery Researchbusiness based in Bude, England which was previously announced on December 19,2005.  This action coincided with the conclusion of the 30-day consultationperiod with employees mandated by U.K. law.  We reduced the number of employeesby 76 positions to streamline and refine our Discovery Research business andassociated cost structure as a result of our fourth quarter 2005 completion of thefour-year $90 million file enrichment project with Pfizer Inc.  More than halfof the employees affected left the Company under a voluntary separation plan. In addition, a restructuring of our US based employees resulted in a staffreduction of 9 employees.  As a result of these actions, the Company recorded apre-tax restructuring charge in the first quarter 2006 of approximately $807and $120 related to our Discovery Research and Discovery Informatics divisions,respectively, for one-time termination benefits and outplacement costs.  Thesecosts are recorded in the consolidated statement of operations in the restructuringcharge line item.  All costs associated with these restructurings were paid bythe end of the second quarter.

 

Thefollowing table summarizes the restructuring activity as of June 30, 2006:

 

|                                     |   | Discovery Informatics |   | Discovery Research |   |  

Total   |
|------------------------------------------|--------|-----------------------|--------|--------------------|--------|-----------------|
| Restructuring  charge first quarter 2006 |   | $ 120       |   | $ 807    |   | $927       |
| Cash  payments first quarter 2006        |   | (114)                 |   | (803)              |   | (917)           |
| Accrual  balance at March 31, 2006       |   | $ 6         |   | $ 4      |   | $10        |
| Cash  payments second quarter 2006       |   | (6)                   |   | (4)                |   | (10)            |
| Accrual  balance at June 30, 2006        |   | $ --        |   | $ --     |   | $ --  |

** **

** **

**(12)     Long-termInvestments**

 

Since 2001, wehave invested in the Life Science Ventures II fund administered by A.M. Pappas. This fund invests in new and developing companies in the life science sector. Our investment commitment of $2,500 represents approximately 2.0% of the totalcapital of the fund.  As of June 30, 2006 we had invested $2,075 or 83% ofour total commitment.  The fund's managers record investment impairmentswhen identified, for which we recognize our pro-rata share of such impairments.  During the first quarter of 2005, we recorded our pro-ratashare of impairments totaling $88.  Our net investment balance in the A.M.Pappas Life Science Ventures II Fund at June 30, 2006 totals $1,520, and isreflected in investments recorded at cost on the balance sheet. 

 

Duringthe third quarter 2005, we received shares of common stock of InfinityPharmaceuticals, a private cancer drug discovery and development company,valued at $191 as part of an early termination agreement for a software licensecontract.  Compensation for the early termination agreement consisted of cash plusshares and represented the full value of our software license agreement.  Ourinvestment in the shares is also recorded in investments recorded at cost onthe balance sheet.  In April 2006, Infinity Pharmaceuticals announced itsintent to merge with Discovery Partners International, Inc. to become a publiccompany.  As of June 30, 2006, the merger had not yet been completed.  Uponcompletion of the merger, our investment in the combined company will be movedto Marketable Securities with the value of the investment beingmarked-to-market each period thereafter.

 

| 18 |
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**Item 1.  FinancialStatements (continued)**

** **

**(13)     Segments**

 

The Company operates in tworeporting segments, Discovery Informatics and Discovery Research.  TheCompany's Discovery Informatics segment designs, or in-licenses, and sellslicenses to software suites that provide computer-aided molecular modeling andvisualization, virtual screening, combinatorial library design, data storageand analysis, and structure-activity relationships to customers inpharmaceutical, biotechnology and related life science fields ofresearch.  The Company's Discovery Research segment provides drug discoveryservices to pharmaceutical and biotechnology companies.  High-end servicesoffered are based on application by Tripos of its proprietary high-throughputcombinatorial chemistry, and our ChemSpace database searching and selectiontechnologies, including the Lead Hopping method for quick identification ofalternative chemistries for customer's needs.

 

Summarized financialinformation concerning the industry segments follows:

 

DI = Discovery Informatics

DR = Discovery Research

 

|                                                        | ** ** | **Three-Months End June 30,** |
|-------------------------------------------------------------|------------|-------------------------------|
|                                                        |       | **2006**                      |   | 2005 |
|                                                        |       | **DI**                        | **DR** | **Total** |   | DI | DR | Total |
| Revenues:                                                   |       |                          |   |   |   |   |   |   |
| DI products (including  hardware)

                    |       | **$ 6,218**              | **$ -- ** | **$ 6,218 ** |   | $ 5,860 | $ -- | $ 5,860  |
| DI services                                                 |       | **1,728**                     | **-- ** | **1,728 ** |   | 580 | -- | 580  |
| DR products &  services                                 |       | **--**                        | **961 ** | **961 ** |   | -- | 6,919 | 6,919  |
| Total  revenues                                             |       | **$ 7,946**              | **$ 961 ** | **$ 8,907 ** |   | $ 6,440 | $ 6,919 | $ 13,359  |
|                                                        |       | ** **                    | ** ** | ** ** |   |   |   |   |
| Depreciation & amortization                             |       | **$ 562**                | **$ 736 ** | **$ 1,298 ** |   | $ 325 | $ 383 | $ 708  |
| Corporate non-allocated                                     |       | ** **                    | ** ** | ** 44 ** |   |   |   |  91  |
| Depreciation & amortization  on statement of operations |       | ** **                    | ** ** | **$ 1,342 ** |   |   |   | $ 799  |
|                                                        |       | ** **                    | ** ** | ** ** |   |   |   |   |
| Operating income (loss)                                     |       | **$ 1,055**              | **$ (1,270)** | **$ (215)** |   | $ 935 | $ 497 | $ 1,432  |
| Non-allocated corporate  department expense                 |       | ** **                    | ** ** | **(1,325)** |   |   |   | (1,557) |
| Operating loss on  statement of operations                  |       | ** **                    | ** ** | **$ (1,540)** |   |   |   | $ (125) |
|                                                        |       | ** **                    | ** ** | ** ** |   |   |   |   |
| Long-lived assets                                           |       | **$ 15,629**             | **$ 20,586** | **$ 36,215 ** |   | $ 17,604 | $ 23,815 | $ 41,419  |
|                                                        |       | ** **                    | ** ** | ** ** |   |   |   |   |
| Total assets (1)                                            |       | **$ 24,990**             | **$ 29,879** | **$ 54,869 ** |   | $ 27,440 | $ 37,178 | $ 64,618  |
| Consolidated cash                                           |       | ** **                    | ** ** | **3,192 ** |   |   |   | 6,169  |
| Total assets  on balance sheet                              |       | ** **                    | ** ** | **$ 58,061 ** |   |   |   | $ 70,787  |

(1)           Excludes cash and cash equivalents and restricted cash of $3,192 and$6,169 in 2006 and 2005, respectively as cash and cash equivalents aremonitored on a consolidated basis.

| 19 |
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----

**Item 1.  FinancialStatements (continued)**

** **

**(13)     Segments(continued)**

 

|                                                        | ** ** | ** **                  |
|-------------------------------------------------------------|------------|-----------------------------|
|                                                        | ** ** | **Six-Months End June 30,** |
|                                                        |       | **2006**                    |   | 2005 |
|                                                        |       | **DI**                      | **DR** | **Total** |   | DI | DR | Total |
| Revenues:                                                   |       |                        |   |   |   |   |   |   |
| DI products (including  hardware)                           |       | **$ 12,118**           | **$ -- ** | **$ 12,118 ** |   | $ 12,133 | $ -- | $ 12,133  |
| DI services                                                 |       | **2,517**                   | **-- ** | **2,517 ** |   | 1,248 | -- | 1,248  |
| DR products &  services                                 |       | **--**                      | **2,742 ** | ** 2,742 ** |   | -- | 15,021 |  15,021  |
| Total  revenues                                             |       | **$ 14,635**           | **$ 2,742 ** | **$ 17,377 ** |   | $ 13,381 | $ 15,021 | $ 28,402  |
|                                                        |       | ** **                  | ** ** | ** ** |   |   |   |   |
| Depreciation & amortization                             |       | **$ 1,124**            | **$ 1,458 ** | **$ 2,582 ** |   | $ 693 | $ 1,433 | $ 2,126  |
| Corporate non-allocated                                     |       | ** **                  | ** ** | **88 ** |   |   |   | 181  |
| Depreciation & amortization  on statement of operations |       | ** **                  | ** ** | **$ 2,670 ** |   |   |   | $ 2,307  |
|                                                        |       | ** **                  | ** ** | ** ** |   |   |   |   |
| Operating income (loss)                                     |       | **$ 926**              | **$ (3,440)** | **$  (2,514)** |   | $ 2,028 | $ 1,180 | $  3,208  |
| Non-allocated corporate  department expense                 |       | ** **                  | ** ** | **(2,720)** |   |   |   | (3,028) |
| Operating income (loss) on  statement of operations         |       | ** **                  | ** ** | **$  (5,234)** |   |   |   | $  180  |
|                                                        |       | ** **                  | ** ** | ** ** |   |   |   |   |
| Long-lived assets                                           |       | **$ 15,629**           | **$ 20,586** | **$ 36,215 ** |   | $ 17,604 | $ 23,815 | $ 41,419  |
|                                                        |       | ** **                  | ** ** | ** ** |   |   |   |   |
| Total assets (2)                                            |       | **$ 24,990**           | **$ 29,879** | **$ 54,869 ** |   | $ 27,440 | $ 37,178 | $ 64,618  |
| Consolidated cash                                           |       | ** **                  | ** ** | **3,192 ** |   |   |   | 6,169  |
| Total assets  on balance sheet                              |       | ** **                  | ** ** | **$ 58,061 ** |   |   |   | $ 70,787  |

 

(2)           Excludes cash and cash equivalents and restricted cash of $3,192 and$6,169 in 2006 and 2005, respectively as cash and cash equivalents aremonitored on a consolidated basis.

** **

 

**(14)      Stock-basedCompensation**

 

Prior to January 1, 2006, we accounted forstock-based compensation plans under the intrinsic value method as permittedunder Accounting Principles Board Opinion No. 25 ("APB 25"), "*Accountingfor Stock Issued to Employees*", and related Interpretations.  UnderAPB 25, generally no compensation expense was recognized because the exerciseprice of the options equaled the fair value of the stock on the grant date.

| 20 |
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----

 

 

**Item1.  Financial Statements (continued)**

** **

**(14)      Stock-basedCompensation (continued)**

 

Effective January 1, 2006, we adopted thefair value recognition provisions of SFAS No. 123R ("FAS 123R"),"Share-Based Payment," using the modified-prospective transition method.  Underthis transition method, compensation expense was recognized beginningJanuary 1, 2006 and includes (a) compensation expense for allshare-based employee compensation arrangements granted prior to, but not yetvested as of January 1, 2006, based on the grant date fair value estimatedin accordance with the original provisions of FAS 123, and (b) compensationexpense for all share-based employee compensation arrangements grantedsubsequent to January 1, 2006, based on the grant date fair valueestimated in accordance with the provisions of FAS 123R.  Under themodified-prospective transition method of FAS 123R, results for prior periods arenot restated. 

 

As a result of adoptingFAS 123R on January 1, 2006, earnings before income taxes and net incomefor the three- and six-months ended June 30, 2006 were both $126 and $218 lower,respectively, than if we had continued to account for share-based compensationunder APB No. 25.  Basic earnings per share for the three- and six-monthsended June 30, 2006 was reduced by $0.01 and $0.02 per share,respectively, as a result of the adoption of this statement.  The majority ofoptions granted by the Company qualify as Incentive Stock Options (ISO) forwhich no tax benefit is available to be recognized until the options areexercised and sold by the grantee within one year of exercise.  Typically, Non-Qualifying(NQ) options provide a deferred tax benefit to the Company at the time of grantand normally a tax benefit in the year of exercise.  However, due to theCompany's present net deferred tax asset position, a valuation allowance wasrecorded to offset the projected tax benefit from the compensation expenserecorded in the second quarter and year to date.  The Company will only realizethe tax benefits when and if they result in an actual reduction in taxespayable.

 

Prior to the adoption of FAS 123R, we presentedtax benefits for which we received deductions resulting from the exercise ofstock options as operating cash flows in the Consolidated Condensed Statementsof Cash Flows.  FAS 123R requires the cash flows from the tax benefitsresulting from tax deductions in excess of the compensation expense recognizedfor those options (excess tax benefits) to be classified as financing cashflows.  There were no exercises of stock options in the first half of 2006.  Theeffect of FAS 123R on our year-to-date consolidated statement of cash flows wasto add back the $218 of non-cash compensation expense to the cash flows fromoperating activities.  Since no options were exercised during the first or secondquarter of 2006, no tax benefits were recorded as financing proceeds in thecash flow statement.

 

The following tableillustrates the effect on the second quarter and six-months of 2005 netearnings and earnings per basic and diluted common share if we had applied thefair value recognition provisions of FAS 123 to options granted under ourstock-based employee compensation plans.  For purposes of this pro formadisclosure, the value of the options was estimated using a Black-Scholesoption-pricing valuation model and amortized to expense over the options'vesting periods. 

| 21 |
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**Item1.  Financial Statements (continued)**

** **

**(14)      Stock-basedCompensation (continued)**

 

|                                                                                                                                                                                                        |            | Three-month Period |            | Six-month Period  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|
|                                                                                                                                                                                                        |            | 06-30-2005         |            | 06-30-2005        |
| Net  income as reported                                                                                                                                                                                     | ** ** | $ 811    | ** ** | $ 792   |
| Deduct:  Total stock-based employee     compensation expense determined      under fair value based method for all     awards, net of related tax effects | ** ** | 188           | ** ** | 302          |
| Pro  forma net income                                                                                                                                                                                       | ** ** | $ 623    | ** ** | $ 490   |
|                                                                                                                                                                                                        | ** ** |               | ** ** |              |
| Pro  forma income per share:                                                                                                                                                                                | ** ** |               | ** ** |              |
|       Basic  and diluted- as reported                                                                                                                                         | ** ** | $ 0.08   | ** ** | $ 0.08  |
|       Basic  and diluted- pro forma                                                                                                                                           | ** ** | $ 0.06   | ** ** | $ 0.05  |
|                                                                                                                                                                                                        | ** ** | ** **         | ** ** |              |

** **

 

**Equity Incentive Plans.**  In 2005, we adoptedthe 2005 Equity Incentive Plan ("2005 Plan") that provides for incentive and/ornon-statutory stock options, stock appreciation rights, restricted stock,restricted stock units, performance shares and units, deferred stock units anddividend equivalents to be granted to our employees, consultants anddirectors.  A total of 800,000 shares are available for issuance under the 2005Plan plus any outstanding options under the Company's 1994 Employee StockOption Plan that subsequently expire unexercised, up to a maximum of 300,000shares.  As of June 30, 2006, only stock options have been granted.  Stockoptions may be granted under the 2005 Plan at an exercise price not less than100% of the fair market value on the date of grant.  Options become exercisableand expire at the times and terms established by the administrator, butgenerally vest over four years and expire five to ten years after the grantdate.  The Company satisfies the exercise of stock options by issuing newshares.  Options for 25 shares were granted during the six months ended June 30,2006.  No options have been exercised in 2006. 

 

The fair value of each option award is estimatedon the date of grant using the Black-Scholes valuation model based onassumptions for volatility, interest rates, dividend rates, expected timeoutstanding until exercised (expected term) and expected forfeitures made atthe time of the grant.  The requisite service life equals the vesting term,primarily four years.  Expected volatilities are based on daily observations ofthe historical volatility of our common stock over comparable length periodsand other factors.  No adjustment was made in contemplation of the affect offuture events.  We estimate option exercises and employee terminations based onhistorical data for groups of employees that have similar exercise andtermination behavior (the groups identified are: a. employees, b. officers, andc. directors).  The expected term of options granted is derived by consideringactual historical exercise data and represents the period of time that optionsgranted are expected to be outstanding.  The risk-free interest rate is basedon the U.S Treasury yield curve in effect at the time of the grant.

| 22 |
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**Item1.  Financial Statements (continued)**

** **

**(14)     Stock-based Compensation (continued)**

 

Asummary of option activity under the plans for the six months ended June 30,2006 is as follows:

 

| **Directors**                 |  

 

Shares | Weighted Average  Exercise Price | Weighted Average  Remaining Contractual Term | Aggregate Intrinsic  Value |
|-------------------------------|------------------------|----------------------------------|----------------------------------------------|----------------------------|
| Outstanding,  January 1, 2006 | 417               | $8.64                            |                                         |                       |
| Granted                       | --                | --                               |                                         |                       |
| Exercised                     | --                | --                               |                                         |                       |
| Forfeited                     | --                | --                               |                                         |                       |
| Expired                       | (15)                   | $4.25                            |                                         |                       |
| Outstanding,  June 30, 2006   | 402               | $8.80                            | 4.7 years                                    | $0                         |
| Options  Exercisable          | 345               | $9.22                            | 4.2 years                                    | $0                         |

 

| **Officers**                  |  

 

Shares | Weighted Average  Exercise Price | Weighted Average Remaining  Contractual Term | Aggregate Intrinsic  Value |
|-------------------------------|------------------------|----------------------------------|----------------------------------------------|----------------------------|
| Outstanding,  January 1, 2006 | 867               | $7.62                            |                                         |                       |
| Granted                       | --                | --                               |                                         |                       |
| Exercised                     | --                | --                               |                                         |                       |
| Forfeited                     | --                | --                               |                                         |                       |
| Expired                       | (64)                   | $3.62                            |                                         |                       |
| Outstanding,  June 30, 2006   | 803               | $7.95                            | 4.4 years                                    | $0                         |
| Options  Exercisable          | 667               | $8.75                            | 4.1 years                                    | $0                         |

 

| **Employees**                 |  

 

Shares | Weighted Average  Exercise Price | Weighted Average  Remaining Contractual Term | Aggregate Intrinsic  Value |
|-------------------------------|------------------------|----------------------------------|----------------------------------------------|----------------------------|
| Outstanding,  January 1, 2006 | 671               | $5.83                            |                                         |                       |
| Granted                       | 25                | $2.99                            |                                         |                       |
| Exercised                     | --                | --                               |                                         |                       |
| Forfeited                     | (7)                    | $4.05                            |                                         |                       |
| Expired                       | (31)                   | $5.14                            |                                         |                       |
| Outstanding,  June 30, 2006   | 658               | $5.77                            | 4.3 years                                    | $0                         |
| Options  Exercisable          | 452               | $6.71                            | 3.8 years                                    | $0                         |

 

Asummary of the status of the Company's Nonvested shares as of June 30, 2006 andchanges during the six months then ended is as follows:

|  

 

Nonvested Shares |   |  

 

Shares |   |   |
|----------------------------------|--------|------------------------|--------|--------|
| Nonvested  at January 1, 2006    |   | 492               |   |   |
| Granted                          |   | 25                |   |   |
| Vested                           |   | (100)                  |   |   |
| Forfeited                        |   | (19)                   |   |   |
| Nonvested  at June 30, 2006      |   | 398               |   |   |

 

 

| 23 |
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**Item1.  Financial Statements (continued)**

** **

**(14)     Stock-based Compensation (continued)**

 

As of June 30, 2006, there was approximately $465of total unrecognized compensation expense related to nonvested stock options. This expense is expected to be recognized in the remainder of 2006, 2007, 2008and 2009 in the amounts of $219, $164, $60, and $22, respectively.  The totalfair value of shares vested during the three and six-month periods ended June30, 2006 was $109 and $189, respectively plus the value of the ESPP sharesvesting in the same periods of $17 and $29, respectively.  

 

**Employee Stock Purchase Plan. **In 2002, we adopted the2002 Employee Stock Purchase Plan that allows eligible employees to purchasedstock at the lower of 85% of the fair market value of the stock on theenrollment date or exercise date as defined by the plan.  Issuances of sharesunder the Employee Stock Purchase Plan occur each six months on June 30 andDecember 31.  Pursuant to the plan, employee purchases are limited to 10% ofannual compensation.  The plan originally had 250 shares reserved forissuance.  In 2004 the shareholders approved an increase in the reserve of 450shares.  The plan is in effect for ten years unless terminated or amended soonerby the Board of Directors.  At June 30, 2006, 418 shares have been purchasedunder this plan leaving 282 shares available for future issuance.  79 shareswere issued on June 30, 2006.  The value of the 15% discount and a pro-ratashare of the fair value of the implied six-month options is included in thecost of stock-based compensation expense for the three and six-months ending June30, 2006.

 

**1996 Director Stock Plan.**  The Director StockPlan provides for automatic and discretionary issuances of the Company's commonstock to non-employee directors.  The principle purpose of the Plan is tocompensate the non-employee Directors for their service on the Board. Compensation is paid quarterly in the form of 50% cash and 50% in common stockissued from the Plan's reserve based on the closing market value on the lasttrading day of each fiscal quarter.  Compensation expense for the Board ofDirectors is reflected in General and Administrative expense for all periodspresented.  The total expense is the combination of the cash portion and marketvalue of the stock component on the date of issue.

 

An initial reserve of 160 shares was approved bythe shareholders in 1996 with an expiration date of May 2006.  A proposal toextend the Plan an additional five years was approved at the Annual Meeting ofShareholders held on May 17, 2006.  As of June 30, 2006, approximately 99 sharesremain available for issuance.  Further details on the 1996 Director Stock Plancan be found in the Company's Proxy Statement for its 2006 Annual Meeting ofShareholders.  

 

**(15)     SeriesC Preferred Stock**

** **

On May 4, 2006, Tripos completed the sale of 1,833shares of Redeemable Convertible Preferred Stock ("Preferred Stock") at a priceof $3.00 per share and issued 550 five-year common stock warrants exercisableat $3.50 per share to Midwood Capital, a private equity firm, for gross proceedsof $5,500.  Net proceeds from this transaction, after the placement agent's feeand estimated legal and other costs incurred by the Company, were approximately$4,900, of which $3,100 was utilized to reduce the borrowings under therevolving line of credit to zero.  The warrants to purchase common stock wereexercisable upon issuance.  The shares of Preferred Stock representapproximately 18 percent of Tripos' outstanding common stock on an as-convertedbasis (1 preferred share is convertible into 1 share of common stock).  Eachoutstanding share of Preferred Stock is entitled to voting rights equal to thenumber of full shares of Common Stock into which such shares are convertible onthe date of issuance.  The Preferred Stock also has preferential distributionrights in the event of a liquidation, dissolution or winding-up of the Companyor a deemed liquidation.  The Preferred Stock bears a dividend at an annualrate of 10.5% and is redeemable in two years at the option of the holders.  Ifcertain events occur prior to 

| 24 |
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**Item 1.  FinancialStatements (continued)**

** **

**(15)     SeriesC Preferred Stock (continued)**

 

January 26, 2007, which events relate primarilyto a sale or acquisition of Tripos, the dividends will be accelerated such thatthe holders of the Preferred Stock will receive dividends in the aggregateamount of $958 (or dividends in the aggregate amount of $1,155 if the eventoccurs on or after January 26, 2007) inclusive of any dividends received todate.  This financing strengthened the Company's balance sheet, enhancing itsability to explore strategic alternatives and support current and potentialbusiness initiatives. 

 

Upon issuance, the fair value of the warrantswas determined based on the Black-Scholes option-pricing model and recorded onthe balance sheet as a liability in the amount of $1,040.  The warrants weredetermined to be a liability, as under Emerging Issues Task Force ("EITF) 00-19,"Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company's Own Stock", they could not be recorded in equity due toregistration rights obligations and cash penalty requirements that were notcapped in the event of an unsuccessful registration.  The maximum penalty forfailure to register or maintain effectiveness of a registration was determinedto exceed the spread between the fair value of a registered and unregisteredshare and, as such, cash settlement was assumed for this determination.  The weighted-averageassumptions utilized in determining the Black-Scholes values were as follows: stock price-$2.96; strike price-$3.50; dividend yield-0%; risk-free interestrate-5.0%; volatility factor-0.79 and expected life-5 years.  The Company willreassess the fair value of the warrants on a quarterly basis until exercise orexpiration and record any resulting gain or loss through "other income" in thestatement of operations.  The Company evaluated the conversion feature of thepreferred stock under FAS No. 133, "Accounting for Derivative Instruments andHedging Activities" and determined that it was clearly and closely related tothe host contract (preferred stock) and was more akin to equity.  Theconversion feature therefore was not separated from the host contract.  The equityfeatures of the preferred stock are voting rights similar to common stock,participation in distributions to common shareholders, the holder has aresidual interest in the Company, and the preferred shares are not mandatorilyredeemable.  The Company therefore determined that the conversion featureshould be evaluated under EITF No. 98-5, " Accounting for ConvertibleSecurities with Beneficial Conversion Features or Contingently Adjustable ConversionRations" and EITF No. 00-27, "Application of Issue No. 98-5 to CertainConvertible Instruments."  After taking into account the allocation of theproceeds to the warrants, the Company determined that the Preferred Stockcontained a beneficial conversion feature valued at $1,015 based upon theintrinsic value of the shares at the closing stock price versus the valueassigned to the preferred stock.  Together, the value assigned to the warrantsand the beneficial conversion feature created a preferred stock discount in theamount of $2,055, which is being accreted through preferred dividend expenseover a two-year period using the effective interest rate methodology.  Inaddition the transaction costs of $588 were recorded as a deferred issuancecost on the balance sheet and are being amortized to interest expense over atwo-year period also using the effective interest rate methodology.  Includedin the transaction costs are 16 warrants valued at $29 to purchase common stockissued to the placement agent.  These warrants were issued with the same termsas the warrants issued to the holders of Preferred Stock.  Accretion of thepreferred stock discount and amortization of the deferred issuance cost duringthe second quarter 2006 totaled $124 and $36, respectively.  The Companyadjusted the warrant valuation at June 30, 2006 to the fair value at that date of$682 indicated by Black-Scholes, reducing the liability by $358 and recording again through "other income" in the statement of operations.  The Black-Scholesassumptions utilized at June 30 were the same as the assumption utilized uponissuance with the exception of the stock price reduced to $2.17, the risk-freeinterest rate adjusted to 5.1% and the expected life reduced to 4.85 years.

 

 

| 25 |
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**Item 1.  FinancialStatements (continued)**

** **

**(15)     SeriesC Preferred Stock (continued)**

 

Cash in the amount of $388 was deposited into aseparate account at LaSalle Bank to cover dividends payable up to December 31,2006.  On June 30, 2006, dividends of $93 were paid from this account toMidwood Capital.  The remaining balance and accrued interest of $297 are shownas "Restricted cash" on the Consolidated Balance Sheets.

 

** **

**(16)     NewAccounting Pronouncements**

 

##  

** **

** **

**(17)      SubsequentEvents**

 

In August 2006, the Company conducted a further smallerreduction of staff levels at its laboratory facility in Bude, England.  Costsassociated with this effort, when finalized, will be reflected in the Company'sthird quarter 2006 financial results.

 

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** **

**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations**

**Forward-lookingStatements**

 

The remainder of this report may contain certainstatements that are forward-looking and involve risks and uncertainties.  Wordssuch as "expects", "anticipates", "projects","estimates", "intends", "plans","believes", variations of such words and similar expressions areintended to identify such forward looking statements.  These statements arebased on current expectations and projections made by management and are notguarantees of future performance.  Therefore, actual events, outcomes andresults may differ materially from what is expressed or forecast in suchforward-looking statements.  Among the factors that could cause actual resultsto differ materially from the forward-looking statements are set forth underthe caption "Risk Factors" in Part 1A of Tripos' Form 10*-*K for 2005. Tripos undertakes no obligation to update any forward-looking statements inthis Form 10-Q.

 

The following discussion should be read inconjunction with the audited consolidated financial statements and notesthereto.

** **

**Overview**

** **

We provide products andservices to the pharmaceutical, biotechnology, and life science industries tosupport early stage research activities.  Our offerings are applied principallyto assist research chemists to make decisions about the most productive newcompounds to make and test as potential therapeutics.  Through our ownchemistry laboratories, we can also make those compounds for our clients. Through strategic partnerships, we can also participate more directly with ourclients in the development and testing of new therapeutic compounds for ourclients.

 

The industries that weserve are highly research driven.  Mature pharmaceutical companies typicallyspend up to 20% of their annual revenues on research to find new blockbusterdrugs.  This research process consists of several phases from early discoveryof compounds of interest, through testing of the promising ones for activityand safety in animals, to final testing of these compounds in humans.  Theinvestment in research activity increases dramatically in the second and thirdphases.  Tripos' offerings are most relevant to the initial phase of thisactivity, namely discovery of compounds.  Our products and services aredesigned and intended to provide our pharmaceutical and biotechnology customerswith improved ways to identify and select the most promising drug candidates totake forward into the more expensive and time consuming stages of the drugdevelopment process.   Depending on the number of compounds that a particularcompany has in different stages of their new therapeutic pipeline, they mayreduce or increase investment in the other phases of research.  Further,decisions by the pharmaceutical industry concerning their research investmentsare strongly influenced by decisions by the various governments of the worldregarding drug pricing and regulation.

| 27 |
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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 

Tripos' software products are primarily sold ona renewable license basis, typically with terms of one to three years.  Thisbusiness is generally predictable, as we have experienced high renewal rates inthe past for licenses.  Tripos management closely monitors license expirationsand deploys sales staff to ensure the highest probability of renewals.  Tripos'service businesses, both informatics and chemistry, are much less predictable. The sales cycles for these offerings are typically long -- from six to eighteenmonths -- and are highly influenced by factors in the macro-economicenvironment, including the general state of the pharmaceutical industry and theextent to which governments regulate local pharmaceutical pricing.  To forecastpotential business in these areas, Tripos management strives to closelyinteract with the management of our customers and is closely involved inbusiness development activities for material service project opportunities.

 

Large service contracts for pharmaceuticalresearch, both informatics and chemistry, are complex and, because they aredeployed in research applications where outcomes are uncertain, have a largerisk component.  Risk management in these projects begins with the definitionof project requirements and continues through performance metrics and customeracceptance milestones.  Due to the complexity of the projects and changingpriorities within client organizations, it is typical that many decision pointswill arise that require management attention both at Tripos and at the client. To mitigate the project difficulties, Tripos has developed a focused process inwhich management monitors milestones in the project plan according to theprocess workflow.  Despite best efforts, however, some projects are ofsufficient complexity that they present challenges that require revisions tothe project plan and scope. 

 

Having been a publiccompany spinout in 1994 with limited capital, we have focused on profitabilityand cashflow.  That said, we have not always been profitable, but have achievedprofitability in certain years.  Major investments, such as the recentexpansion of our chemistry research laboratories in England, have been fundedby other successful investments (e.g. Arena Pharmaceuticals), cash fromoperations, temporary use of debt capacity, and grant funding.

 

We license our DiscoveryInformatics products and post-contract support ("PCS") as eitherperpetual licenses or time-based licenses, typically one to three-yearrenewable contracts.  The magnitude of these license fees is dependent on eachcustomer's required usage levels, that is, the number of locations andindividual users.  Variations in licensing levels range from tens of thousandsup to several million dollars.  The following are descriptions of our currentsales models for discovery software:

 

**Perpetual licenses:**

Software pricing istaken from our price list based on the quantity of individual modules andnumber of users.  Customers are billed upon delivery.  Revenue for software isrecognized upon delivery of product and issuance of perpetual keys.  PCS isoptional for each customer and is priced as a fixed percentage of the totalcurrent list price of the software purchased. Where applicable, PCS istypically billed annually.

 

The Company has analyzedthe other elements included in its multiple element arrangements involvingperpetual licenses, and has determined it has sufficient Vendor SpecificObjective Evidence ("VSOE") to allocate revenues to PCS and/ortraining.  VSOE for PCS and training is established based on the price chargedwhen those elements are sold separately.  For PCS, this allocation amount isestablished based on the renewal rate specified in the arrangement, which isconsistently priced at a percentage of the list price of the purchasedlicenses.  Training is charged consistently from the Company's price list.

 

| 28 |
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**Item 2. Management's Discussion and Analysis ofFinancial Condition and Results of Operations (continued)**

**Bundled licenses:**

Time-based bundledlicenses are an alternative to perpetual licenses.  This type of license allowsour customers to obtain multiple software products bundled with PCS that iscoterminus with the period of the arrangement.  A bundled license includesspecific software modules and specified numbers of users of each module withall product and access keys delivered on or before the effective date of thecontract.  Tripos software is sold to professional users on an "off theshelf" basis in which the customer is responsible for installation.  Thesenon-cancelable, non-refundable contracts are normally three years in durationalthough certain customers request shorter or longer contract periods.  At the endof the contract term, the customer must renew the license, or the software willcease to operate.  PCS, which includes unspecified updates, upgrades, and"help desk" services, is included in the total price of thecontract.  The PCS provided under bundled arrangements is the same as thatprovided to customers under perpetual agreements.  Bundled contract pricing istaken from our established price list (includes package pricing and a-la-cartpricing) that is based on the number of users and length of term.  Allcontracted products are delivered at inception.  If the customer should wantadditional modules, users, or license to any new software products, thecustomer must enter a new contract (or addendum) and pay the incremental feesto purchase these items.  Software revenue and PCS revenues under bundledlicense agreements are recognized ratably over the contract period.

 

**Term licenses:**

Term Licenses representone-year arrangements for a software product and one-year of PCS.  The price istaken from the Company's price list by product.  The support renewal fee is afixed percentage of the software price (similar to perpetual model).  The PCSprovided for under term arrangements is the same as that provided to customersunder perpetual agreements.  Software and support pricing are separately statedand billed upon delivery of product.  To continue to operate the software, thecustomer must pay their annual renewal fee.  Software revenue and PCS revenuesunder term license agreements are recognized ratably over the contract period.

 

Our integration ofchemistry and biological data in the life sciences industries creates a revenueopportunity for discovery informatics services (software consulting).  To servethis market, we maintain a staff of specialists who use our proprietary dataintegration framework, such as FormsBuilder, SMART-IDEA, Benchware Notebook,ChemCoreRIO and AUSPYXTM to configure customized solutions for datamanagement.  Revenue may be generated on a billable rate per day, or uponachievement of milestones or deliverables and is recognized as productionactivities are performed.  These contracts may also generate substantiallicense fee revenue for our proprietary software technologies.  Similarly toour discovery informatics products, licensing levels are dependent on thenumber of users and sites and may range from the low hundred-thousands up tomillion dollar levels.

 

We develop andmanufacture general screening compound libraries for sale to the life sciencesindustry for a fee per compound delivered.  In addition we offer ourLeadDiscovery libraries which include higher value intellectual property rights(such as patent applications).  These compounds and libraries have created theopportunity to offer follow-up discovery research methods to customers fordesign and synthesis of focused libraries for lead optimization.  We alsomarket a comprehensive research process to our life sciences customers forrapid and cost effective discovery.  This process combines advancedinformatics, chemistry, and biology products and services, with proprietarydiscovery technologies for efficient lead development, refinement, andoptimization resulting in a tightly integrated process to facilitate synergiesin drug discovery. 

 

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**Item 2. Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 

In the past we haveacted as a reseller of computer hardware.  Hardware sales are generally made tofacilitate our software customers' access to hardware components and not a primaryfocus of our sales activities.  We act as an authorized reseller and only orderhardware products on an "as needed" basis, and thus do not maintainany inventory.

 

We license discoveryinformatics tools to customers, provide ongoing support (including upgradesselected by customers) and provide informatics services to customers thatenable integration of our existing and newly developed discovery tools tocustomers' discovery operations.  We generally expense research and developmentcosts associated with software enhancements and new functionality.  Thus, asignificant portion of the costs associated with development and enhancement ofsoftware is accounted for as research and development and not as a cost ofsoftware sales.  Certain software development projects require substantialcommitments of time and resources.  Costs of these projects are capitalizedupon achievement of technological feasibility and/or a working model accordingto the Financial Accounting Standards Board ("FASB") Statement ofFinancial Accounting Standards ("SFAS") No. 86.  

Quarterly expensesinclude the fixed costs of research and development for software developmentand new chemistry research.  We believe that core selling and administrativecosts will remain generally consistent on an annual basis.  Variability inquarterly expenses primarily occurs in relation to the level of revenues.  Thisis due to sales compensation, bonuses, staffing for selling, general andadministrative functions and for periodic marketing activities such asappearances at trade exhibitions.  The relationship between the quarterlyamounts presented for cost of sales or research and development expense mayfluctuate based on the utilization of our employees on either billablecontracts or research projects.

 

Ourrevenues and expenses vary from quarter to quarter depending upon, among otherthings, the timing of customers' budget processes, the success of our salesefforts, the lengthy sales cycle and our ability to influence customers andprospective customers to make decisions to outsource portions of theirdiscovery process, the size of the customers' capital expenditure budgets, theability to produce compound libraries and achieve product release schedules(including by Tripos' third party software providers and collaborators) in atimely manner, the rate of market acceptance of new products and enhancedversions of existing products, the timing of new product introductions by usand other vendors, changes in licensing and pricing policies (ours, our partnersand that of other vendors), consolidation in the customer base, clientinvolvement in decision points in contracts related to project plans, ourability to accurately match contract costs to milestone or contract performancerequirements on our larger collaborative arrangements, and changes in generaleconomic, regulatory, and competitive conditions.  See Note 1 of the Notes toConsolidated Financial Statements for a discussion of revenue recognitionpolicies.  Because much of our software license and PCS revenue along with ourcontracted discovery research revenue is recognized ratably over multipleperiods, fluctuations in our quarterly revenues and earnings are causedprincipally by sales of compounds or by achievement of milestones on specific projects. Our management team monitors quarterly business activity with the aid of salespipeline reports and monthly financial reports.

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

** **

**Resultsof Operations**(Amountsin thousands, except per share amounts)

 

**Net sales** for the second quarter of 2006 were $8,907compared to $13,359 in 2005, a decrease of 33%.  Discovery informaticsproducts and support sales increased 6% to $6,210 in second quarter 2006 from $5,849for same period in 2005.  This increase is primarily attributable to licensesfor technologies provided to Wyeth Pharmaceuticals as part of our informaticsservice contract, expansion of licenses with existing customers and strongproduct sales in the Pacific Rim.  Discovery informatics services revenues forthe second quarter of 2006 increased 198% to $1,728 from $580 in the second quarterof 2005.  The increase was principally attributable to revenues related toprogress on the Wyeth informatics contract in 2006 compared to a collection ofsmaller assignments in the prior year.  The timing of revenue recognition fromdiscovery informatics services may fluctuate during any period based onachievement of contractual milestones.  Discovery research sales accounted for$961 in the second quarter of 2006 and $6,919 in the same period in 2005, adecrease of $5,958 or 86%.  This decrease in discovery research business wasattributable to the completion of our four-year $90 million strategic compoundfile enrichment and hit follow-up contract with Pfizer, Inc. in the fourthquarter of 2005.  Revenues from Pfizer in the second quarter 2005 were $6,255. Hardware sales for the second quarter 2006 were $8 compared to $11 in 2005.  Wedo not actively market hardware products, but rather facilitate customer demandas necessary.

 

For the six-month period in 2006, total netsales decreased 39% to $17,377 from $28,402 for the same period in 2005.  Thedecrease was primarily attributable to the completion of the four-yeardiscovery research contract with Pfizer at the end of 2005.  Discovery softwareand support sales were essentially flat for the six-month periods at $12,093and $12,112 in 2006 and 2005, respectively.  Revenues from discoveryinformatics services increased by 102% to $2,517 for the six-month period in2006 from $1,248 in 2005.  The increase in discovery informatics servicerevenues is principally attributable to work being performed on the project forWyeth for the implementation of our Benchware SMART-IDEA technologies and progresson other projects.  Discovery research revenues decreased by 82% for the firstsix months in 2006 to $2,742 from $15,021.  The decrease in discovery researchrevenues was from the completion of the Pfizer compound file enrichment projectin 2005.  Revenues from discovery research projects for other customers arehigher than 2005 by 14%.   

 

Net sales for the Company's activities outsideof North America represented approximately 47% and 77% for the three-monthperiods and 48% and 78% for the six-month periods ending June 30, 2006 and 2005,respectively.  North American net sales accounted for 53% of 2006 and 23% of 2005total second quarter sales.  For the respective six-month periods, NorthAmerican sales were 52% in 2006 and 22% in 2005.  Net sales in Europe decreased $6,225 or 64% to $3,515 for the second quarter of 2006 compared to 2005,and accounted for 39% and 73%, respectively, of total sales.  Year-to-date netsales in Europe declined to $6,985 in 2006 from $20,879 in 2005, a decline of67%.  The decrease in Europe is principally related to revenues included in2005 related to progress on the Pfizer strategic compound design and synthesisproject that was contracted through our U.K. office and completed in the fourthquarter 2005.  Net sales in the Pacific Rim increased by 20% for the second quarterof 2006 compared to the same period in 2005, but still trailed 2005 on ayear-to-date basis by 3%.  The quarterly increase in Pacific Rim revenues wereprimarily from discovery informatics and support.  In 2005, informaticsrevenues were adversely impacted by a patent infringement suit in Japan related to a third-party software product.  The third-party supplier has introduced anon-infringing product as a replacement.  In addition, the suit has recentlybeen settled by the local distributor working with the third-party supplier.  The Pacific Rim accounted for 7% and 4% of net sales for the three-month periodsin 2006 and 2005, respectively, and 8% and 5% for the six-month periods.

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

** **

**Cost of sales** for the three-month period ending June30, 2006 decreased by $3,492 or 51% to $3,394 compared to $6,886 for the sameperiod in 2005.  Cost of sales as a percent of net sales was 38% and 52% forthe three-month periods in 2006 and 2005, respectively.  Included in the 2005cost of sales was approximately $4,500 related to the Pfizer contract.  Inaddition, we incurred an inventory charge for chemical compound inventoriesthat no longer met acceptable purity levels.  The 2006 cost of sales numberincludes approximately $186 of incremental amortization expense related tocapitalized software development costs for products that were released to themarket in the third quarter of 2005.  Six-month year-to-date cost of salesdeclined 53% to $6,961 in 2006 from $14,793 in 2005.  Cost of sales was 40% and52% of total net sales for 2006 and 2005, respectively.  The 2005 year-to-date costof sales included $9,203 incurred in discovery research activities for thePfizer compound file enrichment project.

 

**Gross profit** margin for the second quarter 2006 increasedto 62% of total net sales versus 48% in the second quarter of 2005, primarilydue to a shift in business mix.  Relatively higher margin Discovery Informaticsnow represents a larger percentage of business compared to the second quarterof 2005.  This shift is a result of our completion of the four-year $90 million Discovery Research contract with Pfizer,Inc. in the fourth quarter of 2005.  Gross profit margin in the second quarterrelated to Discovery Informatics products and support declined to 77% in 2006versus 81% in 2005 due to increased amortization expense related to capitalizedsoftware costs for new products released in latter-2005 and costs attributableto the launch of Surflex-Dock.  Gross profit margin in the second quarter of2006 remained at 37% in Discovery Informatics Services compared to the prioryear.  DiscoveryResearch gross profit margin decreased from 22% to 6% for the second quarterand were negatively impacted by cost overruns on one contract and initialstages on another that included pass-through costs from a third-party vendor atno margin.

 

Six-month year-to-date gross profit marginimproved to 60% in 2006 from 48% in the 2005 six-month year-to-date period.  Year-to-dategross margin benefited from the Discovery Informatics Services contract withWyeth in 2006 compared to the zero margin recognized on the milestone deliveryunder the Schering contract in 2005.  Gross profit margin in Discovery Researchdecreased from 23% to 10% for year-to-date periods due to the previouslymentioned cost overruns on one contract and initial stages on another thatincluded pass-through costs from a third party vendor at not margin.  Theseevents plus inventory provisions combined with lower revenues in the businessunit resulted in the lower margins for the first half of the year.

 

**Sales and marketing** expenses increased 3%to $2,776 for the second quarter of 2006 from $2,685 in the same period in 2005. Sales and marketing expenses as a percentage of net sales were 31% and 20% for thethree-month periods in 2006 and 2005, respectively.  For the six-month periodin 2006, sales and marketing expenses were $5,786 compared to $5,630, anincrease of 3%.  Sales and marketing was 33% of total net sales for the firsthalf of 2006 and 20% in 2005.  The increases in sales and marketing spending wereattributable to additional employees in 2006, including a vice president of marketing,versus the year-ago periods.  The increase as a percentage of total revenues isprimarily due to overall lower sales (post Pfizer).

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 

**Research and development**expenses for the quarterincreased by $640 or 32% to $2,631 from $1,991 and represented 30% and 15% ofnet sales in 2006 and 2005, respectively.  Six-month year-to-date R&Dexpense was $5,453 in 2006 compared to $3,912 in 2005, an increase of 39%. Year-to-date R&D expense as a percent to total sales was 31% and 14% in2006 and 2005, respectively.  The increase in R&D expense year-over-yearwas partially attributable to reduced levels of capitalization of new developmentcosts related to discovery informatics products.  In 2006 we capitalized $220and $455 for the three and six-month periods, respectively, while in 2005 wecapitalized $558 and $1,157 for the quarter and year-to-date periods.  We havebeen developing one enterprise-wide product in 2006 compared to fivecomputational chemistry software products in 2005.  R&D expense alsoincreased in the second quarter of 2006 at our laboratory facility in England to $858 from $555 in the second quarter of 2005 due to higher utility costs andless efficient operations arising from managing multiple smaller contracts. With the conclusion of the large Pfizer discovery research contract in 2005,our chemistry operations have changed from servicing primarily one largecontract to several smaller contracts.  This change, coupled with a substantialincrease in utility costs, has resulted in more costs expensed as R&Drather than being charged to cost of sales or absorbed into inventory for thesecond quarter of 2006. 

 

The six-month year-to-date period in 2006 wasaffected by inefficiencies and redundant staff at our discovery researchfacility during a statutory consultation period in the first quarter leading upto a reduction in force.  In December 2005 we announced that we had initiated a 30 dayconsultation period as mandated by UK law to complete a reduction in force forour Discovery Research business based in Bude, England.  We initiated thisaction to streamline our Discovery Research business and associated coststructure as a result of our successful completion of the four-year $90 millionfile enrichment project with Pfizer in the fourth quarter of 2005.  Wecompleted this process in January 2006, reducing our workforce by 76positions.  Reorganization and reassignment of chemistry staff were finalizedduring February. Inaddition, due to the lower staffing levels and increased facility costs, weestimate that we will pass approximately $935 of charges through our incomestatement in fiscal 2006 asa result of the adoption of Statement of Financial Accounting Standards("SFAS") No. 151 "Inventory Costs-an amendment of ARB No. 43,Chapter 4" ("FAS 151").   FAS 151 clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage) to require that these items be included as current-periodcharges and not included in inventory. 

 

**General and administrative**expenses decreased $276 or14% to $1,646 in 2006 from $1,922 for the second quarter of 2005, and represented18% and 14% of net sales for the corresponding periods.  G&A expense forthe six-month period in 2006 was $3,484, a 10% decrease from 2005.  The reducedG&A expense for 2006 is a result of reduced staff, lower public companycosts and lower legal defense costs now that we have met our deductible in theclass action lawsuit (see Note 3 for further details).

 

**Stock-Based Compensation** expense is included eacharea of expense (Selling and Marketing, Research and Development, and Generaland Administrative) in the second quarter and year-to-date periods of 2006. The totals of $126 and $218 for the quarter and year-to-date periods,respectively, are now required under FAS 123R.  Prior year amounts werereflected on a pro-forma basis in the footnotes to the financial statements. See Note 14 for a further discussion of the prior year amounts and stock-basedcompensation accounting treatment. 

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (Continued)**

 

**Restructuring charge**in the first quarter of2006 represents the January 24, 2006 completion of a reduction in force for our DiscoveryResearch business based in Bude, England that was initiated in December 2005 followingcompletion of the four-year****$90 million file enrichment project for Pfizer.  This action coincided with the conclusion of the 30-dayconsultation period with employees mandated by U.K. law.  We reduced the numberof employees at the laboratory by 76 positions.  More than half of theemployees affected left the Company under a voluntary separation plan.  Inaddition, a restructuring of our US based employees resulted in a reduction of9 positions.  As a result of these actions, the Company recorded pre-taxrestructuring charges of approximately $807 and $120 in the first quarter 2006 relatedto our Discovery Research and Discovery Informatics divisions, respectively,for one-time termination benefits and outplacement costs.  Of the $927 chargereflected in the statement of operations, $10 remains to be paid in the secondquarter 2006.  The annualized effect of the downsizing is estimated to resultin a cash savings from payroll and related benefits of $2,400.  This amountwould have been distributed as follows:  $250 in Selling and Marketing; $1,790in Research and Development; and $360 in General and Administrative.  Certaindepartments within R&D would have qualified for absorption into inventoryand ultimately reduced through cost of sales.  Other variable costs related toproduction are not estimable at this time.

** **

The Company is executing another smallerreduction in staffing levels in the third quarter of 2006.  Costs of thisadditional restructuring, when finalized, will be reflected in the thirdquarter financial statements.

** **

**Interest expense**increased to $527 in thesecond quarter of 2006 from $393 in the same period in 2005.  For the six-monthperiods, interest expense increased to $1,028 in 2006 from $781 in 2005.  Theincreases were primarily due to higher interest rates on our revolving line ofcredit, mortgage note, and capital leases, along with additional amortizationof the debt discount that arose from the funding of the Optive Researchacquisition in early 2005 and the amortization of the deferred issuance costsrelated to the Convertible Preferred Stock transaction occurring in the secondquarter of 2006.  

 

**Other income**was $881 for the secondquarter in 2006 versus a loss of $650 in 2005.  Included in 2006 is $472 relatedto currency gains, $358 non-cash gain on the revaluation of common stockwarrants and $53 of interest income.  The 2005 second quarter loss resultedfrom a currency loss of $746 that was partially offset by a gain of $58 fromthe sale of shares of NuVasive, Inc. and interest income of $35.  In thesix-month year-to-date period for 2006, other income totaled $1,172 thatincluded currency gains of $723, the non-cash gain on the revaluation of commonstock warrants and interest income of $78.  For the same year-to-date period in2005, we had a loss from other items netting to $657.  This total includedcurrency losses of $874 that were partially offset by interest income of $63and net gains from unconsolidated investments of $152.  The net gains frominvestments arose from sales of NuVasive and losses on our holdings in the A.M.Pappas Life Science II fund.****

** **

**Income tax** benefit was $16 for the first six-monthsof 2006 compared to a benefit of $2,050 for the same period in 2005, which representeffective tax rates of 0% and (163%), respectively.  The 0% effective tax ratefor 2006 reflects management's current estimate of the distribution of earningsamong the statutory jurisdictions in which we operate, realization of R&Dtax credits in the U.K. and the valuation of certain net operating loss carry forwards.The rate for 2005 included recording of R&D tax credits in the U.K. for a prior period when it became more likely than not that they would be realized.

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (Continued)**

** **

**Liquidity,Capital Resources and Capital Commitments**

 

Net cash used in operations in 2006 was $4,065. The primary uses of cash were from a net loss of $5,074 increases ininventories of $1,769, reductions in accounts payable and accrued expenses of $3,219along with lower deferred revenues of $4,995 and the noncash gain onrevaluation of commons stock warrants of $358.  These uses of cash werepartially offset by collections of accounts receivable of $7,930, reduction ofprepaid expenses and other current assets of $653, plus the add-back ofnon-cash depreciation and amortization, including the amortization of debtdiscount, totaling $2,796, along with the add-back of non-cash stock-basedcompensation expense of $218 and accretion of the deferred issuance costs of $36. The increase in inventory is primarily related to on-going customer contractsand development of our next generation of compounds for our LeadQuest andLeadDiscovery libraries.  The drop in accounts receivable reflects the normalseasonal collection of balances.  Reductions in deferred revenue reflect theratable recognition of revenue in the year and the cyclicality of softwarecontract renewals.  Payments on accounts payable and accrued expenses alsoreflect the seasonality of the balances.  Net cash provided by operations in2005 was $967.  The primary sources of cash were from reductions in accountsreceivable of $5,427, reductions in inventory of $2,157 plus the add-back ofnon-cash depreciation and amortization, including the amortization of debtdiscount, totaling $2,335.  These sources of cash were partially offset bypayments of accounts payable and accrued expenses of $4,878, a change indeferred tax benefit of $1,177 along with additions to prepaid expenses of $736with a reduction in deferred revenue of $2,716 less the pre-tax gain of $240from the sale of shares of NuVasive common stock.  The change in the 2005deferred tax benefit is a result of recording R&D tax credits in the U.K.  Collections of accounts receivables and reductions in deferred revenues both continueregular annual cyclical patterns.  Reductions in the 2005 inventory levelreflect deliveries to Pfizer in the period.

 

Cash provided by investing activities during 2006totaled $3,030, consisting of proceeds from the sale of equipment of $3,799,partially offset by property and equipment acquisitions of $314 and capitalizeddevelopment costs for our discovery informatics software products of $455.  Cashused in investing activities during 2005 totaled $4,151 and were for propertyand equipment acquisitions of $537, capitalized development costs for ourdiscovery informatics software products of $1,157, investment in the A.M.Pappas Life Science II fund of $125 and the cash used in the acquisition ofOptive Research, Inc. of $4,753.  These were partially offset by $1,995 ofproceeds received in sale of equipment and $426 of gross proceeds from the saleof NuVasive shares.  Over the next 12 to 18 months of 2006-2007, we may beasked to fund the remainder of our investment commitment ($425) to the A.M.Pappas Life Science II Fund.  

 

For 2006, cash used in financing activities was$1,697.  Cash payments on long-term debt and capital lease obligations totaled$8,967.  This was partially offset by borrowings under our revolving line ofcredit of $2,300 and net proceeds from the issuance of convertible preferredstock of $4,891.  Payments of dividends on the preferred stock amounted to $93. For 2005, $4,759 of cash was generated through financing activities from theissuance of common stock of $500 and subordinated debt of $3,500 to fund partof the acquisition of Optive Research.  We had a net increase in outstandingborrowings on our line of credit with LaSalle Bank of $2,400 while making paymentson our mortgage and capital leases of $1,670. 

** **

OnApril 18, 2006, the Company and LaSalle Bank completed an amendment to theexisting credit facility and mortgage loan.  The term of the revolving line ofcredit was extended to January 1, 2007 and the line of credit was amended to$6,000.  The amended line of credit has a borrowing base equal to 80% ofdomestic and insured foreign accounts receivable plus $1.8 million allowance forthe excess equity in 

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (Continued)**

 

U.S. real estate, a revised minimum shareholders' equitycovenant tested quarterly and a minimum consolidated cash balance covenanttested monthly.  The annual clean-down requirement was eliminated.  Interest onthe mortgage loan was modified to LIBOR plus 3.0%.  All other terms of therevolving line of credit remain the same.

 

On May 4, 2006, the Company completed the saleof 1.8 million shares of ConvertiblePreferred Stock at a price of $3.00 per share and issued 550 thousand five-yearcommon stock warrants exercisable at $3.50 per share to Midwood Capital, aBoston-based investment partnership, for gross proceeds of $5,500.  The sharesof Convertible Preferred Stock represented approximately 18% of Tripos'outstanding common stock on an as-converted basis at the time of thetransaction.  The Convertible Preferred Stock bears a dividend at an annualrate of 10.5% and is redeemable in two years. If certain events occur prior toJanuary 26, 2007, which events related primarily to a sale or acquisition ofTripos, the dividends will be accelerated such that the holders of theConvertible Preferred Stock will receive dividends in the aggregate amount of$958 (or dividends in the aggregate amount of $1,155 if the event occurs on orafter January 26, 2007) inclusive of any dividends received to date.  Netproceeds from this transaction, after the placement agent's fee and estimatedlegal and other costs, were approximately $4,900.  This financing strengthenedthe Company's balance sheet, enhancing its ability to explore strategicalternatives and support current and potential business initiatives. 

 

```
We expect to fund prospective operating needs and capital expenditures through cash from operations and other resources that become available to us.  We believe that we will be able to satisfy our liquidity and capital expenditure requirements for at least the next twelve months from the following sources:   cash, accounts receivable balances, projected cash flows from operations, access to available borrowings from LaSalle Bank, the proceeds from the sale of Convertible Preferred Stock and incremental capital leases, if any.  Also, we intend to seek a further extension of the LaSalle Bank facility prior to its expiration.  Although we have taken steps intended to better align our operating costs to our expected revenues as a result of the completion of our four year Pfizer contract, our working capital could be adversely affected if we are not entirely successful in these efforts.  We expect that our capital expenditure requirements will be substantially lower than in recent years due to the completion of our chemistry laboratory expansion.  See Note 8 of the Notes to Consolidated Financial Statements for a discussion of our credit facilities.
```

 

In addition, we areexploring the sale of our headquarters building and thelease-back of a portion of the facility.  If completed, the transaction wouldeliminate the existing mortgage balance on the property and generate excesscash.  We anticipate that this transaction could provide prospective savings tothe Company by reducing the ongoing cost of occupancy.

 

Although we have no current plans to do so, fromtime to time in the future we may determine to further enhance our capitalresources.  In making decisions regarding access to additional capital, wewould consider the availability and terms of financing alternatives, and theexpected financial impact of any financing, including any near-term dilutiveimpact, that we might incur in pursuit of our objective to maintain financialflexibility to support planned and opportunistic growth of our business and theongoing consideration of our strategic objectives.  Additional capital may bein the form of equity or debt securities, and may be raised in public offeringor private placement transactions.  

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (Continued)**

 

**Critical Accounting Policies**

 

For further discussionof the Company's critical accounting policies, please see the section entitled"Critical Accounting Policies" in Management's Discussion andAnalysis of Financial Condition and Results of Operations in Form 10-K for theyear ending December 31, 2005.   With the adoption of FAS 123R at the beginningof fiscal 2006, we have determined that "Stock-Based Compensation" should be included asone of the Company's identified critical accounting policies. We account forstock-based compensation in accordance with the provisions of SFAS 123R. We use the Black-Scholes option-pricing model, which requires the input ofhighly subjective assumptions.  These assumptions include estimating thelength of time employees will retain their stock options before exercising them("expected term"), the estimated volatility of the Company's common stock priceover the expected term and the number of options that will ultimately notcomplete their vesting requirements ("forfeitures").  Changes in the subjectiveassumptions can materially affect the estimated fair value of stock-basedcompensation and consequently, the related amount recognized on theconsolidated statements of operations.  See Note 14 of the Notes toConsolidated Financial Statements in this Form 10-Q for further discussion ofstock-based compensation.  There have been no material changes to the othercritical accounting policies previously reported in our Annual Report on Form10-K for the fiscal year ended December31, 2005.

** **

**New Accounting Pronouncements**

 

In February 2006, the FASB issued SFAS No. 155"Accounting for Certain Hybrid Financial Instruments-an amendment of FASBStatements No. 133 and 140" ("FAS 155").  FAS 155 addresses the following: a) permits fair value remeasurement for any hybrid financialinstrument that contains an embedded derivative that otherwise would requirebifurcation; b) clarifies which interest-only strips and principal-only stripsare not subject to the requirements of Statement 133; c) establishes arequirement to evaluate interests in securitized financial assets to identifyinterests that are freestanding derivatives or that are hybrid financialinstruments that contain an embedded derivative requiring bifurcation; d)clarifies that concentrations of credit risk in the form of subordination arenot embedded derivatives; and e) amends Statement 140 to eliminate theprohibition on a qualifying special-purpose entity from holding a derivativefinancial instrument that pertains to a beneficial interest other than anotherderivative financial instrument. FAS 155 is effective for all financialinstruments acquired or issued after the beginning of an entity's first fiscalyear that begins after September 15, 2006.  We are currently evaluating therequirements of FAS 155, but do not expect that the adoption will have a materialeffect on our financial statements. 

** **

Periodic reports on Form 10-Q, Form 10-K andother filings with the Securities and Exchange Commission ("SEC") onForm 8-K and S-8, can be found on the Tripos web site at www.tripos.comunder the heading Investor Relations - SEC Filings.

** **

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**Item 3. Quantitative and Qualitative Disclosuresabout Market Risk**

 

Our exposure to marketrisks is limited to foreign exchange variances and fluctuations in interestrates.  To date, interest rate exposure has not resulted in a materialimpact.   During 2003, 2004 and 2005, the Company did experience a significantimpact from foreign exchange.  The costs to perform the custom design andsynthesis contract with Pfizer are incurred in British pounds sterling while weare compensated in U.S. dollars for much of the work.  As a result, our grossprofit was adversely affected by the decline in the U.S. dollar against thepound.  Part of this effect was offset through foreign currency forwardcontracts whose gains were recorded in "Other Income".

 

Our foreign exchangerisk is presently limited to currencies that historically have exhibited onlyminor fluctuations although from 2003 through 2005, these currencies have shownmore significant variation.  Assets outside the United States subject tocurrency fluctuation are located in England, Germany and France.  Our investments in foreign subsidiaries with a functional currency other than the U.S.dollar are not hedged.  The assets in foreign subsidiaries most susceptible toexchange rate variances were as follows:  US dollar/UK pound balances 2005$13.0 million, and US dollar/Euro balances 2005 $3.0 million.  The potentialreduction in fair value resulting from a hypothetical 10% adverse change in USdollar/UK pound currency exchange rates would be approximately $1.3 million atDecember 31, 2005, while the same 10% adverse movement in the US dollar/Eurorates would be approximately, $300,000 for 2005.  Any loss in fair value ofpermanently invested funds would be reflected in Other Comprehensive Income andwould not impact our net income. 

 

Our interest rate riskis attributable to borrowings under the line-of-credit and mortgage loan.  Wemonitor our exposure to floating interest rate risk on line-of-creditborrowings along with the outstanding balance on the mortgage loan and may, attimes, endeavor to mitigate this risk through the use of appropriate hedginginstruments.

 

**Item 4.  Controls and Procedures**

 

We have established andmaintain disclosure controls and procedures that are designed to ensure thatmaterial information relating to the Company and our subsidiaries required tobe disclosed by us in the reports that we file or submit under the SecuritiesExchange Act of 1934 is recorded, processed, summarized, and reported withinthe time periods specified in the SEC's rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate to allowtimely decisions regarding required disclosure.  In designing andevaluating the disclosure controls and procedures, management recognized thatany controls and procedures, no matter how well designed and operated, canprovide only a reasonable assurance of achieving the desired control objectives,and management was necessarily required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.  

 

The Company's ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof the design and operation of the Company's disclosure controls and procedures(as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Actof 1934, as amended) as of the end of the period covered by this report. Basedupon that evaluation, the Company's Chief Executive Officer and Chief FinancialOfficer have concluded that the Company's disclosure controls and procedures wereeffective at the reasonable assurance level as of the date of such evaluation. 

 

During the quarterlyperiod covered by this report, there were no other changes in the Company'sinternal control over financial reporting that have materially affected, or arereasonably likely to materially affect, the Company's internal control overfinancial reporting.

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**PART II**

**OTHER INFORMATION**

 

Item 1.     LegalProceedings

          OnAugust 4, 2006, the federal district court in St. Louis, Missouri approved the tentativeagreement reached on March 21, 2006 to settle a class action litigation suitagainst the Company.  Thetotal amount of the settlement is $3,150 which is to be paid by our insurers.  Acourt date has not yet been set to review the terms of the March 21, 2006tentative settlement in the shareholder derivative suit.  See "ContingentLiabilities" in the Notes to Unaudited Financial Statements above for a generaldescription of legal proceedings.  Reference is made to the "Legal Proceedings"section of our Form 10-K for the year ending December 31, 2005 for a detaileddescription of legal proceedings.

** **

Item 1A.   Risk Factors

          Adescription of the risk factors associated with our business is contained inItem 1A, "Risk Factors," of our 2005 Annual Report on Form 10-K filed with theSecurities and Exchange Commission on April 11, 2006 and incorporated herein byreference.  These cautionary statements are to be used as a reference inconnection with any forward-looking statements.  The factors, risks anduncertainties identified in these cautionary statements are in addition tothose contained in any other cautionary statements, written or oral, which maybe made or otherwise addressed in connection with a forward-looking statementor contained in any of our subsequent filings with the Securities and ExchangeCommission.

 

Item2.     Unregistered Sales of Equity Securities and Useof Proceeds

          None

 

Item3.     Defaults upon Senior Securities

          None

 

Item4.     Submission of Matters to a Vote of SecurityHolders

 

Three matters weresubmitted to a vote of the shareholders of the Company at its Annual Meeting ofShareholders on May 17, 2006:

 

1) The followingdirectors were elected to serve for the ensuing year or until the earlier ofdeath, resignation or removal.  Votes cast were as follows:

|              | Votes           | Votes                           |
|-------------------|-----------------|---------------------------------|
|              | "For" | "Withhold  Authority" |
| Ralph S. Lobdell  | 6,674,445       | 1,411,695                       |
| Alfred Alberts    | 6,686,627       | 1,399,513                       |
| Stewart Carrell   | 6,408,729       | 1,677,411                       |
| John P. McAlister | 8,014,026       | 72,114                          |
| Gary Meredith     | 5,790,924       | 2,295,216                       |
| Ferid Murad       | 5,806,106       | 2,280,034                       |

 

2) To extend the term ofthe 1996 Director Compensation Plan for an additional five years.  The measurewas approved based on the following voting results:

| Votes "For" | Votes  "Against" | Votes  "Abstain" | Broker  "Non-votes" |
|-----------------------|----------------------------|----------------------------|-------------------------------|
| 4,082,512             | 1,498,455                  | 97,804                     | 4,514,151                     |

 

3) A stockholder proposal requesting that theBoard put the Company up for sale was voluntarily withdrawn by its proponent.

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**PARTII**

**OTHER INFORMATION,CONTINUED**

 

 

Item5.     Other Information

          None

 

Item6.     Exhibits 

           31.1    Section302 Certification of the Chief Executive Officer

           31.2    Section302 Certification of the Chief Financial Officer

           32.1    WrittenStatement of Chief Executive Officer and Chief Financial Officer Pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

 

 

 

 

 

 

 

**TRIPOS, INC.**

**SIGNATURES**

** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned hereunto duly authorized.

 

TRIPOS, INC.

 

| Date:  | August 11, 2006 | /s/  John P. McAlister                |
|--------|-----------------|---------------------------------------|
|   |            | President and                         |
|   |            | Chief Executive Officer               |
|   |            |                                  |
| Date:  | August 11, 2006 | /s/ B. James Rubin                    |
|   |            | Senior Vice President,                |
|   |            | Chief Financial Officer and Secretary |
|   |            |                                  |
| Date:  | August 11, 2006 | /s/ John D. Yingling                  |
|   |            | Vice President,                       |
|   |            | Chief Accounting Officer and          |
|   |            | Assistant Secretary                   |

 

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