LEXICON GENETICS INC/TX - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM _____________ TO _____________

COMMISSION FILE NUMBER: 000-30111

LEXICON GENETICS INCORPORATED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 76-0474169
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)

8800 TECHNOLOGY FOREST PLACE
THE WOODLANDS, TEXAS 77381
(ADDRESS OF PRINCIPAL EXECUTIVE
OFFICES AND ZIP CODE)

(281) 863-3000
(REGISTRANT'S TELEPHONE NUMBER,
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 the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.

Yes X No
--------- -----------

As of November 4, 2002, 52,353,180 shares of the registrant's common
stock, par value $0.001 per share, were outstanding.

LEXICON GENETICS INCORPORATED

TABLE OF CONTENTS

PAGE
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FACTORS AFFECTING FORWARD-LOOKING STATEMENTS................................................................. 2

PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - September 30, 2002 (unaudited) and December 31, 2001.................. 3
Consolidated Statements of Operations (unaudited) - Three and Nine Months Ended
September 30, 2002 and 2001.................................................................... 4
Consolidated Statements of Cash Flows (unaudited) - Nine Months Ended
September 30, 2002 and 2001.................................................................... 5
Notes to Consolidated Financial Statements (unaudited).............................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................................................... 9
Item 3. Quantitative and Qualitative Disclosures About Market Risk.......................................... 17

Item 4. Controls and Procedures............................................................................. 17
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.................................................................... 17

SIGNATURES................................................................................................... 18

The Lexicon name and logo, LexVision(R) and OmniBank(R) are registered
trademarks and Genome5000(TM) and e-Biology(TM) are trademarks of Lexicon
Genetics Incorporated.

------------

FACTORS AFFECTING FORWARD LOOKING STATEMENTS

This quarterly report on Form 10-Q contains forward-looking statements.
These statements relate to future events or our future financial performance. We
have attempted to identify forward-looking statements by terminology including
"anticipate," "believe," "can," "continue," "could," "estimate," "expect,"
"intend," "may," "plan," "potential," "predict," "should" or "will" or the
negative of these terms or other comparable terminology. These statements are
only predictions and involve known and unknown risks, uncertainties and other
factors, including the risks outlined under "Item 2. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Risk Factors," that
may cause our or our industry's actual results, levels of activity, performance
or achievements to be materially different from any future results, levels or
activity, performance or achievements expressed or implied by these
forward-looking statements.

Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we cannot guarantee future results,
levels of activity, performance or achievements. We are not under any duty to
update any of the forward-looking statements after the date of this quarterly
report on Form 10-Q to conform these statements to actual results, unless
required by law.

2

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LEXICON GENETICS INCORPORATED

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PAR VALUE)

The accompanying notes are an integral part of these
consolidated financial statements.

3

LEXICON GENETICS INCORPORATED

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

The accompanying notes are an integral part of these
consolidated financial statements.

4

LEXICON GENETICS INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

The accompanying notes are an integral part of these
consolidated financial statements.

5

LEXICON GENETICS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of Lexicon
Genetics Incorporated (Lexicon or the Company) have been prepared in accordance
with generally accepted accounting principles for interim financial information
and pursuant to the rules and regulations of the Securities and Exchange
Commission (SEC). Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.

In the opinion of management, all adjustments (consisting of normal
recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the nine-month period ended September 30, 2002
are not necessarily indicative of the results that may be expected for the year
ended December 31, 2002.

The accompanying consolidated financial statements include the accounts
of Lexicon and its subsidiary. Intercompany transactions and balances are
eliminated in consolidation.

For further information, refer to the financial statements and
footnotes thereto included in Lexicon's annual report on Form 10-K for the year
ended December 31, 2001, as filed with the SEC.

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141, "Business
Combinations," and No. 142, "Goodwill and Other Intangible Assets." These
statements, which Lexicon fully adopted on January 1, 2002, generally require
that all business combinations initiated after June 30, 2001 be accounted for
using the purchase method. Additionally, any resulting goodwill will not be
amortized, but rather will be subject to at least an annual impairment test.
Acquired intangible assets will be separately recognized and amortized over
their useful lives.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This new standard on asset
impairment, which Lexicon adopted effective January 1, 2002, supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of." The adoption of this standard had no impact on the
Company.

2. RESTRICTED CASH AND INVESTMENTS

Lexicon is required to maintain restricted cash, cash equivalents or
investments to collateralize borrowings made under the synthetic lease agreement
under which it leases its office and laboratory facilities in The Woodlands,
Texas (see Note 7). As of September 30, 2002 and December 31, 2001, the Company
maintained restricted cash and investments of $57.2 million and $43.3 million,
respectively, to collateralize borrowings of $55.0 million and $41.7 million.

3. COMPREHENSIVE LOSS

Comprehensive loss is comprised of net loss and unrealized gains and
losses on long-term investments, which are considered available-for-sale
securities. Comprehensive loss for the three-month

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and nine-month periods ended September 30, 2002 was $16.8 million and $45.5
million, respectively, reflecting a $45,000 and $0.3 million unrealized gain on
long-term investments, respectively. Net loss for the three-month and nine-month
periods ended September 30, 2002 included a $0.2 million realized loss on the
sale of long-term investments. There was no difference between net loss and
comprehensive loss in the comparable prior year periods.

4. NET LOSS PER SHARE

Net loss per share is computed using the weighted average number of
shares of common stock outstanding during the applicable period. Shares
associated with stock options and warrants are not included because they are
antidilutive. There are no differences between basic and diluted net loss per
share for all periods presented.

5. DEFERRED STOCK COMPENSATION

Deferred stock compensation represents the difference between the
exercise price of stock options and the fair value of Lexicon's common stock at
the date of grant. Deferred stock compensation is amortized over the vesting
periods of the individual stock options for which it was recorded, generally
four years. For the nine months ended September 30, 2002 and 2001, Lexicon
amortized $7.7 million and $8.1 million, respectively, of deferred stock
compensation. If vesting continues in accordance with the outstanding individual
stock options, Lexicon expects to record amortization expense for deferred stock
compensation as follows: $2.6 million during the last three months of 2002,
$10.2 million during 2003 and $0.9 million during 2004. The amount of stock
based compensation expense to be recorded in future periods may decrease if
unvested options for which deferred stock compensation expense has been recorded
are subsequently canceled or forfeited or may increase if additional options are
granted to individuals other than employees or directors.

6. COELACANTH ACQUISITION

On July 12, 2001, Lexicon completed the acquisition of Coelacanth
Corporation (Coelacanth) in a merger, under an Agreement and Plan of Merger
entered into on June 13, 2001. Coelacanth, now Lexicon Pharmaceuticals (New
Jersey), Inc., forms the core of Lexicon Pharmaceuticals, the division of the
Company responsible for small molecule compound discovery. The results of
Lexicon Pharmaceuticals (New Jersey), Inc. are included in the Company's results
of operations subsequent to the acquisition.

7. COMMITMENTS AND CONTINGENCIES

In October 2000, Lexicon entered into a synthetic lease agreement under
which the lessor purchased the Company's existing laboratory and office
buildings and animal facility in The Woodlands, Texas and agreed to fund the
construction of an additional laboratory and office building and a second animal
facility. The synthetic lease agreement was subsequently expanded to include
funding for the construction of a central plant facility. Including the purchase
price for the Company's existing facilities, the synthetic lease, as amended,
provided for funding of up to $55.0 million in property and improvements. The
term of the agreement is six years, which includes the construction period and a
lease period. Lease payments for the new facilities began upon completion of
construction, which occurred at the end of the first quarter of 2002. Lease
payments are subject to fluctuation based on LIBOR rates. Based on a LIBOR rate
of 1.81% at September 30, 2002 the Company's total lease payments would be
approximately $1.1 million per year. At the end of the lease term, the lease may
be extended for one-year terms, up to seven additional terms, or the Company may
purchase the properties for a price including the outstanding lease balance. If
the

7

Company elects not to renew the lease or purchase the properties, it may arrange
for the sale of the properties to a third party or surrender the properties to
the lessor. If the Company elects to arrange for the sale of the properties or
surrender the properties to the lessor, it has guaranteed approximately 86% of
the total original cost as the residual fair value of the properties. The
Company is required to maintain restricted cash or investments to collateralize
borrowings made under the synthetic lease agreement. In addition, Lexicon has
agreed to maintain cash and investments of at least $30.0 million in excess of
the Company's restricted cash and investments. If the Company's cash and
investments fall below that level, the Company may be required to seek a waiver
of that agreement or to purchase the properties or arrange for their sale to a
third party. Because the Company's cost to purchase the properties would not
materially exceed the amount of restricted cash and investments it is required
to maintain under the synthetic lease, the Company believes that any requirement
that it do so would not have a material adverse effect on its financial
condition.

On February 13, 2002, the FASB announced that it intended to propose
for adoption before the end of 2002 that companies be required to consolidate
special purpose entities, such as the lessor under Lexicon's synthetic lease, on
their balance sheets under certain circumstances. In a proposed interpretation
dated June 28, 2002, the FASB outlined new rules that would require such
consolidation by a lessee that provides a residual value guarantee or similar
arrangement to the lessor/special purpose entity. While the lessor under the
Company's synthetic lease qualifies for off-balance sheet treatment under
current rules, the Company will be required to consolidate the lessor on the
Company's balance sheet if the FASB's proposed interpretation as currently
drafted is adopted. If such consolidation is required, the Company's balance
sheet will reflect as assets additional property and equipment approximating the
$55.0 million funded under the synthetic lease for property and improvements and
the same amount as a liability. In addition, the Company will be required to
depreciate such property and improvements over their useful lives. The proposed
guidance would require companies with calendar-fiscal years that have existing
special purpose entities, such as Lexicon, to apply the new standards on April
1, 2003. Lexicon believes that the consolidation of the lessor, if required,
will not have a material adverse effect on its financial condition or results of
operations.

On May 23, 2002, Lexicon Pharmaceuticals (New Jersey), Inc. signed a
ten-year lease for a 76,000 square-foot facility in Princeton, New Jersey. The
lease provides for an escalating yearly rent payment of $1.3 million in the
first year, $1.7 million in years two and three, $1.8 million in years four to
six, $2.0 million in years seven to nine and $2.1 million in year ten. The lease
also provides Lexicon Pharmaceuticals with the option in the second year of the
lease to borrow $2.0 million in tenant improvement funds from the landlord, at
which time rental payments due under the lease will increase as the tenant
improvement allowance is amortized over a ten-year period. Lexicon is the
guarantor of the obligations of Lexicon Pharmaceuticals (New Jersey), Inc. under
the lease.

8

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

OVERVIEW

We are a biopharmaceutical company focused on the discovery of
breakthrough treatments for human disease. We are using gene knockout technology
to systematically discover the physiological functions of genes in living
mammals, or in vivo. We generate our gene function discoveries using knockout
mice - mice whose DNA has been altered to disrupt, or "knock out," the function
of the altered gene. Our patented gene trapping and gene targeting technologies
enable us to rapidly generate these knockout mice by altering the DNA of genes
in a special variety of mouse cells, called embryonic stem (ES) cells, which can
be cloned and used to generate mice with the altered gene. We employ an
integrated platform of advanced medical technologies to systematically discover
and validate which genes, when knocked out, result in a favorable medical
profile with pharmaceutical utility. We then pursue those genes and the proteins
they encode as potential targets for therapeutic intervention in our drug
discovery programs.

We employ internal resources and drug discovery alliances to discover
potential small molecule drugs, therapeutic antibodies and therapeutic proteins
for in vivo-validated drug targets that we consider to have high pharmaceutical
value. We use our own sophisticated libraries of drug-like chemical compounds
and an industrialized medicinal chemistry platform to identify small molecule
drug candidates for our in vivo-validated drug targets. We have established
alliances with Abgenix, Inc. for the discovery and development of therapeutic
antibodies based on our drug target discoveries and with Incyte Genomics, Inc.
for the discovery and development of therapeutic proteins. In addition, we have
established collaborations and license agreements with many other leading
pharmaceutical and biotechnology companies under which we receive fees and, in
many cases, are eligible to receive milestone and royalty payments, for access
to some of our technologies and discoveries for use in their own drug discovery
efforts.

We derive substantially all of our revenues from subscriptions to our
databases, drug discovery alliances, functional genomics collaborations for the
development and, in some cases, analysis of the physiological effects of genes
altered in knockout mice, technology licenses and compound library sales. To
date, we have generated a substantial portion of our revenues from a limited
number of sources.

Our operating results and, in particular, our ability to generate
additional revenues are dependent on many factors, including our success in
establishing research collaborations and technology licenses, new database
subscriptions, expirations of our research collaborations and database
subscriptions, the success rate of our discovery efforts leading to
opportunities for new research collaborations and licenses, as well as milestone
payments and royalties, the timing and willingness of collaborators to
commercialize products which may result in royalties, and general and
industry-specific economic conditions which may affect research and development
expenditures. Our future revenues from database subscriptions, collaborations
and alliances are uncertain because our existing agreements have fixed terms or
relate to specific projects of limited duration. Our future revenues from
technology licenses are uncertain because they depend, in large part, on
securing new agreements. Subject to limited exceptions, we do not intend to
continue to make our compound libraries available for purchase in the future.
Our ability to secure future revenue-generating agreements will depend upon our
ability to address the needs of our potential future subscribers, collaborators
and licensees, and to negotiate agreements that we believe are in our long-term
best interests. We may determine that our interests are better served by
retaining rights to our discoveries and advancing our therapeutic programs to a
later stage, which could limit our near-term revenues. Because of these and
other factors, our quarterly operating results have fluctuated in the past

9

and are likely to do so in the future, and we do not believe that
quarter-to-quarter comparisons of our operating results are a good indication of
our future performance.

Since our inception, we have incurred significant losses and, as of
September 30, 2002, we had an accumulated deficit of $135.9 million. Our losses
have resulted principally from costs incurred in research and development,
general and administrative costs associated with our operations, and non-cash
stock-based compensation expenses associated with stock options granted to
employees and consultants prior to our April 2000 initial public offering.
Research and development expenses consist primarily of salaries and related
personnel costs, material costs, legal expenses resulting from intellectual
property prosecution and other expenses related to our drug discovery and
LexVision programs, the development and analysis of knockout mice and our other
functional genomics research efforts, and the development of compound libraries.
General and administrative expenses consist primarily of salaries and related
expenses for executive, finance and other administrative personnel, professional
fees and other corporate expenses including business development and general
legal activities, as well as expenses related to our patent infringement
litigation against Deltagen, Inc., which was settled in September 2001. In
connection with the expansion of our drug discovery programs and our functional
genomics research efforts, we expect to incur increasing research and
development and general and administrative costs. As a result, we will need to
generate significantly higher revenues to achieve profitability.

CRITICAL ACCOUNTING POLICIES

Revenue Recognition

Fees for access to our databases and other functional genomics
resources are recognized ratably over the subscription or access period.
Payments received in advance under these arrangements are recorded as deferred
revenue until earned. Collaborative research payments are generally
non-refundable, regardless of the success of the research effort, and are
recognized as revenue as we perform our obligations related to such research.
Milestone-based fees are recognized upon completion of specified milestones
according to contract terms. Non-refundable technology license fees are
recognized as revenue upon the grant of the license to third parties, when
performance is complete and there is no continuing involvement. A change in our
revenue recognition policy or changes in the terms of contracts under which we
recognize revenues could have an impact on the amount and timing of our
recognition of revenues.

Research and Development Expenses

Research and development expenses consist of costs incurred for
company-sponsored as well as collaborative research and development activities.
These costs include direct and research-related overhead expenses and are
expensed as incurred. Patent costs and technology license fees for technologies
that are utilized in research and development and have no alternative future use
are expensed when incurred.

Stock-Based Compensation

Deferred stock-based compensation and related amortization represents
the difference between the exercise price of stock options granted and the fair
value of our common stock at the applicable date of grant. Stock-based
compensation is amortized as research and development expense or general and
administrative expense, as appropriate, over the vesting period of the
individual stock options for which it was recorded, generally four years. If
employees and consultants continue to vest in accordance with their individual
stock options, we expect to record amortization expense for deferred stock-based
compensation as follows: $2.6 million during the last three months of 2002,
$10.2 million during 2003

10

and $0.9 million during 2004. The amount of stock-based compensation expense to
be recorded in future periods may decrease if unvested stock options for which
deferred stock-based compensation has been recorded are subsequently canceled or
forfeited or may increase if additional stock options are granted to individuals
other than employees or directors.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or SFAS, No. 141, "Business
Combinations," and No. 142, "Goodwill and Other Intangible Assets." These
statements, which we fully adopted on January 1, 2002, generally require that
all business combinations initiated after June 30, 2001 be accounted for using
the purchase method. Additionally, any resulting goodwill will not be amortized,
but rather will be subject to at least an annual impairment test. Acquired
intangible assets will be separately recognized and amortized over their useful
lives.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This new standard on asset
impairment, which we adopted effective January 1, 2002, supersedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of." The adoption of this standard had no impact on the Company.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2002 and 2001

Revenues. Total revenues decreased 41% to $8.0 million in the three
months ended September 30, 2002 from $13.5 million in the corresponding period
in 2001. The decrease was primarily the result of our recognition of revenues in
the third quarter of 2001 for technology license fees under sublicense
agreements completed in that period with GlaxoSmithKline plc and Merck & Co.,
Inc., and to a lesser extent, our recognition of revenues under agreements with
pharmaceutical and biotechnology companies for access to chemical libraries and
optimization services, as a result of our acquisition of Coelacanth in July
2001. These decreases were offset in part by a $0.9 million increase in revenues
derived from functional genomics collaborations for the development and analysis
of knockout mice.

Research and Development Expenses. Research and development expenses,
including stock-based compensation expense, increased 32% to $19.8 million in
the three months ended September 30, 2002 from $15.0 million in the
corresponding period in 2001. The increase of $4.8 million was primarily
attributable to increased personnel costs to support the expansion of our drug
discovery programs, the development and analysis of knockout mice and our other
functional genomics research efforts. Research and development expenses for both
three-month periods included $1.3 million of stock-based compensation primarily
relating to option grants made prior to our April 2000 initial public offering.

General and Administrative Expenses. General and administrative
expenses, including stock-based compensation expense, decreased 11% to $5.8
million in the three months ended September 30, 2002 from $6.4 million in the
corresponding period in 2001. The decrease of $0.6 million was due primarily to
a reduction in legal costs as a result of the September 2001 settlement of our
patent infringement litigation against Deltagen, Inc., offset by additional
personnel costs. General and administrative expenses for both three-month
periods included $1.3 million of stock-based compensation primarily relating to
option grants made prior to our April 2000 initial public offering.

11

Interest and Other Income, Net. Interest and other income, net
decreased to $0.7 million in the three months ended September 30, 2002 from $1.7
million in the corresponding period in 2001. The decrease resulted from lower
average cash and investment balances and lower average interest rates during the
2002 period.

Net Loss and Net Loss Per Common Share. Net loss increased to $16.8
million in the three months ended September 30, 2002 from $6.2 million in the
corresponding period in 2001. Net loss per common share increased to $0.32 in
the three months ended September 30, 2002 from $0.12 in the corresponding period
of 2001. A portion of the net loss for the three months ended September 30, 2002
and 2001 was attributable to stock-based compensation expense. Excluding
stock-based compensation expense, we would have had a net loss of $14.2 million
and net loss per common share of $0.27 in the three months ended September 30,
2002, as compared to a net loss of $3.6 million and net loss per common share of
$0.07 in the corresponding period in 2001.

Our quarterly operating results have fluctuated in the past and are
likely to do so in the future, and we believe that quarter-to-quarter
comparisons of our operating results are not a good indication of our future
performance.

Nine Months Ended September 30, 2002 and 2001

Revenues. Total revenues increased 24% to $25.1 million in the nine
months ended September 30, 2002 from $20.3 million in the corresponding period
in 2001. Of the $4.8 million increase, $5.7 million was derived from increased
revenues from functional genomics collaborations for the development and
analysis of knockout mice and from our drug discovery alliance with Incyte
Genomics, Inc., offset by a decrease of $1.0 million in revenues for access to
our chemical libraries and optimization services as a result of our decision to
use our compound libraries principally in our own drug discovery efforts and
not, subject to limited exceptions, to make them available for purchase.

Research and Development Expenses. Research and development expenses,
including stock-based compensation expense, increased 56% to $55.6 million in
the nine months ended September 30, 2002 from $35.6 million in the corresponding
period in 2001. The increase of $20.0 million was primarily attributable to
increased personnel costs to support the expansion of our drug discovery
programs, the development and analysis of knockout mice and our other functional
genomics research efforts. Research and development expenses for the nine months
ended September 30, 2002 and 2001 included $3.9 million and $4.1 million,
respectively, of stock-based compensation primarily relating to option grants
made prior to our April 2000 initial public offering.

General and Administrative Expenses. General and administrative
expenses, including stock-based compensation expense, increased 13% to $17.7
million in the nine months ended September 30, 2002 from $15.8 million in the
corresponding period in 2001. The increase of $1.9 million was due primarily to
additional personnel costs, offset by a reduction in legal costs as a result of
the September 2001 settlement of our patent infringement litigation against
Deltagen, Inc. General and administrative expenses for the nine months ended
September 30, 2002 and 2001 included $3.8 million and $4.0 million,
respectively, of stock-based compensation primarily relating to option grants
made prior to our April 2000 initial public offering.

Interest and Other Income, Net. Interest and other income, net
decreased to $2.5 million in the nine months ended September 30, 2002 from $6.8
million in the corresponding period in 2001. The decrease resulted from lower
average cash and investment balances, lower average interest rates and a loss of
$197,000 realized on the sale of long-term investments during the 2002 period.

12

Net Loss and Net Loss Per Common Share. Net loss increased to $45.8
million in the nine months ended September 30, 2002 from $24.2 million in the
corresponding period in 2001. Net loss per common share increased to $0.88 in
the nine months ended September 30, 2002 from $0.49 in the corresponding period
of 2001. A portion of the net loss for the nine months ended September 30, 2002
and 2001 was attributable to stock-based compensation expense. Excluding
stock-based compensation expense, we would have had a net loss of $38.1 million
and net loss per common share of $0.73 in the nine months ended September 30,
2002, as compared to a net loss of $16.1 million and net loss per common share
of $0.32 in the corresponding period in 2001.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations from inception primarily through sales
of common and preferred stock, contract and milestone payments to us under our
database subscription, collaboration and license agreements, equipment financing
arrangements and leasing arrangements. From our inception through September 30,
2002, we had received net proceeds of $242.6 million from issuances of common
and preferred stock, including $203.2 million of net proceeds from the initial
public offering of our common stock in April 2000. In addition, from our
inception through September 30, 2002, we received $81.7 million in cash payments
from database subscription and technology license fees, drug discovery
alliances, functional genomics collaborations, sales of compound libraries and
reagents, and government grants, of which $78.4 million had been recognized as
revenues through September 30, 2002.

As of September 30, 2002, we had $119.6 million in cash, cash
equivalents, short-term and long-term investments (including restricted cash and
investments), as compared to $166.8 million as of December 31, 2001. We used
cash of $32.0 million in operations in the nine months ended September 30, 2002.
This consisted primarily of the net loss for the period of $45.8 million offset
by non-cash charges of $7.7 million related to stock-based compensation expense,
$6.6 million related to depreciation expense and $0.9 million related to
amortization of intangible assets other than goodwill. Investing activities
provided cash of $88.2 million in the nine months ended September 30, 2002,
principally as a result of net maturities of short-term investments and the sale
of long-term investments, offset in part by purchases of property and equipment.
We received cash of $0.5 million in financing activities in the nine months
ended September 30, 2002, principally as a result of stock option exercises.

In October 2000, we entered into a synthetic lease agreement under
which the lessor purchased our existing laboratory and office buildings and
animal facility in The Woodlands, Texas and agreed to fund the construction of
an additional laboratory and office building and a second animal facility. The
synthetic lease agreement was subsequently expanded to include funding for the
construction of a central plant facility for the distribution of utilities and
related services among our facilities. Including the purchase price for our
existing facilities, the synthetic lease, as amended, provided for funding of up
to $55.0 million in property and improvements. The term of the agreement is six
years, which includes the construction period and a lease period. Lease payments
for the new facilities began upon completion of construction, which occurred at
the end of the first quarter of 2002. Lease payments are subject to fluctuation
based on LIBOR rates. Based on a LIBOR rate of 1.81% at September 30, 2002, our
total lease payments would be approximately $1.1 million per year. At the end of
the lease term, the lease may be extended for one-year terms, up to seven
additional terms, or we may purchase the properties for a price including the
outstanding lease balance. If we elect not to renew the lease or purchase the
properties, we may arrange for the sale of the properties to a third party or
surrender the properties to the lessor. If we elect to arrange for the sale of
the properties or surrender the properties to the lessor, we have guaranteed
approximately 86% of the total original cost as the residual fair value of the
properties. We are required to maintain restricted cash or investments to
collateralize borrowings made under the synthetic lease agreement. In addition,
we have agreed to maintain cash and investments of at least $30.0 million in
excess of our restricted cash and investments. If our cash and investments fall
below that level, we may

13

be required to seek a waiver of that agreement or to purchase the properties or
arrange for their sale to a third party. Because our cost to purchase the
properties would not materially exceed the amount of restricted cash and
investments we are required to maintain under the synthetic lease, we believe
that any requirement that we do so would not have a material adverse effect on
our financial condition. As of September 30, 2002 and December 31, 2001, we
maintained restricted cash and investments of $57.2 million and $43.3 million,
respectively, to collateralize borrowings of $55.0 million and $41.7 million.

On February 13, 2002, the FASB announced that it intended to propose
for adoption before the end of 2002 that companies be required to consolidate
special purpose entities, such as the lessor under our synthetic lease, on their
balance sheets under certain circumstances. In a proposed interpretation dated
June 28, 2002, the FASB outlined new rules that would require such consolidation
by a lessee that provides a residual value guarantee or similar arrangement to
the lessor/special purpose entity. While the lessor under our synthetic lease
qualifies for off-balance sheet treatment under current rules, we will be
required to consolidate the lessor on our balance sheet if the FASB's proposed
interpretation as currently drafted is adopted. If such consolidation is
required, our balance sheet will reflect as assets additional property and
equipment approximating the $55.0 million funded under the synthetic lease for
property and improvements and the same amount as a liability. In addition, we
will be required to depreciate such property and improvements over their useful
lives. The proposed guidance would require companies with calendar-fiscal years
that have existing special purpose entities, such as ours, to apply the new
standards on April 1, 2003. We believe that the consolidation of the lessor, if
required, will not have a material adverse effect on our financial condition or
results of operations. We will continue to monitor the FASB's proposals and
evaluate their impact on our synthetic lease.

On May 23, 2002, Lexicon Pharmaceuticals (New Jersey), Inc. signed a
ten-year lease for a 76,000 square-foot facility in Princeton, New Jersey. The
lease provides for an escalating yearly rent payment of $1.3 million in the
first year, $1.7 million in years two and three, $1.8 million in years four to
six, $2.0 million in years seven to nine and $2.1 million in year ten. The lease
also provides Lexicon Pharmaceuticals with the option in the second year of the
lease to borrow $2.0 million in tenant improvement funds from the landlord, at
which time rental payments due under the lease will increase as the tenant
improvement allowance is amortized over a ten-year period. Lexicon is the
guarantor of the obligations of Lexicon Pharmaceuticals (New Jersey), Inc. under
the lease.

Our future capital requirements will be substantial and will depend on
many factors, including our ability to obtain database subscription, alliance,
collaboration and technology license agreements, the amount and timing of
payments under such agreements, the level and timing of our research and
development expenditures, market acceptance of our products, the resources we
devote to developing and supporting our products and other factors. Our capital
requirements will also be affected by any expenditures we make in connection
with license agreements and acquisitions of and investments in complementary
technologies and businesses. We expect to devote substantial capital resources
to continue our research and development efforts, to expand our support and
product development activities, and for other general corporate activities. We
believe that our current unrestricted cash and investment balances and revenues
we expect to derive from subscriptions to our databases, functional genomics
collaborations, technology licenses and drug discovery alliances will be
sufficient to fund our operations at least through the end of 2003. During or
after this period, if cash generated by operations is insufficient to satisfy
our liquidity requirements, we will need to sell additional equity or debt
securities or obtain additional credit arrangements. Additional financing may
not be available on terms acceptable to us or at all. The sale of additional
equity or convertible debt securities may result in additional dilution to our
stockholders.

14

DISCLOSURE ABOUT MARKET RISK

We are exposed to limited market and credit risk on our cash
equivalents, which have maturities of three months or less. We maintain a
short-term investment portfolio which consists of U.S. government agency debt
obligations and investment grade commercial paper that mature three to twelve
months from the time of purchase, which we believe are subject to limited market
and credit risk. Additionally, we hold long-term investments consisting of U.S.
government agency debt obligations with a maturity of greater than twelve months
from the time of purchase. These investments are also subject to market and
credit risk. A hypothetical one percent increase in market rates would result in
a decrease of approximately $0.5 million in the fair value of our long-term
investments as of September 30, 2002. We currently do not hedge interest rate
exposure or hold any derivative financial instruments in our investment
portfolio.

We have operated primarily in the United States and substantially all
sales to date have been made in U.S. dollars. Accordingly, we have not had any
material exposure to foreign currency rate fluctuations.

RISK FACTORS

Our business is subject to certain risks and uncertainties, including
those referenced below:

Risks Related to Our Business

o we have a history of net losses, and we expect to continue to incur net
losses and may not achieve or maintain profitability

o our quarterly operating results have been and likely will continue to
fluctuate, and we believe that quarter-to-quarter comparisons of our
operating results are not a good indication of our future performance

o we are an early-stage company with an unproven business strategy

o we will need additional capital in the future and, if it is not
available, we will have to curtail or cease operations

o we face substantial competition in the discovery of the functions of
genes and in our drug discovery and product development efforts

o we rely heavily on collaborators to develop and commercialize
pharmaceutical products based on genes that we identify as promising
candidates for development as drug targets

o any cancellation by or conflicts with our collaborators could harm our
business

o we have no experience in developing and commercializing pharmaceutical
products on our own

o we may engage in future acquisitions, which may be expensive and time
consuming and from which we may not realize anticipated benefits

o if we lose our key personnel or are unable to attract and retain
additional personnel, we may be unable to pursue collaborations or
develop our own products

15

o we may encounter difficulties in managing our growth, which could
increase our losses

o because our entire OmniBank mouse clone library is located at a single
facility, the occurrence of a disaster could significantly disrupt our
business

Risks Related to Our Industry

o our ability to patent our discoveries is uncertain because patent laws
and their interpretation are highly uncertain and subject to change

o our patent applications may not result in enforceable patent rights

o if other companies and institutions obtain patents claiming the
functional uses of genes and gene products based upon gene sequence
information and predictions of gene function, we may be unable to
obtain patents for our discoveries of biological function in knockout
mice

o we may become involved in patent litigation and other disputes
regarding intellectual property rights, and can give no assurance that
we will prevail in any such litigation or other dispute

o issued patents may not fully protect our discoveries, and our
competitors may be able to commercialize products similar to those
covered by our issued patents

o our rights to the use of technologies licensed by third parties are not
within our control

o we may be unable to protect our trade secrets

o we may become subject to regulation under the Animal Welfare Act, which
could subject us to additional costs and permit requirements

o we and our collaborators are subject to extensive and uncertain
government regulatory requirements, which could increase our operating
costs or adversely affect our ability to obtain government approval of
products based on genes that we identify in a timely manner or at all

o the uncertainty of pharmaceutical pricing and reimbursement may
decrease the commercial potential of our products and affect our
ability to raise capital

o security risks in electronic commerce or unfavorable internet
regulation may deter future use of our products and services

o we use hazardous chemicals and radioactive and biological materials in
our business; any disputes relating to improper handling, storage or
disposal of these materials could be time consuming and costly

o we may be sued for product liability

o public perception of ethical and social issues may limit or discourage
the use of our technologies, which could reduce our revenues

16

For additional discussion of the risks and uncertainties that affect
our business, see "Item 1. Business - Risk Factors" included in our annual
report on Form 10-K for the year ended December 31, 2001, as filed with the
Securities and Exchange Commission.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See "Disclosure about Market Risk" under "Item 2. Management's
Discussion and Analysis of Financial Condition and Results of Operations for
quantitative and qualitative disclosures about market risk.

ITEM 4. CONTROLS AND PROCEDURES

Lexicon's chief executive officer and chief financial officer have
concluded that the Company's disclosure controls and procedures (as defined in
Securities Exchange Act of 1934 (the "Exchange Act") Rules 13a-14 (c) and
15d-14(c)) are sufficiently effective to ensure that the information required to
be disclosed by the Company in the reports it files under the Exchange Act is
gathered, analyzed and disclosed with adequate timeliness, accuracy and
completeness, based on an evaluation of such controls and procedures conducted
within 90 days prior to the date hereof.

Subsequent to the Company's evaluation, there were no significant
changes in internal controls or other factors that could significantly affect
internal controls, including any corrective actions with regard to significant
deficiencies and material weaknesses.

PART II - OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

EXHIBIT NO. DESCRIPTION
----------- -----------

99.1 -- Certification of CEO and CFO Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K:

None.

17

SIGNATURES

Pursuant to the requirements of the Securities Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

LEXICON GENETICS INCORPORATED

Date: November 6, 2002 By: /s/ ARTHUR T. SANDS
-------------------------------------
Arthur T. Sands, M.D., Ph.D.
President and Chief Executive Officer

Date: November 6, 2002 By: /s/ JULIA P. GREGORY
-------------------------------------
Julia P. Gregory
Executive Vice President and
Chief Financial Officer

18

CERTIFICATIONS

I, Arthur T. Sands, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Lexicon Genetics
Incorporated;

2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;

b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date");
and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent functions):

a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and

19

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: November 6, 2002

/s/ ARTHUR T. SANDS
-----------------------------------------
Arthur T. Sands, M.D., Ph.D.
President and Chief Executive Officer

20

CERTIFICATIONS

I, Julia P. Gregory, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Lexicon Genetics
Incorporated;

2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;

b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date");
and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent functions):

d) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and

e) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and

21

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

Date: November 6, 2002

/s/ JULIA P. GREGORY
-----------------------------------------
Julia P. Gregory
Executive Vice President and Chief
Financial Officer

22

INDEX TO EXHIBITS

EXHIBIT NO. DESCRIPTION
----------- -----------

99.1 -- Certification of CEO and CFO Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002