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 JUNE 30, 2003

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 August 1, 2003, 62,538,748 shares of the registrant's common
stock, par value $0.001 per share, were outstanding.

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LEXICON GENETICS INCORPORATED

TABLE OF CONTENTS

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.

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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.

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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.

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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.

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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 six-month period ended June 30, 2003 are not
necessarily indicative of the results that may be expected for the year ended
December 31, 2003.

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, 2002, as filed with the SEC.

2. RECLASSIFICATION

The accompanying statement of cash flows for the six months ended June
30, 2002, has been revised to reflect the reclassification of restricted cash
from cash and cash equivalents into a separate line item.

3. RESTRICTED CASH AND INVESTMENTS

Lexicon is required to maintain restricted cash or investments to
collateralize borrowings made under the synthetic lease agreement under which it
leases its office and laboratory facilities in The Woodlands, Texas, as well as
to collateralize standby letters of credit for the leases on its office and
laboratory facilities in East Windsor and Hopewell, New Jersey (see Note 7). As
of June 30, 2003 and December 31, 2002, the Company maintained restricted cash
and investments of $57.7 million under these agreements.

4. 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 and six-month periods ended
June 30, 2002 was $14.3 million and $28.7 million, which includes a $0.6 million
and $0.3 million unrealized gain on long-term investments. During 2002, Lexicon
sold its available-for-sale securities. As a result there was no difference
between net loss and comprehensive loss in the three-month and six-month periods
ended June 30, 2003.

5. 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

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included because they are antidilutive. There are no differences between basic
and diluted net loss per share for all periods presented.

6. STOCK-BASED COMPENSATION

Lexicon's stock-based compensation plans are accounted for under the
recognition and measurement provisions of Accounting Principles Board (APB)
Opinion No. 25, "Accounting for Stock Issued to Employees, and Related
Interpretations." Under the intrinsic value method described in APB Opinion No.
25, no compensation expense is recognized if the exercise price of the employee
stock option equals the market price of the underlying stock on the date of
grant. Lexicon recognized $2.6 million and $2.5 million of stock-based
compensation during the three-month periods ended June 30, 2003 and 2002,
respectively, and $5.1 million during each of the six-month periods ended June
30, 2003 and 2002, which was primarily related to option grants made prior to
Lexicon's April 2000 initial public offering. The following table illustrates
the effect on net loss and net loss per share if the fair value recognition
provisions of Financial Accounting Standards Board (FASB) No. 123 "Accounting
for Stock Based Compensation," had been applied to all outstanding and unvested
awards in each period:

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 for the distribution of
utilities and related services among our facilities. 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 and may be extended at our option for up to seven additional
one-year terms. Alternatively, the lease may be terminated at an earlier date if
we elect to (1) purchase the properties for a price equal to the $55.0 million
funded under the synthetic lease for property and improvements plus the amount
of any accrued but unpaid lease payments, (2) arrange for the sale of the
properties to a third party or (3) 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. 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 1.1% at June 30, 2003 the
Company's total lease payments would be approximately $0.8 million per year. The
Company is required to maintain restricted cash or investments to collateralize
amounts funded under the synthetic lease agreement. In addition, Lexicon has
agreed to maintain cash and investments of at least $12.0 million in excess of
the Company's restricted cash and

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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 $55.0 million
funded under the synthetic lease for property and improvements and would likely
be less than 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. As of June 30, 2003 and December 31, 2002, the Company maintained
restricted cash and investments of $57.2 million to collateralize funding for
property and improvements under the synthetic lease of $55.0 million.

Effective July 1, 2003, Lexicon will be required to consolidate the
lessor under the synthetic lease, in accordance with FASB Interpretation No. 46
(FIN 46), "Consolidation of Variable Interest Entities." FIN 46 requires that
unconsolidated variable interest entities be consolidated by their primary
beneficiaries. A primary beneficiary is the party that absorbs a majority of the
entity's expected losses or residual benefits. Accordingly, if the synthetic
lease remains in place as of September 30, 2003, Lexicon's balance sheet as of
such date will reflect as assets additional property and equipment approximating
the $55.0 million funded under the synthetic lease for property and
improvements, less accumulated depreciation, and a similar amount as a
liability. The Company will also be required to depreciate such improvements
over their useful lives. Whether or not the synthetic lease remains on Lexicon's
balance sheet as of September 30, 2003, Lexicon's statements of operations for
the third quarter of 2003 will reflect a charge of approximately $2.3 million
for depreciation through June 30, 2003, as a cumulative effect of an accounting
change.

The Company intends to replace the synthetic lease agreement covering
all of the facilities in The Woodlands, Texas, and is currently engaged in
discussions to do so. The Company expects that any such new arrangement would
require substantially lower amounts of restricted cash and investments while
increasing lease payments with respect to these facilities, as compared to the
synthetic lease agreement.

Lexicon's subsidiary leases laboratory and office space in East Windsor
and Hopewell, New Jersey. The East Windsor lease expires in January 2004. The
Hopewell lease is a ten-year lease entered into in May 2002 for a 76,000
square-foot facility in New Jersey. Lexicon's subsidiary has exercised its
option under the lease to obtain $2.0 million in funds from the landlord to be
used for tenant improvements. The lease provides that the expiration of the term
of the lease will be extended to June 30, 2013, the tenth anniversary of the
date on which the landlord provides the tenant improvement funds, and that such
funds will be amortized over a ten-year period. Accordingly, the escalating
yearly base rent payment under the lease will be $1.3 million in the first year,
$2.1 million in years two and three, $2.2 million in years four to six, $2.3
million in years seven to nine and $2.4 million in year ten. Lexicon is the
guarantor of the obligations of its subsidiary under the lease. The Company is
required to maintain restricted investments to collateralize the East Windsor
and Hopewell leases. As of June 30, 2003, the Company had $0.5 million in
restricted investments to collateralize standby letters of credit for these
leases.

8. SUBSEQUENT EVENT

In July 2003, Lexicon completed the public offering and sale of 10.0
million shares of its common stock at a price of $5.25 per share, for net
proceeds of $49.0 million, after deducting underwriting discounts of $3.1
million and estimated offering expenses of $0.4 million. The underwriters have
the option to purchase up to an additional 1.5 million shares of common stock
from Lexicon to cover over-allotments, if any. Lexicon currently intends to use
the net proceeds for research and development, but may use a portion of the net
proceeds to acquire or invest in complementary products and technologies or for
general corporate purposes.

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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 use proprietary gene knockout
technology to systematically discover the physiological functions of genes in
mice and to identify which corresponding human genes encode potential targets
for therapeutic intervention, or drug targets. The study of mice can be a very
powerful tool for understanding human genetics because of the close similarity
of gene function and physiology in mice and humans. Approximately 99% of all
human genes have a counterpart in the mouse genome. 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 cells, which can be cloned and used to generate mice with the
altered gene. We then employ an integrated platform of advanced medical
technologies to systematically discover and validate, in vivo, the physiological
functions and pharmaceutical utility of the genes we have knocked out and the
drug targets they encode.

We are working both independently and with our drug discovery
collaborators to discover potential small molecule drugs, therapeutic antibodies
and therapeutic proteins for those in vivo-validated drug targets that we
consider to have high pharmaceutical value. We are working with Genentech, Inc.
to discover the functions of secreted proteins and potential antibody targets
identified through Genentech's internal drug discovery research. We are working
with Abgenix, Inc. to discover and develop therapeutic antibodies for in
vivo-validated drug targets identified in our own research. We are also working
with Incyte Corporation to discover and develop 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,
in return for granting access to some of our technologies and discoveries for
use in such companies' own drug discovery efforts.

We derive substantially all of our revenues from drug discovery
alliances, subscriptions to our databases, target validation collaborations for
the development and, in some cases, analysis of the physiological effects of
genes altered in knockout mice, and technology licenses. To date, we have
generated a substantial portion of our revenues from a limited number of sources
and have not generated any revenue from sales of pharmaceuticals.

Our operating results and, in particular, our ability to generate
additional revenues are dependent on many factors, including:

o our ability to establish new research collaborations, database
subscriptions and technology licenses, and the timing of such
arrangements;

o the expiration or other termination of research collaborations with our
collaborators and database subscriptions, which may not be renewed or
replaced;

o the success rate of our discovery efforts leading to opportunities for
new research collaborations and licenses, as well as milestone payments
and royalties;

o the timing and willingness of collaborators to commercialize
pharmaceutical products that would result in milestone payments and
royalties; and

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o general and industry-specific economic conditions which may affect our
and our collaborators' 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 part, on securing new
agreements. 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 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 June
30, 2003, we had an accumulated deficit of $184.5 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, facility costs, depreciation on property and
equipment, 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 target validation
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, information technology
and general legal activities. In connection with the expansion of our drug
discovery programs and our target validation 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

We recognize revenues when persuasive evidence of an arrangement exists,
delivery has occurred or services have been rendered, the price is fixed and
determinable, and collectability is reasonably assured. Payments received in
advance under these arrangements are recorded as deferred revenue until earned.

Fees for access to our databases and other functional genomics resources
are recognized ratably over the subscription or access period. Collaborative
research payments are recognized as revenue as we perform our obligations
related to such research to the extent such fees are non-refundable.
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.

Revenues recognized from multiple element contracts are allocated to
each element of the arrangement based on the relative fair value of the
elements. The determination of fair value of each element is based on objective
evidence. When revenues for an element are specifically tied to a separate
earnings process, revenue is recognized when the specific performance obligation
associated with the

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element is completed. When revenues for an element are not specifically tied to
a separate earnings process, they are recognized ratably over the term of the
agreement.

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: $5.1 million during the remaining six months of 2003
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.

Goodwill Impairment

Goodwill is not amortized, but is tested at least annually for
impairment at the reporting unit level. Impairment is the condition that exists
when the carrying amount of goodwill exceeds its implied fair value. The first
step in the impairment process is to determine the fair value of the reporting
unit and then compare it to the carrying value, including goodwill. If the fair
value exceeds the carrying value, no further action is required and no
impairment loss is recognized. Additional impairment assessments may be
performed on an interim basis if we encounter events or changes in circumstances
that would indicate that, more likely than not, the carrying value of goodwill
has been impaired.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2002, the Financial Accounting Standards Board, or FASB,
issued Statement of Financial Accounting Standards, or SFAS, No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure." This
statement amends SFAS 123, "Accounting for Stock-Based Compensation," to provide
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In addition, this
statement amends the disclosure requirements of SFAS 123 to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based accounting for employee compensation and the effect
of the method used on reported results. The Company is currently evaluating
whether to adopt the fair value based method.

In January 2003, the FASB issued Interpretation, or FIN, No. 46,
"Consolidation of Variable Interest Entities." FIN 46 requires that
unconsolidated variable interest entities be consolidated by their

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primary beneficiaries. A primary beneficiary is the party that absorbs a
majority of the entity's expected losses or residual benefits. FIN 46 applies
immediately to variable interest entities created after January 31, 2003 and to
existing variable interest entities in the periods beginning after June 15,
2003. 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. As adopted on July 1, 2003, FIN 46 will
require us to consolidate the lessor under our synthetic lease. Accordingly, if
the synthetic lease remains in place as of September 30, 2003, our balance sheet
as of such date will reflect as assets additional property and equipment
approximating the $55.0 million funded under the synthetic lease for property
and improvements, less accumulated depreciation, and a similar amount as a
liability. We would be required to depreciate such improvements over their
useful lives. Whether or not the synthetic lease remains on Lexicon's balance
sheet as of September 30, 2003, our statement of operations for the third
quarter of 2003 will reflect a charge of approximately $2.3 million for
depreciation through June 30, 2003, as a cumulative effect of an accounting
change. We are currently seeking to replace the synthetic lease. See "-
Liquidity and Capital Resources."

RESULTS OF OPERATIONS

Three Months Ended June 30, 2003 and 2002

Revenues. Total revenues decreased 5% to $8.9 million in the three
months ended June 30, 2003 from $9.4 million in the corresponding period in
2002. The decrease of $0.5 million was primarily the result of higher revenues
in the 2002 period from technology license agreements.

Research and Development Expenses. Research and development expenses
increased 9% to $20.8 million in the three months ended June 30, 2003 from $19.0
million in the corresponding period in 2002. The increase of $1.8 million was
primarily attributable to increased personnel costs and facilities 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 periods included $1.3 million of
stock-based compensation.

General and Administrative Expenses. General and administrative expenses
were $6.0 million both in the three months ended June 30, 2003 and in the
corresponding period in 2002. General and administrative expenses for both
periods included $1.3 million of stock-based compensation.

Interest and Other Income. Interest and other income decreased to $0.3
million in the three months ended June 30, 2003 from $0.7 million in the
corresponding period in 2002. The decrease resulted from lower average cash and
investment balances and lower average interest rates during the 2003 period.

Net Loss and Net Loss Per Common Share. Net loss increased to $17.6
million in the three months ended June 30, 2003 from $14.9 million in the
corresponding period in 2002. Net loss per common share increased to $0.34 in
the three months ended June 30, 2003 from $0.29 in the corresponding period of
2002. As a complement to reporting net loss and net loss per common share in
accordance with generally accepted accounting principles, or GAAP, Lexicon
provides net loss and net loss per common share excluding non-cash, stock-based
compensation. Lexicon uses these measures in establishing budgets and believes
they are useful in measuring the performance of the Company's business.
Excluding stock-based compensation expense of $2.6 million and $2.5 million in
the three months ended June 30, 2003 and 2002, respectively, we would have had a
net loss of $15.1 million and net loss per common share of $0.29 in the three
months ended June 30, 2003, as compared to a net loss of $12.4 million and net
loss per common share of $0.24 in the corresponding period in 2002.

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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.

Six Months Ended June 30, 2003 and 2002

Revenues. Total revenues were $17.0 million in the six months ended June
30, 2003, effectively unchanged from $17.1 million in the corresponding period
of 2002.

Research and Development Expenses. Research and development expenses
increased 13% to $40.6 million in the six months ended June 30, 2003 from $35.9
million in the corresponding period in 2002. The increase of $4.7 million was
primarily attributable to increased personnel costs and depreciation and
amortization 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 periods included
$2.6 million of stock-based compensation.

General and Administrative Expenses. General and administrative
expenses, including stock-based compensation expense, decreased 2% to $11.8
million in the six months ended June 30, 2003 from $12.0 million in the
corresponding period in 2002. General and administrative expenses for both
periods included $2.6 million of stock-based compensation.

Interest and Other Income. Interest and other income decreased to $0.8
million in the six months ended June 30, 2003 from $1.8 million in the
corresponding period in 2002. The decrease resulted from lower average cash and
investment balances and lower average interest rates during the 2003 period.

Net Loss and Net Loss Per Common Share. Net loss increased to $34.8
million in the six months ended June 30, 2003 from $29.0 million in the
corresponding period in 2002. Net loss per common share increased to $0.66 in
the six months ended June 30, 2003 from $0.56 in the corresponding period of
2002. Excluding stock-based compensation expense of $5.1 million in both
periods, the net loss was $29.7 million and net loss per common share was $0.57
in the six months ended June 30, 2003, as compared to a net loss of $23.9
million and net loss per common share of $0.46 in the corresponding period in
2002.

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 June 30, 2003,
we had received net proceeds of $242.8 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 June 30, 2003, we received $113.2 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 $105.5 million had been recognized as
revenues through June 30, 2003. In July 2003, we completed a public offering of
our common stock from which we received $49.0 million in net proceeds.

As of June 30, 2003, we had $95.6 million in cash, cash equivalents and
short-term investments, including restricted cash and investments, as compared
to $123.1 million as of December 31, 2002. Restricted cash and investments were
$57.7 million at both such dates. We used cash of $25.4 million in operations in
the six months ended June 30, 2003. This consisted primarily of the net loss for
the period of $34.8 million offset by non-cash charges of $5.1 million related
to stock-based compensation expense, $5.0 million related to depreciation
expense and $0.6 million related to amortization of intangible assets

13

other than goodwill. Investing activities provided cash of $19.9 million in the
six months ended June 30, 2003, principally as a result of net maturities of
short-term investments, offset in part by an increase in restricted cash.

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 and may be
extended at our option for up to seven additional one-year terms. Alternatively,
the lease may be terminated at an earlier date if we elect to (1) purchase the
properties for a price equal to the $55.0 million funded under the synthetic
lease for property and improvements plus the amount of any accrued but unpaid
lease payments, (2) arrange for the sale of the properties to a third party or
(3) 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. 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 1.1% at June 30, 2003, our total lease payments would be approximately $0.8
million per year. We are required to maintain restricted cash or investments to
collateralize amounts funded under the synthetic lease agreement. In addition,
we have agreed to maintain cash and investments of at least $12.0 million in
excess of our restricted cash and investments. If our cash and investments fall
below that level, we 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 our
cost to purchase the properties would not materially exceed the $55.0 million
funded under the synthetic lease for property and improvements and would likely
be less than 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
June 30, 2003 and December 31, 2002, we maintained restricted cash and
investments of $57.2 million to collateralize funding for property and
improvements under the synthetic lease of $55.0 million.

We intend to replace our synthetic lease agreement covering all of our
facilities in The Woodlands, Texas, and we are currently engaged in discussions
to do so. We expect that any such new arrangement would require us to maintain
substantially lower amounts of restricted cash and investments while increasing
our lease payments with respect to these facilities, as compared to our
synthetic lease agreement.

In May 2002, our subsidiary Lexicon Pharmaceuticals (New Jersey), Inc.
signed a ten-year lease for a 76,000 square-foot facility in Hopewell, New
Jersey. Our subsidiary has exercised its option under the lease to obtain $2.0
million in funds from the landlord to be used for tenant improvements. The lease
provides that the expiration of the term of the lease will be extended to June
30, 2013, the tenth anniversary of the date on which the landlord provides the
tenant improvement funds, and that such funds will be amortized over a ten-year
period. Accordingly, the escalating yearly base rent payment under the lease
will be $1.3 million in the first year, $2.1 million in years two and three,
$2.2 million in years four to six, $2.3 million in years seven to nine and $2.4
million in year ten. We are the guarantor of the obligations of our subsidiary
under the lease.

In December 2002, we borrowed $4.0 million under a convertible
promissory note we issued to Genentech. The proceeds of the loan are to be used
to fund research efforts under our alliance with Genentech for the discovery of
therapeutic proteins and antibody targets. The note matures on or before
December 31, 2005, but we may prepay it at any time. We may repay the note, at
our option, in cash or in

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shares of our common stock valued at the then-current market value, or in a
combination of cash and shares, subject to certain limitations. The note accrues
interest at an annual rate of 8%, compounded quarterly.

Our future capital requirements will be substantial and will depend on
many factors, including our ability to obtain alliance, collaboration,
technology license and database subscription 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 that we may develop
and the resources we devote to developing and supporting such products. Our
capital requirements will also be affected by any expenditures we make in
connection with license agreements and acquisitions of and investments in
complementary products and technologies. 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, including the $49.0 million in net proceeds from our July 2003 public
offering, and revenues we expect to derive from drug discovery alliances,
subscriptions to our databases, target validation collaborations and technology
licenses will be sufficient to fund our operations at least through the next 24
months. 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, and in the case of debt securities,
could subject us to restrictive covenants.

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, investment grade commercial paper, corporate debt securities and
certificates of deposit that mature three to 12 months from the time of
purchase, which we believe are subject to limited market and credit risk. 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 Company and 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 we will need additional capital in the future and, if it is not
available, we will have to curtail or cease operations

o we are an early-stage company, and we have not successfully developed
or commercialized any therapeutics or drug targets that we have
identified

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

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

o we rely on several key collaborators for a significant portion of our
revenues

o cancellations 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 lack the capability to manufacture compounds for preclinical
studies, clinical trials or commercial sales and will rely on third
parties to manufacture our potential products

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

o because all of our target validation operations are located at a single
facility, the occurrence of a disaster could significantly disrupt our
business

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

Risks Related to Our Industry

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

o our patent applications may not result in patent rights

o if other companies and institutions obtain patents relating to our drug
target or product candidate discoveries, we may be unable to obtain
patents for our inventions based upon those discoveries and may be
blocked from using or developing some of our technologies and products

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

o we may be involved in patent litigation and other disputes regarding
intellectual property rights and may require licenses from third
parties for our discovery and development and planned commercialization
activities. We may not prevail in any such litigation or other dispute
or be able to obtain required licenses.

o we use intellectual property that we license from third parties. If we
do not comply with these licenses, we could lose our rights under them

o we have not sought patent protection outside of the United States for
some of our inventions, and some of our licensed patents only provide
coverage in the United States

o we may be unable to protect our trade secrets

o our efforts to discover, evaluate and validate potential targets for
therapeutic intervention and our drug discovery programs are subject to
evolving data and other risks inherent in the drug discovery process

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

o if we obtain regulatory approval for our potential products, we will
remain subject to extensive and rigorous ongoing regulation

o the uncertainty of pharmaceutical pricing and reimbursement may
decrease the commercial potential of any products that we or our
collaborators may develop and affect our ability to raise capital

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

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, 2002 and the section
captioned "Risk Factors" included in our Registration Statement on Form S-3
(Registration No. 333-101549), as supplemented by the Prospectus Supplement
dated July 23, 2003, each 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Our annual meeting of stockholders was held on April 30, 2003 to
consider and vote upon the following proposals:

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(1) The following individuals were nominated and elected as Class
III directors, with the following numbers of shares voted for
and withheld for such directors:

(2) The following additional matter was considered and approved,
with the following numbers of shares voted for, voted against
and abstaining with respect to such matter:

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

(b) Reports on Form 8-K:

On May 1, 2003, we filed a Current Report on Form 8-K dated May
1, 2003 relating to our issuance of a press release reporting
our financial results for the quarter ended March 31, 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange 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: August 6, 2003 By: /s/ ARTHUR T. SANDS
------------------------------------------
Arthur T. Sands, M.D., Ph.D.
President and Chief Executive Officer

Date: August 6, 2003 By: /s/ JULIA P. GREGORY
------------------------------------------
Julia P. Gregory
Executive Vice President and
Chief Financial Officer

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INDEX TO EXHIBITS