UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

(Mark One)
	ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2003

 

or

 

o

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

 

Commission File Number: 0-27118

 

PHARMACOPEIA, INC.

(Exact name of registrant as specified in its charter)

 

 

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 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 ý  No o

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

Class		Outstanding at April 30, 2003
Common Stock, $.0001 par value		23,674,401 shares

 

 

PHARMACOPEIA, INC.

 

Form 10-Q

 

Table of Contents

 

Item
PART I.  FINANCIAL INFORMATION
Item 1.		Unaudited Consolidated Financial Statements:
		Balance Sheets – March 31, 2003 and December 31, 2002
		Statements of Operations – Three Months Ended March 31, 2003 and 2002
		Statements of Cash Flows – Three Months Ended March 31, 2003 and 2002
		Notes to Unaudited Consolidated Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures about Market Risk
Item 4.		Controls and Procedures
PART II.  OTHER INFORMATION
Item 1.		Legal Proceedings
Item 2.		Changes in Securities and Use of Proceeds
Item 3.		Defaults upon Senior Securities
Item 4.		Submission of Matters to a Vote of Security Holders
Item 5.		Other Information
Item 6.		Exhibits and Reports on Form 8-K
Signature
Index to Exhibits

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1.  Unaudited Consolidated Financial Statements

 

Pharmacopeia, Inc.

Consolidated Balance Sheets

(Dollars in thousands)

 

		March 31, 2003			December 31, 2002
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	31,579		$	28,236
Marketable securities		114,864			112,835
Trade receivables, net of allowance for doubtful accounts of $1,045 and $1,634 respectively		14,839			35,571
Prepaid expenses and other current assets		6,209			5,505
Total current assets		167,491			182,147
Property and equipment - net		13,396			14,157
Goodwill - net		34,404			34,404
Capitalized software - net		8,048			8,656
Other intangibles - net		—			116
Other assets		567			625
Total assets		$	223,906		$	240,105
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	2,389		$	2,497
Accrued liabilities		15,969			20,429
Deferred revenue, current portion		24,079			29,076
Total current liabilities		42,437			52,002
Deferred revenue, long-term		3,206			4,766
Stockholders’ equity:
Capital stock		2			2
Additional paid-in capital		285,079			284,733
Treasury stock		(8,340		)	(8,340		)
Accumulated deficit		(99,274		)	(93,821		)
Accumulated comprehensive income		796			763
Total stockholders’ equity		178,263			183,337
Total liabilities and stockholders’ equity		$	223,906		$	240,105

 

See accompanying notes to these unaudited financial statements.

 

3

 

Pharmacopeia, Inc.

Consolidated Statements of Operations

(Dollars in thousands, except per share data)

 

		For the Three Months Ended March 31,
		2003			2002
Revenue:
Software license, service and other		$	17,219		$	19,621
Drug discovery		7,521			7,219
Total revenue		24,740			26,840
Cost of revenue:
Software license, service and other		5,169			4,763
Drug discovery		5,776			4,854
Total cost of revenue		10,945			9,617
Gross margin		13,795			17,223
Operating costs and (benefit):
Research and development		5,733			7,319
Sales, general and administrative		14,658			17,066
Restructuring		(384		)	—
Total operating costs and expenses		20,007			24,385
Operating loss		(6,212		)	(7,162		)
Interest and other income, net		1,136			1,280
Loss before provision for income taxes		(5,076		)	(5,882		)
Provision for income taxes		377			121
Net loss		$	(5,453	)	$	(6,003	)
Net loss per share - Basic		$	(0.23	)	$	(0.25	)
Net loss per share - Diluted		$	(0.23	)	$	(0.25	)
Weighted average number of common stock outstanding
Basic		23,617			23,681
Diluted		23,617			23,681

 

See accompanying notes to these unaudited financial statements.

 

4

 

Pharmacopeia, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)

 

		For the Three Months Ended March 31,
		2003			2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(5,453	)	$	(6,003	)
Adjustments to reconcile net loss to net cash provided by operations
Depreciation		1,586			1,427
Amortization		1,882			1,884
Contribution of stock to 401(k) members		281			329
Non-cash compensation		10			114
Changes in assets and liabilities:
Accounts receivable		20,732			20,254
Prepaid and other current assets		(704		)	(567		)
Other assets		15			321
Accounts payable		(113		)	(1,826		)
Accrued liabilities		(4,458		)	(4,024		)
Deferred revenue		(6,554		)	(7,341		)
Net cash provided by operating activities		7,224			4,568
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(800		)	(2,018		)
Purchases of marketable securities		(18,552		)	(45,935		)
Proceeds from sales of marketable securities		16,638			15,208
Increase in capitalized software development costs		(1,158		)	(605		)
Net cash used in investing activities		(3,872		)	(33,350		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock		57			155
Purchases of treasury stock		—			(6,879		)
Principal payments under capital lease obligations		(3		)	(35		)
Net cash provided by (used in) financing activities		54			(6,759		)
Exchange rate effect on cash and equivalents		(63		)	(36		)
Net increase (decrease) in cash and equivalents		3,343			(35,577		)
Cash and equivalents, beginning of period		28,236			68,891
Cash and equivalents, end of period		$	31,579		$	33,314
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest		$	5		$	20
Income taxes		$	141		$	369

 

See accompanying notes to these unaudited financial statements.

 

5

 

Pharmacopeia, Inc.

Notes to Unaudited Consolidated Financial Statements

 

1.  Basis of Presentation

 

The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, these unaudited financial statements do not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial statements have been included.

 

Interim results are not necessarily indicative of the results that may be expected for the year.  For further information, refer to the financial statements and disclosures thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

 

Certain amounts in prior periods have been reclassified to conform with current period presentation.

 

2.  Net Loss Per Share

 

The Company computes net loss per share in accordance with Statement of Financial Accounting Standard (SFAS) No. 128, Earnings Per Share.  Under the provisions of SFAS No. 128, basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted-average number of common shares outstanding during the period.  Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted-average number of common and dilutive common equivalent shares outstanding during the period.  Diluted earnings per share are required to be calculated to include the potentially dilutive effect of the conversion of outstanding stock options. Because the Company has a net loss for the periods presented, the inclusion of outstanding stock options would be anti-dilutive and therefore the weighted-average shares used to calculate both basic and diluted loss per share are the same.

 

6

 

3.  Segment Information

 

The Company operates in two industry segments.  The Company’s Software segment, Accelrys Inc. (“Accelrys”), provides molecular modeling and simulation, bioinformatics and cheminformatics software, and related services that facilitate the discovery and development of new drug and chemical products and processes in the pharmaceutical, biotechnology, chemical, petrochemical and materials industries.  The Company’s Drug Discovery segment, Pharmacopeia Drug Discovery, Inc. (“PDD”), provides drug discovery services to pharmaceutical and biotechnology companies based on proprietary combinatorial chemistry, high-throughput screening, and Accelrys technologies. The accounting policies of the reportable segments are the same as those of the Company. Summarized financial information concerning the industry segments follows (dollars in thousands):

 

		Three Months Ended March 31, 2003
		Accelrys			PDD			Total
Revenue:
Software licenses, service and other		$	17,219		$	—		$	17,219
Drug discovery		—			7,521			7,521
Total revenue		$	17,219		$	7,521		$	24,740
Operating loss		$	(5,372	)	$	(840	)	$	(6,212	)

 

		Three Months Ended March 31, 2002
		Accelrys			PDD			Total
Revenue:
Software licenses, service and other		$	19,621		$	—		$	19,621
Drug discovery		—			7,219			7,219
Total revenue		$	19,621		$	7,219		$	26,840
Operating loss		$	(6,343	)	$	(819	)	$	(7,162	)

 

		Accelrys			PDD			Total
Total assets - March 31, 2003		$	92,051		$	131,855		$	223,906
Total assets - December 31, 2002		$	104,143		$	135,962		$	240,105

 

4.  Stock-Based Compensation

 

Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) encourages, but does not require, companies to record compensation cost for stock-based compensation plans at fair value.  As permitted by SFAS 123, the Company has elected to continue following Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees,” (“APB 25”) and related interpretations, to account for stock-based compensation.  Under APB 25, no compensation expense is recognized at the time of option grant because the exercise price of the Company’s employee stock option equals the fair market value of the underlying common stock on the date of grant.

 

Had the Company followed the fair value measurement provisions of SFAS 123, the following table summarizes the pro forma net loss and pro forma net loss per share that would have been recorded (in thousands, except per share data):

 

7

 

		Three Months Ended March 31,
		2003			2002
Net loss
As reported		$	(5,453	)	$	(6,003	)
Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(3,053		)	(3,044		)
Pro forma		$	(8,506	)	$	(9,047	)
Basic and diluted net loss per share:
As reported		$	(0.23	)	$	(0.25	)
Pro forma		$	(0.36	)	$	(0.38	)

 

The fair value of each option granted during 2003 and 2002 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

 

		2003		2002
Dividend yield		0	%	0	%
Expected volatility		88.28	%	92.29	%
Risk-free interest rate		3.25	%	4.30	%
Expected life (years)		6.5		5.5

 

5.  Treasury Stock

 

During the third quarter of 2001, the Company’s Board of Directors authorized a stock repurchase program under which up to 1,000,000 shares of Pharmacopeia common stock with a market value up to $16 million be acquired in the open market.  The program has been concluded, and as of March 31, 2003, the Company repurchased a total of 643,900 shares for $8.3 million.

 

6.  Restructuring

 

During the third quarter of 2002, the Company announced that it was undertaking various actions to restructure its operations to improve its overall financial performance.  The restructuring effort included a reduction in force of 71 employees, of which 68 had been terminated as of March 31, 2003, and the closure of certain facilities. As a result of this plan, restructuring related charges of approximately $4.3 million were recognized as operating expense in the third quarter of 2002.  Based on a subsequent analysis of costs incurred and remaining costs to complete the restructuring, the Company determined that certain costs originally contemplated under the plan would not be incurred, and as such, the related amounts were reversed during the first quarter of 2003.

 

The following table summarizes the balance of the accrued restructuring reserve, which has been included in accrued liabilities at March 31, 2003 (dollars in thousands):

 

		Severance Costs for Involuntary Employee Terminations			Costs to Exit Lease Obligations			Total
Balance at August 6, 2002		$	2,367		$	1,973		$	4,340
Utilization of Reserves:
Cash		(2,076		)	(423		)	(2,499		)
Reserve reductions		(95		)	(289		)	(384		)
Balance at March 31, 2003		$	196		$	1,261		$	1,457

 

8

 

Item 2.           Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis of financial condition and results of operations of Pharmacopeia, Inc. (“Pharmacopeia” or the “Company”) should be read in conjunction with the Unaudited Financial Statements and related notes included elsewhere in this Form 10-Q, and also in conjunction with the Consolidated Financial Statements and related notes included in the Company’s Form 10-K for the year ended December 31, 2002.

 

This report, including, without limitation, this section regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding the Company and its business, financial condition, results of operations, and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Report.  Additionally, statements concerning future matters such as the development of new products, enhancements of technologies, possible changes in legislation, and other statements regarding matters that are not historical are forward-looking statements.

 

Although forward-looking statements in this Report reflect the good faith judgment of the Company’s management, such statements can only be based on facts and factors currently known by the Company.  Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements.  The Company undertakes no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Report.  Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this Report.

 

The Company’s registration statements on Form S-1 (Reg. No. 33-98246), most recent Form 10-K, and this Report, describe certain risk factors and uncertainties that may cause actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by such forward-looking statements.  These risk factors and uncertainties should be considered in connection with any investment in the Company’s common stock.

 

BUSINESS OVERVIEW

 

Pharmacopeia is a leader in enabling science and technology that accelerates and improves the drug discovery and chemical development processes. Pharmacopeia’s drug discovery subsidiary, Pharmacopeia Drug Discovery, Inc. (“PDD”), integrates proprietary small molecule combinatorial and medicinal chemistry, high-throughput screening, in-vitro pharmacology, computational methods and informatics to discover and optimize lead compounds.  Pharmacopeia’s software subsidiary, Accelrys Inc. (“Accelrys”), develops and commercializes molecular modeling and simulation software for the life sciences and materials research markets, cheminformatics and decision support systems, and bioinformatics tools including gene sequence analysis. Pharmacopeia employs approximately 700 people and is headquartered in Princeton, NJ.

 

RESULTS OF OPERATIONS

 

THREE MONTHS ENDED MARCH 31, 2003 AND 2002

 

Total revenue decreased 8% to $24.7 million in the first quarter of 2003 compared to $26.8 million in the first quarter of 2002.

 

9

 

Accelrys software license, service and other revenue decreased 12% to $17.2 million in the first quarter of 2003 compared to $19.6 million in the first quarter of 2002.  Revenue decreased 21% to $12.9 million in the European and US regions combined, including revenue from a strategic alliance.  Excluding the effect of the strategic alliance, revenue decreased 9%.  Revenue in Asia increased 32% to $4.3 million from $3.3 million.  The net decrease in revenue was principally due to the lack of annual license renewals in the biotech and materials science sectors throughout the world.

 

Drug Discovery revenue increased 4% to $7.5 million in the first quarter of 2003 compared to $7.2 million in the first quarter of 2002.  The increase was primarily due to increased milestone revenue partially offset by decreased services revenue.  Milestone revenue recorded in the quarters ended March 31, 2003 and 2002 was $1.4 million, and $0.25 million, respectively.  Excluding the revenue from milestones, revenue decreased 12% to $6.1 million in the first quarter of 2003 compared to $7.0 million in the first quarter of 2002.

 

Accelrys license, service and other gross margin decreased 19% to $12.1 million (70% of related revenue) in the first quarter of 2003 compared to $14.9 million (76% of related revenue) in the first quarter of 2002.  The $2.8 million decrease in gross margin resulted from the 12% decrease in revenue, from an increase in direct costs due to the mix of products sold and additional costs resulting from the release of new products in 2003 which has resulted in increased capitalized software amortization expense, and additional documentation costs.

 

Gross margin generated from Drug Discovery decreased 26% to $1.7 million (23% of related revenue) in the first quarter of 2003 compared to $2.4 million (33% of related revenue) in the first quarter of 2002.  Excluding the effect of the increased milestone revenue, which carries no significant associated cost of revenue, the gross margin decreased substantially due to the mix of revenue.  The lower margin resulted from increased resources allocated to funded projects, resulting in increased direct and allocated fixed costs.

 

Research and development expenses decreased by 22% to $5.7 million in the first quarter of 2003 compared to $7.3 million in the first quarter of 2002.  The decrease in research and development expenses is attributable to cost efficiencies realized at Accelrys due to the consolidation of research efforts and reductions implemented in the prior year, and to the reduction of internally funded drug discovery programs in the Drug Discovery business.

 

Sales, general and administrative expenses decreased by 14% to $14.7 million in the first quarter of 2003 compared to $17.1 million in the first quarter of 2002.  The decrease in sales, general and administrative expenses is attributable to the restructuring undertaken in the prior year.

 

During the first quarter of 2003, the Company was able to terminate a facility lease, the expected remaining obligation under which had been included in prior year’s restructuring, and finalized certain other severance obligations.   As such, the Company was able to reverse an excess portion of the restructuring liability during the first quarter of 2003.

 

Net interest and other income decreased 11% to $1.1 million in the first quarter of 2003 compared to $1.3 million in the first quarter of 2002.  The decrease is due to lower average investment balances and decreases in market interest rates.

 

The Company recorded an income tax provision of $0.4 million for the first quarter of 2003 compared to $0.1 million for first quarter of 2002.  The increase is due to state and foreign taxes. These provisions differ from the Federal tax rate primarily because of the effect of permanent book-tax differences, net operating loss carryforwards, and net operating loss carrybacks.

 

10

 

As a result of the lower revenues and lower costs described above, the Company generated a net loss of $5.5 million ($0.23 per diluted share) in the first quarter of 2003 compared to a net loss of $6.0 million ($0.25 per diluted share) in the first quarter of 2002.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The Company has funded its activities to date primarily through the sale of equity securities, software licenses, software maintenance services, and drug discovery services.  As of March 31, 2003, the Company had cash, cash equivalents, and marketable securities of $146.4 million compared to $141.0 million as of December 31, 2002.

 

Cash provided by operations increased by $2.7 million in the first quarter of 2003 compared to the first quarter of 2002.  The increase is primarily attributable to the collection of high dollar accounts receivable balances generated during the fourth quarter of 2002.  Cash used in investing activities decreased by $29.5 million in the first quarter of 2003 compared to the first quarter of 2002 due to the timing of investments and reduced capital purchases.  Cash used in financing activities decreased by $6.8 million in the first quarter of 2003 compared to the first quarter of 2002 due to purchases of treasury stock in the prior year, which were not duplicated in the current year.

 

The Company anticipates that its capital requirements may increase in future periods as a result of seasonal sales trends, additional research and development activities, and the acquisition of additional equipment.  The Company’s capital requirements may also increase in future periods as the Company seeks to expand its technology platform through investments, licensing arrangements, technology alliances, or acquisitions.

 

The Company anticipates that its existing capital resources will be adequate to fund the Company’s operations at least through 2003.  However, there can be no assurance that changes will not occur that would consume available capital resources before then.  The Company’s capital requirements depend on numerous factors, including the ability of the Company to continue to generate software sales, the ability of the Company to extend existing Drug Discovery agreements and to enter into additional arrangements, competing technological and market developments, changes in the Company’s existing collaborative relationships, the cost of filing, prosecuting, defending, and enforcing patent claims and other intellectual property rights and the outcome of related litigation, the purchase of additional capital equipment, acquisitions of other businesses or technologies, and the progress of the Company’s customers’ milestone and royalty producing activities.  There can be no assurance that additional funding, if necessary, will be available on favorable terms, if at all.  The Company’s forecasts of the period of time through which its financial resources will be adequate to support its operations are forward looking information, and actual results could vary.  The factors described earlier in this paragraph will impact the Company’s future capital requirements and the adequacy of its available funds.

 

RISK FACTORS

 

You should carefully consider the risks described below before investing in our publicly-traded securities.  The risks described below are not the only ones facing us.  Our business is also subject to the risks that affect many other companies, such as competition, technological obsolescence, labor relations, general economic conditions, geopolitical changes and international operations.  Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity.

 

11

 

CERTAIN RISKS RELATED TO OUR BUSINESS AS A WHOLE

 

Our success depends in part upon the successful implementation of our management’s strategic plan. Our management has been, and continues to be, engaged in the consideration and exploration of strategic alternatives for our businesses, including the possible separation by various means of our Drug Discovery business from our Accelrys software operation.  There can be no assurance that any such strategic alternative will be implemented or, if completed, that it will enhance the value of either or both of our businesses.  Such alternatives also may include the acquisition of businesses and technologies which complement or supplement our existing businesses and technologies. However, management may be unable to identify suitable strategic opportunities, choose the wrong technologies or businesses to pursue or be unable to negotiate suitable prices or favorable terms with respect to strategic opportunities.  The occurrence of any of the foregoing may have a material adverse effect on our business.

 

The agreement with our major Drug Discovery customer expires this year.  During the year ended December 31, 2002, we earned approximately 12% of our consolidated revenue from one major customer in our Drug Discovery Segment.  The agreement with this key customer expires by its terms in October 2003.  We have initiated negotiations with the customer concerning renewal of this agreement; however, renewal of the agreement, on the same, similar or other favorable terms, or at all, is uncertain.  The termination of this agreement, without renewal on acceptable terms, will have a material adverse effect on PDD, and our business as a whole.  There can be no assurance we will be able to renew the agreement with this significant customer on the same, similar or other favorable terms, or at all.

 

Pharmaceutical and biotechnology companies may discontinue or decrease their use of our services and products.  We depend on pharmaceutical and biotechnology companies that use our services for a large portion of our PDD revenue. Further, these companies (together with diversified chemical and other industrial companies) comprise the principal market for our Accelrys modeling, simulation, data analysis and related software products and services.  Although there is a history among pharmaceutical and biotechnology companies of outsourcing drug research and development functions, this practice may not continue. Similarly, these companies have frequently utilized outside software vendors for key tools used in drug discovery and chemical development, rather than developing needed information and analysis tools internally.  Our revenue depends to a large extent on research and development expenditures by the pharmaceutical, biotechnology, chemical and agricultural industries, particularly companies in these industries outsourcing research and development projects and adding new and improved technologies to accelerate their drug discovery and chemical development initiatives.  These expenditures are based on a wide variety of factors, including the resources available for purchasing research equipment, the spending priorities among various types of research, policies regarding expenditures during recessionary periods and the benefits of new software tools versus their costs of licensure.  Since a large proportion of our software customers license our products on an annual basis or buy maintenance contracts from us annually, if their spending priorities shift, our revenues may be impacted.  Also, general economic downturns in our customers’ industries or any decrease in research and development expenditures could harm our operations, as could increased popularity of management theories which counsel against outsourcing of critical business functions. In addition, the popularity of scientific thinking that disfavors expensive products such as large diversity libraries could negatively impact our revenue or our sales mix. Any decrease in drug discovery spending by pharmaceutical and biotechnology companies, or in chemical or materials spending by chemical and agricultural companies, could cause our revenues to decline and adversely impact our profitability.

 

Our ability to increase revenue and grow our business is dependent upon our success in adding new customers and expanding our existing customer relationships.  In order to generate

 

12

 

the additional revenue needed to continue growth, we must add new customers and retain, and expand upon, our existing customer relationships. These efforts depend significantly upon, among other factors:

 

•                  our successful development of new products;

•                  the success of our business development, sales and marketing efforts;

•                  biotechnology and pharmaceutical company spending for the outsourcing of chemistry and other drug discovery services; and

•                  the willingness of current and potential biotechnology, pharmaceutical and diversified chemical customers to invest in new modeling, simulation and informatics solutions.

 

If we are unable to add revenues from additional or expanded customer relationships, we may not be able to grow our business.

 

Our future profitability is uncertain. We generated a small profit in 2000, and we have generated losses in 2001, 2002 and the first quarter of 2003.  Our future profitability depends upon many factors, including several that are beyond our control. These factors include:

 

•                  changes in the demand for our products and services;

•                  the introduction of competitive drug discovery services and software;

•                  our ability to license desirable technologies;

•                  changes in the research and development budgets of our customers and potential customers; and

•                  our ability to successfully and timely develop, introduce and market new products, services and product enhancements cost effectively.

 

We operate in business lines that change rapidly and in unexpected ways. Rapid technological change and uncertainty due to new and emerging technologies characterize the software, drug discovery and chemical development industries. We may be unable to develop, integrate and market, on a timely basis, the new and enhanced products and services necessary to keep pace with competitors. Our products and services may be rendered obsolete by the offerings of our competitors. Failure to anticipate or to respond to changing technologies, or significant delays in the development or introduction of products or services, could cause customers to delay or decide against purchases of our products or services.

 

Failure to attract and retain skilled personnel could have a material adverse effect on us. Our success depends in part on the continued service of key scientific, software, sales, engineering and management personnel and our ability to identify, hire and retain additional personnel. There is intense competition for qualified personnel. In particular, we believe that there is a shortage of scientists qualified to work in the Drug Discovery segment. The competition among drug discovery and development companies to hire such scientists is particularly intense. Immigration laws may further restrict our ability to attract or hire qualified personnel. We may not be able to continue to attract and retain the personnel necessary for the development of the Drug Discovery segment. Failure to attract and retain key personnel could have a material adverse effect on our business, financial condition and results of operations. Further, we are highly dependent on the principal members of our scientific and management staff, including:

 

•                  Joseph A. Mollica, Ph.D., Chairman of the Board, President and Chief Executive Officer;

•                  Mark J. Emkjer, Executive Vice President and President, Accelrys; and

•                  Stephen A. Spearman, Ph.D., Executive Vice President and Chief Operating Officer, PDD,

 

13

 

and the managers reporting to these senior executives.  One or more of these key employees could retire or otherwise leave our employ within the foreseeable future, and the loss of any of these people could have a material adverse effect on our business, financial condition and results of operations. We do not, and do not intend to, maintain key person life insurance on the life of any employee.

 

We are dependent upon some of our suppliers. We currently rely on two suppliers to provide plastic filter bottom microtiter plates that are used in the assay plate preparation process. We have, over the past year, developed a process such that we are not entirely dependent upon these suppliers.  Should we be unable, in some instances, to obtain an adequate supply of these or comparable filter bottom plates at commercially reasonable rates, our ability to continue to prepare assay plates could be adversely affected, which in turn could harm our business.

 

We may be unable to develop strategic relationships with large pharmaceutical, biotechnology, chemical and technology companies.  A component of our business strategy is to develop strategic relationships with larger pharmaceutical, biotechnology, chemical and technology companies.  We believe that through such relationships we can add revenue, expand our distribution channels, maximize our research and development resources, improve our competitive position and increase market awareness and acceptance of Drug Discovery and scientific software products. To date, we have entered into significant strategic relationships with such companies as Schering-Plough, IBM, Oracle and HP.  There can be no assurance that any such relationship will continue, that relationships with similar large organizations can be developed, or that any such existing or new alliances will produce substantial revenue or profit opportunities.

 

We are subject to risks associated with the operation of an international business. In 2002, approximately 53% of our consolidated revenue was derived from customers outside the United States, both through international subsidiaries and on an export basis. Approximately 36% of our revenue was derived from customers in Europe and approximately 17% was derived from customers in the Asia/Pacific region. We anticipate that international revenue will continue to account for a significant percentage of overall revenue. Our international operations are subject to risks inherent in the conduct of international business, including:

 

•                  unexpected changes in regulatory requirements;

•                  longer payment cycles;

•                  currency exchange rate fluctuations;

•                  import and export license requirements;

•                  tariffs and other barriers;

•                  political and economic instability;

•                  limited intellectual property protection;

•                  difficulties in collecting trade receivables;

•                  difficulties in managing distributors or representatives;

•                  difficulties in staffing and managing foreign subsidiary or joint venture operations; and

•                  potentially adverse tax consequences.

 

We may not be able to sustain or increase international revenue. Any of the foregoing factors may have a material adverse effect on our international operations and, therefore, our business, financial condition and results of operations. Our direct international sales generally are denominated in local currencies. Fluctuations in the value of currencies in which we conduct business relative to the United States dollar result in currency transaction gains and losses, and the impact of future exchange rate fluctuations cannot be accurately predicted. Future fluctuations in currency exchange rates may have a material adverse impact on revenue from international sales, and thus on our business, financial condition and results of operations. When deemed

 

14

 

appropriate, we may engage in currency exchange rate hedging transactions in an attempt to mitigate the impact of adverse exchange rate fluctuations. However, currency hedging policies may not be successful, and they may increase the negative impact of exchange rate fluctuations.

 

Investments in Sales Efforts.  Both our Drug Discovery and software products and services involve lengthy sales cycles, often requiring us to expend considerable financial and personnel resources without any assurance that revenue will be recognized.  These sales cycles typically are long for a number of reasons.  In Drug Discovery, factors include the strategic nature of Drug Discovery partnerships, the size of many such transactions, the confidential and proprietary nature of the biological targets against which we screen our chemical compound libraries, and the unique terms typically found in each services transaction.  With respect to software sales, sales cycles are impacted by the time and resources required to educate potential customer organizations as to the value and comparative advantages of our products. As a result, we may expend substantial funds and effort to negotiate agreements for services and products in both of our business segments, but may ultimately be unable to consummate a sale. In these circumstances, our results of operations and ability to achieve profitability are adversely affected.

 

Consolidation within the pharmaceutical and biotechnology industries may lead to fewer potential customers for our products and services.  A significant portion of our customer base consists of pharmaceutical and biotechnology companies. Mergers between large multinational pharmaceutical companies have accelerated in recent years. Continued consolidation within the pharmaceutical and biotechnology industries may result in fewer customers for our products and services. If one of the parties to a consolidation uses the products or services of our competitors, we may lose existing customers as a result of such consolidation.

 

Our operations may be interrupted by the occurrence of a natural disaster or other catastrophic event at our primary facilities.   We depend on our laboratories and equipment for the continued operation of our business. Our research and development operations and administrative functions are primarily conducted at our facilities in the Princeton, New Jersey area, San Diego, California and Cambridge, United Kingdom.  Although we have contingency plans in effect for natural disasters or other catastrophic events, catastrophic events could still disrupt our operations. Even though we carry business interruption insurance policies, we may suffer losses as a result of business interruptions that exceed the coverage available under our insurance policies. Any natural disaster or catastrophic event in our facilities or the areas in which they are located could have a significant negative impact on our operations.

 

Terrorist attacks or acts of war may seriously harm our business.   Terrorist attacks or acts of war may cause damage or disruption to our company, our employees, our facilities and our customers, which could significantly impact our revenue, costs and expenses and financial condition. The terrorist attacks that took place in the United States on September 11, 2001 were unprecedented events that have created many economic and political uncertainties, some of which may materially adversely affect our business, results of operations and financial condition. The long-term effects on our company of the September 11, 2001 attacks are unknown. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility have created many economic and political uncertainties, which could materially adversely affect our business, results of operations, and financial condition in ways that we currently cannot predict.

 

Because our stock price may be volatile, our stock price could experience substantial declines.  The market price of our common stock has historically experienced and may continue to experience volatility. Our quarterly operating results, changes in general conditions in the economy or the financial markets and other developments affecting us or our competitors could cause the market price of our common stock to fluctuate substantially. In addition, in recent years,

 

15

 

the stock market has experienced significant price and volume fluctuations. During the past two years, the stock market, and in particular technology companies, also have experienced significant decreases in market value. This volatility and the recent market decline has affected the market prices of securities issued by many companies, often for reasons unrelated to their operating performance, and may adversely affect the price of our common stock.

 

As institutions hold the majority of our common stock in large blocks, substantial sales by these stockholders could depress the market price for our shares.  As of March 31, 2003, our company’s six largest stockholders held approximately 53% of our outstanding common stock.  As a result, if one or more of these major stockholders were to sell all or a portion of their holdings, or if the market were to perceive that such sale or sales may occur, the market price of our common stock may fall significantly.

 

Because we do not intend to pay dividends, you will benefit from an investment in our common stock only if it appreciates in value.   We have never declared or paid any cash dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the expansion of our business and do not expect to pay any cash dividends in the foreseeable future. As a result, the success of your investment in our common stock will depend entirely upon any future appreciation in its value. There is no guarantee that our common stock will appreciate in value or even maintain the price at which you purchased your shares.

 

Anti-takeover provisions under the Delaware general corporation law, provisions in our certificate of incorporation and bylaws, and our adoption of a stockholder rights plan may render more difficult the accomplishment of mergers or the assumption of control by a principal stockholder, making more difficult the removal of management. Certain provisions of the Delaware General Corporation Law may delay or deter attempts to secure control of our company without the consent of our management. Also, our governing documents provide for a staggered board of directors, which will make it more difficult for a potential acquiror to gain control of our Board of Directors. In 2002, we adopted a stockholder rights plan, which is triggered upon commencement or announcement of a hostile tender offer or when any one person or group acquires 15% or more of our common stock. The rights plan, once triggered, enables stockholders to purchase our common stock, and the stock of the entity acquiring us, at reduced prices. These provisions of our governing documents and stockholder rights plan, and of Delaware law, could have the effect of delaying, deferring or preventing a change of control, including without limitation a proxy contest, making more difficult the acquisition of a substantial block of our common stock. The provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. Further, the existence of these anti-takeover measures may cause potential bidders to look elsewhere, rather than initiating acquisition discussions with us.

 

If we consume cash more quickly than expected, we may be unable to raise additional capital and we may be forced to curtail operations. We anticipate that our existing capital resources will be adequate to fund our operations at least through 2003.  However, changes may occur that would consume available capital resources before that time. Our capital requirements will depend on numerous factors, including:

 

•                  costs associated with software sales;

•                  costs associated with drug discovery services;

•                  our internal proprietary drug discovery activities;

•                  competing technological and market developments;

•                  changes in our existing collaborative relationships;

•                  the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights and the outcome of related litigation;

 

16

 

•                  the purchase of additional capital equipment;

•                  acquisitions of other businesses or technologies; and

•                  the progress of our milestone and royalty producing activities.

 

If we determine that we must raise additional capital, the capital could be raised through public or private financings involving debt or equity. However, additional capital may not be available on favorable terms, or at all. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, products or potential markets that we would not otherwise relinquish.

 

CERTAIN RISKS RELATED TO INTELLECTUAL PROPERTY

 

Positions taken by the U.S. patent and trademark office or non-U.S. patent and trademark officials may preclude us from obtaining sufficient or timely protection for our intellectual property. The patent positions of pharmaceutical, biotechnology and software companies are uncertain and involve complex legal and factual questions. Consequently, some or all of our patent applications may not issue into patents, and any issued patents may provide ineffective remedies or be challenged or circumvented. The coverage claimed in a patent application can be significantly reduced before the patent is issued. There is a significant risk that the scope of a patent may not be sufficient to prevent third parties from marketing other products or technologies with the same functionality of our products and technologies. Consequently, some or all of our patent applications may not issue into patents, and any issued patents may provide ineffective remedies or be challenged or circumvented.

 

Third parties may have filed patent applications of which we may or may not have knowledge, and which may adversely affect our business. Patent applications in the U.S. are maintained in secrecy for 18 months from filing or until a patent issues. Under certain circumstances, patent applications are never published but remain in secrecy until issuance. As a result, others may have filed patent applications for products or technology covered by one or more pending patent applications upon which we are relying. There may be third-party patents, patent applications and other intellectual property or information relevant to our software, chemical compositions and other technologies which are not known to us and that block or compete with our software, chemical compositions or other technologies, or limit the scope of patent protection available to us. Moreover, from time to time, patents may issue which block or compete with our software, chemical compositions or other technologies, or limit the scope of patent protection available to us.  Litigation may be necessary to enforce patents issued to us or to determine the scope and validity of the intellectual property rights of third parties.

 

We may not be able to protect adequately the trade secrets and confidential information that we disclose to our employees. We rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. Competitors through their independent discovery (or improper means, such as unauthorized disclosure or industrial espionage) may come to know proprietary information. We generally require employees and consultants to execute confidentiality and assignment-of-inventions agreements. These agreements typically provide that all materials and confidential information developed by or made known to the employee during the employee’s relationship with us are to be kept confidential, and that all inventions arising out of the employee’s relationship with us are our exclusive property. Our employees and consultants may breach these agreements, and in some instances we may not have an adequate remedy. Additionally, in some instances, we may have failed to require that employees and consultants execute confidentiality and assignment-of-inventions agreements.

 

17

 

Foreign laws may not afford us sufficient protections for our intellectual property, and we may not seek patent protection outside the United States. We believe that our success depends, in part, upon our ability to obtain international protection for our intellectual property. However, the laws of some foreign countries may not be as comprehensive as those of the U.S. and may not be sufficient to protect our proprietary rights abroad. In addition, we may decide not to pursue patent protection outside the United States, because of cost and confidentiality concerns. Accordingly, our international competitors could obtain foreign patent protection for, and market overseas, products and technologies for which we are seeking U.S. patent protection.

 

We may not be able to adequately defend our intellectual property from third party infringement, and third party challenges to our intellectual property may adversely affect our rights and be costly and time consuming. Some of our competitors have, or are affiliated with companies having, substantially greater resources than we have, and those competitors may be able to sustain the costs of complex patent litigation to a greater degree and for longer periods of time than us. Uncertainties resulting from the initiation and continuation of any patent or related litigation could have a material adverse effect on our ability to compete in the marketplace pending resolution of the disputed matters. If our competitors prepare and file patent applications in the United States that claim technology also claimed by us, we may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office to determine the priority of invention, which could result in substantial costs to us, even if the outcome is favorable to us. Similarly, opposition proceedings may occur overseas, which may result in the loss or narrowing of the scope of claims or legal rights. Such proceedings will at least result in delay in the issuance of enforceable claims. An adverse outcome could subject us to significant liabilities to third parties and require us to license disputed rights from third parties or cease using the technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In limited instances, we have licensed source codes of certain products to customers or collaborators. For these reasons, policing unauthorized use of our software products may be difficult.

 

A patent issued to us may not be sufficiently broad to protect adequately our rights in intellectual property to which the patent relates. Even if patents are issued to us, these patents may not sufficiently protect our interest in our software, chemical compositions or other technologies because the scope of protection provided by any patents issued to or licensed by us are subject to the uncertainty inherent to patent law. Third parties may be able to design around these patents or develop unique products providing effects similar to our products. In addition, others may discover uses for our software, chemical compositions or technologies other than those uses covered in our patents, and these other uses may be separately patentable. A number of pharmaceutical and biotechnology companies, and research and academic institutions, have developed technologies, filed patent applications or received patents on various technologies that may be related to our business. Some of these technologies, patent applications or patents may conflict with our technologies, patent applications or patents. These conflicts could also limit the scope of patents, if any, that we may be able to obtain, or result in the denial of our patent applications.

 

We may be subject to claims of infringement by third parties. Third parties may claim infringement by us of their intellectual property rights. In addition, to the extent our employees are involved in research areas similar to those areas in which they were involved at their former employers, we may be subject to claims that our employees or we have inadvertently or otherwise used or disclosed the alleged trade secrets or other proprietary information of a former employer. From time to time, we have received letters claiming or suggesting that our products or activities may infringe third party patents or other intellectual property rights. Our products may infringe patent or other intellectual property rights of third parties. A number of patents may have been

 

18

 

issued or may be issued in the future that could cover certain aspects of our technology and that could prevent us from using technology that we use or expect to use. We may be required to seek licenses for or otherwise acquire rights to technology as a result of claims of infringement. We may not possess proper ownership or access rights to the intellectual property we use. Third parties or other companies may bring infringement suits against us.  We expect, in general, that software product developers will be subject to more infringement claims as the number of products and competitors in our industry segments grows and the functionality of products in different industry segments overlaps. Any claims, with or without merit, could be time consuming to defend, result in costly litigation, divert management’s attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all. In the event of a successful claim of product infringement against us, our failure or inability to license or design around the infringed technology could have a material adverse effect on our business, financial condition and results of operations.

 

CERTAIN RISKS RELATED TO ACCELRYS

 

Our ability to increase Accelrys software revenue may depend upon increased market acceptance of our products and services. Accelrys products are currently used primarily by molecular modeling and simulation and gene sequence analyses specialists. Our strategy is to expand usage of our products and services by marketing and distributing our software, in part through our desktop-based products, to a broader, more diversified group of experimentalists, such as scientists and engineers. If we cannot expand our customer base to include experimentalists, or if we otherwise cannot successfully market and sell our desktop-based products and related services, we may not be able to increase our software revenue, or such revenue may decline. In general, increased market acceptance and greater market penetration of our software products depend upon several factors, including:

 

•                  overall product performance;

•                  ease of implementation and use;

•                  accuracy of simulation;

•                  breadth and integration of product offerings;

•                  the extent to which users achieve the intended research and development benefits from their use of the products and services; and

•                  willingness of customers to pay for such use.

 

Our software products and services may not achieve market acceptance or penetration in their target industries or other industries. Failure to increase market acceptance or penetration may restrict substantially the future growth of our software business and may have a material adverse effect on our company as a whole.

 

We may be unable to develop and market new Accelrys products that are necessary to increase revenue. The success of our software business plan depends heavily upon increases in revenue. Our strategy is to increase software revenue in a number of ways, including:

 

•                  adding more computational modeling, simulation, and analyses tools to our current portfolio of tools for chemists and biologists;

•                  offering more bioinformatics and cheminformatics database software that captures and manages the data created by customers’ drug discovery and chemical development activities, including the data created by the use of computational modeling, simulation, and analyses software;

 

19

 

•                  creating and marketing genomic, biological and/or chemical data content for use in conjunction with the software offered to support customers’ drug discovery activities; and

•                  developing more knowledge management workflow software to automate the flow of genomic, biological and chemical data and information and project status between and among workgroups and the enterprise.

 

We do not have sufficient historical or comparative sales data to rely upon to indicate that our new products or data content services will achieve the desired level of commercial success.

 

We face strong competition in the scientific software sector. The market for our software products is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Competition currently comes from the following principal sources:

 

•                  other molecular simulation software packages and software for analysis of chemical and biological data;

•                  desktop software applications, including chemical drawing, molecular modeling and analytical data simulation applications;

•                  consulting and outsourcing services;

•                  other types of simulation software provided to engineers; and

•                  firms supplying databases, such as chemical or genomic information databases, database management systems and information technology.

 

In addition, some of our software licenses grant the right to sublicense our software. As a result, our software customers and third-party licensees could develop specific simulation applications using our software developer’s kit and compete with us by distributing these programs to our potential customers. Customers or licensees could also develop their own simulation technology or informatics software and cease using our software products and services. Some of our competitors and potential competitors in this sector have longer operating histories than us and have greater financial, technical, marketing, research and development and other resources. Many of our software competitors offer products and services directed at more specific markets than those we target, enabling these competitors to focus a greater proportion of their efforts on these markets. Some offerings that compete with our software products are developed and made available at lower cost by governmental organizations and academic institutions, and these entities may be able to devote substantial resources to product development and also offer their products to users for little or no charge.

 

If we are unable to license software to, or collect receivables from, our early stage biotechnology customers, it may have a material adverse effect on our operating results.  We frequently license our modeling, simulation, data analysis and informatics software to smaller, development stage biotechnology customers. Often these customers have limited or no operating history, and require considerable funding to launch their businesses. As we have experienced in recent quarters, they often significantly scale back, or altogether cease, operations.  Therefore, there is considerable risk in counting on these types of entities for revenue growth.  For entities that remain in business, transactions with these customers carry a higher degree of financial risk. Our customers, particularly our development stage customers, are vulnerable to, and may be impacted by, the current tightening of available credit and capital, and general economic slowdown occurring in the United States and our other key markets. As a result of these conditions, our customers may be unable to license or, if under a license, may be unable to pay for, Accelrys software products. If we are not able to collect such amounts, we may be required to write-off significant accounts receivable and recognize bad debt expense. We recorded a provision for doubtful accounts of $1.3 million in fiscal 2002 compared to $0.3 million in fiscal

 

20

 

2001.  Failure of these businesses, and write-offs and difficulties associated with collection of receivables from these customers, could materially adversely affect our operating results.

 

Defects or malfunctions in our software products, or in the products of our software technology partners, could hurt our reputation among software customers and expose us to liability. Our software business and the level of customer acceptance of our products depend upon the continuous, effective and reliable operation of our computer software and related tools and functions. Defects could occur in current or future Accelrys products. To the extent that our software malfunctions and our customers’ use of our products is interrupted, our software reputation and business could suffer. We may also be subject to liability for the defects and malfunctions of third party technology partners and others with whom our software products and services are integrated.

 

Our quarterly operating results in the software business could vary significantly. We have historically experienced stronger financial performance in the third and fourth calendar quarters of each year followed by a comparative decline in the first and second quarters. Quarterly operating results may continue to fluctuate as a result of a number of factors, including lengthy sales cycles, market acceptance of new products and upgrades, timing of new product introductions, changes in pricing policies, changes in general economic and competitive conditions, seasonal slowdowns, and the timing and integration of acquisitions. We also expect to continue to experience fluctuations in quarterly operating results due to general and industry specific economic conditions that may affect the research and development expenditures of pharmaceutical and biotechnology companies. Due to the possibility of fluctuations in our revenues and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.

 

CERTAIN RISKS RELATED TO PHARMACOPEIA DRUG DISCOVERY, INC.

 

The agreement with a second key PDD customer is terminable under certain circumstances.  During the year ended December 31, 2002, we earned approximately 10% of our PDD revenue, and 2% of our consolidated revenue, from a second key customer in our Drug Discovery business.  The agreement with this significant customer has a stated term of five years; however, the customer has the right to terminate the agreement as early as the first quarter of 2005 in the event we are unable to deliver to the customer a lead compound meeting criteria specified in the agreement by a certain deadline.  Thereafter, the customer again has the right to terminate the agreement prior to the expiration of its stated term if we cannot deliver additional lead compounds meeting these criteria prior to dates set forth in the agreement.  The customer also has the right to terminate the agreement in the event that we breach the agreement.  The termination of this agreement will have a material adverse effect on PDD, and may have a material adverse effect on our company’s business as a whole. There can be no assurance that we will be able to deliver compliant compounds to the customer before the enumerated dates.

 

Some of the development and marketing activities of PDD are, or will be, conducted by third parties. If these third parties fail to perform their functions satisfactorily, our revenue and earnings from PDD could be delayed, reduced or eliminated.  The ultimate success of the business plan for our Drug Discovery subsidiary heavily depends upon the successful discovery, development and commercialization of pharmaceutical products. Our drug discovery endeavors will result in commercialized pharmaceutical products, if at all, only after significant pre-clinical and clinical development, requisite regulatory approvals, establishment of manufacturing capabilities and successful marketing. We do not currently have the technology, facilities, personnel or experience to accomplish all of these tasks on our own, and we will likely not have all the necessary resources in the foreseeable future. Therefore, we continue to depend heavily upon the expertise and dedication of sufficient resources by collaborative partners and/or by third

 

21

 

parties under service contracts to develop and commercialize products primarily based on therapeutic antibodies and lead compounds discovered by us. If a third party working for us under a service contract fails to perform the contracted services adequately, our efforts with respect to the drug candidate under contract could be delayed or terminated. Further, if a collaborative partner fails to develop or commercialize a compound or product with respect to which it has rights from us, we may not receive any future milestone payments or royalties associated with that compound or product. Similarly, because we rely heavily on our strategic collaborators and service providers, our revenue could be adversely affected if our collaborators and/or service providers:

 

•                  fail to select a target or product candidate we have identified for subsequent development;

•                  fail to gain the requisite regulatory approvals of product candidates;

•                  do not successfully commercialize products that we originate;

•                  do not conduct their service or collaborative activities in a timely manner;

•                  do not devote sufficient time or resources to our partnered programs or potential products;

•                  terminate their alliances or arrangements with us;

•                  develop, either alone or with others, products that may compete with our product candidates;

•                  dispute our respective allocations of rights to any products or technology developed during our collaborations; or

•                  merge with a third party that may wish to terminate our collaboration or service contract.

 

Disputes may arise between our collaborative partners and us as to royalties and milestones to which we are entitled.  The compound basis for drugs developed by a customer may be a derivative or optimized version of the compound provided to the customer by us. While our existing collaborative agreements provide that we will receive milestone payments and royalties with respect to certain products developed from certain derivative compounds, there can be no assurance that disputes will not arise over the application of payment provisions to such products. There can be no assurance that current or future collaborative partners will not pursue alternative technologies, or develop alternative products either on their own or in collaboration with others, including our competitors, as a means for developing treatments based on the targets which are the subject of the collaborative arrangements with us.

 

There may be only a limited market for PDD’s drug discovery services.  The pricing and nature of PDD’s drug discovery services are such that there may only be a limited number of potential customers for these services. Continued consolidation in the pharmaceutical and biotechnology industries may further decrease the number of potential customers. The acceptance by potential customers of our services is important in determining profitability. Historically, pharmaceutical companies have conducted lead compound identification and optimization within their own research departments due to the highly proprietary nature of the activities being conducted, the central importance of these activities to their drug discovery and development efforts, and the desire to obtain maximum patent and other proprietary protection on the results of their internal programs. In order to achieve our business objectives for PDD, we must convince these companies that our technology and expertise justify the outsourcing of these programs to us. There can be no assurance that we will be able to attract customers on acceptable terms for our products and services or to develop a sustainable profitable business. Moreover, the pricing and nature of our combinatorial libraries is such that there may only be a limited number of pharmaceutical companies that are potential customers for such libraries. There can be no assurance that we will be able to establish additional collaborative or licensing arrangements, that any such arrangements or licenses will be on terms favorable to us, or that current or future collaborative or licensing arrangements will ultimately be successful.

 

22

 

We may be unable to manage the multiple relationships and interests involved in our collaborative arrangements and drug discovery programs.  We may need to successfully structure and manage multiple drug discovery programs and collaborative relationships, including maintaining confidentiality of the research being performed for multiple customers. We may be unable to manage successfully conflicts between competing drug development programs of third parties to which we offer services. Conflicts also may arise between customers as to proprietary rights to particular compounds in our libraries or as to proprietary rights to biological targets such as receptors or enzymes against which we screen compounds in our libraries. The occurrence of conflicts could have a material adverse effect on our business, financial condition or results of operations.

 

Our current and potential customers are primarily from, and are subject to risks faced by, the pharmaceutical, biotechnology and chemical industries.  For the foreseeable future, we will derive a substantial portion of our revenue from fees paid by pharmaceutical companies, chemical companies and larger biotechnology companies for our products and services. As a result, we are subject to risks and uncertainties that affect the pharmaceutical, chemical and biotechnology industries and to possible reduction and delays in research and development expenditures by companies in these industries. Our revenue may also be adversely affected by mergers and consolidation in the pharmaceutical, biotechnology and chemical industries, which will reduce the number of potential customers.

 

We may be unsuccessful in producing and licensing proprietary technology developed from our internal research and development efforts or acquired from a third party.  We have expended and continue to expend time and money on internal research and development with the intention of producing proprietary technologies in order to patent and then license them to other companies. However, we may not be successful in producing any valuable technology or successful in licensing it to a third party. To the extent we are unable to produce technology that we can license, we may not receive any revenue related to our internal research and development efforts.

 

If we use biological and hazardous materials in a manner that causes injury or violates laws, we may be liable for damages. Our Drug Discovery activities may involve the use of potentially harmful biological materials as well as hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could exceed our resources. We are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations could be significant.

 

SHOULD ONE OR MORE OF THE ABOVE-DESCRIBED RISKS OR UNCERTAINTIES MATERIALIZE, OR SHOULD THE UNDERLYING ASSUMPTIONS PROVE INCORRECT, OUR ACTUAL RESULTS MAY VARY MATERIALLY FROM THOSE ANTICIPATED.

 

23

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

The Company is exposed to various market risks consisting primarily of changes in foreign currency exchange rates.  The Company’s international sales generally are denominated in local currencies.  In the first quarter of 2003, approximately 58% of the Company’s consolidated revenue was derived from customers outside the United States (including 36% from customers in Europe and 22% from customers in the Asia/Pacific region).  As such, the Company’s exchange rate risk is greatest for Dollar/Euro and Dollar/Yen fluctuations.  When deemed appropriate, the Company engages in exchange rate-hedging transactions in an attempt to mitigate the impact of adverse exchange rate fluctuations.  At March 31, 2003, the Company had no hedging transactions in effect.

 

The Company does not use derivative financial instruments for trading or speculative purposes.  However, the Company regularly invests excess cash in overnight repurchase agreements that are subject to changes in short-term interest rates.  The Company believes that the market risk arising from holding these financial instruments is minimal.

 

The Company’s exposure to market risks associated with changes in interest rates relates primarily to the increase or decrease in the amount of interest income earned on its investment portfolio since the Company has minimal debt.  The Company ensures the safety and preservation of invested funds by limiting default risks, market risk, and reinvestment risk.  The Company mitigates default risk by investing in investment grade securities.  A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of the Company’s interest sensitive financial instruments at March 31, 2003.

 

Item 4.  Controls and Procedures

 

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended, within the 90 days prior to the filing date of this report. Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective as of the evaluation date.

 

There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation described above.

 

24

 

PART II - OTHER INFORMATION

 

Item 1.	Legal Proceedings
	The Company is not a party to any material litigation and is not aware of any threatened material litigation.
Item 2.	Changes in Securities and Use of Proceeds - None
Item 3.	Defaults upon Senior Securities – None
Item 4.	Submission of Matters to a Vote of Security Holders - None
Item 5.	Other Information – None
Item 6.	Exhibits and Reports on Form 8-K
	(a) Exhibits – See Exhibit Index
	(b) Reports on Form 8-K
		(i)	Current report on Form 8-K filed March 28, 2003 reported under Item 9 relating to certifications furnished by the CEO and CFO pursuant Section 906 of the Sarbanes-Oxley Act of 2002 in connection with the Annual Report of Pharmacopeia, Inc. for the period ended December 31, 2002.

 

25

 

SIGNATURE

 

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.

 

 

	PHARMACOPEIA, INC.
	By:		/s/John J. Hanlon
			John J. Hanlon
			Executive Vice President and Chief Financial Officer (Duly Authorized Officer and Chief Financial Officer)
			Date:  May 12, 2003

 

26

 

CERTIFICATION OF CHIEF EXECUTIVE OFFICER

 

I, Joseph A. Mollica, certify that:

 

1.                                       I have reviewed this quarterly report on Form 10-Q of Pharmacopeia, Inc.;

 

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 these 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

 

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:  May 12, 2003

 

 

	/s/Joseph A. Mollica
	Joseph A. Mollica, Ph.D.
	Chairman of the Board, President and Chief Executive Officer

 

27

 

CERTIFICATION OF CHIEF FINANCIAL OFFICER

I, John J. Hanlon, certify that:

 

1.                                       I have reviewed this quarterly report on Form 10-Q of Pharmacopeia, Inc.;

 

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 these 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

 

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:  May 12, 2003

 

 

	/s/John J. Hanlon
	John J. Hanlon
	Executive Vice President and Chief Financial Officer

 

28

 

PHARMACOPEIA, INC.

 

INDEX TO EXHIBITS

 

No.		EXHIBIT
10.9(a)#		Amendment, effective as of May 1, 2003, to Employment Agreement between the Company and Joseph A. Mollica, Ph.D.
10.13(a)		Amendment No. 3, effective as of April 17, 2003, to the Collaboration and License Agreements by and between Pharmacopeia, Inc., Schering Corporation, and Schering-Plough, Ltd.
99.1		Certification of Chief Executive Officer
99.2		Certification of Chief Financial Officer

 

#

Represents a management contract or compensatory plan or arrangement.

 

29