ACCELRYS, INC.

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 December 31, 2004

or

o		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: 0-27118

ACCELRYS, INC.

(Exact name of registrant as specified in its charter)

Delaware		33-0557266
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

10188 Telesis Court, Suite 100, San Diego, California		92121-1761
(Address of principal executive offices)		(Zip code)

(858) 799-5000

(Registrant’s telephone number, including area code)

Former address: 9685 Scranton Road, San Diego, California

(Former name, former address and former fiscal year, if changed since last report)

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 January 31, 2005
Common Stock, $.0001 par value		26,582,344 shares

Form 10-Q

Item		Page

PART I. FINANCIAL INFORMATION		3

Item 1.	Unaudited Consolidated Financial Statements:	3

	Balance Sheets — December 31, 2004 and December 31, 2003	3

	Statements of Operations — Three and Nine Months Ended December 31, 2004 and 2003	4

	Statements of Cash Flows — Nine Months Ended December 31, 2004 and 2003	5

	Notes to Unaudited Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28

Item 4.	Controls and Procedures	28

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	29

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29

Item 3.	Defaults Upon Senior Securities	29

Item 4.	Submission of Matters to a Vote of Security Holders	29

Item 5.	Other Information	29

Item 6.	Exhibits	29

Signature		30

Exhibit Index		31

PART I - - FINANCIAL INFORMATION

Item 1. Unaudited Consolidated Financial Statements

Accelrys, Inc.

Consolidated Balance Sheets

(Dollars and share amounts in thousands, except per share data)

	December 31,			December 31,
	2004			2003
ASSETS	(unaudited)			(note 1)
Current assets:
Cash and cash equivalents	$	18,786		$	26,985
Restricted cash	7,133			—
Marketable securities	33,162			106,546
Trade receivables, net of allowance for doubtful accounts of $93 and $505, respectively	32,830			39,780
Prepaid expenses and other current assets	8,590			4,197
Current assets of discontinued operations	—			3,994
Total current assets	100,501			181,502
Property and equipment, net	8,910			8,441
Goodwill	43,298			34,072
Intangible assets, net of accumulated amortization of $621 and $0, respectively	10,879			—
Software development costs, net of accumulated amortization of $30,087 and $26,555, respectively	8,565			7,634
Other assets	886			960
Long-term assets of discontinued operations	—			7,058
Total assets	$	173,039		$	239,667

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,153		$	1,850
Accrued liabilities	23,056			18,819
Deferred revenue, current portion	36,648			24,595
Current liabilities of discontinued operations	—			6,420
Total current liabilities	60,857			51,684
Deferred revenue, long-term	6,719			4,924
Lease obligations, long-term	2,209			—
Long-term liabilities of discontinued operations	—			325
Stockholders' equity:
Preferred stock, $.0001 par value, 2,000 shares authorized, none issued and outstanding	—			—
Common stock, $.0001 par value, 40,000 shares authorized, 26,582 and 24,949 shares issued, respectively	2			2
Additional paid-in capital	253,078			287,592
Unearned compensation	(1,694		)	(536		)
Lease guarantee	(714		)	—
Treasury stock, 644 shares	(8,340		)	(8,340		)
Accumulated deficit	(139,998		)	(97,318		)
Accumulated comprehensive income	920			1,334
Total stockholders' equity	103,254			182,734
Total liabilities and stockholders' equity	$	173,039		$	239,667

See accompanying notes to these unaudited consolidated financial statements.

Accelrys, Inc.

Consolidated Statements of Operations

(Dollars and shares in thousands, except per share data, unaudited)

	For the Three Months						For the Nine Months
	Ended December 31,						Ended December 31,
	2004			2003			2004					2003
Revenue	$	22,229		$	31,577		$		50,687			$	68,342
Cost of revenue	5,161			4,507			12,084					14,676
Gross margin	17,068			27,070			38,603					53,666
Research and development	4,659			4,578			13,164					13,386
Sales and marketing	10,109			9,502			25,348					25,629
General and administrative	4,139			4,890			11,827					13,579
Lease abandonment	3,612			—			3,612					—
Write-off (reversal) of in-process research and development	(250		)	—			450					—
Total operating costs and expenses	22,269			18,970			54,401					52,594
Operating income (loss) from continuing operations	(5,201		)	8,100			(15,798				)	1,072
Spin-off transaction costs	—			(700		)	—					(700		)
Interest and other income, net	184			939			1,257					3,032
Loss from continuing operations before provision (benefit) for income taxes	(5,017		)	8,339			(14,541				)	3,404
Provision (benefit) for income taxes	(362		)	140			252					731
Income (loss) from continuing operations	(4,655		)	8,199			(14,793				)	2,673
Discontinued operations:
Loss from discontinued operations	—			(347		)	(1,117				)	(717		)
Net income (loss)	$	(4,655	)	$	7,852		$			(15,910	)	$	1,956
Income (loss) from continuing operations per share:
- Basic	$	(0.18	)	$	0.34		$			(0.60	)	$	0.11
- Diluted	$	(0.18	)	$	0.33		$			(0.60	)	$	0.11
Loss from discontinued operations per share:
- Basic	$	—		$	(0.01	)	$			(0.04	)	$	(0.03	)
- Diluted	$	—		$	(0.01	)	$		(0.04		)	$	(0.03	)
Net income (loss) per share:
- Basic	$	(0.18	)	$	0.33		$		(0.64		)	$	0.08
- Diluted	$	(0.18	)	$	0.32		$	(0.64			)	$	0.08
Weighted average shares of common stock outstanding:
- Basic	25,841			23,870			24,876					23,796
- Diluted	25,841			24,926			24,876					24,499

See accompanying notes to these unaudited consolidated financial statements.

Accelrys, Inc.

Consolidated Statements of Cash Flows

(Dollars in thousands)

	For the Nine Months
	Ended December 31,
	2004				2003
OPERATING ACTIVITIES:
Net income (loss)	$	(15,910		)	$		1,956
Adjustments to reconcile net income (loss) to net cash used by operating activities
Depreciation	3,283				3,363
Amortization	3,227				3,660
Write-off of in-process research and development	450				—
Contribution of stock to 401(k) members	431				762
Amortization of unearned compensation	405				—
Non-cash compensation	—				83
Changes in assets and liabilities:
Trade receivables	(20,354			)	(22,775			)
Prepaid expenses and other current assets	(4,021			)	176
Other assets	177				(470			)
Accounts payable	(4,586			)	(2			)
Accrued liabilities	6,176				3,289
Deferred revenue	12,538				4,049
Net cash used by operating activities	(18,184			)	(5,909			)
INVESTING ACTIVITIES:
Capital expenditures	(3,654			)	(2,117			)
Increase in capitalized software development costs	(3,338			)	(3,095			)
Acquisition of business, net of cash acquired	(10,910			)	—
Purchases of marketable securities	(44,352			)	(74,255			)
Proceeds from sales of marketable securities	105,170				81,882
Net cash provided by investing activities	42,916				2,415
FINANCING ACTIVITIES:
Proceeds from issuance of common stock	1,625				1,667
Net cash provided by financing activities	1,625				1,667
Exchange rate effect on cash and cash equivalents	458				703
Cash distribution to PDD (see Note 6)	(46,500			)	—
Net cash used in discontinued operations	(1,233			)	(3,470			)
Net decrease in cash and cash equivalents	(20,918			)	(4,594			)
Cash and cash equivalents, beginning of period	39,704				31,579
Cash and cash equivalents, end of period	$	18,786			$	26,985
SUPPLEMENTAL INFORMATION:
Cash paid during the period for:
Interest expense	$		5		$	—
Income tax expense	436				$	155

See accompanying notes to these unaudited consolidated financial statements.

Accelrys, Inc.

Notes to Unaudited Consolidated Financial Statements

1. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States 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. These financial statements should be read in conjunction with the audited financial statements and disclosures thereto included in the Company’s Annual Report (under our former name Pharmacopeia, Inc.) on Form 10-K for the year ended December 31, 2003.

On April 1, 2004 the Company changed its fiscal year end from December 31 to March 31.

On April 30, 2004 the Company completed the spin-off of the Company’s Drug Discovery segment, Pharmacopeia Drug Discovery, Inc. (“PDD”), see Note 6. The operations, financial position and cash flows of PDD have been represented as discontinued operations in the accompanying financial statements.

On May 11, 2004, the Company’s shareholders approved the change of the Company’s name to Accelrys, Inc. from Pharmacopeia, Inc.

2. Business Combination

On September 27, 2004, the Company acquired all of the outstanding common shares of SciTegic, Inc. (“SciTegic”). The results of SciTegic’s operations have been included in the consolidated financial statements since that date. SciTegic is a leading provider of workflow software solutions for the scientific research market. The primary reason for the acquisition was to complement the Company’s existing product offerings.

The aggregate purchase price was $20.8 million including $13.4 million of cash and 1,166,218 common shares of stock valued at $7.4 million. The per share value of the stock issued was $6.37 determined on the average market price of Accelrys’ common shares over the five-day period including two days before, the day of and two days after the terms of the acquisition were agreed to and announced. On the date of acquisition, 1,040,119 common shares of stock were issued to SciTegic stockholders and 126,099 common shares of stock (earnout shares) were deposited into an escrow account. Further, the Company deposited $3.2 million of the cash consideration into an escrow account.

On January 31, 2005, a portion of the cash escrow was released to the former SciTegic stockholders pursuant to the terms of the merger agreement. Subject to indemnification claims by the Company, the remaining cash escrow may be released to the former SciTegic stockholders on September 27, 2005. The stock held in escrow, earnout shares, will be released in four semi-annual installments to former SciTegic stockholders subject to, among other things, the continued employment by the Company of two founders of SciTegic through the period starting September 27, 2004 and ending September 27, 2006.

In addition to the earnout shares above, 208,225 common shares of stock were deposited in the escrow account for the two founders of SciTegic. The Company recorded deferred compensation of $1.3 million related to these shares. Additionally, the Company converted SciTegic employees’ unvested stock options into unvested options in the Company resulting in deferred compensation. As of December 31, 2004, the remaining deferred compensation balance was $1.4 million.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. During the quarter ended December 31, 2004, the Company finalized the valuation of certain intangible assets with the assistance of a third-party valuation company. The following allocation was made based upon management’s review of the tangible and intangible assets and liabilities of SciTegic.

At September 27, 2004
(in thousands)
Current assets		$	3,471
Property and equipment		163
In-process research and development assets		450
Other long-term assets		21
Intangible assets not subject to amortization-
Trademark/Tradename		2,500
Intangible assets subject to amortization-
Developed Technology (five year weighted-average useful life)	6,750
Customer Relationships (ten year weighted-average useful life)	1,650
Backlog (two and one-quarter year weighted-average useful life)	550
Contract based (five year weighted-average useful life)	50
		9,000
Goodwill		9,726
Total assets acquired		25,331

Current liabilities		(2,297		)
Deferred revenue		(2,172		)
Long-term liabilities		(15		)
Total liabilities acquired		(4,484		)

Net assets acquired		20,847

The $0.5 million assigned to in-process research and development assets were written off at the date of acquisition in accordance with FASB Interpretation No.4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. Those write-offs are included in the Statement of Operations as a separate line item.

Of the $9.7 million assigned to goodwill, there will be no deduction for tax purposes as this was a stock acquisition.

Assuming the acquisition had occurred on April 1 of the following respective periods, the pro forma consolidated results of operations would be as follows (in thousands, except per share data):

	For the Three Months					For the Nine Months
	Ended December 31,					Ended December 31,
	2004			2003		2004			2003
Total revenue	$	22,229		$	34,494	$	54,501		$	74,169
Net income (loss)	(4,655		)	8,437		(16,154		)	2,358

Net income (loss) per share:
Basic	$	(0.18	)	$	0.35	$	(0.65	)	$	0.10
Diluted	$	(0.18	)	$	0.34	$	(0.65	)	$	0.10

3. Net Income (Loss) Per Share

The Company computes net income (loss) per share in accordance with Statement of Financial Accounting Standard No. 128, “Earnings Per Share” (“SFAS 128”). Under the provisions of SFAS 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 shares and dilutive common equivalent shares outstanding during the period. Diluted earnings per share include the potentially dilutive effect of outstanding stock options, or other dilutive securities. In periods presented where the Company had a net loss the inclusion of common stock equivalents for 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.

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 income (loss) and pro forma net income (loss) per share that would have been recorded (in thousands, except per share data):

	Three Months Ended December 31,						Nine Months Ended December 31,
	2004			2003			2004			2003
Net income (loss):
As reported	$	(4,655	)	$	7,852		$	(15,910	)	$		1,956
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(1,665		)	(2,397		)	(5,697		)	(8,618			)
Pro forma	$	(6,320	)	$	5,455		$	(21,607	)	$	(6,662		)

Basic net income (loss) per share:
As reported	$	(0.18	)	$	0.33		$	(0.64	)	$	0.08
Pro forma	$	(0.24	)	$	0.23		$	(0.87	)	$	(0.28		)

Diluted net income (loss) per share:
As reported	$	(0.18	)	$	0.32		$	(0.64	)	$	0.08
Pro forma	$	(0.24	)	$	0.22		$	(0.87	)	$	(0.28		)

The fair value of each option granted during 2004 and 2003 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

	2004		2003
Dividend yield	0	%	0	%
Expected volatility	69.25	%	85.82	%
Risk-free interest rate	3.93	%	3.79	%
Expected life (years)	3.7		6.3

5. Restructuring and lease abandonment

During the quarter ended September 30, 2002, the Company announced that it was undertaking various actions to restructure its operations to improve its overall financial performance. As of December 31, 2004 the remaining obligation under this restructuring was related to the closure of a facility. The following table summarizes the activity and balance of the

restructuring liability during the quarter ended December 31, 2004 (dollars in thousands):

	Costs to Exit Lease
	Obligations
Balance at September 30, 2004	$	981
Utilization of Reserves:
Cash	(68		)
Effect of foreign exchange	72
Balance at December 31, 2004	$	985

During the quarter ended March 31, 2004, the Company executed a restructuring plan for the purpose of making research and development activities more efficient and reducing general and administrative costs. The restructuring effort included a reduction in workforce of 73 employees, of which all had received notice of such reduction by March 31, 2004 and all of which had been terminated as of June 28, 2004. As a result, restructuring related charges of approximately $2.8 million were recognized as operating expense during the quarter ended March 31, 2004.

The following table summarizes the activity and balance of the restructuring reserve liability during the quarter ended December 31, 2004 (dollars in thousands):

	Severance Cost for
	Involuntary Employee
	Terminations
Balance at September 30, 2004	$	13
Utilization of Reserves:
Cash	(13		)
Balance at December 31, 2004	$	0

During the quarter ended December 31, 2004, the Company recorded a charge of $3.6 million related to the move of its corporate headquarters. This charge represents the future rent and rent related obligations on the former headquarters building, net of subtenant lease income. Upon initially closing its financial statements for the quarter ended December 31, 2004, the Company included a restructuring charge of $4.7 million related to the relocation of the corporate headquarters to a new facility. This preliminary amount assumed that the Company would not be able to sublease the abandonment property. The assumption was based on the fact that the Company had not been successful in obtaining a subtenant for the former facility and it was uncertain that the Company would find a subtenant in the future. However, on February 3, 2005, the Company executed a sublease agreement with a subtenant for the former facility. Under the terms of the sublease agreement, Accelrys will receive from the subtenant monthly rental payments and reimbursement of certain operating expenses related to the facility. This subsequent event reduced the estimated lease abandonment by $1.1 million, to $3.6 million, and reduced the quarterly and year-to-date loss per share by $0.04 to $(0.18) and $(0.64) per share, respectively.

The following table summarizes the activity and balance of the lease abandonment liability during the quarter ended December 31, 2004 (dollars in thousands):

	Costs to Exit Lease
	Obligations
Lease abandonment	$	3,612
Utilization of Reserves:
Cash	(410		)
Balance at December 31, 2004	$	3,202

6. Spin-off of Pharmacopeia Drug Discovery, Inc.

On April 30, 2004 the Company completed the spin-off of PDD into an independent, separately traded, publicly held company through the distribution to the Company’s stockholders of a dividend of one share of PDD common stock for every two shares of Accelrys common stock. The Company has received an opinion of counsel that the transaction qualified for treatment as a tax-free spin-off. As a result of this transaction, the Company made a capital contribution of $46.5 million to PDD and incurred costs of approximately $2.3 million which were accrued at March 31, 2004, and have been paid out as of

December 31, 2004. For the one-month period ended April 30, 2004, the discontinued PDD operations had revenue of $1.3 million and a pretax loss of $(1.1) million.

7. Guarantee

On April 30, 2004, the landlords of the New Jersey facilities related to the PDD operations consented to the assignment of the leases to PDD. Despite the assignment, the landlords required Accelrys to guarantee the remaining lease obligations representing approximately $29.2 million in future payments through April 2016. The probability-weighted fair market value of this guarantee was calculated in accordance with Financial Accounting Standard Board Interpretation No. 46 (FIN 46) “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” and resulted in a liability which is being amortized over the lease term. At December 31, 2004, the liability is $0.7 million.

8. Restricted Cash

At December 31, 2004, the Company had a restricted cash balance of $7.1 million consisting of two separate amounts.

During the quarter ended June 30, 2004, the Company signed a nine-year sublease agreement for corporate facilities in San Diego. Under the terms of the sublease, the Company was required to place $6.6 million in a restricted cash account to ensure performance under the sublease agreement. The cash restriction periodically decreases over the term of the sublease agreement pursuant to which cash is released to Accelrys.

Additionally, $0.5 million of cash is restricted under the transition services agreement with PDD in which the Company agreed to provide certain infrastructure to PDD over a one-year term. On April 30, 2005, any remaining cash will be released back to Accelrys.

9. Income Taxes

The Company accounts for income taxes using the liability method. Under the liability method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates applicable to future years to differences between the financial carrying amounts and the tax basis of existing assets and liabilities. The provision for income taxes is based on the Company’s estimates for taxable income of the various legal entities and jurisdictions in which it operates. As such, income tax expense may vary from the customary relationship between income tax expense and pretax accounting income.

10. Variable Interest Entity

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46). In December 2003, the FASB modified FIN 46 to make certain technical corrections and address certain implementation issues that had arisen. FIN 46 provides a new framework for identifying variable interest entities (VIEs) and determining when a company should include the assets, liabilities, noncontrolling interest and results of activities of a VIE in its consolidated financial statements.

In general, a VIE is a corporation, partnership, limited-liability corporation, trust, or any other legal structure used to conduct activities or hold assets that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities, or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations.

FIN 46 requires a VIE to be consolidated if a party with an ownership, contractual or other financial interest in the VIE (a variable interest holder) is obligated to absorb a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the VIE’s residual returns (if no party absorbs a majority of the VIE’s losses), or both. A variable interest holder that consolidates the VIE is called the primary beneficiary. Upon consolidation, the primary beneficiary generally must initially record all of the VIE’s assets, liabilities and noncontrolling interest at fair value and subsequently account for the VIE as if it were consolidated based on majority voting interest. FIN 46 also requires disclosures about VIE’s that the variable interest holder is not required to consolidate but in which it has a significant variable interest.

FIN 46 was effective immediately for VIE’s created after January 31, 2003. The provisions of FIN 46, as revised, were adopted as of December 31, 2003, for the Company’s interest in all VIE’s. In October 2004, the FASB revised FIN 46 to

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

This Report contains forward-looking statements that are based upon current expectations that are within the meaning of the Private Securities Reform Act of 1995. We intend that such statements be protected by the safe harbor created thereby. Forward-looking statements involve risks and uncertainties and our actual results and the timing of events may differ significantly from the results discussed in the forward-looking statements. Examples of such forward-looking statements include, but are not limited to, statements about:

• our quarterly financial performance;

• our capital requirements, and resources;

• our strategy to increase revenue;

• development of new products;

• our intent to develop and sell products and services to companies in the nanotechnology industry;

• technological change and uncertainty of new and emerging technologies;

• potential competitors or products;

• future employment of our key employees;

• development of strategic relationships;

• our ability to add revenue, expand distribution channels, maximize research and development resources, improve our competitive position and increase market awareness and acceptance of our products;

• acquiring complementary businesses, products or technologies and our ability to integrate those businesses, products or technologies, if any;

• compliance with the Sarbanes-Oxley Act of 2002;

• international exposure for a significant percentage of future overall revenue;

• our development center in India;

• statements about potential future dividends;

• statements about protection of our intellectual property; and

• possible changes in legislation.

Although forward-looking statements in this Report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties (including those discussed in “Risk Factors” below) and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. We undertake 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 following discussion and analysis of our financial condition and results of operations 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 our Form 10-K for the year ended December 31, 2003 (under our former name Pharmacopeia, Inc.).

The Report describes 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.

BUSINESS OVERVIEW

We are a leading provider of software for computation, simulation, and the management and mining of scientific data used by biologists, chemists and materials scientists, including nanotechnology researchers, for product design as well as drug discovery and development. Our technology and services are designed to meet the needs of today’s leading research organizations.

On April 30, 2004, we spun off our drug discovery subsidiary, Pharmacopeia Drug Discovery, Inc. (“PDD”), which integrates proprietary small molecule combinatorial and medicinal chemistry, high-throughput screening, in-vitro pharmacology, computational methods and informatics to discover and optimize lead compounds and drug candidates. The spin-off of PDD resulted in PDD becoming an independent, separately traded, publicly held company. This was accomplished through the distribution to our stockholders of a dividend of one share of PDD common stock for every two

RESULTS OF OPERATIONS

THREE MONTHS ENDED DECEMBER 31, 2004 AND 2003

	For the Three Months
	Ended December 31,
													Percent
	2004				**		2003				**		Change
Revenue	$		22,229		100	%	$	31,577			100	%	-30	%
Cost of revenue	5,161				23	%	4,507				14	%	15	%
Gross Margin	17,068				77	%	27,070				86	%	-37	%
Research and development	4,659				21	%	4,578				14	%	2	%
Sales and marketing	10,109				45	%	9,502				30	%	6	%
General and administrative	4,139				19	%	4,890				15	%	-15	%
Lease abandonment	3,612				16	%	—				0	%	100	%
Write-off of in-process research and development	(250			)	-1	%	—				0	%	100	%
Total operating costs and expenses	22,269				100	%	18,970				60	%	17	%
Operating income (loss) from continuing operations	(5,201			)	-23	%	8,100				26	%	-164	%
Spin-off transaction costs	—				0	%	(700			)	-2	%	-100	%
Interest and other income, net	184				1	%	939				3	%	-80	%
Income (loss) from continuing operations before provision (benefit) for income taxes	(5,017			)	-23	%	8,339				26	%	-160	%
Provision (benefit) for income taxes	(362			)	-2	%	140				0	%	-359	%
Income (loss) from continuing operations	(4,655			)	-21	%	8,199				26	%	-157	%
Discontinued operations:
Loss from Discontinued Operations	—				0	%	(347			)	-1	%	-100	%
Net Income (loss)	$	(4,655		)	-21	%	$		7,852		25	%	-159	%

** Line items expressed as a percent of revenue in the respective periods.

Revenue decreased 30% to $22.2 million in the quarter ended December 31, 2004 compared to $31.6 million reported in the quarter ended December 31, 2003. The decrease in revenue was attributed principally to the transition to subscription accounting for annual and multi-year licenses. In January 2004 we began offering a new license to our customers which requires subscription accounting. Under this new license, revenue is recognized ratably over the license term. This contrasts with our previous annual license offering, whereby we recognized 64% of the license revenue in the quarter in which the license was executed and amortized the other 36% of the revenue over the remaining term of the contract to correspond to the costs of post-sales support. Under this new license, the unrecognized revenue, amortized over the remaining term of the agreement, will be accounted for as “deferred revenue” on the balance sheet. The Company also licenses its software on perpetual licenses whereby we recognize 85% of the license revenue in the quarter in which the license is executed and amortize the remaining 15% of the revenue over the term of the maintenance agreement. In addition to the impact of the change to subscription accounting, consulting and contracts revenue has decreased by $1.9 million as the Company transitions to repeatable and more profitable services.

Cost of revenue was 15% higher at $5.2 million in the quarter ended December 31, 2004 compared to $4.5 million in the quarter ended December 31, 2003. Higher amortization of previously capitalized software development costs, amortization of intangible assets from the SciTegic acquisition, and an increase in Client Services due to increased staffing levels to fulfill software services were partially offset by lower royalties and documentation and shipping costs.

Research and development expenses were 2% higher in the quarter ended December 31, 2004 quarter at $4.7 million when compared to the $4.6 million recorded in the quarter ended December 31, 2003. Higher personnel-related costs as a result of research and development activities at SciTegic were partially offset by higher capitalization of software development costs.

Research and development expense consists primarily of the employment-related costs of personnel associated with developing new software products, enhancing existing products, testing and developing product documentation. Software research and development expense is capitalized in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Cost of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86). Capitalized software development costs consist primarily of the employment-related costs and consulting fees paid to consultants in relation to the development of products that have not yet been released.

The following table shows the breakout of research and development costs and the amount of capitalized software development for the periods indicated (dollars in thousands):

	Three Months Ended December 31,
	2004			2003			% Change
Research and development:
Gross software development costs	$	6.0		$	5.6		8	%
Less: Capitalized software development costs	(1.4		)	(1.0		)	38	%
Reported research and development expenses	$	4.7		$	4.6		2	%

Sales and marketing expenses increased by 6% to $10.1 million in the quarter ended December 31, 2004 compared to $9.5 million in the quarter ended December 31, 2003. The increase in expenses was related to our New Business Development Group which was established during calendar 2004 and sales costs associated with SciTegic.

General and administrative expenses decreased 15% to $4.1 million in the quarter ended December 31, 2004 compared to $4.9 million recorded in the quarter ended December 31, 2003. The decrease in general and administrative is due to lower head-count and other costs as a result of the spin-off of PDD.

Lease abandonment of $3.6 million was recorded in the quarter related to the move of the corporate headquarters to a new building. This charge has been recorded net of sublease income on the former facility. The Company received a rent abatement period on the new lease that coincides with the with the remaining term on the former headquarters. Therefore, the Company will receive free rent on its new facility, which will be accounted for as a reduction of average monthly rent over the life of the new lease.

Write-off of in-process research and development costs. As a result of the finalization of the valuation of the assets acquired in the acquisition of SciTegic on September 27, 2004, we adjusted our preliminary estimate of the write-off related to the portion of the purchase price allocated to in-process research and development downward by $0.3 million.

Spin-off transaction costs were $0.7 million in the quarter ended December 31, 2003 related to transaction costs associated with the spin-off of PDD. As of December 31, 2004, all of these expenses have been paid.

Net interest and other income was $0.2 million in the quarter ended December 31, 2004 compared to $0.9 million in the quarter ended December 31, 2003. The decrease is due to lower average investment balances as we used cash for general operations, the acquisition of SciTegic and the spin-off of PDD.

The provision (benefit) for income tax was a benefit of $0.4 million in the quarter ended December 31, 2004 compared to a provision of $0.1 million recorded in the quarter ended December 31, 2003. The benefit in the quarter ended December 31, 2004 includes a credit of $0.9 million related to an expected refund of taxes previously withheld in Japan. Otherwise, changes in the tax provision are due to income recognized in foreign jurisdictions.

A loss from discontinued operations of ($0.3) million was recorded in the quarter ended December 31, 2003 representing the net of revenues and expenses at PDD for such period. Since the spin-off of PDD was consummated on April 30, 2004, no amount of discontinued operations was realized in the quarter ended December 31, 2004.

A net loss of ($4.7) million or ($0.18) per share was reported for the quarter ended December 31, 2004 compared to net income of $7.9 million or $0.32 per diluted share reported in the quarter ended December 31, 2003. The results for the quarter ended December 31, 2003 included a net loss from discontinued operations at PDD of $(0.3) million or ($0.01) per share.

NINE MONTHS ENDED DECEMBER 31, 2004 AND 2003

	For the Nine Months
	Ended December 31,
												Percent
	2004				**		2003			**		Change
Revenue	$		50,687		100	%	$	68,342		100	%	-26	%
Cost of revenue	12,084				24	%	14,676			21	%	-18	%
Gross Margin	38,603				76	%	53,666			79	%	-28	%
Research and development	13,164				26	%	13,386			20	%	-2	%
Sales and marketing	25,348				50	%	25,629			38	%	-1	%
General and administrative	11,827				23	%	13,579			20	%	-13	%
Lease abandonment	3,612				7	%	—			0	%	100	%
Write-off of in-process research and development	450				1	%	—			0	%	100	%
Total operating costs and expenses	54,401				107	%	52,594			77	%	3	%
Operating income (loss) from continuing operations	(15,798			)	-31	%	1,072			2	%	-1574	%
Spin-off transaction costs	—				0	%	(700		)	-1	%	-100	%
Interest and other income, net	1,257				2	%	3,032			4	%	-59	%
Income (loss) from continuing operations before provision (benefit) for income taxes	(14,541			)	-29	%	3,404			5	%	-527	%
Provision (benefit) for income taxes	252				0	%	731			1	%	-66	%
Income (loss) from continuing operations	(14,793			)	-29	%	2,673			4	%	-653	%
Discontinued operations:
Loss from Discontinued Operations	(1,117			)	-2	%	(717		)	-1	%	56	%
Net Income (loss)	$	(15,910		)	-31	%	$	1,956		3	%	-913	%

** Line items expressed as a percent of revenue in the respective periods.

Revenue for the nine months ended December 31, 2004 was 26% lower at $50.7 million compared to revenue of $68.3 million reported in the nine months ended December 31, 2003. The decrease in revenue was attributed principally to the effects of transitioning from up-front revenue recognition to subscription revenue accounting as a result of contractual changes made to our licensing agreements. In addition about $1.1 million of revenue from consortia was recognized in the nine months ended December 31, 2003 as compared to $0.1 million recognized in the nine months ended December 31, 2004. This decrease in revenue from consortia was attributable primarily due to scheduled terminations in 2003 and our launch of the Nanotechnology Consortium on July 1, 2004. Revenue from consulting was $3.0 million lower for the nine months ended December 31, 2004 when compared to the nine months ended December 31, 2003 as the Company focuses on repeatable and more profitable services.

In January 2004 we began offering a new license to our customers which requires subscription accounting. Under this new license, revenue is recognized ratably over the license term. This contrasts with our previous annual license offering, whereby we recognized 64% of the license revenue in the quarter in which the license was executed and amortized the other 36% of the revenue over the remaining term of the contract to reflect the costs of post-sales support. Under this new license, the unrecognized revenue, amortized over the remaining term of the agreement, will be accounted for as “deferred revenue” on the balance sheet. We also license our software on perpetual licenses whereby we recognize 85% of the license revenue in the quarter in which the license is executed and amortize the remaining 15% of the revenue over the term of the maintenance

agreement.

Cost of revenue was 18% lower at $12.1 million for the nine months ended December 31, 2004 compared to $14.7 million in the nine months ended December 31, 2003. Lower royalties, client service costs and documentation and shipping costs were partially offset by higher amortization of previously capitalized software development costs. In addition, $0.6 million of amortization expense related to the amortization of intangible assets from the SciTegic acquisition was recorded in the nine months ended December 31, 2004 as compared to $1.6 million of amortization expense related to purchased technology was recorded in the nine months ended December 31, 2003.

Research and development expenses were 2% lower in the nine months ended December 31, 2004 at $13.2 million compared to $13.4 million recorded in the nine months ended December 31, 2003. Lower personnel-related costs were partially offset by lower capitalization of software development costs.

The following table shows the breakout of research and development costs and the amount of capitalized software development for the periods indicated (dollars in thousands):

	Nine Months Ended December 31, 2004
	2004			2003			% Change
Research and development:
Gross software development costs	$	16.2		$	16.5		-2	%
Less: Capitalized software development costs	(3.0		)	(3.1		)	-2	%
Reported research and development expenses	$	13.2		$	13.4		-2	%

Sales and marketing expenses decreased by 1% to $25.3 million in the nine months ended December 31, 2004 compared to $25.6 million in the nine months ended December 31, 2003. Lower sales and marketing expenses were partially offset by the expenses related to our New Business Development Group which was established during calendar 2004.

General and administrative expenses decreased 13% to $11.8 million in the nine months ended December 31, 2004 compared to $13.6 million recorded in the nine months ended December 31, 2003. The decrease in general and administrative is due to lower head-count and other costs as a result of the spin-off of PDD.

Lease abandonment of $3.6 million was recorded in the quarter related to the move of the corporate headquarters to a new building. This charge includes sublease income on the former facility. The Company received a rent abatement period on the new lease that coincides with the with the remaining term on the former headquarters. Therefore, the Company will receive free rent on its new facility, which will be accounted for as a reduction of average monthly rent over the life of the new lease.

Write-off of in-process research and development costs. As a result of the valuation of the assets acquired in the acquisition of SciTegic in September 2004, we recorded a write-off of $0.5 million in the nine months ended December 31, 2004 related to the portion of the purchase price allocated to in-process research and development.

Spin-off transaction costs were $0.7 million in the nine months ended December 31, 2003 related to transaction costs associated with the spin-off of PDD. As of December 31, 2004, all of these expenses have been paid.

Net interest and other income was $1.3 million in the nine months ended December 31, 2004 compared to $3.0 million in the nine months ended December 31, 2003. The decrease is due to lower average investment balances as the Company used cash for general operations, the acquisition of SciTegic and the spin-off of PDD.

The provision for income tax was $0.3 million in the nine months ended December 31, 2004 compared to $0.7 million in the nine months ended December 31, 2003. The decrease in the provision for income tax expense includes a credit of $0.9 million related to an expected refund of taxes previously withheld in Japan in the nine months ended December 31, 2004.

Otherwise, changes in the tax provision are due to income recognized in foreign jurisdictions.

A loss from discontinued operations of ($1.1) million was recorded in the nine months ended December 31, 2004 representing the net revenues and expenses at PDD for such period. For the nine months ended December 31, 2003 the loss was ($0.7) million.

A net loss of ($15.9) million or ($0.64) per share was reported for the nine months ended December 31, 2004 compared to net income of $2.0 million or $0.08 per diluted share reported in the nine months ended December 31, 2003. The net loss for the nine months ended December 31, 2004 and net income for the nine months ended December 31, 2003 included the losses from discontinued operations at PDD representing ($0.04) and ($0.03) per share, respectively.

LIQUIDITY AND CAPITAL RESOURCES

We have funded our activities to date primarily through the sale of software licenses, software maintenance and related services, equity securities, and interest income. Also, prior to the spin-off of PDD, funding was provided through the sale of drug discovery services. As of December 31, 2004, we had cash, restricted cash, cash equivalents, and marketable securities of $59.1 million compared to $141.6 million as of March 31, 2004. On April 30, 2004, we made a capital contribution to PDD of $46.5 million in cash and securities and incurred costs of approximately $2.3 million which were accrued at March 31, 2004 and have been paid as of December 31, 2004. On September 27, 2004, we paid $10.9 million in cash as part of the total purchase price of $20.8 million for the acquisition of SciTegic.

Cash used in operations increased by $12.3 million in the nine months ended December 31, 2004 compared to the nine months ended December 31, 2003. The increase is attributable to the loss in the nine months ended December 31, 2004 compared to net income for the nine months ended December 31, 2003 and the use of prepaid assets, both of which are partially offset by an increase in deferred revenue due to transition to subscription accounting. Cash provided by investing activities increased by $40.5 million in the nine months ended December 31, 2004 compared to the nine months ended December 31, 2003 due to the sale of marketable securities to fund the capital contribution to the PDD business under the contractual agreements of the spin-off. This increase is partially offset by the use of cash for the acquisition of SciTegic. Cash provided by financing activities decreased by $0.1 million in the nine months ended December 31, 2004 compared to the nine months ended December 31, 2003 due to a decrease in option exercises.

We anticipate that our 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. Our capital requirements may also increase in future periods as we seek to expand our technology platform through investments, licensing arrangements, technology alliances, or acquisitions.

We anticipate that our existing capital resources will be adequate to fund our operations at least through the next twelve months. However, there can be no assurance that changes will not occur that might consume available capital resources before then. Our capital requirements depend on numerous factors, including our ability to continue to generate software sales, competing technological and market developments, 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, and acquisitions of other businesses or technologies. There can be no assurance that additional funding, if necessary, will be available on favorable terms, if at all. Our forecasts of the period of time through which our financial resources will be adequate to support our operations are forward looking information, and actual results could vary. The factors described earlier in this paragraph will impact our future capital requirements and the adequacy of our available funds.

The following summarizes our long-term contractual obligations as of March 31, 2004. This table has been updated from the Company’s most recently filed 10-K to include the effects of the assignment of the PDD leases to PDD, the guarantee of the PDD leases, the new corporate facility lease in San Diego and the sublease of the former corporate facility (dollars in thousands).

	Payments Due by Period
Contractual Obligations	Total			Less than 1 Year			1 to 3 Years			4 to 5 Years			After 5 Years
Operating leases	$		46,399	$	3,807		$	6,901		$	7,580		$	28,111
Total	$	46,399		$		3,807	$		6,901	$		7,580	$		28,111

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.

CERTAIN RISKS RELATED TO OUR BUSINESS

Our quarterly operating results 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. Additionally, fluctuations in revenue recognition may result as subscription license sales increase. 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 revenue and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.

Our future profitability is uncertain. We generated losses in the twelve months ended 2001, 2002, 2003, the three months ended March 31, 2004 and the nine months ended December 31, 2004. Continuing net losses may limit our ability to fund our operations and we may not generate income from operations in the future. Our future profitability depends upon many factors, including several that are beyond our control. These factors include without limitation:

• the rate of adoption by our customers of our new subscription licenses option;

• changes in the demand for our products and services;

• the introduction of competitive 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, cost effectively and timely develop, introduce and market new products, services and product enhancements.

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, pricing strategies and other market activities of industry participants. We currently face competition 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;

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

• academic and government sponsored institutes focused on nanotechnology.

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 and resources 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. Finally, we also face competition from open source software initiatives, in which developers provide software and intellectual property free over the internet.

We are subject to pricing pressures in the markets we serve. In response to competition and general adverse economic conditions in the markets we serve, we may be required to modify our pricing practices. This development may adversely affect our revenue and earnings. We generally license our software products and services on a “right to use” basis pursuant to licenses over a specified period of time or in perpetuity. Changes in our pricing model or any other future broadly-based changes to our prices and pricing policies could lead to a decline or delay in revenue as our sales force and customers adjust to the new pricing policies.

Our investments in sales and business development efforts may not result in additional sales of our products and services. Our products and services involve lengthy sales and business development cycles, often requiring us to expend considerable financial and personnel resources without any assurance that revenue will be recognized. These sales and business development cycles typically are long for a number of reasons. Software 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 collaborative relationships, services and products, but may ultimately be unable to consummate the related transaction. Under such circumstances, our results of operations and ability to achieve profitability will be adversely affected.

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 for at least the next twelve months. 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;

• 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; and

• acquisitions of other businesses or technologies.

If we determine that we must raise additional capital, we may attempt to do so 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.

Our ability to increase our software revenue may depend upon increased market acceptance of our products and services. Our products are currently used primarily by molecular modeling and simulation 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, client-server solutions, and related services to a broader, more diversified group of biologists, chemists, and engineers. If we cannot expand our customer base by selling our desktop-based products, client-server solutions, 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 of our products and services 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 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 scientists, including chemists, biologists, and materials scientists

• offering more informatics solutions that capture and manage the data created by customers’ drug discovery and chemical development activities, including the data created by the use of computational modeling, simulation, and analysis software;

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

• 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; and

• developing enhanced modeling and informatics tools to address the needs of companies engaged in nanotechnology research.

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. As a result, we may not be able to increase revenue.

Delays in release of new or enhanced software products or services or undetected errors in our software products or services may result in increased cost to us, delayed market acceptance of our products and delayed or lost revenue. To achieve market acceptance, new or enhanced software products or services can require long development and testing periods, which may result in delays in scheduled introduction. Any delays in the release schedule for new or enhanced software products or services may delay market acceptance of these products or services and may result in delays in new customer orders for these new or enhanced software products or services or the loss of customer orders. In addition, new or enhanced software products or services may contain a number of undetected errors or “bugs” when they are first released. As a result, in the months following the introduction of certain releases, we generally devote significant resources to correct these errors. There can be no assurance, however, that all of these errors can be corrected. Although we test each new or enhanced software product or service before being released to the market, there can be no assurance that significant errors will not be found in existing or future releases.

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 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 adversely impacted by, the tightening of available credit and capital during periods of contraction affecting 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 payments, we may be required to write-off significant accounts receivable and recognize bad debt expense. As a result of these types of exposures and other potential exposures, we recorded a provision for doubtful accounts of $1.2 million, $0.4 million, less than $0.1 million and less than $0.1 million for the twelve months ended December 31, 2002, the twelve months ended December 31, 2003, the three months ended March 31, 2004 and the nine months ended December 31, 2004, respectively. Failure of these businesses, write-offs and difficulties associated with collection of receivables from these customers, could materially and adversely affect our operating results.

We will need to achieve commercial acceptance of our products and services in the nanotechnology industry to obtain significant product revenue from that industry. We intend to develop and sell our products and services to companies in the nanotechnology industry. We do not know when a market for nanotechnology-enabled products will develop, if at all, and we cannot reasonably estimate the projected size of any market that may develop. In addition, nanotechnology-enabled products may achieve some degree of market acceptance in one segment of the nanotechnology industry but may not achieve market acceptance in other segments of the industry for which we are developing products. If the segments of the market we are targeting fail to accept nanotechnology-enabled products or to determine that other products were superior, we may not be able to achieve commercial acceptance of our products and services. Even if we develop nanotechnology products and those products achieve commercial acceptance, if the size of the potential markets for our products is not sufficient, we will be unable to generate significant revenue from the nanotechnology industry.

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 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.

Pharmaceutical, biotechnology and industrial chemical companies may discontinue or decrease their use of our services and products. We are dependent on pharmaceutical and biotechnology companies. 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. In addition, 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, and chemical industries, particularly companies in these industries adding new and improved technologies to accelerate their drug discovery and chemical development initiatives. The willingness of these companies to expand or continue is dependent on 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 revenue may be impacted. Also, general economic downturns in our customers’ industries or any decrease in customers’ research and development expenditures could harm our operations.

Health care reform and restrictions on reimbursement may affect the ability of pharmaceutical, biotechnology and industrial chemical companies to purchase or license our software products or services, which may affect our results of operations and financial condition. The continuing efforts of government and third party payers in our markets to contain or reduce the cost of health care may reduce the profitability of pharmaceutical, biotechnology and industrial chemical companies causing them to reduce research and development expenditures. Because our products and services depend on such research and development expenditures, our revenues may be significantly reduced. We cannot predict what actions federal, state or private payers for health care goods and services may take in response to any health care reform proposals or legislation.

Our sales forecast and/or revenue projections may not be accurate. We use a “pipeline” system, a common industry practice, to forecast sales and trends in our business. Our sales personnel monitor the status of proposals, including the date when they estimate a customer will make a purchase decision and the potential size of the order. We aggregate these estimates on a quarterly basis in order to generate a sales pipeline. While the pipeline process provides us with some guidance in business planning and forecasting, it is based on estimates only and is therefore subject to risks and uncertainties. Any variation in the conversion of the pipeline into revenue or the pipeline itself could cause us to improperly plan or budget and thereby adversely affect our business, results of operations and financial condition.

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, business development, engineering and management personnel

and our ability to identify, hire and retain additional personnel. There is intense competition for qualified personnel. 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 our business. 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. 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 intend to maintain key person life insurance on the life of any employee.

We may be unable to develop strategic relationships with large technology companies. A component of our business strategy is to develop strategic relationships with larger 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 scientific software products. To date, we have entered into significant strategic relationships with such companies as 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.

If we choose to acquire new and complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or to successfully integrate an acquired business or technology in a cost-effective and non-disruptive manner. From time to time, we may choose to acquire complementary businesses, products or technologies instead of developing them ourselves. We do not know if we will be able to complete any acquisitions, or whether we will be able to successfully integrate any acquired businesses, operate them profitably or retain their key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing

business and distract company management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms and, in the case of equity financing that may result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.

There can be no assurance as to the effect of the SciTegic acquisition or future acquisitions on our business or operating results. From time to time, we may acquire other companies that would be complementary to our business. Acquisitions may result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities, amortization expenses related to intangible assets and the possible impairment of goodwill, which could harm our profitability. In addition, acquisitions involve numerous risks, including, among other things: higher than estimated acquisition expenses; difficulties in successfully assimilating the operations, technologies and personnel of the acquired company; diversion of management’s attention from other business concerns; risks of entering markets in which we have no or limited direct prior experience; and the potential loss of key employees and customers as a result of the acquisition. In this regard, in September 2004, we acquired SciTegic, Inc., a privately held company providing workflow software solutions for the research science market. Pursuant to this transaction, SciTegic shareholders will receive approximately $12.9 million of cash and up to 1,166,218 shares of Accelrys common stock in exchange for their SciTegic shares, and up to 334,324 additional Accelrys common shares over the next two years subject to certain conditions. There can be no assurance as to the effect of the SciTegic acquisition or future acquisitions on our business or operating results.

Recently enacted and proposed changes in securities laws and regulations are likely to increase our costs. The Sarbanes-Oxley Act of 2002 (“SOX”) requires changes in some of our corporate governance and securities disclosure or compliance practices. The Securities and Exchange Commission (the “SEC”) has promulgated new rules on a variety of subjects and Nasdaq has issued revisions to its requirements for companies that are Nasdaq-listed. In June 2003 the SEC adopted certain rules as directed by Section 404 of SOX. These rules require that publicly held companies, including us, include in their annual report to shareholders a report of management on our internal controls over financial reporting. Our independent auditors will be required to attest to management’s assessment of internal controls over financial reporting. We will be required to comply with this new requirement in our annual report for the year ending March 31, 2005. If our financial reporting controls are not deemed effective, there will be an adverse impact on our reputation that could negatively impact our stock price.

We also expect compliance with SOX to increase our corporate governance, legal and accounting costs. Further, SOX and the related SEC and Nasdaq compliance rules may make it more difficult and expensive for us to obtain director

and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These laws and regulations could make it more difficult for us to attract and retain qualified members of our board of directors, or qualified executive officers. We continually evaluate and monitor regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.

We are subject to risks associated with the operation of an international business. For the nine months ended December 31, 2004, approximately 48% of the Company’s consolidated revenue was derived from customers outside the United States, both through international subsidiaries and on an export basis. Approximately 25% of our revenue was derived from customers in Europe and approximately 23% was derived from customers in the Asia/Pacific region. We anticipate that international revenue will continue to account for a significant percentage of future overall revenue. Our international operations continue to expand, with functions such as software development, sales and customer support increasingly being performed outside the United States. In this connection, we intend to continue the expansion of our development center in Bangalore, India.

Our non-U.S. 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 unrest, terrorism and economic instability;

• disruption of our operations due to local labor conditions;

• limited intellectual property protection;

• difficulties in collecting trade receivables;

• difficulties in managing distributors or representatives;

• difficulties in managing an organization spread over various countries;

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

• potentially adverse tax consequences.

Our success depends, in part, on our ability to anticipate and address these risks. There can be no assurance that we would do so effectively, or that these or other factors will not adversely affect our business or operating results.

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 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.

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. 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.

We expect that our stock price will fluctuate significantly, and you may not be able to resell your shares at or above your investment price. The stock market, historically and particularly in recent years, has experienced significant volatility and in particular with technology company stocks. The volatility of technology company stock prices often does not relate to the operating performance of the companies represented by the stock. Factors that could cause volatility in the price of our common stock include without limitation:

• actual and anticipated fluctuations in our quarterly financial and operating results;

• market conditions in the technology and software sectors;

• issuance of new or changed securities analysts’ reports or recommendations;

• developments or disputes concerning our intellectual property or other proprietary rights;

• introduction of technological innovations or new commercial products by us or our competitors;

• market acceptance of our products and services; and

• additions or departures of key personnel.

These and other external factors may cause the market price and demand for our common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of common stock and may otherwise negatively affect the liquidity of our common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending the lawsuit. Such a lawsuit could also divert the time and attention of our management.

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 January 2005, the top ten institutional holders of our common stock held approximately 52% 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, our stockholders will benefit from an investment in our common stock only if our stock price 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 acquirer 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.

Our operations may be interrupted by the occurrence of a natural disaster or other catastrophic event at our primary facilities. Our research and development operations and administrative functions are primarily conducted at our facilities in San Diego, California, Cambridge, United Kingdom, and Bangalore, India. 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.

Our insurance coverage may not be sufficient to avoid impacts on our financial position or results of operations resulting from claims or liabilities against us, and we may not be able to obtain insurance coverage in the future. We maintain insurance coverage for protection against many risks of liability. The extent of our insurance coverage is under continuous review and is modified as we deem it necessary. Despite this insurance, it is possible that claims or liabilities against us may have a material adverse impact on our financial position or results of operations. We may not be able to obtain any insurance coverage, or adequate insurance coverage, when our existing insurance coverage expires.

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 and biotechnology companies are uncertain and involve complex legal and factual questions. 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 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 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 our 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 or consultant during his, her or its relationship with us are to be kept confidential, and that all inventions arising out of the employee’s or consultant’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.

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 or other technologies because the scope of protection provided by any patents issued to or licensed by us are subject to the uncertainty inherent in 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 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, software organizations 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 one of 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 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 THE SPIN-OFF OF PDD

There can be no assurance that Accelrys will be successful on a stand-alone basis. Our Board of Directors approved the plan to separate the Accelrys and PDD businesses through the spin-off to our stockholders of 100% of the outstanding shares of common stock of PDD which was completed on April 30, 2004. The transaction resulted in PDD being an independent, publicly-traded company. Following the spin-off, we not been able to rely on the financial and other resources and the cash flows generated from the combined Accelrys and PDD operations. Previously, we operated our businesses as part of a broader corporate organization rather than as a stand-alone company. Historically, certain corporate functions had been centralized for PDD and Accelrys. As a result of disengaging the PDD operations from our business, it has been difficult for us to accurately forecast our future operating performance

We may be required to indemnify PDD, or may not be able to collect on indemnification rights from PDD. As part of the spin-off, we and PDD have agreed to indemnify one another with respect to the indebtedness, liabilities and obligations that will be retained by our respective companies. One such obligation includes a guarantee by us of PDD’s obligations under the existing New Jersey laboratory and headquarters leases, with respect to which PDD will indemnify us should we be required to make any payment under the guarantee. These indemnification obligations could be significant. PDD’s ability to satisfy any such indemnification obligations (including, without limitation, PDD’s commitment to indemnify us in the event of our payment under our guarantee of its leases) will depend upon PDD’s future financial strength. We cannot assure you that, if PDD becomes obligated to indemnify us for any substantial obligations, PDD will have the ability to do so. There also can be no assurance that we will be able to satisfy any indemnification obligations to PDD. Any required payment by PDD or us could have a material adverse effect on its or our business, and any failure by PDD or us to satisfy its obligations could have a material adverse effect on the other company’s business.

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.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are exposed to various market risks including changes in foreign currency exchange rates. The Company’s international sales generally are denominated in local currencies. For the nine months ended December 31, 2004, approximately 48% of our consolidated revenue was derived from customers outside the United States (including 25% from customers in Europe and 23% from customers in the Asia/Pacific region). As such, our exchange rate risk is greatest for Dollar/Pound, Dollar/Euro and Dollar/Yen fluctuations. When deemed appropriate, we may engage in exchange rate-hedging transactions in an attempt to mitigate the impact of adverse exchange rate fluctuations. At December 31, 2004, we had no such hedging transactions in effect.

We do not use derivative financial instruments for trading or speculative purposes. However, we regularly invest excess cash in short-term investments, municipal securities, commercial paper, corporate bonds, and mortgage-backed securities that are subject to changes in short-term interest rates. We believe that the market risk arising from holding these financial instruments is minimal.

Because we have minimal debt, our exposure to market risks associated with changes in interest rates arise from increases or decreases in interest income earned on our investment portfolio. We attempt to ensure the safety and preservation of invested funds by limiting default risks, market risk, and reinvestment risk. We mitigate default risk by investing in investment grade securities. A hypothetical 100 basis point decrease in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at December 31, 2004.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures. Our management, with the participation of our Chief Executive Officer and our then acting Chief Accounting Officer, has evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2004. Based on that evaluation, our Chief Executive Officer and our then acting Chief Accounting Officer concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

We are currently undergoing a comprehensive effort to comply with Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX”). Compliance is required as of March 31, 2005. The compliance process has included, without limitation, the following:

1. Define project scope,

2. Perform entity level assessment,

3. Identify significant accounts and related processes,

4. Document processes, transactions and controls,

5. Test and evaluate design and operating effectiveness of controls, and

6. Identify control deficiencies and implement improvements.

As of December 31, 2004, we have not discovered any internal control deficiencies that we would consider a material weakness. There is no assurance that internal control problems will not emerge from future testing or that we will be able to comply with the requirements of Section 404 by the March 31, 2005 deadline.

Changes in Internal Control over Financial Reporting. There were no material changes in our internal controls over financial reporting during the quarter ended December 31, 2004 that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Accelrys, Inc. and Subsidiaries

Exhibit Index

2.1		Agreement and Plan of Merger and Reorganization dated September 13, 2004 by and among the Company, Nashville Acquisition Corporation, SciTegic, Inc., Mathew Hahn and David Rogers as Principal Shareholders, and Mathew Hahn as Shareholder Representative (incorporated by reference to Exhibit 99.1 to the Company’s Report on Form 8-K dated September 16, 2004).
3.1		Restated Certificate of Incorporation of the Registrant (incorporated by Reference to Exhibit 3.1 to the Company’s Report on Form 10-K for the year ended December 31, 1996).
3.3		Bylaws of the Registrant, as amended (incorporated by Reference to Exhibit 3.3 to the Company’s Report on Form 10-K for the year ended December 31, 1996).
3.3(a)		Amendment to Bylaws of the Registrant dated July 31, 1997 (incorporated by Reference to Exhibit 3.3(a) to the Company’s Report on Form 10-Q for the quarter ended September 30, 1997).
3.3(b)		Amendment to Bylaws of the Registrant dated January 17, 2002 (incorporated by Reference to Exhibit 3.3(b) to the Company’s Report on Form 10-K for the year ended December 31, 2001).
4.1		Rights Agreement, dated as of September 6, 2002, between Accelrys, Inc. and American Stock Transfer & Trust Company, as Rights Agent, which includes as Exhibit A thereto the Certificate of Designations, Preferences and Rights of Series A Junior Participating Preferred Stock and Exhibit B thereto the Form of Right Certificate (incorporated by Reference to Exhibit 4.1 to the Company’s Report on Form 8-K dated September 4, 2002).
10.1#		Amended 1994 Incentive Stock Plan (incorporated by Reference to Exhibit 10.5 to the Company’s Report on Form 10-K for the year ended December 31, 1995 (File Number 000-27188)).
10.1(a)#		Amendment No. 1 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(a) to the Company’s Report on Form 10-K for the year ended December 31, 2000).
10.1(b)#		Amendment No. 2 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(b) to the Company’s Report on Form 10-K for the year ended December 31, 2000).
10.1(c)#		Amendment No. 3 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.5(a) to the Company’s Report on Form 10-Q for the quarter ended June 30, 1997).
10.1(d)#		Amendment No. 4 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(d) to the Company’s Report on Form 10-K for the year ended December 31, 2000).
10.1(e)#		Amendment No. 5 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(e) to the Company’s Report on Form 10-K for the year ended December 31, 2000).
10.1(f)#		Amendment No. 6 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(f) to the Company’s Report on Form 10-K for the year ended December 31, 2000).
10.1(g)#		Amendment No. 7 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(g) to the Company’s Report on Form 10-K for the year ended December 31, 2000).
10.1(h)#		Amendment No. 8 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.54 to the Company’s Report on Form 10-Q for the quarter ended June 30, 2000).
10.1(i)#		Amendment No. 9 to the 1994 Incentive Stock Plan (incorporated by reference to Exhibit 10.1(i) to the Company’s Report on Form 10-Q for the quarter ended March 31, 2002).
10.2#		1995 Employee Stock Purchase Plan (incorporated by Reference to Exhibit 10.6 to the Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).
10.2(a)#		Amendment No. 1 to the Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.2(a) to the Company’s Report on Form 10-Q for the quarter ended March 31, 2001).
10.3#		1995 Director Option Plan (incorporated by reference to Exhibit 10.7 to the Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).
10.3(a)#		Amendment No. 1 to 1995 Director Option Plan (incorporated by reference to Exhibit 10.3(a) to the Company’s report on form 10-K for the year ended December 31, 2000).
10.3(b)#		Amendment No. 2 to the 1995 Director Option Plan (incorporated by reference to Exhibit 10.3(b) to the Company’s report on Form 10-Q for the quarter ended March 31, 2001).

10.4		Lease Agreement between Accelrys and Eastpark at 8A (incorporated by Reference to Exhibit 10.13 to the Company’s Registration Statement on Form S-1 (Reg. No. 33-98246)).
10.4(a)		Amendment dated as of January 22, 1996 to Lease Agreement between Accelrys and Eastpark at 8A (incorporated by reference to Exhibit 10.13(a) to the Company’s Report on Form 10-K for the year ended December 31, 1995 (File Number 000-27188)).
10.4(b)		Third Amendment to Lease Agreement dated March 31, 1996 between Accelrys and Eastpark at 8A (incorporated by reference to Exhibit 10.13(b) to the Company’s Report on Form 10-Q for the quarter ended June 30, 1996).
10.5#		Employment Agreement dated as of February 26, 2001 between the Company and Joseph A. Mollica, Ph.D. (incorporated by reference to the Company’s Report on form 10-K for the year ended December 31, 2000).
10.5(a)#		Amendment, effective as of May 1, 2003, to employment agreement between
		the Company and Joseph A. Mollica, Ph.D. (incorporated by reference to exhibit 10.9(a) to the Company’s report on Form 10-Q for the quarter ended March 31, 2003.)
10.6		Lease dated November 12, 1998 between Molecular Simulations Inc. and San Diego Tech Center, LLC (incorporated by reference to Exhibit 10.47 to the Company’s Report on Form 10-K for the year ended December 31, 1998).
10.7#		Form of Indemnity Agreement for Directors and Executive Officers (incorporated by reference to Exhibit 10.48 to the Company’s Report on Form 10-K for the year ended December 31, 1998).
10.8		Lease Agreement, dated May 1, 1999, between Accelrys and South Brunswick Rental I, LTD (incorporated by reference to Exhibit 10.49 to the Company’s Report on Form 10-Q for the quarter ended June 30, 1999).
10.9#		Accelrys, Inc. 2000 Stock Option Plan (incorporated by reference to the Company’s Report on form 10-K for the year ended December 31, 2000).
10.10#		Accelrys, Inc. Executive Non-Qualified Deferred Compensation Plan (incorporated by reference to Exhibit 10.52 to the Company’s Report on Form 10-Q for the quarter ended March 31, 2000).
10.11		Form of Stock Purchase Agreement, dated as of March 8, 2000, among the company and the investors set forth therein (incorporated by reference to Exhibit 10.53 to the Company’s Report on Form 10-Q for the quarter ended March 31, 2000.)
10.12		Employment Agreement dated May 1, 2001 between the Company and Michael R. Stapleton. (incorporated by reference to the Company’s Report on form 10-Q for the quarter ended September 30, 2001).
10.12(a)#		Separation Agreement and Release of Claims dated September 30, 2002, by and between Accelrys, Inc. and Michael R. Stapleton (incorporated by reference to Exhibit 10.28 to the Company’s Report on Form 10-K for the year ended December 31, 2003).
10.13		Lease Agreement dated July 29, 2001 among the Masters, Fellows and Scholars of Trinity College, Cambridge, Accelrys Limited, and Accelrys Inc. and Trinity College (CJP) Limited (incorporated by reference to the Company’s Report on form 10-Q for the quarter ended September 30, 2001).
10.14#		Employment Agreement dated December 3, 2002 by and between Accelrys, Inc. and Mark J. Emkjer (incorporated by reference to Exhibit 10.28 to the Company’s Report on Form 10-K for the year ended December 31, 2003).
10.15		Lease, dated August 20, 2003, between Accelrys, Inc. and Eastpark at 8A (Building 1000) (incorporated by reference to the Company’s report on form 10-Q for the quarter ended September 30, 2003)
10.16		Lease, dated August 20, 2003, between Accelrys, Inc. and Eastpark at 8A (Building 3000) (incorporated by reference to the Company’s report on form 10-Q for the quarter ended September 30, 2003)
10.17		Accelrys, Inc. 2004 New-Hire Equity Incentive Plan
10.18*		Sublease, dated May 18, 2004, between Accelrys, Inc. and Pfizer Inc.
10.19*		Lease, dated May 18, 2004, between Accelrys, Inc. and AGRRI Seaview, L.LC.
10.20*		Sublease, dated January 27, 2005, between Accelrys, Inc. and QUALCOMM Incorporated
31.1*		Section 302 Certification of the Principal Executive Officer
31.2*		Section 302 Certification of the Principal Financial Officer
32*		Section 906 Certification of the Chief Executive Officer and Chief Financial Officer

+ Confidential treatment granted.

++ Confidential treatment requested.

# Represents a management contract or compensatory plan or arrangement.

* Filed herewith

Item 1.		Legal Proceedings —
		We are not currently subject to any material pending legal proceedings. However, we may become subject to other lawsuits from time to time in the ordinary course of our business, and any such lawsuit could harm our business.

Item 2.		Unregistered Sales of Equity 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 - see Exhibit Index attached

	ACCELRYS, INC.

	By:	/s/ David M. Sankaran

	David M. Sankaran
	Senior Vice President and
	Chief Financial Officer (Duly
	Authorized Officer and Chief
	Financial Officer)

	Date: February 7, 2005

For the transition period from to

ACCELRYS, INC.

Table of Contents

Consolidated Statements of Operations

Accelrys, Inc.

RESULTS OF OPERATIONS