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

FORM 10-Q

(Mark One)

For the period from April 1, 2004 through June 30, 2004

Commission File Number: 0-27118

ACCELRYS, INC.
(Exact name of registrant as specified in its charter)

(858) 799-5000
(Registrant’s telephone number, including area code)

Former name: Pharmacopeia, Inc.
(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 |X| No |_|

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

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

ACCELRYS, INC.

Form 10-Q

Table of Contents

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PART I — FINANCIAL INFORMATION

Item 1. Unaudited Consolidated Financial Statements

Accelrys, Inc.
Consolidated Balance Sheets
(Dollars and share amounts in thousands)

See accompanying notes to these unaudited consolidated financial statements.

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Accelrys, Inc.
Consolidated Statements of Operations
(Dollars in thousands, except per share data, unaudited)

See accompanying notes to these unaudited consolidated financial statements.

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Accelrys, Inc.
Consolidated Statements of Cash Flows
(Dollars in thousands)

See accompanying notes to these unaudited consolidated financial statements.

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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 5. 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. Net 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 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. The Company has a net loss for the periods presented; accordingly, 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.

3. 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.

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

        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:

4. Restructuring

        During the third quarter of 2002, the Company announced that it was undertaking various actions to restructure its operations to improve its overall financial performance. As of June 30, 2004 the remaining obligation under this restructuring was related to a closure of a facility. The following table summarizes the activity and balance of the restructuring liability during the quarter ended June 30, 2004 (dollars in thousands):

        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 force of 73 Accelrys employees, of which all had been terminated as of June 30, 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 June 30, 2004 (dollars in thousands):

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5. 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 its 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 the majority of which were paid during the quarter ended June 30, 2004. For the one-month ended April 30, 2004, the discontinued PDD operations had revenue of $1.3 million and a pretax loss of $(1.1) million.

6. Guarantee

        Subsequent to 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 the Company to guarantee the remaining lease obligation representing approximately $32.2 million in future payments through April 2016 in event PDD does not perform under the terms of the lease. 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 results in a remaining liability of $745 thousand in short- and long-term liabilities as of June 30, 2004.

7. Restricted Cash

        At June 30, 2004, the Company has a restricted cash balance of $7.1 million consisting of two separate balances. During the quarter, 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 decreases over the term of the sublease agreement.

        Additionally, $500 thousand 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. At the end of the term, any remaining cash will be released back to Accelrys.

8. 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 used in the tax rate calculation.

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

        The following discussion and analysis of financial condition and results of operations of Accelrys, Inc. (“Accelrys” or the “Company”) should be read in conjunction with the Unaudited Financial Statements and related notes included elsewhere in this Form 10-Q, and also in conjunction with the Consolidated Financial Statements and related notes included in the Company’s Form 10-K for the year ended December 31, 2003.

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

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

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

BUSINESS OVERVIEW

        We develop and commercializes molecular modeling and simulation software for the life sciences and materials research markets, cheminformatics and decision support systems, and bioinformatics tools including gene sequence analysis. On April 30, 2004, the Company spun off its 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 its stockholders of a dividend of one share of PDD common stock for every two shares of Accelrys common stock.

        As of June 30, 2004 the Company employed approximately 503 employees and is headquartered in San Diego, California.

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RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2004 AND 2003

        Revenue decreased 26% to $14.2 million in the quarter ended June 30, 2004 compared to $19.1 million in the quarter ended June 30, 2003. The decrease in revenue was attributed to the early annual software license renewal of $700 thousand, at the customer’s request, in March 2004 as compared to the scheduled annual renewal in June 2004, the discontinuance of delivering low margin disparate consulting work of $1.0 million, finalization of our last consortium in 2003 of $700 thousand, and the effects of transitioning from up-front revenue recognition to subscription revenue accounting as a result of contractual changes made to our licensing agreement of approximately $2.0 million.

        In January 2004 we issued a new license offering, 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. 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.

        Cost of revenue decreased 24% to $3.8 million in the quarter ended June 30, 2004 compared to $5.0 million in the quarter ended June 30, 2003. The decrease was a result of the completion of the amortization of acquired technologies completed in 2003, lower royalties due to a decrease in orders and lower costs associated with the fulfillment of consulting work as a result of lower consulting revenue. These costs remained consistent as a percent of revenue.

        Research and development expenses decreased 10% to $4.1 million in the quarter ended June 30, 2004 compared to $4.6 million in the quarter ended June 30, 2003. The decrease in research and development expense is due primarily to cost savings associated with the January 2004 restructuring. These costs increased as a percent of revenue due to a decrease in revenue, as described above.

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        Software research and development expense consists primarily of the employment-related costs of personnel associated with developing new products, enhancing existing products, testing software products 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:

        Sales and marketing expenses decreased by 13% to $7.8 million in the quarter ended June 30, 2004 compared to $9.0 million in the quarter ended June 30, 2003. The decrease in sales and marketing expenses is primarily attributable to lower head-count. These costs have increased as a percent of revenue due to a decrease in revenue, as described above.

        General and administrative expenses decreased 10% to $4.0 million in the quarter ended June 30, 2004 compared to $4.5 million in the quarter ended June 30, 2003. The decrease in general and administrative is due to lower head-count and lower corporate charges as a result of the spin-off of the PDD business. These costs have increased as a percent of revenue due to a decrease in revenue, as described above.

        Net interest and other income decreased 35% to $0.6 million in the quarter ended June 30, 2004 compared to $0.9 million in the quarter ended June 30, 2003. The decrease is due to lower average investment balances as the Company made a capital contribution to PDD under the terms of the spin-off agreement.

        Provision for income tax expense decreased to $0.1 million for the quarter ended June 30, 2004 compared to $0.4 million for quarter ended June 30, 2003. The decrease is due to the increased loss.

        Loss from discontinued operations increased to $1.1 million for the one month ended April 30, 2004, which is the date of the spin-off of the PDD business, compared to $0.3 million loss in the quarter ended June 30, 2004. The Company will not incur any further discontinued operation losses in the future from the PDD business.

        A net loss of ($6.2) million or ($.25) per share was reported for the June 2004 quarter compared to a net loss of ($3.8) million or ($.16) per share recognized in the June 2003 quarter. The results for the June 2004 quarter included a net loss from discontinued Pharmacopeia Drug Discovery (PDD) operations of ($1.1) million. The comparable net loss from the discontinued PDD operations in the June 2003 quarter was ($345) thousand. The loss from discontinued operations represented ($.05) per share in 2004 and ($.01) per share in 2003.

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LIQUIDITY AND CAPITAL RESOURCES

        The Company has funded its activities to date primarily through the sale of equity securities, software licenses, software maintenance and related services. Also, prior to the spin-off of PDD funding was provided through the sale of drug discovery services. As of June 30, 2004, the Company had cash, restricted cash, cash equivalents, and marketable securities of $83.8 million compared to $141.6 million as of March 31, 2004. On April 30, 2004, the Company 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 the majority of which were paid during the quarter ended June 30, 2004.

        Cash used in operations increased by $6.2 million in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. The increase is primarily attributable to an increased loss, payments made under the January 2004 restructuring plan and payments made pursuant to the spin-off of PDD, as referred to above. Cash provided by investing activities increased by $51.1 million in the quarter ended June 30, 2004 compared to the quarter ended June 30, 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. Cash provided by financing activities increased by $0.4 million in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003 due to option exercises.

        The following summarizes our long-term contractual obligations as of March 31, 2004 (in thousands). 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 and the corporate facility lease in San Diego, discussed in footnotes 6 and 7 above.

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

        The Company anticipates that its existing capital resources will be adequate to fund the Company’s operations at least through the next twelve months. However, there can be no assurance that changes will not occur that would consume available capital resources before then. The Company’s capital requirements depend on numerous factors, including the ability of the Company to continue to generate software sales, 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. The Company’s forecasts of the period of time through which its financial resources will be adequate to support its operations are forward looking information, and actual results could vary. The factors described earlier in this paragraph will impact the Company’s future capital requirements and the adequacy of its available funds.

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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 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 transaction was completed on April 30, 2004. The transaction has resulted in PDD being an independent, publicly-traded company.

        We believe that separating PDD from Accelrys will resolve difficulties we have encountered regarding the effective operation and development of the two businesses within a single publicly-traded corporation. We further believe the spin-off will enhance the performance of Accelrys by providing the company with greater focus on its software business and with a clearer story to enable investors to better evaluate the company and assign an appropriate market valuation. There can be no assurance that Accelrys, as a stand-alone entity, will be able to benefit from these items.

        Accelrys has not been an independent company, and will no longer be 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; after a transition period following the distribution, each company will be responsible for fulfilling these functions independently. Our estimates concerning the costs for independent corporate administrative functions (such as overhead functions, corporate governance, securities compliance, exchange listing and investor relations services) may be substantially lower than the actual costs incurred. As a result, it will be difficult for anyone to accurately forecast future operating performance for Accelrys. Further, Accelrys may need to obtain financing on a stand-alone basis after the spin-off, which may be difficult because financial and other resources may not be as strong as they were prior to the distribution. Any future financing will have to be raised without reference to or reliance on the financial condition of the historical consolidated company. There can be no assurance that Accelrys will be able to obtain financing after the distribution on acceptable terms, or at all.

        The combined market value of our shares and those of PDD after the spin-off may not be equal to or greater than the market value of our shares prior to the distribution. There is no assurance that an active public market for our common stock will be sustained. In addition, the smaller size of the market capitalization of the Company after the distribution compared to our market capitalization prior to the distribution may result in our loss of stock research analyst coverage, which could adversely impact each entity’s stock market following. Further, the market price of our stock may fluctuate substantially, as in recent years the stock market has experienced significant price and volume changes and the Company’s stock price has been volatile. In addition, following the distribution, our current stockholders will now own separate securities in PDD and the Company. The possibility remains that some stockholders may sell shares of our common stock for various reasons, including the fact that the business profile or market capitalization of that entity as a stand-alone company does not fit their investment objectives. Given the large concentration of our stockholdings among our top six stockholders, substantial sales of shares by one or more of these stockholders could depress the market price for our shares.

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        If the distribution is taxable, stockholders could be required to pay tax on the fair market value of the shares of PDD common stock received, and we could incur a corporate tax liability. If the spin-off fails to qualify as a tax-free distribution for U.S. federal income tax purposes, our stockholders who received PDD shares would be treated as if they had received a taxable distribution in an amount equal to the fair market value of the PDD common stock received. In such event, a corporate income tax could also be payable by us on the excess of the fair market value of the PDD stock over our adjusted tax basis in the stock. Further, even if the distribution is tax-free to our stockholders, we could be subject to corporate income tax on any gain inherent in PDD’s stock if one or more persons acquire a 50% or greater interest in PDD as part of a plan or series of related transactions that included the spin-off.

        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 after the distribution 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.

CERTAIN RISKS RELATED TO OUR BUSINESS

         Pharmaceutical and biotechnology 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 research and development expenditures could harm our operations.

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         Our ability to increase revenue and grow our business is dependent upon our success in adding new customers and expanding our existing customer relationships. In order to generate the additional revenue needed to grow, we must add new customers and retain, and expand upon, our existing customer relationships. These efforts depend significantly upon, among other factors:

• our successful development of new products;
• the success of our business development, sales and marketing efforts; and
• the willingness of current and potential biotechnology, pharmaceutical, chemical, petrochemical and diversified technology customers to invest in new modeling, simulation and informatics solutions.

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

         Our future profitability is uncertain. We generated losses in 2002, 2003, the three months ended March 31, 2004 and June 30, 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:

• 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 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, and 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 pharmaceutical, biotechnology, chemical and technology companies. A component of our business strategy is to develop strategic relationships with larger pharmaceutical, biotechnology, chemical and technology companies. We believe that through such relationships we can add revenue, expand our distribution channels, maximize our research and development resources, improve our competitive position and increase market awareness and acceptance of 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.

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         We are subject to risks associated with the operation of an international business. For the three months ended June 30, 2004, approximately 56% of the Company’s consolidated revenue was derived from customers outside the United States, both through international subsidiaries and on an export basis. Approximately 26% of our revenue was derived from customers in Europe and approximately 30% 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 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.

         Investments in Sales and Business Development Efforts. Accelrys 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. In these circumstances, our results of operations and ability to achieve profitability are adversely affected.

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         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.

         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.

         Because our stock price may be volatile, our stock price could experience substantial declines. The market price of our common stock has historically experienced and may continue to experience volatility. Our quarterly operating results, changes in general conditions in the economy or the financial markets and other developments affecting us or our competitors could cause the market price of our common stock to fluctuate substantially. In addition, in recent years, the stock market has experienced significant price and volume fluctuations and, during the past two years, the stock market (and in particular technology companies) has experienced significant decreases in market value. This volatility and the recent market decline has affected the market prices of securities issued by many companies, often for reasons unrelated to their operating performance, and may adversely affect the price of our common stock.

         As institutions hold the majority of our Common Stock in large blocks, substantial sales by these stockholders could depress the market price for our shares. As of July 2004, the top ten institutional holders of our common stock held approximately 53% of our outstanding common stock. As a result, if one or more of these major stockholders were to sell all or a portion of their holdings, or if the market were to perceive that such sale or sales may occur, the market price of our common stock may fall significantly.

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

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         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.

         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;
• 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.

        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.

         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.

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         Our ability to increase Accelrys software revenue may depend upon increased market acceptance of our products and services. Accelrys products are currently used primarily by molecular modeling and simulation and gene sequence analyses specialists. Our strategy is to expand usage of our products and services by marketing and distributing our software, in part through our desktop-based products, 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 may restrict substantially the future growth of our software business and may have a material adverse effect on our company as a whole.

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

• adding more computational modeling, simulation, and analyses tools to our current portfolio of tools for chemists and biologists;
• offering more 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; and
• developing more knowledge management workflow software to automate the flow of genomic, biological and chemical data and information and project status between and among workgroups and the enterprise.
• 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.

         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. Competition currently comes from the following principal sources:

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

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• 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 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.

         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 impacted by, the current tightening of available credit and capital, and general economic slowdown occurring in the United States and our other key markets. As a result of these conditions, our customers may be unable to license or, if under a license, may be unable to pay for, Accelrys software products. If we are not able to collect such amounts, we may be required to write-off significant accounts receivable and recognize bad debt expense. As a result of the exposures above and other potential exposures, we recorded a provision for doubtful accounts of $1.3 million and $0.4 million in 2002 and 2003, respectively. Failure of these businesses, write-offs and difficulties associated with collection of receivables from these customers, could materially adversely affect our operating results.

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

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         Our quarterly operating results in the software business could vary significantly. We have historically experienced stronger financial performance in the third and fourth calendar quarters of each year followed by a comparative decline in the first and second quarters. Quarterly operating results may continue to fluctuate as a result of a number of factors, including lengthy sales cycles, market acceptance of new products and upgrades, timing of new product introductions, changes in pricing policies, changes in general economic and competitive conditions, seasonal slowdowns, and the timing and integration of acquisitions. Additionally, changes in the timing of revenue recognition may result if subscription 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.

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.

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         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

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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.

         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.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company is exposed to various market risks consisting primarily of changes in foreign currency exchange rates. The Company’s international sales generally are denominated in local currencies. In the quarter ended June 30, 2004, approximately 56% of the Company’s consolidated revenue was derived from customers outside the United States (including 26% from customers in Europe and 30% from customers in the Asia/Pacific region). As such, the Company’s exchange rate risk is greatest for Dollar/Euro and Dollar/Yen fluctuations. When deemed appropriate, the Company engages in exchange rate-hedging transactions in an attempt to mitigate the impact of adverse exchange rate fluctuations. At June 30, 2004, the Company had no hedging transactions in effect.

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

The Company’s exposure to market risks associated with changes in interest rates relates primarily to the increase or decrease in the amount of interest income earned on its investment portfolio since the Company has minimal debt. The Company ensures the safety and preservation of invested funds by limiting default risks, market risk, and reinvestment risk. The Company mitigates default risk by investing in investment grade securities. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of the Company’s interest sensitive financial instruments at June 30, 2004.

Item 4. Controls and Procedures

        The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2004. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2004. There were no material changes in the Company’s internal control over financial reporting during the three months ended June 30, 2004.

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PART II — OTHER INFORMATION

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SIGNATURE

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

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ACCELRYS, INC.

INDEX TO EXHIBITS

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