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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For The Quarterly Period Ended June 30, 2004

OR

Commission File Number: 0-19171

ICOS CORPORATION

(Exact name of registrant as specified in its charter)

(425) 485-1900

(Registrant’s telephone number, including area code)

Not Applicable

(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 for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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.

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ICOS CORPORATION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

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PART 1. Financial Information

ITEM 1. Financial Statements

ICOS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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ICOS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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ICOS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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ICOS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, unless otherwise noted)

(unaudited)

1. Summary of Significant Accounting Policies

The accompanying condensed consolidated financial statements present the results of operations, financial position and cash flows of ICOS Corporation and its wholly-owned subsidiaries, herein collectively referred to as ICOS. All material intercompany transactions and balances between entities consolidated in these financial statements have been eliminated.

The accompanying condensed consolidated financial statements have not been audited. We have condensed or omitted certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States. We believe the disclosures made are adequate to make the information presented not misleading. However, you should read these condensed consolidated financial statements in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Ultimate results could differ from those estimates.

In our opinion, the accompanying condensed consolidated financial statements include all adjustments, consisting only of normal recurring items, necessary to present fairly our financial position as of June 30, 2004 and December 31, 2003, and our results of operations for the three and six months ended June 30, 2004 and 2003, and our cash flows for the six months ended June 30, 2004 and 2003. Interim results are not necessarily indicative of results for a full year.

Stock Based Compensation

We apply the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for our employee stock option grants. Accordingly, we do not recognize compensation expense for options granted to employees with an exercise price equal to or in excess of the fair value of the underlying common shares at the date of grant. We recognize compensation expense for restricted stock grants over the applicable vesting period.

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Had we determined compensation cost based on the fair value of our stock options on the grant date under Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation,” our net loss and net loss per share would have been the following pro forma amounts:

The estimated per share weighted-average grant date fair value of stock options awarded during the three and six months ended June 30, 2004, was $20.83 and $27.15, respectively, and $18.84 and $17.16, respectively, during the three and six months ended June 30, 2003. Amounts were determined using the Black-Scholes option pricing model based on the following assumptions:

In March 2004, the Financial Accounting Standards Board issued an Exposure Draft of a proposed Statement of Financial Accounting Standards entitled “Share-Based Payment.” This proposed Statement addresses accounting for stock based compensation and would result in stock based compensation costs, including options, being recognized as an expense in the financial statements. The proposed Statement would eliminate the ability to account for stock based compensation transactions using APB Opinion No. 25, and generally would require that such transactions be accounted for using a fair value based method. If approved, the proposed Statement would be applied to public entities, prospectively, for fiscal years beginning after December 15, 2004.

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2. Revenue from Collaborations and Licenses of Technology

The following tables summarize our revenue from collaborations with related parties and licenses of technology for the three and six months ended June 30, 2004 and 2003.

3. Lilly ICOS Operating Results

Lilly ICOS, our 50/50 owned joint venture with Eli Lilly and Company (Lilly), is marketing its first commercial product, Cialis^® (tadalafil), for the treatment of erectile dysfunction, in North America and Europe. Cialis is also available outside of North America and Europe, in which markets Lilly has exclusive rights and pays royalties to Lilly ICOS equal to 20% of net sales. Cialis is currently available in approximately 70 countries worldwide.

The following table summarizes the operating results of Lilly ICOS for the three and six months ended June 30, 2004 and 2003.

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4. Comprehensive Loss

5. Net Loss per Common Share

Net loss per common share is calculated using the weighted-average number of common shares outstanding during the period. For the three and six months ended June 30, 2004, shares issuable upon exercise of options to acquire 11.1 million shares of common stock and 4.5 million shares of common stock issuable upon the conversion of convertible subordinated debt, were excluded from the computation of net loss per common share because their impact would be antidilutive. For the three and six months ended June 30, 2003, shares issuable upon exercise of options to acquire 10.7 million shares of common stock, shares issuable upon exercise of warrants to acquire 7.4 million shares of common stock, and 4.1 million shares of common stock issuable upon the conversion of convertible subordinated debt, were excluded from the computation of net loss per common share because their impact would be antidilutive.

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

The following management discussion and analysis is intended to provide information which will enhance a reader’s understanding of our business, results of operations, financial condition and related matters. It is organized as follows:

ICOS is a biotechnology company that is dedicated to bringing innovative therapeutic products to patients. We are marketing our first product, Cialis (tadalafil), for the treatment of erectile dysfunction, through Lilly ICOS. Our goal is to develop and commercialize treatments for serious unmet medical needs, such as chronic obstructive pulmonary disease (COPD), benign prostatic hyperplasia (BPH), cancer and inflammatory diseases.

Cialis (tadalafil)

Our first commercial product, Cialis, is being prescribed around the world for patients with erectile dysfunction. Cialis is being marketed by Lilly ICOS, which has rights to commercialize Cialis in North America and Europe. Lilly has exclusive rights to market Cialis in the remainder of the world, and pays royalties to Lilly ICOS, equal to 20% of net sales, in those territories. Cialis is currently available in approximately 70 countries worldwide.

Later this year, we expect to begin a clinical study of tadalafil to treat patients with BPH, a condition characterized by benign enlargement of the prostate gland which can cause a number of troublesome urinary tract symptoms as a man ages. It is estimated that over 6 million men in the U.S. and Europe are receiving drug treatment for BPH.¹

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IC485

IC485 is an orally administered, small molecule PDE4 inhibitor that is currently in clinical development. In the fourth quarter of 2003, we initiated a Phase 2 clinical study with IC485 for the potential treatment of COPD. We expect to complete this study and provide clinical data in the first half of 2005.

Discovery and Preclinical Research

We continue to evaluate possible new product candidates in our discovery and preclinical research programs and expect to advance one or two new molecules into Phase 1 clinical studies over the next year or so. Our most advanced discovery and preclinical research compounds include additional phosphodiesterase inhibitors for inflammatory and other diseases, an oral leukocyte function-associated antigen one (LFA-1) antagonist for psoriasis, a cell cycle checkpoint inhibitor for cancer and an oral kinase antagonist used as a modulator of B lymphocyte function for inflammatory diseases, such as autoimmune disorders, and for cancer.

Results of Operations

Critical Accounting Policies and Estimates

Our critical accounting policies and estimates are identified and discussed in our Annual Report on Form 10-K for the year ended December 31, 2003. They include revenue recognition, accounting for our share of the operating results of our unconsolidated affiliates and estimating expenses from third party contract research and clinical study activities.

General

Our results of operations may vary significantly from period to period. Operating results will depend on, among other factors, the timing, cost and success of new product launches by ICOS or its affiliates, competition for our or our affiliates’ products, the timing of expenses, continued funding by collaboration partners, and the timing and progression of research, development, marketing and sales activities. We may experience significant fluctuations in collaboration revenue from related parties (cost reimbursement revenue), revenue from licenses of technology and contract manufacturing revenue. Cost reimbursement revenue will vary depending upon the timing and amount of marketing and sales activities, the extent and timing of research and development collaboration activities, and our level of participation in those activities. Revenue from licenses of technology will vary as a result of (i) the nature and extent of product collaboration and other licensing transactions, (ii) the timing of milestone payments, and (iii) changes in estimated development costs and/or expected completion dates, which depend on the success of clinical studies and other research and development efforts. Contract manufacturing revenue may fluctuate depending upon our needs to manufacture our own internal product candidates, our ability to attract third parties to utilize any remaining manufacturing capacity and the particular terms of the manufacturing agreements. Changes in joint venture collaboration activities, including both research and development programs and activities associated with commercialized products, are subject to the joint oversight of the collaborating parties, and could cause the amount of affiliate losses to fluctuate significantly from period to period.

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Net Loss

We reported a net loss of $51.9 million ($0.82 per share) for the three months ended June 30, 2004, compared to a net loss of $11.5 million ($0.19 per share) for the three months ended June 30, 2003. We reported a net loss of $138.2 million ($2.18 per share) for the six months ended June 30, 2004, compared to a net loss of $52.0 million ($0.84 per share) for the six months ended June 30, 2003.

Revenue

Total revenue for the second quarter of 2004 was $17.9 million, compared to $26.7 million for the second quarter of 2003. Total revenue for the first six months of 2004 was $34.4 million, compared to $33.8 million for the first six months of 2003.

Cost reimbursement revenue totaled $14.7 million in the second quarter of 2004, compared to $2.6 million in the second quarter of 2003, and was $28.8 million for the first six months of 2004, compared to $8.0 million for the first six months of 2003. The 2004 increases, for both periods, reflect higher cost reimbursement from Lilly ICOS, primarily for our sales force that is promoting Cialis in the United States. Cost reimbursement revenue in 2003 included amounts associated with our terminated Pafase^® (rPAF-AH) and endothelin receptor antagonist programs.

We did not recognize any revenue from licenses of technology in 2004, compared to $21.3 million and $22.0 million, respectively, for the second quarter and first six months of 2003. 2003 technology license fee revenue included $21.3 million recognized in conjunction with our reacquisition, from Biogen, of sole development rights to the LFA-1 antagonist program.

Contract manufacturing revenue was $3.2 million in the second quarter of 2004, compared to $2.7 million in the second quarter of 2003, and was $5.7 million for the first six months of 2004, compared to $3.8 million for the first six months of 2003. The increases reflect greater utilization of manufacturing capacity for third-party contracts and other services provided under the associated agreements.

Operating Expenses

Total operating expenses were $34.7 million in the second quarter of 2004, compared to $30.6 million in the second quarter of 2003. Total operating expenses were $68.4 million for the first six months of 2004, compared to $60.9 million for the first six months of 2003.

Research and development. Research and development expenses decreased $5.6 million from the second quarter of 2003, to $17.5 million in the second quarter of 2004. Research and development expenses decreased $13.5 million from the first six months of 2003, to $34.8 million for the first six months of 2004. These decreases were primarily due to discontinuation of certain clinical programs in 2003 and early 2004, partially offset by the costs of incremental Lilly ICOS research and development activities being performed by ICOS personnel in 2004.

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The following table provides information regarding our research and development expenses, by project, for the three and six months ended June 30, 2004 and 2003:

Through June 30, 2004, cumulative research and development expenditures for IC485 were $31.1 million. Because of the uncertainties of clinical research and development, at this time we are unable to provide estimates of project completion dates, the timing of our research and development efforts and the costs of completing research and development for IC485.

Marketing and selling. Marketing and selling expenses increased $8.9 million from the second quarter of 2003, to $10.1 million in the second quarter of 2004. Marketing and selling expenses increased $17.7 million from the first six months of 2003, to $19.9 million in the first six months of 2004. These increases reflect costs associated with our U.S. sales force promoting Cialis. For the most part, our U.S. sales force was recruited, trained and initially deployed in the 2003 third quarter.

Cost of contract manufacturing. Contract manufacturing expenses increased $0.8 million from the second quarter of 2003, to $3.0 million in the second quarter of 2004. Contract manufacturing expenses increased $2.5 million from the first six months of 2003, to $5.5 million in the first six months of 2004. These increases reflect greater utilization of manufacturing capacity for third-party contracts and other services provided under the associated agreements.

General and administrative. General and administrative expenses were $4.0 million in both the second quarter of 2004 and 2003, and were $8.2 million in the first six months of 2004, compared to $7.5 million in the first six months of 2003. General and administrative expenses consist primarily of costs associated with corporate support functions, general management and other activities not related to research and development, marketing and sales or contract manufacturing.

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Equity in Losses of Lilly ICOS

In the second quarter of 2004, our equity in losses of Lilly ICOS totaled $35.1 million, compared to $20.0 million in the second quarter of 2003. For the first six months of 2004, our equity in losses of Lilly ICOS totaled $104.3 million, compared to $41.6 million for the first six months of 2003. Lilly ICOS losses increased, in 2004, primarily due to sales and marketing costs associated with the launches of Cialis in the United States, Canada and Mexico. See Lilly ICOS Results of Operations below.

Interest Expense

In the second quarter and first six months of 2004, we incurred $1.7 million and $3.4 million, respectively, of interest expense on $278.7 million of 2% convertible subordinated notes, issued in mid-2003.

Gain on Sale of Partnership Interests

In the second quarter of 2003, we recognized a $10.0 million gain upon the sale of our partnership interests in ICOS-TBC to Encysive Pharmaceuticals, Inc.

Interest and Other Income

Interest and other income was $1.7 million in the second quarter of 2004, compared to $2.3 million in the second quarter of 2003, and $3.5 million in the first six months of 2004, compared to $6.1 million in the first six months of 2003. The decreases reflect lower average interest rates earned in 2004, partially offset by the impact of higher average balances during the 2004 period, due to investment of the proceeds from our mid-2003 convertible debt offering. Interest and other income for the first six months of 2003 included $1.2 million in gains on the sale of investment securities realized in the 2003 first quarter.

Lilly ICOS Results of Operations

Cialis is being manufactured and marketed, in North America and Europe, by Lilly ICOS. Lilly markets Cialis elsewhere in the world, and pays royalties, to Lilly ICOS, equal to 20% of net sales in those territories.

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For the second quarter ended June 30, 2004, Lilly ICOS reported a net loss of $70.5 million, compared to a net loss of $40.1 million for the second quarter ended June 30, 2003. For the six months ended June 30, 2004, Lilly ICOS reported a net loss of $209.3 million, compared to a net loss of $83.2 million for the six months ended June 30, 2003. Worldwide net product sales of Cialis for the three and six month periods ended June 30, 2004 and 2003 were as follows:

Total Lilly ICOS revenue for the second quarter of 2004 was $111.4 million, compared to $25.0 million for the second quarter of 2003. Total Lilly ICOS revenue for the first six months of 2004 was $193.1 million, compared to $42.6 million for the first six months of 2003. Revenue for the 2004 second quarter included $6.4 million in royalties on Cialis sales reported by Lilly, compared to $3.1 million in royalties for the second quarter of 2003. Revenue for the first six months of 2004 included $13.1 million in royalties, compared to $4.1 million in royalties for the first six months of 2003. The 2004 increases in revenue, for both the quarter and year-to-date, reflect the global expansion of Cialis availability, from introduction in Europe, Australia and New Zealand in February 2003, to approximately 70 countries worldwide at June 30, 2004.

Total expenses were $181.9 million in the second quarter of 2004, compared to $65.1 million in the second quarter of 2003. Total expenses were $402.4 million in the first six months of 2004, compared to $125.7 million in the first six months of 2003.

Cost of sales increased $6.8 million from the second quarter of 2003, to $9.0 million in the second quarter of 2004, and $11.8 million from the first six months of 2003, to $15.6 million in the first six months of 2004. As a percent of net product sales, cost of sales was 8.6% in the second quarter of 2004, compared to 9.9% in the second quarter of 2003, and 8.6% in the first six months of 2004, compared to 9.8% in the first six months of 2003.

Selling, general and administrative expenses increased $109.3 million from the second quarter of 2003, to $157.8 million in the second quarter of 2004. Selling, general and administrative expenses increased $262.0 million from the first six months of 2003, to $352.9 million in the first six months of 2004. The increases are primarily due to 2004 sales and marketing activities and programs associated with the launches of Cialis in the United States, Canada and Mexico.

Research and development expenses were $15.1 million in the second quarter of 2004, compared to $14.3 million in the second quarter of 2003, and were $33.9 million in the first six months of 2004, compared to $31.0 million in the first six months of 2003.

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Liquidity and Capital Resources

At June 30, 2004, we had cash, cash equivalents, investment securities and associated interest receivable of $354.0 million, compared to $469.5 million at December 31, 2003. The decrease primarily reflects cash used in operations and to fund our investment in Lilly ICOS.

We used $30.9 million in cash for operating activities during the first six months of 2004, compared to $42.9 million during the first six months of 2003. The change in operating cash flow reflects higher cost reimbursements collected in 2004, partially offset by higher cash operating expenses, including interest, in 2004.

We used $127.1 million in cash for investing activities during the first six months of 2004, compared to generating $94.0 million from investing activities in the first six months of 2003. Cash used for investing activities in the first six months of 2004 included a $41.0 million net increase in our investment portfolio, compared to a $138.3 million net decrease in our investment portfolio during the first six months of 2003. The increase in our investment portfolio in 2004 reflects conversion of cash equivalents held at the end of the prior year into investments with slightly longer maturities. Investing outflows in the first six months of 2004 included $89.3 million of affiliate capital contributions, compared to $47.1 million of affiliate capital contributions in the first six months of 2003. Cash inflows from investing activities in 2004 and 2003 also included $6.0 million and $4.0 million, respectively, in proceeds associated with the sale of our partnership interests in ICOS-TBC.

We generated $5.7 million in cash proceeds from stock options in the first six months of 2004, for 0.5 million shares of our common stock, compared to $5.1 million in the first six months of 2003, for 0.5 million shares of our common stock. Financing cash inflows for the first six months of 2003 also included (i) approximately $242.2 million of net proceeds from the private placement of convertible subordinated notes and (ii) $4.3 million in borrowings under a line of credit with Biogen, which were subsequently forgiven.

Our existing cash and cash equivalents, investment securities, interest income from our investments, cash flow from other operating activities, including anticipated payments from Lilly ICOS and cash flow from potential future collaborations, may be sufficient to fund our future operations over the next few years. However, in view of the early stage of the commercialization of Cialis in North America and Europe, our ongoing research and development efforts, and potential expansion of our operations through in-licensing or other means, it is possible that we may need to seek additional financing sometime over that period. Additional financing may not be available when we need it or may be unavailable on acceptable terms. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures, for some of our marketing and selling activities or our research and development programs, or grant rights to third parties to develop and market product candidates that we would prefer to develop and market on our own.

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Our future cash requirements will depend on various factors which, to some extent, are beyond our control, including:

We have engaged in collaborations and joint development agreements with other parties where the capabilities and strategies of the other parties complement ours. Although corporate collaborations, partnerships and joint ventures have provided cost reimbursement revenue to us in the past, we cannot assure you that this type of revenue will be available to us in the future. The vast majority of our cost reimbursement revenue, through August 2003, was for reimbursement of the cost of research and development services that we provided. Beginning in September 2003, collaboration revenue includes reimbursement for the cost of sales services that we provide to Lilly ICOS related to commercialization of Cialis in the United States.

We intend to expand our operations and portfolio of product candidates in clinical studies, as well as to continue discovery and preclinical research to identify additional product candidates. We also intend to continue to engage in pre-marketing activities necessary to bring our product candidates to market and to expand marketing and selling capabilities for our approved product. Due to the uncertainties of drug development and commercialization, as discussed elsewhere herein, we are unable to determine if, or when, any of our current product candidates will begin to generate net cash inflows.

In the future, we may pursue new growth opportunities in a variety of ways including, but not limited to, internal discovery and development of new products, in-licensing of products and technologies and/or merger or acquisition of companies with desirable products and/or technologies. Expansion of our operations, including the U.S. launch of Cialis, will increase our future operating expenses. Furthermore, we may need to make incremental expenditures for additional laboratory, production and office facilities to accommodate the activities and personnel associated with these increased development and commercialization efforts. Any of these activities may require substantial capital investment.

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Important Factors Regarding Forward-Looking Statements

This report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “possible,” “potential,” “predict,” “should” or “will” or the negative of such terms or other comparable terminology. Forward-looking statements are only predictions that provide our current expectations or forecasts of future events. In particular, forward-looking statements include:

From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public, such as other filings with the Securities and Exchange Commission, press releases or in our communications and discussions with investors and analysts at meetings and on webcasts and telephone calls. Any or all of our forward-looking statements in this report and in any other public statements that we make may turn out to be wrong. Inaccurate assumptions we might make and known and unknown risks, uncertainties and other factors may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, based on the information available to us at the time the statements are made, we cannot guarantee future results, performance or achievements. You should not place undue reliance on these forward-looking statements.

Except as required under federal securities laws and regulations, we do not have any intention or obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and Annual Reports on Form 10-K. Also note that we provide a cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our business under the caption Risk Factors in this report. These Risk Factors could cause our actual results to differ materially from expected or historical results.

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Risk Factors

ICOS operates in an environment that involves a number of risks and uncertainties. The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may impair our business operations. If any of the following risks actually occur, our business, operating results and financial position could be harmed.

Risks Related to Our Business

We have a history of losses and may never achieve profitability.

We have incurred significant operating losses since we began operations in 1990. As of June 30, 2004, we had an accumulated deficit of $727.7 million. We currently do not expect to achieve profitability, on a quarterly basis, for at least two years. Even if we do become profitable, we cannot assure you that we would be able to sustain or increase profitability on a quarterly or annual basis. We anticipate that operating expenses will increase in the future as we continue development of our potential products, seek to obtain necessary regulatory approvals and manufacture and market these product candidates. Directly, and through Lilly ICOS, we expect to incur substantial marketing and other costs related to commercializing Cialis in the United States, Europe, Mexico and Canada. Even if we successfully develop other products, we may be unable to generate sufficient revenues from Cialis and other products to achieve and maintain profitability.

Our operating results are subject to fluctuations that may cause our stock price to decline.

Our operating results have fluctuated in the past and are likely to continue to do so in the future. Our revenue is unpredictable and may fluctuate due to many factors, some of which we cannot control. For example, factors affecting our revenues presently or in the future could include:

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Revenue historically recognized under our prior collaborative agreements is not an indicator of revenue from any future collaborations. In addition, our expenses, including payments owed by us under licensing or collaborative arrangements, are unpredictable and may fluctuate from quarter to quarter. We believe that quarter to quarter comparisons of our operating results are not a good indicator of our future performance and should not be relied upon to predict our future performance.

It is possible that, in the future, our operating results in a particular quarter or quarters will not meet the expectations of securities analysts or investors, causing the market price of our common stock to decline. In the past, some companies that have experienced decreases in the market price of their stock have been subject to securities class action litigation. A securities class action lawsuit against us could result in substantial damages, costs and a diversion of our management’s attention and resources.

Even though Cialis has been approved for commercial sale, if we or others identify previously unknown side effects, approval could be withdrawn or sales of Cialis could be significantly reduced.

If we or others identify previously unknown side effects, or if manufacturing problems occur:

Any of the above occurrences could harm or prevent sales of Cialis or could increase the costs and expenses of commercializing and marketing Cialis.

We may be unable to establish sales and marketing capabilities necessary to successfully commercialize Cialis or our potential products.

We have little experience in selling or marketing pharmaceutical products and have only recently hired experienced sales and marketing managers and pharmaceutical sales representatives. Lilly is providing the majority of the sales and marketing resources to Lilly ICOS. Because we expect to market or co-market Cialis and our potential products through a direct sales force, we will need to either successfully deploy our sales force or contract with a third party to provide a sales force to meet our needs. We may be unable to establish marketing, sales and distribution capabilities necessary to commercialize and gain market acceptance for Cialis or for our potential products. In addition, co-promotion or other marketing arrangements with others to commercialize potential products could significantly limit the revenues we derive from these potential products, and these parties may fail to commercialize our potential products successfully.

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The success of Cialis depends, in large part, on the promotion, sales and distribution activities of our partner, Lilly.

Through Lilly ICOS, we and Lilly have joint responsibility for the promotion, sale and distribution of Cialis in North America and Europe. In addition, Lilly has promotion, sales and distribution rights to Cialis for the other parts of the world, with royalties to be paid to Lilly ICOS. We believe that, for Cialis to be widely adopted, the efforts of a sizeable, experienced pharmaceutical sales force are needed. We expect to rely heavily on Lilly for promotion, sales and marketing of Cialis, even with respect to our joint responsibilities, because we have limited staff, capabilities and experience in these areas, and we may or may not be capable of independently fulfilling our responsibilities. If Lilly fails to devote appropriate resources to promote, sell and distribute Cialis, sales of Cialis could be reduced. In addition, if Lilly breaches or terminates its agreement with us, or otherwise fails to conduct its activities related to Cialis in a timely manner, sales of Cialis could be delayed, reduced or become substantially more costly for us to achieve.

Cialis and our potential products, even if approved by the FDA or regulatory agencies outside of the United States, may not achieve market acceptance among hospitals, insurers or patients.

Failure of Cialis and our potential products to achieve market acceptance would impair our ability to become profitable. We believe that the degree of market acceptance of Cialis and our potential products will depend on:

In addition, market acceptance depends on the effectiveness of our marketing strategies in the face of intense competition. To date, we have relied significantly on the marketing experience of Lilly, as we have limited sales and marketing experience or capabilities.

We may be unable to compete successfully in the markets for pharmaceutical and biotechnological products.

The markets in which we compete are well established and intensely competitive. We may be unable to compete successfully against our current and future competitors. Our failure to compete successfully may result in pricing reductions, reduced gross margins, failure to achieve market acceptance for our products and an inability to achieve profitability.

Cialis and our potential products, if approved and commercialized, compete or will compete against well-established existing therapeutic products or treatments. For example, Pfizer Inc. has already successfully commercialized Viagra^® (sildenafil citrate), a PDE5 inhibitor that competes with our product, Cialis. Also, Bayer AG, together with its marketing partner GlaxoSmithKline, began marketing Levitra^® (vardenafil HCl) in the United States in August 2003. The FDA approved Cialis for sale in the United States in November 2003. Pfizer, Bayer AG

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and GlaxoSmithKline have invested substantial resources in marketing their PDE5 inhibitor products, and we would anticipate that they would continue their efforts to aggressively compete in this market. In addition, a number of pharmaceutical and biotechnology companies are currently developing new products targeting the same diseases and medical conditions that we target.

Our competitors include pharmaceutical companies, biotechnology companies, academic and research institutions and government agencies. Many of these organizations, including those named in the preceding paragraph, have substantially more experience and more capital, research and development, regulatory, manufacturing, sales, marketing, human and other resources than we do. Furthermore, large pharmaceutical companies have been consolidating, which has increased their resources and concentrated valuable intellectual property assets. As a result, our competitors may:

We face, and will continue to face, intense competition from other companies for collaborative arrangements with pharmaceutical and biotechnology companies, for relationships with academic and research institutions, and for licenses to proprietary technology. In addition, we anticipate that we will face increased competition in the future as new companies enter our markets and as scientific developments surrounding protein-based and small molecule therapeutics continue to accelerate.

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Our preclinical tests and clinical studies may fail to demonstrate the safety and efficacy of our product candidates, which could prevent or significantly delay their regulatory approval.

Successful development of pharmaceutical and biotechnology products is highly uncertain, and very few research and development projects produce a commercial product. Any failure or substantial delay in completing clinical studies for our product candidates may severely harm our business. We must subject our potential product candidates to extensive preclinical and clinical testing to demonstrate their safety and efficacy for humans before obtaining regulatory approval for the sale of any of such products. Clinical studies are expensive, time-consuming and may take years to complete. We may not complete preclinical tests and clinical studies of product candidates under development, and the results of the tests and studies may fail to demonstrate the safety or efficacy of such product candidates to the extent necessary to obtain regulatory approvals or to make commercialization of the product candidates worthwhile. At any time during these clinical studies, factors such as ineffectiveness of the product candidate, discovery of unacceptable toxicities or side effects, development of disease resistance or other physiological factors, or delays in patient enrollment, could cause us to interrupt, limit, delay or abort the development of these product candidates.

In addition, success in preclinical and early clinical studies does not ensure that late-stage or large-scale studies will succeed. Many companies in the pharmaceutical and biotechnology industries, including us, have suffered significant setbacks in clinical studies, even after promising results had been obtained in earlier studies. We have stopped two late-stage, Phase 3 clinical studies of product candidates following interim analyses: a Phase 3 study of Pafase for the treatment of severe sepsis was stopped in late 2002; and a study of LeukArrest^™ (rovelizumab) for the treatment of ischemic stroke was stopped in early 2000. In January 2004, results of a Phase 2 clinical study of RTX for the treatment of interstitial cystitis showed that RTX was not effective in relieving patients’ symptoms. We anticipate that only some of our product candidates may show safety and efficacy in clinical studies and many may encounter difficulties or delays during clinical development.

Government regulatory authorities may not approve our product candidates or may delay their approval.

Any failure to receive the regulatory approvals necessary to commercialize our product candidates could cause our business to fail. Our product candidates are subject to extensive and rigorous government regulation. For example, the FDA regulates, among other things, the development, testing, manufacture, safety, efficacy, record keeping, labeling, storage, approval, advertising, promotion, sale and distribution of pharmaceutical products. Our products marketed abroad are also subject to extensive regulation by foreign governments. Except for Cialis, none of our product candidates has been approved for sale in any country. In addition, we have only limited experience in filing and pursuing applications necessary to gain regulatory approvals, which may impede our ability to obtain such approvals.

The regulatory review and approval process, which includes preclinical and clinical studies of each product candidate, is lengthy, expensive and uncertain. To secure FDA approval, we must submit extensive preclinical and clinical data and supporting information to the FDA, for each indication for which we are seeking approval, to

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establish the product candidate’s safety and efficacy. The approval process may take years to complete and may involve ongoing requirements for post-marketing studies. Any FDA or other regulatory approval of our product candidates, once obtained, may be withdrawn. The effect of government regulation may be to:

In addition, regulatory compliance may prevent us from introducing new or improved products or may require us to stop marketing products. If we fail to comply with the laws and regulations pertaining to our business, we may be subject to sanctions, including the temporary or permanent suspension of operations, product recalls, marketing restrictions and civil and criminal penalties.

We may be unable to establish or maintain the manufacturing capabilities necessary to develop and commercialize our products.

We do not have facilities to manufacture small molecule products, such as Cialis, and we do not have sufficient manufacturing capacity to manufacture biological product candidates in quantities necessary for commercial sale. In addition, our manufacturing capacity may be inadequate to complete all clinical studies contemplated by us over time. We intend to rely significantly on contract manufacturers, including collaboration partners, to produce large quantities of drug material needed for clinical studies and commercialization of Cialis and our potential products. We will have to depend on these manufacturers to deliver materials on a timely basis and to comply with regulatory requirements, including Good Manufacturing Practices, or GMP, regulations enforced by the FDA through its facilities inspection program. Contract manufacturers may be unable to meet our needs with respect to timing, quantity or quality of materials, and may fail to satisfy applicable regulatory requirements with respect to the manufacture of these materials. If we are unable to contract for a sufficient supply of needed materials on acceptable terms, or if we should encounter delays or difficulties in our relationships with manufacturers, our revenues and potential profitability may be lower. For example, our ability to satisfy demand for our products could be reduced, which could adversely affect our operating results. Further, our clinical studies may be delayed, which would delay the submission of product candidates for regulatory approval and the market introduction and subsequent commercialization of our potential products.

Manufacturing product candidates in compliance with regulatory requirements is complex, time-consuming and expensive. If we make changes in our manufacturing processes, the FDA and corresponding foreign authorities may require us to demonstrate that the changes have not caused the resulting drug material to differ significantly from the drug material previously produced. Also, we may want to rely on results of prior preclinical and clinical studies performed using the previously produced drug material. Depending on the type and degree of differences between the newer and older drug material, we may be required to conduct additional animal and clinical studies to demonstrate that the newly produced drug material is sufficiently similar to the previously produced drug material.

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We have made manufacturing changes and are likely to make additional manufacturing changes for the production of our product candidates currently in development. Manufacturing changes could result in delays in development or regulatory approval or in reduction or interruption of commercial sales of our potential products, any of which could impair our competitive position.

We may develop our manufacturing capacity in part by expanding our current facilities or building or purchasing new facilities. Any of these activities would require substantial additional funds, and we would need to hire and train significant numbers of employees to staff these facilities. We may be unable to develop manufacturing facilities that are sufficient to produce drug material for clinical studies or commercial use. Moreover, we and any contract manufacturers that we may use must continually adhere to current GMP regulations. The FDA pre-market approval of our product candidates will not be granted if our facilities or the facilities of contract manufacturers cannot pass a preapproval plant inspection. In complying with these regulations and foreign regulatory requirements, we and any of our contract manufacturers will be obligated to expend time, money and effort in production, record keeping and quality control in an effort to ensure that our potential products meet applicable specifications and other requirements. If we or any of our contract manufacturers fail to comply with these requirements, we may be subject to regulatory sanctions.

Cialis is currently manufactured for Lilly ICOS by Lilly and it is expected that Cialis will continue to be manufactured by Lilly for sale in all markets where regulatory approval is granted.

Our business may be harmed if we cannot obtain sufficient quantities of raw materials and process them reliably and timely.

We depend on others for the timely supply of raw materials used to manufacture Cialis and to conduct preclinical testing and clinical studies of product candidates. Once a supplier’s materials have been selected for use in our manufacturing process, the supplier in effect becomes a sole or limited source of that raw material due to regulatory compliance procedures. Presently, Lilly is the sole authorized provider of the active pharmaceutical ingredient, or API, utilized in the manufacture of Cialis, and all API production for Cialis is conducted at a single Lilly facility. Lilly relies on a third-party vendor which has the exclusive rights to mill the API to conform the drug substance to specifications used in the manufacturing process. Once milled, the refined API is shipped to various Lilly locations, where the drug substance is manufactured into tablets, packaged and made ready for sale. At each of these stages in the manufacturing process, Lilly ICOS depends on an exclusive provider (i.e., Lilly or another vendor) for the timely supply and processing of raw materials. If any of these suppliers or processing facilities were to cease production or otherwise fail to supply Lilly ICOS with raw materials or manufacturing services in a timely manner, Lilly ICOS and ICOS could be materially adversely affected. Similar risks exist with respect to raw materials used in testing and developing our other product candidates.

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If we are unable to adequately protect our intellectual property rights and legal right to sell Cialis, the value of Cialis or of our potential products could be diminished.

Our success depends to a significant extent on our ability and the ability of our collaboration partners to obtain, maintain and enforce patents and other proprietary rights. Our success, and that of our collaboration partners, is also dependent upon our and our collaboration partners’ ability to lawfully make, use and sell our products. Patent law relating to the scope of claims in the biotechnology field in which we operate is still evolving and subject to a substantial degree of uncertainty. Accordingly, there may be third-party patents or patent applications relevant to Cialis or our potential products that might block or compete with the technologies and products covered by our patents or patent applications. We also cannot be certain that our pending patent applications will result in issued patents, or that others have not filed patent applications for technology covered by our pending applications, or that we were the first to invent the technology.

Additionally, although we own or control a number of patents, the issuance of a patent is not conclusive as to its validity or enforceability; third parties therefore may challenge the validity or enforceability of our patents. We cannot assure you how much protection, if any, will be given to our patents if we attempt to enforce them and they are challenged in court or in other proceedings. It is possible that a competitor may successfully challenge our patents or that challenges will result in revocation or invalidation of the patents or in limitations of their coverage. Furthermore, the cost of litigation and administrative proceedings to uphold the validity and enforceability of patents can be substantial. If we are unsuccessful in such proceedings, third parties may be able to use our patented technologies without paying licensing fees or royalties to us.

Moreover, competitors may infringe our patents or successfully avoid them through design innovation. To prevent infringement or unauthorized use, we may need to file infringement claims, which are expensive and time-consuming. In an infringement proceeding a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the ground that its technology is not covered by our patents. Policing unauthorized use of our intellectual property is difficult. We cannot assure you that we will be able to detect and prevent misappropriation of our proprietary rights, particularly in countries where the laws may not protect such rights as fully as in the United States.

In addition to our patented technology, we also rely on unpatented technology, trade secrets and confidential information. We may be unable to effectively protect our rights to this technology or information. Other parties may independently develop substantially equivalent information and techniques or otherwise gain access to or disclose our technology. It is our policy to require each of our employees, consultants and corporate partners to execute a confidentiality and intellectual property agreement at the commencement of an employment, consulting or collaborative relationship with us. These agreements may not, however, provide effective protection of our technology or information and, in the event of unauthorized use or disclosure, they may not provide adequate remedies.

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We may be subject to substantial costs and liability or be prohibited from commercializing Cialis and our potential products as a result of patent infringement litigation and other proceedings relating to patent rights.

Patent litigation is very common in the pharmaceutical industry. We cannot assure you that third parties will not assert patent or other intellectual property infringement claims against us or our collaboration partners with respect to technologies used in Cialis or in our potential products.

For example, on October 22, 2002, the U.S. Patent and Trademark Office (PTO) issued to Pfizer a “method of use” U.S. Patent No. 6,469,012. Later that day, Pfizer filed a lawsuit in United States District Court for the District of Delaware against ICOS, Lilly and Lilly ICOS alleging that the proposed marketing of Cialis would infringe this patent. In September 2003, the PTO ordered the reexamination of U.S. Patent No. 6,469,012. The reexamination process is provided for by law and requires the PTO to consider the validity of the patent based on substantial new questions of patentability raised by the PTO. In October 2003, ICOS, Lilly ICOS and Lilly filed a motion for a stay with the District Court to suspend the patent infringement lawsuit, pending the outcome of the reexamination. In November 2003, the judge granted the requested stay. We believe that Pfizer’s lawsuit lacks merit and intend to vigorously pursue our defenses.

The Pfizer suit and any additional claims that might be brought against us relating to infringement of patents may cause us to incur significant expenses and, if successfully asserted against us, may cause us to pay substantial damages. Furthermore, as a result of a patent infringement suit brought against us or our collaboration partners, we or our collaboration partners may be forced to stop or delay developing, manufacturing or selling Cialis or potential products that are claimed to infringe a third party’s intellectual property unless that party grants us or our collaboration partners rights to use its intellectual property. We or our collaboration partners may be unable to obtain these rights on commercially reasonable terms, if at all. Even if we or our collaboration partners were able to obtain rights to the third party’s intellectual property, these rights may be nonexclusive, thereby giving our competitors access to the same intellectual property. For example, if Pfizer were to prevail in its suit against us, we might be subject to substantial damages, prohibited from marketing Cialis for the treatment of erectile dysfunction in the United States, or required to enter into a license agreement to market Cialis in the United States. We cannot assure you that any required agreement would be available on commercially reasonable terms, if at all. In the event that we are unable to profitably market Cialis in the United States, our future financial condition, and our ability to obtain additional funding, would be adversely affected, including our ability to pursue our product development programs.

Ultimately we may be unable to commercialize Cialis or some of our potential products or may have to cease some of our business operations as a result of patent infringement claims, which could severely harm our business. Even if we were to prevail, any litigation could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations.

Additionally, we may have to resort to costly and time-consuming proceedings and litigation to determine the validity or scope of the proprietary rights of others. For example, we, Lilly and eleven other companies were involved in an opposition proceeding in the European Patent Office in which we opposed a patent previously granted

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by the European Patent Office to Pfizer. This patent (EP702555) is a “method of use” patent related to U.S. Patent No. 6,469,012 subsequently granted to Pfizer in the United States. Although the opposition proceeding was successful before the Opposition Division of the European Patent Office, which, on July 18, 2001, revoked all of the claims, Pfizer has appealed. Pfizer’s European patent had been nationalized by Pfizer in most European countries. Lilly ICOS brought suits challenging the patent in several of these countries. Generally, these cases have been stayed pending the appellate decision in the opposition proceeding before the European Patent Office. The resolution of the European Patent Office appeal and pending or subsequent litigation in the various European countries could take years. If Pfizer’s patent were not ultimately revoked by the European Patent Office or by the courts in European countries, we might be subject to litigation by Pfizer in Europe, prohibited from marketing Cialis for the treatment of erectile dysfunction in some European countries, or required to enter into license agreements to market Cialis in Europe. We cannot assure you that such agreements would be available on commercially reasonable terms, if at all.

We, Lilly and Lilly ICOS, as appropriate, have also initiated or are defending lawsuits against Pfizer in other jurisdictions around the world with respect to patents corresponding to Pfizer’s U.S. and the European Patent Office “method of use” patents. Presently, litigation is pending in Australia, Brazil, Canada, Mexico, New Zealand and South Africa. Litigation in other countries may ensue as the world-wide commercialization of Cialis proceeds. The resolution of the litigation in these various countries could take years. If Pfizer’s patent in any one or more of the countries were not ultimately revoked by the courts, Lilly ICOS or Lilly might be prohibited from marketing Cialis for the treatment of erectile dysfunction in those countries, or be required to enter into license agreements to market Cialis in those countries. We cannot assure you that such agreements would be available on commercially reasonable terms, if at all.

Furthermore, after seeking advice of counsel, we may undertake research and development with respect to potential products even when we are aware of third-party patents that may be relevant to these potential products, on the basis that such third-party patents may be challenged or licensed by us. We may be subject to patent infringement claims if our subsequent challenges to such patents were not to prevail. In addition, if our subsequent attempts to license such patents were to prove unsuccessful, we may be unable to commercialize these potential products after having incurred significant expenditures.

We may be required to defend lawsuits or pay damages in connection with the alleged or actual harm caused by Cialis or our product candidates.

We face inherent exposure to product liability claims in the event that the use of Cialis or our product candidates is alleged to have resulted in harm to others. This risk exists with respect to usage in clinical studies as well as for products that we sell. We may incur significant liability if product liability or malpractice lawsuits against us are successful. Furthermore, product liability claims, regardless of their merits, could be costly and divert management’s attention from other business concerns, or adversely affect our reputation and the demand for our products. Although we maintain product liability insurance, we cannot be certain that this coverage is adequate or that it will continue to be available to us on acceptable terms.

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If we are unable to obtain additional funding needed to develop, market and sell our potential products, we could be required to delay, scale back or eliminate expenditures for some of our programs or grant rights to third parties to develop and market our potential products.

Our business does not currently generate the cash needed to finance our operations. We will require substantial financial resources to conduct the time-consuming and costly research, preclinical development, clinical studies, manufacturing, regulatory, and sales and marketing activities necessary to commercialize our potential products. We may need to seek additional financing through public or private sources, including equity or debt financings, and through other alternatives, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements. Financing may, however, be unavailable when we need it or may not be available on acceptable terms, if at all. If we raise additional funds by issuing common stock or convertible debt securities, the percentage ownership of our existing stockholders could be reduced. Any debt or equity securities that we issue may have rights superior to those of our common stock. We may also issue debt that has rights superior to those of the holders of our convertible subordinated debt. If we are unable to raise additional funds when we need them, we could be required to delay, scale back or eliminate expenditures for some of our development programs or grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally. If we are required to grant such rights, the ultimate value of these product candidates to us may be reduced.

We have a significant amount of debt that may adversely affect our financial condition.

We have outstanding $278.7 million aggregate principal amount of convertible subordinated notes, bearing interest at 2%. The notes mature on July 1, 2023. However, on July 1, 2010, July 1, 2013 and July 1, 2018, holders of the notes may require us to repurchase all or part of their notes, for cash, at a price equal to 100% of the principal amount of the notes plus accrued interest. This is a significant amount of debt that carries a substantial debt service obligation. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required principal and interest payments on the notes, we will be in default under the terms of an indenture, which could, in turn, cause defaults under our future debt obligations.

Even if we are able to meet our debt service obligations, the amount of debt we have could materially and adversely affect us in a number of ways, including by:

Our ability to meet our debt service obligations will depend on our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control.

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If we fail to negotiate or maintain successful collaborative arrangements with third parties, our development and marketing activities may be delayed or reduced.

We have entered into, and we expect to continue to enter into, collaborative arrangements with third parties who provide us with funding, intellectual property and/or who perform research, development, regulatory compliance, manufacturing, or marketing activities relating to Cialis and some or all of our product candidates. If we fail to secure or maintain successful collaborative arrangements, our development and marketing activities may be delayed or reduced. Currently, we have collaborative arrangements with Lilly, other companies and research laboratories. We may be unable to negotiate additional collaborative arrangements or, if necessary, modify our existing arrangements on acceptable terms.

Our collaborative agreements can be terminated by our partners under certain conditions. In addition, our partners may separately pursue competing products, therapeutic approaches or technologies to develop treatments for the diseases targeted by us or our collaborative efforts. Even if our partners continue their contributions to the collaborative arrangements, they may nevertheless determine not to actively pursue the development or commercialization of any resulting products. Disputes may arise between us and our partners as to a variety of matters, including obligations under our agreements and ownership of intellectual property rights. Also, our partners may fail to perform their obligations under the collaborative arrangements or may be slow in performing their obligations. In addition, our partners may experience financial difficulties at any time that could prevent them from having available funds to contribute to these collaborations. In these circumstances, our ability to develop and market potential products could be severely limited.

Acquisitions, mergers or investments in businesses, products or technologies could harm our business, operating results and stock price.

We may acquire, merge with or invest in other businesses, products or technologies that are intended to complement our existing business. From time to time in the ordinary course of business, we have had discussions and negotiations with companies regarding business combinations or investing in these companies’ businesses, products or technologies. Our management has limited or no prior experience in assimilating acquired or merged companies. Any acquisitions or investments we complete will likely involve some or all of the following risks: