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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the transition period from        to       

Commission File Number: 0-27488

INCYTE CORPORATION

(Exact name of registrant as specified in its charter)

Experimental Station, Route 141 & Henry Clay Road,

Building E336, Wilmington, DE  19880

(Address of principal executive offices)

(302) 498-6700

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x   Yes      o   No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o   Yes      x No

The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 97,171,223 as of November 4, 2008.

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INCYTE CORPORATION

INDEX

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PART I:    FINANCIAL INFORMATION

Item 1.    Financial Statements

INCYTE CORPORATION

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

*          The condensed consolidated balance sheet at December 31, 2007 has been derived from the audited financial statements at that date.

See accompanying notes.

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INCYTE CORPORATION

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)

See accompanying notes.

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INCYTE CORPORATION

Condensed Consolidated Statements of Comprehensive Loss

(in thousands)

(unaudited)

See accompanying notes.

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INCYTE CORPORATION

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

See accompanying notes.

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INCYTE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008

(Unaudited)

1.      Organization and business

Incyte Corporation (“Incyte,” “we,” “us,” or “our”) is a drug discovery and development company focused on developing proprietary small molecule drugs to treat serious unmet medical needs.  We have a pipeline with programs in oncology, inflammation, diabetes, and human immunodeficiency virus (HIV).

2.      Summary of significant accounting policies

Basis of presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  The condensed consolidated balance sheet as of September 30, 2008 and the condensed consolidated statements of operations, comprehensive loss, and cash flows for the three and nine months ended September 30, 2008 and 2007 are unaudited, but include all adjustments, consisting only of normal recurring adjustments, which we consider necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.  The condensed consolidated balance sheet at December 31, 2007 has been derived from audited financial statements.

Although we believe that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote information normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year.  The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Fair Value Measurements

We adopted Financial Accounting Standards Board Statement No. 157, Fair Value Measurements (“SFAS 157”) effective January 1, 2008.  SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (“the exit price”) in an orderly transaction between market participants at the measurement date.  The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures.  In determining fair value we use quoted prices and observable inputs. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of us. The fair value hierarchy is broken down into three levels based on the source of inputs as follows:

Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 – Valuations based on observable inputs and quoted prices in active markets for similar assets and liabilities.

Level 3 – Valuations based on inputs that are unobservable and models that are significant to the overall fair value measurement.

We have determined that our fair value requirements are in accordance with the requirements of SFAS 157, therefore, the implementation of SFAS 157 did not have any impact on our consolidated financial condition or results of operations.  Our marketable securities consist of investments in corporate debt securities, mortgage backed securities, U.S. Treasury notes, and other U.S. government agency securities that are classified as available-for-sale.  We classify marketable securities available to fund current operations as current assets on the condensed consolidated balance sheet.  Marketable securities are classified as long-term assets on the consolidated balance sheets if (i) they have been in an unrealized loss position for longer than six months and (ii) we have the ability to hold them until the carrying value is recovered and such holding period may be longer than one year.

The following fair value hierarchy table presents information about each major category of our financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2008 (in thousands):

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Recent Accounting Pronouncements

In May 2008, the Financial Accounting Standards Board issued Staff Position No. Accounting Principles Board 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“FSP No. APB 14-1”).  FSP No. APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s nonconvertible debt borrowing rate.  FSP No. APB 14-1 is effective for us as of January 1, 2009.  We do not expect the adoption of APB 14-1 to have a material impact on our consolidated financial statements.

3.      Revenues

For the three and nine months ended September 30, 2008, one customer contributed 42% and 30% of revenues, respectively.  For the three and nine months ended September 30, 2007, one customer contributed 84% and 83% of revenues, respectively.

Three customers comprised 79% of the accounts receivable balance at September 30, 2008.  Three customers comprised 68% of the accounts receivable balance at December 31, 2007.

4.      Collaborative research and license agreement

Effective in January 2006, we entered a collaborative research and license agreement with Pfizer Inc. (“Pfizer”) for the pursuit of our CCR2 antagonist program.  Pfizer gained worldwide development and commercialization rights to our portfolio of CCR2 antagonist compounds.  Pfizer’s rights extend to the full scope of potential indications, with the exception of multiple sclerosis and autoimmune nephritides, where we retained worldwide rights, along with certain compounds.  We do not have obligations to Pfizer on pre-clinical development candidates we select for pursuit in these indications.  The agreement will terminate upon the expiration of the last to expire of patent rights licensed under the agreement. Prior to such expiration, either party can terminate the agreement for the uncured material breach of the agreement by the other party or for the insolvency of the other party. In addition, Pfizer may terminate the agreement at any time upon 90 days’ notice.  We received an upfront nonrefundable, non-creditable payment of $40 million in January 2006 and are eligible to receive additional future development and milestone payments.

We determined that there were two deliverables under the agreement:  (i) the worldwide license and (ii) our obligations in connection with a research plan (the “Research Plan”), which were limited to completion of chemistry and biology research services on Pfizer’s behalf by our full time equivalents (FTEs).  We concluded that these deliverables should be accounted for as a single unit of accounting and the $40 million upfront payment should be recognized as revenue over the two year term that we complete our obligations in connection with the Research Plan, our estimated performance period under the agreement.  We have no further substantive obligations to Pfizer after the completion of our obligations in connection with the Research Plan.  All milestone payments will be recognized as revenue upon the achievement of the associated milestone.  Consistent with the terms of the agreement and our original expectations at the inception of the agreement, the Research Plan concluded after two years in January 2008 and, as such, there are no remaining substantive obligations to Pfizer under the agreement.

Contract revenues related to the upfront consideration received, research services provided to Pfizer, and the difference between the cash received and the present value of convertible subordinated notes issued to Pfizer (the “Pfizer Notes”), of approximately $0.7 million were recognized for the nine months ended September 30, 2008 and $5.9 million and $20.9 million were recognized for the three and nine months ended September 30, 2007, respectively.

5.      Stock compensation

Under the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123R”), we recorded $3.9 million and $11.1 million of stock compensation expense on our unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2008.  We recorded $2.6 million and $7.4 million of stock compensation expense on our

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unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2007, respectively.  We utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted, with the following weighted-average assumptions:

The risk-free interest rate is derived from the U.S. Federal Reserve rate in effect at the time of grant.  The expected life calculation is based on the observed and expected time to the exercise of options by our employees based on historical exercise patterns for similar type options.  Expected volatility is based on the historical volatility of our common stock over the period commensurate with the expected life of the options.   A dividend yield of zero is assumed based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends.  Options granted have a seven-year term and vest over a three-year period with a one-year cliff (i.e., vesting occurs as to one-third (1/3) at the end of the first year and in equal monthly installments on a monthly basis for the remaining two years).

Based on our historical experience, we have assumed an annualized forfeiture rate of 5% for our options.  Under the true-up provisions of SFAS 123R, we will record additional expense if the actual forfeiture rate is lower than we estimated, and will record a recovery of prior expense if the actual forfeiture is higher than we estimated.

The amortization of stock compensation under SFAS 123R for the period after its adoption was calculated in accordance with FASB Interpretation (“FIN”) No. 28.  Total compensation cost of options granted but not yet vested, as of September 30, 2008, was $11.4 million, which is expected to be recognized over the weighted average period of 3.05 years.

The following table summarizes activity under all stock option plans:

6.      Common stock offering

On August 6, 2008, we completed a public offering of 12,075,000 shares of our authorized but unissued common stock at a price to the public of $9.00 per share pursuant to an effective shelf registration statement, resulting in net proceeds of approximately $101.7 million after deducting the underwriting discounts and offering expenses.  Entities affiliated with Julian C. Baker, one of our directors and principal stockholders, purchased an aggregate of 1,100,000 shares of our common stock in this offering.

7.      Net loss per share

For all periods presented, both basic and diluted net loss per common share are computed by dividing the net loss by the number of weighted average common shares outstanding during the period.  Stock options and potential common shares issuable upon conversion of our 3½% convertible senior notes due 2011 (the “3½% Senior Notes”), 3½% convertible subordinated notes due 2011 (the “3½% Subordinated Notes”), and the Pfizer Notes were excluded from the computation of diluted net loss per share, as their share effect was anti-dilutive for all periods presented.  The potential common shares that were excluded from the diluted net loss per share

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computation at September 30, 2008 and 2007, respectively, are as follows:

8.      Segment reporting

Our operations are treated as one operating segment, drug discovery and development, in accordance with FASB Statement No. 131 Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”).

9.    Other expenses

Below is a summary of the activity related to other expenses recorded for the periods in which activity related to our restructuring programs has taken place through the nine months ended September 30, 2008.  The estimates below have been made based upon management’s best estimate of the amounts and timing of certain events included in the restructuring plan that will occur in the future. It is possible that the actual outcome of certain events may differ from the estimates.  Changes will be made to the restructuring accrual at the point that the differences become determinable.  The accrual balances for the restructuring plans are included in accrued restructuring and other liabilities (long-term) in the consolidated balance sheets.

2004 Restructuring

2002 Restructuring

Maxia Acquisition Costs

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

The following discussion of our financial condition and results of operations as of and for the three and nine months ended September  30, 2008 should be read in conjunction with the financial statements and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q and our audited financial statements as of and for the year ended December 31, 2007 included in our Annual Report on Form 10-K previously filed with the SEC.

This report contains forward-looking statements that involve risks and uncertainties.  These statements relate to future periods, future events or our future operating or financial plans or performance.  These statements can often be identified by the use of forward-looking terminology such as “expects,” “believes,” “intends,” “anticipates,” “estimates,” “plans,” “may,” or “will,” or the negative of these terms, and other similar expressions.  These forward-looking statements include statements as to:

·   the discovery, development, formulation, manufacturing and commercialization of our compounds and our product candidates;

·   focus on our drug discovery and development efforts;

·   conducting clinical trials internally, with collaborators, or with clinical research organizations;

·   our collaboration and strategic alliance strategy; anticipated benefits and disadvantages of entering into collaboration agreements;

·   our licensing, investment and commercialization strategies;

·   the regulatory approval process, including determinations to seek U.S. Food and Drug Administration (FDA) and other international health authorities approval for, and plans to commercialize, our products in the United States and abroad;

·   the safety, effectiveness and potential benefits and indications of our product candidates and other compounds under development; potential uses for our product candidates and our other compounds;

·   the timing and size of our clinical trials; the compounds expected to enter clinical trials; timing of clinical trial results;

·   our ability to manage expansion of our drug discovery and development operations;

·   future required expertise relating to clinical trials, manufacturing, sales and marketing;

·   obtaining and terminating licenses to products, compounds or technology, or other intellectual property rights;

·   the receipt from or payments pursuant to collaboration or license agreements resulting from milestones or royalties; the decrease in revenues from our information product-related activities;

·   plans to develop and commercialize products on our own;

·   plans to use third party manufacturers;

·   expected expenses and expenditure levels; expected uses of cash; expected revenues and sources of revenues;

·   expected losses; fluctuation of losses;

·   our profitability; the adequacy of our capital resources to continue operations;

·   the need to raise additional capital;

·   the costs associated with resolving matters in litigation;

·   our expectations regarding competition;

·   our investments, including anticipated expenditures, losses and expenses;

·   our gene and genomics-related patent prosecution and maintenance efforts; and

·   our indebtedness, and debt service obligations.

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These forward-looking statements reflect our current views with respect to future events, are based on assumptions and are subject to risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from those projected and include, but are not limited to:

·    our ability to discover, develop, formulate, manufacture and commercialize a drug candidate or product;

·   the risk of unanticipated delays in research and development efforts;

·   the risk that previous preclinical testing or clinical trial results are not necessarily indicative of future clinical trial results;

·   risks relating to the conduct of our clinical trials;

·   changing regulatory requirements;

·   the risk of adverse safety findings;

·   the risk that results of our clinical trials do not support submission of a marketing approval application for our product candidates;

·   the risk of significant delays or costs in obtaining regulatory approvals;

·   risks relating to our reliance on third party manufacturers, collaborators, and clinical research organizations;

·   risks relating to the development of new products and their use by us and our current and potential collaborators;

·   risks relating to our inability to control the development of out-licensed drug compounds or drug candidates;

·   our ability to in-license a potential drug compound or drug candidate;

·   the cost of accessing, licensing or acquiring potential drug compounds or drug candidates developed by other companies;

·   the costs of terminating any licensing or access arrangement for third party drug compounds or drug candidates;

·   costs associated with prosecuting, maintaining, defending and enforcing patent claims and other intellectual property rights;

·   our ability to maintain or obtain adequate product liability and other insurance coverage;

·   the risk that our product candidates may not obtain regulatory approval;

·   the impact of technological advances and competition;

·   the ability to compete against third parties with greater resources than ours;

·   competition to develop and commercialize similar drug products;

·   our ability to obtain patent protection and freedom to operate for our discoveries and to continue to be effective in expanding our patent coverage;

·   the impact of changing laws on our patent portfolio;

·   developments in and expenses relating to litigation;

·   the impact of past or future acquisitions on our business;

·   the results of businesses in which we have made investments;

·   our ability to obtain additional capital when needed;

·   fluctuations in net cash used by investing activities;

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·   our history of operating losses; and

·   the risks set forth under “Risk Factors.”

Given these risks and uncertainties, you should not place undue reliance on these forward-looking statements. Except as required by federal securities laws, we undertake no obligation to update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

In this report all references to “Incyte,” “we,” “us” or “our” mean Incyte Corporation and our subsidiaries, except where it is made clear that the term means only the parent company.

Incyte is our registered trademark.  We also refer to trademarks of other corporations and organizations in this Quarterly Report on Form 10-Q.

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Overview

Incyte is a drug discovery and development company focused on developing proprietary small molecule drugs to treat serious unmet medical needs. We have a pipeline with programs in oncology, inflammation, diabetes and human immunodeficiency virus (HIV).

Our wholly-owned pipeline includes the following compounds:

In March 2008, we announced that we would not advance our lead CCR5 antagonist into Phase IIb trials and that we are seeking to out-license this program. This decision reflects our objective to focus our resources on programs that we believe have the greatest near-term value.

We anticipate incurring additional losses for several years as we expand our drug discovery and development programs.  We also expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial.  Conducting clinical trials for our drug candidates in development is a lengthy, time-consuming and expensive process.  We do not expect to generate product sales from our drug discovery and development efforts for several years, if at all. If we are unable to successfully develop and market pharmaceutical products over the next several years, our business, financial condition and results of operations would be adversely impacted.

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Critical Accounting Policies and Significant Estimates

The preparation of financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from those estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements:

·    Revenue recognition;

·    Research and development costs;

·    Valuation of long-lived assets;

·    Restructuring charges; and

·    Stock compensation.

Revenue Recognition.   Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectibility is reasonably assured.  We have entered into various types of agreements for access to our information databases and use of our intellectual property.  Revenues are deferred for fees received before earned or until no further obligations exist.  We exercise judgment in determining that collectibility is reasonably assured or that services have been delivered in accordance with the arrangement.  We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment.  We assess collectibility based primarily on the customer’s payment history and on the creditworthiness of the customer.

Revenues from ongoing database agreements are recognized evenly over the access period.  Revenues from licenses to our intellectual property are recognized when earned under the terms of the related agreements.  Royalty revenues are recognized upon the sale of products or services to third parties by the licensee or other agreed upon terms.  We estimate royalty revenues based on previous period royalties received and information provided by the third party licensee.  We exercise judgment in determining whether the information provided by licensees is sufficiently reliable for us to base our royalty revenue recognition thereon.

Under agreements involving multiple products, services and/or rights to use assets, the multiple elements are divided into separate units of accounting when certain criteria are met, including whether the delivered items have stand alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items.  When separate units of accounting exist, consideration is allocated among the separate elements based on their respective fair values.  The determination of fair value of each element is based on objective evidence from historical sales of the individual elements by us to other customers.  If such evidence of fair value for each undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value for each undelivered element does exist or until all elements of the arrangement are delivered.  When elements are specifically tied to a separate earnings process, revenue is recognized when the specific performance obligation tied to the element is completed.  When revenues for an element are not specifically tied to a separate earnings process, they are recognized ratably over the term of the agreement.

In connection with our collaborative research and license agreement with Pfizer Inc. (“Pfizer”), we received an upfront non-refundable payment of $40.0 million in January 2006.  The $40.0 million upfront fee was recorded as deferred revenue and was recognized on a straight-line basis over two years, our estimated performance period under the agreement.   In February 2006 and October 2007, Pfizer purchased, for a total of $20.0 million, a convertible subordinated note due 2013 and a convertible subordinated note due 2014 (collectively, the “Pfizer Notes”).  As the Pfizer Notes are non-interest bearing, they have been discounted to their net present value.  The difference between the cash received and the present value of the Pfizer Notes, plus the related beneficial conversion feature, totals $3.2 million for each note, which represented additional consideration from Pfizer under the agreement.  We have accounted for this additional consideration as deferred revenue and have recognized it over our estimated performance period under the agreement.   We recognized contract revenues for research services provided by our full time equivalents to Pfizer in the periods in which the services were performed.  We received a $3.0 million milestone payment from Pfizer in the second quarter of 2007.  All milestone payments will be recognized as revenue upon the achievement of the associated milestone.

Research and Development Costs.   In accordance with Statement of Financial Accounting Standards No. 2 (“SFAS 2”), Accounting for Research and Development Costs, it is our policy to expense research and development costs as incurred.  We often contract with clinical research organizations (“CROs”) to facilitate, coordinate and perform agreed upon research and development of a new drug.  To ensure that research and development costs are expensed as incurred, we record monthly accruals for clinical trials and preclinical testing costs based on the work performed under the contract.

These CRO contracts typically call for the payment of fees for services at the initiation of the contract and/or upon the achievement of

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certain clinical trial milestones.  In the event that we prepay CRO fees, we record the prepayment as a prepaid asset and amortize the asset into research and development expense over the period of time the contracted research and development services are performed in accordance with EITF 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities.  Most professional fees, including project and clinical management, data management, monitoring, and medical writing fees are incurred throughout the contract period.  These professional fees are expensed based on their percentage of completion at a particular date.

Our CRO contracts generally include pass through fees.  Pass through fees include, but are not limited to, regulatory expenses, investigator fees, travel costs, and other miscellaneous costs, including shipping and printing fees.  We expense the costs of pass through fees under our CRO contracts as they are incurred, based on the best information available to us at the time.  The estimates of the pass through fees incurred are based on the amount of work completed for the clinical trial and are monitored through correspondence with the CROs, internal reviews and a review of contractual terms.  The factors utilized to derive the estimates include the number of patients enrolled, duration of the clinical trial, estimated patient attrition, screening rate and length of the dosing regimen.   CRO fees incurred to set up the clinical trial are expensed during the setup period.

Valuation of Long-Lived Assets.   We assess the impairment of long-lived assets, which includes property and equipment as well as intangible and other assets, whenever events or changes in circumstances indicate that the carrying value may not be recoverable.  Factors we consider important that could indicate the need for an impairment review include the following:

·    Significant changes in the strategy of our overall business;

·    Significant underperformance relative to expected historical or projected future operating results;

·    Significant changes in the manner of use of the acquired assets;

·    Significant negative industry or economic trends;

·    Significant decline in our stock price for a sustained period; and

·    Our market capitalization relative to net book value.

When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 144, Accounting for the Impairment or Disposal of Long Lived Assets (“SFAS 144”), we perform an undiscounted cash flow analysis to determine if impairment exists.  If impairment exists, we measure the impairment based on the difference between the asset’s carrying amount and its fair value.

Restructuring Charges.   Costs associated with restructuring activities initiated after December 31, 2002, are accounted for in accordance with FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”).  Costs associated with restructuring activities initiated prior to December 31, 2002 have been recorded in accordance with Emerging Issues Task Force (“EITF”) Issue No. 94-3,  Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)  (“EITF 94-3”) and Staff Accounting Bulletin No. 100, Restructuring and Impairment Charges  (“SAB 100”).  Restructuring costs resulting from the acquisition of Maxia Pharmaceuticals, Inc. (“Maxia”) have been recorded in accordance with EITF Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination (“EITF 95-3”).  The restructuring charges are comprised primarily of costs to exit facilities, reduce our workforce, write-off fixed assets, and pay for outside services incurred in the restructuring.  The workforce reduction charge is determined based on the estimated severance and fringe benefit charge for identified employees.  In calculating the cost to exit the facilities, we estimate for each location the amount to be paid in lease termination payments, the future lease and operating costs to be paid until the lease is terminated, the amount, if any, of sublease receipts and real estate broker fees.  This requires us to estimate the timing and costs of each lease to be terminated, the amount of operating costs, and the timing and rate at which we might be able to sublease the site.  To form our estimates for these costs, we perform an assessment of the affected facilities and consider the current market conditions for each site.  We also estimate our credit adjusted risk free interest rate in order to discount our projected lease payments in accordance with SFAS 146.  Estimates are also used in our calculation of the estimated realizable value on equipment that is being held for sale.  These estimates are formed based on recent history of sales of similar equipment and market conditions.  Our assumptions on either the lease termination payments, operating costs until terminated, the offsetting sublease receipts and estimated realizable value of fixed assets held for sale may turn out to be incorrect and our actual cost may be materially different from our estimates.  Our estimates of future liabilities may change, requiring us to record additional restructuring charges or reduce the amount of liabilities recorded.

At the end of each reporting period, we evaluate the remaining accrued balances to ensure their adequacy, that no excess accruals are retained and the utilization of the provisions are for their intended purposes in accordance with developed exit plans.  We periodically evaluate current available information and adjust our restructuring reserve as necessary.  We also make adjustments related to accrued professional fees to adjust estimated amounts to actual.

Stock Compensation.  Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123R”), Share-Based Payment, which revised Statement of Financial Accounting Standards 123 (“SFAS 123”), Accounting for Stock-Based Compensation. SFAS 123R requires all share-based payment transactions with employees,

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including grants of employee stock options, to be recognized as compensation expense over the requisite service period based on their relative fair values.  SFAS 123R requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility and expected option lives, as well as expected option forfeiture rates, to value equity-based compensation.  SFAS 123R requires the recognition of the fair value of stock compensation in the statement of operations.  Prior to the adoption of SFAS 123R, stock-based compensation expense related to employee stock options was not recognized in the statement of operations.  Prior to January 1, 2006, we had adopted the disclosure-only provisions under SFAS 123.  Under the provisions of SFAS 123R, we recorded $3.9 million and $11.1 million of stock compensation expense for the three and nine months ended September 30, 2008, respectively, and $2.6 million and $7.4 million for the three and nine months ended September 30, 2007, respectively.

Results of Operations

We recorded net losses of $44.8 million and $130.5 million and basic and diluted net losses per share of $0.48 and $1.50 per share for the three and nine months ended September 30, 2008, respectively, as compared to net losses of $24.5 million and $65.1 million and basic and diluted net losses per share of $0.29 and $0.77 per share in the corresponding periods in 2007.

Revenues.

Our contract revenues for the nine months ended September 30, 2008 decreased to $0.7 million from $20.9 million for the nine months ended September 30, 2007 as we have fully recognized at September 30, 2008 contract revenues associated with the Pfizer $40.0 million upfront fee, the debt discount and beneficial conversion feature related to the Pfizer Notes and the reimbursement of certain expenses by Pfizer for research and development expenses pursuant to the collaborative research and license agreement.

Our license and royalty revenues for the nine months ended September 30, 2008 decreased to $2.3 million from $3.8 million for the nine months ended September 30, 2007.    License and royalty revenues were derived from the licensing of our gene- and genomic-related intellectual property.   We expect that revenues generated from information products, including licensing of gene- and genomic-related intellectual property, will decline as we focus on our drug discovery and development programs.

Operating Expenses.

Research and development expenses.

We currently track research and development costs by natural expense line and not costs by project.  For salary and benefit related costs, the increase from the three and nine months ended September 30, 2007 to the three and nine months ended September 30, 2008 was primarily the result of increased headcount to sustain our development pipeline.  Stock compensation increased for the three and nine months ended September 30, 2008 as compared to the three and nine months ended September 30, 2007 due primarily to an increase in our average stock price.  Stock compensation expense may fluctuate from period to period based on the number of options granted, stock price volatility and expected option lives, as well as expected option forfeiture rates which are used to value equity-based compensation.  For clinical research and outside services, the increase from the three and nine months ended September 30, 2007 to the three and nine months ended September 30, 2008 is due primarily from the growth and advancement of our clinical pipeline.  The decrease in occupancy and all other costs for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 is due primarily to a decrease in depreciation expense.

Research and development expenses may fluctuate from period to period depending upon the stage of certain projects and the level of

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pre-clinical and clinical trial-related activities.  Many factors can affect the cost and timing of our clinical trials, including requests by regulatory agencies for more information, inconclusive results requiring additional clinical trials, slow patient enrollment, adverse side effects among patients, insufficient supplies for our clinical trials and real or perceived lack of effectiveness or safety of our investigational drugs in our clinical trials.  In addition, the development of all of our products will be subject to extensive governmental regulation. These factors make it difficult for us to predict the timing and costs of the further development and approval of our products.

Selling, general and administrative expenses.

Salary and benefits related expenses were consistent for the three and nine months ended September 30, 2008 as compared to the corresponding periods in 2007.  Stock compensation increased for the three and nine months ended September 30, 2008 as compared to the three and nine months ended September 30, 2007 due primarily to an increase in our average stock price.  Stock compensation expense may fluctuate from period to period based on the number of options granted, stock price volatility and expected option lives, as well as expected option forfeiture rates which are used to value equity-based compensation.   Other contract service and outside costs increased for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 due primarily to increased professional services fees.

Other expenses.     Total other expenses for the three and nine months ended September 30, 2008 were $(0.1) million and $(0.9) million, respectively, compared to $(0.6) million and $(0.5) million, respectively, for the corresponding periods in 2007, and represent gains recorded from changes in estimated sublease income from a facility closed in connection with previously announced restructuring programs.

Interest and Other Income, net.     Interest and other income, net, for the three and nine months ended September 30, 2008 was $1.3 million and $4.7 million, respectively, compared to $2.9 million and $10.7 million for the corresponding periods in 2007.   The decrease is due primarily to lower average cash balances and lower interest rates for the three and nine months ended September 30, 2008 as compared to the corresponding periods in 2007.

Interest Expense.    Interest expense for the three and nine months ended September 30, 2008 was $6.3 million and $18.6 million, respectively, compared to $6.0 million and $17.9 million, respectively, for the corresponding periods in 2007.

Liquidity and Capital Resources

Due to our significant research and development expenditures, we have not been profitable and have generated operating losses since we were incorporated in 1991 through 1996 and in 1999 through September 30, 2008.  As such, we have funded our research and development operations through sales of equity securities, the issuance of convertible notes, cash received from customers, and collaborative arrangements.   At September 30, 2008, we had available cash, cash equivalents, and short-term and long-term marketable securities of $249.9 million.  Our cash and marketable securities balances are held in a variety of interest-bearing instruments, including obligations of U.S. government agencies, high-grade corporate bonds, asset backed and mortgage backed securities and government agency and treasury money market accounts.   Available cash is invested in accordance with our investment policy’s primary objectives of liquidity, safety of principal and diversity of investments.  Recent distress in the financial markets has had an adverse impact on financial market activities including, among other things, extreme volatility in security prices, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of others. We have assessed the implications of these factors on our current business and determined that there has not been a significant impact to our financial position, results of operations or liquidity during the first nine months of 2008.

Net cash used in operating activities was $108.6 million for the nine months ended September 30, 2008 and net cash used in operating activities was $65.2 million for the nine months ended September 30, 2007.  The $43.4 million increase was due primarily to the increase in our net loss during 2008.

Our investing activities, other than purchases, sales and maturities of marketable securities, have consisted predominantly of capital expenditures.  Net cash provided by investing activities was $103.0 million for the nine months ended September 30, 2008, which

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represented primarily sales and maturities of marketable securities of $103.4 million.  In the future, net cash used by investing activities may fluctuate significantly from period to period due to the timing of capital expenditures, maturities/sales and purchases of marketable securities, and acquisitions, including possible earn-out payments to former stockholders of Maxia.

Net cash provided by financing activities was $104.3 million and $1.0 million for the nine months ended September 30, 2008 and 2007, respectively.  For the nine months ended September 30, 2008, we received $101.7 million of net proceeds from issuance of common stock.   Also for the nine months ended September 30, 2008, we received $2.6 million of proceeds from issuance of common stock under our stock plans and employee stock purchase plan.  For the nine months ended September 30, 2007, we received $1.0 million from issuance of common stock under our stock plans and employee stock purchase plan.

The following summarizes our significant contractual obligations as of September 30, 2008 and the effect those obligations are expected to have on our liquidity and cash flow in future periods:

The amounts and timing of payments related to vacated facilities may vary based on negotiated timing of lease terminations.  We have entered into sublease agreements for our vacated space with scheduled payments to us of $2.8 million (less than 1 year) and $4.2 million (years 1-3); these scheduled payments are not reflected in the above table.

The table above excludes certain commitments that are contingent upon future events. The most significant of these contractual commitments that we consider to be contingent obligations are summarized below.

Commitments related to Maxia are considered contingent commitments as future events must occur to cause these commitments to be enforceable.  In February 2003, we completed our acquisition of Maxia.  Under the merger agreement, former Maxia stockholders have the right to receive certain earn out amounts of up to a potential aggregate amount of $14.0 million upon the occurrence of certain research and development milestones set forth in the merger agreement.  Twenty percent of each earn out payment, if earned, will be paid in cash and the remaining eighty percent will be paid in shares of our common stock such that an aggregate of $2.8 million in cash and $11.2 million in our common stock (based upon the then fair value) could potentially be paid pursuant to the earn out milestones.  The milestones are set to occur as Maxia products enter various stages of human clinical trials and may be earned at any time prior to the tenth anniversary of the consummation of the merger.  In any event, no more than 13,531,138 shares of our common stock may be issued to former Maxia stockholders in the aggregate pursuant to the merger agreement.  None of these milestones has been achieved as of September 30, 2008.

We have entered into licenses in the past and may in the future continue to seek to license additional rights relating to compounds or technologies in connection with our drug discovery and development programs.  Under these licenses, we may be required to pay up-front fees, milestone payments, and royalties on sales of future products.

We believe that our cash, cash equivalents and marketable securities will be adequate to satisfy our capital needs for at least the next twelve months.  Our cash requirements depend on numerous factors, including our expenditures in connection with alliances, license agreements and acquisitions of and investments in complementary products, technologies and businesses; expenditures in connection with potential repayments of our 3½% convertible senior notes due 2011, 3½% convertible subordinated notes due 2011, and the Pfizer Notes; expenditures in connection with our drug discovery and development programs; expenditures in connection with litigation or other legal proceedings; competing technological and market developments; the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights; our receipt of any milestone or other payments under any collaborative agreements we may enter into, including the agreement with Pfizer; and costs associated with the integration of new operations assumed through any mergers and acquisitions.  Changes in our research and development plans or other changes affecting our operating expenses may result in changes in the timing and amount of expenditures of our capital resources.  We expect that future revenues generated from information products, including licensing of intellectual property, will continue to decline as we focus on drug discovery and development programs, and in 2008, will not represent a significant source of cash inflow for us.

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Off Balance Sheet Arrangements

We have no off-balance sheet arrangements other than those that are discussed above.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk