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  • 10-K (Mar 15, 2007)
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DGI RESOLUTION INC 10-K 2006

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K

(Mark One)

 

 

x

 

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

For the fiscal year ended December 31, 2005

or

o

 

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

For the transition period from                 to

 

Commission File Number 000-30469


deCODE genetics, Inc.

(Exact name of registrant as specified in its charter)

Delaware 

04-3326704

(State or other jurisdiction of

(I.R.S. Employer

incorporation or organization)

Identification No.)

 

Sturlugata 8, Reykjavik, Iceland

(Address of principal executive offices)

+ 354-570-1900

(Registrant’s telephone number, including area code)


Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

Name of each exchange on which registered

 

None

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 par value

(Title of Class)


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o   No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o   No x

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

Large accelerated filer o      Accelerated filer x      Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, based on the closing price of the common stock ($9.39 per share), as of June 30, 2005, was $486,747,834.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of February 28, 2006.

Class

 

Number of Shares

 

Common Stock, $.001 par value

54,874,548

 

DOCUMENTS INCORPORATED BY REFERENCE

None

 




PART I

Item 1.                        Business

Overview

Headquartered in Reykjavik, Iceland, deCODE is a biopharmaceutical company applying its discoveries in human genetics to develop drugs for common diseases. Our population approach and resources enable us to isolate genes and drug targets directly involved in the development of many of the diseases which are the biggest challenges to public health. We are turning these discoveries into a growing pipeline of therapeutics aimed at combating the causes of disease, not just the signs and symptoms. As these diseases are common and current therapies are of limited effectiveness, we believe that our strategy represents a significant opportunity to create better medicine with major potential in the global marketplace.

We believe that deCODE’s advantage derives from our population approach to human genetics and the ability to apply this approach across the drug development process. In Iceland, we have comprehensive population resources that enable our scientists to efficiently conduct genome- and population-wide scans to identify key genes and gene variants contributing to common diseases. The proteins encoded by these genes, and other proteins with which they interact in the disease pathway, offer drug targets that we believe are directly involved in the onset and progression of disease. Small-molecule drugs that target these proteins may therefore represent a direct means of modulating the onset or progression of the disease.

Through our medicinal chemistry and structural biology subsidiaries based in the United States, we are able to discover novel small-molecule therapeutic compounds, take candidate compounds through pre-clinical testing, and manufacture sufficient quantities for early-stage clinical trials. Our product development group designs and implements our clinical development programs. By leveraging the capabilities of Encode, our wholly-owned clinical research organization in Reykjavik, and our expertise in genetics and drug and disease modeling, we are able to make the drug development process a more efficient and sensitive means of testing and optimizing the therapeutic and commercial potential of new drugs. In certain programs we have also taken advantage of the fact that drug targets we have identified through our genetics research have already been targeted by other companies to develop compounds for other indications. By licensing these compounds or entering into co-development arrangements, we have been able to bypass several years of drug discovery and development and enter directly into Phase II clinical trials.

At the beginning of 2006, we have five lead drug discovery and development programs, including three compounds in clinical trials. The most advanced of these programs are in heart attack, peripheral artery disease (PAD), and asthma. We have successfully completed a series of Phase II clinical trials in Iceland for DG031, a compound we licensed from Bayer HealthCare AG that we are developing for the prevention of heart attack. In 2006, we plan to initiate a multi-center, Phase III clinical trial for DG031. In early 2006, we concluded the Phase I clinical program for DG041, our compound for PAD, a form of atherosclerosis that constricts blood flow to the legs and arms. This program showed DG041 to be well-tolerated and to effectively inhibit platelet aggregation without increasing bleeding time, and we plan to begin a Phase II clinical trial in the first half of this year. In asthma, we are conducting a Phase II trial on behalf of the developer of a compound originally designed as a treatment for a different disease. We expect to have data on this trial as early as the second quarter of 2006. Also, in 2006, we expect to file Investigational New Drug applications (INDs) for DG051, our follow-on compound for the prevention of heart attack, and for DG061, a novel compound for the treatment of pain.

We are also applying our findings to create DNA-based diagnostics. Because such tests analyze the same links between genetic variation and disease that we have used to identify drug targets, they can be employed as an aid in developing more effective disease prevention strategies by helping individuals to

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better understand their inherited risk of a given condition, as well as to identify patients likely to respond well to a given drug.

deCODE also leverages its capabilities to provide services to fee-paying customers. Our services and products include medicinal chemistry, structural biology, clinical trials, genotyping, and instruments and software. deCODE also provides services to fee-paying customers, enabling them to take advantage of deCODE’s capabilities. Revenue from these activities helps to support our drug discovery and development infrastructure, and conserve our cash resources for use in our proprietary therapeutics programs

deCODE, is a Delaware corporation, incorporated in 1996. Our principal executive offices are located at Sturlugata 8, Reykjavik, Iceland. Our telephone number is +354-570-1900 and our website address is www.decode.com. We make available free of charge through the Investor Relations section of our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission, or the SEC. We include our website address in this Annual Report on Form 10-K only as an inactive textual reference and do not intend it to be an active link to our website. You may read and copy materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, D.C. 20549. You may get information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains on internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

References in this report to deCODE, the “Company”, “we” and “us” refer to deCODE genetics, Inc., a Delaware company: to deCODE genetics, Inc.’s wholly owned subsidiary, Islensk erfdagreining ehf., an Icelandic company registered in Reykjavik, and its subsidiaries, as well as to deCODE genetics, Inc.’s wholly-owned subsidiaries deCODE chemistry, Inc. and deCODE biostructures, Inc., Delaware corporations, and their subsidiaries.

Our target discovery programs and drug development pipeline

We have actively studied the genetics and pathology of over 50 different common diseases using our population genetics approach. Our clinical and pre-clinical programs include diseases where deCODE has mapped a gene to genome-wide significance and diseases where deCODE has identified genetic variations that are associated with increased risk of developing a disease. We validate genetic variations associated with elevated disease incidence in populations outside of Iceland and use a variety of biological methods to prioritize the most promising targets for drug discovery and development. Other prioritization criteria include both medical and business considerations.

Based on our findings and prioritization criteria we are actively pursuing target discovery, pre-clinical and clinical development in 32 different therapeutic areas, including heart attack where we are developing two drugs. Our 5 most advanced programs that are in clinical development or at a late stage in pre-clinical development are listed in the following table.

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Dates reflect the earliest expected time based on deCODE’s own expectations that the compound may be entered into development (following an Investigational New Drug application) or enter the given phase of clinical trials.

Therapy area

 

 

 

Compound

 

IND

 

Phase I

 

Phase II

 

Phase III

 

Cardiovascular

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Heart attack

 

 

DG031

 

 

n

 

 

n

 

 

 

n

 

 

 

2Q06

 

 

Heart attack

 

 

DG051

 

 

3Q06

 

 

 

 

 

 

 

 

 

 

 

 

 

Peripheral Arterial Disease

 

 

DG041

 

 

n

 

 

n

 

 

 

1H06

 

 

 

 

 

 

Inflammatory

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Asthma

 

 

 

 

 

n

 

 

n

 

 

 

«

 

 

 

 

 

 

Central Nervous System

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pain

 

 

DG061

 

 

4Q06

 

 

 

 

 

 

 

 

 

 

 

 

 


Legend:   n Phase completed   « Phase expected to end 2Q06

In addition to the late stage programs in drug discovery and development, deCODE is actively pursuing gene discovery and target validation in the following programs: addiction to alcohol, addiction to nicotine, Alzheimer’s disease, anxiety, atopy/allergy, autism, benign prostatic hypertrophy, chronic obstructive pulmonary disease, coronary artery restenosis, endometriosis, hypertension, infectious diseases, migraine, diabetes type 2, obesity, osteoporosis, Parkinson’s disease, polycystic ovary syndrome, preeclampsia, psoriasis, restless leg syndrome, rheumatoid arthritis, schizophrenia, sleep apnea, vascular disease/stroke and various forms of cancer.

Our strategy and approach: From genes to drugs

The primary focus of deCODE’s business strategy is the discovery and commercialization of novel therapeutics based upon our gene discoveries. We believe our population approach and unique competence in human genetics give us a competitive advantage, one which we are able to apply across the breadth of drug development, from target discovery through clinical trials.

Human genetics offers several advantages as a foundation for developing better drugs. We believe most medicines today are compounds that are aimed at treating the symptoms of disease, seldom the underlying causes. The reason is that to date the basic biology and pathogenesis of most of the big public health challenges—such as heart attack, stroke, obesity, diabetes or asthma—are poorly understood. These diseases are common because of their complexity, and arise due to the interplay of both genetic and environmental factors. Human genetics offers a means of unraveling this complexity and a window into the biology of disease. Through the identification of key genes involved in predisposition to a given disease, it is possible to study the proteins these genes encode and to develop an understanding of the biological pathway of the disease. Drugs targeting key elements in the pathway may be able to effectively disrupt the disease process.

Using our population approach and resources, we can efficiently conduct population- and genome-wide scans to hone in on key genetic factors involved in any common disease. We believe deCODE is a world leader in gene discovery in the common diseases. As of the beginning of 2006 we had isolated fifteen key genes involved in eleven common diseases with major unmet medical need. These genes have provided us with drug targets we believe are rooted in the basic biology of human disease, enabling us to pursue drug discovery and development work on a small number of targets with high potential therapeutic impact.

The isolation of genes contributing significant risk for common diseases requires the ability to gather and correlate detailed information on disease and genetic variation across as large a group of people as possible: ideally, across an entire population. To do this effectively it is also critical to have accurate and

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comprehensive genealogical records, the only means for tracing how the genetic components of disease travel between generations. We believe a population with all three sets of data—genetic, medical and genealogical—is the scarce resource in human genetics. In Iceland, deCODE has brought this information together. Along with its genealogy database covering the entire present day population and stretching back to the founding of the country more than 1000 years ago, deCODE has gathered genotypic and medical data from more than 110,000 volunteer participants in our gene research in Iceland—over half of the adult population.

Using our genealogy database, our scientists can link together patients affected by any disease into large extended families. Applying high-throughput genotyping and proprietary data-mining instruments, we first “map” genes through linkage analysis, honing in on small segments of particular chromosomes that related patients share to a much higher degree than would be expected by chance. More detailed analysis of these regions with denser sets of markers enables us to isolate the key genes associated with risk of the disease, as well as the variants or haplotypes of these genes that are highly correlated with the disease.

Unlike companies studying predetermined genes, gene expression patterns, or genes in animal models, deCODE’s approach allows for a virtually hypothesis-free discovery process that can pinpoint key inherited causes of human disease in a human population. Following the isolation of major genes, we analyze the proteins the genes encode, the biological function of these proteins, and the interaction of these with other proteins in an effort to identify the biological pathway of a given disease. In most cases, the proteins encoded by the disease-genes themselves serve as good drug targets. If they do not, other points in the disease pathway may be selected for therapeutic intervention. The development of DG041 for atherosclerosis (PAD) is an example of how we have gone from the isolation of a disease gene to a compound in clinical trials using our own target and drug discovery capabilities. The development of DG031 for heart attack is an example of how we can accelerate the drug development process based upon our target discovery work by in-licensing a promising existing compound. In our program in pain, our chemistry group has utilized work in the pathway we identified in our PAD program to rapidly advance a lead pre-clinical compound. With this compound, DG061, we aim to pursue the major opportunity that exists for developing effective alternative drugs to the selective Cox-2 inhibitors and other non-steroidal anti-inflammatory drugs (NSAIDs).

We are also applying our unique capabilities in human genetics to make the clinical development process a more efficient and effective means of evaluating the therapeutic potential of new drugs. In an information-rich clinical trial (IRCT) we can integrate the same data used to identify drug targets to select participants whom we believe are susceptible to a particular disease. This enables trials that are smaller and more efficient than traditional trials, and the results can be applied to understand not just whether people respond to a drug but who responds best and why. We believe this offers a means for better managing risk in the development process; speeding drug development; lowering cost; and maximizing the patient benefit from, and market potential of, new drugs.

deCODE has integrated capabilities for drug discovery and development, ranging from in vitro and model organism-based biology through structure-based drug design, medicinal chemistry and Current Good Manufacturing Practices (cGMP) manufacturing. These capabilities enable us to speed the discovery of developmental compounds and maximize the value coming out of our gene discovery work.

Our biology group, based in Reykjavik, conducts functional work on genes we have isolated, drawing out the biological pathways of disease and identifying optimal points for therapeutic intervention. Through the design of biological assays and screening of compound libraries we are able to identify compounds that effectively block or stimulate target proteins.

Our structural biology group on Bainbridge Island, near Seattle, is one of the leading groups in the industry in protein expression and three-dimensional protein structure determination. The analysis of three-dimensional images of target proteins and how they are bound by therapeutic compounds provides

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our drug discovery teams with new insight into the nature of compounds that may be able to deliver maximum therapeutic effect. The structural biology group has also developed automation hardware, software and protein crystallization products which we sell to research organizations and laboratories around the world. The group also provides fee-based services to a large number of clients.

deCODE’s chemistry group based outside Chicago conducts lead discovery, medicinal chemistry and production of cGMP materials in quantities sufficient for pre-clinical and clinical studies. The group employs advanced tools for absorption, distribution, metabolism and excretion (ADME) profiling, physicochemical property optimization and pre-formulation. While some of these resources are used for our internal drug discovery projects, the chemistry group also provides a full range of services to external clients.

deCODE’s product development group based in Brighton, Michigan, is responsible for the design and execution of clinical development programs. This group was expanded in 2005 to advance the rapidly expanding pipeline of developmental compounds coming out of deCODE’s target and drug discovery work. We bring genetic, biological and clinical data to bear on the breadth of the drug development process which we believe makes our clinical trials sensitive and efficient instruments for testing new drugs and for reducing late stage attrition. The product development group also works with deCODE’s informatics and statistics group to process, analyze, interpret, and report clinical trial data.

This comprehensive infrastructure for drug discovery and clinical development allows deCODE to pursue product development in-house; partner projects on favorable terms; and pursue in-licensing opportunities of existing compounds based on information about the specific qualities we wish to see in a developmental drug. With the strengthening of our clinical development resources, deCODE is rapidly growing its capacity to leverage its genetics discoveries and develop innovative new drugs and diagnostics, with the aim of using our knowledge of the pathology and biology of disease to lower costs and cut development time. At the same time, we are also leveraging our capabilities in genotyping, structural biology and chemistry to generate revenue for the Company in the near-term through our fee-for-service service offerings.

Our clinical programs

The descriptions below of our clinical development programs of DG031, DG041 and our Phase II study of an asthma treatment illustrate what we believe to be the advantages of our approach for making better drugs.

Our clinical programs: DG031 for the prevention of heart attack

Our program in heart attack (also called myocardial infarction or MI) is an example of how our population genetics approach is pointing the way toward the discovery and effective clinical development of new, more effective drugs targeting the root biological causes of disease.

Heart attack is the leading killer in the industrialized world. Nearly half of men and one-third of women who reach the age of forty will suffer a heart attack in their lifetime. Currently, there are effective drugs for treating some of the contributing risk factors for heart attack, such as high-cholesterol, diabetes and hypertension. However, we believe that there are no existing drugs aimed at preventing the pathogenesis of the disease itself. Our work is focused on meeting this need based upon a better understanding of the biological processes that lead to heart attack.

Through a population-based, genome-wide study involving hundreds of heart attack patients from across Iceland, deCODE scientists discovered common variants in the gene encoding FLAP, or 5-lipoxygenase activating protein, that confer a nearly twofold increased risk of the disease. This represents a risk at least as great as elevated cholesterol. The FLAP protein regulates the synthesis of leukotrienes,

5




molecules known to be potent drivers of inflammation. Our functional studies showed that the at-risk variants of the FLAP gene led specifically to increased production of leukotriene B4 (LTB4). LTB4 is produced by cells in the atherosclerotic plaques that build up inside artery walls. Inflammation in plaques contributes to their instability and propensity to rupture, the event directly preceding most heart attacks.

Our isolation of the FLAP gene therefore provided compelling evidence that we had identified a basic mechanism increasing risk of heart attack. Further genetics and functional research added weight to this discovery. We found that individuals who had previously suffered a heart attack but who did not have one of the at-risk versions of the FLAP gene also produced more LTB4 compared to people with no history of heart disease. This finding supports our belief that we have identified a major biological process involved in heart attack in general—and a pathway through which both genetic and environmental risk factors act.

deCODE scientists also isolated another gene further down the leukotriene pathway from FLAP. One variant of this gene in particular, which we refer to as HapK, confers increased risk of heart attack. The protein encoded by this gene, the leukotriene A4 hydrolase (LTA4H), is directly involved in producing LTB4. In line with the functional work on the at-risk variants of the FLAP gene, HapK appears to confer increased risk of heart attack by increasing the production of LTB4. The role of the at-risk versions of both the FLAP and LTA4H genes in increasing risk of heart attack has been confirmed in studies in Europe and the United States.

These findings have pointed us to a novel, direct and potentially powerful therapeutic approach for preventing heart attack: inhibiting the activity of the branch of the leukotriene pathway that produces LTB4. In October of 2003, deCODE in-licensed a compound from Bayer AG, now known as DG031, that inhibits leukotriene synthesis through its binding to FLAP. Because of the extensive safety and clinical data already gathered on the compound through previous clinical testing in another indication, in-licensing enabled us to advance directly into Phase II clinical testing.

In 2004 and 2005, deCODE conducted a series of Phase II clinical trials for DG031. The main purpose of these trials was to examine whether by inhibiting FLAP with various dose levels of DG031 it would be possible to reduce levels of LTB4. These trials enrolled a total of 368 patients with a history of heart attack and the at-risk variants of either or both the FLAP and LTA4H genes. The results demonstrated that DG031 was well-tolerated and reduced production of LTB4 in a dose-dependent manner. This effect was on top of the effects of the current standard of care, including a majority of patients who were taking statins.

The Phase II program thus demonstrated that DG031 can effectively help correct the biological process through which genetic predisposition to heart attack manifests itself. Moreover, the nature of this process has an important bearing on the therapeutic potential of DG031 and other compounds targeting the products of disease genes in common diseases. In our work in heart attack, as in virtually all of the programs in which we have identified genes, genetic susceptibility appears to act primarily by either up-regulating or down-regulating the activity of an important biological pathway. That is, the genetic variants correlated with common diseases appear to push individuals to one extreme or other of what is probably a normal distribution of the activity of a given biological pathway. We believe that this is the reason why in many instances we find both at-risk and protective variants of the same genes.

This is important from a therapeutic perspective because it means that while it may be most efficient and of greatest immediate medical benefit to first develop such treatments for those at highest risk, in order to bring them down the risk spectrum, the eventual therapeutic goal from a public health perspective may be much broader: to bring everyone, even those at “average” risk, down to the risk profile of those who are least likely to suffer the disease. This is the paradigm that has, for example been followed with the statin drugs. These were first developed to treat those with extremely high levels of LDL cholesterol. However it is now widely accepted that that they may be of benefit to just about anyone middle aged or older who may be at risk of cardiovascular disease and whose LDL levels are not already very low.

6




We are also applying our genetics discoveries to optimize the late-stage clinical development process. The most striking replication of the at-risk variant of the LTA4H gene, known as HapK, was made through analysis of genotypic and heart disease data in African American participants in deCODE’s studies in the United States. Among African Americans the at-risk variant is less common than it is among Americans of European descent, but whereas people of European origin who carry HapK are at a 16% increased risk of heart attack compared to controls, African Americans with HapK are at an approximately 250% increased risk. This is a major discovery from a public health perspective, and it is one we are using to help us to design an effective Phase III clinical trial for DG031. By focusing recruitment on the group of patients who are at highest risk through the pathway targeted by the compound, we believe we can design a small and highly sensitive trial with the highest possible likelihood of success, at the same time testing the drug in the group that should derive the greatest immediate benefit from a new drug.

We are designing the Phase III trial under a Special Protocol Assessment with the FDA. The trial we have proposed is a multicenter Phase III study that will focus on African Americans who carry HapK and have a history of heart disease. We hope to initiate enrollment for this trial in the second quarter of 2006.The primary endpoint of the trial will be to measure DG031’s effectiveness in reducing the composite endpoint of cardiovascular death, non-fatal heart attack, stroke, hospitalization for heart attack and the need for urgent revascularization.

Before a Phase III study can be conducted we must obtain regulatory approvals as well as the approval of institutional review boards for patient recruitment at the various sites participating in the multi-center trial. We need to contract with an outside party who will be responsible for recruiting participating physicians and patients. We also need to contract with manufacturers for the supply of the drug substance and drug tablets, conforming to our time constraints and regulatory standards, which in turn depends on the timely availability of ingredients and the successful manufacture of the clinical supplies. We are in the process of obtaining the proper approvals, and have contracted with outside suppliers for production and packaging of the clinical supplies and with a contract research organization for organization of the study.

As a follow-on to DG031, we are developing DG051, an inhibitor of LTA4H, a different target in the leukotriene pathway. DG051 is also aimed at decreasing the production of LTB4. It appears to provide potent inhibition of LTB4 production, is orally bioavailable, and appears to have minimal potential for drug-drug interaction. We anticipate filing an investigational new drug (IND) application on DG051 in 2006.

Our clinical programs: DG041 for the treatment of PAD

In our program in peripheral artery disease (PAD), we went from the isolation of a disease gene to the conclusion of a Phase I clinical program in little over four years. This represents a significant improvement on the average development time for comparable compounds in the pharmaceutical industry.(1) We believe that our efficiency in this program is the result of two strengths in our approach: our use of human genetics for target discovery, which provides us with a small number of targets directly implicated in the cause of disease and the focus and quality of our drug discovery groups.

PAD is a vascular disorder that affects over 10% of the population and one in five people over the age of 70. The initial symptoms include intermittent pain in the legs while walking or exercising, due to the narrowing by atherosclerotic plaques of one or more major arteries in the legs. The restriction of blood flow leads to insufficient oxygenation of muscle tissue. As the disease worsens it can lead to tissue damage, ulceration and gangrene, and in extreme cases may require the amputation of the affected limb. The disease is under-diagnosed, and the current mainstay of treatment is surgery to bypass the occluded vessels. Currently, no drug treatment is available that targets the underlying causes of PAD or prevents its progression.


(1)          J.A. DiMasi et al., Journal of Health Economics 22 (2003) 151—185.

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With our developmental compound DG041 we hope to directly address this need. Our population genetics studies identified versions of the gene encoding the EP3 receptor for prostaglandin E2 (PGE2) that correlate with a significantly increased risk of the disease. Functional analysis underscores the important role of EP3 in modulating the biology of the platelet. Binding of PGE2 to EP3 is known to increase platelet aggregation, a process we believe may play a role in the disease.

DG041 is an inhibitor of the EP3 receptor, and the first clinical candidate developed entirely through deCODE’s own capabilities in gene discovery and drug development. It is a novel, first-in-class, orally-administered small molecule for the treatment of PAD. In early 2005, deCODE submitted an IND for DG041 to the FDA and initiated a Phase I clinical development program. Early results in Phase I trials showed DG041 to be well-tolerated and to effectively inhibit platelet aggregation in a dose-dependent manner without increasing bleeding time. Based on our findings in the fall of 2005 our chemistry unit developed a new formulation that increased the bioavailability of DG041 by nearly four fold. Consequently we initiated subsequent dose escalation studies on this formulation and concluded the Phase I trials in February 2006. Nearly 200 healthy subjects were exposed to DG041 in these studies at doses up to 1600mg/day for seven days. The results of the Phase I program showed DG041 to be well-tolerated, without any drug-related significant adverse events noted, and that DG041 can effectively inhibit platelet aggregation in a dose-dependent manner without increasing bleeding time. We expect to begin a Phase II clinical trial in the first half of 2006.

Our clinical programs: Third party compound in asthma

In 2005, deCODE began a Phase II clinical trial in asthma on behalf of the developer of a compound initially developed for another indication. This compound targets a gene previously isolated by deCODE that plays an important role in the inflammatory cascade involved in the development of asthma. The Phase II trial, which is being conducted in Iceland by our subsidiary Encode, is a randomized, double-blind and placebo-controlled trial that examines safety and tolerability of the drug, as well as the effectiveness of the drug in improving lung function and reducing airway inflammation at the various dose levels as measured by various clinical tests and biomarkers. Under the terms of the agreement with the developer of the compound, deCODE will receive milestone payments based on success in clinical development and royalties on sales of a marketed drug.

Diagnostics

We believe diagnostics represent an additional avenue for creating value from our gene discoveries. Since genetic variants linked to disease are by definition markers of disease susceptibility, we can apply the same findings we employ in our drug discovery efforts to the development of DNA-based diagnostic tests. We believe that such tests may be useful as a means for identifying patients who are likely to respond well to drugs that target the same disease pathway, and to identify individuals who are at a particularly high risk of a given disease. We also have expertise for developing diagnostics to gauge individual responsiveness to existing drugs, which are commonly referred to as pharmacogenomic tests. We have not commercialized any diagnostic products and we may never do so.

Drug discovery and development services

In order to offset the cost of maintaining its proprietary drug development infrastructure, deCODE utilizes its capabilities in medicinal chemistry, structural biology and clinical trials to offer contract services to fee-paying customers, principally pharmaceutical and biotechnology companies.

·       Our medicinal chemistry subsidiary, deCODE chemistry, Inc., based in Woodridge, Illinois, provides a full range of drug discovery technology and services using multiple integrated high-throughput technologies to streamline the drug discovery process.

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·       Our structural biology subsidiary, deCODE biostructures, Inc., based in Bainbridge Island, near Seattle, determines three-dimensional X-ray crystal structures of target proteins for structure-based drug design and development.

·       Our clinical research organization subsidiary Encode conducts information-rich clinical trials for our proprietary programs and for contract customers, principally pharmaceutical and biotechnology companies.

Additional service offerings

At our research facility in Reykjavik, we have what we believe is the highest-throughput microsatellite genotyping laboratory in the world, capable of generating tens of millions of genotypes per month. In addition to the capability to genotype a large number of microsatellite markers in parallel, both rapidly and efficiently, the laboratory has efficient procedures to type focused subsets of both microsatellites and single nucleotide polymorphisms (SNPs). We also have in place efficient, automated systems for all stages of the genotyping process, from DNA isolation and amplification to plate preparation and the generation, storage and analysis of genotypic data. Our customers for genotyping services include pharmaceutical companies, research consortia and academic institutions.

Collaborations

F. Hoffmann-La Roche (Roche).

Therapeutics.   In 2002, we entered into an agreement with Roche to collaborate on four diseases that had been the subject of an earlier collaboration with Roche. Under this agreement, which expired on February 1, 2005, we are entitled to receive royalties on the sales of any drugs that are developed coming out of work conducted under this alliance. Under this agreement we discovered genes linked to diabetes and Roche continues drug discovery based on one of these discoveries. We may receive milestone payments as Roche advances compounds through the development process as well as royalties on successfully marketed drugs.

In November 2004, we signed a new three-year agreement with Roche to co-develop inhibitors of PDE4 for the prevention and treatment of vascular disease, including stroke. This agreement continues work advanced under the 2002 agreement, and we will focus on optimizing lead compounds identified under the previous agreement and beginning clinical development. Under the agreement, as of the end of 2005, we received $2.0 million of research funding. We and Roche will share drug discovery and clinical trials costs under this new agreement, and we may receive an additional $4.0 million of research funding over the remaining term of the agreement as well as milestone payments and royalties based on drug sales.

Diagnostics.   In June 2001, we signed a five-year alliance with Roche’s diagnostics division to develop and market DNA-based diagnostics to gauge predisposition to major diseases and to predict responsiveness to major therapeutics used to treat those diseases. Under the agreement we have, as of the end of 2005, we received $41.1 million in research funding, up-front fees and milestone payments. We may receive $3.1 million in additional research funding over the remainder of the term of the agreement as well as milestone payments upon the achievement of research and development milestones and royalties on the sales of diagnostic products developed.

Merck & Co, Inc. (Merck).

Obesity.   In September 2002, we entered into an alliance with Merck aimed at developing new treatments for obesity. The research and development portion of the agreement expired in September 2005. Under this agreement we discovered three genes linked to obesity, and Merck has generated lead series of compounds against one of the targets we have validated through our genetics research. We may receive milestone payments as Merck advances compounds developed under the alliance through the development process, as well as royalties on successfully marketed drugs.

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Information-Rich Clinical Trials.   In February 2004, we entered into an agreement with Merck to conduct information-rich clinical trials on a range of Merck’s developmental compounds that Merck selects for inclusion in the program. The term of the alliance is seven years, subject to termination by Merck after five years. Under the terms of the agreement, we may receive royalties on sales of drugs and diagnostics developed as part of the alliance. We received a one-time technology access fee of $10.0 million, will share research funding for the clinical development of compounds and pharmacogenomic analysis, and will receive milestone payments as compounds or pharmacogenomic tests reach the market. To date, Merck has not selected any compounds for development under the agreement.

National Institute of Allergy and Infectious Diseases (NIAID).

In September 2004, we were awarded a five-year $23.9 million contract by the NIAID, part of the U.S. National Institutes of Health (NIH). Under the contract, we are applying our population approach and resources to discover genetic factors associated with susceptibility to certain infectious diseases and with responsiveness to vaccines targeting such diseases. The University of New Mexico will be working with us to conduct functional validation of biological pathways discovered through our genetic research. The National Center for Genome Resources will provide bioinformatics resources to make study information and results available to the scientific community.

Bayer HealthCare AG (Bayer).

In 2003, Bayer granted us an exclusive worldwide license to develop, make and sell a compound that had been developed and tested against a drug target that we had discovered might play a role in myocardial infarction. The compound had been developed as a potential treatment for asthma and subjected to substantial clinical development work on behalf of Bayer. During the previous clinical testing of the compound, now named DG031, more than 1,000 people were dosed with the drug, without any significant safety or tolerability issues. In connection with the license, Bayer transferred ownership of its IND associated with this compound to deCODE. As a result, we have been able to use the data that Bayer compiled and submitted in support of its IND. Under the agreement, we will pay Bayer milestone payments upon the achievement of specified developmental milestones and royalties on sales of the drug. The agreement gives Bayer the right of first negotiation to be our manufacturer of the compound.

Patents and Proprietary Rights

Patents and other proprietary rights protections are an essential element of our business. We rely on patents, trade secret law and contractual non-disclosure and confidentiality arrangements to protect our proprietary information and technology. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary rights are covered by valid and enforceable patents, contractual confidentiality obligations, or if they are effectively maintained as trade secrets.

Accordingly, we actively seek patent protection in the United States and other jurisdictions to protect technology, inventions and improvements to inventions that are commercially important to the development of our business. These include, among other things, the compounds that we invent and will develop as potential drugs, the genes and related drug targets we discover; mutations and variants of genes and related processes; new uses of existing third party compounds that may be used to manipulate those genes, mutations and drug targets; technologies which may be used to discover and characterize genes; therapeutic or diagnostic processes, tests and other inventions based on those genes; as well as methods developed in our biostructures and pharmaceutical groups for the discovery and development of drugs. As of year-end 2005, we had approximately 29 issued U.S. patents and approximately 11 issued patents in non-US jurisdictions. We also had approximately 57 pending patent applications in the US, and in most cases corresponding pending international PCT or national patent applications in non-US jurisdictions that we have deemed to be of commercial interest.

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We have filed series of composition of matter type patent applications for the compounds we have discovered ourselves, that are the main focus of our pre-clinical and clinical development, including DG041, DG051 and DG061.

We have licensed from Bayer a composition of matter patent and a manufacturing process patent for DG031. The licensed patents expire in 2009 and 2012, respectively.

We have also applied for additional patents on our own, claiming specific uses of DG031 and for other compounds with similar mode of action, and methods for selecting those patients that we believe are most likely to benefit from administration of those compounds due to their specific genetic makeup. Such patents that would cover approved uses of DG031, if issued and found to be valid and enforceable if challenged, could extend the lifecycle of DG031 for several years beyond the expiry of the patents that we licensed from Bayer. However, it is not certain that such patents will ultimately be issued, and even if issued, that they will be enforceable in infringement proceedings before the courts.

The United States Drug Price Competition and Patent Term Restoration Act of 1984, known as the Hatch-Waxman Act, provides for the restoration of up to 5 years of patent term for a patent that covers a new product or its use, to compensate for time lost from the effective life of the patent due to the regulatory review process of the FDA. An application for patent term restoration is subject to approval by the U.S. Patent and Trademark Office in conjunction with the FDA. If our clinical trials of DG031 are successful and we ultimately receive the FDA’s approval to market the drug, we expect to seek to extend the term of one of the patents we licensed from Bayer. However, there can be no assurance that we will receive a patent term extension.

The Hatch­Waxman Act also establishes a 5 year period of marketing exclusivity from the date of NDA approval for new chemical entities (NCE) approved after September 24, 1984. We believe that DG031 is an NCE, and if the NDA for DG031 is approved, we expect to receive such marketing exclusivity. Under the Hatch-Waxman Act generic versions of innovative medicines may be approved without the complete safety and efficacy studies contained in an NDA. Instead, the generic manufacturer may submit an Abbreviated New Drug Application (ANDA) or a so-called Section 505(b)(2) (or “paper”) NDA. During the 5 year  marketing exclusivity period for an NCE, a manufacturer that proposes to sell a generic version of DG031 may not submit to the FDA an ANDA or a paper NDA except that such applications may be submitted after 4 years if they contain a certification of patent invalidity or noninfringement. If at the time such an application is submitted we have received a use patent for DG031 that is listed in the FDA’s Approved Drug Products with Therapeutic Equivalence Evaluations, or Orange Book, and if we commence a suit alleging patent infringement in a timely manner after the ANDA or paper NDA for a generic drug is submitted, FDA approval of the generic drug will automatically be stayed for up to 30 months from the expiration of the 5 year marketing exclusivity period to allow a judicial resolution of the infringement action. Thus, under the Hatch-Waxman Act, the combination of NCE marketing exclusivity and the 30 month stay may create as much as a 7 1/2 exclusivity period for our marketing and sale of DG031.

Other jurisdictions have statutory provisions similar to those of the Hatch-Waxman Act, that afford both patent extensions and market exclusivity for drugs that have obtained market authorizations, such as European Supplementary Protection Certificates that extend effective patent life and European data exclusivity rules that create marketing exclusivity for certain time periods following marketing authorization. European data exclusivity in more generous than the equivalent NCE marketing exclusivity in the US, possibly as long as 11 years. We believe that if we obtain marketing authorization for DG031 in Europe or other jurisdictions with similar statutory provisions, DG031 may be eligible for patent term extension and marketing exclusivity under these provisions and we plan to seek such privileges.

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Competition

We face, and will continue to face, intense competition in our gene discovery programs from pharmaceutical companies, biotechnology companies, universities and other research institutions. A number of entities are attempting to rapidly identify and patent genes responsible for causing diseases or an increased susceptibility to diseases and to develop products based on these discoveries.

We also face intense competition in drug development, particularly from pharmaceutical and biotechnology companies. Certain of these companies may, using other approaches, identify and decide to pursue the discovery and development of new drugs targets or disease pathways that we have identified through our human population genetics research. Many of our competitors, either alone or together with their collaborative partners, have substantially greater financial resources and larger research and development operations than we do. These competitors may discover, characterize or develop important genes, drug targets or drug leads before we or our collaborators do or may obtain regulatory approvals of their drugs more rapidly than we or our collaborators do.

Developments by others may render pharmaceutical product candidates or technologies that we or our collaborators develop obsolete or non-competitive. Any product candidate that we or our collaborators successfully develop may compete with existing therapies that have long histories of safe and effective use.

Our competitors may obtain patent protection or other intellectual property rights that could limit our rights, or our customers’ ability, to use our technologies or databases, or commercialize therapeutic or diagnostics products. In addition, we face, and will continue to face, intense competition from other companies for collaborative arrangements with pharmaceutical and biotechnology companies, for establishing relationships with academic and research institutions and for licenses to proprietary technology.

Our ability to compete successfully will depend, in part, on our ability, and that of our collaborators, to: develop proprietary products; develop and maintain products that reach the market first, and are technologically superior to and more cost effective than other products on the market; obtain patent or other proprietary protection for our products and technologies; attract and retain scientific and product development personnel; obtain required regulatory approvals; and manufacture, market and sell products that we develop.

Government Regulation

Regulation by governmental authorities will be a significant factor in our ongoing research and development activities. In addition, the development, production and marketing of any pharmaceutical and diagnostic products which we or a partner may develop is subject to regulation by governmental authorities. Strict regulatory controls govern the pre-clinical and clinical testing, design, manufacture, labeling, supply, distribution, recordkeeping, reporting, sale, advertising and marketing of the products. These regulatory controls will influence our and our partners’ ability to successfully manufacture and market therapeutic or diagnostic products.

Our success will depend, in part, on the development and marketing of products based on our research and development. Most countries require a company to obtain and maintain regulatory approval for a product from the relevant regulatory authority to enable the product to be marketed. Obtaining regulatory approval and complying with appropriate statutes and regulations is time-consuming and requires the expenditure of substantial resources.

In the United States we and our products are subject to comprehensive regulation by the United States Food and Drug Administration (FDA). The process required by the FDA before our drug products may be approved for marketing in the United States generally involves (i) pre-clinical new drug laboratory and animal tests, (ii) submission to the FDA of an investigational new drug (IND) application, which must

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become effective before clinical trials may begin, (iii) adequate and well-controlled human clinical trials to establish the safety and efficacy of the drug for its intended indication, (iv) submission to the FDA of a new drug application (NDA), (v) review by an advisory committee to FDA for recommendations regarding whether the NDA should be approved, and (vi) FDA review of the NDA in order to determine, among other things, whether the drug is safe and effective for its intended uses. There is no assurance that the FDA review process will result in product approval on a timely basis, if at all.

Pre-clinical tests include laboratory evaluation of product chemistry and formulation, as well as animal studies to assess the potential safety and efficacy of the product. Pre-clinical tests are generally subject to FDA regulations regarding Good Laboratory Practice. The results of the pre-clinical tests are submitted to the FDA as part of an IND and are reviewed by the FDA prior to the commencement of clinical trials or during the conduct of the clinical trials, as appropriate.

Clinical trials are conducted under protocols that detail such matters as the objectives of the study, the parameters to be used to monitor safety and the efficacy criteria to be evaluated. Each protocol must be submitted to the FDA as part of the IND. Further, each protocol must be reviewed and approved by an institutional review board (IRB), and study subjects must provide informed consent to participation in the study. Clinical trials are subject to oversight by the IRB at each study site and by the FDA. An IRB or the FDA may prevent a study from being initiated, or may suspend or terminate studies once initiated.

Clinical trials are typically conducted in three sequential phases, which may overlap. During Phase I, when the drug is initially given to human subjects, the product is tested for safety, dosage tolerance, absorption, distribution, metabolism and excretion. Phase II involves safety, tolerability and efficacy of the product across a range of doses with the goal of identifying appropriate doses and patients for further study. Phase III trials are undertaken in order to further evaluate clinical efficacy and to further test for safety within an expanded patient population. The FDA may suspend clinical trials at any point in this process if it concludes that clinical subjects are being exposed to an unacceptable health risk.

Clinical trials must be conducted and monitored in accordance with good clinical practice (GCP) and other regulatory requirements. For applications to the FDA, clinical studies must be adequate and well controlled. Following the clinical trials, we will analyze the data and determine whether the clinical trials successfully demonstrated the safety and efficacy of the product. If they do, we will prepare and submit a new drug application (NDA). The FDA conducts a preliminary review of the NDA to determine whether to file the application and begin substantive review, or to refuse to file the application on the ground that FDA considers it incomplete.

We will need FDA approval of our products, including a pre-approval inspection of the manufacturing processes and facilities used to produce such products to assess conformance with current good manufacturing practices (cGMP), before such products may be marketed in the United States. The FDA may also inspect the clinical trial sites to ensure their conformance with GCP. The process of obtaining approvals from the FDA can be costly, time-consuming and subject to unanticipated delays. There can be no assurance that the FDA will grant approvals of our proposed products, processes or facilities on a timely basis, if at all. Any delay or failure to obtain such approvals would have a material adverse effect on our business, financial condition and results of operations. Moreover, even if regulatory approval is granted, such approval may include conditions of approval such as additional studies or significant limitations on indicated uses for which a product could be marketed.

Among the conditions for NDA approval is the requirement that the prospective manufacturer’s operating procedures conform to cGMP requirements, which must be followed at all times. In complying with those requirements, manufacturers (including a drug sponsor’s third party contract manufacturers) must continue to expend time, money and effort in the area of production and quality control to ensure compliance. Domestic manufacturing establishments are subject to periodic inspections by the FDA in order to assess, among other things, cGMP compliance. To supply a product for use in the United States,

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foreign manufacturing establishments also must comply with cGMP and are subject to periodic inspection by the FDA or by regulatory authorities in certain of such countries under reciprocal agreements with the FDA.

Both before and after approval is obtained, a product, its manufacturer and the holder of the NDA for the product are subject to comprehensive regulatory oversight. FDA regulations impose requirements for recordkeeping, periodic reporting, and reporting of adverse experiences with the product. Violations of regulatory requirements at any stage, including the pre-clinical and clinical testing process, the approval process, or thereafter (including after approval) may result in various adverse consequences, including the FDA’s delay in approving or refusal to approve a product, withdrawal of an approved product from the market, seizure of the product, injunction against the company, and/or the imposition of criminal penalties against the manufacturer and/or NDA holder and/or officers and employees. In addition, later discovery of previously unknown problems may result in restrictions on such product, manufacturer or NDA holder, including withdrawal of the product from the market. Also, new government requirements may be established that could delay or prevent regulatory approval of our products under development.

The FDA has implemented accelerated approval procedures for certain pharmaceutical agents that treat serious or life-threatening diseases and conditions, especially where no satisfactory alternative therapy exists. We cannot predict the ultimate impact, however, of the FDA’s accelerated approval procedures on the timing or likelihood of approval of any of our potential products or those of any competitor. In addition, the approval of a product under the accelerated approval procedures may be subject to various conditions, including the requirement to verify clinical benefit in post-marketing studies, and the authority on the part of the FDA to withdraw approval under streamlined procedures if such studies do not verify clinical benefit.

Diagnostic products are regulated as medical devices in the United States. Devices are subject to similar types of FDA regulatory controls and enforcement actions as apply to drugs, but many aspects of device regulation differ. Medical devices are classified into one of three classes, Class I, II or III, on the basis of their risk and the controls deemed necessary to assure their safety and effectiveness, with Class I presenting the least risk. Regulatory controls for devices include labeling, recordkeeping, reporting, and adherence to the FDA’s quality system requirements, or QSR, including good manufacturing practices.

Most Class I devices and some Class II devices are exempt from FDA premarket review. Most Class II devices and some Class III devices require FDA review and clearance of a premarket notification under Section 510(k) of the Federal Food, Drug, and Cosmetic Act (FDC Act) prior to marketing. A 510(k) notification must demonstrate that the device is substantially equivalent to a predicate device, which is a device marketed prior to 1976 or to a marketed device shown to be substantially equivalent under the 510(k) notification process. In addition, Class II devices are subject to special controls, such as performance standards, patient registries, and FDA guidances. Class III devices, and devices determined to be not substantially equivalent to a predicate device, require FDA approval of a premarket approval application (PMA) prior to marketing. A PMA must contain manufacturing data, pre-clinical data, and data from clinical testing that demonstrates the device is safe and effective for its intended use. The FDA may refer a PMA for review by an advisory panel of outside experts for a recommendation regarding approval. FDA approval of the PMA is required prior to marketing and distribution. The FDA may impose conditions of approval or restrictions on the sale, distribution, or use of the device.

The conduct of device clinical trials is subject to FDA regulation, including requirements for IRB approval, informed consent, recordkeeping, and reporting. In addition, a significant risk device requires FDA approval of an investigational device exemption (IDE) application. A nonsignificant risk device does not require IDE approval and is subject to abbreviated recordkeeping and reporting requirements. Significant risk devices include implants, life-supporting and life-sustaining devices, devices of substantial

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importance in diagnosing, curing, mitigating or treating disease, and devices that otherwise present a potential for serious risk to the health, safety, or welfare of a subject.

To the extent our diagnostic products may be intended for use as prognostic tests for selecting patients most likely to benefit from drug therapies, such products may be studied in the clinical trials of the related drug product under the regulatory provisions governing pharmaceutical clinical trials, but require a separate PMA approval or 510(k) clearance under the medical device requirements. The FDA’s policy for co-development of therapeutic and diagnostic products is evolving, and changes in FDA’s regulatory policy can affect the development, testing, regulatory approval pathway, and marketing of our products.

FDA has developed special rules for in vitro reagents that are not approved or cleared as diagnostic products. FDA has imposed restrictions on the manufacture, labeling, sale, distribution, advertising, promotion and use of analyte specific reagents (ASRs). FDA defines ASRs as antibodies, specific receptor proteins, ligands, nucleic acid sequences, and similar reagents which, through specific binding or chemical reaction with substances in a specimen, are intended for use in a diagnostic application for identification and quantification of an individual chemical substance or ligand in biological specimens. An ASR can be used by a clinical laboratory to develop in-house (“home brew”) laboratory assays if the laboratory is certified for high complexity testing under the Clinical Laboratory Improvement Act of 1998 as amended (CLIA). Most, but not all, ASRs are exempt from 510(k) premarket notification or PMA approval, and all are subject to good manufacturing practices (GMP) requirements and to the restrictions on their sale, distribution and use imposed by FDA regulation. In addition, FDA regulates Research Use Only (RUO) diagnostic products, which by their mandatory labeling are not intended for use in diagnostic procedures. The clinical usefulness of RUO products is unknown and thus their use is limited to research purposes only. Diagnostic products and reagents that we develop now and in the future may be subject to these and other applicable FDA regulations.

For devices with an approved PMA, the manufacturer must submit periodic reports containing information on safety and effectiveness and other information specified in FDA regulations, and modifications to the product or its intended use can trigger the need to file a PMA Supplement for approval by FDA. For devices with a cleared 510(k) notification, modifications to the device that can affect its safety or effectiveness may require the submission of a new 510(k) prior to marketing the modified device. All devices are subject to continuing regulation by the FDA, including record-keeping and reporting requirements, and reporting when a device may have caused or contributed to a death or serious injury or has malfunctioned in a way that would be likely to cause or contribute to a death or serious injury if the malfunction were to recur.

Product labeling and promotional activities for drug and device products are subject to scrutiny by the FDA, and products may be promoted only for their approved indications. Violations of promotional requirements for drugs and devices may also involve violations of the federal False Claims Act, anti-kickback laws, and other federal or state laws. In addition to the government bringing claims under the federal False Claims Act, qui tam, or “whistleblower,” actions may be brought by private individuals on behalf of the government. Also, competitors may bring litigation under the Lanham Act or challenges under industry self-regulation groups relating to product advertising.

The European Community (EC) and EC member states maintain drug regulatory systems for medicinal products and medical devices that are comparable in their rigor to those in the United States. Clinical trials of medicinal products require government authorizations (based on evidence of safety from pre-clinical tests and other sources), must be reviewed and approved by ethics committees, and must be carried out in compliance with good clinical practice. There is no guarantee that permission will be granted for clinical trials of new medicinal products, and permission can be withdrawn if safety issues arise during a clinical trial.

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Medicinal products may not be introduced to the market in the EC unless a marketing authorization has been granted by a competent authority. Marketing authorization applications for new chemical entities may be submitted to multiple EC member states under the mutual recognition system (which results in harmonized conditions of approval) or to the European Medicines Agency (EMEA), which administers a system that leads to a single marketing authorization that is valid in all EC member states. For certain new chemical entities, as well as all biotechnology products, submission to the EMEA is mandatory. Requirements for marketing authorization applications are similar to those for NDAs in the United States, including requirements for proof of safety, efficacy and quality. These requirements are demanding, and there is no assurance that a product for which a marketing authorization application is submitted will be approved. Manufacturing facilities must also comply with EC requirements for good manufacturing practice, and if located in the EC must be licensed by the competent authority of the relevant member state. Requirements may be imposed for post-marketing studies, and there are detailed requirements for post-market surveillance of safety (pharmacovigilance). Advertising and promotion are scrutinized by authorities in each member state, and in some cases by the EMEA as well. Products may be removed from the market, permanently or temporarily, if safety questions arise, and there are only limited procedural requirements before such actions can be taken.

In addition to these controls under Medicines Law, most EC member states maintain some form of control over the pricing or reimbursement of medicinal products. In many member states, marketing may not commence until a price or reimbursement level has been determined, and in some member states products are also subject to cost-effectiveness reviews that can, for practical purposes, determine whether they will be utilized.

The EC maintains a separate system for medical devices, including in vitro diagnostic devices that may be developed in conjunction with medicinal products whose use depends on biomarkers. Manufacturers must meet requirements for quality control, which may entail interaction with quasi-governmental Notified Bodies, and comply with essential requirements and standards adopted under EC law. There is no harmonized system of control on the advertising and promotion of medical devices, and requirements vary from country to country. In addition, many EC member states maintain systems to evaluate new medical devices to determine whether they are cost-effective or otherwise appropriate for use in national health systems, other maintain other systems to control pricing or reimbursement of medical devices.

Environmental

deCODE’s primary research facilities and laboratory are located in Reykjavik, Iceland. We operate under applicable Icelandic and European Union laws and standards, with which we believe that we comply, relating to environmental, hazardous materials and other safety matters. Our research and manufacturing activities involve the generation, use and disposal of hazardous materials and wastes, including various chemicals and radioactive compounds. These activities are subject to standards prescribed by Iceland and the EU. We do not believe that compliance with these laws and standards will have any material effect upon our capital expenditures, earnings or competitive position, or that we will have any material capital expenditures in relation to environmental control facilities for the remainder of this fiscal year or any succeeding fiscal year.

Our activities in the U.S. involve the controlled use of hazardous materials. We are subject to U.S. federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of such materials and certain waste products. Although we believe that our activities in the U.S. currently comply with the standards prescribed by such laws and regulations, the risk of accidental contamination or injury from these materials cannot be eliminated. In the event of such an accident, we could be held liable for any damages that result and any such liability could exceed our resources. In addition, there can be no assurance that we will not be required to incur significant costs to comply with environmental laws and regulations in the future.

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Employees

As of December 31, 2005, deCODE and all of its subsidiaries employed 480 full-time staff. Of the total number, approximately 153 were employed in the United States and 327 in Iceland. More than 113 held Ph.D. or M.D. degrees and approximately 410 held college degrees. 369 employees were engaged in, or directly supported, research and development activities, of whom 300 worked within the laboratory facilities and 69 held positions associated with the development and support of informatics. 71 employees were engaged in various professional support functions such as Finance, Business Development, Legal, Communications, Human Resources and Clinical Collaborations, and 41 were employed in administrative support, facilities management, cleaning and security. In addition, we utilized part-time employees and outside contractors and consultants as needed and plan to continue to do so.

Certain Financial Information

Research and Development Expenses

Cost of revenue, including costs incurred in connection with collaborative programs for 2005, 2004 and 2003, were $37.3 million, $43.4 million and $45.9 million, respectively. The cost of revenue, including costs incurred in connection with collaborative programs represent our customer-sponsored research and development activities.

Our costs of research and development for proprietary programs for 2005, 2004 and 2003, was $43.7 million, $24.9 million and $17.6 million, respectively.

Geographic Information

Long-lived assets located in the United States and Iceland were $26,231,000 and $13,494,000, respectively at December 31, 2005 and $22,955,000 and $55,115,000, respectively at December 31, 2004.

Revenues attributed to the United States and to Iceland were $15,486,000 and $28,469,000, respectively, for 2005, $13,680,000 and $28,447,000, respectively for 2004, and $13,744,000 and $33,067,000, respectively, for 2003.

Significant Customers

Historically, a substantial portion of deCODE’s revenue has been derived from contracts with a limited number of significant customers. deCODE’s largest customer, Roche, accounted for approximately 23%, 30% and 43% of the company’s consolidated revenue in 2005, 2004 and 2003, respectively. Merck accounted for approximately 15%, 22% and 18% of the company’s consolidated revenue in 2005, 2004 and 2003, respectively. During the year ended December 31, 2005, divisions of the National Institutes of Health (NIH) represented 13% of consolidated revenue. The loss of any significant customer may significantly lower deCODE’s revenues which could affect the resources available to support our drug discovery programs.

Item 1A.                Risk Factors

In Addition to the other information contained in this Form 10-K, you should consider the following risk factors in evaluating our business and prospects. We also note that this annual report on Form 10-K contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, forward-looking statements can be identified by terminology such as “may, “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of such terms or other comparable terminology. These statements are only expectations. We cannot assure our investors that our expectations and assumptions will prove to have been correct. We undertake no intention or obligation to update or revise any forward-looking statements,

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whether as a result of future events, new information or otherwise. Actual events or results may differ materially due to a number of factors, including those set forth in this section and elsewhere in this Form 10-K. These factors include, but are not limited to, the risks set forth below.

Risks Related to Our Development of DG031

The Phase III clinical trial for DG031 will require the recruitment of patients based on ethnicity and haplotype status; recruitment rates may be lower than we expect thus delaying the trial and hurting our commercial prospects.

In our Phase III clinical trial for DG031, we will be testing the hypothesis whether African American patients who (a) carry the HapK haplotype in LTA4H and (b) have experienced a hospitalization and/or admission for procedures and testing for unstable angina or myocardial infarction will experience reduced rates of acute cardiovascular events when treated with DG031, as compared to placebo on top of concomitantly administered standard of care. In order to recruit a sufficient number of patients to obtain statistically significant evidence for the efficacy of DG031, we will require the participation of a large number of African American patients willing to be tested for haplotype status and to participate in the clinical trial for at least 12 months. Many factors outside our control may reduce the willingness of patients to be tested and participate in the clinical trial. If we fail to recruit a sufficient number of patients in a timely manner the trial may be delayed or we may fail to show the efficacy of the drug. This may delay or prevent the marketing approval of DG031, which could adversely impact our financial results and commercial prospects.

We have only indirect evidence from biomarkers studies about the effectiveness of DG031 and this data may not be validated in the Phase III clinical trial.

The data collected during the Phase I and Phase II clinical trials for DG031, which is the basis for our continuing development of this drug, does not provide evidence of whether DG031 will prove to be an effective treatment to reduce the rate of acute cardiovascular events in the prospective treatment population. In order to prove or disprove the validity of our assumption about the efficacy of DG031, we will have to conduct the Phase III trial, which will be of at least 36 months duration from the recruitment of the first patient, although the time may vary due to unforeseen circumstances. Various factors which we do or do not control may cause delays in the launch of the clinical trial or cause the trial to be lengthier or costlier than anticipated. Until data from the trial can be collected and analyzed we will not know whether DG031 is an effective treatment and regulatory review by the FDA will ultimately determine whether the drug gains marketing approval. The outcome of this process is uncertain and delays or failure to gain market approval could adversely impact our financial results and commercial prospects.

Our patent protection for DG031 may provide marketing exclusivity for only a limited term.

The patents we licensed from Bayer for DG031 expire in 2009 and 2012. While we will seek to obtain one or more use patents protecting our proprietary rights to specific uses of this compound for a longer period, we cannot be certain that we will obtain such patents or that they will adequately protect us. In addition, although we may seek to extend the term of one of the patents we licensed from Bayer and to obtain marketing exclusivity under the Hatch-Waxman Act and equivalent foreign statutes, we cannot be certain that we will be successful. Expiration of the patent(s) prior to regulatory approval may affect our ability to gain the full benefit of such possible term extension/marketing exclusivity. Further, even if regulatory approval is received before patent expiration, the U.S. Patent and Trademark Office and/or FDA may not rule on our application for term extension in a timely manner. If we cannot obtain new patents or fully extend the term of patent protection under one of the patents we licensed from Bayer, the amount of revenues that we will be able to derive from an approved product based on these patents may be adversely affected.

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Risks Related to Our Business

We may not successfully develop or derive revenues from any products.

We use our technology and research capabilities to identify genes and gene variations that contribute to certain diseases and then develop small molecule drugs that target proteins produced by these genes. Although we have identified genes that we believe are likely to cause certain diseases, we may not be correct and may not be successful in identifying any other similar genes or in developing drugs based on these discoveries. Many experts believe that some of the diseases we are targeting are caused by both genetic and environmental factors. Even if we identify specific genes that are partly responsible for causing diseases, any therapeutic or diagnostic products we develop as a result of our genetic work may not detect, prevent, treat or cure a particular disease. Any pharmaceutical or diagnostic products that we or our collaborators are able to develop will fail to produce revenues unless we:

·       establish that they are safe and effective;

·       successfully compete with other technologies and products;

·       ensure that they do not infringe on the proprietary rights of others;

·       establish that they can be manufactured in sufficient quantities at reasonable costs;

·       obtain and maintain regulatory approvals for them; and

·       can market them successfully.

We may not be able to meet these conditions. We expect that it will be years, if ever, before we will recognize significant revenue from the development of therapeutic or diagnostic products.

If we continue to incur operating losses longer than anticipated, or in amounts greater than anticipated, we may be unable to continue our operations.

We incurred a net loss of $62.8 million, 57.3 million and $35.1 million for the years ended December 31, 2005, 2004 and 2003, respectively, and had an accumulated deficit of $450.2 million at December 31, 2005. We have never generated a profit and we have not generated revenues except for payments received in connection with our research and development collaborations with Roche, Merck and others, from contract services, Emerald BioSystems products and instruments, and under grants. Our research and development expenditures and general and administrative costs have exceeded our revenue to date, and we expect to spend significant additional amounts to fund research and development in order to enhance our core technologies and undertake product development (including drug development and related clinical trials). We do not expect to receive royalties or other revenues from commercial sales of products developed using our technology in the near term. It may be several years before product revenues materialize, if they do at all. As a result, we expect to incur net losses for several years. If the time required to generate product revenues and achieve profitability is longer than we currently anticipate or the level of losses is greater than we currently anticipate, we may not be able to continue our operations.

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If our assumption about the role of genes in disease is wrong, we may not be able to develop useful products.

The products we hope to develop involve new and unproven approaches. They are based on the assumption that information about genes may help scientists to better understand complex disease processes. Scientists generally have a limited understanding of the role of genes in diseases, and few products based on gene discoveries have been developed. Of the products that exist, all are diagnostic products. To date, we know of no therapeutic products based on disease-gene discoveries. If our assumption about the role of genes in the disease process is wrong, our gene discovery programs may not result in products.

In order to conduct clinical trials and to market our drugs we will have to develop methods to produce these drugs using clinically approved methods and at commercially viable rates

In order to conduct clinical trials we may need to contract with third parties in order to obtain sufficient amounts of our drugs. These contractors need to implement the necessary technology and obtain the necessary ingredients in order to produce the drugs to exacting standards set by us and the regulatory bodies. This is an uncertain and time consuming process and any disruption in it may delay or harm our ability to continue clinical development. For drugs which have reached the last stage of clinical trials we will have to develop methods to scale up the production of the drug at commercially viable rates, securing both a contractor or partner with the ability to implement this process and obtain a secure and economical supply of the necessary ingredients. If we are not able to scale the process in a timely manner or do not have the ability to produce the drug economically, we may not have the ability to enter the market with a viable product. This would harm our financial and commercial prospects.

Clinical trials required for our product candidates or the products of our customers and partners are expensive and time-consuming, their outcome is uncertain and we may not achieve our projected development goals in the timeframes we have announced and expect.

Before obtaining regulatory approvals for the commercial sale of any of our products under development, we must demonstrate through pre-clinical studies and clinical trials that the product is safe and effective for use in each target indication. Pre-clinical testing and clinical development are long, expensive and uncertain processes. It may take several years to complete testing for a product and failure can occur at any stage of testing. The length of time necessary to complete clinical trials varies significantly and may be difficult to predict. Factors that can cause delay or termination of our clinical trials include:

·       slower than expected patient enrollment due to the nature of the protocol, the proximity of patients to clinical sites, the eligibility criteria for the study, competition with clinical trials for other drug candidates or other factors;

·       lower than expected retention rates of patients in a clinical trial;

·       delayed approval of study protocol and pharmacogenomic components of studies by regulatory agencies in different countries, some of which are still developing policies with respect to  pharmacogenomic testing;

·       inadequately trained or insufficient personnel at the study site to assist in overseeing and monitoring  clinical trials;

·       delays in approvals or failure to obtain approval from the pertinent review boards or regulatory  authorities;

·       longer treatment time required to demonstrate effectiveness or determine the appropriate product dose;

·       lack of sufficient supply of the product candidate;

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·       adverse medical events or side effects in treated patients;

·       lack of effectiveness of the product candidate being tested; and

·       regulatory changes.

Even if we obtain positive results from pre-clinical or clinical trials for a particular product, we may not achieve the same success in future trials of that product. In addition, some or all of the clinical trials we undertake may not demonstrate sufficient safety and efficacy to obtain the requisite regulatory approvals, which could prevent the creation of marketable products. Our product development costs will increase if we have delays in testing or approvals, if we need to perform more or larger clinical trials than planned or if our trials are not successful. Delays in our clinical trials may harm our financial results and the commercial prospects for our products. Delays or termination of clinical trials that we conduct for our partners or customers may also harm our financial results as payments under these contracts may be delayed, reduced or curtailed.

Co-development of therapeutic and diagnostic products may be required, and delays in the development and approval of a commercially available diagnostic may delay drug approval or impede market acceptance of the therapeutic product.

The use of some of our therapeutic products may be dependent upon the selection of patients using both clinical and genetic markers. This may require co-development and clinical testing of the therapeutic drug and a related diagnostic product. In the United States, drug approval could be delayed until we successfully obtain FDA approval of the related diagnostic product. In addition, if the diagnostic test cannot be performed on a commercially viable basis, it may impede market acceptance of our approved therapeutic products. To successfully co-develop and market a drug and diagnostic we may also need to establish and maintain successful partnerships with manufacturing and marketing partners for diagnostic products. If necessary partnerships can not be established or maintained, the development of our therapeutics and/or diagnostics may be delayed or may fail.

If we are not able to obtain sufficient additional funding to meet our capital requirements, we may be forced to reduce or terminate our research and product development programs.

We have spent substantial amounts of cash to fund our research and development activities and expect to continue to spend substantial amounts for these activities over the next several years. We expect to use cash to collect, generate and analyze genotypic and disease data from volunteers in our disease-gene research programs; to conduct drug discovery and development activities (including clinical trials); and to continue other research and development activities. Many factors will influence our future capital needs, including:

·       the number, breadth and progress of our discovery and research programs;

·       our ability to attract customers;

·       our ability to commercialize our discoveries and the resources we devote to commercialization;

·       the amount we spend to enforce patent claims and other intellectual property rights; and

·       the costs and timing of regulatory approvals.

We have relied on, and may continue to rely on, revenues generated by our corporate alliances and fee-paying customers for significant funding of our research efforts. Historically, a substantial portion of our revenue has been derived from contracts with a limited number of significant customers. Our largest partner, Roche, accounted for approximately 23%, 30% and 43% of our consolidated revenue in the years ended December 31, 2005, 2004 and 2003, respectively. Revenue under our alliances with Merck

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accounted for approximately 15%, 22% and 18% of our consolidated revenue in the years ended, December 31, 2005, 2004 and 2003, respectively. During the year ended December 31, 2005, divisions of the NIH represented 13% of our consolidated revenue. Work under the Merck obesity agreement and the Roche 2002 agreement has been substantially completed, and this may significantly lower our revenues and affect the resources available to support our drug discovery programs, which will increase our need for additional funding.

In addition, we may seek additional funding through public or private equity offerings and debt financings. We may not be able to obtain additional financing when we need it or the financing may not be on terms favorable to us or our stockholders. Stockholders’ ownership will be diluted if we raise additional capital by issuing equity securities.

If we raise additional funds through collaborations and licensing arrangements, we may have to relinquish rights to some of our technologies or product candidates, or grant licenses on unfavorable terms. If adequate funds are not available, we would have to scale back or terminate our discovery and research programs and product development.

The commercial success of any products that we may develop will depend upon the degree of market acceptance among physicians, patients, healthcare payors and the medical community.

Any products that we may develop may not gain market acceptance among physicians, patients, healthcare payors and the medical community. If these products do not achieve an adequate level of acceptance, we may not generate material product revenues and we may not become profitable. The degree of market acceptance of any of our product candidates, if approved for commercial sale, will depend on a number of factors, including:

·       demonstration of efficacy and safety in clinical trials;

·       the prevalence and severity of any side effects;

·       potential or perceived advantages over alternative treatments;

·       the timing of market entry relative to competitive treatments;

·       the ability to offer our product candidates for sale at competitive prices;

·       relative convenience and ease of administration;

·       the strength of marketing and distribution support;

·       sufficient third party coverage or reimbursement; and

·       the product labeling or product insert required by the FDA or regulatory authorities in other countries.

If we cannot successfully develop a marketing and sales force or maintain suitable arrangements with third parties to market and sell our products, our ability to deliver products may be impaired.

We currently have no experience in marketing or selling pharmaceutical products. In order to achieve commercial success for any approved product, we must either develop a marketing and sales force, which will require substantial additional funds and personnel, or, where appropriate or permissible, enter into arrangements with third parties to market and sell our products. We might not be successful in developing marketing and sales capabilities. Further, we may not be able to enter into marketing and sales agreements with others on acceptable terms, and any such arrangements, if entered into, may be terminated. If we develop our own marketing and sales capability, it will compete with other companies that currently have experienced, well-funded and larger marketing and sales operations. To the extent that we enter into co-

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promotion or other sales and marketing arrangements with other companies, revenues will depend on the efforts of others, which may not be successful.

If we cannot successfully form and maintain suitable arrangements with third parties for the manufacturing of the products we may develop, our ability to develop or deliver products may be impaired.

We have no experience in manufacturing products for commercial purposes and do not have manufacturing facilities that can produce sufficient quantities of drugs for large scale clinical trials. Accordingly, we must either develop such facilities, which will require substantial additional funds, or rely on contract manufacturers for the production of products for development and commercial purposes. In order to conduct our currently planned Phase III clinical trial of DG031, we will have to contract with third parties to manufacture a sufficient supply of the drug for the trial and to produce tablets containing DG031 in amounts sufficient for the clinical trial. While we have signed contracts with suppliers for the production of DG031 material and tablets for the planned launch of our Phase III clinical trial, we have not received the finished drug tablets, and we may fail to secure sufficient supply of the drug in a timely manner over the duration of the trial.

The manufacture of our products for clinical trials and commercial purposes is subject to Good Manufacturing Practices (cGMP) regulations promulgated by the FDA. The manufacture of diagnostic products is subject to the FDA’s quality system requirements (QSR). In the event that we are unable to develop satisfactory manufacturing facilities or obtain or retain third party manufacturing for our products, we will not be able to commercialize such products as planned. We may not be able to enter into agreements for the manufacture of future products with manufacturers whose facilities and procedures comply with cGMP, QSR and other regulatory requirements. Our current dependence upon others for the manufacture of our products may adversely affect our ability to develop and deliver such products on a timely and competitive basis and, in the longer term, the profit margin, if any, on the sale of future products and our ability to develop and deliver such products on a timely and competitive basis.

Our reliance on the Icelandic population may limit the applicability of our discoveries to certain populations.

The genetic make-up and prevalence of disease generally varies across populations around the world. Common complex diseases generally occur with a similar frequency in Iceland and other European populations. However, the populations of other nations may be genetically predisposed to certain diseases because of mutations not present in the Icelandic population. As a result, we and our partners may be unable to develop diagnostic and therapeutic products that are effective on all or a portion of people with such diseases. For our business to succeed, we must be able to apply discoveries that we make on the basis of the Icelandic population to other markets.

If a substantial portion of participants in our genetics research studies withdraw their informed consent, our ongoing research may suffer.

We depend on the willingness of Icelandic volunteers to participate in our genetics research studies. All of the participants in our genetic studies have signed an informed consent form, which gives deCODE permission to process data and blood samples that the participant has donated for research purposes. Participants may at any time revoke this permission by withdrawing their consent. If, for any reason, a substantial portion of participants in our studies were to withdraw their consent, we would not be able to continue population genetic research in some or all of the diseases that we are studying. This would diminish our ability to discover new drug targets and to develop products based on these discoveries. If our ability to use population genetic data is impaired, we may also not be able to fulfill some contractual obligations with our partners.

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If we fail to protect confidential data adequately, we could incur a liability.

Under laws and regulations in force in Iceland, including applicable European laws, directives and regulations, all information on individuals that is used in our population research is anonymized under the protocols and supervision of the Data Protection Authority of Iceland. If we fail to comply with these laws and regulations, we could lose public support for participation in our research and we could be liable to legal action. Any failure to comply fully with all confidentiality requirements could lead to liability for damages incurred by individuals whose privacy is violated, the loss of our customers and reputation and the loss of the goodwill and participation of the Icelandic population, including healthcare professionals. These eventualities could materially adversely affect our work in Iceland.

Some parts of our product development services create a risk of liability from clinical trial participants and the parties with whom we contract.

Through our wholly owned subsidiary Encode, we conduct clinical trials of products we are developing and contract with drug companies and clinical research organizations to perform a wide range of services to assist them in bringing new drugs to market. Our services include:

·       supervising clinical trials;

·       data and laboratory analysis;

·       patient recruitment; and

·       acting as investigators in conducting clinical trials.

If, in the course of these trials or activities,

·       we do not perform our services to contractual or regulatory standards;

·       we fail to obtain permission to conduct trials from the appropriate authorities in Iceland;

·       patients or volunteers suffer personal injury caused by or death from adverse reactions to the test drugs or otherwise;

·       there are deficiencies in the professional conduct of the investigators with whom we contract;

·       our laboratories inaccurately report or fail to report lab results; or

·       our informatics products violate rights of third parties,

then we could be held liable for these eventualities by the regulatory agencies or the drug companies and clinical research organizations with whom we contract or by study participants. We maintain product liability insurance for claims arising from the use of products we are developing in clinical trials conducted by Encode and are covered by the product liability insurance of the drug companies and clinical research organizations for whom we provide clinical trial services for claims arising from the use of their products in such trials. Such insurance may be inadequate and in any event would not cover the risk of a customer deciding not to do business with us as a result of poor performance or claims for a customer’s financial loss as the result of our failure to perform our contractual obligations properly.

Use of therapeutic or diagnostic products developed as a result of our programs may result in product liability claims for which we have inadequate insurance.

The users of any therapeutic or diagnostic products developed by us or our collaborators as a result of our discovery or research programs (including participants in our clinical trials) may bring product liability claims against us. Except as described above with respect to clinical trials conducted by Encode, we currently do not carry liability insurance to cover such claims (although we expect to obtain such insurance

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for our Phase III trial of DG031). We are not certain that we or our collaborators will be able to obtain such insurance or, if obtained, that sufficient coverage can be acquired at a reasonable cost. If we cannot protect against potential liability claims, we or our collaborators may find it difficult or impossible to commercialize products.

Our fee-for-service work bears certain risks of liability to our customers.

Our subsidiaries, deCODE chemistry, Inc., deCODE biostructures, Inc., and Emerald Biosystems, Inc., provide services, equipment and products (including software) for third party customers who pay us on a fee-for-service or product basis. In this function, we often synthesize compounds, manufacture Active Pharmaceutical Ingredient (API) material and provide recommendations for research direction for our customers. We also provide contract research services in X-ray crystallographic structure determination of protein-ligand complexes for customers, and often recommend targets to customers based on these determinations. In addition, we sell instruments and software to these customers.

We may be liable to our customers for damages if we perform such services negligently or with willful misconduct, or if we provide customers with defective products, equipment or software. We also may be held liable for failure to meet specifications or failure to comply with other contractual conditions. While our agreements with customers limit our liability and while we carry general commercial liability insurance, such contractual limitations may not be effective in the event of our material breach of the agreements, gross negligence, or willful misconduct and such insurance may not be adequate. We also supply compounds for clinical trials conducted by our customers. In doing so, we may provide materials requiring certification of compliance with cGMP regulations applicable to production of such materials. If we are found not to have complied with such requirements, we may incur liabilities related to such failures. If participants in these trials suffer personal injury or death from adverse reactions to the test drugs, we could be held liable to our customers or the participants. We maintain product liability insurance for claims arising from the use of products we supply. However, such insurance may be inadequate. Failure to perform to customer expectation also may limit future business from our existing customers, or could result in the holdback of certain payments due to us. We integrate software and products purchased or licensed from third parties suppliers into certain of our products, equipment and software sold to our customers. While we evaluate such items for defects and possible intellectual property infringement issues, and attempt to obtain contractual protections from suppliers, in the event any such items purchased or licensed from suppliers are defective or violate intellectual property rights of third parties, we may not be able to fully recover any of our damages or our customers’ damages from suppliers of such items.

Our facilities where work for customers is conducted are subject to audits by the FDA and by customers. In the event we are found in non-compliance by the FDA, there is a risk that such facility may be subject to corrective measures up to and including the closure of the facility. Such closure would have impact on our ability to meet customer obligations as well as obligations relating to our internal programs. Customer audits may lead to disputes regarding compliance with contractual terms, which could lead to potential disputes and/or liabilities as described above.

In addition, we typically have the obligation to maintain the confidentiality of proprietary information of our customers. While we have systems in place to ensure that such confidentiality is protected, we do conduct work on our internal projects at the same facilities where we work for our customers; therefore, there is an increased risk that customers may claim that we have violated our confidentiality obligations or used their proprietary information in our proprietary projects.

Increased leverage as a result of our convertible debt may harm our financial condition and results of operations.

On December 31, 2005, we had $158.6 million of outstanding debt as reflected in our balance sheet. We may incur additional indebtedness in the future and our outstanding 3.5% Senior Convertible Notes

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(the “Notes”) do not restrict our future issuance of indebtedness. Our level of indebtedness will have several important effects on our future operations, including, without limitation:

·       a portion of our cash flow from operations will be dedicated to the payment of any interest required with respect to outstanding indebtedness;

·       increases in our outstanding indebtedness and leverage will increase our vulnerability to adverse changes in general economic and industry conditions, as well as to competitive pressure; and

·       depending on the levels of our outstanding debt, our ability to obtain additional financing for working capital, capital expenditures, general corporate and other purposes may be limited.

Our ability to make payments of principal and interest on our indebtedness depends upon our future performance, which will be subject to the success of our development and commercialization of new pharmaceutical products, general economic conditions, industry cycles and financial, business and other factors affecting our operations, many of which are beyond our control. If we are not able to generate sufficient cash flow from operations in the future to service our debt, we may be required, among other things:

·       to seek additional financing in the debt or equity markets;

·       to refinance or restructure all or a portion of our indebtedness, including the Notes;

·       to sell selected assets; or

·       to reduce or delay expenditures on planned activities, including but not limited to clinical trials, and development and commercialization activities.

Such measures might not be sufficient to enable us to service our debt. In addition, any such financing, refinancing or sale of assets might not be available on economically favorable terms.

We may be unable to hire and retain the key personnel upon whom our success depends.

We depend on the principal members of our management and scientific staff, including Dr. Kari Stefansson, Chairman, President and Chief Executive Officer. We have not entered into agreements with any of these people that bind them to a specific period of employment. If any of these people leave, our ability to conduct our operations may be negatively affected. Our future success also will depend in part on our ability to attract, hire and retain additional personnel. There is intense competition for such qualified personnel and we cannot be certain that we will be able to continue to attract and retain such personnel. Failure to attract and retain key personnel could have a material adverse effect on us.

Currency fluctuations may negatively affect our financial condition.

We primarily expend or generate cash in U.S. dollars, our functional currency. We also publish our consolidated financial statements in U.S. dollars. Currency fluctuations can affect our financial results because a portion of our cash reserves, our debt and our operating costs are in Icelandic kronas. A fluctuation of the exchange rates of the Icelandic krona against the U.S. dollar can thus adversely affect the “buying power” of our cash reserves and revenues. Most of our long-term liabilities are U.S. dollar denominated. However, we may enter into hedging transactions if we have substantial foreign currency exposure in the future. We may have increased exposure as a result of investments or payments from collaborative partners.

Our contracts may terminate upon short notice.

Many of our contracts for research services are terminable on short notice. This means that our contracts could be terminated for numerous reasons, any of which may be beyond our control such as a

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reduction or reallocation of a customer’s research and development budget or a change in a customer’s overall financial condition. The loss of a large contract or multiple smaller contracts, or a significant decrease in revenue derived from a contract, could significantly reduce our profitability and require us to reallocate under-utilized physical and professional resources.

Risks Related to Our Collaborative Relationships

If we are unable to form and maintain the collaborative relationships that our business strategy requires, our programs will suffer and we may not be able to develop products.

Our strategy for developing products and deriving revenues from them is dependent, in part, upon our ability to enter into collaborative arrangements with research collaborators, corporate partners and others. We may rely on these arrangements both to provide funding necessary to our product development and to obtain goods and services that we require for our product development. We do not have the capacity to conduct large scale Phase III clinical trials and will rely on partnerships or third party contractors to conduct our Phase III trials, including our currently planned Phase III trial of DG031. We will rely on these third parties to provide us with clinical material for the trial and various services necessary to organize and conduct a multi-center, multinational study, as well as other goods and services. We have not entered into contracts for all goods and services required for the Phase III trial of DG031 at this time. Our arrangement for this and other Phase III trials will be subject to risks described below, with respect to our collaborative relationships.

If our collaborations are not successful or if we are not able to manage multiple collaborations successfully, our programs may suffer. If we increase the number of collaborations, it will become more difficult to manage the various collaborations successfully and the potential for conflicts among the collaborators as to rights to the technology and products generated under work conducted with us will increase.

Dependence on collaborative relationships may lead to delays in product development, product defects and disputes over rights to technology.

We have formed, and may in the future form additional, collaborative relationships (including relationships with clinical research organizations to conduct clinical trials on our behalf) that will, in some cases, make us dependent on collaborators for the pre-clinical studies and/or clinical trials and for regulatory approval of any products that we are developing. Failure of such collaborators to perform under these agreements properly in a timely manner, or at all, may lead to delays in our product development. In addition, if participants in the trials conducted by our collaborators suffer personal injury or death as a result of actions of the collaborators, we could be held liable. In some cases, our agreements with collaborators typically allow them significant discretion in electing whether and how to pursue such activities. We cannot control the amount and timing of resources collaborators will devote to these programs or potential products.

Our collaborators may stop supporting our products or providing services to us if they develop or obtain rights to competing products. Disputes may arise in the future over the ownership of rights to any technology developed with collaborators. These and other possible disagreements between our collaborators and us could lead to delays in the collaborative research, development or commercialization of products. Such disagreements could also result in litigation or require arbitration to resolve.

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Risks Related to Our Industry

Concerns regarding the use of genetic testing results may limit the commercial viability of any products we develop.

Other companies have developed genetic predisposition tests that have raised ethical concerns. It is possible that employers or others could discriminate against people who have a genetic predisposition to certain diseases. Concern regarding possible discrimination may result in governmental authorities enacting restrictions or bans on the use of all, or certain types of, genetic testing. Similarly, such concerns may lead individuals to refuse to use genetic tests even if permissible. These factors may limit the market for, and therefore the commercial viability of, products that our collaborators and/or we may develop.

We may not be able to compete successfully with other companies and government agencies in the development and marketing of products and services.

A number of companies are attempting to rapidly identify and patent genes that cause diseases or an increased susceptibility to diseases. Competition in this field and our other areas of business, including drug discovery and development, is intense and is expected to increase. We have numerous competitors, including major pharmaceutical and diagnostic companies, specialized biotechnology firms, universities and other research institutions, and other government-sponsored entities and companies providing healthcare information products. Our collaborators, including Roche and Merck, may also compete with us. Many of our competitors, either alone or with collaborators, have considerably greater capital resources, research and development staffs and facilities, and technical and other resources than we do, which may allow them to discover important genes or develop drugs based on such discoveries before we do. We believe that a number of our competitors are developing competing products and services that may be commercially successful and that are further advanced in development than our potential products and services. To succeed, we, together with our collaborators, must discover disease-predisposing genes, characterize their functions, develop genetic tests or therapeutic products and related information services based on such discoveries, obtain regulatory and other approvals, and launch such services or products before competitors. Even if we or our collaborators are successful in developing effective products or services, our products and services may not successfully compete with those of our competitors, including cases where the competing drugs use the same mechanism of action as our products. Our competitors may succeed in developing and marketing products and services that are more effective than ours or that are marketed before ours.

Competitors have established, and in the future may establish, patent positions with respect to gene sequences related to our research projects. Such patent positions or the public availability of gene sequences comprising substantial portions of the human genome could decrease the potential value of our research projects and make it more difficult for us to compete. We may also face competition from other entities in gaining access to DNA samples used for research and development purposes. Our competitors may also obtain patent protection or other intellectual property rights that could limit our rights, or our customers’ ability, to use our technologies or databases, or commercialize therapeutic or diagnostics products. In addition, we face, and will continue to face, intense competition from other companies for collaborative arrangements with pharmaceutical and biotechnology companies, for establishing relationships with academic and research institutions and for licenses to proprietary technology.

We expect competition to intensify as technical advances are made and become more widely known. Our future success will depend in large part on maintaining a competitive position in the genomic field. Rapid technological development may result in products or technologies becoming obsolete before we recover the expenses we incur in developing them.

Our ability to compete successfully will depend, in part, on our ability, and that of our collaborators, to:

·       develop proprietary products;

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·       develop and maintain products that reach the market first, and are technologically superior to, and  more cost effective than, other products on the market;

·       obtain patent or other proprietary protection for our products and technologies;

·       attract and retain scientific and product development personnel;

·       obtain required regulatory approvals; and

·       manufacture, market and sell products that we develop.

Changes in outsourcing trends and economic conditions in the pharmaceutical and biotechnology industries could adversely affect our growth.

Economic factors and industry trends that affect our primary customers, pharmaceutical and biotechnology companies, also affect our business. For example, the practice of many companies in these industries has been to outsource to organizations like us the conduct of genetic research, clinical research, sales and marketing projects and chemistry and structural biology research and development projects. If these industries reduce their present tendency to outsource those projects, our operations, financial condition and growth rate could be materially and adversely affected. These alliances and arrangements are both time consuming and complex and we face substantial competition in establishing these relationships. In addition, our ability to generate new business could be impaired by general economic downturns in our customers’ industries. We have experienced increasing pressure on the part of our customers to reduce expenses, including the use of our services as a result of negative economic trends generally and in the pharmaceutical industry. If pharmaceutical and biotechnology companies discontinue or decrease their usage of our services, for example, as a result of an economic slowdown or increased competition from outsourcing companies in India and China, our revenues and earnings could be lower than we expect, and our revenues may decrease or not grow at historical rates.

If regulatory approvals for products resulting from our gene discovery programs are not obtained, we will not be able to derive revenues from these products.

Government agencies must approve new drugs and diagnostic products in the countries in which they are to be marketed. We cannot be certain that we can obtain regulatory approval for any drugs or diagnostic products resulting from our gene discovery programs. The regulatory process can take many years and require substantial resources. Because some of the products likely to result from our disease research programs involve the application of new technologies and may be based upon a new therapeutic approach, various government regulatory authorities may subject such products to substantial additional review. As a result, these authorities may grant regulatory approvals for these products more slowly than for products using more conventional technologies. Furthermore, regulatory approval may impose limitations on the use of a drug or diagnostic product.

Even if a product is approved for marketing, it and its manufacturer must undergo continuing review. Discovery of previously unknown problems with a product may require the performance of additional clinical trials or the change of the labeling of the product and may have adverse effects on our business, financial condition and results of operations, including withdrawal of the product from the market.

Third party reimbursement and health care reform policies may reduce market acceptance of our products.

Our success will depend in part on the price and extent to which we will be paid for our products by government and health administration authorities, private health insurers and other third party payers. Reimbursement for newly approved healthcare products is uncertain. Third party payers, including Medicare in the United States, are increasingly challenging the prices charged for medical products and services. They are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement for new therapeutic products. We cannot be certain that any third party insurance coverage will be available to patients for any products we discover or develop. If third party payers do not

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provide adequate coverage and reimbursement levels for our products, the market acceptance of these products may be materially reduced.

Numerous governments have undertaken efforts to control growing healthcare costs through legislation, regulation and voluntary agreements with medical care providers and pharmaceutical companies. If cost containment efforts limit the profits that can be derived from new drugs, our customers may reduce their research and development spending which could reduce the business they outsource to us.

Our corporate compliance program cannot guarantee that we are in compliance with all applicable federal and state regulations in the United States, Iceland, the European Union and elsewhere.

The development, manufacturing, distribution, pricing, sales, marketing and reimbursement of our products, together with our general operations are subject to extensive federal and state regulations in the United States and national or supra-national laws and regulations in Europe and other parts of the world. While we have developed and instituted a corporate compliance program based on current best practices, we cannot assure you that we or our employees are or will be in compliance with all potentially applicable federal and state regulations and/or laws. If we fail to comply with any of these regulations and/or laws, a range of actions could result, including, but not limited to, the termination of clinical trials, the failure to approve a product candidate, restrictions on our products or manufacturing processes, including withdrawal of our products from the market, significant fines, exclusion from government healthcare programs or other sanctions or litigations.

Our operations involve a risk of injury or damage from hazardous materials, and if an accident were to occur, we could be subject to costly and damaging liability claims.

In the course of our work, we handle and produce hazardous materials and chemicals as well as compounds which may have known or unknown characteristics such as toxicity and reactivity with other compounds. Although we have systems in place to manage such compounds and their characteristics, the risk of accidental contamination or injury from these materials cannot be completely eliminated. Any such contamination or injury could result in negative effects to our personnel or facilities, which could lead to liabilities as well as impacting our ability to meet customer obligations and conduct our internal programs.

Risks Related to Our Intellectual Property

We may not be able to protect the proprietary rights that are critical to our success.

Our success will depend in part on our ability to protect our products, our genealogy database and genotypic data and any other proprietary databases that we develop and our proprietary software and other proprietary methods and technologies. Despite our efforts to protect our proprietary rights, unauthorized parties may be able to obtain and use information that we regard as proprietary.

While we require employees, business partners, academic collaborators and consultants to enter into confidentiality agreements, there can be no assurance that proprietary information will not be disclosed, that others will not independently develop substantially equivalent proprietary information and techniques, otherwise gain access to our trade secrets or disclose such technology, or that we can meaningfully protect our trade secrets.

Our commercial success will depend in part on obtaining patent protection. The patent positions of pharmaceutical, biopharmaceutical and biotechnology companies, including deCODE, are generally uncertain and involve complex legal and factual considerations that are constantly evolving. We cannot be sure that:

·       any of our pending patent applications will result in issued patents;

·       we will develop additional proprietary technologies that are patentable;

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·       any patents issued to us or our partners will provide a basis for commercially viable products, will  provide us with any competitive advantages or will not be challenged by third parties; or

·       the patents of others will not have an adverse effect on our ability to do business.

If we are unable to obtain patent protection for our technology or discoveries, the value of our proprietary resources may be adversely affected.

In addition, patent law relating to the scope of claims in the area of genetics and gene discovery is still evolving and subject to uncertainty, including in areas important to us such as patenting of discoveries for the development of therapeutic methods, diagnostic methods and products that predict inherited susceptibility to diseases and diagnostic methods and products that predict drug response and disease progression. Accordingly, the degree of future protection for our proprietary rights is uncertain and, we cannot predict the breadth of claims allowed in any patents issued to us or others. We could also incur substantial costs in litigation if we are required to defend ourselves in patent suits brought by third parties or if we initiate such suits to enforce our own patents against potential infringers.

Others may have filed and in the future are likely to file patent applications covering products or technology that are similar or identical to our products and technology. The fact that patent applications of others may not publish until they issue as patents in the US, or are not published until 18 months after filing in the US and other jurisdictions may have adverse effect on our own patent filings and business, particularly if they claim subject matter similar to that of our clinical programs. In addition, others may develop competitive products outside the protection that may be afforded by the claims of our patents. We cannot be certain that our patent applications will have priority over any patent applications of others. The mere issuance of a patent does not guarantee that it is valid or enforceable; thus even if we are holding or are granted patents, we cannot be sure that they would be valid and enforceable against third parties. Further, a patent does not provide the patent holder with freedom to operate in a way that infringes the patent rights of others. Any legal action against us or our partners claiming damages and seeking to enjoin commercial activities relating to the affected products and processes could, in addition to subjecting us to potential liability for damages, require us or our partners to obtain a license in order to continue to manufacture or market the affected products and processes. There can be no assurance that we or our partners would prevail in any action or that any license required under any patent would be made available on commercially acceptable terms, if at all. If licenses are not available, we or our partners may be required to cease marketing our products or practicing our methods.

If expressed sequence tags, SNPs, or other sequence information become publicly available before we apply for patent protection on a corresponding full-length or partial gene, our ability to obtain patent protection for those genes or gene sequences could be adversely affected. In addition, other parties are attempting to rapidly identify and characterize genes through the use of SNP genotyping, gene expression analysis and other technologies. If any patents are issued to other parties on these partial or full-length genes or gene products or uses for such genes or gene products, the risk increases that the sale of our or our collaborators’ potential products or processes may give rise to claims of patent infringement. The amount of supportive data required for issuance of patents for human therapeutics is highly uncertain. If more data than we have available is required, our ability to obtain patent protection could be delayed or otherwise adversely affected. Even with supportive data, the ability to obtain patents is uncertain in view of evolving examination guidelines, such as the utility and written description guidelines that the U.S. Patent and Trademark Office has adopted.

Our patent applications covering DG041, DG051 and DG061 have not issued yet as patents.

The most important compounds that we have currently in pre-clinical and clinical development and we have discovered ourselves are DG041, DG051 and DG061. We have filed composition of matter-type patent applications covering the compounds in the US. However, these patent applications are in the early stages of patent prosecution before the United States Patent and Trademark Office (USPTO) and we have

31




no certainty or indication from the USPTO that these patent applications will issue as patents. The USPTO is currently facing considerable backlog for examining pending patent applications so considerable time may elapse before we will have more certainty as to the patentability of the compounds. Should the USPTO ultimately reject our patent applications covering DG041, DG051 or DG061, or should others have filed or obtained issued patent covering the same, the value and potential of these programs for our business would be adversely affected.

Any patent protection we obtain for our products may not prevent marketing of similar competing products.

Patents on our products may not prevent our competitors from designing around and developing similar compounds or compounds with similar modes of action that may compete successfully with our products. Such third party compounds may prove to be superior to our products or gain wider market acceptance and thus adversely affect any revenue stream that we could otherwise expect from sales of our products.

Any patents we obtain may be challenged by producers of generic drugs.

Patents covering innovative drugs, which are also commonly referred to as “branded drugs” or “pioneer drugs,” face increased scrutiny and challenges in the courts from manufacturers of generic drugs who may receive benefits such as limited marketing co-exclusivity if the challenge is successful. Such patent challenges typically occur when the generic manufacturer files an Abbreviated New Drug Application with the FDA and asserts that the patent or patents covering the branded drug are invalid or unenforceable, forcing the owner or licensee of the branded drug to file suit for patent infringement. If any patents we obtain covering our pharmaceutical products are subject to such successful patent challenges, our marketing exclusivity may be eliminated or reduced in time, which would thus adversely affect any revenue stream that we could otherwise expect from sales of our products.

Risks Related to Investing in Our Stock

Future sales of common stock may dilute our stockholders.

We may sell common stock in the future in one or more transactions at prices and in a manner we determine from time to time. If we sell common stock in more than one transaction, existing stockholders who previously purchased stock may be materially diluted by subsequent sales of common stock.

The price of our common stock is volatile and the market value of your investment may decrease.

The market prices for common stock of biotechnology and pharmaceutical companies, including ours, have historically been highly volatile, and the market has from time to time experienced significant price and volume fluctuations that are unrelated to the actual performance of particular companies. In addition to the various risks described elsewhere in this Form 10-K, the following factors could have an adverse effect on the market price of our common stock:

·       fluctuations in our operating results;

·       announcement of technological innovations or new therapeutic products by us or others;

·       clinical trial results;

·       developments concerning agreements with collaborators;

·       actual or threatened litigation;

·       governmental regulation and regulatory actions;

·       changes in patent laws;

·       developments concerning patent or other proprietary rights;

·       public concern as to the safety of drugs developed by us or others;

32




·       future sales of substantial amounts of common stock by existing stockholders; and

·       general market conditions and economic and other external factors, including disasters, wars and other crises.

We may issue preferred stock with rights that could affect your rights and prevent a takeover of the business.

Our board of directors has the authority, without further approval of our stockholders, to fix the rights and preferences, and to issue up to 6,716,666 shares of preferred stock. In addition, Delaware corporate law imposes limitations on certain business combinations. These provisions could, under certain circumstances, delay or prevent a change in control of deCODE and, accordingly, could adversely affect the price of our common stock.

We currently do not intend to pay dividends on our common stock and consequently, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates.

We currently do not plan to pay dividends on shares of our common stock in the near future. Consequently, your only opportunity to achieve a return on your investment in our company will be if the market price of our common stock appreciates.

Item 1B.               Unresolved Staff Comments

None.

Item 2.                        Properties

Our headquarters are in Iceland in an approximately 150,000 square-foot, three-story building, used both for our laboratories and offices. The building is leased under a fifteen year operating lease expiring in 2020. We also lease a total of 31,000 square feet in a building at Krokhals 5, Reykjavik, to house additional laboratory facilities and storage, including Encode’s operation. The Krokhals 5 lease is also leased under a fifteen year operating lease expiring in 2020.

Our principal executive offices and discovery laboratories in the United States are located in Woodridge, Illinois, and encompass approximately 103,000 square feet with the capability to expand our offices and laboratories to 200,000 square feet. Additionally, we occupy approximately a 19,000 square foot leased office and laboratory facility in Bainbridge Island, Washington.

We lease approximately 5,100 square feet of office space in Brighton, Michigan which houses our product development group.

We also lease approximately 6,500 square feet of office space in Waltham, Massachusetts, for finance and 1,600 square feet of office space in New York, New York for investor relations and corporate communications.

Item 3.                        Legal Proceedings

Other than claims and legal proceedings that arise form time to time in the ordinary course of business that are not material, deCODE has no pending legal proceedings except as follows:

On or about April 20, 2002, an amended class action complaint, captioned In re deCODE genetics, Inc. Initial Public Offering Securities Litigation (01 Civ. 11219(SAS)), alleging violations of federal securities laws in connection with deCODE’s initial public offering was filed in the United States District Court for the Southern District of New York on behalf of certain purchasers of deCODE common stock. The complaint names deCODE, two individuals who were executive officers of deCODE at the time of its initial public offering (the “Individual Defendants”), and the two lead underwriters (the “Underwriter Defendants”) for our initial public offering in July 2000 (the “IPO”) as defendants.

33




deCODE is aware that similar allegations have been made in hundreds of other lawsuits filed (many by some of the same plaintiff law firms) against numerous underwriter defendants and issuer companies (and certain of their current and former officers) in connection with various public offerings conducted in recent years. All of the lawsuits that have been filed in the Southern District of New York have been consolidated for pretrial purposes before United States District Judge Shira Scheindlin. Pursuant to the underwriting agreement executed in connection with our IPO, deCODE has demanded indemnification from the Underwriter Defendants. The Underwriter Defendants have asserted that our request for indemnification is premature.

Pursuant to an agreement the Individual Defendants have been dismissed from the case without prejudice.

On July 31, 2003, our Board of Directors (other than our Chairman and Chief Executive Officer, who recused himself because he was an Individual Defendant) approved a proposed partial settlement with the plaintiffs in this matter, subject to a number of conditions, including the participation of a substantial number of other issuer defendants in the proposed settlement, the consent of deCODE’s insurers to the settlement, and the completion of acceptable final settlement documentation. Any direct financial impact of the proposed settlement is expected to be borne by deCODE’s insurers.

In conjunction with the plaintiffs, the settling issuer defendants filed a motion seeking the court’s preliminary approval of the settlement. The court granted preliminary approval of the settlement on February 15, 2005, subject to certain modifications. On August 31, 2005, the court issued a preliminary order further approving the modifications to the settlement and certifying the settlement classes. The court also appointed the Notice Administrator for the settlement and ordered that notice of the settlement be distributed to all settlement class members beginning on November 15, 2005. The settlement fairness hearing has been set for April 24, 2006. Following the hearing, if the court determines that the settlement is fair to the class members, the settlement will be approved. There can be no assurance that this proposed settlement will be approved and implemented in its current form, if at all. If the settlement of the IPO litigation is not consummated, deCODE expects to contest the allegations in the action vigorously. Due to the inherent uncertainties of litigation and because the settlement approval process is at a preliminary stage, we cannot predict the ultimate outcome of this matter.

Due to the inherent uncertainties of litigation, and the fact that the settlement of the litigation relating to our IPO remains subject to court approval, the ultimate outcome of this matter cannot be predicted. If deCODE were required to pay significant monetary damages in the event that the IPO settlement is unconsummated or as a result of an adverse determination in the other actions described above (or any other lawsuits alleging similar claims filed against deCODE and deCODE’s directors and officers in the future), deCODE’s business could be significantly harmed. Even if such litigations conclude in deCODE’s favor, deCODE may be required to expend significant funds to defend against the allegations. deCODE is unable to estimate the range of possible loss from the above litigations and no amounts have been provided for such matters in deCODE’s financial statements.

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

None.

34




PART II

Item 5.                        Market for the Company’s Common Equity and Related Stockholder Matters

The Company’s Common Stock is traded on the Nasdaq National Market under the symbol “DCGN”. The following table sets forth, for the calendar periods indicated, the range of high and low sale prices for the Common Stock of the Company on the Nasdaq National Market:

 

 

High

 

Low

 

2004

 

 

 

 

 

First Quarter

 

$

13.80

 

$

8.15

 

Second Quarter

 

$

11.41

 

$

6.98

 

Third Quarter

 

$

8.70

 

$

5.10

 

Fourth Quarter

 

$

8.35

 

$

6.07

 

2005

 

 

 

 

 

First Quarter

 

$

8.04

 

$

5.57

 

Second Quarter

 

$

9.97

 

$

5.09

 

Third Quarter

 

$

10.67

 

$

7.83

 

Fourth Quarter

 

$

9.94

 

$

7.14

 

 

We have neither declared nor paid dividends on our common stock since our inception and do not plan to pay dividends in the foreseeable future. Any earnings that we may realize will be retained to finance our growth.

As of February 20, 2006, there were 4,522 holders of record of the Common Stock.

35




Item 6.                        Selected Financial Data

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and the notes to those statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report. The following data with regard to the consolidated balance sheets at December 31, 2005 and 2004 and the related statements of operations and cash flows for the years ended December 31, 2005 and 2004 has been derived from consolidated financial statements audited by Deloitte & Touche LLP, an independent registered public accounting firm. The following data with regard to the consolidated balance sheets at December 31, 2003, 2002 and 2001 and the related statements of operations and cash flows for the three years ended December 31, 2003 has been derived from consolidated financial statements audited by PricewaterhouseCoopers LLP, independent registered public accounting firm. Consolidated balance sheets at December 31, 2005 and 2004 and the related statements of operations and cash flows for each of the three years in the period ended December 31, 2005 and the notes thereto appear elsewhere in this annual report.

 

 

For the Year Ended December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(Tabular amounts in thousands,
except share and per share amounts)

 

Revenue

 

$

43,955

 

$

42,127

 

$

46,811

 

$

41,065

 

$

26,099

 

Operating expenses

 

 

 

 

 

 

 

 

 

 

 

Research and development, including cost of revenue

 

81,011

 

68,349

 

63,466

 

89,612

 

70,954

 

Selling, general and administrative

 

20,118

 

20,187

 

17,178

 

18,685

 

12,402

 

Impairment, employee termination and other charges (2)

 

 

 

951

 

64,790

 

 

Total operating expenses

 

101,129

 

88,536

 

81,595

 

173,087

 

83,356

 

Operating loss

 

(57,174

)

(46,409

)

(34,784

)

(132,022

)

(57,257

)

Interest income

 

6,397

 

2,903

 

1,151

 

2,954

 

6,925

 

Interest expense

 

(7,484

)

(8,983

)

(3,478

)

(3,079

)

(440

)

Other non-operating income and (expense), net

 

(4,489

)

(4,766

)

1,988

 

(72

)

(1,675

)

Loss before cumulative effect of change in accounting principle

 

(62,750

)

(57,255

)

(35,123

)

(132,219

)

(52,447

)

Cumulative effect of change in milestone revenue recognition method

 

 

 

 

333

 

 

Net loss

 

$

(62,750

)

$

(57,255

)

$

(35,123

)

$

(131,886

)

$

(52,447

)

Basic and diluted net loss per share:

 

 

 

 

 

 

 

 

 

 

 

Loss before cumulative effect of change in accounting principle

 

$

(1.17

)

$

(1.07

)

$

(0.68

)

$

(2.69

)

$

(1.26

)

Cumulative effect of change in milestone revenue recognition method

 

-

 

-

 

-

 

0.01

 

-

 

Net loss

 

$

(1.17

)

$

(1.07

)

$

(0.68

)

$

(2.68

)

$

(1.26

)

Shares used in computing basic and diluted net loss per share

 

53,823,999

 

53,422,931

 

51,507,869

 

49,098,254

 

41,634,009

 

Pro forma amounts assuming new milestone revenue recognition method was applied retroactively:

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

 

 

 

 

$

23,182

 

Net Loss

 

 

 

 

 

 

 

 

 

(55,364

)

Basic and diluted net loss per share

 

 

 

 

 

 

 

 

 

(1.33

)

 

36




 

 

 

As of December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(In thousands)

 

Cash and cash equivalents

 

$

65,943

 

$

70,238

 

$

68,669

 

$

87,244

 

$

153,061

 

Total assets(1)

 

206,758

 

288,252

 

183,475

 

213,417

 

249,900

 

Total long-term liabilities

 

190,572

 

197,950

 

49,874

 

56,533

 

44,428

 

Total stockholders’ equity (deficit) (1)

 

(9,337

)

52,396

 

93,407

 

125,246

 

170,733

 


(1)          In March 2002, deCODE completed the acquisition of MediChem Life Sciences, Inc. (MediChem) in a stock-for-stock exchange accounted for as a purchase transaction. Total consideration for the acquisition was $85,845,000. deCODE’s Statements of Operations include the results of MediChem from March 18, 2002, the date of acquisition.

(2)          In September 2002, deCODE recorded impairment, employee termination benefits and other charges in the total amount of $64,790,000.

Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Management’s Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2005 and for each of the three years in the period then ended should be read in conjunction with the audited consolidated financial statements and notes thereto set forth elsewhere in this report.

This Annual Report on Form 10-K contains forward-looking statements, including our expectations of future industry conditions, strategic plans and forecasts of operational results. Various risks may cause our actual results to differ materially. A list and description of some of the risks and uncertainties is contained below and in the summary of risk factors included in Item 1A.

Overview

deCODE is a biopharmaceutical company applying its discoveries in human genetics to develop drugs for common diseases. Our population approach and resources enable us to isolate genes and drug targets directly involved in the development of many of the biggest challenges to public health. We are turning these discoveries into a growing pipeline of therapeutics aimed at combating the causes of disease, not just the signs and symptoms. As these diseases are common and current therapies are of limited effectiveness, we believe that our strategy represents a significant opportunity to create better medicine with major potential in the global marketplace.

We believe that deCODE’s advantage derives from our population approach to human genetics and the ability to apply this approach across the drug development process. In Iceland, we have comprehensive population resources that enable our scientists to efficiently conduct genome- and population-wide scans to identify key genes and gene variations contributing to common diseases. The proteins encoded by these genes, and other proteins with which they interact in the disease pathway, offer drug targets that we believe are directly involved in the onset and progression of disease. Small-molecule drugs that target these proteins may therefore represent a direct means of modulating the onset or progression of the disease.

Through our medicinal chemistry and structural biology subsidiaries based in the United States, we are able to discover novel small-molecule therapeutic compounds, take candidate compounds through pre-clinical testing, and manufacture sufficient quantities for early-stage clinical trials. Our product development group designs and implements our clinical development programs. By leveraging the capabilities of Encode, and our expertise in genetics and drug and disease modeling, we are able to make the drug development process a more efficient and sensitive means of testing and optimizing the therapeutic and commercial potential of new drugs. In certain programs we have also taken advantage of the fact that drug targets we have identified through our genetics research have already been targeted by other companies to develop compounds for other indications. By licensing these compounds or entering

37




into co-development arrangements, we have been able to bypass over several years of drug discovery, entering directly into Phase II clinical trials.

Our goal is to bring to market new drugs for major indications, and in so doing make the company profitable and create value for our shareholders. To achieve this goal we must ensure that we have the capabilities and financial means to expand and advance our pipeline through the long, risky and expensive process of drug development and on to the market. This requires us to constantly evaluate the optimal balance between several factors, including the level of our investment in research and development, the preservation of cash resources and their deployment for product development, and the financing environment.

In order to support our drug development infrastructure, to focus the use of our cash resources on our proprietary therapeutics programs, and to diversify risk in our overall drug development portfolio, we leverage our capabilities to form corporate alliances and to provide services to fee-paying customers. We also receive contract and grant funding from various governmental agencies. We have formed drug and other product development alliances with Roche and Merck, among others. In addition to conducting work on our targets in our collaborative and internal programs, our medicinal chemistry subsidiary provides drug discovery services and contract manufacturing of therapeutic compounds for human clinical trials for our fee-for-service customers. Our other service offerings include protein crystallography products and instruments, as well as protein structure analysis contract services through our structural biology subsidiary; clinical trials services through Encode; and DNA analysis services through our genotyping laboratory in Reykjavik.

We derive revenues primarily from research funding and other fees from our service customers and collaborative partners; milestone payments and upfront, exclusivity, technology-access and technology-development fees under our collaboration agreements constitute most of the rest of our revenues. While we are entitled to royalties or profit-sharing under the terms of some of our agreements, due to the extended time period for the development and commercialization of a saleable product or therapy, we have not yet received royalties or profit sharing under any of our contracts and do not expect to do so for several years, if at all. Our expenses consist primarily of research and development expenses such as, salaries and related employee costs, materials and supplies, and contractor services.

We believe that ongoing work in genetics and advancing our drug development programs, particularly the conduct of clinical trials on a growing number of our compounds, will require significant and increasing expenditures. In 2005, we concluded the Phase II clinical studies for DG031, our developmental compound for the prevention of heart attack; initiated our Phase I clinical program for DG041, our developmental compound for peripheral artery disease (PAD); and initiated a Phase II trial in asthma. In the first half of 2006, we expect to finalize our protocol and begin enrollment for a Phase III trial for DG031; we have concluded our Phase I program for DG041and expect to begin Phase II; and we expect to conclude our Phase II trial in asthma. We are also advancing our pre-clinical work on our follow-on compound in heart attack, DG051, and on DG061 for pain, and expect these to be the next programs we bring into clinical development. We anticipate incurring additional net losses at least through the next several years, due to, in addition to the above-mentioned factors, depreciation and amortization, as well as stock-based compensation and other non-cash charges. We expect that our revenues and losses will fluctuate from quarter to quarter and that such fluctuations may be substantial, especially because progress in our scientific work and milestone payments that are related to progress can fluctuate between quarters. We do not believe that comparisons of our quarter-to-quarter performance are a good indication of future performance.

At December 31, 2005, we had $155.6 million in cash, cash equivalents and investments and as we advance and broaden our drug development pipeline we will require significant additional capital for product development and so we will continue to investigate additional avenues of financing. Our ability to obtain capital will be affected by conditions in the global financial markets and in the pharmaceutical

38




industry. We expect that downturns in the market valuations of biotechnology companies and of the equity markets more generally will restrict our ability to raise additional capital on attractive terms, while more favorable conditions in those markets will present opportunities for us.

The difficulties facing the pharmaceutical industry present for us both near-term challenges and significant longer-term opportunities. One of the main issues confronting big pharmaceutical companies is their lack of promising new drugs to treat major indications. As many leading brand-name drugs come off patent and face generic competition, developing successful new medicines will become critical for filling the gap. In the short term, the financial pressures on pharmaceutical companies may be reflected in their research and development spending, making it more difficult for us to sign corporate alliances with significant up-front funding, or lengthening the time required to negotiate such deals. We believe that in the medium to longer term, however, companies such as ours may be well positioned to play an important role in filling the gap in the pipeline of new drugs, either alone or as partners of pharmaceutical companies. Our partnerships demonstrate that the industry is already investing in the development of new therapeutics based on our approach.

Research and Development Programs

The following is a summary of the development of our drug candidates in late pre-clinical or clinical development. Because of uncertainties involved in the drug development process, the actual timing for the events described below may differ materially from that provided in this summary.

·       Our most advanced developmental compound is DG031 for the prevention of heart attack. In 2005, we concluded the Phase II clinical trials for DG031. We have submitted the safety summary and results of the Phase II trials to the FDA and have conducted an end of Phase II meeting with the FDA. We are working with the FDA under a Special Protocol Assessment to finalize the protocol for a Phase III outcome trial for DG031 which will focus on African Americans with the HapK variant in the LTA4H gene. The initiation of the DG031 Phase III trial may be affected by timelines for manufacturing, packaging, labeling and shipping of clinical supplies, negotiating with CROs for clinical trial performance, and the approval process for the study protocol by local Institutional Review Boards (IRB) and/or the FDA. We expect to begin enrolling patients for the Phase III trial in the first half of 2006.

·       DG041 is our lead compound for the treatment of atherosclerosis of the extremities, or peripheral artery disease (PAD). DG041 is a first-in-class small molecule inhibitor of the EP3 receptor for prostaglandin E2, a G-protein coupled receptor (GPCR) encoded by a gene we have shown to be associated with increased risk of developing the disease. Our IND application for DG041 was accepted by the FDA in February 2005 and on this basis we began the Phase I program for this compound. In fall 2005, our chemistry group developed a new formulation which increased bioavailability by nearly four fold, and we concluded the Phase I program in early 2006. Nearly 200 healthy subjects were exposed to DG041 in these studies at doses up to 1600mg/day for seven days. The results of the Phase I program showed DG041 to be well-tolerated, without any drug-related significant adverse events noted, and that DG041 can effectively inhibit platelet aggregation in a dose-dependent manner without increasing bleeding time. We expect to begin a Phase II clinical trial in the first half of 2006.

·       In asthma, we are conducting a Phase II trial on behalf of another company. This compound inhibits MAP3K9, a kinase encoded by a gene we have linked to risk of asthma. We expect to conclude this study in the second quarter of 2006.

·       As a follow-on to DG031, we are developing an inhibitor of LTA4H, a compound which is likewise aimed at preventing heart attack by decreasing the production of LTB4. Our pre-clinical compound, DG051, appears to provide potent inhibition of LTB4 production, is orally bioavailable, and with minimal potential for drug-drug interaction. We anticipate filing an IND on DG051 in 2006.

39




·       Utilizing compounds discovered in our program on peripheral artery disease, our drug discovery group is bringing forward a lead pre-clinical candidate, DG061, for the treatment of pain. Pre-clinical studies of DG061 demonstrate that it is efficacious in a mouse model for pain. Moreover, by targeting the EP3 receptor for prostaglandins E2, it may be possible to avert the risk of cardiovascular events and gastric ulceration that accompany the long-term use of selective Cox-2 inhibitors and other NSAIDs. deCODE expects to file an IND on DG061 in 2006.

·       We are pursuing a PDE4 inhibitor program for vascular disease/stroke pursuant to our 2004 agreement with Roche and working on identifying and advancing a lead pre-clinical compound.

We use many of our employee and infrastructure resources across several programs, and many of our research and development costs are indirectly attributable to an individually named program or are directed broadly to applicable research programs. However, taking into account costs that are specifically attributable to individual programs and allocations of our research and development program costs based upon those direct costs, we have cumulatively invested $12.6 million, $10.6 million and $4.0 million and $6.0 million in our Myocardial Infarction (MI), PAD, stroke and asthma programs, respectively, from the beginning of 2003 to date. Inception to-date costs are not available as these costs were not historically tracked by program.

We have not applied for or received marketing approval from the applicable regulatory authorities in any country for any of our drug candidates. In order for us to achieve marketing approval in the United States, the FDA must conclude that our clinical data establish the safety and efficacy of our drug candidate. Other countries have similar requirements. Historically, the results from pre-clinical testing and early clinical trials (through Phase II) have often not been predictive of success in later clinical trials. Many new compounds have shown promising results in early clinical trials, but subsequently failed to establish sufficient safety and efficacy data to obtain necessary marketing approvals. Additional risks and uncertainties involved in the development and commercialization of any products are described above under the caption “Risk Factors”. We expect that it will be several years, if ever, before we receive revenues from the commercial sale of our therapeutic products.

Furthermore, our strategy includes the option of entering into collaborative arrangements with third parties to participate in the development and commercialization of our products. Entering into a collaboration with a partner at any point in the development or commercialization of a product is a business decision. When making this decision we do and will consider, among other matters, the complexity of the indication, the size, complexity and expense of necessary development and/or commercialization efforts, competition in the market and size of the applicable market, an assessment of our own resources—financial and operational, and an assessment of the resources of a potential partner. In the event that we do collaborate on any of the above programs in the future, a partner will have a level of control, which may be significant, over the pre-clinical development or clinical trial process for a product. As a result the completion date of such a partnered program could largely be under control of that third party rather than under our control. We cannot forecast with any degree of certainty which proprietary drug candidate will be subject to future collaborative arrangements or how such arrangements would affect our development plan or capital requirements.

As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will receive cash inflows from the commercialization and sale of a product.

Acquisitions and in-licensing

As part of our business strategy, we continue to consider joint development programs and merger and acquisition opportunities that may provide us with products in late-stage development, intellectual property or financial resources, or with capabilities that will help accelerate our downstream drug discovery efforts.

40




In January 2006, we acquired all of the outstanding shares of Urdur Verdandi Skuld ehf. (“UVS”), a privately-held cancer research firm, from Iceland Genomics Corporation, Inc. (“IGC”), both companies having their principal offices in Reykjavik, Iceland. As consideration for the purchase, we issued 635,006 shares of deCODE common stock valued at $6,082,000 to IGC. This acquisition will allow us to broaden our cancer program by applying our gene discovery and drug development efforts to a larger population.

In certain programs we have taken advantage of the fact that drug targets we have identified through our genetics research have already been employed by other companies to make developmental compounds for other indications. By licensing these compounds or entering into co-development arrangements we have been able to leapfrog over several years of drug discovery, entering directly into Phase II clinical trials. We are currently preparing a Phase III clinical trial for DG031, our lead developmental compound for the prevention of heart attack, which we licensed from Bayer HealthCare AG. We are also conducting a Phase II trial in asthma on behalf of a third party. We continue to investigate additional such possibilities for the in-licensing or co-development of promising existing compounds that may effectively act against targets we have identified through our gene discovery work.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires us to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported period. On an ongoing basis we evaluate our estimates, which include, among others, those related to revenue recognition, property and equipment, goodwill and intangible assets, materials and supplies, derivative financial instruments, income taxes, litigation and other contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. The impact and any associated risks related to these and our other accounting policies on our business or operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, please refer to our notes to the Consolidated Financial Statements. There can be no assurance that actual results will not differ from the estimates referred to above.

We believe the following policies to be the most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain.

Collaborations and Revenue

Our collaborative arrangements and the recognition of revenue in such arrangements is the accounting policy most critical to us. A substantial portion of our revenues relate to funded research collaborations. Our revenues from research and development collaboration agreements are recorded and recognized in accordance with the applicable performance requirements and terms of the respective contracts, generally either (i) as contract research costs are incurred, usually ratably over the period of effort, (ii) according to the level of efforts expended based on the ratio of contract research costs incurred to expected total costs, or (iii) upon the achievement of substantive milestones. Our accounting recognition policies with respect to each significant element of our revenue is summarized as follows:

Research funding and other service fees.   Research funding is recognized as earned, typically ratably over the period of effort. Funding payments are not refundable in the event that the related efforts are not successful. Other service revenues from negotiated rate contracts are recognized based upon the terms of the underlying contract generally either (i) on a per diem basis as services are rendered; (ii) on the basis of efforts expended, generally upon the ratio of costs incurred to total expected costs of providing the service;

41




or (iii) upon completion of the service rendered. Any losses on contracts are provided for when they are determinable. Included in revenue are billings to customers for the cost of materials purchased by deCODE.

Milestone payments.   In arrangements with multiple elements entered into before June 15, 2003 where (i) the milestone event is substantive, (ii) there is substantial effort involved in achieving the milestone, (iii) the milestone payment amount is commensurate with the magnitude of the related achievement, and (iv) the associated follow-on revenue streams bear a reasonable relationship to one another, we recognize revenue using the substantive milestone method. Under the substantive milestone method, deCODE records revenue when the milestone has been achieved and payment is due and payable under the terms of the respective agreement and we recognize revenue when acknowledgement of achievement of applicable performance requirements is received from the collaborator. Milestone payments without the above characteristics are recognized on a retrospective basis over the contractual term of the underlying agreement. In arrangements with multiple elements entered into after June 15, 2003, if the milestone is substantive in nature and there is uncertainty in the achievement of the milestone and there is no further obligation on our part, we record revenue when the milestone has been achieved and payment is due and payable under the terms of the respective agreement and we recognize revenue when acknowledgement of achievement of applicable performance requirements is received from the collaborator (“Milestone Payment Method”). If the milestone is earned and we have no further obligation under the contract for performance, then we will record revenue when the milestone has been achieved and payment is due and payable under the terms of the respective agreement and we retroactively recognize revenue through the current period based on the total contractual term and amortize the balance over the remaining contractual term.

Up-front, exclusivity, technology access, and technology development fees.   We recognize revenue from non-refundable fees not specifically tied to a separate earnings process ratably over the expected customer relationship period or estimated period of performance. Changes in estimates could impact revenue in the period the estimate is changed. If our estimate of the period of performance shortens or lengthens, the amount of revenue we recognize from such non-refundable fees not specifically tied to a separate earnings process could increase or decrease in the period the change in estimate becomes known; future related revenues would be adjusted accordingly.

Revenue estimates are reviewed and revised throughout the lives of our contracts and are made based upon current facts and circumstances. If changes in these estimates or other material adjustments to revenue are identified, the adjustments to profits resulting from such revisions will be recorded on a cumulative basis in the period in which the revisions are made.

Long-Lived Assets, Goodwill and Intangibles

We periodically review property and equipment, goodwill and intangibles for potential impairments and to assess whether their service lives have been affected by continued technological change and development. There were no events in 2005, 2004 and 2003 that triggered an impairment review nor did our annual review indicate any recoverability issues. Should we determine that there has been an impairment of our fixed assets, goodwill or other intangible assets in the future we would suffer an increase to our net loss or a reduction of our net income in the period such a determination is made. In light of experience and the current technological environment, in 2004 we changed certain of our salvage value and useful life estimates for equipment and furniture and fixtures for purposes of depreciation. These changes in estimates had the effect of increasing depreciation expense in 2004 by $2.2 million as compared to 2003. Should we determine that the pace of technological change or other matters dictate that we change the service lives or other estimates inherent in determining the carrying-values of our long-lived assets, there will be an impact on depreciation expense from the date of the change.

42




Materials and Supplies

We value our materials and supplies at the lower of cost or market, cost being determined on the first-in, first-out method. We apply judgment in determining necessary provisions for slow moving, excess and obsolete materials and supplies based on historical experience and anticipated usage, giving effect to general market conditions. Any rapid technological changes or future business developments could result in an increase in the amount of obsolete materials and supplies on hand. Furthermore, if our estimates of our needs for materials and supplies prove to be inaccurate, additional provision may be required for incremental excess and obsolete items. We recorded charges for write-down of obsolete and excess materials and supplies of $0.1 million, $0.1 million and $0.8 million for the years ended December 31, 2005, 2004 and 2003, respectively. In 2005, 2004 and 2003, we used materials and supplies for which we had made provisions for in prior years as slow-moving, excess and obsolete, benefiting otherwise reported operating expenses by $0.8 million, $1.4 million and $0.8 million, respectively.

Foreign Exchange Transactions

Our functional currency is the U.S. dollar. However, in light of the significance of our operations outside the United States, an important element of our cost base is or will be denominated in Icelandic krona, including much of our payroll and other operating expenses and some of our long-term borrowings. As a consequence of the nature our business and operations, our reported financial results and cash flows are exposed to the risks associated with fluctuations in the exchange rates of the U.S. dollar, the Icelandic krona and other world currencies. To manage our exposure to fluctuations in exchange rates, we have entered into, and will likely continue to enter into derivative instruments to hedge our exposure to such fluctuations. The net impact of foreign exchange on the translated amount of our non-US dollar denominated liabilities, net together with transaction gains and losses, amounted to losses of $0.1 million for the year-ended December 31, 2005. Although the significant weakening of the U.S. dollar vis-à-vis the Icelandic krona during 2003 and 2004 somewhat abated during 2005, currency fluctuations may continue to adversely affect our financial results.

Income Taxes

Significant estimates are required in determining our provision for income taxes, including interpretations of existing tax laws and regulations. Various internal and external factors may have favorable or unfavorable effects on our future effective tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, changing interpretations of existing tax laws or regulations, future research and development spending and future levels of capital expenditures. The preparation of financial statements requires us to evaluate the positive and negative evidence bearing upon the realizability of our deferred tax assets resulting from deductible operating losses and other items. Due primarily to our history of operating losses and the expectation that such losses will continue into the foreseeable future, we have concluded that, insufficient positive evidence exists to justify the recognition of our net deferred tax assets in our balance sheet. Although there can be no assurance that losses generated to date will be used to offset future taxable income, an adjustment to the valuation of our current net deferred tax assets in the future would increase income in the period that we made a determination that such an adjustment was appropriate. Income tax in Iceland is payable in Icelandic krona. Consequently, the US dollar value of our net operating loss carryforwards and other deferred tax assets and liabilities is subject to fluctuations in exchange rates. Such fluctuations over time may increase or reduce the reported US dollar balance of our deferred tax assets and liabilities, and there would be a corresponding gain or loss reported in our income statement.

43




Litigation and Other Contingencies

We consider litigation and other claims and potential claims or contingencies in preparing our financial statements under generally accepted accounting principles in the United States of America. We maintain accruals for litigation and other contingencies when we believe a loss to be probable and reasonably estimated. In doing so, we assess the likelihood of any adverse judgments or outcomes with respect to legal and other matters as well as potential of probable losses. We base our accruals on information available at the time of such determination. Changes or developments in the relevant action or our strategy in such proceedings could materially affect our results of operations for any particular quarterly or annual period. Since the recognition of a loss is dependent upon factors not completely in the control of management, timing of a charge, if any, is difficult to predict with certainty.

Recent Accounting Pronouncements

In March 2005, the FASB issued FASB Interpretation (“FIN”) 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143”. FIN 47 clarifies that conditional asset retirement obligations meet the definition of liabilities and should be recognized when incurred if their fair values can be reasonably estimated. We adopted the provisions of FIN 47 effective December 31, 2005. The adoption of FIN 47 had no impact on our results of operations or financial position.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Correction” (“SFAS No. 154”), a replacement of APB Opinion No. 20 and Statement No. 3. SFAS No. 154 changes the requirements for the accounting and reporting of a change in accounting principles. SFAS No. 154 applies to all voluntary changes in accounting principles as well as to changes required by an accounting pronouncement that does not include specific transition provisions. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

Results of Operations from the Years Ended December 31, 2005, 2004 and 2003

Our results of operations have fluctuated from period to period and may continue to fluctuate in the future based upon, among other things, the pace and progress of our proprietary research and clinical development efforts, the timing and composition of funding under our various collaborative agreements, and the progress of our own research and development efforts. Results of operations for any period may be unrelated to results of operations for any other period. In addition, historical results should not be viewed as indicative of future operating results. We are subject to risks common to companies in our industry and at our stage of development, including risks inherent in our research and development efforts, reliance upon collaborative partners, development by us or our competitors of new technological innovations, ability to market products or services, dependence on key personnel, dependence on key suppliers, protection of proprietary technology, ability to obtain additional financing, ability to negotiate collaborative arrangements, and compliance with governmental and other regulations. In order for a product to be commercialized based on our research, we and our collaborators must conduct pre-clinical tests and clinical trials, demonstrate the efficacy and safety of our product candidates, obtain regulatory approvals or clearances and enter into manufacturing, distribution and marketing arrangements, as well as obtain market acceptance. We do not expect to receive revenues or royalties based on therapeutic or diagnostic products for a period of years, if at all.

Financial highlights as of and for the year ended December 31, 2005 include:

·       At December 31, 2005, we had $155.6 million in cash, cash equivalents and investments compared to $198.3 million (including restricted cash) at December 31, 2004. The net utilization of $42.7 million in 2005 reflects costs associated with the advancement of our drug development programs as reflected in the $54.0 million cash used in operations, together with the net proceeds from the sale

44




and leaseback of our Sturlugata and Krokhals facilities in Reykjavik, Iceland ($22.0 million) and also the refinancing of the mortgage on our Woodridge, IL facility.

·       Research and development expense for proprietary programs was $43.7 million in 2005 as compared to $24.9 million in 2004 and $17.6 million in 2003. The increase in our research and development expenses for proprietary programs is the result principally of costs associated with the advancement of our lead drug development programs in clinical trials.

·       In March 2005, we entered into a financing for the sale and leaseback of our headquarters facility at Sturlugata 8, Reykjavik, Iceland. The sale price for the property was 3.4 billion Icelandic kronas ($54.8 million after taking into account a forward foreign exchange contract we entered into in connection with the sale of the property). As a result of the sale, we have removed the remaining net book value of the property ($29.3 million) from our balance sheet, deferred the resulting gain and have begun recognizing the gain to earnings over the 15 year term of the leaseback. A portion of the proceeds from the sale of Sturlugata 8 went to prepay approximately $38.6 million of short and long-term debt that was secured by mortgages on the property and, in this connection, we have recorded a loss on early extinguishment debt amounting to $3.1 million. We have leased the property back under a 15 year non-cancelable lease agreement at a rent of 21.4 million Icelandic kronas (approximately $0.3 million as of December 31, 2005) per month, subject to changes based on the Icelandic consumer price index. We are accounting for the leaseback as an operating lease.

·       In June 2005, we entered into a financing for the sale and leaseback of our facility at Krokhals 5D and 5E, Reykjavik, Iceland. The sale price for the property was 502 million Icelandic kronas (approximately $7.6 million after taking into account a sales commission). As a result of the sale, the remaining net book value of the property ($4.0 million) has been removed from the balance sheet, and we have begun recognizing the deferred gain to earnings over the 15 year term of the leaseback. A portion of the proceeds from the sale of Krokhals were used to prepay approximately $1.8 million of long-term debt that was secured by a mortgage on the property. deCODE has leased the Krokhals 5D and 5E property back under a 15 year non-cancelable lease agreement at a rent of 4.1 million Icelandic krona (approximately $0.06 million as of December 31, 2005) per month, subject to changes based on the Icelandic consumer price index.

·       Our revenue in 2005 was $44.0 million as compared to $42.1million in 2004 and $46.8 million in 2003. Revenue for the periods presented generally reflects our strategic focus on drug discovery and development. Specifically, the increase in revenue in 2005 as compared to 2004 is mainly due to grant monies earned, service contract fees and the addition of the Roche alliance to co-develop inhibitors of PDE4, offset by the completion of research funding under the 2002 agreement with Roche and the Merck obesity research program.

Revenue

Our business strategy is focused on turning our discoveries into new drugs for the treatment of common diseases. At the same time, we leverage our capabilities to generate revenue through corporate alliances and through service contracts. In the majority of our programs we are pursuing drug development on our own. In certain others, we have formed alliances with pharmaceutical and biotechnology firms through which we can cover some of the cost of conducting basic research and spread the risk and investment involved in product development. We have entered into research, development, commercialization, and fee for service alliances and contracts across our business. Depending on the nature of each prospective business opportunity, the key components of the commercial terms of such arrangements typically include one or more of the following: research funding; up-front, exclusivity, technology access, and technology development fees; fees for particular services; milestone payments; license or commercialization fees; and royalties or profit sharing from the commercialization of products.

45




Significant elements of our revenue is summarized as follows:

 

 

For the Year Ended December 31,

 

 

 

2005

 

2004

 

2003

 

 

 

(In thousands)

 

Research funding and service fees

 

$

29,111

 

$

31,723

 

$

34,712

 

Milestone payments

 

1,216

 

1,835

 

5,794

 

Up-front, exclusivity, technology access, and technology development fees

 

4,538

 

4,116

 

4,000

 

Grant funding

 

7,287

 

2,032

 

1,006

 

Other

 

1,803

 

2,421

 

1,299

 

 

 

$

43,955

 

$

42,127

 

$

46,811

 

 

Collaborations with our most significant partners include:

F. Hoffmann-La Roche (Roche)

Therapeutics.   In 2002, we entered into an agreement with Roche to collaborate on four diseases that had been the subject of an earlier collaboration with Roche. During 2004 and through January 2005, we collaborated with Roche on two of those diseases. Under this agreement we discovered genes linked to diabetes and Roche continues drug discovery based on one of these discoveries. Under the 2002 agreement, which expired on February 1, 2005, we received $20.0 million in research funding and we are entitled to receive royalties on the sales of any drugs that are developed coming out of work conducted under this agreement.

In November 2004, we signed a new three-year agreement with Roche to co-develop inhibitors of PDE4 for the prevention and treatment of vascular disease, including stroke. This agreement continues work advanced under the 2002 agreement, and we will focus on optimizing lead compounds identified under the previous agreement and beginning clinical development. Under this agreement, as of the end of 2005, we received $2.0 million of research funding. We will share drug discovery and clinical trials costs under this new agreement, and we may receive an additional $4.0 million of research funding over the remaining term of the agreement as well as milestone payments and royalties based on drug sales.

Diagnostics.   In June 2001, deCODE signed a five-year alliance with Roche’s diagnostics division to develop and market DNA-based diagnostics for major diseases. More recently deCODE has added research programs aimed at developing diagnostics to predict drug response for major therapeutics used to treat those diseases, in order to help select the most effective treatment of those available. Under the agreement deCODE has received $41.1 million in research funding, up-front fees and milestone payments. deCODE may receive $3.1 million in additional research funding over the remainder of the term of the agreement as well as milestone payments upon the achievement of research and development milestones and royalties on the sales of diagnostic products developed.

Revenues from these alliances with Roche amounted to $10.0 million, $12.6 million and $19.9 million for the years ended December 31, 2005, 2004 and 2003, respectively. Costs incurred with these collaborative programs with Roche amounted to $8.3 million, $19.5 million and $19.6 million for the years ended December 31, 2005, 2004 and 2003, respectively.

Merck & Co, Inc. (Merck)

Obesity.   In September 2002, we entered into a three year alliance with Merck aimed at developing new treatments for obesity. Under the alliance, we combined research efforts with Merck in the genetics of obesity to identify, validate and prioritize a series of drug targets to take into development. During the three-year research program, which has now expired, we have received research funding, technology access fees and milestone payments in the aggregate amount of $25.3 million. In addition, we may receive further

46




technology access fees in the total aggregate amount of $2.0 million. Subject to Merck’s developing products based on collaboration discoveries, we may also receive development milestones and royalties. We have discovered three genes linked to obesity under this alliance, and Merck has generated a lead series of compounds against one of the targets we validated through our genetics research.

Revenues from this alliance with Merck amounted $6.3 million, $7.9 million and $8.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. Costs incurred in connection with this alliance with Merck amounted to $2.9 million, $4.6 million and $5.2 million for the years ended December 31, 2005, 2004 and 2003, respectively.

Information-Rich Clinical Trials.   In February 2004, we entered into an agreement with Merck which provides that deCODE will conduct information-rich clinical trials on a range of Merck’s developmental compounds that Merck selects for inclusion in the program. The term of the alliance is seven years, subject to termination by Merck after five years. The collaboration involved three agreements: (a) a License and Research Collaboration Agreement; (b) a Stock and Warrant Purchase Agreement; and (c) a Warrant Agreement. Under the terms of the License and Research Collaboration Agreement, we will receive royalties on sales of drugs and diagnostics developed as part of the alliance, will receive milestone payments as compounds or pharmacogenomic tests reach the market, will receive research funding for the clinical development of compounds and pharmacogenomic analysis, and received a one-time technology access fee of $10.0 million. A contingency clause on the technology access fee provides that if deCODE rejects the first two non-exclusive development compounds that Merck presents to the collaboration, then Merck has the right to request a refund of $2,500,000 of the technology access fee. The remaining amount of the technology access fee is non-refundable. To date, Merck has not selected any compounds for development under the agreement.

The warrant was valued at $6,300,000 using a Black Scholes model with the following assumptions: lives of one to five years, risk free interest rates of 1.24% to 3.07%, volatility of 90% and no dividend yield. The one-time technology access fee of $10,000,000 and the $2,700,000 premium received on the sale of common stock less the estimated fair value of the warrant of $6,300,000, together netting to $6,400,000, has been recorded as deferred revenue. This amount less the refundable amount of $2,500,000 ($3,900,000) is being recognized as revenue according to level of efforts over the seven-year development term. The refundable $2,500,000 technology access fee will be recognized as revenue according to level of efforts retrospectively over the seven-year development term commencing upon satisfaction of the. To date, Merck has not selected any compounds for development under the agreement that has advanced to patients.

Revenues from this alliance with Merck amounted to $0.2 million and $0.8 million for the years ended December 31, 2005 and 2004, respectively. Costs incurred in connection with this alliance with Merck amounted to $0.1 million and $1.3 million for the years ended December 31, 2005 and 2004, respectively.

Grant Funding

We have received various research grants from divisions of the United States National Institutes of Health (NIH), the Commission of the European Communities (EC) and private foundations. Research grants for multiple years are based on approved budgets with budgeted amounts subject to approval on an annual basis. NIH grants generally provide for 100% reimbursement of allowable expenditures while the grant under the EC generally provides for fifty percent reimbursement of allowable research and development related expenditures. Our significant research contracts include:

National Institute of Allergy and Infectious Diseases (NIAID).   In September 2004, deCODE was awarded a five-year $23,900,000 contract by the NIAID, a division of NIH. Under the contract, deCODE will apply its population approach and resources to discover genetic factors associated with susceptibility to

47




certain infectious diseases and with responsiveness to vaccines targeting such diseases. deCODE may receive $18.4 million in additional research funding over the remaining term of the agreement.

For the years ended December 31, 2005, 2004 and 2003, we recognized revenue of $7.3 million, $2.0 million and $1.0 million from research grants. Costs incurred with research grants amounted to $7.7 million, $2.0 million and $1.0 million for the years ended December 31, 2005, 2004 and 2003, respectively.

Revenue for the years ended December 31, 2005, 2004 and 2003 are as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Revenue

 

$

43,955

 

$

42,127

 

$

46,811

 

 

$

1,828

 

 

 

4

%

 

 

$

(4,684

)

 

 

(10

)%

 

 

Revenue for the periods presented generally reflects our strategic focus on drug discovery and development. Specifically the increase in revenue in 2005 as compared to 2004 is mainly due to grant monies earned, service contract fees and the addition of the Roche alliance to co-develop inhibitors of PDE4, offset by the completion of research funding under the 2002 agreement with Roche and the Merck obesity research program. Revenue decrease as compared to the 2003 period is reflective of the transition of our business from the generation of near-term revenue through service partnerships and other means to a greater focus on the development of new drugs in major indications. At December 31, 2005 we had $12.3 million in deferred revenue, compared to $15.9 million at the close of the 2004. We expect that our revenues will fluctuate from period to period and that such fluctuations may be substantial especially because progress in our scientific work, including milestone payments that are related to progress, can fluctuate between periods.

Cost of Revenue, including Collaborative Programs

Cost of revenue, including costs incurred in connection with collaborative programs for the years ended December 31, 2005, 2004 and 2003 are as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Cost of Revenue, Including Collaborative Programs

 

$

37,263

 

$

43,407

 

$

45,870

 

 

$

(6,144

)

 

 

(14

)%

 

 

$

(2,463

)

 

 

(5

)%

 

 

Our cost of revenue consists of the costs of services provided to customers, collaborators and under grants, including the entirety of the costs incurred in connection with programs that have been partnered and on which we receive research funding. At times, we invested in addition to costs covered by research funding received in such collaborative programs. The decrease in our cost of revenue, including costs incurred in connection with collaborative programs over the periods presented, in general reflects a relative lessening of our investment in programs on which we receive research funding.

Our cost of revenue, including costs incurred in connection with collaborative programs in 2005 as compared to 2004 includes (i) an overall decrease in direct salary and employee related expenses ($0.9 million), (ii) less in chemicals and consumables ($1.3 million), which drives (iii) lower allocation of overheads ($0.4 million) and depreciation and amortization ($4.4 million) and also an increase in contractor services ($0.9 million). The lower depreciation and amortization is also due to the sale-leaseback of our facilities in Iceland during 2005 which reduced our depreciation expense.

Our cost of revenue, including costs incurred in connection with collaborative programs in 2004 as compared to 2003 includes (i) an overall decrease in direct salary and employee related expenses

48




($2.0 million) which drives a (ii) lower allocation of overheads, depreciation and amortization ($1.7 million), together with (iii) a relative net benefit of $0.5 million resulting from chemicals and consumables we used for which there was relatively little or no attendant cost as a result of prior provisions we had made as slow moving, excess or obsolete according to our accounting policy, (iv) increases in outside contractor services ($1.6 million), and (v) more in chemicals and consumables ($0.6 million).

Although the strengthening of the Icelandic krona versus the U.S. dollar has somewhat abated during 2005, the relative strengthening of the Icelandic krona versus the U.S. dollar in 2004 and 2003 has appreciably affected the U.S. dollar reported amounts of our expenses denominated in Icelandic krona (e.g., a portion of our salary and employee related expenses included in cost of revenue) and may continue to do so.

Research and Development—Proprietary Programs

Research and development for proprietary programs for the years ended December 31, 2005, 2004 and 2003 is as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Research and Development—Proprietary Programs

 

$

43,748

 

$

24,942

 

$

17,596

 

$

18,806

 

 

75

%

 

 

$

7,346

 

 

 

42

%

 

 

The increase in our research and development expenses in proprietary programs results from our emphasis on and increasing expenditures in product development, including pre-clinical and clinical work on our lead drug discovery and development programs. Importantly, in 2005 we concluded a Phase II trial for DG031, our lead developmental compound for the prevention of heart attack and are currently preparing a Phase III clinical for this compound. In 2005, we also funded and implemented a Phase I trials for DG041, our developmental compound in Peripheral Artery Disease and co-funded a Phase II trial in asthma for a compound developed by another company; a portion of the costs of this trial are included in our research and development expenses for proprietary programs. Further, among other pre-clinical programs we are developing a compound to inhibit the LTA4 hydrolase, a protein encoded by a second gene within the same pathway targeted by DG031 that we have also linked to significantly increased risk of heart attack, and we have begun a PDE4 inhibitor program for vascular disease/stroke pursuant to our 2004 agreement with Roche. In 2005, we also initiated a program to develop inhibitors to the EP3 receptor for prostaglandins E2 for the management of pain.

Our research and development expenses for the years ended December 31, 2005, 2004 and 2003 consist of the following:

 

 

2005

 

2004

 

2003

 

Salaries and other personnel costs

 

$

18,072

 

$

10,233

 

$

8,375

 

Materials and supplies

 

4,600

 

3,671

 

2,650

 

Contractor services and other third party costs

 

13,285

 

3,938

 

3,669

 

Overhead expenses

 

4,630

 

1,603

 

1,773

 

Depreciation and amortization

 

3,089

 

5,123

 

3,883

 

Stock-based compensation

 

72

 

374

 

467

 

Database license fee reversal

 

 

 

(3,221

)

 

 

$

43,748

 

$

24,942

 

$

17,596

 

 

Increases in the research and development costs of our proprietary programs (e.g., salaries and attendant costs, usage of chemicals and consumables) will likely continue, particularly as we advance our

49




clinical development and proprietary drug development programs. Further, we have granted salary increases to our personnel and have added clinical development executives to our staff, which will contribute to future increases in our research and development costs for proprietary programs. The lower depreciation and amortization is also due to the sale-leaseback of our facilities in Iceland during 2005 which reduced our depreciation expense. Our rent increase will increase due to the above transaction. This will be offset by the deferred gain on the sale-leaseback which is being amortized over the term of the lease.

Although the strengthening of the Icelandic krona versus the U.S. dollar has somewhat abated during 2005, the relative strengthening of the Icelandic krona versus the U.S. dollar in 2004 and 2003 has appreciably affected the U.S. dollar reported amounts of our expenses denominated in Icelandic krona (e.g., a portion of our salary and employee related expenses included in cost of revenue) and may continue to do so.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the years ended December 31, 2005, 2004 and 2003 are as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Selling, General and Administrative

 

$

20,118

 

$

20,187

 

$

17,178

 

 

$

(69

)

 

 

-

%

 

 

$

3,009

 

 

 

18

%

 

 

Our selling, general and administrative expenses for 2005 compared to 2004 are essentially unchanged. Salaries and employee related costs did increase ($0.9 million) and legal expenses increased with activity around our intellectual property and patent applications ($0.2 million), but then outside contractor service costs have decreased with efficiencies gained in this second year of implementation of the provisions of the Sarbanes Oxley Act of 2002 ($0.3 million). There is also a relative decrease in our selling, general and administrative expenses for the year ended December 31, 2005 as compared to the 2004 due to severance costs ($0.3 million) and an accrual for probable losses related to grant monies received in pre-acquisition periods of MediChem ($0.4 million) recorded in 2004.

Our selling, general and administrative expenses for 2004 increased compared to 2003, notably including (i) increased salaries and employee related costs ($0.7 million), (ii) employee incentives ($1.4 million), (iii) severance costs ($0.6 million), (iv) greater travel and overhead expenses ($0.7 million), (v) recruiting fees related to the addition of new members to our Board of Directors and also our efforts to hire necessary clinical development and regulatory staff ($0.4 million), (vi) an accrual for probable losses related to grant monies received in pre-acquisition periods of MediChem ($0.4 million), offset by lower stock-based compensation ($1.1 million). We also grant annual salary increases to our personnel and are making efforts to recruit new members to our Board of Directors—which will increase our selling, general and administrative expenses.

Although the strengthening of the Icelandic krona versus the U.S. dollar has somewhat abated during 2005, the relative strengthening of the Icelandic krona versus the U.S. dollar in 2004 and 2003 has appreciably affected the U.S. dollar reported amounts of our expenses denominated in Icelandic krona (e.g., a portion of our salary and employee related expenses included in cost of revenue) and may continue to do so.

Stock-Based Compensation

For purposes of our consolidated statements of operations, we have allocated stock-based compensation to expense categories based on the nature of the service provided by the recipients of the

50




stock option and restricted stock grants. We value the stock options we grant to non-employees using the Black-Scholes option-pricing model.

Stock-based compensation expense for the years ended December 31, 2005, 2004 and 2003 is as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Cost of revenue, including collaborative programs

 

$

 

$

362

 

$

861

 

 

$

(362

)

 

 

(100

)%

 

 

$

(499

)

 

 

(58

)%

 

Research and development expense

 

72

 

374

 

467

 

 

(302

)

 

 

(81

)%

 

 

(93

)

 

 

(20

)%

 

Selling, general and administrative expense 

 

369

 

435

 

1,112

 

 

(66

)

 

 

(15

)%

 

 

(677

)

 

 

(61

)%

 

Total stock based compensation

 

$

441

 

$

1,171

 

$

2,440

 

 

$

(730

)

 

 

(62

)%

 

 

$

(1,269

)

 

 

(52

)%

 

 

With little compensation expense being attributed to our more recent stock option grants, stock-based compensation expense has been decreasing as grants made in earlier years become fully vested. Historical stock-based compensation is not necessarily representative of the effects on reported income or loss for future years due to, among other things, the vesting period of the stock options, the value of stock options that have been granted in recent times and the required change to the fair value method.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). This Statement replaces FASB Statement No. 123 and supersedes APB Opinion No. 25. SFAS No. 123R eliminates the ability to account for employee share-based compensation transactions using the intrinsic method used by deCODE. SFAS No. 123R requires such transactions be accounted for using a fair-value-based method that would result in expense being recognized in deCODE’s financial statements. In April 2005, the Securities and Exchange Commission (“SEC”) adopted a rule that defers the required effective date of SFAS No. 123R to fiscal years beginning after June 15, 2005 (January 1, 2006 for deCODE). Under SFAS No. 123R, companies must calculate and record in the income statement the cost of equity instruments, such as stock options or restricted stock, awarded to employees for services received; pro forma disclosure is no longer permitted. The cost of the equity instruments is to be measured based on fair value of the instruments on the date they are granted and is required to be recognized over the period during which the employees are required to provide services in exchange for the equity instruments.

51




SFAS No. 123R provides two alternatives for adoption: (1) a “modified prospective” method in which compensation cost is recognized for all awards granted subsequent to the effective date of this statement as well as for the unvested portion of awards outstanding as of the effective date; or (2) a “modified retrospective” method which follows the approach in the “modified prospective” method, but also permits entities to restate prior periods to record compensation cost calculated under SFAS No. 123 for the pro forma disclosure. deCODE will adopt SFAS 123R using the modified prospective method. Prior to January 1, 2006, we accounted for stock options granted to employees and shares issued under our employee stock purchase plan in accordance with the intrinsic value method permitted under APB Opinion No. 25 and therefore no compensation expense generally was recognized for these awards.

We expect to incur additional stock compensation expense in our Consolidated Statement of Operations related to unvested stock options granted as of December 31, 2005 and future stock option grants as we adopt the provisions of SFAS No. 123R effective January 1, 2006. The impact of adopting SFAS No. 123R on periods after adoption cannot be accurately estimated at this time, as it will depend on the market value and the amount of share based awards granted in future periods. Because options vest over several years and because we expect to grant options in future years, the pro forma results of applying the provisions of SFAS No. 123 as presented in Note 2 to the Consolidated Financial Statements are not necessarily representative of the pro forma results in future years.

At December 31, 2005, we had approximately $8.5 million of unamortized compensation expense, related to options granted prior to January 1, 2006, to be recognized through 2009, based on the vesting terms of the option agreements and the date the options were granted. Of the $8.5 million of unamortized compensation expense, approximately $3.9 million of it will be recognized in the consolidated statements of operations in the year ended December 31, 2006. These amount do not take into consideration any grants subsequent to December 31, 2005 and also do not take into consideration any forfeiture rate discount as proscribed by SFAS No. 123R.

Interest Income

Interest income for the years ended December 31, 2005, 2004 and 2003 is as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Interest Income

 

$

6,397

 

$

2,903

 

$

1,151

 

 

$

3,494

 

 

 

120

%

 

 

$

1,752

 

 

 

152

%

 

 

Our interest income has increased with rising rates and increasing returns on a greater amount of cash and investments. We expect to use our cash and investments principally for advancing our drug and clinical development programs. In the meantime, we will invest the proceeds received in accordance with our policy, having the objective of preserving principal while maximizing income we receive from our investments without significantly increasing risk. We expect to maintain our portfolio of cash equivalents and investments in a variety of securities, including auction rate securities, commercial paper, money market funds, mutual fund investments and government and non-government debt securities.

Interest Expense

Interest expense for the years ended December 31, 2005, 2004 and 2003 is as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Interest Expense

 

$

7,484

 

$

8,983

 

$

3,478

 

 

$

(1,499

)

 

 

(17

)%

 

 

$

5,505

 

 

 

158

%

 

 

52




Our interest expense principally reflects interest on our 3.5% Senior Convertible Notes due 2011 that we issued in April 2004.

In March 2005, we prepaid $38.6 million of short and long-term debt that was secured by mortgages on Sturlugata 8. Also in March 2005, we refinanced the mortgage on our Woodridge, IL facility, paying-down $4.0 million on the existing mortgage. Further, in June 2005, we prepaid $1.8 million of long-term debt that was secured by mortgages on Krokhals 5D and 5E. As a result of these prepayments and refinancing, our future interest expense is expected to be approximately $5.6 million on an annual basis.

Other Non-Operating Income and Expense, Net

Other non-operating income and expense for the years ended December 31, 2005, 2004 and 2003 is as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Other Non-Operating Income And Expense, Net

 

$

(4,489

)

$

(4,766

)

$

1,988

 

 

$

277

 

 

 

6

%

 

 

$

(6,754

)

 

 

(340

)%

 

 

Our other non-operating income and expense, net consists principally of the net impact of foreign exchange, unrealized and realized gains and losses on derivative financial instruments and, in 2005, loss on early extinguishment of debt and a realized loss on the sale of investments.

As a consequence of the nature of our business and operations, our reported financial results and cash flows are exposed to the risks associated with fluctuations in the exchange rates of the U.S. dollar, the Icelandic krona and other world currencies. The net impact of foreign exchange on the translated amount of our non-US dollar denominated liabilities, net together with transaction gains and losses, amounted to loss of $0.1 million, $3.3 million and $0.1 million in 2005, 2004 and 2003, respectively.

Our losses on derivative financial instruments in 2005 ($0.2 million) resulted from three forward foreign currency exchange options we entered into as economic hedges against foreign exchange rate fluctuations on our ISK-denominated operating expenses but that did not qualify for hedge accounting.

Our losses on derivative financial instruments in 2004 stem from the two cross-currency swaps we entered into as economic hedges against foreign exchange rate fluctuations on our foreign currency debt but that did not qualify for hedge accounting. In March 2004, we liquidated our two cross-currency swaps receiving $9.7 million in proceeds. We realized a loss on this early termination that, together with unrealized losses on the swaps during the 2004, amounted to $1.5 million.

As a result of having prepaid the short and long-term debts that were secured by mortgages on Sturlugata 8 we have recorded a loss on early extinguishment debt during 2005 amounting to $3.1 million and consisting of (i) prepayment fees ($1.4 million), (ii) write-off of remaining unamortized finance costs ($1.4 million), and (iii) remaining unamortized discount on the long-term debt ($0.3 million).

In December 2005, we sold investments and realized a loss on the sale of $1.0 million.

Income Taxes

As of December 31, 2005, we had an accumulated deficit of $450.2 million and did not owe any Icelandic or U.S. federal income taxes nor did we pay any in the years ended December 31, 2005, 2004 or 2003. Realization of deferred tax assets is dependent on future earnings, if any. As of December 31, 2005, we had net operating loss carryforwards for U.S. federal income tax purposes of approximately $45.7 million to offset future taxable income in the United States that expire at various dates through 2025. Also,

53




as of December 31, 2005 our foreign subsidiaries had net operating loss carryforwards of approximately $239.7 million that expire in varying amounts beginning in 2006.

Net Loss and Basic and Diluted Net Loss Per Share

Net loss and basic and diluted net loss per share for the years ended December 31, 2005, 2004 and 2003 are as follows:

 

 

 

 

 

 

 

 

2005 as Compared
to 2004

 

2004 as Compared
to 2003

 

 

 

2005

 

2004

 

2003

 

$ Change

 

% Change

 

$ Change

 

% Change

 

 

 

(In thousands, except%)

 

Net Loss

 

$

62,750

 

$

57,255

 

$

35,123

 

 

$

5,495

 

 

 

10

%

 

$

22,132

 

 

63

%

 

Basic and Diluted Net Loss Per Share

 

$

1.17

 

$

1.07

 

$

0.68

 

 

$

0.10

 

 

 

9

%

 

$

0.39

 

 

57

%

 

 

Net loss and basic and diluted net loss per share both increased in the years ended December 31, 2005 and 2004, principally on account of higher research and development related to the advancement of our drug development programs, lower revenues, higher interest expense related to our convertible notes issued in April 2004 and the impact, both realized and unrealized, of foreign exchange fluctuations.

Liquidity and Capital Resources

We have financed our operations primarily through funding from research and development collaborative agreements, and the issuance of equity securities and long-term financing instruments ($828 million from the beginning of 1999 to-date). Future funding under terms of our existing agreements is approximately $50 million excluding milestone payments, royalties and other payments that we may earn under such collaborations.

We make significant investments in proprietary research and development and we incur the costs of such activities. In the near term, this requires us to devote resources to our in-house drug and clinical development which we believe will better position us to capture the most value to us in our discoveries. As we identify promising discoveries for further development, we may choose to continue the development ourselves into and through clinical trials, regulatory approvals, manufacturing, distribution and marketing. In other cases we are or will be working to varying degrees with partners. The decisions we make as to these matters will affect our cash requirements.

Our cash requirements depend on numerous factors, including the level and timing of our research and development expenditures; our ability to access the capital markets; to obtain new research and development collaboration agreements; to obtain and maintain contract service agreements in our pharmaceuticals, biostructures, clinical research trials and genotyping service groups; expenditures in connection with alliances, license agreements and acquisitions of and investments in complementary technologies and businesses; competing technological and market developments; the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights; the purchase of additional capital equipment; and capital expenditures at our facilities. Changes in our research and development plans, notably the entry into clinical trials of drugs based on our discoveries, or other changes affecting our operating expenses may result in changes in the timing and amount of expenditures of our capital resources.

In December 2005, we filed a universal shelf registration statement on Form S-3 with the Securities and Exchange Commission (“SEC”) for the issuance and sale from time to time of debt and equity securities either individually or in units, in one or more offerings, with a total value of up to $100 million. As of December 31, 2005, we had not consummated any sales under this registration statement.

54




At December 31, 2005, we had $155.6 million of cash, cash equivalents and investments. As we advance and broaden our drug development pipeline we will require significant additional capital for product development and so we will continue to investigate additional avenues of financing, such as further public or private equity offerings, additional debt financing, other forms of financing or added collaborations and licensing arrangements. However, no assurance can be given that additional financing or collaborations and licensing arrangements will be available when needed, or that if available, will be obtained on favorable terms. If adequate funds are not available when needed, we may have to curtail operations or attempt to raise funds on unattractive terms.

In January 2006, we acquired all of the outstanding shares of a Urdur Verdandi Skuld ehf. (“UVS”), a privately-held cancer research firm, from Iceland Genomics Corporation, Inc. (“IGC”), both companies having their principal offices in Reykjavik, Iceland. As consideration for the purchase, we issued 635,006 shares of deCODE common stock valued at $6,082,000 to IGC. This acquisition will allow us to broaden our cancer program by applying our gene discovery and drug development efforts to a larger population. This acquisition will not have a material impact on our capital requirements in the future.

 

 

For the Year Ended December 31,

 

 

 

2005

 

2004

 

2003

 

 

 

(In thousands)

 

Cash provided by (used in):

 

 

 

 

 

 

 

Operating activities

 

$

(54,033

)

$

(29,936

)

$

(20,331

)

Investing activities

 

95,832

 

(124,653

)

(792

)

Financing activities

 

(46,094

)

156,158

 

2,548

 

Cash and cash equivalents, at end of period

 

65,943

 

70,238

 

68,669

 

 

Cash and Cash Equivalents.   At December 31, 2005, we had $65.9 million in cash and cash equivalents. Together with our investments at December 31, 2005 ($89.6 million), this balance is approximately $42.7 million less than at December 31, 2004. Significant cash flows during the year ended December 31, 2005 include, the net proceeds from the sale and leaseback financing of our Sturlugata 8 headquarters facility ($54.8 million), the net proceeds from the sale and leaseback financing of our Krokhals facility ($7.7 million), prepayments of short and long-term debts secured by mortgages on Sturlugata 8 ($38.6 million), prepayments of short and long-term debts secured by mortgages on our Krokhals facility ($1.8 million), refinancing of the mortgage on our Woodridge, IL facility ($4.0 million), other debt service ($3.0 million), capital expenditures ($4.0 million), and costs associated with the advancement of our drug development programs as reflected in the $54.0 million of cash we used in operating activities during the year ended December 31, 2005.

Available cash is invested in accordance with our investment policy’s primary objectives of liquidity and safety of principal while maximizing the income we receive from our investments without significantly increasing risk. Our cash is deposited only with financial institutions in Iceland, the United Kingdom and the United States having a high credit standing (A-/A3 or better). We expect to maintain our portfolio of cash equivalents and investments in a variety of securities, including auction rate securities commercial paper, money market funds, mutual fund investments and government and non-government debt securities.

At December 31, 2005, our cash is largely invested in U.S. dollar denominated money market and checking accounts and also in Icelandic krona denominated accounts. At December 31, 2005, our investments are comprised of auction rate securities and a corporate bond.

Operating Activities.   Net cash used in operating activities increased to $54.0 million for the year ended December 31, 2005 as compared to $29.9 million for the year ended December 31, 2004 and $20.3 million for the year ended December 31, 2003. As more fully described above, the increase in use of cash in operating activities is most importantly attributable to the significant research and development

55




investments being made in advancing our drug and clinical development programs. The balance of our deferred revenue has decreased during 2005 as we recognize revenue as work progresses under collaborative contracts with significant up-front monies paid. Also, during 2005, we have experienced lower average turnover of our receivables largely on account of monies due under grants.

Investing Activities.   Our investing activities have consisted of short-term investments in marketable securities (consisting mainly of auction rate securities, US government securities and in an intermediate term bond mutual fund), capital expenditures and, in the year ended December 31, 2005, the sale and leaseback of our headquarters facilities at Sturlugata, and Krokhals 5D and 5E in Reykjavik, Iceland.

We principally made replacement capital expenditures during 2005, 2004 and 2003 and did invest in certain computer and laboratory equipment. We have experienced the pace of necessary capital expenditures increase somewhat of late and this trend may continue. Although we believe we will continue to make largely replacement capital expenditures in the near-term, net cash used in investing activities may in the future fluctuate significantly from period to period due to timing of our capital expenditures and other investments as well as changing business needs.

As more fully described below, in March 2005, we entered into a financing with an Icelandic real estate company for the sale and leaseback of our headquarters facility at Sturlugata 8, Reykjavik, Iceland. The sale price for the property was 3.4 billion Icelandic kronas ($54.8 million after taking into account a standard forward foreign exchange contact we entered into in connection with the sale). In June 2005, we entered into a financing with an Icelandic real estate company for the sale and leaseback of our facility at Krokhals 5D and 5E, Reykjavik, Iceland. The sale price for the property was 502 million Icelandic kronas (approximately $7.7 million after taking into account the sales commission).

Financing Activities.   Net cash of $46.1 million was used in financing activities in the year ended December 31, 2005, as compared to $156.2 million that was provided in the year ended December 31, 2004 and $2.5 million that was provided in the year ended December 31, 2003. Financing activities for the year ended December 31, 2005 largely consisted of prepayments of short and long-term debts secured by mortgages on Sturlugata 8 ($38.6 million), prepayments of long-term debts secured by mortgages on Krokhals 5D and 5E ($1.8 million) refinancing of the mortgage on our Woodridge, IL facility ($4.0 million) which freed-up $6.0 million of previously restricted cash (reflected above in investing activities), the sale-and-leaseback of certain equipment ($1.2 million) and other debt service ($3.0 million). Financing activities for the year-ended December 31, 2004 largely consisted of net proceeds from our convertible notes ($143.8 million), equity proceeds and the portion of the monies received by us in the information-rich clinical trial alliance with Merck relating to the sale of common stock and warrants ($13.6 million), proceeds in the liquidation of our two cross-currency swaps ($9.7 million) and installment payments on debt and capital lease obligations ($6.8 million).

A portion of the proceeds from the sale of our headquarters facility at Sturlugata 8 went to prepay approximately $34.1 million of long-term debt that was secured by mortgages on the property, (our Tier A bonds, Tier B loan and March 2004 loan) and $4.5 million of short-term borrowings. We have leased the property back under a 15 year non-cancelable lease agreement at a rent of 21.4 million Icelandic kronas per month (approximately $0.3 million as of December 31, 2005), subject to changes based on the Icelandic consumer price index. Under the terms of the lease we will continue to pay property taxes and insurance and will be responsible for the property’s maintenance. The monthly rent will be revised as of July 1, 2010 to reflect changes in capital markets as well as our credit quality. Under the terms of the lease, we have a right of first refusal on any sale of the property and a priority right to extend the term of the lease at its expiration. The lease provides us with the option to redenominate the rent in currencies other than Icelandic kronas at a predetermined rate as of July 1, 2007.

In March 2005, we refinanced the mortgage on our Woodridge, IL facility, paying-down $4.0 million of the then existing $10.2 million mortgage and eliminating restricted cash collateral totaling $6.0 million.

56




The principal amount of the new mortgage ($6.2 million) is payable in monthly installments of $26,000 for two years and three months with a final payment of $5.5 million due in June 2007. The new mortgage carries an interest rate of three-month LIBOR + 2.25% (6.32% at December 31, 2005).

A portion of the proceeds from the sale of Krokhals 5D and 5E were used to prepay approximately $1.8 million of long-term debt that was secured by a mortgage on the property. deCODE has leased the Krokhals 5D and 5E property back under a 15 year non-cancelable lease agreement at a rent of 4.1 million Icelandic kronas (approximately $0.1million as of December 31, 2005) per month, subject to changes based on the Icelandic consumer price index. The lease is a 15 year operating lease.

Contractual Commitments and Off-Balance Sheet Arrangements.   The following summarizes our contractual obligations at December 31, 2005, and the effects such obligations are expected to have on our liquidity and cash flows in future periods:

 

 

Payments Due by period

 

 

 

Total

 

Less Than
1 Year

 

1-3 Years

 

3-5 Years

 

More than
5 Years

 

 

 

(In thousands)

 

3.5% senior convertible notes, including interest

 

$

178,875

 

 

$

5,250

 

 

$

10,500

 

$

10,500

 

$

152,625

 

Operating leases

 

73,598

 

 

5,973

 

 

10,679

 

10,196

 

46,750

 

Long-term debt, including interest

 

6,745

 

 

923

 

 

5,822

 

 

 

Capital lease obligations, including interest

 

2,485

 

 

1,391

 

 

1,086

 

8

 

 

 

 

$

261,703

 

 

$

13,537

 

 

$

28,087

 

$

20,704

 

$

199,375

 

 

Under the terms of certain technology licensing agreements, deCODE is obligated to make payments upon the achievement of established milestones leading to the discovery of defined products. These payments could total $6.0 million, of which deCODE believes $1.0 million may be incurred in 2006, with the timing of payments of the remainder not determinable at the current time. These potential payments are not included in the above table.

All material intercompany balances and transactions have been eliminated. We do not have any other significant relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. Additionally, holders of our 3.5% senior convertible notes may elect to convert their notes into shares of our common stock at any time at a price of $14.00 per share.

Item 7A.                Quantitative and Qualitative Disclosures About Market Risk

The primary objectives of our investment activities are to preserve principal, maintain a high degree of liquidity to meet operating needs, and obtain competitive returns subject to prevailing market conditions. Investments are made primarily in high-grade corporate bonds, asset-backed debt securities and U.S. government agency debt securities. These investments are subject to risk of default, changes in credit rating and changes in market value. These investments are also subject to interest rate risk and will decrease in value if market interest rates increase. A hypothetical 100 basis point increase in interest rates would result in an approximate $0.3 million decrease in the fair value of our investments as of December 31, 2005. Due to the nature of our investments and relatively short effective maturities of debt instruments, interest rate risk is mitigated. Changes in interest rates do not affect interest expense incurred on the Company’s Convertible Notes, because they bear interest at a fixed rate. The market value of the Convertible Notes was $123.4 million on December 31, 2005.

57




As a consequence of the nature our business and operations our reported financial results and cash flows are exposed to the risks associated with fluctuations in the exchange rates of the U.S. dollar, the Icelandic krona and other world currencies. We continue to monitor our exposure to currency risk. A hypothetical 10.0% decrease in value of the US dollar against the Icelandic krona would result in a loss of approximately $0.1 million on our Icelandic krona denominated non-U.S. dollar assets and liabilities. We have historically purchased instruments to hedge these general risks through the use of derivative financial instruments; however, we have no derivative instruments outstanding as of December 31, 2005.

As of December 31, 2005 we did not have any financing arrangements that were not reflected in our balance sheet.

Item 8.                        Financial Statements and Supplementary Data

 

Page

 

Reports of Independent Registered Public Accounting Firms

 

59,60

 

Consolidated Balance Sheets

 

61

 

Consolidated Statements of Operations

 

62

 

Consolidated Statements of Changes in Stockholders’ Equity

 

63

 

Consolidated Statements of Cash Flows

 

66

 

Notes to Consolidated Financial Statements

 

67

 

 

58




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
deCODE genetics Inc.:

We have audited the accompanying consolidated balance sheets of deCODE genetics Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework and our report dated March 14, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ Deloitte & Touche LLP

Boston, Massachusetts
March 14, 2006

59




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of deCODE genetics, Inc.:

In our opinion, the accompanying consolidated statements of operations, stockholders’ equity and cash flows present fairly, in all material respects, the results of operations and cash flows of deCODE genetics, Inc. and its subsidiaries for the year ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

Boston, Massachusetts
February 27, 2004, except for the four paragraph of the section titled “Mortgage Loans” in footnote 11 for which the date is March 15, 2004

60




deCODE genetics, Inc.

CONSOLIDATED BALANCE SHEETS

 

 

December 31,

 

 

 

2005

 

2004

 

 

 

(In thousands, except
share amounts)

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

65,943

 

$

70,238

 

Investments

 

89,611

 

122,082

 

Receivables

 

7,856

 

6,450

 

Other current assets

 

3,541

 

4,307

 

Total current assets

 

166,951

 

203,077

 

Restricted cash

 

-

 

6,000

 

Property and equipment, net

 

24,500

 

60,447

 

Goodwill

 

8,863

 

8,863

 

Other long-term assets and deferred charges

 

6,444

 

9,865

 

Total assets

 

$

206,758

 

$

288,252

 

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

4,732

 

$

5,829

 

Accrued expenses and other current liabilities

 

12,823

 

9,528

 

Short-term borrowings

 

 

5,069

 

Current portion of capital lease obligations

 

1,313

 

1,745

 

Current portion of long-term debt

 

550

 

7,081

 

Deferred revenue

 

6,105

 

8,654

 

Total current liabilities

 

25,523

 

37,906

 

Capital lease obligations, net of current portion

 

1,046

 

1,194

 

Long-term debt, net of current portion

 

155,653

 

189,535

 

Deferred gain on sale-leaseback

 

27,654

 

-

 

Deferred revenue

 

6,219

 

7,221

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ equity (deficit):

 

 

 

 

 

Preferred stock, $0.001 par value; Authorized: 6,716,666 shares; Issued and outstanding: none

 

 

 

Common stock, $0.001 par value; Authorized: 100,000,000 shares; Issued and outstanding: 54,762,095 and 54,742,595, respectively, at December 31, 2005; and 54,539,069 and 54,522,069 respectively, at December 31, 2004

 

55

 

55

 

Additional paid-in capital

 

444,401

 

442,999

 

Notes receivable

 

(2,898

)

(3,111

)

Deferred compensation

 

(418

)

 

Accumulated deficit

 

(450,215

)

(387,465

)

Accumulated other comprehensive income

 

(139

)

38

 

Treasury stock, 19,500 and 17,000 shares stated at cost at December 31, 2005 and 2004, respectively

 

(123

)

(120

)

Total stockholders’ (deficit) equity

 

(9,337

)

52,396

 

Total liabilities and stockholders’ equity (deficit)

 

$

206,758

 

$

288,252

 

 

The accompanying notes are an integral part of these consolidated financial statements.

61




deCODE genetics, Inc.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

For the Years Ended December 31,

 

 

 

2005

 

2004

 

2003

 

 

 

(In thousands, except per
share amounts)

 

Revenue

 

$

43,955

 

$

42,127

 

$

46,811

 

Operating expenses:

 

 

 

 

 

 

 

Cost of revenue, including collaborative programs.

 

37,263

 

43,407

 

45,870

 

Research and development—proprietary programs

 

43,748

 

24,942

 

17,596

 

Selling, general and administrative

 

20,118

 

20,187

 

17,178

 

Impairment, employee termination benefits and other charges

 

 

 

951

 

Total operating expenses

 

101,129

 

88,536

 

81,595

 

Operating loss

 

(57,174

)

(46,409

)

(34,784

)

Interest income

 

6,397

 

2,903

 

1,151

 

Interest expense

 

(7,484

)

(8,983

)

(3,478

)

Other non-operating (expense) and income, net

 

(4,489

)

(4,766

)

1,988

 

Net loss

 

$

(62,750

)

$

(57,255

)

$

(35,123

)

Basic and diluted net loss per share

 

$

(1.17

)

$

(1.07

)

$

(0.68

)

Shares used in computing basic and diluted net loss per share

 

53,824

 

53,423

 

51,508

 

 

The accompanying notes are an integral part of these consolidated financial statements.

62




deCODE genetics, Inc.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

(In thousands, except share amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

 

 

 

 

 

 

Shares

 

Additional

 

 

 

 

 

 

 

Comprehensive

 

 

 

Total

 

 

 

Common
Stock

 

Par
Value

 

Paid-In
Capital

 

Notes
Receivable

 

Deferred
Compensation

 

Accumulated
Deficit

 

Income
(Loss)

 

Treasury
Stock

 

Stockholders’
Equity (Deficit)

 

 

 

(In thousands, except share amounts)

 

Balance at January 1, 2002

 

53,545,234

 

$

54

 

 

$

431,494

 

 

 

$

(7,607

)

 

 

$

(2,642

)

 

 

$

(295,087

)

 

 

$

(1