Form 10-Q

10-Q 1 d10q.htm FORM 10-Q Form 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For The Quarterly Period Ended September 30, 2006

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

Commission File Number: 0-19171

ICOS CORPORATION

(Exact name of registrant as specified in its charter)

Washington

91-1463450

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer Identification No.)


22021 20th Avenue S.E., Bothell, WA		98021
(Address of principal executive offices)		(Zip code)

(425) 485-1900

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is 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. (Check one):

Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date.


		Class				Outstanding at September 30, 2006
		Common Stock, $0.01 par value				65,532,763

ICOS CORPORATION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS



		PAGE NO.
PART I. Financial Information

ITEM 1.	Financial Statements

	Condensed Consolidated Statements of Operations for the Three Months and Nine Months Ended September 30, 2006 and 2005	1

	Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005	2

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005	3

	Notes to Condensed Consolidated Financial Statements	4

ITEM 2.	Management’s Discussion and Analysis of Results of Operations and Financial Condition	13

ITEM 3.	Quantitative and Qualitative Disclosures about Market Risk	27

ITEM 4.	Controls and Procedures	27

PART II. Other Information

ITEM 1.	Legal Proceedings	28

ITEM 1A.	Risk Factors	28

ITEM 6.	Exhibits and Reports on Form 8-K	42

SIGNATURE		43

PART I. Financial Information

ITEM 1. Financial Statements

ICOS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006*			2005*			2006*			2005*
Revenue:
Lilly ICOS collaboration:
Marketing and sales	$	9,110		$	6,812		$	26,756		$	20,055
Research and development		7,265			6,816			20,491			16,626

		16,375			13,628			47,247			36,681
Contract manufacturing		4,265			5,347			10,668			11,323
Co-promotion services		—			1,791			—			4,634

Total revenue		20,640			20,766			57,915			52,638

Equity in income (losses) of Lilly ICOS		39,974			10,038			110,650			(11,330	)

Operating expenses:
Research and development		25,343			21,435			76,911			64,943
Marketing and selling		13,168			10,871			39,798			31,854
Cost of contract manufacturing		4,641			4,350			11,430			9,432
General and administrative		8,121			5,324			25,056			15,296

Total operating expenses		51,273			41,980			153,195			121,525

Operating income (loss)		9,341			(11,176	)		15,370			(80,217	)

Other income (expense):
Interest expense		(1,704	)		(1,704	)		(5,113	)		(5,113	)
Interest and other income		2,302			1,426			5,479			4,867

Total other income (expense)		598			(278	)		366			(246	)

Income (loss) before income taxes		9,939			(11,454	)		15,736			(80,463	)
Provision for income taxes		220			—			595			—

Net income (loss)	$	9,719		$	(11,454	)	$	15,141		$	(80,463	)


Net income (loss) per common share
Basic and diluted	$	0.15		$	(0.18	)	$	0.23		$	(1.26	)

Weighted-average common shares outstanding
Basic		64,552			64,075			64,450			63,940

Diluted		65,223			64,075			65,165			63,940

Net income for the three months and nine months ended September 30, 2006, includes $5.4 million and $17.7 million, respectively, in stock option compensation expense recognized in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS 123R), which we adopted on January 1, 2006. We recognized no stock option compensation expense during the three and nine months ended September 30, 2005. Had we recognized stock option compensation expense for the three and nine months ended September 30, 2005, as now required by FAS 123R, our proforma net loss would have been $19.3 million and $104.0 million, respectively, reflecting $7.9 million and $23.6 million, respectively, in proforma stock option expense for those periods. See Notes 2 and 6 to our condensed consolidated financial statements for additional information.

See accompanying notes to condensed consolidated financial statements.

ICOS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(unaudited)


	September 30, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	21,191		$	10,023
Investment securities, at market value		85,196			113,686
Interest receivable		1,496			1,241
Receivable from Lilly ICOS		22,138			14,300
Other		5,103			5,274

Total current assets		135,124			144,524
Investment securities, at market value		79,922			37,832
Investment in Lilly ICOS		46,502			35,497
Property and equipment, net		18,269			17,995
Deferred financing costs and other		4,818			5,919

	$	284,635		$	241,767


LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Payables and accruals	$	20,749		$	19,466
Accrued interest		1,393			2,787
Deferred revenue		1,458			134

Total current liabilities		23,600			22,387

Convertible subordinated debt		278,650			278,650


Stockholders’ deficit:
Common stock		655			650
Additional paid-in capital		829,463			819,339
Unearned equity compensation		—			(15,919	)
Accumulated other comprehensive loss		(311	)		(777	)
Accumulated deficit		(847,422	)		(862,563	)

Total stockholders’ deficit		(17,615	)		(59,270	)

	$	284,635		$	241,767

See accompanying notes to condensed consolidated financial statements.

ICOS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)


	Nine Months Ended September 30,
	2006			2005
Cash flows from operating activities:
Net income (loss)	$	15,141		$	(80,463	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Equity in (income) losses of Lilly ICOS		(110,650	)		11,330
Distributions from Lilly ICOS		99,645			—
Stock–based compensation		22,216			946
Depreciation and amortization		5,006			4,320
Amortization of deferred financing costs and net investment premiums		1,134			2,495
Changes in operating assets and liabilities:
Receivables and other assets		(7,397	)		(4,516	)
Payables and accruals		1,272			(5,094	)

Net cash provided by (used in) operating activities		26,367			(70,982	)


Cash flows from investing activities:
Purchases of investment securities		(192,802	)		(173,779	)
Maturities of investment securities		105,574			66,449
Sales of investment securities		73,894			206,520
Acquisitions of property and equipment		(5,280	)		(3,497	)
Investment in Lilly ICOS		—			(36,764	)

Net cash provided by (used in) investing activities		(18,614	)		58,929


Cash flows from financing activities:
Proceeds from stock options		3,415			5,519

Net cash provided by financing activities		3,415			5,519

Net increase (decrease) in cash and cash equivalents		11,168			(6,534	)
Cash and cash equivalents, beginning of period		10,023			12,778

Cash and cash equivalents, end of period	$	21,191		$	6,244

Supplemental disclosure of cash flow information:
Interest payments on convertible subordinated debt	$	5,573		$	5,573

Income taxes paid	$	580		$	—

See accompanying notes to condensed consolidated financial statements.

ICOS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(unaudited)

1.	Pending Acquisition by Eli Lilly and Company

On October 16, 2006, ICOS Corporation and Eli Lilly and Company (Lilly), entered into an Agreement and Plan of Merger, pursuant to which Lilly will acquire all of the outstanding stock of ICOS for a purchase price of $32 per share in cash, without interest. Completion of the merger is subject to customary conditions, including the approval of ICOS’ shareholders, the absence of any material adverse effect on ICOS’ business and applicable regulatory approvals. The merger is expected to close near the end of 2006. Upon execution of the merger agreement, ICOS incurred $2.0 million in financial advisory fees, which will be expensed in the 2006 fourth quarter.

Also, on October 16, 2006, ICOS and Mellon Investor Services LLC, as Rights Agent, entered into a second amendment to ICOS’ Rights Agreement dated August 9, 2002 (the Rights Agreement), as amended, to permit the execution of the merger agreement and the proposed merger, without triggering the separation or exercise of the Rights (as defined) or any adverse event under the Rights Agreement.

2.	Summary of Significant Accounting Policies

The accompanying condensed consolidated financial statements present the results of operations, financial position and cash flows of ICOS Corporation and subsidiaries (collectively, ICOS), all of which are wholly-owned. All significant intercompany transactions and balances have been eliminated in consolidation.

ICOS and Lilly each own 50% of Lilly ICOS LLC (Lilly ICOS) and have joint authority to make decisions on its behalf. Accordingly, we account for our investment using the equity method, whereby the cost of our investment is adjusted for (i) our share of Lilly ICOS’ total comprehensive income or loss, and (ii) distributions from Lilly ICOS. Our share of Lilly ICOS’ net income or net loss is reported in our condensed consolidated statements of operations as equity in income (losses) of Lilly ICOS, and our share of Lilly ICOS’ unrealized gains and losses, if any, are reported as a component of accumulated other comprehensive income (loss).

The accompanying condensed consolidated financial statements have not been audited. We have condensed or omitted certain information and footnote disclosures normally included in financial statements presented in accordance with accounting principles generally accepted in the United States. We believe the disclosures made are adequate to make the information presented not misleading. However, you should read these condensed consolidated financial statements in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2005.

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

In our opinion, the accompanying condensed consolidated financial statements include all adjustments, consisting only of normal recurring items, necessary to present fairly our financial position as of September 30, 2006 and December 31, 2005, and our results of operations for the three and nine months ended September 30, 2006 and 2005, and our cash flows for the nine months ended September 30, 2006 and 2005. Interim results are not necessarily indicative of results for a full year.

Stock-Based Compensation

Prior to January 1, 2006, we accounted for our stock-based compensation according to the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS 123). Accordingly, we recognized compensation expense for restricted shares and restricted stock units, but we did not recognize compensation expense for stock options granted to employees and directors with exercise prices equal to or in excess of the fair value of the underlying shares at the date of grant.

Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS 123R), which replaced FAS 123. Under FAS 123R, we are now required to also recognize compensation expense for all stock options, based on estimated grant-date fair values. Because we adopted FAS 123R using the modified prospective transition method, prior period results were not restated.

Our condensed consolidated statements of operations for the three and nine months ended September 30, 2006, include compensation expense related to (i) stock-based awards granted prior to, but not fully vested as of, January 1, 2006, based on grant-date fair value estimated in accordance with the proforma provisions of FAS 123, and (ii) stock-based awards granted in 2006, based on grant-date fair value estimated in accordance with FAS 123R.

We recognize stock-based compensation expense on a straight-line basis over the applicable vesting period. FAS 123R requires us to estimate future forfeitures, at the time of grant, and recognize compensation expense for only those awards that are expected to vest. We estimate future forfeitures for stock-based awards based on our historical experience. We reevaluate our estimate of forfeitures in subsequent periods and, if applicable, recognize a cumulative effect adjustment, in the period of the change, if the revised estimate of forfeitures differs significantly from the previous estimate. For periods ending prior to January 1, 2006, our proforma disclosures included the impact of forfeitures in the period in which the forfeitures occurred.

In accordance with the provisions of FAS 123R, on January 1, 2006, we reclassified $15.9 million of unearned compensation to additional paid-in capital in our condensed consolidated balance sheet.

Reclassifications

Certain amounts reported in the prior year have been reclassified to conform to the 2006 presentation.

3.	Lilly ICOS Operating Results

Lilly ICOS is marketing Cialis® (tadalafil), in North America and Europe, for the treatment of erectile dysfunction. Cialis is also available outside of North America and Europe, where Lilly has exclusive marketing rights and pays royalties to Lilly ICOS based on net sales in those territories.

The following table summarizes the operating results of Lilly ICOS for the three and nine months ended September 30, 2006 and 2005.


	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006		2005
	(In thousands)					(In thousands)
Revenue:
Product sales, net	$	190,578	$	154,157		$	540,513	$	411,233
Royalties		11,008		8,172			33,738		24,972

Total revenue		201,586		162,329			574,251		436,205

Expenses:
Cost of sales*		15,031		12,378			42,783		34,064
Selling, general and administrative		91,830		112,152			268,689		375,411
Research and development		15,087		18,035			42,409		50,322

Total expenses		121,948		142,565			353,881		459,797

Net income (loss)	$	79,638	$	19,764		$	220,370	$	(23,592	)

ICOS Corporation’s share of net income (loss)	$	39,974	$	10,038		$	110,650	$	(11,330	)


* Includes $103 per month of license fee amortization applicable only to Lilly’s interest in Lilly ICOS.

4. Comprehensive Income (Loss)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006		2005
	(In thousands)					(In thousands)
Net income (loss)	$	9,719	$	(11,454	)	$	15,141	$	(80,463	)
Net unrealized gain (loss) on investment securities		525		(96	)		466		(149	)
Equity in Lilly ICOS’ unrealized gain (loss) on foreign currency hedge		—		(399	)		—		707

Comprehensive income (loss)	$	10,244	$	(11,949	)	$	15,607	$	(79,905	)

5.	Net Income (Loss) per Common Share

Net income (loss) per common share is calculated based on the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per common share is calculated based on the weighted-average number of common shares and other dilutive securities. Dilutive potential common shares resulting from the assumed exercise of outstanding stock options and vesting of restricted shares and restricted stock units are determined using the treasury stock method. Dilutive potential common shares resulting from the assumed conversion of convertible subordinated debt are determined using the if-converted method.

The following table sets forth the computation of basic and diluted net income (loss) per share for the three and nine months ended September 30, 2006 and 2005.


	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006		2005
	(In thousands, except per share data)					(In thousands, except per share data)
Numerator:
Net income (loss)	$	9,719	$	(11,454	)	$	15,141	$	(80,463	)

Denominator:
Weighted-average common shares – basic		64,552		64,075			64,450		63,940
Dilutive stock options, restricted shares and restricted stock units		671		—			715		—

Weighted-average common shares – diluted		65,223		64,075			65,165		63,940

Numerator/Denominator:
Net income (loss) per common share – basic and diluted	$	0.15	$	(0.18	)	$	0.23	$	(1.26	)


Antidilutive securities excluded from the computation of diluted net income (loss) per common share were as follows:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006		2005
	(In thousands)					(In thousands)
Restricted shares		—		818			—		818
Shares issuable upon:
Exercise of stock options		9,996		11,302			10,007		11,302
Conversion of subordinated debt		4,531		4,531			4,531		4,531

6.	Stock-Based Compensation

The ICOS Corporation 1999 Long-Term Incentive Plan (Restated Plan) permits, at the discretion of our Board of Directors or a committee thereof (Board), the award of stock, stock units, stock appreciation rights and/or stock options to our employees, directors and consultants. Each restricted share constitutes one share of our common

stock. Each restricted stock unit constitutes the right to one share of our common stock. Holders of restricted shares have the same voting, dividend and certain other rights as our common stockholders. Nonvested restricted shares are considered issued and outstanding as of the date of grant; however, such shares cannot be transferred prior to vesting. Holders of restricted stock units do not have voting rights; however, holders do have the right to receive dividends in an amount equivalent to those paid to other stockholders. Shares underlying restricted stock units are not issued until vested and delivered.

A total of 15.4 million shares of common stock have been made available for grant under the Restated Plan and its predecessors since adoption. At September 30, 2006, approximately 2.2 million shares were reserved and remained available for grant thereunder.

Change in Accounting for Stock-Based Compensation

As a result of adopting FAS 123R, our operating expenses for the three and nine months ended September 30, 2006 include $5.4 million and $17.7 million, respectively, in stock option expense. Our operating expenses for the three and nine months ended September 30, 2005 include $0.9 million in stock-based compensation for restricted share awards. As permitted by FAS 123, no stock option expense was recognized during 2005.

The following table illustrates the effect on net income (loss) and net income (loss) per share had we applied the provisions of FAS 123R to stock-based compensation awards in the periods presented:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005 - Proforma			2006			2005 - Proforma
	(In thousands)						(In thousands)
Net income (loss):
As reported	$	9,719		$	(11,454	)	$	15,141		$	(80,463	)
Add: Stock–based employee compensation expense included in reported net income (loss)		7,089			946			22,216			946
Deduct: Stock–based employee compensation expense determined under fair–value based method for all awards		(7,089	)		(8,822	)		(22,216	)		(24,524	)

Net income (loss) (2006 as reported; 2005 proforma)	$	9,719		$	(19,330	)	$	15,141		$	(104,041	)

Net income (loss) per share — basic and diluted:
As reported	$	0.15		$	(0.18	)	$	0.23		$	(1.26	)

Proforma				$	(0.30	)				$	(1.63	)

Had we applied APB 25 in the three and nine months ended September 30, 2006, stock-based compensation expense would have been $1.7 million and $4.6 million, respectively, and net income would have been $15.1 million ($0.23 per share) and $32.8 million ($0.51 per share), respectively.

The following table shows the allocation of 2006 actual and 2005 proforma stock-based compensation expense.


	Three Months Ended September 30,					Nine Months Ended September 30,
	2006			2005 - Proforma		2006		2005 - Proforma
	(In thousands)					(In thousands)

Research and development	$	2,713		$	3,568	$	8,854	$	10,125
Marketing and selling		1,055			1,163		3,150		3,420
Cost of contract manufacturing		590			421		1,150		1,077
General and administrative		2,731			3,670		9,062		9,902

Total stock-based compensation expense	$	7,089		$	8,822	$	22,216	$	24,524


The following table shows 2006 actual and 2005 proforma stock-based compensation expense by type of award:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2006			2005 - Proforma		2006		2005 - Proforma
	(In thousands)					(In thousands)
Stock options	$	5,404		$	7,876	$	17,657	$	23,578
Restricted shares		1,318			946		3,724		946
Restricted stock units		367			—		835		—

	$	7,089		$	8,822	$	22,216	$	24,524


Stock Options

A summary of stock options as of and for the nine months ended September 30, 2006 is presented below.

	Number of Shares			Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Life		Aggregate Intrinsic Value
	(In thousands)					(Years)		(In thousands)
Outstanding at December 31, 2005		10,941		$	33.45		5.8	$	25,314

Granted		791			24.91
Forfeited or expired		(459	)		33.50
Exercised		(388	)		10.11

Outstanding at September 30, 2006		10,885		$	33.66		5.4	$	11,232

Exercisable at September 30, 2006		8,951		$	34.90		4.8	$	10,711

Aggregate intrinsic value in the above table represents the aggregate amount, for all options, by which the December 31, 2005, and September 30, 2006 closing share prices exceed the exercise price of the stock options at those dates. This value will fluctuate in the future based on the fair market value of our common stock. The aggregate intrinsic value of stock options exercised during the three and nine months ended September 30, 2006 was $1.0 million and $5.4 million, respectively. The grant-date fair value of options exercised in the three and nine months ended September 30, 2006, calculated using the Black-Scholes-Merton option pricing model, was $0.5 million and $2.1 million, respectively. As of September 30, 2006, there was $23.1 million of unrecognized compensation related to unvested stock options which is expected to be recognized over a weighted-average period of 2.1 years.

The estimated per share weighted-average grant-date fair values of stock options granted during the three and nine months ended September 30, 2006, were $9.65 and $11.07, respectively, and $11.96 and $12.05, respectively, during the three and nine months ended September 30, 2005. Amounts were determined using the Black-Scholes-Merton option pricing model based on the following assumptions:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Expected dividend yield	0.0	%	0.0	%	0.0	%	0.0	%
Expected volatility	37.0	%	43.0	%	37.0	%	43.3	%
Risk-free interest rate	4.0	%	4.1	%	4.3	%	4.0	%
Expected life in years	6.3		6.3		6.3		6.3

The assumptions used in calculating the value of stock options, which involve inherent uncertainties and the application of management judgment, were based on the following:

•

Expected dividend yield — reflects ICOS’ present intention to retain earnings, if any, for use in the operation and expansion of our business;

•

Expected volatility — determined considering historical volatility of our common stock over the preceding six years, implied volatility of near-the-money traded stock options with remaining contractual maturities of approximately two years and significant changes in our business that have resulted in lower volatility, both implied and during the past two years;

•

Risk-free interest rate — based on the yield available on U.S. Treasury zero coupon issues with a remaining term approximating the expected life of the stock option awards; and,

•

Expected life — calculated using the “simplified method” in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107.

Restricted Shares

A summary of restricted shares as of and for the nine month period ended September 30, 2006, is presented below:


	Number of Shares		Weighted Average Grant- Date Fair Value Per Share
	(In thousands)
Outstanding at December 31, 2005	818		$	22.03
Granted	127			24.27
Forfeited	(18	)		23.61
Vested	—			—

Outstanding at September 30, 2006	927		$	22.31

The grant-date fair value of restricted share awards is the closing market price of our common stock on that day. Restricted share awards granted in 2006 vest annually, on the anniversary date, over a 4 year period. During the three and nine months ended September 30, 2005, the Company issued 0.8 million of restricted share awards with a weighted-average grant-date fair value per share of $22.03. Restricted share awards granted in 2005 vest at the end of a period of continued service ranging between 3 and 5 years. As of September 30, 2006, there was $14.3 million of unrecognized compensation related to nonvested restricted shares which is expected to be recognized over a weighted-average period of 3.0 years.

Restricted Stock Units

A summary of restricted stock units outstanding as of and for the nine months ended September 30, 2006, is presented below:


	Number of Restricted Stock Units		Weighted Average Grant-Date Fair Value Per Share
	(In thousands)
Outstanding at December 31, 2005	—		$	—
Granted	275			24.34
Forfeited	(27	)		24.87
Vested	—			—

Outstanding at September 30, 2006	248		$	24.28

The grant-date fair value of restricted stock unit awards is the closing market price of our common stock on that day. Restricted stock unit awards granted in 2006 vest annually, on the anniversary date, over a 4 year period. There were no restricted stock unit awards granted in 2005. As of September 30, 2006, there was $5.1 million of unrecognized compensation related to nonvested restricted stock units which is expected to be recognized over a weighted-average period of 3.2 years.

7.	Income Taxes

For the three and nine months ended September 30, 2006, we recognized $0.2 million and $0.6 million, respectively, in U.S. Federal alternative minimum tax (AMT) and state income taxes. AMT may be recoverable, in future years, to the extent the regular Federal income tax exceeds AMT.

8.	Legal Proceedings

In October 2002, Pfizer Inc., Pfizer Limited, and Pfizer Ireland Pharmaceuticals filed a patent infringement suit against ICOS, Lilly ICOS and Lilly in the United States District Court for the District of Delaware. Pfizer contends that the use, offering for sale, selling, manufacture, or importing of Cialis, into the United States, for the treatment of erectile dysfunction by any of the defendants infringes claim 24 of Pfizer’s U.S. Patent No. 6,469,012 (or the Pfizer Patent), and seeks a declaratory judgment to that effect. Pfizer also seeks a permanent injunction, attorneys’ fees, costs and expenses. In January 2003, we filed an answer denying the central allegations of plaintiffs’ complaint and asserting various affirmative defenses.

The U.S. Patent and Trademark Office (PTO) subsequently ordered reexamination of the Pfizer Patent claims. In reexamination, the PTO is required to reconsider the patentability of claims if substantial new questions of

patentability are raised by any party including the PTO itself. The District Court stayed, or suspended, the patent infringement suit, pending the outcome of the reexamination. Subsequently, Lilly ICOS and others filed several reexamination requests regarding the Pfizer Patent, most of which were accepted and merged with the PTO’s ordered reexamination.

In reexamination, the PTO Examiner issued several office actions rejecting Pfizer claim 24 (the basis of Pfizer’s patent infringement suit against us), culminating in a final office action issued on March 27, 2006. In particular, the Examiner rejected claim 24 on the basis that certain prior art rendered the claimed invention not new, and therefore unpatentable under 35 U.S.C. §102(b), and obvious, under the judicially created doctrine of obviousness-type double patenting. Pfizer filed a response to the final office action on May 24, 2006, and has appealed the Examiner’s decision to the PTO’s Board of Patent Appeals and Interferences. Pfizer filed its Appeal Brief in this appeal on July 24, 2006. Pfizer may subsequently appeal the Board’s decision to the U.S. Court of Appeals for the Federal Circuit.

Litigation is inherently unpredictable and the eventual outcome in a particular case is impossible to determine in advance. We believe that Pfizer’s suit lacks merit and intend to vigorously pursue our various defenses. If Pfizer were to prevail in its suit against us, however, we might be subject to substantial damages, prohibited from marketing Cialis for the treatment of erectile dysfunction in the United States, or required by Pfizer to enter into a licensing agreement to market Cialis in the United States. Any such adverse result could have a material adverse effect on our business, financial position, results of operations and cash flows.

In July 2005, a lawsuit was filed against ICOS by Vanderbilt University in the United States District Court for the District of Delaware. Vanderbilt filed the lawsuit asserting that three of its researchers contributed to the conception of the inventions reflected in U.S. Patent Nos. 5,859,006 and 6,140,329. U.S. Patent No. 5,859,006 is ICOS’ patent claiming tadalafil and certain related compounds; U.S. Patent No. 6,140,329 is ICOS’ patent claiming the use of tadalafil and certain related compounds to treat erectile dysfunction. Tadalafil is the active ingredient in Cialis, which is marketed in North America by Lilly ICOS, which has an exclusive license to U.S. Patent Nos. 5,859,006 and 6,140,329. The Vanderbilt lawsuit requests that the Court direct the U.S. Commissioner of Patents and Trademarks to add the three individual researchers as co-inventors on these patents, which, if granted, could entitle Vanderbilt to some ownership rights in the patents. ICOS filed a response to the complaint in September 2005, denying the central allegations of Vanderbilt’s complaint and setting forth various affirmative defenses. While the Company is diligently evaluating Vanderbilt’s claims and seeking additional information, we currently believe that Vanderbilt’s claims lack merit and intend to defend the lawsuit vigorously. A trial date has been set for March 2007. It is premature to assess what, if any, impact the lawsuit might have on our business, financial position, results of operations and cash flows.

Snohomish County (WA) Superior Court on behalf of ICOS shareholders concerning the proposed acquisition of all of ICOS’ outstanding common stock by Eli Lilly and Company. The complaint names as defendants ICOS, certain of its officers and directors, and Lilly and alleges that the ICOS defendants breached their fiduciary duties by adopting the Merger Agreement and approving the proposed transaction. The complaints seek an injunction preventing the completion of the proposed transaction, and to recover unspecified damages. ICOS believes the lawsuits are without merit and intends to defend the actions vigorously.

ITEM 2.

Management’s Discussion and Analysis of Results of Operations and Financial Condition

Our Management’s Discussion and Analysis of Results of Operations and Financial Condition should be read in conjunction with (i) our consolidated financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and in our annual report on Form 10-K for the year ended December 31, 2005, and (ii) with the information under the heading “Management’s Discussion and Analysis of Results of Operations and Financial Condition” in our annual report on Form 10-K for the year ended December 31, 2005.

Pending Acquisition by Eli Lilly and Company

On October 16, 2006, ICOS Corporation and Lilly, entered into an Agreement and Plan of Merger, pursuant to which Lilly will acquire all of the outstanding stock of ICOS for a purchase price of $32 per share in cash, without interest. Completion of the merger is subject to customary conditions, including the approval of ICOS’ shareholders, the absence of any material adverse effect on ICOS’ business and applicable regulatory approvals. The merger is expected to close near the end of 2006. Upon execution of the merger agreement, ICOS incurred $2.0 million in financial advisory fees, which will be expensed in the 2006 fourth quarter.

Important Factors Regarding Forward-Looking Statements

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

•

information concerning possible or assumed future results of operations, trends in financial results and business plans;

•

statements about financial guidance;

•

statements about our product development schedule and the potential success of our research and development efforts;

•

statements about our expectations regarding regulatory approvals for any of our product candidates;

•

statements about our potential or prospects for future product sales;

•

statements about the level of our costs and operating expenses, and about the expected composition of our revenues and operating expenses;

•

statements about our future capital requirements and the sufficiency of our cash, cash equivalents, investments, distributions of expected profits from Lilly ICOS and financing proceeds to meet future capital and operating requirements;

•

statements about the outcome of contingencies, such as legal proceedings;

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other statements about our plans, objectives, expectations and intentions; and

•

other statements that are not historical fact.

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

Except as required under federal securities laws and regulations, we do not have any intention or obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our quarterly reports on Form 10-Q, current reports on Form 8-K and annual reports on Form 10-K. Also note that we provide a cautionary discussion of risks, uncertainties and possibly inaccurate assumptions relevant to our business and industry under the caption “Risk Factors” in Part II, Item 1A. of this report. These risk factors could cause our actual results to differ materially from expected or historical results.

Certain forward-looking statements are based on Lilly’s and ICOS’ current expectations, estimates and projections relating to the proposed acquisition of ICOS by Lilly, including the expected closing of the transaction and the benefits thereof. Such statements are subject to a number of assumptions, risks and uncertainties, many of which are beyond the control of Lilly and ICOS. Accordingly, no assurances can be given that the proposed transaction will occur or that such results will be achieved. There are a number of important factors that could cause actual results to differ materially from those projected, including risks associated with our ability to satisfy the conditions to closing set

forth in the definitive agreement, product commercialization, research and clinical development, regulatory approvals, manufacturing, collaboration arrangements, liquidity, competition, intellectual property claims, litigation and other risks.

Overview

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

•

In the section entitled “ICOS Corporation Background,” we briefly describe our primary sources of revenue and cash, the importance of collaborations to our business, the business environment in which we operate, our approved product (Cialis) and our research and development programs.

•

In “Results of Operations,” we identify each of our most critical accounting policies and estimates, including our accounting for stock-based compensation, as well as the primary factors that are likely to contribute to significant variability of our results of operations from period to period. We then provide detailed narrative regarding significant changes in our and Lilly ICOS’ results of operations for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005.

•

Finally, under the section entitled “Liquidity and Capital Resources,” we discuss our September 30, 2006 liquidity, our cash flows for the nine months ended September 30, 2006, compared to the nine months ended September 30, 2005, and factors that may influence our future cash requirements.

ICOS Corporation Background

ICOS Corporation is a biotechnology company that is dedicated to bringing innovative therapeutic products to patients. Through Lilly ICOS, we are marketing Cialis (tadalafil) for the treatment of erectile dysfunction. Directly or through Lilly ICOS, we are also working to develop and commercialize treatments for serious unmet medical needs such as benign prostatic hyperplasia (BPH), hypertension, pulmonary arterial hypertension (PAH), cancer and inflammatory diseases.

We recognize revenue for services we provide, under sales and marketing, research and development, contract manufacturing and co-promotion agreements, and for amounts earned from licensing of our technology. The majority of our revenue relates to cost reimbursement for sales and marketing and research and development activities that we conduct on behalf of Lilly ICOS. Our sources of cash from operating activities include, among other items, distributions to be received based on the profitability of Lilly ICOS and amounts earned from the aforementioned revenue sources.

The discovery and development of a new drug product is a rigorous process, involving a significant degree of risk. Since the underlying biology of many diseases is not completely understood, it is very difficult to discover and develop a drug that can withstand the extensive preclinical and clinical testing necessary to demonstrate its safety and efficacy in humans. As a result, very few research and development projects result in a commercially approved product. Our long-term business growth depends on our ability to successfully develop and commercialize important new therapeutic treatments, which includes potential new indications for tadalafil, the active ingredient in Cialis.

Over the years, we have established collaborations with pharmaceutical and biotechnology companies to enhance our internal development capabilities, to acquire rights to additional product candidates, to gain access to the capabilities of our collaboration partners and to offset a substantial portion of the financial risk of developing individual product candidates. Our most significant ongoing collaboration is Lilly ICOS. We expect to establish additional collaborations with pharmaceutical and other biotechnology companies in the future.

We operate in a highly regulated business environment. Cialis and our product candidates require extensive regulatory review, oversight and approval prior and subsequent to commercialization. For example, the FDA regulates, among other things, the development, manufacture, approval, advertising, promotion, sale and distribution of pharmaceutical products. Our products marketed abroad are also subject to extensive regulation by foreign governments. The regulatory processes are lengthy, expensive and uncertain. They may take years to complete, may involve ongoing requirements for post-marketing studies and can affect the nature, content, timing and cost of our marketing efforts.

The markets in which we compete are well established and intensely competitive. Cialis and our product candidates, if approved and commercialized, compete or are likely to compete against existing therapeutic products or treatments. In addition, a number of pharmaceutical and biotechnology companies are currently developing products targeting the same diseases and medical conditions that we target. Key factors affecting our markets include: the timing and scope of regulatory approvals; safety and efficacy of therapeutic products; cost and availability of these products; availability of alternative treatments; changes in medical insurance programs that affect the reimbursement for particular prescription drugs; and, protection of patent and proprietary rights. Although, we believe that we are positioned to compete adequately with respect to these factors in the future, our future success is currently difficult to predict. Cialis has only been available in Europe since February 2003 and in North America since November 2003. Our product candidates are in various stages of research and development and, accordingly, are subject to substantial research, development, regulatory approval and commercialization risks. Since timing of market entry can be an important factor in determining a new product’s eventual success and profitability, the speed with which we can develop products and receive regulatory approval will likely be important to our commercial success.

Cialis

Our first commercial product, Cialis, is being prescribed around the world as an on-demand treatment for patients with erectile dysfunction. Cialis is manufactured and marketed by Lilly ICOS in North America and Europe. Lilly has exclusive rights to market Cialis in all other parts of the world, and pays royalties to Lilly ICOS based on net sales in those territories.

Overall growth in market demand for erectile dysfunction drugs, Lilly ICOS’ ability to capture and retain increased market share, and Lilly ICOS’ flexibility in setting the sales price for Cialis, each may significantly affect revenues and expected profitability from Cialis and, in turn, our results of operations and cash flows. Worldwide sales of Cialis increased 26% in the 2006 third quarter, to $245.6 million, compared to $195.1 million in the third quarter of 2005. For the first nine months of 2006, worldwide sales of Cialis were $701.8 million, compared to $536.1 million for the corresponding period of 2005. For the month of September 2006, Cialis U.S. market share was 26.6%, compared to 24.8% in the same month of the prior year.¹ In Europe, Canada and Mexico combined, Cialis held a 35.5% aggregate market share for August 2006, an increase of 3.0 percentage points of share since August 2005.²

Clinical Programs

Tadalafil

Lilly ICOS is currently evaluating tadalafil for potential new commercial opportunities in erectile dysfunction (ED) and other indications, including the following:

Once-A-Day for Erectile Dysfunction

In June 2006, we announced that Lilly ICOS had submitted, to the European Medicines Agency (EMEA), a regulatory filing seeking marketing approval of Cialis 2.5 mg and 5 mg once-a-day dosing to treat erectile dysfunction. Lilly ICOS filed a licensing application for once-a-day dosing in Canada in July 2006 and plans to file a supplemental new drug application for once-a-day dosing in the United States late in 2006. If approved, the first launches of once-a-day dosages could occur in late 2007. The regulatory filings followed the completion of three Phase 3 clinical studies that evaluated the efficacy and safety of Cialis when administered once-a-day for the treatment of ED.

¹	IMS Health, IMS National Prescription Audit Plus™ (based on total prescriptions), September 2006.

²	IMS Health, IMS MIDAS (based on tablets from wholesalers to pharmacies), August 2006.

Benign Prostatic Hyperplasia (BPH)

In 2005, Lilly ICOS completed a Phase 2 clinical study and reported positive results in the treatment of lower urinary tract symptoms in men with BPH. In August 2006, Lilly ICOS began enrolling patients in a Phase 2b clinical study to evaluate the efficacy and safety of multiple doses of tadalafil, compared to placebo, for symptoms of BPH. This trial may serve as a pivotal study to support regulatory filings seeking approval of tadalafil for the treatment of BPH.

Hypertension

In 2005, Lilly ICOS initiated a Phase 2 study to evaluate the efficacy and safety of tadalafil, compared to placebo, for the treatment of mild to moderate hypertension. The proof-of-concept Phase 2 study was recently completed, in which 180 patients were dosed once-a-day with 5 mg tadalafil, 20 mg tadalafil, or placebo, for eight weeks. The results were consistent with results previously reported from clinical pharmacology studies conducted for the ED indication. Patients in the 5 mg tadalafil group had a mean blood pressure decline of 5.5/7.5 mm Hg. Patients in the 20 mg tadalafil group had a mean blood pressure decline of 5.5/8.3 mm Hg. Results at both doses were statistically significantly better than the mean 2.1/3.0 mm Hg decrease noted among patients in the placebo group. Treatment was well tolerated by the men and women in the study. Dyspepsia and headache were the most frequent adverse events. The magnitude of reduction in blood pressure induced by tadalafil in this clinical trial would likely be insufficient for tadalafil to compete successfully in the broad hypertension marketplace for first line therapy. Lilly ICOS is considering next steps for this program.

Pulmonary Arterial Hypertension (PAH)

In August 2005, Lilly ICOS initiated a Phase 3 study to evaluate the efficacy and safety of tadalafil, compared to placebo, for the treatment of PAH. The study is being conducted in North America, Europe and Japan, and patient enrollment is ongoing.

Discovery and Preclinical Research

We continue to evaluate possible new product candidates in our discovery and preclinical research programs. Our most advanced discovery and preclinical research compounds include a cell cycle checkpoint/DNA repair inhibitor, for its potential to improve the effectiveness of radiation and chemotherapy treatments, and an oral leukocyte function-associated antigen one (LFA-1) antagonist that is potentially useful in the treatment of inflammatory diseases. Psoriasis will be the initial disease target for the LFA-1 antagonist.

Discontinued Product Candidates

In March 2005, we announced that a Phase 2 study of IC485, a PDE4 inhibitor we were evaluating for the treatment of chronic obstructive pulmonary disease, did not meet the primary endpoint of improved lung function. We have no plans for further development of IC485.

Results of Operations

Critical Accounting Policies and Estimates

Our critical accounting policies include revenue recognition, accounting for our share of the operating results of our unconsolidated affiliates (presently only Lilly ICOS), estimating expenses from contracted research and clinical study activities conducted by various third parties and our accounting for stock-based compensation awards. Except as discussed below regarding our adoption of Statement of Financial Accounting Standards No. 123 (revised 2004) “Share-Based Payment” (FAS 123R), there have been no significant changes in the critical accounting policies and estimates disclosed in our annual report on Form 10-K for the year ended December 31, 2005.

Accounting for Stock-Based Compensation

Prior to January 1, 2006, we accounted for our stock-based compensation according to the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS 123). Accordingly, we did not recognize compensation expense for stock options granted to employees and directors with exercise prices equal to or in excess of the fair value of the underlying shares at the date of grant.

Effective January 1, 2006, we adopted the provisions of FAS 123R, which replaced FAS 123. Under FAS 123R we are required to recognize compensation expense for all employee and director share-based payment awards, including stock options, restricted shares and restricted stock units, based on estimated grant-date fair values. Because we adopted FAS 123R using the modified prospective transition method, prior period results were not restated.

Our condensed consolidated statements of operations for the three and nine months ended September 30, 2006, include compensation expense related to (i) stock-based awards granted prior to, but not fully vested as of, January 1, 2006, based on grant-date fair values estimated in accordance with the proforma provisions of FAS 123, and (ii) stock-based awards granted in 2006, based on grant-date fair values estimated in accordance with FAS 123R.

The fair value of our restricted shares and restricted stock unit awards is the closing market price of our common stock on the date of the grant, less any amounts required to be paid by the award recipients. We estimate the fair value of our stock options using the Black-Scholes-Merton option valuation model, which includes assumptions regarding the expected term of our option awards, expected future volatility in the market price of our common stock, future risk-free interest rates, and future dividends, if any, on our common stock.

The assumptions used in calculating the fair value of stock-based compensation awards involve inherent uncertainties and the application of management judgment. If factors were to change, and we used different assumptions, depending on the nature and amount of our future stock-based awards, our stock-based compensation expense in the future could be materially different from that reported for 2006 or proforma for years before 2006. In addition, if our actual forfeiture rate varies significantly from our current estimate, the amount of stock-based compensation expense recognized in future periods will be affected.

General

Our results of operations may vary significantly from period to period. Operating results will depend on, among other factors: market demand and competition for our product, Cialis, and other products marketed by us or our affiliates; the timing, cost and success of new product launches (or launches of new dosage regimens for existing products) by us or our affiliates; the timing and magnitude of other operating expenses, including expenses of Lilly ICOS; the level of funding by collaboration partners; and the nature, timing and progression of research, development, marketing, sales and contract manufacturing activities. We may experience significant fluctuations in collaboration revenue, revenue from licenses of technology, revenue from co-promotion services, and contract manufacturing revenue. Collaboration revenue will vary depending upon the timing and amount of marketing and sales activities, the extent and timing of research and development collaboration activities, and our level of participation in those activities. Revenue from licenses of technology will vary as a result of (i) the nature and extent of product collaboration and other licensing transactions, (ii) the timing of milestone payments, and (iii) changes in estimated development costs and/or expected completion dates, which depend on the success of clinical studies and

other research and development efforts. Revenue from co-promotion services depends on the nature and extent of co-promotion arrangements that we may enter into. Contract manufacturing revenue may fluctuate depending upon our needs to manufacture our own internal product candidates, our ability to attract third parties to utilize any remaining manufacturing capacity and the particular terms and the nature of the development and manufacturing services that we provide.

Condensed Consolidated Statements of Operations

The following table shows our reported results of operations for the three and nine months ended September 30, 2006 and 2005 and proforma amounts, for the three and nine months ended September 30, 2005, as if we had applied the provisions of FAS 123R in those periods.


	Three Months Ended September 30,									Nine Months Ended September 30,
	2006			2005 - Proforma			2005 - As Reported			2006			2005 - Proforma			2005 - As Reported
	(In thousands, except per share data)
Revenue
Lilly ICOS collaboration	$	16,375		$	13,628		$	13,628		$	47,247		$	36,681		$	36,681
Contract manufacturing		4,265			5,347			5,347			10,668			11,323			11,323
Co-promotion services		—			1,791			1,791			—			4,634			4,634

Total revenue		20,640			20,766			20,766			57,915			52,638			52,638

Equity in income (losses) of Lilly ICOS		39,974			10,038			10,038			110,650			(11,330	)		(11,330	)

Operating expenses
Research and development		25,343			24,516			21,435			76,911			74,581			64,943
Marketing and selling		13,168			11,938			10,871			39,798			35,178			31,854
Cost of contract manufacturing		4,641			4,726			4,350			11,430			10,464			9,432
General and administrative		8,121			8,676			5,324			25,056			24,880			15,296

Total operating expenses		51,273			49,856			41,980			153,195			145,103			121,525

Operating income (loss)		9,341			(19,052	)		(11,176	)		15,370			(103,795	)		(80,217	)

Other income (expense)
Interest expense		(1,704	)		(1,704	)		(1,704	)		(5,113	)		(5,113	)		(5,113	)
Interest and other income		2,302			1,426			1,426			5,479			4,867			4,867

Total other income (expense)		598			(278	)		(278	)		366			(246	)		(246	)

Income (loss) before income taxes		9,939			(19,330	)		(11,454	)		15,736			(104,041	)		(80,463	)
Provision for income taxes		220			—			—			595			—			—

Net income (loss)	$	9,719		$	(19,330	)	$	(11,454	)	$	15,141		$	(104,041	)	$	(80,463	)

Net income (loss) per share
Basic and diluted	$	0.15		$	(0.30	)	$	(0.18	)	$	0.23		$	(1.63	)	$	(1.26	)


Weighted average common shares outstanding
Basic		64,552			64,075			64,075			64,450			63,940			63,940

Diluted		65,223			64,075			64,075			65,165			63,940			63,940

Net income (loss)

Our net income was $9.7 million ($0.15 per diluted share) for the three months ended September 30, 2006, compared to a proforma net loss of $19.3 million ($0.30 per share) and a reported net loss of $11.5 million ($0.18 per share), both for the three months ended September 30, 2005. Our net income was $15.1 million ($0.23 per diluted share) for the nine months ended September 30, 2006, compared to a proforma net loss of $104.0 million ($1.63 per share) and a reported net loss of $80.5 million ($1.26 per share), both for the nine months ended September 30, 2005.

Revenue

Total revenue was $20.6 million in the third quarter of 2006, compared to $20.8 million in the third quarter of 2005. Total revenue was $57.9 million in the first nine months of 2006, compared to $52.6 million for the first nine months of 2005.

Lilly ICOS collaboration revenue totaled $16.4 million in the 2006 third quarter, compared to $13.6 million in the third quarter of 2005, and was $47.2 million for the first nine months of 2006, compared to $36.7 million for the first nine months of 2005. The increases in the third quarter of 2006, as compared to 2005, primarily reflect reimbursement for 100% of the costs of 40 contract (non-employee) sales representatives retained by ICOS to promote Cialis in the U.S. beginning in January 2006. The increases in the nine months ended September 30, 2006, as compared to 2005, reflect the aforementioned reimbursement of costs associated with the contract sales representatives, as well as incremental research and development activities performed by ICOS personnel on behalf of Lilly ICOS during 2006.

Co-promotion services revenue was $1.8 million and $4.6 million, respectively, in the three and nine months ended September 30, 2005, representing fees earned under an arrangement, with Solvay Pharmaceuticals, Inc., which ended in December 2005.

Equity in income (losses) of Lilly ICOS

Our equity in income of Lilly ICOS was $40.0 million and $110.7 million, respectively, in the three and nine months ended September 30, 2006, compared to equity in income of $10.0 million and equity in losses of $11.3 million, respectively, in the three and nine months ended September 30, 2005. See Lilly ICOS Results of Operations later herein.

Operating Expenses

Total operating expenses were $51.3 million for the three months ended September 30, 2006, compared to $49.9 million proforma and $42.0 million as reported, both for the three months ended September 30, 2005. Total operating expenses were $153.2 million for the nine months ended September 30, 2006, compared to $145.1 million proforma and $121.5 million as reported both for the nine months ended September 30, 2005.

Research and development

Research and development expenses were $25.3 million for the three months ended September 30, 2006, compared to $24.5 million proforma for the three months ended September 30, 2005. Research and development expenses were $76.9 million for the nine months ended September 30, 2006, compared to $74.6 million proforma for the nine months ended September 30, 2005. The increases reflect incremental activities performed on behalf of Lilly ICOS and higher expenses associated with discovery and preclinical research and development programs. Proforma research and development expense during the first nine months of 2005 includes $3.7 million in costs associated with a clinical program which was discontinued in the 2005 first quarter.

The following table provides information regarding our research and development expenses, by project:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006		2005 - Proforma		2005 - As Reported		2006		2005 - Proforma		2005 - As Reported
	(In thousands)						(In thousands)
Cialis (tadalafil) (approved product)	$	7,314	$	6,201	$	5,450	$	20,472	$	16,103	$	13,824
Discontinued clinical project		—		—		—		—		3,690		3,425
Indirect clinical costs		1,959		2,393		1,830		6,258		7,473		5,581
Discovery and preclinical research		16,070		15,922		14,155		50,181		47,315		42,113

Total research and development expenses	$	25,343	$	24,516	$	21,435	$	76,911	$	74,581	$	64,943

Marketing and selling

Marketing and selling expenses were $13.2 million for the three months ended September 30, 2006, compared to $11.9 million proforma for the three months ended September 30, 2005. Marketing and selling expenses were $39.8 million for the nine months ended September 30, 2006, compared to $35.2 million proforma for the nine months ended September 30, 2005. The increases primarily reflect the costs of the 40 contract (non-employee) sales representatives retained to promote Cialis in the U.S. beginning in January 2006.

General and administrative

General and administrative expenses were $8.1 million for the three months ended September 30, 2006, compared to $8.7 million proforma for the three months ended September 30, 2005. General and administrative

expenses were $25.1 million for the nine months ended September 30, 2006, compared to $24.9 million proforma for the nine months ended September 30, 2005. The decrease in the three months ended September 30, 2006, as compared to 2005, relates primarily to lower stock-based compensation, partially offset by legal costs related to the proposed acquisition by Lilly. The higher year-to-date costs in 2006, as compared to 2005, reflect higher employee salaries and outside legal costs, partially offset by lower stock-based compensation.

Interest and Other Income

Interest and other income was $2.3 million and $5.5 million, respectively, for the three and nine months ended September 30, 2006, compared to $1.4 million and $4.9 million, respectively, for the three and nine months ended September 30, 2005. The increases primarily reflect higher average invested balances and higher interest rates earned during 2006 compared to 2005.

Income Taxes

We recognized $0.2 million and $0.6 million in U.S. Federal alternative minimum tax for the three and nine months ended September 30, 2006. No income tax expense was recorded in 2005.

Lilly ICOS Results of Operations

See Note 3 of the Notes to Condensed Consolidated Financial Statements for a condensed summary of Lilly ICOS’ operating results for the three and nine months ended September 30, 2006 and 2005.

Worldwide net product sales of Cialis for the three months ended September 30, 2006 and 2005 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
	(In thousands)				(In thousands)
Lilly ICOS territories:
United States	$	94,946	$	77,437	$	271,262	$	191,300
Europe		75,427		61,992		214,387		179,181
Canada and Mexico		20,205		14,728		54,864		40,752

Total Lilly ICOS		190,578		154,157		540,513		411,233
Royalty territories		55,040		40,860		161,240		124,860

Worldwide total	$	245,618	$	195,017	$	701,753	$	536,093

Total Lilly ICOS revenue for the third quarter of 2006 was $201.6 million, compared to $162.3 million for the third quarter of 2005. Total Lilly ICOS revenue for the first nine months of 2006 was $574.3 million, compared to $436.2 million for the first nine months of 2005.

Net sales of Cialis in the U.S. increased $17.5 million (22.6%) and $80.0 million (41.8%), to $94.9 million and $271.3 million, respectively, in the three and nine months ended September 30, 2006, compared to the same periods

in the prior year. Net sales of Cialis in Europe increased $13.4 million (21.7%) and $35.2 million (19.6%), to $75.4 million and $214.4 million, respectively, in the three and nine months ended September 30, 2006, compared to the same periods in the prior year. Net sales of Cialis in Canada and Mexico, combined, increased $5.5 million (37.2%) and $14.1 million (34.6%), to $20.2 million and $54.9 million, respectively, in the three and nine months ended September 30, 2006, compared to the same periods in the prior year. The net sales increases reflect the impact of market share gains, market growth and price increases since the beginning of 2005. The U.S. net sales increase for the 2006 nine months also reflects the impact of an estimated $27 million in aggregate U.S. wholesaler inventory reductions during the 2005 first quarter.

Total Lilly ICOS expenses were $121.9 million in the third quarter of 2006, compared to $142.6 million in the third quarter of 2005. Total expenses were $353.9 million in the first nine months of 2006, compared to $459.8 million in the first nine months of 2005.

Cost of sales, including royalties payable by Lilly ICOS equal to 5.0% of its net product sales, was 7.9% of net product sales in both the three and nine months ended September 30, 2006 compared to 8.0% and 8.3%, respectively, of net product sales in the three and nine months ended September 30, 2005. The percentage decrease was primarily the result of price increases in 2005 and 2006.

Selling, general and administrative expenses decreased $20.3 million from the third quarter of 2005, to $91.8 million in the 2006 third quarter. Selling, general and administrative expenses decreased $106.7 million from the first nine months of 2005, to $268.7 million in the first nine months of 2006. The decreases for both periods were primarily due to refinements in the U.S. sales force configuration and lower consumer marketing expenses.

Research and development expenses decreased to $15.1 million in the third quarter of 2006, compared to $18.0 million in the third quarter of 2005. Research and development expenses decreased to $42.4 million in the first nine months of 2006, compared to $50.3 million in the first nine months of 2005. These decreases were primarily the result of completing, in 2005, a BPH Phase 2 clinical study as well as other regulatory studies, partially offset by increased costs associated with the PAH and BPH clinical studies in 2006.

Liquidity and Capital Resources

At September 30, 2006, we had cash, cash equivalents, investment securities and associated interest receivable of $187.8 million, compared to $162.8 million at December 31, 2005. The increase is primarily a result of cash provided by operating activities for the nine months ended September 30, 2006.

We generated $26.4 million in cash from operating activities during the nine months ended September 30, 2006, compared to using $71.0 million during the nine months ended September 30, 2005. The change in operating cash flow primarily reflects $99.6 million in cash distributions received from Lilly ICOS during the first nine months of 2006. We expect to receive future cash distributions from Lilly ICOS, subject to Lilly ICOS’ continuing profitability and cash requirements.

We used $18.6 million in cash from investing activities during the first nine months of 2006, compared to generating $58.9 million during the first nine months of 2005. Cash used for investing activities during the first nine months of 2006 included a $13.3 million net increase in our investment portfolio, compared to a $99.2 million net decrease in our investment portfolio during the first nine months of 2005. We invested $36.8 million in Lilly ICOS during the first nine months of 2005.

Net cash provided by financing activities (from the exercise of stock options) totaled $3.4 million in the first nine months of 2006, compared to $5.5 million in the first nine months of 2005.

Our existing cash and cash equivalents, investment securities, interest income from our investments, distributions of expected profits from Lilly ICOS, and cash flow from potential future collaborations, are believed to be sufficient to fund our operations for at least the next twelve months. However, in view of (i) the fact that Lilly ICOS only recently became profitable, (ii) our ongoing research and development efforts, and (iii) potential expansion of our operations through in-licensing, collaborations or acquisitions, it is possible that we may need additional financing. Additional financing may not be available when we need it or may be unavailable on acceptable terms. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures for some of our marketing and selling activities or our research and development programs, grant rights to third parties to develop and market product candidates that we would prefer to develop and market on our own, or forego attractive in-licensing, collaboration or acquisition opportunities.

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

•

continued successful commercialization of Cialis around the world;

•

acquisitions of products, technologies or businesses, if any;

•

funding levels for research and development programs, including continued funding from our collaboration partners;

•

the results, timing and extent of preclinical and clinical studies;

•

the time and costs involved in filing and prosecuting patents and enforcing and defending patent claims;

•

the regulatory process in the U.S. and other countries;

•

relationships with research and development collaborators;

•

capital contributions to our affiliates;

•

capital expenditures for property, plant and equipment;

•

competing technological and market development activities; and

•

the time and costs of manufacturing, scale-up and commercialization activities.

We have engaged in collaborations and joint development arrangements with other parties where the capabilities and strategies of the other parties complement ours. Depending on the specific terms of our collaborative agreements, we may record revenue to the extent we are reimbursed for services we provide on behalf of a jointly owned entity. For example, we record collaboration revenue for research, development, marketing and sales services we provide to or on behalf of Lilly ICOS. Although collaborations, partnerships and joint ventures have provided revenue to us in the past, we cannot assure you that this type of revenue will be available to us in the future.

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

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

ITEM 3.

Quantitative and Qualitative Disclosures about Market Risk

At September 30, 2006, our financial instruments include cash, cash equivalents, marketable investment securities, receivables, accounts payable and convertible subordinated debt. We do not use derivative financial instruments in our investment portfolio. Our exposure to market risk for changes in interest rates relates primarily to our marketable investment securities and convertible subordinated debt. Because of the relatively short maturities of our investments, we do not expect interest rate fluctuations to materially affect the aggregate value of our financial assets. The fair value of our convertible subordinated debt is expected to change inversely to changes in interest rates. Also, the fair value of our convertible subordinated debt is expected to change as our stock price and the expected volatility of our stock price change. The fair value of our convertible subordinated debt was $237.2 million at September 30, 2006, with a carrying amount of $278.7 million at that date.

ITEM 4.

Controls and Procedures

(a)

Evaluation of disclosure controls and procedures. Our chief executive officer and our chief financial officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this quarterly report, have concluded that, as of that date, our disclosure controls and procedures were effective.

(b)

Changes in internal control over financial reporting. There were no significant changes in our internal control over financial reporting during the third quarter of 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II.

Other Information

ITEM 1.

Legal Proceedings

On October 18, 2006, two purported shareholder class action lawsuits (Max Kaiser v. ICOS Corporation, et al. (Case No. 06-2-11897-7) and Michael Boteler v. ICOS Corporation, et al. (Case No. 06-2-11898-5)) were filed in Snohomish County (WA) Superior Court on behalf of ICOS shareholders concerning the proposed acquisition of all of ICOS’ outstanding common stock by Eli Lilly and Company. The complaint names as defendants ICOS, certain of its officers and directors, and Lilly and alleges that the ICOS defendants breached their fiduciary duties by adopting the Merger Agreement and approving the proposed transaction. The complaints seek an injunction preventing the completion of the proposed transaction, and to recover unspecified damages. ICOS believes the lawsuits are without merit and intends to defend the actions vigorously.

For a description of our other material pending legal proceedings, see notes to our Condensed Consolidated Financial Statements in Part I, Item 1 and Risk Factors in Part II, Item 1A. See also Part I, Item 3 of our annual report on Form 10-K for the year ended December 31, 2005 and Part II, Item 1 of our quarterly report on Form 10-Q for the quarter ended March 31, 2006.

ITEM 1A.

Risk Factors

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

Risks Related to the Pending Acquisition by Eli Lilly and Company

Failure to complete the merger with Lilly could negatively impact our stock price and adversely affect our future financial condition, operations and prospects.

If the merger with Lilly is not completed for any reason, we may be subject to a number of material risks, including the following:

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if the merger agreement is terminated, we may be required in specific circumstances, to pay a termination fee of $55 million to Lilly;

•

the price of our common stock may decline to the extent that the current market price of our stock reflects an assumption that the merger will be completed;

•

we must pay our expenses related to the merger, including substantial legal, accounting and financial advisory fees, and other expenses related to the merger, even if the merger is not completed; and

•

our day-to-day operations may be disrupted due to the substantial time and effort our management must devote to completing the transaction.

These risks could negatively impact our stock price and adversely affect our future financial condition, operations and prospects.

In addition, our current and prospective employees may experience uncertainty about their future role with Lilly until Lilly’s strategies with regard to us are announced or executed. This may adversely affect our ability to attract and retain key management, research and development, manufacturing, sales and marketing and other personnel.

We intend to comply with the securities and antitrust laws of the United States and any other jurisdiction in which the proposed transaction is subject to review. The reviewing authorities may seek to impose conditions before giving their approval or consent to the transaction. A delay in obtaining the necessary regulatory approvals will delay the completion of the transaction. We have not yet obtained any governmental or regulatory approvals required to complete the transaction. We may be unable to obtain these approvals or to obtain them within the timeframe contemplated by the merger agreement.

If the merger agreement is terminated and our board of directors determines to seek another merger or business combination, it may not be able to find a partner willing to pay an equivalent or more attractive price than that which would have been paid in the merger with Lilly.

Risks Related to Our Business

We have a history of losses and may be unable to sustain profitability.

We have incurred significant operating losses since we began operations in 1990. As of September 30, 2006, we had an accumulated deficit of $847.4 million. We cannot assure you that we will be able to maintain or increase profitability. Directly, and through Lilly ICOS, we expect to continue to incur substantial marketing and other expenses related to commercializing Cialis in the United States, Europe, Mexico and Canada. Furthermore, Lilly ICOS may incur significant expenses in demonstrating safety and efficacy in order to provide a basis for seeking regulatory approvals to market tadalafil in new indications and dosage regimens. We anticipate that operating expenses will increase in the future as we continue development of our potential products, seek to obtain necessary regulatory approvals and manufacture and market these product candidates. Lilly ICOS and/or ICOS may be unable to generate sufficient revenues from Cialis and other products to maintain profitability. Overall changes in market demand for erectile dysfunction drugs, and Lilly ICOS’ ability to capture and retain market share, will significantly affect revenues and expected profitability from Cialis and, in turn, our results of operations and cash flows.

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

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

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level of demand for our products, including changes in physician prescribing habits, and unfavorable publicity concerning our products or similar products;

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changes in wholesaler buying patterns;

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changes in reimbursement rates or policies;

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timing of non-recurring license fees and the achievement of milestones under license and collaborative agreements;

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government regulation, including regulations related to the marketing of our products;

•

increased competition for new or existing products;

•

timing and success of product launches;

•

level of our contract manufacturing for third parties;

•

fluctuations in foreign currency exchange rates;

•

changes in our product marketing, selling and pricing strategies and programs; and

•

inability to provide adequate supply of our products.

In addition, our expenses, including payments owed by us under licensing or collaborative arrangements, are unpredictable and may fluctuate from quarter to quarter. We believe that quarter to quarter comparisons of our operating results are not a good indicator of our future performance and should not be relied upon to predict our future performance. It is possible that, in the future, our operating results in a particular quarter or quarters will not meet the expectations of securities analysts or investors, causing the market price of our common stock to decline.

If we or others identify additional side effects, or if manufacturing problems occur, approval of Cialis could be withdrawn or sales of Cialis could be significantly reduced.

General post-marketing surveillance of Cialis is ongoing, as well as specific studies that are required as part of our marketing approvals in various jurisdictions or to provide a basis for seeking regulatory approvals to market in additional indications. Either of these sources could result in the identification of new or potential side effects. For example, in May 2005, Lilly ICOS added certain vision-related adverse events to the label for Cialis, based on reports from post-marketing surveillance. Subsequently, there was substantial media attention regarding a possible connection between use of Viagra^® (sildenafil citrate), another PDE5 inhibitor for the treatment of erectile dysfunction, and the development of non-arteritic anterior ischemic optic neuropathy (NAION), a condition that may lead to permanent visual impairment or blindness. A causal relationship between the development of NAION and use of these drugs has not been established. Such a causal relationship could be established in the future.

If we or others identify additional or potential side effects, or if manufacturing problems occur:

•

sales may be adversely affected;

•

we may take Cialis off the market;

•

regulatory approval may be withdrawn or other regulatory sanctions may be imposed;

•

reformulation of the product, additional clinical studies, and/or changes in labeling of the product may be required;

•

changes to or re-approvals of our or our partner’s manufacturing facilities may be required;

•

our reputation in the marketplace may suffer; and

•

lawsuits, including class action suits, may be brought against us.

The success of Cialis depends, in large part, on the promotion, sales and marketing activities of our partner, Lilly. Similarly, the success of our potential products in development could depend on our ability to arrange assistance from third parties.

Through Lilly ICOS, we and Lilly have joint responsibility for the promotion and sale of Cialis in North America and Europe. Lilly has rights to Cialis for the other parts of the world, with royalties to be paid to Lilly ICOS. We believe that the efforts of a sizeable pharmaceutical sales force and experienced marketing staff are important to the continued success of the product. We have relied, and expect to continue to rely, heavily on Lilly for promotion, sales and marketing of Cialis, even with respect to our joint responsibilities. We have limited staff and experience in these areas, and we may or may not be capable of independently fulfilling our responsibilities. We and Lilly also rely on contract sales organizations to perform sales activities for Cialis.

If Lilly fails to devote appropriate resources to promotion and sales activities, sales of Cialis could be reduced or could fail to reach their full potential. In addition, if Lilly breaches or terminates its agreement with us, or otherwise fails to conduct its activities related to Cialis in an effective or timely manner, sales of Cialis could be delayed, reduced or become substantially more costly for us to achieve. We will face similar risks with respect to new product candidates that we commercialize (i.e., without the assistance of a third party, we may be unable to establish marketing, sales and distribution capabilities necessary to successfully commercialize new products). Co-promotion or other marketing arrangements with others may be needed to commercialize our potential products. However, these arrangements could significantly limit the revenues we derive from these potential products and increase associated operating expenses. Additionally, these parties may fail to commercialize our potential products successfully.

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

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

Cialis and our potential products, if approved and commercialized, compete or will compete against well established existing therapeutic products or treatments. For example, Pfizer Inc. markets Viagra^® (sildenafil citrate), a PDE5 inhibitor that competes with our product, Cialis. GlaxoSmithKline and Bayer AG, outside the United States, and GlaxoSmithKline and Schering-Plough Corporation, in the United States, are marketing Levitra^® (vardenafil HCl), a third PDE5 inhibitor. Pfizer, Bayer AG, GlaxoSmithKline and Schering-Plough have invested substantial resources in marketing their PDE5 inhibitor products, and we would anticipate that they would continue efforts to aggressively compete in this market. In addition, a number of pharmaceutical and biotechnology companies are currently developing new products targeting the same diseases and medical conditions that we target. Another PDE5 inhibitor, Zydena™ (udenafil), was approved for marketing in Korea in November 2005, and an investigational new drug application related to this product has been filed with the FDA. Other erectile dysfunction treatments are in development, and any other products or technologies that are directly or indirectly successful in treating erectile dysfunction could negatively impact the market for Cialis. If a PDE5 inhibitor with a time of effectiveness comparable to or longer than that of Cialis or a generic PDE5 inhibitor is successfully commercialized, it might have a significant adverse effect on the market for Cialis.

Our competitors include pharmaceutical companies, biotechnology companies, academic and research institutions and government agencies. Many of these organizations, including those who market PDE5 inhibitors that compete with Cialis, have substantially more experience and more capital, research and development, regulatory, manufacturing, sales, marketing, human and other resources than we do. As a result, our competitors may:

•

develop products that are safer, more effective or less costly than any of our current or future products or that render our products obsolete;

•

obtain FDA and other regulatory approvals or reach the market with their products more rapidly than we can or with labeling claims more favorable than ours, which would reduce the potential sales of our product candidates;

•

obtain intellectual property rights that could increase our costs or prevent development or commercialization of our product candidates;

•

devote greater resources to market or sell their products;

•

adapt more quickly to new technologies and scientific advances;

•

initiate or withstand substantial price competition more successfully than we can;

•

have greater success in recruiting skilled workers from the limited pool of available talent;

•

more effectively negotiate third-party licensing and collaborative arrangements; and

•

take advantage of acquisition or other opportunities more readily than we can.

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

The successful development of new therapeutic products is complex and takes a long time, and our efforts may not result in commercial products.

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

In addition, success in preclinical and early clinical studies does not ensure that late-stage or large-scale studies will succeed. Many companies in the pharmaceutical and biotechnology industries, including us, have suffered significant setbacks in clinical studies, even after promising results had been obtained in earlier studies. We have stopped two late-stage, Phase 3 clinical studies of product candidates following interim analyses: a Phase 3 study of Pafase^® (rPAF-AH) for the treatment of severe sepsis was stopped in 2002; and a study of LeukArrest™ (rovelizumab) for the treatment of ischemic stroke was stopped in 2000.

We anticipate that only some of our product candidates will show safety and efficacy in clinical studies and many may encounter difficulties or delays during clinical development. Our efforts to obtain approval for additional indications for tadalafil are subject to many of the same risks associated with new products.

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

Any failure to receive the regulatory approvals necessary to commercialize our product candidates, including once-a-day dosing of Cialis in ED and additional indications for tadalafil, could severely harm our business. Human

therapeutic products are subject to extensive and rigorous government regulation. For example, the FDA regulates, among other things, the development, testing, manufacture, safety, efficacy, record keeping, labeling, storage, approval, advertising, promotion, sale and distribution of pharmaceutical products. Products marketed abroad are also subject to extensive regulation by foreign governments. Except for Cialis, we have not had any product candidate approved for sale in any country. In addition, we have only limited experience in filing and pursuing applications necessary to gain regulatory approvals, which may impede our ability to obtain such approvals.

The regulatory review and approval process is lengthy, expensive and uncertain. To secure FDA approval, we must submit extensive manufacturing, preclinical and clinical data and supporting information to the FDA, for each indication for which we are seeking approval, to establish the product candidate’s safety and efficacy. The approval process may take years to complete and may involve ongoing requirements for post-marketing studies. Any FDA or other regulatory approval of our product candidates, once obtained, may be withdrawn. The effect of government regulation may be to:

•

delay marketing potential products for a considerable period of time;

•

limit the indicated uses for which potential products may be marketed;

•

specify contraindications or other risk management requirements that may limit the use of our products;

•

impose costly requirements on us as a condition of approval or continued use of our products; and

•

provide competitive advantage to other pharmaceutical and biotechnology companies.

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

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

We do not currently have facilities to manufacture Cialis or our product candidates in quantities necessary for commercial sale. In addition, our manufacturing capacity may be inadequate to complete all clinical studies contemplated by us over time. We intend to rely significantly on contract manufacturers, including collaboration partners, to produce large quantities of drug material needed for clinical studies and commercialization of Cialis and our potential products. Cialis is currently manufactured by Lilly. Lilly recently announced that it will discontinue operations at a facility that manufactures Cialis for markets outside the United States. Lilly will need to transition this manufacturing to another facility and we will be dependent on Lilly to avoid an interruption in supply. In general we depend, and will continue to depend on contract manufacturers to deliver materials on a timely basis and to comply with regulatory requirements, including Good Manufacturing Practices, or GMP, regulations enforced by the FDA through its facilities inspection program. Contract manufacturers may be unable to meet our needs with respect to timing, quantity or quality of materials, and may fail to satisfy applicable regulatory requirements with respect to the manufacture of these materials. If we are unable to contract for a sufficient supply of needed materials on acceptable terms, or if we should encounter delays or difficulties in our relationships with manufacturers, our revenues and potential profitability may be lower.

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

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

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

Our success depends to a significant extent on our ability and the ability of our collaboration partners to obtain, maintain and enforce patents and other proprietary rights. Patent law relating to the scope of claims in the pharmaceutical and biotechnology fields in which we operate is still evolving and subject to a substantial degree of uncertainty. Accordingly, there may be third-party patents or patent applications relevant to Cialis or our potential products that might block or compete with the technologies and products covered by our patents or patent applications. We also cannot be certain that our pending patent applications will result in issued patents or that others have not filed patent applications for technology covered by our pending applications or that we were the first to invent the technology. A third party has filed a claim seeking to add three individuals as co-inventors on two ICOS patents. This lawsuit is described herein, in our Notes to Condensed Consolidated Financial Statements in Part I, Item 1, in Part I, Item 3, of our annual report on Form 10-K for the year ended December 31, 2005, and in Part II, Item 1, of our quarterly report on Form 10-Q for the quarter ended March 31, 2006.

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

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

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

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

Patent litigation is common in the pharmaceutical industry. Third parties may assert patent or other intellectual property infringement claims against us or our collaboration partners regarding Cialis or our potential products. For example, we are subject to a patent lawsuit filed by Pfizer in October 2002, which alleges that the use, offering for sale, selling, manufacture or importing of Cialis, into the United States, for the treatment of erectile dysfunction by any of the defendants infringes one claim of a U.S. patent held by Pfizer. This lawsuit is described herein, in our Notes to Condensed Consolidated Financial Statements in Part I, Item 1, in Part I, Item 3, of our annual report on Form 10-K for the year ended December 31, 2005, and in Part II, Item 1, of our quarterly report on Form 10-Q for the quarter ended March 31, 2006.

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

Furthermore, after seeking advice of counsel, we may undertake research and development regarding potential products, even when we are aware of third-party patents that may be relevant to these potential products, on the basis that such third-party patents may be challenged or licensed by us. We may be subject to patent infringement

claims if our subsequent challenges to such patents were not to prevail. Additionally, if our subsequent attempts to license such patents were to prove unsuccessful, we may be unable to commercialize these potential products after having incurred significant expenditures.

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

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

We may be subject to product liability or other claims related to the products we manufacture for third parties.

We manufacture recombinant protein bulk product under contract for third parties who, in many cases, intend to use them in human clinical trials and distribute them to the public. Even though we do not distribute, market or sell the products to end users ourselves, we may be required to defend lawsuits or pay damages if any of the products is alleged to have harmed someone. We take steps to protect ourselves against the potential liabilities associated with these risks, including obtaining agreements from our customers to limit our liabilities and to indemnify us. However, we cannot be certain that these agreements will be adequate to protect us against potential claims relating to our contract manufacturing services. The scope of these agreements may vary from contract to contract. If we faced a claim that was not resolved by the applicable agreement, or if the customer failed to perform under its obligations, we may be inadequately protected or we may not be protected at all. Although we maintain product liability insurance, we cannot be certain that the coverage will apply, that it will be adequate for these claims, or that it will continue to be available to us on acceptable terms.

We may also be subject to claims, by our customers or others, that we committed errors during the manufacturing process. Biologics manufacturing is highly complex and new processes, in particular, can be difficult to develop and predict. Certain events could result in a contaminated product or one that did not actually perform as it was expected to perform. Although such an event may be out of our control, the customer might attempt to hold us liable for any resulting damages. We currently maintain errors and omissions insurance, but we cannot be certain that this coverage is adequate or that it will continue to be available to us on acceptable terms.

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

We have entered into, and we expect to continue to enter into, collaborative arrangements with third parties who provide us with new products or product candidates, intellectual property, and/or funding. In addition, some third parties may perform research, development, regulatory compliance, manufacturing, or marketing activities relating to Cialis and some or all of our product candidates. The environment for collaborations relating to promising product candidates is extremely competitive. We may be unable to negotiate additional collaborative arrangements or, if necessary, modify our existing arrangements on acceptable terms. If we fail to secure or maintain successful collaborative arrangements, our research, development and marketing activities may be delayed or reduced.

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

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

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

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failure of new product candidates during the research and development stages;

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difficulty of assimilating the new operations and personnel, products or technologies;

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commercial failure of the new products;

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disruption of our ongoing business;

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diversion of resources;

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inability of management to maintain uniform standards, controls, procedures and policies;

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difficulty of managing our growth and information systems;

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reduction in the overall growth rate of the combined organization;

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risks of entering markets in which we have little or no prior experience; and

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impairment of relationships with employees or customers.

In addition, future acquisitions, mergers or investments could result in potentially dilutive issuances of equity securities, use of cash or incurrence of debt and assumption of direct and contingent liabilities, any of which could have an adverse effect on our business and operating results or the price of our common stock.

The failure to attract or retain key management and technical employees and consultants could harm our business.

We are highly dependent on the efforts and abilities of our current management and key technical personnel. Our success will depend in part on retaining the services of our existing management and key personnel and attracting and retaining new highly qualified personnel. Failure to retain our existing key management and technical personnel or to attract additional highly qualified personnel could, among other things:

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delay our ongoing discovery research efforts;

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delay preclinical or clinical testing of our product candidates;

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delay the regulatory approval process;

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compromise our ability to negotiate additional collaborative arrangements; or

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prevent us from successfully commercializing our product candidates.

In our field, competition for qualified management and technical personnel is intense. In addition, many of the companies with which we compete for experienced personnel have greater financial and other resources than we do. As a result of these factors, we may be unsuccessful in recruiting and retaining sufficient qualified personnel.

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

We will require substantial financial resources to continue to market and sell Cialis and to conduct the time-consuming and costly research, preclinical development, clinical studies, manufacturing, regulatory, and sales and marketing activities necessary to commercialize our potential products. We may need to seek additional financing through public or private sources, including equity or debt financings, and through other alternatives, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements. Financing may, however, be unavailable when we need it or may be unavailable on acceptable terms. If we raise additional funds by issuing common stock or convertible debt securities, the percentage ownership of our existing stockholders could be reduced. Any debt or equity securities that we issue may have rights superior to those of our common stock. We may also issue debt that has rights superior to those of the holders of our convertible subordinated debt. If we are unable to raise additional funds when we need them, we may be required to delay, scale back or eliminate expenditures for some of our marketing and selling activities and our research and development programs, grant rights to third parties to develop and market product candidates that we would prefer to develop and market on our own, and forego attractive in-licensing, collaboration or acquisition opportunities. If we are required to grant such rights, the ultimate value, to us, of our product candidates may be reduced.

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

We have outstanding $278.7 million aggregate principal amount of convertible subordinated notes, bearing interest at 2%. The notes mature on July 1, 2023, although holders of the notes may require us to repurchase all or part of their notes, for cash, on certain specified dates, the first of which occurs in July 2010. This is a significant amount of debt that carries a substantial debt service obligation. Our ability to meet our debt service obligations will depend on our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control.

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

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limiting our ability to obtain financing for working capital, acquisitions or other purposes;

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limiting our flexibility in planning for, or reacting to, changes in our business; and

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making us more vulnerable to industry downturns and competitive pressures.

Risks Related to Our Industry

Rapid changes in technology and industry standards could render Cialis or our potential products unmarketable.

We are engaged in a field characterized by extensive research efforts and rapid technological development. New drug discoveries and developments in our field and other drug discovery technologies are accelerating. Our competitors may develop technologies and products that are more effective than any we develop or that render our technology, Cialis or our potential products obsolete or noncompetitive. In addition, Cialis or our potential products could become unmarketable if new industry standards emerge. To be successful, we will need to enhance our product candidates and design, develop and market new product candidates that keep pace with new technological and industry developments.

Our corporate compliance program can never guarantee that we are in compliance with all laws and regulations.

Our operations are subject to extensive government regulation. Although we have developed and implemented a corporate compliance program, we cannot assure you that we or our employees, directors or agents are or will be in compliance with all laws and regulations. The interpretation of these requirements has evolved over time and has been unpredictable. In addition, several states are considering or have recently adopted new laws addressing various

aspects of our business and pharmaceutical compliance in general. If we fail to comply with any of these laws or regulations, various negative consequences could result, including the termination of clinical studies, the failure to gain regulatory approval of a product candidate, restrictions on our products or manufacturing processes, withdrawal of Cialis from the market, significant fines or other penalties and costly litigation.

We may be required to defend lawsuits or pay damages in connection with the alleged or actual violation of fraud and abuse laws.

We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws and false claims laws. Anti-kickback laws make it illegal for a prescription drug manufacturer to offer or pay any remuneration in exchange for, or to induce, the referral of business, including the purchase or prescription of a particular drug. The federal government has published regulations that identify safe harbors or exemptions for types of payment arrangements that do not violate the anti-kickback statutes. We seek to comply with the safe harbors where possible. False claims laws prohibit anyone from knowingly and willingly presenting, or causing to be presented for payment to third-party payors (including Medicare and Medicaid), claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services. Violations of fraud and abuse laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal healthcare programs (including Medicare and Medicaid). If the government were to allege against or convict us of violating these laws, there could be a material adverse effect on our business, including our stock price. Our activities relating to the sale and marketing of our products could be subject to challenge, due to the broad scope of these laws, the absence of guidance in the form of regulations and court decisions addressing certain practices, and the increasing prosecutorial resources and attention being devoted to the sales practices of pharmaceutical companies by law enforcement authorities. During the last few years, several companies have paid multi-million dollar fines for alleged violation of fraud and abuse laws, and several other companies are under active investigation.

If we do not comply with laws regulating the protection of the environment and health and human safety, we could incur substantial liability.

Our research and development activities involve the controlled use of chemicals, viruses, radioactive compounds and other hazardous materials. If an accident involving these materials were to occur, we could be held liable for any resulting damages, which liability could exceed our resources. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous materials and certain waste products. We cannot eliminate the risk of accidental contamination or injury from these materials. We are also subject to numerous health and workplace safety laws and regulations, including those governing laboratory procedures. We may incur substantial costs to comply with, and substantial fines and penalties if we violate, any of these laws or regulations.

Our sales may be affected by coverage and reimbursement decisions of third-party payors.

Sales of Cialis and any new products we develop and commercialize may be affected by the availability of reimbursement from third-party payors, such as state and federal governments, under programs such as Medicare and Medicaid in the United States, private insurance plans and managed care organizations.

Because of the size of the patient population covered by managed care organizations, marketing of pharmaceuticals to them and the pharmacy benefit managers (PBMs) that serve many of these organizations is an important aspect of our business. Third-party payors and PBMs reevaluate their drug benefit plans and drug formularies from time to time, and continued access is not assured. If reimbursement levels for Cialis change adversely or if we fail to obtain reimbursement for our potential products, health care providers may limit how much or under what circumstances they will prescribe or administer them. This could result in lower product sales.

Available Information

Our business was incorporated in the state of Delaware in September 1989. We reincorporated in Washington State in September 2005. The internet address of our corporate website is www.icos.com. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports available free of charge through our internet website. In addition, we will voluntarily provide paper copies of such filings, free of charge, upon request. The ICOS Corporation Code of Conduct, which is our written Code of Ethics under Section 406 of the Sarbanes-Oxley Act of 2002, is also available on our corporate website.

ITEM 6.

Exhibits and Reports on Form 8-K

(a) Exhibits


		Note
2.1	Agreement and Plan of Merger, dated as of October 16, 2006, by and among Eli Lilly and Company, Tour Merger Sub, Inc., and ICOS Corporation.	A

4.1	Amendment No. 2 to Rights Agreement, dated October 16, 2006 by and between ICOS Corporation and Mellon Investor Services LLC.	A

10.1	Amended and Restated Change in Control Severance Agreement by and between Paul N. Clark and ICOS Corporation, dated October 16, 2006.	B

10.2	Amended and Restated Change in Control Severance Agreement by and between Gary L. Wilcox and ICOS Corporation, dated October 16, 2006.	B

10.3	Form of Amended and Restated Change in Control Severance Agreement (entered into by and between ICOS Corporation and each of Leonard Blum, David Goodkin, John Kliewer, Thomas St. John, Michael Stein, Clifford Stocks and Michele Yetman, in each case dated October 16, 2006).	B

10.4	Change in Control Severance Agreement by and between Shing Chang and ICOS Corporation, dated October 16, 2006.	B

10.5	ICOS Corporation Retention, Sale and Special Recognition Bonus Plan	B

31.1	Section 302 Certification of Paul N. Clark	C

31.2	Section 302 Certification of Michael A. Stein	C

32.1	Certification of Paul N. Clark Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	C

32.2	Certification of Michael A. Stein Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	C

(b) Reports on Form 8-K

•

On October 17, 2006, ICOS filed a report on Form 8-K reporting an Agreement and Plan of Merger with Eli Lilly and Company.

•

On October 20, 2006, ICOS filed a report on Form 8-K reporting entry into material agreements related to the Agreement and Plan of Merger with Eli Lilly and Company, including a change in Control Severance Plan and Agreements and Retention, Sale, and Special Recognition Bonus Plan.

Legend to Exhibit Index:


Note
A		Filed as an exhibit to the Company’s Form 8-K Current Report on October 17, 2006 (File No. 000-19171) and incorporated herein by reference.

B		Filed as an exhibit to the Company’s Form 8-K Current Report on October 20, 2006 (File No. 000-19171) and incorporated herein by reference.

C		Filed with this document.

SIGNATURE

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

ICOS CORPORATION


Date: November 2, 2006	By:	/s/ MICHAEL A. STEIN
		Michael A. Stein
		Senior Vice President and Chief Financial Officer (Principal Financial Officer)