UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended December 31, 2006

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

For the transition period from to

Commission File Number: 0-27188

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

Delaware		33-0557266
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

10188 Telesis Court, Suite 100, San Diego, California		92121-4779
(Address of principal executive offices)		(Zip Code)

(858) 799-5000

(Registrant’s telephone number, including area code)

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

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

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

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

The number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, as of January 12, 2007 was 26,472,890, net of treasury shares.

ACCELRYS, INC.
FORM 10-Q — QUARTERLY REPORT
For The Quarterly Period Ended December 31, 2006
Table of Contents

PART I — FINANCIAL INFORMATION
Item 1.		Financial Statements
		Condensed consolidated balance sheets as of December 31, 2006 (unaudited) and March 31, 2006
		Condensed consolidated statements of operations (unaudited) for the three- and nine-month periods ended December 31, 2006 and 2005
		Condensed consolidated statements of cash flows (unaudited) for the nine-month periods ended December 31, 2006 and 2005
		Notes to condensed consolidated financial statements (unaudited)
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures About Market Risk
Item 4.		Controls and Procedures
PART II — OTHER INFORMATION
Item 1A.		Risk Factors
Item 5.		Other Information
Item 6.		Exhibits
Signature

PART I — FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Accelrys, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except per share amounts)

	December 31, 2006			March 31, 2006
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	16,604		$	24,656
Marketable securities	35,194			34,733
Trade receivables, net of allowance for doubtful accounts of $207 and $351 as of December 31, 2006 and March 31, 2006, respectively	27,418			17,289
Prepaid expenses and other current assets	3,646			3,438
Total current assets	82,862			80,116
Restricted cash	8,171			6,633
Property and equipment, net	6,682			7,860
Goodwill	42,663			42,663
Intangible assets, net	7,519			8,671
Other assets	745			812
Total assets	$	148,642		$	146,755
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	1,077		$	1,676
Accrued liabilities	6,925			4,939
Accrued compensation and benefits	7,745			7,009
Current portion of accrued restructuring charges	714			2,936
Current portion of deferred revenue	52,917			51,710
Total current liabilities	69,378			68,270
Deferred revenue, net of current portion	2,557			9,559
Accrued restructuring charges, net of current portion	1,425			1,338
Lease-related liabilities, net of current portion	6,605			4,380

Stockholders’ equity:
Preferred stock, $0.0001 par value; 2,000 shares authorized; no shares issued and outstanding	—			—
Common stock, $0.0001 par value; 40,000 shares authorized; 27,109 and 26,856 shares issued at December 31, 2006 and March 31, 2006, respectively	3			3
Additional paid-in capital	258,271			254,224
Deferred stock-based compensation	—			(522		)
Lease guarantee	(588		)	(635		)
Treasury stock; 644 shares at each of December 31, 2006 and March 31, 2006, respectively	(8,340		)	(8,340		)
Accumulated deficit	(181,631		)	(181,156		)
Accumulated other comprehensive income (loss)	962			(366		)
Total stockholders’ equity	68,677			63,208
Total liabilities and stockholders’ equity	$	148,642		$	146,755

See accompanying notes to these condensed consolidated financial statements.

Accelrys, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)

	Three Months Ended December 31,						Nine Months Ended December 31,
	2006			2005			2006			2005

Revenue	$	20,684		$	20,433		$	61,066		$	62,572
Operating costs and expenses:
Cost of revenue	4,526			4,361			12,248			12,669
Product development	4,697			4,952			14,739			16,374
Sales and marketing	8,616			8,675			21,720			24,560
General and administrative	4,077			3,612			13,168			11,304
Restructuring charges (recoveries)	252			—			247			(4		)
Total operating costs and expenses	22,168			21,600			62,122			64,903
Operating loss	(1,484		)	(1,167		)	(1,056		)	(2,331		)
Interest and other income, net	601			530			1,444			1,630
Income (loss) before taxes	(883		)	(637		)	388			(701		)
Income tax expense (benefit)	198			(70		)	863			611
Net loss	$	(1,081	)	$	(567	)	$	(475	)	$	(1,312	)

Basic and diluted net loss per share	$	(0.04	)	$	(0.02	)	$	(0.02	)	$	(0.05	)
Weighted average shares used to compute basic and diluted net loss per share	26,387			26,143			26,297			26,090

See accompanying notes to these condensed consolidated financial statements.

Accelrys, Inc.
Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

	Nine Months Ended December 31,
	2006			2005

Cash flows from operating activities:
Net loss	$	(475	)	$	(1,312	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation	2,295			2,931
Amortization of acquired intangible assets	1,152			1,314
Share-based compensation	3,344			775
Other	1,152			1,020
Changes in operating assets and liabilities:
Trade receivables	(9,294		)	(18,311		)
Prepaid expenses and other current assets	(54		)	2,378
Restricted cash and other assets	(1,200		)	(377		)
Accounts payable	(663		)	(675		)
Accrued liabilities	1,091			(2,864		)
Deferred revenue	(7,264		)	4,526
Net cash used in operating activities	(9,916		)	(10,595		)
Cash flows from investing activities:
Purchases of property and equipment, net	(847		)	(2,555		)
Purchases of marketable securities	(24,580		)	(5,377		)
Proceeds from sales and maturities of marketable securities	24,391			13,102
Net cash provided by (used in) investing activities	(1,036		)	5,170
Cash flows from financing activities:
Proceeds from issuance of common stock	1,230			857
Net cash provided by financing activities	1,230			857
Exchange rate effect on cash and cash equivalents	1,670			(944		)
Decrease in cash and cash equivalents	(8,052		)	(5,562		)
Cash and cash equivalents at beginning of period	24,656			21,256
Cash and cash equivalents at end of period	$	16,604		$	15,694

See accompanying notes to these condensed consolidated financial statements.

Accelrys, Inc.
Notes to Condensed Consolidated Financial Statements

1. Basis of Presentation and Significant Accounting Policies

Financial Statement Preparation

The condensed consolidated financial statements as of December 31, 2006, and for the three and nine months ended December 31, 2006 and 2005 are unaudited. We have condensed or omitted certain information and 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 fiscal year ended March 31, 2006.

In the opinion of management, these condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of results for the interim periods presented.

Our business is subject to seasonal variations. Historically, we have received approximately two-thirds of our annual customer orders in the second half of our fiscal year. In accordance with our revenue recognition policies, the revenue associated with these orders is generally recognized over the contractual license term. Therefore, because we accrue sales commissions and royalties upon the invoicing of customer orders, we have historically experienced an increase in operating costs and expenses during the second half of our fiscal year with only a minimal corresponding incremental increase in revenue. Additionally, our cash flows from operations have historically been positive in the fiscal quarter ended March 31 as we collect the accounts receivable generated from these customer orders, while we have historically experienced negative cash flows from operations in the other three fiscal quarters. As a result of these seasonal variations, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance and that the interim financial results for the periods presented in this quarterly report are not necessarily indicative of results for a full year or for any subsequent interim period.

Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements include the accounts of our wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, income taxes and the valuation of goodwill, intangibles and other long-lived assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual future results could differ from those estimates.

Revenue Recognition

We recognize revenues in accordance with the American Institute of Certified Public Accountants Statement of Position No. 97-2, Software Revenue Recognition (“SOP No. 97-2”), as amended, U.S. Securities and Exchange Commission (the “SEC”) Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB No. 104”), and Emerging Issues Task Force Issue No. 00-21 (“EITF No. 00-21”), Revenue Arrangements with Multiple Deliverables.

We generate revenue from the following primary sources:

· software licenses,

· provision of support and maintenance services on licensed software, referred to as post-contract customer support (“PCS”), and

· training, installation and implementation services.

Customer billings generated in connection with our revenue-generating activities are intitially recorded as deferred revenue. We then recognize the revenue from these customer billings as set forth below and when all of the following criteria are met:

· a fully executed written contract and/or purchase order has been obtained from the customer (i.e., persuasive evidence of an arrangement exists),

· the contractual price of the product or services has been defined and agreed to in the contract (i.e., price is fixed or determinable),

· delivery of the product or service has occurred and no material uncertainties regarding customer acceptance of the delivered product or service exist, and

· collection of the purchase price from the customer is deemed probable.

Software Licenses

We license software either perpetually or on a term basis. Our standard perpetual software licensing arrangements include twelve months of bundled PCS, while our standard term-based software licensing arrangements typically include PCS for the full duration of the term license. Because we do not have vendor specific objective evidence (“VSOE”) of the fair value of these elements, we recognize as revenue the entire fee for all software licenses ratably over the term of the bundled PCS. Certain of our term-based licenses also allow the customer to substitute purchased products for other products of equal value throughout the term. We account for these arrangements as in-substance subscriptions and, accordingly, we recognize as revenue the entire fee for licenses ratably over the contractual term of the arrangement, which is typically the same as the term of the bundled PCS.

Renewal of PCS under Perpetual Software Licenses

Our PCS includes the right to receive unspecified upgrades or enhancements and technical support. Fees from customer renewals of PCS related to previously purchased perpetual licenses are recognized ratably over the term of the PCS.

Training, Installation and Implementation Services

We provide certain services to our customers, including product training, non-complex product installation and non-complex implementation services which are non-essential to the operation of the software. When sold separately, revenue from these services is generally recognized as the services are delivered according to the contractual terms. Amounts billed but not yet recognized as revenue, and other payments received prior to recognition of revenue, are recorded as deferred revenue.

Multi-Element Arrangements

For multi-element arrangements which include software licenses, PCS and non-complex training, installation and implementation services which are non-essential to the operation of the software, the entire fee for such arrangements is recognized as revenue ratably over the term of the PCS or delivery of the services, whichever is longer.

Software Development Costs

We account for costs incurred to develop our software products in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, Accounting for the Cost of Computer Software to be Sold, Leased or Otherwise Marketed. Accordingly, costs incurred in the research and development of new software products and significant enhancements to existing software products are expensed as incurred, until the technological feasibility of the product has been established. Technological feasibility occurs shortly before our software products are available for general release, and we have determined that costs eligible for capitalization are not material. Accordingly, there were no capitalized software development costs as of December 31, 2006 and March 31, 2006.

Adoption of SFAS No. 123R

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”). SFAS No. 123R requires that employee stock-based compensation is measured based on the grant date fair value of the related employee equity awards and is treated as an expense that is reflected in the financial statements over the related service period. The provisions of SFAS No. 123R were effective for us beginning April 1, 2006. Prior to April 1, 2006, we accounted for our share-based awards to employees and directors under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations and adopted the pro forma disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation. Accordingly, stock-based compensation expense related to employee stock options was recognized only if, on the date of grant, the exercise price of the employee stock option was less than the fair market value of the underlying common stock.

Effective April 1, 2006, we adopted SFAS No. 123R using the modified prospective transition method. Under the modified prospective transition method, the estimated grant date fair value of awards granted to employees and directors on or after April 1, 2006 is recognized as a charge against income over the requisite service period. Additionally, the remaining unrecognized compensation expense associated with the unvested portion of awards granted prior to April 1, 2006, determined under the provisions of SFAS No. 123, is recognized as a charge against income beginning April 1, 2006. In accordance with the modified prospective transition method, our consolidated financial statements for periods prior to April 1, 2006 have not been restated to reflect, and do not include, the impact of our adoption of SFAS No. 123R.

Pursuant to the provisions of SFAS No. 123R, deferred stock-based compensation is no longer reflected as a separate component of stockholders’ equity. As a result, we reversed our remaining deferred stock-based compensation balance as of April 1, 2006 of $0.5 million against additional paid-in capital.

The impact of our adoption of SFAS No. 123R on the condensed consolidated financial statements and the related footnote disclosure information are provided in Note 3.

Income Taxes

We recognize income tax expense (benefit) based on estimates of our consolidated taxable income (loss) taking into account the various legal entities through which, and jurisdictions in which, we operate. As such, income tax expense (benefit) may vary from the customary relationship between income tax expense (benefit) and income (loss) before taxes.

New and Recently Adopted Accounting Standards

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB No. 108”). SAB No. 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Specifically, SAB No. 108 states that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB No. 108 is effective for fiscal years ending after November 15, 2006. We are currently evaluating the impact, if any, SAB No. 108 will have on our results of operations and financial position.

In June 2006, the FASB issued Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes. FIN No. 48, which is effective for fiscal years beginning after December 15, 2006, addresses the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. In addition, FIN No. 48 expands the disclosure requirements concerning unrecognized tax benefits as well as any significant changes that may occur in the next twelve months associated with such unrecognized tax benefits. We will adopt the provisions of FIN No. 48 in the first quarter of fiscal year 2008. We are currently evaluating the impact, if any, FIN No. 48 will have on our results of operations and financial position.

In November 2005, the FASB issued Staff Position Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“FSP Nos. 115-1 and 124-1”), which provide guidance on determining when investments in certain debt and equity securities are considered impaired and whether that impairment is other-than-temporary, and on the measurement of such impairment loss. FSP Nos. 115-1 and 124-1 also include accounting considerations subsequent to the recognition of other-than-temporary impairments and require certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. Our adoption of FSP Nos. 115-1 and

124-1 as of April 1, 2006 did not have a significant impact on our results of operations and financial position.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and SFAS No. 3. Although SFAS No. 154 carries forward the guidance in APB No. 20 and SFAS No. 3 with respect to accounting for changes in estimates, changes in reporting entities, and the correction of errors, SFAS No. 154 establishes new standards for accounting for changes in accounting principles, whereby all such changes must be accounted for by retrospective application to the financial statements of prior periods unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005, with early adoption permitted for changes and corrections made in years beginning after May 2005. Our adoption of SFAS No. 154 as of April 1, 2006 did not have a material impact on our financial position, results of operations or cash flows.

2. Net Loss Per Share

We compute net loss per share pursuant to SFAS No. 128, Earnings Per Share. Accordingly, basic and diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period, without consideration for common share equivalents. Potentially dilutive common share equivalents consist of common stock options and unvested restricted stock awards and restricted stock units (“RSUs”).

Potentially dilutive common share equivalents that were excluded from the basic and diluted net loss per share calculations as their effect would be anti-dilutive totaled approximately 3.7 million shares and 3.8 million shares for the three and nine months ended December 31, 2006, respectively, and 2.6 million shares and 3.7 million shares for the three and nine months ended December 31, 2005, respectively.

3. Share-Based Payments

Share-Based Compensation Plans

On August 2, 2005, our stockholders approved the Amended and Restated 2004 Stock Incentive Plan (the “2004 Plan”). The 2004 Plan authorizes the grant of equity awards to purchase the number of shares of our common stock equal to the sum of (i) 1,900,000 shares and (ii) the number of shares of common stock underlying any stock awards granted under certain prior share-based compensation plans that expire or are cancelled or forfeited without having been exercised in full or that are repurchased by us. Potential types of equity awards that may be granted under the 2004 Plan to our officers, directors, employees and consultants include stock options, restricted stock awards, common stock awards, stock appreciation rights, performance awards and deferred stock units. Pursuant to the 2004 Plan, any shares of common stock that are awarded under the 2004 Plan as restricted stock awards, common stock awards, performance awards or deferred stock units (but not as stock options or stock appreciation rights) are counted against the maximum number of shares of common stock available for issuance under the 2004 Plan based on a 1.15-to-1 ratio. The terms and conditions of specific awards are set at the discretion of our board of directors although generally awards vest over not more than five years, expire no later than ten years from the date of grant and do not have exercise prices less than the fair market value of the underlying common stock on the date of grant. At December 31, 2006, approximately 1,813,000 shares of our common stock remain available for issuance pursuant to awards granted under the 2004 Plan.

On August 2, 2005, our stockholders also approved the 2005 Employee Stock Purchase Plan (the “ESPP”), under which we have reserved 1,000,000 shares of our common stock for issuance. Under the ESPP, employees may defer up to 10% of their base salary to purchase shares of our common stock. The purchase price of the common stock is equal to 85% of the lower of the fair market value per share of our common stock on the commencement date of the applicable offering period or the applicable purchase date. To date, we have issued 69,000 shares under the ESPP and 931,000 shares remain available for future issuance under the ESPP as of December 31, 2006.

We also maintain certain other share-based compensation plans, under which we did not grant awards during fiscal year 2007 and do not intend to grant any further awards in the future.

Our share-based compensation plans contain a provision that allows eligible participants to continue to vest in their stock options upon their retirement, as that term is defined in the plans. To be eligible for continued vesting, participants must be at least 55 years of age and have 5 years of service at the time of their retirement.

During the second quarter of fiscal year 2007, we offered eligible employees the one-time opportunity to surrender any and all stock options granted pursuant to any of our stock plans with an exercise price greater than $9.00 per share in exchange for RSUs (the “Exchange Offer”) based on an exchange ratio determined by our board of directors. The RSUs vest

in three equal annual installments commencing on the date of grant and are subject to the terms and conditions set forth in the 2004 Plan. The offer period commenced on July 28, 2006 and expired on August 25, 2006. On August 26, 2006, all eligible stock options tendered by eligible employees in accordance with the terms of the Exchange Offer were cancelled and RSUs were issued to such eligible employees in accordance with the exchange ratios established by the board of directors. In total, stock options for the purchase of approximately 410,000 shares of our common stock were tendered and cancelled, and RSUs for approximately 105,000 shares of our common stock were granted. Any eligible stock options not tendered remain issued and outstanding in accordance with their original terms and conditions.

Pursuant to SFAS No. 123R, we accounted for the cancellation of the tendered stock options and concurrent grant of RSUs as a modification of the cancelled stock options. Accordingly, we measured the excess of the grant-date fair value of the RSUs over the fair value of the cancelled stock options at cancellation (the “incremental value”) and are recognizing the aggregate of the incremental value and the remaining unamortized grant-date fair value of the cancelled stock options of approximately $0.4 million as share-based compensation expense over the requisite service period of the RSUs.

Share-Based Award Activity

Our stock options generally vest over four years and have a contractual term of 10 years. A summary of stock option activity under our share-based compensation plans is as follows:

	Number of Shares		Weighted Average Exercise Price		Aggregate Intrinsic Value		Weighted Average Remaining Contractual Life
	(In thousands, except per share amounts and years)
Outstanding at April 1, 2006	4,306		$	9.78
Granted	1,055		6.97
Exercised	(186	)	4.67
Expired/Forfeited	(1,352	)	14.39
Outstanding at December 31, 2006	3,823		7.65		$	611	7.3
Exercisable at December 31, 2006	2,193		8.20		$	451	6.0

The aggregate intrinsic value of stock options outstanding and exercisable at December 31, 2006 was based on the closing price of our common stock on December 29, 2006 of $6.01 per share. The total intrinsic value of stock options exercised during the nine months ended December 31, 2006 was $0.4 million and the total cash received from the exercise of stock options during the nine months ended December 31, 2006 was $0.9 million.

In fiscal year 2007, we granted RSUs under the 2004 Plan that vest annually over three years and, once vested, do not expire. Upon vesting of an RSU, employees are issued an equivalent number of shares of our common stock. A summary of RSU activity under our share-based compensation plans is as follows:

	Number of Shares		Weighted Average Grant Date Fair Value
	(In thousands, except per share amounts)
Unvested at April 1, 2006	—		$	—
Granted	481		6.73
Vested	—		—
Forfeited	(29	)	6.97
Unvested at December 31, 2006	452		$	6.72

We also have remaining unvested restricted stock awards of approximately 8,000 shares as of December 31, 2006 that were granted under a prior plan. These restricted stock awards vest annually over three years and, once vested, do not expire. Upon vesting of a restricted stock award, the company’s right to repurchase the underlying shares expires.

Valuation of Share-Based Awards

We estimate the fair value of our share-based awards on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of certain input variables, as follows:

Expected Volatility. Volatility is a measure of the amount the stock price will fluctuate during the expected life of an award. We determine volatility based on our historical stock price volatility over the most recent period equivalent to the expected life of the award and the historical stock price volatilities of comparable publicly traded companies, giving consideration to company-specific events impacting historical volatility that are unlikely to occur in the future as well as anticipated future events that may impact volatility.

Risk-Free Interest Rate. Our assumption of the risk-free interest rate is based on the interest rates on U.S. constant rate treasury securities with contractual terms approximately equal to the expected life of the award.

Expected Dividend Yield. Because we have not paid any cash dividends since our inception and do not anticipate paying dividends in the foreseeable future, we assume a dividend yield of zero.

Expected Award Life. We determine the expected life of an award by considering various relevant factors, including the vesting period and contractual term of the award, our employees’ historical exercise patterns and length of service, the expected future volatility of our stock price, tax implications of exercising an award and employee characteristics. We also consider the expected terms of comparable publicly traded companies.

Under SFAS No. 123R, we are also required to estimate at grant the likelihood that the award will ultimately vest (the “pre-vesting forfeiture rate”) and revise the estimate, if necessary, in future periods if the actual forfeiture rate differs. We determine the pre-vesting forfeiture rate of an award based on our historical pre-vesting award forfeiture experience. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to fiscal year 2007, we accounted for pre-vesting forfeitures as they occurred.

Our determination of the input variables used in the Black-Scholes option pricing model as well as the pre-vesting forfeiture rate is based on various underlying estimates and assumptions that are highly subjective and are affected by our stock price, among other factors. Changes in these underlying estimates and assumptions could materially affect the fair value of our share-based awards and, therefore, the amount of share-based compensation expense to be recognized in our results of operations.

The fair value of stock options and ESPP purchase rights granted during the nine months ended December 31, 2006 and

2005 was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

	Nine Months Ended December 31. 2006
	Stock Options			ESPP Purchase Rights
Expected volatility	60		%	60		%
Risk-free interest rate	4.9		%	5.1		%
Expected option life in years	5.0			0.5
Expected dividend yield	0		%	0		%
Weighted average per share grant date fair value	$	3.89		$	2.18

	Nine Months Ended December 31, 2005
	Stock Options			ESPP Purchase Rights
Expected volatility	66		%	69		%
Risk-free interest rate	4.1		%	3.7		%
Expected option life in years	4.0			0.5
Expected dividend yield	0		%	0		%
Weighted average per share grant date fair value	$	3.08		$	1.23

The fair value of RSUs and restricted stock awards is based on the market price of our common stock on the date of grant.

Share-Based Compensation Expense

The estimated fair value of our share-based awards is recognized as a charge against income on a straight-line basis over the requisite service period, which is the shorter of the vesting period of the award or the period until the participant becomes eligible for retirement. The estimated fair value of share-based awards granted to retirement-eligible participants is recognized as a charge against income immediately upon grant. Total share-based compensation expense recognized in our condensed consolidated statements of operations for the three and nine months ended December 31, 2006 and 2005 was as follows:

	Three Months Ended December 31,				Nine Months Ended December 31,
	2006		2005		2006		2005

Cost of revenue	$	90	$	8	$	245	$	23
Product development	236		181		977		544
Sales and marketing	211		17		590		52
General and administrative	467		2		1,532		23
Total share-based compensation expense	$	1,004	$	208	$	3,344	$	642

Share-based compensation expense recognized in the three and nine months ended December 31, 2006 reflects our adoption of SFAS No. 123R effective April 1, 2006 using the modified prospective transition method. Share-based compensation expense recognized in the three and nine months ended December 31, 2005 relates to share-based awards granted in prior periods accounted for under the provisions of APB No. 25. No share-based compensation expense was capitalized in the periods presented. At December 31, 2006, the gross amount of unrecognized share-based compensation expense relating to unvested share-based awards was approximately $8.2 million, which we anticipate recognizing as a charge against income over a weighted average period of 1.43 years.

Pro Forma Information Under SFAS No. 123 For Periods Prior to April 1, 2006

The following table illustrates the effect on net loss and loss per share for the three and nine months ended December 31, 2005 if we had applied the fair value recognition provisions of SFAS No. 123 to our employee stock awards. For purposes of the SFAS No. 123 pro forma disclosures, the estimated fair value of employee stock awards has been charged against income over the related vesting period of the award on a straight-line basis.

	Three Months Ended December 31, 2005			Nine Months Ended December 31, 2005
	(In thousands, except per share amounts)
Net loss, as reported	$	(567	)	$	(1,312	)
Add: Stock-based employee compensation expense included in net loss, as reported	209			643
Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards	(996		)	(4,290		)
Pro forma net loss	$	(1,354	)	$	(4,959	)
Net loss per share:
Basic and diluted - as reported	$	(0.02	)	$	(0.05	)
Basic and diluted - pro forma	$	(0.05	)	$	(0.19	)

4. Comprehensive Income (Loss)

For the three and nine months ended December 31, 2006 and 2005, comprehensive income (loss) consists of the following:

	Three Months Ended December 31,						Nine Months Ended December 31,
	2006			2005			2006			2005
	(In thousands)
Net loss	$	(1,081	)	$	(567	)	$	(475	)	$	(1,312	)
Foreign currency translation adjustment	61			(171		)	915			(831		)
Unrealized gain on marketable securities	118			21			413			63
Total comprehensive income (loss)	(902		)	(717		)	853			(2,080		)

5. Segment Information

In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, our operations have been aggregated into one reportable segment given the similarities of economic characteristics between the operations and the common nature of the products, services and customers.

6. Guarantees

Guarantee of Lease Obligation of Others

On April 30, 2004, we spun-off our drug discovery subsidiary, Pharmacopeia Drug Discovery, Inc. (“PDD”), into an independent, separately traded, publicly held company through the distribution to our stockholders of a dividend of one share of PDD common stock for every two shares of our common stock. In connection with this spin-off, the landlords of the New Jersey facilities which were used by our PDD operations consented to the assignment of the leases to PDD. Despite the assignment, the landlords required us to guarantee the remaining lease obligations, which totaled approximately $23 million as of December 31, 2006. In accordance with FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, we recognized a liability and corresponding charge to stockholders’ equity for the probability-weighted fair market value of the guarantee. Changes to the fair market value of the liability are recognized in stockholders’ equity. At each of December 31, 2006 and March 31, 2006, the liability for our guarantee of the lease obligation was $0.6 million.

Other Guarantees and Indemnifications

We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. We have also entered into indemnification agreements with our officers and directors. Although the maximum potential amount of future payments we could be required to make under these indemnifications is unlimited, to date we have not incurred material costs to defend lawsuits or settle claims related to these indemnification provisions. Additionally, we have insurance policies that, in most cases, would limit our exposure and enable us to recover a portion of any amounts paid. Therefore, we believe the estimated fair value of these agreements is minimal and likelihood of incurring an obligation is remote. Accordingly, we have not accrued any liabilities in connection with these indemnification obligations as of December 31, 2006.

7. Restructuring Activities

The following summarizes the changes in our accrued restructuring charges liability:

	Severance and Related Costs			Lease Obligation Exit and Facility Closure Costs			Total
	(In thousands)
Balance at December 31, 2002	$	544		$	1,731		$	2,275
Cash payments	(449		)	(281		)	(730		)
Liability adjustments	(95		)	(289		)	(384		)
Balance at December 31, 2003	—			1,161			1,161
Restructuring charges	2,813			—			2,813
Cash payments	(2,197		)	(65		)	(2,262		)
Balance at March 31, 2004	616			1,096			1,712
Restructuring charges	1,358			3,956			5,314
Cash payments	(907		)	(1,342		)	(2,249		)
Liability adjustments	—			(167		)	(167		)
Effect of foreign exchange	—			(17		)	(17		)
Balance at March 31, 2005	1,067			3,526			4,593
Restructuring charges	1,766			1,412			3,178
Cash payments	(1,745		)	(1,662		)	(3,407		)
Effect of foreign exchange	(23		)	(67		)	(90		)
Balance at March 31, 2006	1,065			3,209			4,274
Restructuring charges	397			—			397
Cash payments	(1,135		)	(1,678		)	(2,813		)
Liability adjustments	—			(101		)	(101		)
Effect of foreign exchange	85			297			382
Balance at December 31, 2006	$	412		$	1,727		$	2,139

During fiscal year 2002, we implemented various actions designed to improve our operations and overall financial performance through workforce reductions and the abandonment of two leased facilities. As a result of the implementation of these actions, we recognized a charge of $4.3 million, consisting of $2.3 million in severance benefits from the termination of 71 employees and $2.0 million related to the abandonment of the two leased facilities. The severance benefits were paid in full in fiscal year 2003. During fiscal year 2003, we negotiated the termination of the operating lease for one of the abandoned leased facilities and finalized certain remaining severance obligations which resulted in a $0.4 million reduction to the original $2.0 million liability. Additionally, during fiscal year 2005, we subleased the other abandoned leased facility which resulted in a $0.2 million reduction to the original $2.0 million liability. Our lease obligation for this facility terminates in fiscal year 2008.

During fiscal year 2005, as a result of the relocation of our corporate headquarters, we recorded a lease abandonment charge of $3.6 million representing the future lease obligations, net of estimated future sublease income. Our lease obligation for this facility terminated in the third quarter of fiscal year 2007.

Additionally, during fiscal year 2005, we implemented various actions designed to improve the efficiency of our sales department and eliminate duplicative general and administrative personnel through workforce reductions and the abandonment of a leased facility in Germany. As a result of the implementation of these actions, we recognized a charge of $1.7 million, consisting of $1.4 million in severance benefits from the termination of 42 employees and $0.3 million related to the abandonment of the leased facility. The severance benefits were paid in full in fiscal year 2006. In the second quarter of fiscal year 2007, we made a $0.1 million lease buy-out payment to the landlord of the abandoned facility that terminates our obligations under the lease. As a result of the termination of the lease, we reduced the remaining liability for the abandoned facility to a negligible amount.

In March 2006, we implemented various actions designed to realign our resources with our portfolio of products and services, eliminate redundancies in our workforce and streamline our operations through workforce reductions and abandoning a portion of a leased facility in the United Kingdom. As a result of the implementation of these actions, in March 2006, we recognized a charge of $3.2 million, consisting of $1.8 million in severance benefits from the termination of approximately 50 employees and $1.4 million for our future lease obligations related to the abandoned facility, net of estimated future sublease income. In fiscal year 2007, we recognized a charge of $0.2 million for estimated additional severance benefits to be paid to certain employees terminated under the original restructuring plan and associated legal expenses. We anticipate completing the workforce reductions and payment of severance benefits in fiscal year 2007. The lease obligation for the abandoned facility terminates in fiscal year 2016.

In December 2006, we commenced the implementation of a restructuring plan pursuant to which we will be closing our research and development facility in Bangalore, India. The restructuring plan was undertaken as a result of the substantial completion of our product modernization and integration efforts, and will result in the termination of approximately 60 research and development employees in Bangalore. As a result of the implementation of the restructuring plan, in the third quarter of fiscal year 2007 we recognized a charge of $0.2 million for the postemployment benefits guaranteed to each affected employee under Indian labor law in accordance with SFAS No. 112, Employers’ Accounting for Postemployment Benefits. We estimate that we will incur between $0.5 and $0.7 million in additional restructuring charges in the fourth quarter of fiscal year 2007, the majority of which will be cash expenditures. We anticipate these actions to be substantially completed in the fourth quarter of fiscal year 2007.

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

When used anywhere in this Quarterly Report on Form 10-Q (this “Report”), the words “expect”, “believe”, “anticipate”, “estimate”, “intend”, “plan” and similar expressions are intended to identify forward-looking statements. These forward-looking statements may include statements addressing our future financial and operating results. We have based these forward-looking statements on our current expectations about future events. Such statements are subject to certain risks and uncertainties including those related to execution upon our strategic plans, the successful release and acceptance of new products, the demand for new and existing products, additional competition, changes in economic conditions and those described in documents we have filed with the Securities and Exchange Commission, including this Report in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors,” and in our subsequent reports on Form 10-Q and Form 10-K. All forward-looking statements in this Report are qualified entirely by the cautionary statements included in this Report and such other filings. These risks and uncertainties could cause actual results to differ materially from results expressed or implied by forward-looking statements contained in this Report. These forward-looking statements speak only as of the date of this Report. We disclaim any undertaking to publicly update or revise any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes thereto included elsewhere in this Report.

Overview

Our Business

We design, develop, market, and support software and related services that facilitate the discovery and development of new and improved products and processes in the pharmaceutical, biotechnology, chemical, petrochemical and materials industries. Using our products, researchers may increase the speed and efficiency of the research and development cycle, thereby reducing product development costs and shortening the time to market for new product introductions and process improvements. Our customers include leading commercial, government and academic organizations. Many of the largest pharmaceutical, biotechnology, chemical, and petroleum companies worldwide use our products. We market our products and services worldwide, principally through our direct sales force, augmented by the use of third-party distributors.

Our Marketplace

Historically, we have primarily sold molecular modeling and simulation software. The market for molecular modeling and simulation products in the pharmaceutical and biotechnology industries is challenging due to the maturity of the market, industry consolidation, reduction in the level of discovery research activity, and increased competition, including competition from open source software. We also sell modeling and simulation products to the chemical, petrochemical and materials industries. We believe these industries are in the early stages of adoption of these technologies. Thus we believe the market for our products within these industries is nascent and has experienced modest growth over the past several years. On September 27, 2004, we acquired all of the outstanding common shares of SciTegic, Inc., a leading provider of workflow software solutions for the scientific research market. Following the acquisition of SciTegic, we began to offer data-pipelining and workflow software. This technology is widely applicable within our target industries and represents a significant growth opportunity. There is currently limited competition to this technology in our targeted industries, and we are experiencing strong adoption rates within our customer base.

Our Strategy

Our objective is to strengthen our position as a leading provider of software-based scientific computation, analysis, informatics, knowledge management, workflow products and services. We plan to accomplish our objective by providing a comprehensive set of integrated products and services that are central to the enterprise-wide research and development activities of our customers, and by connecting these tools within an information technology framework. This framework makes it easier for research and development organizations to manage data, information, knowledge, and collaborative processes.

Our strategy for growth is to expand usage of our products and services by marketing and distributing our solutions to a broader group of users, including scientists, engineers and information technology professionals, within our existing customers, as well as to new customers in other industries.

A key enabler of this strategy is the data pipelining and workflow technology we acquired through our SciTegic acquisition. We are utilizing this technology to enable our customers to build solutions which allow them to integrate scientific software and content from across the research and development spectrum. Selling solutions is fundamentally different than our traditional sale of stand-alone modeling and simulation products. We are focused on enhancing our sales processes to emphasize solutions selling and strategic account management. We are also expanding our professional services capabilities to enable our customers to deploy these solutions.

In addition to the activities underway in our sales and service functions, we continue to focus on the componentization of our entire suite of products on our Discovery Studio and Materials Studio platforms. In fiscal year 2007, we continue to migrate our life sciences applications to the Discovery Studio platform.

Finally, in addition to our focus on revenue growth, we continuously evaluate our personnel requirements and cost structure. Over the past several years we have significantly reduced our operating costs through workforce reductions and other cost-savings measures. We will continue our focus on cost control, as well as working capital management as we strive to improve our financial performance.

Critical Accounting Policies

The critical accounting policies and estimates used in the preparation of our consolidated financial statements are described in Item 6, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Annual Report on Form 10-K for the fiscal year ended March 31, 2006. There have been no significant changes in our critical accounting policies and estimates from March 31, 2006, other than as described below.

Valuation of Share-Based Awards

We adopted SFAS No. 123R, effective April 1, 2006, using the modified prospective transition method. Accordingly, beginning in the first quarter of fiscal year 2007, we are recognizing as a charge against income the estimated grant date fair value of share-based awards granted to employees and directors. We estimate the fair value of our share-based stock awards on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of certain input variables, as follows:

Expected Dividend Yield. Because we have not paid any cash dividends since our inception and do not anticipate paying dividends in the foreseeable future, we assume a dividend yield of zero.

Under SFAS No. 123R, we are also required to estimate at grant the likelihood that the award will ultimately vest (the “pre-vesting forfeiture rate”) revise the estimate, if necessary, in future periods if the actual forfeiture rate differs. We determine the pre-vesting forfeiture rate of an award based on our historical pre-vesting award forfeiture experience.

Our determination of the input variables used in the Black-Scholes option pricing model as well as the pre-vesting

forfeiture rate is based on various underlying estimates and assumptions that are highly subjective and are affected by our stock price, among other factors. Changes in these underlying estimates and assumptions could materially affect the fair value of our share-based awards and, therefore, the amount of share-based compensation expense to be recognized in our results of operations.

Results of Operations

Historically, we have received approximately two-thirds of our annual customer orders in the second half of our fiscal year. In accordance with our revenue recognition policies, the revenue associated with these orders is generally recognized over the contractual license term. Therefore, because we accrue sales commissions and royalties upon the invoicing of customer orders, we have historically experienced an increase in operating costs and expenses during the second half of our fiscal year with only a minimal corresponding incremental increase in revenue. As a result of these seasonal variations, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance and that the interim financial results for the periods presented in this Report are not necessarily indicative of results for a full year or for any subsequent interim period.

Comparison of the Three Months Ended December 31, 2006 and 2005

The following table summarizes our results of operations as a percentage of revenue for the respective periods:

	Three Months Ended December 31,
	2006		2005

Revenue	100	%	100	%
Operating costs and expenses:
Cost of revenue	22	%	21	%
Product development	23	%	24	%
Sales and marketing	42	%	43	%
General and administrative	20	%	18	%
Restructuring charges	1	%	0	%
Total operating costs and expenses	107	%	106	%
Operating loss	(7	)%	(6	)%
Interest and other income, net	3	%	3	%
Loss before income taxes	(4	)%	(3	)%
Income tax expense	1	%	0	%
Net loss	(5	)%	(3	)%

Revenue

Revenue increased 1% to $20.7 million for the three months ended December 31, 2006, as compared to $20.4 million for the three months ended December 31, 2005. The increase in revenue was primarily attributable to continued growth in our scientific operating platform product line, offset by reduced sales of certain legacy products that were deemphasized in connection with our restructuring and product line adjustments that have occurred over the past two fiscal years.

Operating Costs and Expenses

Cost of Revenue. Cost of revenue increased 4% to $4.5 million for the three months ended December 31, 2006, as compared to $4.4 million for the three months ended December 31, 2005. As a percentage of revenue, cost of revenue increased to 22% for the three months ended December 31, 2006, as compared to 21% for the three months ended December 31, 2005. The increase in cost of revenue was primarily attributable to higher royalties due to the mix of products sold and a $0.1 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R.

Product Development Expenses. Product development expenses decreased 5% to $4.7 million for the three months ended December 31, 2006, as compared to $5.0 million for the three months ended December 31, 2005. As a percentage of revenue, product development decreased to 23% for the three months ended December 31, 2006, as compared to 24% for the three months ended December 31, 2005. The decrease in product development expenses was primarily attributable to lower personnel expenses resulting from headcount reductions during fiscal year 2006, offset by a $0.1 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R.

Sales and Marketing Expenses. Sales and marketing expenses decreased 1% to $8.6 million for the three months ended December 31, 2006, as compared to $8.7 million for the three months ended December 31, 2005. As a percentage of revenue, sales and marketing expenses decreased to 42% for the three months ended December 31, 2006, as compared to 43% for the three months ended December 31, 2005. The decrease in sales and marketing expenses was primarily attributable to lower personnel and other sales-related expenses resulting from headcount reductions during fiscal year 2006, offset by a $0.2 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R.

General and Administrative Expenses. General and administrative expenses increased 13% to $4.1 million for the three months ended December 31, 2006, as compared to $3.6 million for the three months ended December 31, 2005. As a percentage of revenue, general and administrative expenses increased to 20% for the three months ended December 31, 2006, as compared to 18% for the three months ended December 31, 2005. The increase in general and administrative costs was primarily attributable to a $0.5 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R and a $0.2 million incentive compensation accrual reversal in the third quarter of fiscal year 2006, offset by $0.2 million of outside consulting and accounting fees which were incurred during the third quarter of fiscal year 2006 in relation to the restatement of our previously issued consolidated financial statements.

Restructuring charges. We incurred restructuring charges of $0.2 million for the three months ended December 31, 2006 primarily resulting from the closure of our research and development facility in Bangalore, India and the related termination of approximately 60 employees.

Net Interest and Other Income

Net interest and other income was $0.6 million for the three months ended December 31, 2006, as compared to $0.5 million for the three months ended December 31, 2005. The increase in net interest and other income was primarily attributable to higher cash and marketable securities balances during the three months ended December 31, 2006, offset by unfavorable fluctuations in the value of the U.S. dollar.

Income Tax Expense

We recognized income tax expense of $0.2 million for the three months ended December 31, 2006, as compared to an income tax benefit of $0.1 million for the three months ended December 31, 2005. The increase in income tax expense was primarily attributable to the increase in the deferred tax liability associated with tax deductible goodwill and indefinite-lived intangible assets recognized in the three months ended December 31, 2006.

Comparison of the Nine Months Ended December 31, 2006 and 2005

The following table summarizes our results of operations as a percentage of revenue for the respective periods:

	Nine Months Ended December 31,
	2006		2005

Revenue	100	%	100	%
Operating costs and expenses:
Cost of revenue	20	%	20	%
Product development	24	%	26	%
Sales and marketing	36	%	39	%
General and administrative	22	%	18	%
Restructuring charges (recoveries)	0	%	(0	)%
Total operating costs and expenses	102	%	104	%
Operating loss	(2	)%	(4	)%
Interest and other income, net	2	%	3	%
Income (loss) before income taxes	1	%	(1	)%
Income tax expense	1	%	1	%
Net loss	(1	)%	(2	)%

Revenue

Revenue decreased 2% to $61.1 million for the nine months ended December 31, 2006, as compared to $62.6 million for the nine months ended December 31, 2005. The decrease in revenue was primarily attributable to a decrease in revenues from certain products that were de-emphasized in connection with our restructuring and product line adjustments that have occurred over the past two fiscal years.

Operating Costs and Expenses

Cost of Revenue. Cost of revenue decreased 3% to $12.2 million for the nine months ended December 31, 2006, as compared to $12.7 million for the nine months ended December 31, 2005. As a percentage of revenue, cost of revenue was consistent at 20% for each of the nine months ended December 31, 2006 and 2005. The decrease in cost of revenue was primarily attributable to lower distribution costs, offset by a $0.2 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R.

Product Development Expenses. Product development expenses decreased 10% to $14.7 million for the nine months ended December 31, 2006, as compared to $16.4 million for the nine months ended December 31, 2005. As a percentage of revenue, product development decreased to 24% for the nine months ended December 31, 2006, as compared to 26% for the nine months ended December 31, 2005. The decrease in product development expenses was primarily attributable to lower personnel expenses resulting from headcount reductions during fiscal year 2006, offset by a $0.4 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R.

Sales and Marketing Expenses. Sales and marketing expenses decreased 12% to $21.7 million for the nine months ended December 31, 2006, as compared to $24.6 million for the nine months ended December 31, 2005. As a percentage of revenue, sales and marketing expenses decreased to 36% for the nine months ended December 31, 2006, as compared to 39% for the nine months ended December 31, 2005. The decrease in sales and marketing expenses was primarily attributable to lower personnel and other sales-related expenses resulting from headcount reductions during fiscal year 2006, offset by a $0.5 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R.

General and Administrative Expenses. General and administrative expenses increased 17% to $13.2 million for the nine months ended December 31, 2006, as compared to $11.3 million for the nine months ended December 31, 2005. As a percentage of revenue, general and administrative expenses increased to 22% for the nine months ended December 31, 2006, as compared to 18% for the nine months ended December 31, 2005. The increase in general and administrative costs was primarily attributable to a $1.5 million increase in share-based compensation expense resulting from our adoption of SFAS No. 123R and a $0.3 million increase in outside consulting and accounting fees related to the restatement of our previously issued consolidated financial statements.

Restructuring charges. We incurred restructuring charges of $0.2 million for the nine months ended December 31, 2006 primarily resulting from the closure of our research and development facility in Bangalore, India and the related termination of approximately 60 employees.

Net Interest and Other Income

Net interest and other income was $1.4 million for the nine months ended December 31, 2006, as compared to $1.6 million for the nine months ended December 31, 2005. The decrease in net interest and other income was primarily attributable to unfavorable fluctuations in the value of the U.S. dollar, offset by higher cash and marketable securities balances during the nine months ended December 31, 2006.

Income Tax Expense

We recognized income tax expense of $0.9 million for the nine months ended December 31, 2006, as compared to $0.6 million for the nine months ended December 31, 2005. The increase in income tax expense was primarily attributable to the increase in the deferred tax liability associated with tax deductible goodwill and indefinite-lived intangible assets recognized in the nine months ended December 31, 2006.

Liquidity and Capital Resources

We had cash, cash equivalents, restricted cash and marketable securities of $60.0 million as of December 31, 2006, as compared to $66.0 million as of March 31, 2006, a decrease of $6.0 million. The decrease in cash, cash equivalents, restricted cash and marketable securities during the nine months ended December 31, 2006 was primarily attributable to cash used in operations of $9.9 million, offset by a $1.7 million favorable effect on cash and cash equivalents of changes in foreign currency rates, $1.2 million in proceeds from the issuance of our common stock under employee stock plans, and an increase in restricted cash of $1.5 million resulting from the receipt of a subtenant security deposit. Our operating cash flows on a

quarterly basis are significantly impacted by changes in accounts receivable balances. Due to the seasonality of our business, accounts receivable balances have historically increased significantly in the third quarter of each fiscal year as a result of higher order intake. The collection of these accounts receivable balances has historically resulted in positive cash flows from operations in the fourth quarter of each fiscal year, while we have historically experienced negative cash flows from operations in the other three fiscal quarters.

Net cash used in operating activities was $9.9 million for the nine months ended December 31, 2006, as compared to $10.6 million for the nine months ended December 31, 2005. The decrease in cash used in operating activities was primarily attributable to reduced operating expenditures.

Net cash used in investing activities was $1.0 million for the nine months ended December 31, 2006, as compared to net cash provided by investing activities of $5.2 million for the nine months ended December 31, 2005. Significant components of cash flows from investing activities for the nine months ended December 31, 2006 included net purchases of property and equipment of $0.8 million and a net increase in our marketable securities portfolio of $0.2 million. Significant components of cash flows from investing activities for the nine months ended December 31, 2005 included $2.6 million of net purchases of property and equipment and a net decrease in our marketable securities portfolio of $7.7 million.

Net cash provided by financing activities was $1.2 million for the nine months ended December 31, 2006, compared to $0.9 million for the nine months ended December 31, 2005. Cash flows from financing activities for the nine months ended December 31, 2006 and 2005 consisted solely of proceeds from the issuance of our common stock under employee stock plans.

We have funded our activities to date primarily through the sales of software licenses and related services and the issuance of equity securities.

We anticipate that our capital requirements may increase in future periods as a result of seasonal sales trends, additional product development activities, and the acquisition of additional equipment. Our capital requirements may also increase in future periods as we seek to expand our technology platform through investments, licensing arrangements, technology alliances, or acquisitions.

We anticipate that our existing capital resources will be adequate to fund our operations for at least the next 12 months. However, there can be no assurance that changes will not occur that would consume available capital resources before then. Our capital requirements depend on numerous factors, including our ability to continue to generate software sales, the purchase of additional capital equipment and acquisitions of other businesses or technologies. There can be no assurance that additional funding, if necessary, will be available to us on favorable terms, if at all. Our forecast for the period of time through which our financial resources will be adequate to support our operations is forward looking information, and actual results could vary.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The information called for by this item is provided in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the fiscal year ended March 31, 2006. Our exposures to market risk have not changed materially since March 31, 2006.

Item 4. Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that are designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required financial disclosures. Because of inherent limitations, our disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of such disclosure controls and procedures are met.

As more fully described in Item 9A of our Annual Report on Form 10-K for the year ended March 31, 2006, we reported that our management identified certain control deficiencies that represent material weaknesses in our internal control over financial reporting. The material weaknesses identified by management related to the application of software revenue recognition principles to our term-based and perpetual software license arrangements and the application of SFAS No. 86 to our software development projects. As a result of the identification of these material weaknesses, our principal executive officer and principal financial officer concluded that as of March 31, 2006, our disclosure controls and procedures were not effective pursuant to Exchange Act Rules 13a-15(f) and 15d-15(f).

As of the end of the period covered by this Report, we conducted an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based on this evaluation, our principal executive officer and principal financial officer concluded that, although the remediation actions set forth below had been initiated as of December 31, 2006, these remediation actions had not been in operation for a sufficient period of time and had not yet been tested. Therefore, the identified material weaknesses in our internal control over financial reporting had not been fully remediated and, as a result, our disclosure controls and procedures were not considered to be effective as of December 31, 2006. Notwithstanding the material weaknesses described above, management believes that the consolidated financial statements included in this Report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

Changes in Internal Control Over Financial Reporting

In fiscal year 2007, in order to remediate the identified material weaknesses in our internal control over financial reporting, we initiated the following remediation actions:

(1)		We hired three senior-level accounting employees in March and April 2006 who have significant expertise in financial controls and the application of generally accepted accounting principles relevant to our business, including software revenue recognition.

(2)		We designed a program of additional training regarding our revenue recognition policies intended to ensure all relevant personnel involved in software revenue recognition transactions understand and apply applicable generally accepted accounting principles, and have set an annual minimum training requirement.

(3)		We implemented an enhanced quarterly financial statement close, review and reporting process to include additional levels of analysis and review.

Notwithstanding the initiation of these remediation actions, the identified material weaknesses in our internal control over financial reporting will not be considered remediated until the new controls are fully implemented, in operation for a sufficient period of time, are tested and our management concludes that the new controls are operating effectively.

Except as described above, there were no changes in our internal control over financial reporting during the three months ended December 31, 2006 that materially affected, or are reasonably likely to materially affect, those controls.

PART II — OTHER INFORMATION

Item 1A. Risk Factors

You should carefully consider the risks described below before investing in our publicly-traded securities. The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as competition, technological obsolescence, labor relations, general economic conditions, geopolitical changes and international operations. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity. The risks described below could cause our actual results to differ materially from those contained in forward-looking statements we have made in this Report, the information incorporated herein by reference and those we may make from time to time.

Certain Risks Related to Our Marketplace and Environment

Our revenue from the sale of modeling, simulation and informatics software to the life science discovery research marketplace, which has historically constituted a significant portion of our overall revenue, has been declining over the past several years and may continue to decline in future years. Historically we have derived a significant portion of our revenue from the sale of modeling, simulation and informatics software to the discovery research departments in pharmaceutical and biotechnology companies. Such revenues have been declining over the past several years. We believe this decline is due to several factors, including industry consolidation, a general reduction in the level of discovery research activity by our customers, increased competition, including competition from open source software, and reductions in profit and related information technology spending by our customers, due in part to the expiration of patents on profitable drugs. If such declines continue and we do not increase the revenue we derive from our other product and service offerings, our business could be adversely impacted.

Our ability to sustain or increase revenues will depend upon our success in developing, marketing and selling software and service solutions to both our existing customers and to new customers. Our strategy involves transforming our product and service offerings by providing tools and components to our customers which allow our customers to integrate software applications and data more easily. A key enabler of this strategy is the data pipelining and workflow technology we acquired through the September 2004 acquisition of SciTegic, Inc. We are utilizing SciTegic’s Pipeline Pilot technology to enable our customers to build solutions which allow them to receive greater value from their data, information and knowledge. Selling this type of solution is fundamentally different than our historical sale of modeling and simulation products, and this type of offering is dependant upon our ability to build a successful services offering. Our sales and services management are focused on transforming our sales process to allow us to be successful with this type of sale. In addition, we are adding personnel and defining services offerings to enable our customers to successfully deploy these solutions. There can be no assurance that we will be successful in this transformation of our sales processes and in the building of our services capabilities. If we are not successful, our ability to sustain or increase revenue may be adversely impacted.

Our ability to sustain or increase revenues will depend upon our success in entering new markets and in deriving additional revenues from our existing customers. Our products are currently used primarily by molecular modeling and simulation specialists in discovery research organizations. Our strategy is to expand usage of our products and services by marketing and distributing our software to a broader, more diversified group of biologists, chemists, engineers and informaticians within our existing pharmaceutical and biotechnology customers, as well as to new customers in other industries. However, our products and services may not achieve market acceptance or penetration in targeted new departments within our customers or in new industries. As a result, we may not be able to sustain or increase revenue.

We may be unable to develop strategic relationships with our customers. Our strategy is to expand usage of our products and services by marketing and distributing solutions to a broader, more diversified group of biologists, chemists, engineers and informaticians throughout our customers’ research and development organizations. A key component of our business strategy is to become a preferred provider of scientific software and solutions. Becoming a preferred vendor will require substantial re-training and new skills development within our sales and service personnel and deployment of a successful account-management sales model. We believe that developing strategic relationships with our customers may lead to additional revenue opportunities. However, there can be no assurance that any such relationships will develop or that such relationships will produce additional revenue or profit opportunities.

Consolidation within the pharmaceutical and biotechnology industries may continue to lead to fewer potential customers for our products and services. A significant portion of our customer base consists of pharmaceutical and biotechnology companies. Continued consolidation within the pharmaceutical and biotechnology industries may result in fewer customers for our products and services. If one of the parties to a consolidation uses the products or services of our competitors, we may lose existing customers as a result of such consolidation.

Health care reform and restrictions on reimbursement may affect the ability of pharmaceutical, biotechnology and industrial chemical companies to purchase or license our products or services, which may affect our results of operations and financial condition. The continuing efforts of government and third-party payers in the markets we serve to contain or reduce the cost of health care may reduce the profitability of pharmaceutical, biotechnology and industrial chemical companies causing them to reduce research and development expenditures. Because our products and services depend on such research and development expenditures, our revenues may be significantly reduced. We cannot predict what actions federal, state or private payers for health care goods and services may take in response to any health care reform proposals or legislation.

We face strong competition in the scientific software sector. The market for our products is competitive. We currently face competition from other scientific software providers, larger technology and solutions companies, in-house development by our customers, as well as academic and government institutions and the open source community.

Some of our competitors and potential competitors in this sector have longer operating histories than us and have greater financial, technical, marketing, research and development and other resources. Many of our competitors offer products and services directed at more specific markets than those we target, enabling these competitors to focus a greater proportion of their efforts and resources on these markets. Some offerings that compete with our products are developed and made available at lower cost by government organizations and academic institutions, and these entities may be able to devote substantial resources to product development and also offer their products to users for little or no charge. We also face competition from open source software initiatives, in which developers provide software and intellectual property free over the Internet. In addition, many of our customers spend significant internal resources in order to develop their own software.

There can be no assurance that our current or potential competitors will not develop products, services or technologies that are comparable to, superior to, or render obsolete, the products, services and technologies we offer. There can be no assurance that our competitors will not adapt more quickly than us to technological advances and customer demands, thereby increasing such competitors’ market share relative to ours. Any material decrease in demand for our technologies or services may have a material adverse effect on our business, financial condition and results of operations.

We are subject to pricing pressures in the markets we serve. We operate in a competitive marketplace which has led to significant pricing pressure and declines in average selling price over the past several years. In response to competition and general adverse economic conditions in the markets we serve, we may be required to modify our pricing practices. Changes in our pricing model could lead to a decline or delay in revenue as our sales force and customers adjust to the new pricing policies. This development may adversely affect our revenue and earnings.

Our operations may be interrupted by the occurrence of a natural disaster or other catastrophic event at our primary facilities. Our research and development operations and administrative functions are primarily conducted at our facilities in San Diego, California, and Cambridge, United Kingdom. We also conduct sales and customer support activities at our facilities in Burlington, Massachusetts, Paris, France, and Tokyo, Japan. Although we have contingency plans in effect for natural disasters or other catastrophic events, catastrophic events could still disrupt our operations. For example, our San Diego and Tokyo facilities are located in areas that are particularly susceptible to earthquakes. Any natural disaster or catastrophic event in our facilities or the areas in which they are located could have a significant negative impact on our operations.

Our insurance coverage may not be sufficient to avoid material impact on our financial position or results of operations resulting from claims or liabilities against us, and we may not be able to obtain insurance coverage in the future. We maintain insurance coverage for protection against many risks of liability. The extent of our insurance coverage is under continuous review and is modified as we deem it necessary. Despite this insurance, it is possible that claims or liabilities against us may have a material adverse impact on our financial position or results of operations. In addition, we may not be able to obtain any insurance coverage, or adequate insurance coverage, when our existing insurance coverage expires. For example, we do not carry earthquake insurance for our facilities in Tokyo, Japan or San Diego, California, because we were unable to obtain such insurance on commercially reasonable terms.

Certain Risks Related to Our Operations

Defects or malfunctions in our products could hurt our reputation among our customers, result in delayed or lost revenue and expose us to liability. Our business and the level of customer acceptance of our products depend upon the continuous, effective and reliable operation of our software and related tools and functions. To the extent that defects cause our software to malfunction and our customers’ use of our products is interrupted, our reputation could suffer and our revenue could decline or be delayed while such defects are remedied. We may also be subject to liability for the defects and malfunctions of third-party technology partners and others with whom our products and services are integrated.

Delays in the release of new or enhanced products or services or undetected errors in our products or services may result in increased cost to us, delayed market acceptance of our products and delayed or lost revenue. To achieve market acceptance, new or enhanced products or services can require long development and testing periods, which may result in delays in scheduled introduction. Any delays in the release schedule for new or enhanced products or services may delay market acceptance of these products or services and may result in delays in new customer orders for these new or enhanced products or services or the loss of customer orders. In addition, new or enhanced products or services may contain a number of undetected errors or “bugs” when they are first released. Although we test each new or enhanced software product or service before being released to the market, there can be no assurance that significant errors will not be found in existing or future releases. As a result, in the months following the introduction of certain releases, we may need to devote significant resources to correct these errors. There can be no assurance, however, that all of these errors can be corrected.

We are subject to risks associated with the operation of a global business.Our non-U.S. operations are subject to risks inherent in the conduct of international business, including:

· unexpected changes in regulatory requirements;

· longer payment cycles;

· currency exchange rate fluctuations;

· import and export license requirements;

· tariffs and other barriers;

· political unrest, terrorism and economic instability;

· disruption of our operations due to local labor conditions;

· limited intellectual property protection;

· difficulties in collecting trade receivables;

· difficulties in managing distributors or representatives;

· difficulties in managing an organization spread over various countries;

· difficulties in staffing foreign subsidiary or joint venture operations; and

· potentially adverse tax consequences.

Our success depends, in part, on our ability to anticipate and address these risks. There can be no assurance that we will do so effectively or that these or other factors relating to our international operations will not adversely affect our business or operating results.

In order to improve our financial position, we have reduced our headcount, which could negatively impact our business. We have undergone several reductions-in-force over the past few years, and our workforce has declined. While we believe we have sufficient staff to operate our business, we do not have duplicative or redundant resources in many of our functions or operations. As a result, there can be no assurance that further attrition will not impact our ability to operate our business, or adversely impact our revenues.

Failure to attract and retain skilled personnel, including the personnel necessary to address the identified material weaknesses in our internal control over financial reporting, could have a material adverse effect on us. Our success depends in part on the continued service of key scientific, sales, business development, marketing, engineering, management and accounting personnel and our ability to identify, hire and retain additional personnel. There is intense competition for qualified personnel. Immigration laws may further restrict our ability to attract or hire qualified personnel. We may not be able to continue to attract and retain the personnel necessary for the development of our business. Failure to attract and retain key personnel could have a material adverse effect on our business, financial condition and results of operations. Further, we are highly dependent on the principal members of our technical, scientific and management staff. One or more of these key employees could retire or otherwise leave our employ within the foreseeable future, and the loss of any of these people could have a material adverse effect on our business, financial condition and results of operations. We do not intend to maintain key person life insurance on the life of any employee.

In addition to the foregoing, as described in greater detail elsewhere in this Report and in our Annual Report on Form 10-K for the fiscal year ended March 31, 2006, we concluded that our internal control over financial reporting was not effective as of March 31, 2006. In particular, in connection with the restatement of our previously issued financial statements, management identified certain control deficiencies that represented material weaknesses in our internal control over financial reporting. These material weaknesses, which principally arose due to our lack of a sufficient number of employees with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles relevant to our business, were at least partially responsible for our need to restate our previously issued consolidated financial statements. In order to remediate the identified material weaknesses in our internal control over financial reporting, we implemented certain actions, including the hiring of three senior-level accounting employees in March and April 2006 who have significant expertise in financial controls and the application of generally accepted accounting principles relevant to our business, including software revenue recognition. However, one or more of these qualified recruits or existing personnel could leave our employ within the foreseeable future. If not timely and adequately addressed, the loss of any of these individuals could impair our ability to maintain effective internal control over financial reporting and thereby cause a material adverse effect on our business.

If we choose to acquire businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or to successfully integrate an acquired business or technology in a cost-effective and non-disruptive manner. From time to time, we may choose to acquire businesses, products or technologies instead of developing them ourselves. We do not know if we will be able to complete any acquisitions, or whether we will be able to successfully integrate any acquired businesses, operate them profitably or retain their key employees. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract company management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms and, in the case of equity financing that may result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could harm our business and operating results.

Certain Risks Related To Our Financial Performance

We have a history of losses and our future profitability is uncertain.We generated net losses for the nine months ended December 31, 2006 and for the years ended March 31, 2006 and 2005 and December 31, 2003, and the three months ended March 31, 2004. Continuing net losses may limit our ability to fund our operations and we may not generate income from operations in the future. Our future profitability depends upon many factors, including several that are beyond our control. These factors include without limitation:

· changes in the demand for our products and services;

· the introduction of competitive software;

· our ability to license desirable technologies;

· changes in the research and development budgets of our customers and potential customers; and

· our ability to successfully, cost effectively and timely develop, introduce and market new products, services and product enhancements.

Our sales forecast and/or revenue projections may not be accurate. We use a “pipeline” system, a common industry practice, to forecast sales and trends in our business. Our sales personnel monitor the status of proposals, including the date when they estimate a customer will make a purchase decision and the potential size of the order. We aggregate these estimates on a quarterly basis in order to generate a sales pipeline. While the pipeline process provides us with some guidance in business planning and forecasting, it is based on estimates only and is therefore subject to risks and uncertainties. Any variation in the conversion of the pipeline into revenue or the pipeline itself could cause us to improperly plan or budget and thereby adversely affect our business, results of operations and financial condition.

If we are unable to license software to, or collect receivables from our customers our operating results may be adversely affected. The majority of our current customers are well-established, large pharmaceutical customers and universities, and other customers include smaller biotechnology companies. We have not experienced significant customer defaults during the past three fiscal years and have recorded a provision for bad debts of less than $0.5 million in each of those periods. Our financial success depends upon the creditworthiness and ultimate collection of amounts due from our customers. If we are not able to collect from our customers, we may be required to write-off significant accounts receivable and recognize bad debt expenses which could materially and adversely affect our operating results.

Our quarterly operating results, particularly our quarterly cash flows, will fluctuate. Quarterly operating results may fluctuate as a result of a number of factors including lengthy sales cycles, market acceptance of new products and upgrades, timing of new product introductions, changes in pricing policies, changes in general economic and competitive conditions, and the timing and integration of acquisitions. We may also experience fluctuations in quarterly operating results due to general and industry specific economic conditions that may affect the research and development expenditures of pharmaceutical and biotechnology companies. In particular, historically we have received approximately two-thirds of our annual customer orders in the second half of our fiscal year. In accordance with our revenue recognition policies, the revenue associated with these orders is generally recognized over the contractual license term. Therefore, because we accrue sales commissions and royalties upon the receipt of customer orders, we generally experience an increase in operating costs and expenses during the second half of our fiscal year with only a minimal corresponding incremental increase in revenue. Additionally, our cash flows from operations have historically been positive in the fiscal quarter ended March 31 as we collect the accounts receivable generated from these customer orders, while we have historically experienced negative cash flows from operations in the other three fiscal quarters. As a result of these seasonal variations, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance and that the interim financial results for the periods presented in this Report are not necessarily indicative of results for a full year or for any subsequent interim period.

Changes in the accounting treatment of employee stock-based compensation has and will continue to adversely affect our results of operations.In December 2004, the FASB issued SFAS No. 123R, which revises SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R requires that employee stock-based compensation is measured based on the grant-date fair value of the related employee equity award and is treated as an expense that is reflected in the financial statements over the related service period. SFAS No. 123R applies to all employee equity awards granted after adoption and to the unvested portion of employee equity awards outstanding as of adoption. We adopted SFAS No. 123R using the modified-prospective method on April 1, 2006. As a result of the adoption of SFAS No. 123R, we recognized a charge against our earnings of $1.0 million and $3.3 million for the three and nine months ended December 31, 2006. We anticipate that the continued application of the accounting provisions of SFAS No. 123R will adversely impact on our future reported results of operations.

The recently completed restatement of our historical financial statements has already consumed, and may continue to consume, a significant amount of our resources and may have a material adverse effect on our business and stock price. In December 2005, we announced that our previously issued consolidated financial statements would be restated to reflect certain accounting adjustments. The restatement process was highly time and resource-intensive and involved substantial attention from management and significant legal and accounting costs. Although we have now completed the restatement, we

cannot guarantee that we will have no further inquiries from the SEC or NASDAQ regarding our restated financial statements or matters relating thereto. Likewise, many companies that have been required to restate their historical financial statements have subsequently experienced stockholder lawsuits relating to their restatements. Any future inquiries from the SEC or NASDAQ as a result of the restatement of our historical financial statements will, regardless of the outcome, likely consume a significant amount of our resources in addition to those resources already consumed in connection with the restatement itself.

If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results, and current and potential stockholders may lose confidence in our financial reporting. We are required by the SEC to establish and maintain adequate internal control over financial reporting that provides reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. We are likewise required, on a quarterly basis, to evaluate the effectiveness of our internal controls and to disclose any changes, significant deficiencies or material weaknesses in those internal controls.

As described in greater detail elsewhere in this Report and in our Annual Report on Form 10-K for the fiscal year ended March 31, 2006, in connection with the restatement process, we identified certain control deficiencies that represented material weaknesses in our internal control over financial reporting. These material weaknesses generally relate to our historical lack of a sufficient number of employees with appropriate levels of accounting knowledge, experience and training in the application of generally accepted accounting principles relevant to our business. Given these material weaknesses, our principal executive officer and principal financial officer concluded that we did not maintain effective internal control over financial reporting as of March 31, 2006.

Since the determination regarding our material weaknesses, we have devoted significant effort and resources to the remediation and improvement of our internal control over financial reporting. In particular, as described elsewhere in this Report, we have recruited a number of qualified individuals to assist in maintaining adequate internal controls, we have initiated a revenue recognition training program and we have implemented an enhanced quarterly and annual financial statement close, review and reporting process. Notwithstanding the implementation of these remediation initiatives, the identified material weaknesses in our internal control over financial reporting will not be considered remediated until the new controls are fully implemented, in operation for a sufficient period of time, are tested and our management concludes that the new controls are operating effectively. Because the remediation initiatives are not yet fully implemented, our principal executive officer and principal financial officer concluded that the identified material weaknesses in our internal control over financial reporting had not been fully remediated and, therefore, our disclosure controls and procedures were not effective as of December 31, 2006.

Although we believe that these efforts and resources have strengthened our internal control over financial reporting, we cannot be certain that these measures will ensure that we maintain adequate internal control over our financial reporting in future periods. Any failure to maintain such internal controls could adversely impact our ability to report our financial results on a timely and accurate basis. If our financial statements are not accurate, investors may not have a complete understanding of our operations. Likewise, if our financial statements are not filed on a timely basis as required by the SEC and NASDAQ, we could face severe consequences from those authorities. In either case, there could result a material adverse affect on our business. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

We may be required to indemnify PDD, or may not be able to collect on indemnification rights from PDD. On April 30, 2004, we spun-off our drug discovery subsidiary, PDD, into an independent, separately traded, publicly held company through the distribution to our stockholders of a dividend of one share of PDD common stock for every two shares of our common stock. As part of the spin-off, we agreed to indemnify the indebtedness, liabilities and obligations of PDD. One such obligation includes a guarantee by us to the landlord of PDD’s obligations under the existing New Jersey laboratory and headquarters leases, with respect to which PDD will indemnify us should we be required to make any payment under the guarantee. These indemnification obligations could be as significant as the remaining future minimum lease payments, which totaled approximately $23 million as of December 31, 2006. PDD’s ability to satisfy any such indemnification obligations (including, without limitation, PDD’s commitment to indemnify us in the event of our payment under our guarantee of its leases) will depend upon PDD’s future financial strength. We cannot assure you that, if PDD becomes obligated to indemnify us for any substantial obligations, PDD will have the ability to do so. There also can be no assurance that we will be able to satisfy any indemnification obligations to PDD. Any failure by PDD to satisfy its obligations and any required payment by us could have a material adverse effect on our business.

Enacted and proposed changes in securities laws and regulations have increased our costs and may continue to increase our costs in the future. Sarbanes-Oxley required changes in some of our corporate governance and securities

disclosure and compliance practices. Under Sarbanes-Oxley, publicly held companies, including us, are required to, among other things, furnish independent annual audit reports regarding the existence and reliability of their internal control over financial reporting and have their chief executive officer and chief financial officer certify as to the accuracy and completeness of their financial reports.

We expect continued compliance with Sarbanes-Oxley to remain costly. Further, Sarbanes-Oxley and the related SEC and NASDAQ compliance rules may make it more difficult and expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These laws and regulations could also make it more difficult for us to attract and retain qualified members of our board of directors, or qualified executive officers. We continually evaluate and monitor regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.

Our business, financial condition and results of operations may be adversely impacted by fluctuations in foreign currency exchange rates. Our international sales generally are denominated in local currencies. Fluctuations in the value of currencies in which we conduct business relative to the United States dollar result in currency transaction gains and losses, and the impact of future exchange rate fluctuations cannot be accurately predicted. Future fluctuations in currency exchange rates may have a material adverse impact on revenue from international sales, and thus on our business, financial condition and results of operations. When deemed appropriate, we may engage in currency exchange rate hedging transactions in an attempt to mitigate the impact of adverse exchange rate fluctuations. However, currency hedging policies may not be successful, and they may increase the negative impact of exchange rate fluctuations.

If we consume cash more quickly than expected, we may be unable to raise additional capital and we may be forced to curtail operations. We anticipate that our existing capital resources will be adequate to fund our operations for at least the next twelve months. However, changes may occur that would consume available capital resources before that time. Our capital requirements will depend on numerous factors, including:

· costs associated with software sales;

· the purchase of additional capital equipment;

· acquisitions of other businesses or technologies; and

· costs associated with addressing the material weaknesses in our internal control over financial reporting as described elsewhere in this Report.

If we determine that we must raise additional capital, we may attempt to do so through public or private financings involving debt or equity. However, additional capital may not be available on favorable terms, or at all. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, products or potential markets that we would not otherwise relinquish.

Certain Risks Related to Owning Our Stock

We expect that our stock price will fluctuate significantly, and you may not be able to resell your shares at or above your investment price. The stock market, historically and in recent years, has experienced significant volatility particularly with technology company stocks. The volatility of technology company stock prices often does not relate to the operating performance of the companies represented by the stock. Factors that could cause volatility in the price of our common stock include without limitation:

· actual and anticipated fluctuations in our quarterly financial and operating results;

· market conditions in the technology and software sectors;

· issuance of new or changed securities analysts’ reports or recommendations;

· developments or disputes concerning our intellectual property or other proprietary rights or other legal claims;

· introduction of technological innovations or new commercial products by us or our competitors;

· market acceptance of our products and services;

· additions or departures of key personnel; and

· the disclosure of the material weaknesses in our internal control over financial reporting as described elsewhere in this Report.

These and other external factors may cause the market price and demand for our common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of common stock and may otherwise negatively affect the liquidity of our common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have periodically instituted securities class action litigation against the issuer.

As institutions hold the majority of our common stock in large blocks, substantial sales by these stockholders could depress the market price for our shares. As of January 12, 2007, the top ten institutional holders of our common stock held approximately 53% of our outstanding common stock. As a result, if one or more of these major stockholders were to sell all or a portion of their holdings, or if the market were to perceive that such sale or sales may occur, the market price of our common stock may fall significantly.

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

Anti-takeover provisions under the Delaware General Corporation Law, provisions in our certificate of incorporation and bylaws, our stockholder rights plan and the employment agreements with our executives may render more difficult the accomplishment of mergers or the assumption of control by a principal stockholder, making more difficult the removal of management. Certain provisions of the Delaware General Corporation Law may delay or deter attempts to secure control of our company without the consent of our management. Also, our governing documents provide for a staggered board of directors, which will make it more difficult for a potential acquirer to gain control of our board of directors. Our stockholder rights plan is triggered upon commencement or announcement of a hostile tender offer or when any one person or group acquires 15% or more of our common stock. The rights plan, once triggered, enables our stockholders (other than the stockholder responsible for triggering the rights plan) to purchase our common stock at reduced prices. In 2006, we entered into substantially identical employment agreements with our executives. These employment agreements contain provisions whereby if an executive’s employment with us is terminated upon the occurrence of a change of control, the executive will be entitled to receive certain severance payments and benefits.

These provisions of our governing documents, stockholder rights plan and employment agreements with our executives, and of Delaware law, could have the effect of delaying, deferring or preventing a change of control, including without limitation a proxy contest, making more difficult the acquisition of a substantial block of our common stock. The provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. Further, the existence of these anti-takeover measures may cause potential bidders to look elsewhere, rather than initiating acquisition discussions with us.

Certain Risks Related to Intellectual Property

We may not be able to protect adequately the trade secrets and confidential information that we disclose to our employees. We rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. Competitors through their independent discovery (or improper means, such as unauthorized disclosure or industrial espionage) may come to know our proprietary information. We generally require employees and consultants to execute confidentiality and assignment-of-inventions agreements. These agreements typically provide that all

materials and confidential information developed by or made known to the employee or consultant during his, her or its relationship with us are to be kept confidential, and that all inventions arising out of the employee’s or consultant’s relationship with us are our exclusive property. Our employees and consultants may breach these agreements, and in some instances we may not have an adequate remedy. Additionally, in some instances, we may have failed to require that employees and consultants execute confidentiality and assignment-of-inventions agreements.

Foreign laws may not afford us sufficient protections for our intellectual property, and we may not seek patent protection outside the United States. We believe that our success depends, in part, upon our ability to obtain international protection for our intellectual property. However, the laws of some foreign countries may not be as comprehensive as those of the United States and may not be sufficient to protect our proprietary rights abroad. In addition, we generally do not pursue patent protection outside the United States because of cost and confidentiality concerns. Accordingly, our international competitors could obtain foreign patent protection for, and market overseas, products and technologies for which we are seeking patent protection in the United States.

A patent issued to us may not be sufficiently broad to protect adequately our rights in intellectual property to which the patent relates. Due to cost and other considerations, we generally do not rely on patent protection to enforce our intellectual property rights, and have filed only a limited number of patent applications. Even if patents are issued to us, these patents may not sufficiently protect our interest in our software or other technologies because the scope of protection provided by any patents issued to or licensed by us are subject to the uncertainty inherent in patent law. Third parties may be able to design around these patents or develop unique products providing effects similar to our products. In addition, others may discover uses for our software or technologies other than those uses covered in our patents, and these other uses may be separately patentable. A number of pharmaceutical and biotechnology companies, software organizations and research and academic institutions, have developed technologies, filed patent applications or received patents on various technologies that may be related to our business. Some of these technologies, patent applications or patents may conflict with our technologies, patent applications or patents. These conflicts could also limit the scope of patents, if any, that we may be able to obtain, or result in the denial of our patent applications.

We may be subject to claims of infringement by third parties.A number of patents may have been issued or may be issued in the future that could cover certain aspects of our technology or functionality of our products and could prevent us from using technology that we use or expect to use, or making or selling certain of our products. In addition, to the extent our employees are involved in research areas similar to those areas in which they were involved at their former employers, we may inadvertently use or disclose alleged trade secrets or other proprietary information of their former employer. Thus, our products may infringe patent or other intellectual property rights of third parties, and we may be subject to infringement claims by third parties. Any such claims, with or without merit, could be time consuming to defend, result in costly litigation, divert management’s attention and resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such licenses may not be available on terms acceptable to us, if at all. In the event of a successful claim of product infringement against us, our failure or inability to license or design around the infringed technology could have a material adverse effect on our business, financial condition and results of operations.

Third-party software codes incorporated into our products could subject us to liability or limit our ability to sell such products. Some of our products include software codes licensed from third parties, including the open source community. Some of these licenses impose certain obligations upon us, including royalty and indemnification obligations. In the case of codes licensed from the open source community, the licenses may also limit our ability to sell products containing such code. Though we generally review the applicable licenses prior to incorporating third party code into our software products, there can be no assurance that such third party codes incorporated into our products would not subject us to liability or limit our ability to sell the products containing such code, thereby having a material adverse affect upon our business.

Item 5. Other Information

On February 1, 2007, we amended the employment agreement with Nicholas Austin, our Vice President, Research and Development, to reflect the fact that Mr. Austin has relocated to Cambridge, United Kingdom and Mr. Austin’s employment has transferred to our United Kingdom subsidiary, Accelrys Limited. Mr. Austin’s base salary and target bonus percentage are unchanged, although now paid in British pounds. The foregoing description is intended only as a summary of the material terms of the amendment to Mr. Austin’s employment agreement and is qualified in its entirety by reference to the full amendment attached as Exhibit 10.2 of this Report.

Item 6. Exhibits

Exhibit Number		Description
3.1		Restated Certificate of Incorporation of Pharmacopeia, Inc. (incorporated by reference to Exhibit 3.1 to Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 1996).
3.2		Certificate of Amendment of the Restated Certificate of Incorporation of Pharmacopeia, Inc. (incorporated by reference to Exhibit 3.1 to Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended March 31, 2005.
3.3		Amended and Restated Bylaws of Accelrys, Inc. as amended on June 9, 2005. (incorporated by reference to Exhibit 3.2 to Accelrys, Inc.’s Annual Report on Form 10-K for the fiscal year ended March 31, 2005)
10.1		Form of Employment Agreement between Accelrys, Inc. and certain of its executives (incorporated by reference to Exhibit 10.5 to Accelrys, Inc.’s Form 10-Q for the quarter ended September 30, 2006)
10.2*		Amendment to Employment Agreement, dated February 1, 2007, between Accelrys, Inc. and Nicholas Austin
31.1*		Section 302 Certification of the Principal Executive Officer
31.2*		Section 302 Certification of the Principal Financial Officer
32.1*		Section 906 Certification of the Chief Executive Officer and Chief Financial Officer

* Filed herewith

SIGNATURE

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

		ACCELRYS, INC.

		By:	/s/ RICK E. RUSSO
			Rick E. Russo
			Senior Vice President and Chief Financial Officer (Duly Authorized Officer and Chief Financial Officer)

			Date: February 2, 2007