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Management's Discussion & Analysis and Risk Factors - Second Quarter 2006

Management's Discussion and Analysis

of Financial Conditions and Results of Operations



This report contains forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. Forward-looking statements include, but are not limited to, statements about:

  .   the marketing and sales of our products and services;

  .   our ability to sustain licensing and other contract-based revenues;

  .   the impact of our NIH contract on future business;

  .   the value of, and expenses associated with, our intellectual property;

  .   our future revenues and profitability, including any revenues from milestone payments and access extension fees, under our DeltaBase collaboration agreements;

  .   the requirements of pharmaceutical and biotechnology companies;

  .   the benefits of knockout mice programs and, in particular, our technologies and products, to the pharmaceutical industry;

  .   the increasing competition we face in the field of knockout mice from both commercial and government organizations;

  .   failures in the drug discovery, development and approval processes by our partners and collaborators;

  .   our ability to successfully execute our business plan and to meet contractual obligations, in view of the Company's limited staff; and

  .   liquidity and capital resources.

In some cases, you can identify forward-looking statements by terms such as "may," "will," "should," "could," "would," "expects," "plans," "anticipates," "believes," "estimates," "projects," "predicts," "potential" and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. These forward-looking statements represent our estimates and assumptions only as of the date of this report.

You should read this report completely and with the understanding that our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements.


1. Overview

Deltagen (or the "Company") is a provider of research tools to the biopharmaceutical industry and to the academic research community. Deltagen has generated an inventory of "knockout mice" in which a single gene has been deleted ("knocked out"). The knockout mice have been analyzed to determine the phenotypic changes associated with that gene deletion. This phenotypic data has been organized in an integrated database known as DeltaBase. DeltaBase contains phenotypic data on 750 different knockout mouse lines. In addition to those 750 knockout mouse lines, Deltagen has approximately 150 additional knockout mouse lines that have not been characterized phenotypically. Deltagen also has approximately 450 knockout lines at the embryonic stem (ES) cell stage.

Our customers and partners/collaborators have included some of the world's largest pharmaceutical companies, including GlaxoSmithKline plc, Merck & Co., Inc., Pfizer Inc., Eli Lilly and Company and Schering-Plough Research Institute.

We generate revenue from our DeltaBase and DeltaOne products and programs.

DeltaBase is our proprietary database that provides information, based on knockout mouse studies, on gene function and validated gene targets for drug discovery. Each knockout mouse underwent a standardized, detailed and extensive analysis in order to determine the function and role that a particular gene plays in the mouse and that gene's suitability as a drug target.

DeltaOne offers access to our portfolio of knockout mice and/or accompanying phenotypic data, as well as any corresponding intellectual property, on a gene-by-gene basis.

The Company has a three-year contract, expiring September 2008, with the United States Government through the National Institutes of Health ("NIH"). Under this contract, the NIH is eligible to order any of the approximately 750 knockout mouse lines (and related phenotypic data) that populate DeltaBase. The NIH is permitted to publish the phenotypic data and make the knockout mouse materials available for licensing to academic institutions. In September 2005, the NIH placed an initial delivery order for 129 knockout lines. No other delivery orders have been submitted.

We derive substantially all of our revenues from a narrow and limited range of sources. Substantially all of our revenues are derived from the provision of knockout mouse lines and related phenotypic data to the biopharmaceutical industry and pursuant to government contracts. Because of continuing consolidation in the biopharmaceutical industry and the finite number of knockout lines in the Company's inventory, significant uncertainty exists with respect to the Company's future revenues.

Our operating results have fluctuated in the past and are likely to do so in the future, and we do not believe that period-to-period comparisons of our operating results are a good indication of our future performance.

2. Critical Accounting Policies and Estimates

The consolidated financial statements of Deltagen for the three-month period ended June 30, 2006 are unaudited, but have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information. These consolidated financial statements have been prepared so that they present fairly, in the opinion of management, the Company's financial position and its results of operations and its cash flows for the period presented.

Under our revenue recognition policy, revenues are recognized when a definitive agreement with a determinable price exists, product delivery and/or invoicing (in each case where there is reasonable assurance of meeting customer-specified criteria) have occurred, and collectibility is reasonably assured. A change in our revenue recognition policy or changes in the terms of contracts under which we recognize revenues could have an impact on the amount and timing of our recognition of revenues.

The preparation of consolidated financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the amounts that are reported in the consolidated financial statements and accompanying disclosures. Although these estimates are based on the Company's best knowledge of current events and actions that the Company may undertake in the future, actual results may differ materially from the estimates.

3. Results of Operations

The Company's consolidated revenues for the three months ended June 30, 2006 totaled $3.749 million, compared to $1.882 million in the first quarter of 2006.  The second quarter revenues were attributable primarily to revenue received from our NIH contract, under which we recognized approximately $3.2 million in the second quarter of 2006. Of this amount, approximately $1.3 million was received during the second quarter and approximately $1.9 million was received early in the third quarter of 2006. No new delivery orders were placed by the NIH in the second quarter of 2006 and there are no assurances that the NIH will place any additional delivery orders. The decrease in non-NIH-related revenues was attributable primarily to the fact that the Company did not recognize any access extension fees under its DeltaBase collaboration agreements during the second quarter of 2006. The Company recognized $0.500 million in extended access fees in the first quarter of 2006.

The Company had interest income of $0.087 million for the three months ended June 30, 2006.

Total consolidated expenses for the three months ended June 30, 2006 were $2.015 million, of which $1.125 million were attributable to third-party royalty and commission obligations and $0.123 million were attributable to a non-cash stock-based compensation expense relating to stock options granted by the Company on March 30, 2006 in accordance with Statement of Financial Standards (SFAS 123R). Other operating expenses, which totaled $0.767 million for the three months ended June 30, 2006, were attributable primarily to salaries and other general and administrative expenses, and patent prosecution expenses. Total consolidated expenses for the first quarter of 2006 were $1.555 million, of which $0.493 million were attributable to third-party royalty and commission obligations. Other operating expenses totaled $1.062 million in the first quarter of 2006. The increase in third-party royalty and commission obligations in the second quarter over the first quarter was due to the increase in revenues in the second quarter, which increased 100% over the first quarter. The decrease in other operating expenses was due to a decrease in patent prosecution expenses and the cessation of legal expenses associated with the administration of the Company's bankruptcy case. Legal and administrative fees associated with prosecution of the Company's patent portfolio were $0.201 million for the three months ended June 30, 2006, compared to $0.373 million in the first quarter of 2006.

As of June 30, 2006, the Company had paid to Lexicon Genetics Incorporated a cumulative total of $1.564 million in royalties toward the $6.0 million royalty cap payable under our February 2005 sublicense assumption and settlement agreement with Lexicon Genetics.

Net income before the provision for income taxes for the three months ended June 30, 2006 was $1.821 million.  Net income after provision for income taxes for such three-month period was $1.483 million.

As of June 30, 2006, the Company had $10.789 million in cash and cash equivalents.

As of June 30, 2006, the Company had accounts receivable of $3.380 million. Of this amount, approximately $1.9 million related to revenues recognized, but not received, in the second quarter under our NIH contract. This amount was received in July 2006. Approximately $1.0 million of the accounts receivable as of June 30, 2006 related to research investment tax credits expected to be received from the French government by Deltagen Europe, S.A.

During the quarter ended June 30, 2006, the Company reduced the reserve allowance against the deferred tax asset by $0.518 million. This adjustment increased the amount of the net tax asset and reduced the income tax expense by equal amounts during the quarter. After this adjustment, the unused tax asset carried as of June 30, 2006 was $0.598 million current and $0.400 million deferred. The Company will continue to evaluate and adjust the recoverability of the deferred tax assets and the level of the valuation allowance.

The balance sheet for 2005 has been audited and the audited consolidated balance sheet will be posted on the Company's website, together with the auditors' report and notes to the financials for such period.

The consolidated financial results for the second quarter of 2006 reflect certain adjustments to the 2005 and first quarter 2006 financials made in connection with the audit. The adjustments are discussed in the notes to the financials for the second quarter of 2006, which will be made available on Deltagen's website. The Company does not intend to update its Management's Discussion & Analysis and Risk Factors for 2005.

4. Publications and Presentations

From time to time, employees of Deltagen are given co-authorship credit on scientific publications and presentations by certain of the Company's customers. Co-authorship credit of a Deltagen employee should not be viewed as an indication that the Company and its employees are engaged in research activities or that the Company has any rights in the subject matter of such publications or presentations. As mentioned previously, the Company is not currently engaged in any research activities, either alone or in collaboration with any of its customers.

Risk Factors Affecting Future Operating Results

There are numerous risks and uncertainties related to both our business and our industry that could cause actual results or events to differ materially from those indicated by forward-looking statements.

We have DeltaBase agreements with GlaxoSmithKline, Pfizer and Merck ("DeltaBase Agreements"). The milestone payments under the DeltaBase Agreements are triggered only when all of the following conditions are satisfied: (i) issuance of patents claiming knockout mice; (ii) such patents having claims with specified language relating to certain recited phenotypes and/or diseases; and (iii) the progression of a drug candidate relating to use of DeltaBase data and/or mouse lines to certain specified drug development and approval milestones. As of June 30, 2006, the Company had been issued ten patents claiming knockout mice. There is significant uncertainty as to how many additional patents, if any, the Company will be successful in obtaining in the future, what the total cost associated with such patent prosecution efforts would be, and whether and to what extent the Company will continue to pursue such patents in the future. In addition, satisfaction of the drug development and approval milestones under our DeltaBase Agreements depends solely upon the efforts and success of our pharmaceutical collaborators, which are not controlled by Deltagen. We may never know whether our DeltaBase collaborators have been successful in their drug development efforts relating to DeltaBase. Our collaborators may also dispute whether milestone triggers have been satisfied and may resist or refuse to pay milestone payments. Furthermore, the more significant milestone payment amounts are associated with drug approval, which is a rare event and takes many years to achieve. As a result of these factors, there is significant uncertainty as to whether the Company will receive any milestone payments and, if so, how many milestone payments the Company may ultimately receive from its DeltaBase Agreements and what the value of any such payments may be. There are no royalty obligations under the DeltaBase Agreements. The Company is a party to a few DeltaOne agreements that specify royalty payments based on sales of approved drugs by such customers. However, these agreements generally involve a relatively small fraction of the targets involved in the DeltaBase Agreements. Therefore, given the relatively few targets involved in these deals and the low probability of approval and significant sales for any given drug compound, we currently do not expect that such royalty payments, if any, would be significant.

For a list of additional risk factors that may affect our future operating results, refer to the "Risk Factors" section of "Management's Discussion and Analysis of Financial Conditions and Results of Operations" for the year ended December 31, 2005, as posted on the Company's website (www.deltagen.com). The risk factors listed there are not the only ones we face and additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair or otherwise affect our business operations.

2006 Deltagen, Inc. All rights reserved.