Management's Discussion and Analysis of Financial Conditions and Results of Operations

THIRD QUARTER 2006

INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

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;
• the declaration and distribution of any future dividends;
• our ability to sustain licensing and other contract-based revenues;
• the impact of our contracts with the NIH and The Wellcome Trust 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.

YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND THE NOTES ACCOMPANYING THE FINANCIAL 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, potentially worth up to about $25 million, 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 ($5.16 million).  A delivery order for four knockout mouse lines ($0.160 million) was placed by the NIH in the third quarter of 2006.  However, there are no assurances that the NIH will place any additional delivery orders during the three-year term of the NIH contract, which expires on September 30, 2008.

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 September 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 September 30, 2006 totaled $0.970 million.  The third quarter revenues were attributable primarily to license fees associated with the provision of knockout mice and related phenotypic data under the Company's DeltaOneTM program.  A delivery order for four knockout mouse lines was placed by the NIH in the third quarter of 2006.  The revenues relating to this delivery order ($0.160 million) will be recognized starting in the fourth quarter of 2006 and through the first two quarters of 2007.  However, there are no assurances that the NIH will place any additional delivery orders during the three-year term of the NIH contract, which expires on September 30, 2008.

The Company had interest income of $0.126 million for the three months ended September 30, 2006.

Total consolidated expenses for the three months ended September 30, 2006 were $0.959 million, of which $0.246 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 $0.590 million for the three months ended September 30, 2006, were attributable primarily to salaries and other general and administrative expenses.  Legal and administrative fees associated with prosecution of the Company's patent portfolio for the three months ended September 30, 2006 were $0.083 million, compared to $0.201 million for the second quarter of 2006 and $0.373 million in the first quarter of 2006.  The decrease in patent-related expenses is due to the Company reducing or discontinuing in the third quarter of 2006 its efforts on the prosecution of certain of its patent applications in an effort to reduce such expenses and after consideration of the factors set forth below.

Net income before provision for income taxes for the three months ended September 30, 2006 was $0.137 million. 

As of September 30, 2006, the Company had $11.993 million in consolidated cash and cash equivalents and $1.808 million in accounts receivable.

4.   Subsequent Events

a.  Completion of Strategic Review:  In July 2006, the Company engaged the services of an investment banking firm to assist the Company in identifying and evaluating various strategic alternatives and opportunities, including possible sale of the Company.  After thoroughly reviewing the alternatives, the Board of Directors of the Company decided in November 2006 not to pursue any such opportunities and terminated its agreement with the investment banking firm.  As a result, the Company currently intends to maximize revenue generation from continued licensing of its existing assets.  However, there is no guarantee that the Company will be successful in maintaining its revenues or that the Company will declare any future dividends.

b.  DeltaBase Milestone Buyouts:  During the strategic review of the Company's alternatives, the Board of Directors of the Company decided it was in the best interest of the Company's shareholders to attempt to negotiate buyouts with its major DeltaBase subscribers.  In October 2006, the Company entered into an agreement with one of its DeltaBase collaborators under which the Company received a one-time buyout payment in exchange for the elimination of any future access extension fees and potential milestone payments that may become due or payable under the DeltaBase agreement with such collaborator.  This buyout does not affect any fees due Deltagen associated with the provision of knockout mouse materials in the future.  The Company received the buyout payment in early December 2006.  The Company is also currently negotiating with another of its DeltaBase collaborators for a buyout of that collaborator's access extension fees and potential milestone payments.  Assuming the Company will be successful in reaching agreement with such collaborator, the Company may discontinue prosecution of a significant portion or all of its patent applications relating to individual knockout mouse lines relating to those DeltaBase collaborations.  Cessation of patent prosecution efforts would significantly reduce operating expenses.  The patent prosecution expenses totaled $1.138 million during 2005 and $0.657 million during the first nine months of 2006.  In determining whether to discontinue prosecution of its patent applications, the Company may take into consideration many factors including, but not limited to, the following factors: the expense of continued patent prosecution; the likelihood of obtaining issued patents; the scope and breadth of any patent claims were such patents to issue; the likelihood that any such patent claims would be valid, enforceable and have commercial value; the likelihood that any such patent claims would recite the same phenotypes or disease indications as those for which our drug collaborators develop and commercialize drugs; the likelihood that drug development and approval milestones will be reached by our DeltaBase collaborators; the likely timing of any such milestone payments; the likelihood that our DeltaBase collaborators would dispute whether milestone payments have been triggered and the expense of litigating with such collaborators, if necessary; and the probability of successfully enforcing any issued patents against potential infringers, together with the expense of such litigation and an estimation of any damages that may be awarded were the Company to prevail. 

c.  Contracts with The Wellcome Trust and GSF:  In November 2006, the Company entered into agreements with The Wellcome Trust and GSF - National Research Center for Environment and Health GmbH ("GSF") for the provision by the Company of knockout mouse lines for distribution to academic researchers.  The terms of these agreements are generally consistent with those of the NIH contract, under which The Wellcome Trust, as a "partner" of the NIH, was eligible for financial terms no less favorable than those under the NIH contract.  The Wellcome Trust and GSF are not obligated to place any orders under these contracts and, to date, have not placed any orders.  However, the Company expects to receive an initial order in the first quarter of 2007.

d.  New Facilities Lease:  In November 2006, the Company signed a lease for new office space located at The Atrium, 1900 South Norfolk Street, Suite 105, San Mateo, CA 94403.  The new address will become effective in January 2007.

e.  Dividend Declaration:  After careful consideration of its various strategic alternatives and opportunities, with the assistance of an investment banking firm, the Company determined that declaration of a dividend would serve best the interests of the Company's shareholders.  The Company will distribute on December 28, 2006 a dividend of $0.20 per share.  The Company's shareholders of record as of the close of business on December 18, 2008 will receive this dividend.  The Company has approximately 38.5 million shares outstanding that are eligible for the dividend.  As a result, the total dividend distribution would be approximately $7.7 million.

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 September 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.  Accordingly, 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.  As a result, the Board of Directors of the Company decided it was in the best interests of the Company's shareholders to attempt to negotiate buyouts with its major DeltaBase subscribers, as described above in the "Subsequent Events" section.  In addition, 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.