form10-q_sept2008.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
 
(Mark One)
 
 
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended September 30, 2008
or
 
 
q
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _____________ to _____________

Commission File Number:  000-30111
 
Lexicon Pharmaceuticals, Inc.
(Exact Name of Registrant as Specified in its Charter)

Delaware
76-0474169
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification Number)

8800 Technology Forest Place
The Woodlands, Texas 77381
(Address of Principal Executive
Offices and Zip Code)
 
(281) 863-3000
(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      ü    No             
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer             Accelerated filer     ü    Non-accelerated filer           (Do not check if a smaller reporting company)  Smaller reporting company         
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes          No        ü     
 
As of October 29, 2008, 136,796,154 shares of the registrant’s common stock, par value $0.001 per share, were outstanding.
 

Lexicon Pharmaceuticals, Inc.
 
Table of Contents
 
 
 
   
Page
2
3
Item 1.
3
 
Consolidated Balance Sheets – September 30, 2008 (unaudited) and December 31, 2007
3
 
Consolidated Statements of Operations (unaudited) – Three and Nine Months Ended September 30, 2008 and 2007
4
 
Consolidated Statements of Cash Flows (unaudited) – Nine Months Ended September 30, 2008 and 2007
5
 
6
Item 2.
13
Item 3.
22
Item 4.
22
23
Item 1A.
23
Item 6.
25
26

 
The Lexicon name and logo, LexVision® and OmniBank® are registered trademarks and Genome5000™, e-Biology™ and 10to10™ are trademarks of Lexicon Pharmaceuticals, Inc.
 
——————

Factors Affecting Forward-Looking Statements
 
This quarterly report on Form 10-Q contains forward-looking statements.  These statements relate to future events or our future financial performance. We have attempted to identify forward-looking statements by terminology including “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “should” or “will” or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks outlined under “Part II, Item 1A. – Risk Factors,” that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels or activity, performance or achievements expressed or implied by these forward-looking statements.
 
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We are not under any duty to update any of the forward-looking statements after the date of this quarterly report on Form 10-Q to conform these statements to actual results, unless required by law.
 
 
Part I – Financial Information
 
Financial Statements
 
Lexicon Pharmaceuticals, Inc.
 
Consolidated Balance Sheets
(In thousands, except par value)
 
   
As of September 30,
    
As of December 31,
  
   
2008
    
2007
  
Assets
  
(unaudited)
        
Current assets:
            
Cash and cash equivalents
  $ 100,209     $ 22,938  
Short-term investments, including restricted investments of $430
     2,230       199,171  
Short-term investments held by Symphony Icon, Inc.
     21,147       36,666  
Accounts receivable, net of allowance for doubtful accounts of $35
     770       1,763  
Prepaid expenses and other current assets
    7,069       4,112  
Total current assets
    131,425       264,650  
Long-term investments
    53,678       —  
Property and equipment, net of accumulated depreciation and amortization of $69,714 and $65,004, respectively
     66,444       70,829  
Goodwill
    25,798       25,798  
Other assets
    6,358       8,019  
Total assets
  $ 283,703     $ 369,296  
 
                
Liabilities, Noncontrolling Interest and Stockholders’ Equity
                
 
                
Current liabilities:
                
Accounts payable
  $ 8,055     $ 7,344  
Accrued liabilities
    9,338       9,093  
Current portion of deferred revenue
    6,670       18,030  
Current portion of long-term debt
    944       880  
Total current liabilities
    25,007       35,347  
Deferred revenue, net of current portion
    14,212       16,126  
Long-term debt
    29,779       30,493  
Other long-term liabilities
    764       759  
Total liabilities
    69,762       82,725  
Noncontrolling interest in Symphony Icon, Inc.
    14,260       30,271  
 
                
Commitments and contingencies
                
 
                
Stockholders’ equity:
                
Preferred stock, $.01 par value; 5,000 shares authorized; no shares issued and outstanding
    —       —  
Common stock, $.001 par value; 300,000 shares authorized; 136,796 and 136,795 shares issued and outstanding, respectively
     137       137  
Additional paid-in capital
    671,484       666,702  
Accumulated deficit
    (471,978 )     (410,535 )
Accumulated other comprehensive gain (loss)
    38       (4 )
Total stockholders’ equity
    199,681       256,300  
Total liabilities and stockholders’ equity
  $ 283,703     $ 369,296  

The accompanying notes are an integral part of these consolidated financial statements.
 
Lexicon Pharmaceuticals, Inc.
 
Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)
 

   
Three Months Ended September 30,
    
Nine Months Ended
September 30,
  
   
2008
    
2007
    
2008
    
2007
  
Revenues:
                        
Collaborative research
  $ 7,202     $ 9,712     $ 22,789     $ 34,460  
Subscription and license fees
    310       455       3,182       1,850  
Total revenues
    7,512       10,167       25,971       36,310  
Operating expenses:
                                
Research and development, including stock-based compensation of $836, $965, $2,913 and $3,000, respectively
    27,642       24,518       85,793       77,402  
General and administrative, including stock-based compensation of $583, $635, $1,868 and $1,830, respectively
    4,692       5,091       15,824       15,395  
Total operating expenses
    32,334       29,609       101,617       92,797  
Loss from operations
    (24,822 )     (19,442 )     (75,646 )     (56,487 )
Impairment of long-term investments
    (3,322 )     —       (3,322 )     —  
Interest income
    956       2,166       5,155       3,811  
Interest expense
    (675 )     (694 )     (2,020 )     (2,077 )
Other expense, net
    (535 )     (8 )     (1,621 )     (34 )
Loss before noncontrolling interest in Symphony Icon, Inc.
    (28,398 )     (17,978 )     (77,454 )     (54,787 )
Loss attributable to noncontrolling interest in Symphony Icon, Inc.
    4,939       3,867       16,011       8,170  
Net loss
  $ (23,459 )   $ (14,111 )   $ (61,443 )   $ (46,617 )
                                 
Net loss per common share, basic and diluted
   $ (0.17 )   $ (0.14 )   $ (0.45 )   $ (0.53 )
Shares used in computing net loss per common share, basic and diluted
    136,796       104,196       136,796       87,331  


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

Lexicon Pharmaceuticals, Inc.
 
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
   
Nine Months Ended September 30,
  
   
2008
    
2007
  
Cash flows from operating activities:
            
Net loss
  $ (61,443 )   $ (46,617 )
Adjustments to reconcile net loss to net cash used in operating activities:
                
Depreciation
    6,057       7,138  
Amortization of Symphony Icon purchase option
    1,606       —  
Loss attributable to noncontrolling interest
    (16,011 )     (8,170 )
Stock-based compensation
    4,781       4,830  
Impairment of long-term investments
    3,322       —  
Changes in operating assets and liabilities:
                
(Increase) decrease in accounts receivable
    993       (561 )
(Increase) decrease in prepaid expenses and other current assets
     (2,957 )     627  
Decrease in other assets
    55       82  
Increase (decrease) in accounts payable and other liabilities
     961       (317 )
Decrease in deferred revenue
    (13,274 )     (17,021 )
Net cash used in operating activities
    (75,910 )     (60,009 )
Cash flows from investing activities:
                
Purchases of property and equipment
    (1,672 )     (1,297 )
Proceeds from disposal of property and equipment
    —       1  
Purchases of investments held by Symphony Icon, Inc.
     —       (44,991 )
Maturities of investments held by Symphony Icon, Inc.
     15,519       5,421  
Purchases of investments
    (39,847 )     (192,982 )
Maturities of investments
    179,830       58,985  
Net cash provided by (used in) investing activities
     153,830       (174,863 )
Cash flows from financing activities:
                
Proceeds from issuance of common stock to Invus, L. P., net of fees
     —       198,135  
Proceeds from issuance of common stock to Symphony Holdings, LLC, net of fees
    —       14,238  
Proceeds from exercise of stock options
    1       884  
Repayment of debt borrowings
    (650 )     (604 )
Proceeds from purchase of noncontrolling interest by preferred shareholders of Symphony Icon, Inc., net of fees
     —       42,714  
Net cash provided by (used in) financing activities
     (649 )     255,367  
Net increase in cash and cash equivalents
    77,271       20,495  
Cash and cash equivalents at beginning of period
    22,938       30,226  
Cash and cash equivalents at end of period
  $ 100,209     $ 50,721  
                 
Supplemental disclosure of cash flow information:
                
Cash paid for interest
  $ 1,962     $ 2,004  
                 
Supplemental disclosure of non-cash investing and financing activities:
                
Common stock issued for purchase option in conjunction with Symphony Icon, Inc. financing
  $ —     $ 8,564  
Unrealized gain (loss) on investments
  $ 42     $ (146 )
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
 
Lexicon Pharmaceuticals, Inc.
 
Notes to Consolidated Financial Statements
(Unaudited)
 
1.      Basis of Presentation
 
The accompanying unaudited consolidated financial statements of Lexicon Pharmaceuticals, Inc. (“Lexicon” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
 
In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ended December 31, 2008.
 
The accompanying consolidated financial statements include the accounts of Lexicon and its wholly-owned subsidiaries, as well as one variable interest entity, Symphony Icon, Inc. (“Symphony Icon”), for which the Company is the primary beneficiary as defined by the Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (revised 2003), “Consolidation of Variable Interest Entities” (“FIN 46R”).  Intercompany transactions and balances are eliminated in consolidation.
 
For further information, refer to the financial statements and footnotes thereto included in Lexicon’s annual report on Form 10-K for the year ended December 31, 2007, as filed with the SEC.
 
2.      Net Loss Per Share
 
Net loss per share is computed using the weighted average number of shares of common stock outstanding during the applicable period. Shares associated with stock options and warrants are not included because they are antidilutive.  There are no differences between basic and diluted net loss per share for all periods presented.
 
3.      Stock-Based Compensation
 
Under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised), “Share-Based Payment,” the Company recorded $1.4 million and $1.6 million of stock-based compensation expense for the three months ended September 30, 2008 and 2007, respectively, and $4.8 million of stock-based compensation expense for the nine months ended September 30, 2008 and 2007.  The Company utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted, with the following weighted-average assumptions for options granted in the nine months ended September 30, 2008 and 2007, respectively.
 
   
Expected Volatility
    
Risk-free Interest Rate
    
Expected Term
    
Estimated Forfeitures
    
Dividend
Rate
  
September 30, 2008:
                                        
Employees
    
66
%
    
2.9
%
    
6
      
22
%
    
0
%
Officers and non-employee directors
    
66
%
    
3.8
%
    
9
      
6
%
    
0
%
September 30, 2007:
                              
Employees
    
67
%
    
4.5
%
    
6
      
21
%
    
0
%
Officers and non-employee directors
    
67
%
    
4.6
%
    
9
      
4
%
    
0
%
 

 
The following is a summary of option activity under Lexicon’s stock option plans for the nine months ended September 30, 2008:
 
   
Options
    
Weighted Average Exercise Price
   
(in thousands)
      
Outstanding at December 31, 2007
    
16,351
    
$
5.65
Granted
    
4,060
      
2.08
Exercised
    
(1
) 
    
1.89
Canceled
    
(3,091
)
    
3.84
Outstanding at September 30, 2008
    
17,319
      
5.14
Exercisable at September 30, 2008
    
11,377
    
$
6.34

4.      Recent Accounting Pronouncements
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”  The statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.  This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute.  Accordingly, this statement does not require any new fair value measurements.  More specifically, SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy, which ranks the quality and reliability of the information used to determine fair values.  SFAS No. 157 was effective January 1, 2008 for financial assets and liabilities and will be effective January 1, 2009 for non-financial assets and liabilities.  The adoption of SFAS No. 157 for financial assets and liabilities did not have an effect on the Company’s financial condition or results of operations.  The Company is currently evaluating the effect, if any, of the adoption of this statement for non-financial assets and liabilities on its financial condition and results of operations.
 
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB Statement No. 115,” which provides a fair value option election that permits entities to irrevocably elect to measure many financial instruments and certain other items at fair value, with changes in fair value recognized in earnings as they occur.  SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities.  SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value.  SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007.  The Company’s adoption of SFAS No. 159 on January 1, 2008 did not materially affect its financial position or results of operations.
 
In December 2007, the FASB issued SFAS No. 141(Revised), “Business Combinations,” which replaces SFAS No. 141, “Business Combinations,” and requires an acquirer to recognize the assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. This statement also requires the acquirer in a business combination achieved in stages to recognize the identifiable assets and liabilities, as well as the non-controlling interest in the acquiree, at the full amounts of their fair values. SFAS No. 141(R) makes various other amendments to authoritative literature intended to provide additional guidance or to confirm the guidance in that literature to that provided in this statement. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company expects to adopt this statement on January 1, 2009.  SFAS No. 141(R)’s impact on accounting for business combinations is dependent upon acquisitions, if any, made on or after that time.
 
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” which amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements. SFAS No. 160 establishes accounting and reporting standards that require the ownership interests in subsidiaries not held by the parent to be clearly identified, labeled and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity. This statement also requires the amount of consolidated net income attributable to the parent and to the non-controlling interest to be clearly identified and presented on the face of the consolidated statement of income. Changes in a parent’s ownership interest while the parent retains its controlling financial interest must be accounted for consistently, and when a subsidiary is deconsolidated, any retained non-controlling equity investment in the former subsidiary must be initially measured at fair value. The gain or loss on the deconsolidation of the subsidiary is measured using the fair value of any non-controlling equity investment. The statement also requires entities to provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. This statement applies prospectively to all entities that prepare consolidated financial statements and applies prospectively for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the effect, if any, of this statement on its financial condition and results of operations.
 
5.      Cash and Cash Equivalents and Investments
 
The fair value of cash and cash equivalents and investments held at September 30, 2008 and December 31, 2007 are as follows:
 
   
As of September 30, 2008
  
   
Amortized Cost
    
Gross Unrealized Gains
    
Gross Unrealized Losses
    
Estimated Fair Value
  
   
(In thousands)
  
Cash and cash equivalents
  
$
100,171
    
$
38
    
$
—
    
$
100,209
  
                                 
Securities maturing within one year:
                                
Certificates of deposit
    
630
      
—
      
—
      
630
  
Corporate debt securities
    
1,600
      
—
      
—
      
1,600
  
Total short-term investments
  
$
2,230
    
$
—
    
$
—
    
$
2,230
  
Short-term investments held by Symphony Icon, Inc.:
                                
Cash and cash equivalents
    
21,147
      
—
      
—
      
21,147
  
Total short-term investments held by Symphony Icon, Inc.
  
$
21,147
    
$
—
    
$
—
    
$
21,147
  
Securities maturing after ten years:
                                
Auction rate securities
    
57,000
      
—
      
(3,322
)
    
53,678
  
Total long-term investments
  
$
57,000
    
$
—
    
$
(3,322
)
  
$
53,678
  
                                 
Total cash and cash equivalents and investments
  
$
180,548
    
$
38
    
$
(3,322
)
  
$
177,264
  



   
As of December 31, 2007
  
   
Amortized Cost
    
Gross Unrealized Gains
    
Gross Unrealized Losses
    
Estimated Fair Value
  
   
(In thousands)
  
Cash and cash equivalents  
  
$
22,950
    
$
—
    
$
(12
)
  
$
22,938
  
                                 
Securities maturing within one year:
                                
Certificates of deposit
    
6,312
      
—
      
(3
)
    
6,309
  
Corporate debt securities
    
41,162
      
12
      
(51
)
    
41,123
  
Commercial paper
    
71,214
      
47
      
—
      
71,261
  
U.S. government agencies securities
    
2,500
      
3
      
—
      
2,503
  
Total securities maturing within one year
    
121,188
      
62
      
(54
)
    
121,196
  
Securities maturing after ten years:
                                
Auction rate securities 
    
77,975
      
—
      
—
      
77,975
  
Total available-for-sale investments 
  
$
199,163
    
$
62
    
$
(54
)
  
$
199,171
  
Short-term investments held by Symphony Icon, Inc.:
                                
Cash and cash equivalents  
    
36,666
      
—
      
—
      
36,666
  
Total short-term investments held by Symphony Icon, Inc.
  
$
36,666
    
$
—
    
$
—
    
$
36,666
  
                                 
Total cash and cash equivalents and investments
  
$
258,779
    
$
62
    
$
(66
)
  
$
258,775
  

There were $5,000 and $123,000 of realized gains for the three and nine months ended September 30, 2008, respectively.  There were no realized gains or losses for the three and nine months ended September 30, 2007.
 
At September 30, 2008, Lexicon held $57.0 million (par value), with an estimated fair value of $53.7 million, of AAA-rated investments with an auction interest rate reset feature, known as auction rate securities.  These notes are issued by various state agencies for the purpose of financing student loans.  The securities have historically traded at par and are redeemable at par plus accrued interest at the option of the issuer. Interest is typically paid at the end of each auction period or semiannually.  Until February 2008, the market for Lexicon’s auction rate securities was highly liquid. Starting in February 2008, a substantial number of auctions “failed,” meaning that there was not enough demand to sell all of the securities that holders desired to sell at auction. The immediate effect of a failed auction is that such holders cannot sell the securities at auction and the interest rate on the security generally resets to a maximum interest rate. In the case of funds invested by Lexicon in auction rate securities which are the subject of a failed auction, Lexicon may not be able to access the funds without a loss of principal, unless a future auction on these investments is successful or the issuer redeems the security.  As of September 30, 2008, Lexicon classified its entire auction rate security investment balance as long-term investments on its consolidated balance sheet because of the Company’s inability to determine when its investments in auction rate securities would be sold.  Lexicon has also modified its current investment strategy to reallocate its investments more into U.S. treasury securities and U.S. treasury-backed money market investments.
 
At September 30, 2008, observable auction rate securities market information was not available to determine the fair value of Lexicon’s investments. Lexicon has estimated the fair value of these securities at $53.7 million as of September 30, 2008 using models of the expected future cash flows related to the securities and taking into account probability-weighted assumptions about the cash flows of the underlying student loans.  For each of its auction rate securities, Lexicon evaluated the risks related to the structure, collateral and liquidity of the investment, and forecasted the probability of a successful auction or redemption at par, issuer default and auction failure for each future auction period.  The assumptions used in preparing the discounted cash flow model include estimates of interest rates, timing and amount of cash flows, liquidity premiums and expected holding periods of the auction rate securities, based on data available as of September 30, 2008.  These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change.  Because Lexicon does not intend to hold these securities until the par value is recoverable and management believes the decline in fair value is other-than-temporary, Lexicon recorded a loss of $3.3 million in the three and nine months ended September 30, 2008 to reflect the decline in value of these securities.  This loss is shown as impairment of long-term investments in the consolidated statements of operations.  If the current market conditions deteriorate further, or a recovery in market values does not occur, Lexicon may be required to record additional unrealized or realized losses in future quarters.
 
In August 2008, the investment bank that sold Lexicon the auction rate securities it currently holds announced a settlement, in principle, with the Securities and Exchange Commission and other state regulatory agencies pursuant to which it has offered Lexicon rights to require the bank to purchase such auction rate securities from Lexicon at par value beginning in June 2010.  Lexicon is also eligible to borrow from an affiliate of the bank at no net cost up to 75% of the market value of the auction rate securities, which loans would become payable upon the bank’s purchase of the auction rate securities.  Lexicon is currently evaluating its options with respect to such offer.
 
Excluding auction rate securities, at September 30, 2008, Lexicon had approximately $123.6 million in cash and cash equivalents and short-term investments, including $21.1 million in investments held by Symphony Icon.  Management believes that the working capital available to Lexicon excluding the funds held in auction rate securities will be sufficient to meet its cash requirements for at least the next 12 months.
 
6.      Fair Value of Financial Instruments
 
The Company uses various inputs in determining the fair value of its investments and measures these assets on a quarterly basis.  Financial assets recorded at fair value in the consolidated balance sheet are categorized by the level of objectivity associated with the inputs used to measure their fair value.  SFAS No. 157 defines the following levels directly related to the amount of subjectivity associated with the inputs to fair valuation of these financial assets:
 
 
·
Level 1 – quoted prices in active markets for identical investments
 
 
·
Level 2 – other significant observable inputs (including quoted prices for similar investments, market corroborated inputs, etc.)
 
 
·
Level 3 – significant unobservable inputs (including the Company’s own assumptions in determining the fair value of investments)
 
The inputs or methodology used for valuing securities are not necessarily an indication of the credit risk associated with investing in those securities.  Based on market conditions and the unavailability of Level 1 inputs, during the nine months ended September 30, 2008, the Company adopted a discounted cash flow valuation methodology for its auction rate securities.  Accordingly, the investments in auction rate securities changed from Level 1 to Level 3 within SFAS No. 157’s valuation levels since the Company’s initial adoption of SFAS No. 157 on January 1, 2008.  The following tables provide the fair value measurements of applicable Company financial assets according to the fair value levels defined by SFAS No. 157 as of September 30, 2008 and December 31, 2007.
 
 
   
Financial Assets at Fair Value
as of September 30, 2008
  
   
Level 1
    
Level 2
    
Level 3
  
   
(in thousands)
  
                   
Cash and cash equivalents
  
$
100,209
    
$
—
    
$
—
  
Short-term investments
    
2,230
      
—
      
—
  
Short-term investments held by  Symphony Icon, Inc.
    
21,147
      
—
      
—
  
Long-term investments
    
—
      
—
      
53,678
  
Total cash and cash equivalents and investments
  
$
123,586
    
$
—
    
$
53,678
  


   
Financial Assets at Fair Value
as of December 31, 2007
  
   
Level 1
    
Level 2
    
Level 3
  
   
(in thousands)
  
                         
Cash and cash equivalents
  
$
22,938
    
$
—
    
$
—
  
Short-term investments
    
199,171
      
—
      
—
  
Short-term investments held by Symphony Icon, Inc.
    
36,666
      
—
      
—
  
Total cash and cash equivalents and investments
  
$
258,775
    
$
—
    
$
—
  

The table presented below summarizes the change in consolidated balance sheet carrying value associated with Level 3 financial assets for the nine months ended September 30, 2008.
 
   
Long-term Investments
  
   
(in thousands)
  
Balance at December 31, 2007
  
$
—
  
Unrealized losses included in earnings as impairment of long-term investments
    
(3,322
)
Net sales and settlements
    
(21,050
)
Transfers into Level 3
    
78,050
  
Balance at September 30, 2008
  
$
53,678
  
 
7.      Debt Obligations
 
In April 2004, Lexicon obtained a $34.0 million mortgage on its facilities in The Woodlands, Texas.  The mortgage loan has a ten-year term with a 20-year amortization and bears interest at a fixed rate of 8.23%.
 
8.      Commitments and Contingencies
 
A Lexicon subsidiary leases laboratory and office space in Hopewell, New Jersey under an agreement which expires in June 2013.  The lease provides for two five-year renewal options at 95% of the fair market rent and includes escalating lease payments.  Rent expense is recognized on a straight-line basis over the original lease term.  Lexicon is the guarantor of the obligations of its subsidiary under this lease.  The Company is required to maintain restricted investments to collateralize a standby letter of credit for this lease.  The Company had $0.4 million in restricted investments as collateral as of September 30, 2008 and December 31, 2007.
 
 
9.      Comprehensive Loss
 
Comprehensive loss consists of:
 
   
Three Months Ended September 30,
  
   
2008
    
2007
  
   
(in thousands)
  
Net loss
  
$
(23,459
)
  
$
(14,111
)
Unrealized gain (loss) on short-term investments
    
23
      
(153
) 
Net recognized loss on long-term investments included in earnings
    
3,322
      
—
  
Net unrealized change in value of long-term investments
    
82
      
—
  
Net comprehensive loss
  
$
(20,196
)
  
$
(14,264
)

   
Nine Months Ended September 30,
  
   
2008
    
2007
  
   
(in thousands)
  
Net loss
  
$
(61,443
)
  
$
(46,617
)
Unrealized gain (loss) on short-term investments
    
42
      
(146
) 
Net comprehensive loss
  
$
(61,401
)
  
$
(46,763
)
                 
 
 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Overview
 
We are a biopharmaceutical company focused on discovering and developing breakthrough treatments for human disease.  We use our proprietary gene knockout technology to knock out, or disrupt, the function of genes in mice and then employ an integrated platform of advanced medical technologies to systematically discover the physiological and behavioral functions of the genes we have knocked out and assess the utility of the proteins encoded by the corresponding human genes as potential drug targets.  For targets that we believe have high pharmaceutical value, we engage in programs for the discovery and development of potential small molecule, antibody and protein drugs.  We have advanced four drug candidates into human clinical trials, with additional drug candidates in preclinical development and compounds from a number of additional programs in various stages of preclinical research.  We believe that our systematic, target biology-driven approach to drug discovery will enable us to substantially expand our clinical pipeline, and we are engaged in efforts that we refer to as our 10TO10 program with the goal of advancing ten drug candidates into human clinical trials by the end of 2010.
 
We are working both independently and through strategic collaborations and alliances to capitalize on our technology and drug target discoveries and to develop and commercialize drug candidates emerging from our drug discovery and development programs.  We have established alliances with Bristol-Myers Squibb Company to discover and develop novel small molecule drugs in the neuroscience field; with Genentech, Inc. for the discovery of therapeutic proteins and antibody targets and the development of antibody and protein drugs based on those targets; and with N.V. Organon for the discovery of another group of therapeutic proteins and antibody targets and the development and commercialization of antibody and protein drugs based on those targets.  In addition, we have established collaborations and license agreements with other leading pharmaceutical and biotechnology companies, research institutes and academic institutions under which we receive fees and, in some cases, are eligible to receive milestone and royalty payments, in return for granting access to some of our technologies and discoveries for use in the other organization’s own drug discovery efforts.  Finally, we have established a product development financing collaboration with Symphony Icon, Inc. under which we have licensed to Symphony Icon our intellectual property rights to our drug candidates LX6171, LX1031 and LX1032, subject to our exclusive option to reacquire all rights to those drug candidates. We are consolidating the financial condition and results of operations of Symphony Icon in accordance with Financial Accounting Standards Board, or FASB, Interpretation No. 46.
 
We derive substantially all of our revenues from drug discovery and development alliances, target validation collaborations for the development and, in some cases, analysis of the physiological effects of genes altered in knockout mice, academic, non-profit and government arrangements, and technology licenses.  To date, we have generated a substantial portion of our revenues from a limited number of sources.
 
Our operating results and, in particular, our ability to generate additional revenues are dependent on many factors, including our success in establishing collaborations, alliances and technology licenses, expirations of our collaborations and alliances, the success rate of our discovery and development efforts leading to opportunities for new collaborations, alliances and licenses, as well as milestone payments and royalties, the timing and willingness of collaborators to commercialize products which may result in royalties, and general and industry-specific economic conditions which may affect research and development expenditures.  Our future revenues from collaborations, alliances and academic, non-profit and government arrangements are uncertain because our existing agreements have fixed terms or relate to specific projects of limited duration. Our future revenues from technology licenses are uncertain because they depend, in large part, on securing new agreements.  Our ability to secure future revenue-generating agreements will depend upon our ability to address the needs of our potential future collaborators, granting agencies and licensees, and to negotiate agreements that we believe are in our long-term best interests.  We may determine that our interests are better served by retaining rights to our discoveries and advancing our therapeutic programs to a later stage, which could limit our near-term revenues.  Because of these and other factors, 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.
 
Since our inception, we have incurred significant losses and, as of September 30, 2008, we had an accumulated deficit of $472.0 million. Our losses have resulted principally from costs incurred in research and development, general and administrative costs associated with our operations, and non-cash stock-based compensation expenses associated with stock options granted to employees and consultants.  Research and development expenses consist primarily of salaries and related personnel costs, external research costs related to our preclinical and clinical efforts, material costs, facility costs, depreciation on property and equipment, legal expenses resulting from intellectual property prosecution and other expenses related to our drug discovery and development programs, the development and analysis of knockout mice and our other target validation research efforts, and the development of compound libraries. General and administrative expenses consist primarily of salaries and related expenses for executive and administrative personnel, professional fees and other corporate expenses, including information technology, facilities costs and general legal activities.  In connection with the expansion of our drug discovery and development programs and our ongoing target validation research efforts, we expect to incur increasing research and development and general and administrative costs. As a result, we will need to generate significantly higher revenues to achieve profitability.
 
Critical Accounting Policies
 
The preparation of financial statements in conformity with generally accepted accounting principles requires us to make judgments, estimates and assumptions in the preparation of our consolidated financial statements and accompanying notes.  Actual results could differ from those estimates.  We believe there have been no significant changes in our critical accounting policies as discussed in our Annual Report on Form 10-K for the year ended December 31, 2007.
 
Recent Accounting Pronouncements
 
In September 2006, the FASB issued Statement of Financial Accounting Standards, or SFAS, No. 157, “Fair Value Measurements.”  The statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.  This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute.  Accordingly, this statement does not require any new fair value measurements.  More specifically, SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy, which ranks the quality and reliability of the information used to determine fair value.  SFAS No. 157 was effective January 1, 2008 for financial assets and liabilities and will be effective January 1, 2009 for non-financial assets and liabilities.  The adoption of SFAS No. 157 for financial assets and liabilities did not have an effect on our financial condition or results of operations.  We are currently evaluating the effect, if any, of the adoption of this statement for non-financial assets and liabilities on our financial condition and results of operations.
 
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB Statement No. 115,” which provides a fair value option election that permits entities to irrevocably elect to measure many financial instruments and certain other items at fair value, with changes in fair value recognized in earnings as they occur.  SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities.  SFAS No. 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value.  SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007.  Our adoption of SFAS No. 159 on January 1, 2008 did not materially affect our financial position or results of operations.
 
In December 2007, the FASB issued SFAS No. 141(Revised), “Business Combinations,” which replaces SFAS No. 141, “Business Combinations,” and requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. This statement also requires the acquirer in a business combination achieved in stages to recognize the identifiable assets and liabilities, as well as the noncontrolling interest in the acquiree, at the full amounts of their fair values. SFAS No. 141(R) makes various other amendments to authoritative literature intended to provide additional guidance or to confirm the guidance in that literature to that provided in this statement. This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  We expect to adopt this statement on January 1, 2009.  SFAS No. 141(R)’s impact on accounting for business combinations is dependent upon acquisitions, if any, made on or after that time.
 
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” which amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements. SFAS No. 160 establishes accounting and reporting standards that require the ownership interests in subsidiaries not held by the parent to be clearly identified, labeled and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity. This statement also requires the amount of consolidated net income attributable to the parent and to the noncontrolling interest to be clearly identified and presented on the face of the consolidated statement of income. Changes in a parent’s ownership interest while the parent retains its controlling financial interest must be accounted for consistently, and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary must be initially measured at fair value. The gain or loss on the deconsolidation of the subsidiary is measured using the fair value of any noncontrolling equity investment. The statement also requires entities to provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. This statement applies prospectively to all entities that prepare consolidated financial statements and applies prospectively for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. We are currently evaluating the effect, if any, of this statement on our financial condition and results of operations.
 
Results of Operations
 
Revenues
 
Total revenues and dollar and percentage changes as compared to the corresponding period in the prior year are as follows (dollar amounts are presented in millions):
 
   
Three Months Ended September 30,
  
Nine Months Ended September 30,
  
   
2008
  
2007
  
2008
  
2007
  
Total revenues
  
$
7.5
    
$
10.2
  
$
26.0
    
$
36.3
  
Dollar decrease
  
$
(2.7
)
        
$
(10.3
)
        
Percentage decrease
    
(26
)%
          
(28
)%
        
 
 
 
 
·
Collaborative research – Revenue from collaborative research for the three months ended September 30, 2008 decreased 26% to $7.2 million, and for the nine months ended September 30, 2008 decreased 34% to $22.8 million, as compared to the comparable period for the prior year, primarily due to the completion in 2007 of the project funded by our award from the Texas Enterprise Fund, the completion in 2007 of the target discovery portion of our alliance with Takeda Pharmaceutical Company Limited, and reduced revenues in the three and nine months ended September 30, 2008 under our alliance with N.V. Organon due to our progress towards completing the target discovery portion of the alliance.
 
 
·
Subscription and license fees – Revenue from subscriptions and license fees for the three months ended September 30, 2008 decreased 32% to $0.3 million, as compared to the comparable period for the prior year. Revenue from subscriptions and license fees for the nine months ended September 30, 2008 increased 72% to $3.2 million, as compared to the comparable period for the prior year, primarily due to an increase in technology license fees.
 
Research and Development Expenses
 
Research and development expenses and dollar and percentage changes as compared to the corresponding period in the prior year are as follows (dollar amounts are presented in millions):
 
   
Three Months Ended September 30,
  
Nine Months Ended September 30,
  
   
2008
  
2007
  
2008
  
2007
  
Total research and development expense
  
$
27.6
    
$
24.5
  
$
85.8
    
$
77.4
  
Dollar increase
  
$
3.1
          
$
8.4
          
Percentage increase
    
13
%
          
11
%
        

Research and development expenses consist primarily of salaries and other personnel-related expenses, facility and equipment costs, laboratory supplies, third-party and other services principally related to preclinical and clinical development activities, and stock-based compensation expenses.
 
 
·
Personnel – Personnel costs for the three months ended September 30, 2008 decreased 16% to $8.8 million, and for the nine months ended September 30, 2008 decreased 3% to $33.1 million, as compared to the comparable period for the prior year, primarily due to lower salary and benefit costs.  Salaries, bonuses, employee benefits, payroll taxes, recruiting and relocation costs are included in personnel costs.
 
 
·
Facilities and equipment – Facilities and equipment costs for the three months ended September 30, 2008 decreased 1% to $4.7 million,  and for the nine months ended September 30, 2008 decreased 8% to $14.1 million, as compared to the comparable period for the prior year, primarily due to a decrease in depreciation expense.
 
 
·
Laboratory supplies – Laboratory supplies expense for the three months ended September 30, 2008 decreased 29% to $2.0 million, and for the nine months ended September 30, 2008 decreased 24% to $6.7 million, as compared to the comparable period for the prior year, primarily due to reallocating resources from genetic research to drug development and as a result of the reduction in our personnel in May 2008.
 
 
·
Third-party and other services – Third-party and other services for the three months ended September 30, 2008 increased 132% to $10.1 million, and for the nine months ended September 30, 2008 increased 98% to $25.3 million, as compared to the comparable period for the prior year, primarily due to an increase in external preclinical and clinical research and development costs.
 
 
·
Stock-based compensation – Stock-based compensation expense for the three months ended September 30, 2008 decreased 13% to $0.8 million, and for the nine months ended September 30, 2008 decreased 3% to $2.9 million, as compared to the comparable period for the prior year.
 
 
·
Other – Other costs for the three months ended September 30, 2008 were $1.2 million, consistent with the comparable period for the prior year. Other costs for the nine months ended September 30, 2008 increased 6% to $3.7 million, as compared to the comparable period for the prior year.
 
General and Administrative Expenses
 
General and administrative expenses and dollar and percentage changes as compared to the corresponding period in the prior year are as follows (dollar amounts are presented in millions):
 
   
Three Months Ended September 30,
  
Nine Months Ended September 30,
  
   
2008
  
2007
  
2008
  
2007
  
Total general and administrative expense
  
$
4.7
    
$
5.1
  
$
15.8
    
$
15.4
  
Dollar increase (decrease)
  
$
(0.4
)
        
$
0.4
          
Percentage increase (decrease)
    
(8
)%
          
3
%
        

General and administrative expenses consist primarily of personnel costs to support our research and development activities, facility and equipment costs, professional fees such as legal fees, and stock-based compensation expenses.
 
 
·
Personnel – Personnel costs for the three months ended September 30, 2008 decreased 7% to $2.3 million, as compared to the comparable period for the prior year, primarily due to lower salary and benefit costs associated with a reduction in our personnel in May 2008.  Personnel costs for the nine months ended September 30, 2008 increased 4% to $8.4 million, as compared to the comparable period for the prior year, primarily due to higher severance costs associated with reductions in our personnel.  Salaries, bonuses, employee benefits, payroll taxes, recruiting and relocation costs are included in personnel costs.
 
 
·
Facilities and equipment – Facilities and equipment costs for the three months ended September 30, 2008 increased 11% to $0.7 million, as compared to the comparable period for the prior year.  Facilities and equipment costs for the nine months ended September 30, 2008 were $1.9 million, consistent with the comparable period for the prior year.
 
 
·
Professional fees – Professional fees for the three months ended September 30, 2008 decreased 10% to $0.7 million, as compared to the comparable period for the prior year.  Professional fees for the nine months ended September 30, 2008 increased 24% to $2.2 million, as compared to the comparable period for the prior year, primarily due to increased market research and other consulting costs.
 
 
·
Stock-based compensation – Stock-based compensation expense for the three months ended September 30, 2008 was $0.6 million, consistent with the comparable period for the prior year.  Stock-based compensation expense for the nine months ended September 30, 2008 increased 2% to $1.9 million as compared to the comparable period for the prior year.
 
 
·
Other – Other costs for the three months ended September 30, 2008 decreased 26% to $0.4 million, and for the nine months ended September 30, 2008 decreased 16% to $1.5 million, as compared to the comparable period for the prior year.
 
Impairment of Long-term Investments, Interest Income, Interest Expense and Other Expense, Net
 
Impairment of Long-Term Investments.  Impairment of long-term investments was $3.3 million for the three and nine months ended September 30, 2008, representing the other-than-temporary decline in fair value of our student loan auction rate securities.
 
Interest Income.  Interest income for the three months ended September 30, 2008 decreased 56% to $1.0 million, as compared to the comparable period for the prior year, primarily due to lower average cash and investment balances as well as lower yields on our investments. Interest income for the nine months ended September 30, 2008 increased 35% to $5.2 million, as compared to the comparable period for the prior year, due to higher average cash and investment balances.
 
Interest Expense.  Interest expense for the three months ended September 30, 2008 was $0.7 million, consistent with the comparable period for the prior year.  Interest expense for the nine months ended September 30, 2008 decreased 3% to $2.0 million as compared to the comparable period for the prior year.
 
Other Expense, Net.  Other expense, net was $0.5 million and $1.6 million in the three and nine months ended September 30, 2008, respectively, primarily due to the amortization of the asset related to the option to purchase the equity of Symphony Icon.  We have recorded the value of the purchase option as an asset, and we are amortizing this asset over the four-year option period.
 
Noncontrolling Interest in Symphony Icon, Inc.
 
For the three months ended September 30, 2008 and 2007, the losses attributable to the noncontrolling interest holders of Symphony Icon were $4.9 million and $3.9 million, respectively.  For the nine months ended September 30, 2008 and 2007, the losses attributed to the noncontrolling interest holders of Symphony Icon were $16.0 million and $8.2 million, respectively.
 
Net Loss and Net Loss per Common Share
 
Net loss increased to $23.5 million in the three months ended September 30, 2008 from $14.1 million in the comparable period for the prior year.  Net loss per common share increased to $0.17 in the three months ended September 30, 2008 from $0.14 in the comparable period for the prior year.  Net loss increased to $61.4 million in the nine months ended September 30, 2008 from $46.6 million in the comparable period for the prior year.  Net loss per common share decreased to $0.45 in the nine months ended September 30, 2008 from $0.53 in the comparable period for the prior year.
 
Our quarterly operating results have fluctuated in the past and are likely to do so in the future, and we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.
 
Liquidity and Capital Resources
 
We have financed our operations from inception primarily through sales of common and preferred stock, contract and milestone payments to us under our drug discovery alliance, target validation, database subscription and license agreements, government grants and contracts, and financing obtained under debt and lease arrangements.  From our inception through September 30, 2008, we had received net proceeds of $550.0 million from issuances of common and preferred stock, including $203.2 million of net proceeds from the initial public offering of our common stock in April 2000, $50.1 million from our July 2003 common stock offering, $37.5 million from our October 2006 common stock offering and $198.0 million from our August 2007 sale of common stock to Invus, L.P.  In addition, from our inception through September 30, 2008, we received $437.4 million in cash payments from drug discovery and development alliances, target validation collaborations, database subscription and technology license fees, sales of compound libraries and reagents, and government grants and contracts, of which $417.6 million had been recognized as revenues through September 30, 2008.
 
As of September 30, 2008, we had $177.3 million in cash, cash equivalents and investments, including $53.7 million in auction rate securities as discussed below under “Disclosure about Market Risk,” and $21.1 million in investments held by Symphony Icon.  As of December 31, 2007, we had $222.1 million in cash, cash equivalents and short-term investments, including $78.0 million in auction rate securities, and $36.7 million in investments held by Symphony Icon.  We used cash of $75.9 million in operations in the nine months ended September 30, 2008. This consisted primarily of the net loss for the period of $61.4 million, a $16.0 million loss attributable to noncontrolling interest, a $13.3 million decrease in deferred revenue, and a net increase in other operating assets net of liabilities of $0.9 million, partially offset by non-cash charges of $6.1 million related to depreciation expense, $4.8 million related to stock-based compensation expense, $3.3 million related to impairment of long-term investments and $1.6 million related to the amortization of the Symphony Icon purchase option.  Investing activities provided cash of $153.8 million in the nine months ended September 30, 2008, primarily due to net maturities of investments of $155.5 million, partially offset by purchases of property and equipment of $1.7 million.  Financing activities used cash of $0.6 million primarily due to principal repayments of $0.7 million on the mortgage loan.
 
In June 2007, we entered into a securities purchase agreement with Invus, L.P, pursuant to which Invus purchased 50,824,986 shares of our common stock for approximately $205.4 million in August 2007.  This purchase resulted in Invus’ ownership of 40% of the post-transaction outstanding shares of our common stock.  Pursuant to the securities purchase agreement, Invus, at its option, also has the right to require us to initiate up to two pro rata rights offerings to our stockholders, which would provide all stockholders with non-transferable rights to acquire shares of our common stock, in an aggregate amount of up to $344.5 million, less the proceeds of any “qualified offerings” that we may complete in the interim involving the sale of our common stock at prices above $4.50 per share.  Invus may exercise its right to require us to conduct the first rights offering by giving us notice within a period of 90 days beginning on November 28, 2009 (which we refer to as the first rights offering trigger date), although we and Invus may agree to change the first rights offering trigger date to as early as August 28, 2009 with the approval of the members of our board of directors who are not affiliated with Invus.  Invus may exercise its right to require us to conduct the second rights offering by giving us notice within a period of 90 days beginning on the date that is 12 months after Invus’ exercise of its right to require us to conduct the first rights offering or, if Invus does not exercise its right to require us to conduct the first rights offering, within a period of 90 days beginning on the first anniversary of the first rights offering trigger date.  The initial investment and subsequent rights offerings, combined with any qualified offerings, were designed to achieve up to $550 million in proceeds to us.  Invus would participate in each rights offering for up to its pro rata portion of the offering, and would commit to purchase the entire portion of the offering not subscribed for by other stockholders.
 
In connection with the securities purchase agreement, we entered into a stockholders’ agreement with Invus under which Invus (a) has specified rights with respect to designation of directors and participation in future equity issuances by us, (b) is subject to certain standstill restrictions, as well as restrictions on transfer and the voting of the shares of common stock held by it and its affiliates, and (c), as long as Invus holds at least 15% of the total number of outstanding shares of our common stock, is entitled to certain minority protections.
 
In June 2007, we entered into a series of related agreements providing for the financing of the clinical development of LX6171, LX1031 and LX1032, along with any other pharmaceutical compositions modulating the same targets as those drug candidates.  Under the financing arrangement, we licensed to Symphony Icon, a wholly-owned subsidiary of Symphony Icon Holdings LLC, our intellectual property rights related to the programs and Holdings contributed $45 million to Symphony Icon in order to fund the clinical development of the programs.  We also entered into a share purchase agreement with Holdings under which we issued and sold to Holdings 7,650,622 shares of our common stock in exchange for $15 million and an exclusive option to acquire all of the equity of Symphony Icon, thereby allowing us to reacquire the programs.  The purchase option is exercisable by us at any time, in our sole discretion, beginning on June 15, 2008 and ending on June 15, 2011 (subject to an earlier exercise right in limited circumstances) at an exercise price of (a) $72 million, if the purchase option is exercised on or after June 15, 2008 and before June 15, 2009, (b) $81 million, if the purchase option is exercised on or after June 15, 2009 and before June 15, 2010 and (c) $90 million, if the purchase option is exercised on or after June 15, 2010 and before June 15, 2011.  The purchase option exercise price may be paid in cash or a combination of cash and common stock, at our sole discretion, provided that the common stock portion may not exceed 40% of the purchase option exercise price.
 
Upon the recommendation of Symphony Icon’s development committee, which is comprised of an equal number of representatives from us and Symphony Icon, Symphony Icon’s board of directors may require us to pay Symphony Icon up to $15 million for Symphony Icon’s use in the development of the programs in accordance with the specified development plan and related development budget.  The development committee’s right to recommend that Symphony Icon’s board of directors submit such funding requirement to us will terminate on the one-year anniversary of the expiration of the purchase option, subject to limited exceptions.
 
In April 2004, we obtained a $34.0 million mortgage on our facilities in The Woodlands, Texas.  The mortgage loan has a ten-year term with a 20-year amortization and bears interest at a fixed rate of 8.23%.  In May 2002, our subsidiary Lexicon Pharmaceuticals (New Jersey), Inc. leased a 76,000 square-foot laboratory and office space in Hopewell, New Jersey.  The term of the lease extends until June 30, 2013.  The lease provides for an escalating yearly base rent payment of $1.3 million in the first year, $2.1 million in years two and three, $2.2 million in years four to six, $2.3 million in years seven to nine and $2.4 million in years ten and eleven.  We are the guarantor of the obligations of our subsidiary under the lease.
 
Our future capital requirements will be substantial and will depend on many factors, including our ability to obtain alliance, collaboration and technology license agreements, the amount and timing of payments under such agreements, the level and timing of our research and development expenditures, market acceptance of our products, the resources we devote to developing and supporting our products and other factors.  Our capital requirements will also be affected by any expenditures we make in connection with license agreements and acquisitions of and investments in complementary technologies and businesses.  We expect to devote substantial capital resources to continue our research and development efforts, to expand our support and product development activities, and for other general corporate activities. We believe that our current unrestricted cash and investment balances and cash and revenues we expect to derive from drug discovery and development alliances, target validation collaborations, government grants and contracts, and technology licenses will be sufficient to fund our operations for at least the next 12 months. During or after this period, if cash generated by operations is insufficient to satisfy our liquidity requirements, we will need to sell additional equity or debt securities or obtain additional credit arrangements. Additional financing may not be available on terms acceptable to us or at all. The sale of additional equity or convertible debt securities may result in additional dilution to our stockholders.
 
Disclosure about Market Risk
 
We are exposed to limited market and credit risk on our cash equivalents which have maturities of three months or less at the time of purchase. We maintain a short-term investment portfolio which consists of U.S. Treasury bills, money market accounts, corporate debt securities and certificates of deposit that mature three to 12 months from the time of purchase and a long-term investment portfolio which consists of auction rate securities that mature greater than 12 months from the time of purchase, which we believe are subject to limited market and credit risk, other than as discussed below.  We currently do not hedge interest rate exposure or hold any derivative financial instruments in our investment portfolio.
 
At September 30, 2008, we held $57.0 million (par value), with an estimated fair value of $53.7 million, of AAA-rated investments with an auction interest rate reset feature, known as auction rate securities.  These notes are issued by various state agencies for the purpose of financing student loans.  The securities have historically traded at par and are redeemable at par plus accrued interest at the option of the issuer. Interest is typically paid at the end of each auction period or semiannually.  Until February 2008, the market for our auction rate securities was highly liquid. Starting in February 2008, a substantial number of auctions “failed,” meaning that there was not enough demand to sell all of the securities that holders desired to sell at auction. The immediate effect of a failed auction is that such holders cannot sell the securities at auction and the interest rate on the security generally resets to a maximum interest rate. In the case of funds invested by Lexicon in auction rate securities which are the subject of a failed auction, we may not be able to access the funds without a loss of principal, unless a future auction on these investments is successful or the issuer redeems the security.  As of September 30, 2008, we classified the entire auction rate security investment balance as long-term investments on our consolidated balance sheet because of our inability to determine when our investments in auction rate securities would be sold.  We have also modified our current investment strategy to reallocate our investments more into U.S. treasury securities and U.S. treasury-backed money market investments.
 
At September 30, 2008, observable auction rate securities market information was not available to determine the fair value of our investments. We have estimated the fair value of these securities at $53.7 million as of September 30, 2008 using models of the expected future cash flows related to the securities and taking into account probability-weighted assumptions about the cash flows of the underlying student loans.  For each of our auction rate securities, we evaluated the risks related to the structure, collateral and liquidity of the investment, and forecasted the probability of a successful auction or a redemption at par, issuer default and auction failure for each future auction period.  The assumptions used in preparing the discounted cash flow model include estimates of interest rates, timing and amount of cash flows, liquidity premiums and expected holding periods of the auction rate securities, based on data available as of September 30, 2008.  These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change.  Because we do not intend to hold these securities until the par value is recoverable and we believe the decline in fair value is other-than-temporary, we recorded a loss of $3.3 million in the three and nine months ended September 30, 2008 to reflect the decline in value of these securities.  This loss is shown as impairment of long-term investments in the consolidated statements of operations.  If the current market conditions deteriorate further, or a recovery in market values does not occur, we may be required to record additional unrealized or realized losses in future quarters.
 
In August 2008, the investment bank that sold us the auction rate securities we currently hold announced a settlement, in principle, with the Securities and Exchange Commission and other state regulatory agencies pursuant to which it has offered us rights to require the bank to purchase such auction rate securities from us at par value beginning in June 2010.  We are also eligible to borrow from an affiliate of the bank at no net cost up to 75% of the market value of the auction rate securities, which loans would become payable upon the bank’s purchase of the auction rate securities.  We are currently evaluating our options with respect to such offer.
 
Excluding auction rate securities, at September 30, 2008, we had approximately $123.6 million in cash and cash equivalents and short-term investments, including $21.1 million in investments held by Symphony Icon.  We believe that the working capital available to us excluding the funds held in auction rate securities will be sufficient to meet our cash requirements for at least the next 12 months.
 
We have operated primarily in the United States and substantially all sales to date have been made in U.S. dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
 
Quantitative and Qualitative Disclosures about Market Risk
 
See “Disclosure about Market Risk” under “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for quantitative and qualitative disclosures about market risk.
 
Controls and Procedures
 
Our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are sufficiently effective to ensure that the information required to be disclosed by us in the reports we file under the Securities Exchange Act is gathered, analyzed and disclosed with adequate timeliness, accuracy and completeness, based on an evaluation of such controls and procedures as of the end of the period covered by this report.
 
Subsequent to our evaluation, there were no significant changes in internal controls or other factors that could significantly affect internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
 
Other Information
 
Item 1A.                      Risk Factors
 
The following risks and uncertainties are important factors that could cause actual results or events to differ materially from those indicated by forward-looking statements.  The factors described below 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 our business operations.
 
Risks Related to Our Need for Additional Financing and Our Financial Results
 
 
·
we will need additional capital in the future; if it is unavailable, we will be forced to significantly curtail or cease operations and, if it is not available on reasonable terms, we will be forced to obtain funds by entering into financing agreements on unattractive terms
 
 
·
we have a history of net losses, and we expect to continue to incur net losses and may not achieve or maintain profitability
 
 
·
we have licensed the intellectual property, including commercialization rights, to our drug candidates LX6171, LX1031 and LX1032 to Symphony Icon and will not receive any future royalties or revenues with respect to these drug candidates unless we exercise our option to purchase Symphony Icon
 
 
·
at September 30, 2008, we held $57.0 million (par value), with an estimated fair value of $53.7 million, of auction rate securities for which auctions have failed and, as a result, we may not be able to access these funds without a loss of principal
 
 
·
our operating results have been and likely will continue to fluctuate, and we believe that period-to-period comparisons of our operating results are not a good indication of our future performance
 
Risks Related to Discovery and Development of Our Drug Candidates
 
 
·
we are an early-stage company, and have not proven our ability to successfully develop and commercialize drug candidates based on our drug target discoveries
 
 
·
clinical testing of our drug candidates in humans is an inherently risky and time-consuming process that may fail to demonstrate safety and efficacy, which could result in the delay, limitation or prevention of regulatory approval
 
Risks Related to Our Relationships with Third Parties
 
 
·
disagreements with Symphony Icon regarding the development of our drug candidates LX6171, LX1031 or LX1032 could negatively affect or delay their development
 
 
·
we are dependent in many ways upon our collaborations with major pharmaceutical companies, and if we are unable to achieve milestones under those collaborations or if our collaborators’ efforts fail to yield pharmaceutical products on a timely basis, our opportunities to generate revenues and earn royalties will be reduced
 
 
·
conflicts with our collaborators could jeopardize the success of our collaborative agreements and harm our product development efforts
 
 
 
·
we lack the capability to manufacture materials for preclinical studies, clinical trials or commercial sales and rely on third parties to manufacture our drug candidates, which may harm or delay our product development and commercialization efforts
 
 
·
we rely on third parties to carry out drug development activities
 
Risks Related to Regulatory Approval of Our Drug Candidates
 
 
·
our drug candidates are subject to a lengthy and uncertain regulatory process that may not result in the necessary regulatory approvals, which could adversely affect our ability to commercialize products
 
 
·
if our potential products receive regulatory approval, we or our collaborators will remain subject to extensive and rigorous ongoing regulation
 
Risks Related to Commercialization of Products
 
 
·
the commercial success of any products that we may develop will depend upon the degree of market acceptance of our products among physicians, patients, health care payors, private health insurers and the medical community
 
 
·
if we are unable to establish sales and marketing capabilities or enter into agreements with third parties to market and sell our drug candidates, we may be unable to generate product revenues
 
 
·
if we are unable to obtain adequate coverage and reimbursement from third-party payors for any products that we may develop, our revenues and prospects for profitability will suffer
 
 
·
our competitors may develop products and technologies that make our products and technologies obsolete
 
 
·
we may not be able to manufacture our drug candidates in commercial quantities, which would prevent us from commercializing our drug candidates
 
Risks Related to Our Intellectual Property
 
 
·
if we are unable to adequately protect our intellectual property, third parties may be able to use our technology, which could adversely affect our ability to compete in the market
 
 
·
we may be involved in patent litigation and other disputes regarding intellectual property rights and may require licenses from third parties for our discovery and development and planned commercialization activities, and we may not prevail in any such litigation or other dispute or be able to obtain required licenses
 
 
·
we use intellectual property that we license from third parties, and if we do not comply with these licenses, we could lose our rights under them
 
 
·
we have not sought patent protection outside of the United States for some of our inventions, and some of our licensed patents only provide coverage in the United States, and as a result, our international competitors could be granted foreign patent protection with respect to our discoveries
 
 
·
we may be subject to damages resulting from claims that we, our employees or independent contractors have wrongfully used or disclosed alleged trade secrets of their former employers
 
 
Risks Related to Employees, Growth and Facilities Operations
 
 
·
the loss of key personnel or the inability to attract and retain additional personnel could impair our ability to expand our operations
 
 
·
our collaborations with outside scientists may be subject to restriction and change
 
 
·
difficulties we may encounter managing our growth may divert resources and limit our ability to successfully expand our operations
 
 
·
security breaches may disrupt our operations and harm our operating results
 
 
·
any contamination among our knockout mouse population could negatively affect the reliability of our scientific research or cause us to incur significant remedial costs
 
 
·
because all of our target validation operations are located at a single facility, the occurrence of a disaster could significantly disrupt our business
 
Risks Related to Environmental and Product Liability
 
 
·
we use hazardous chemicals and radioactive and biological materials in our business, and any claims relating to improper handling, storage or disposal of these materials could be time consuming and costly
 
 
·
we may be sued for product liability
 
Risks Related to Our Common Stock
 
 
·
our stock price may be extremely volatile
 
 
·
we may engage in future acquisitions, which may be expensive and time consuming and from which we may not realize anticipated benefits
 
 
·
future sales of our common stock may depress our stock price
 
 
·
Invus’ ownership of our common stock and its other rights under the stockholders’ agreement we entered into in connection with Invus’ $205.4 million initial investment in our common stock provide Invus with substantial influence over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, as well as other corporate matters
 
For additional discussion of the risks and uncertainties that affect our business, see “Item 1A. Risk Factors” included in our annual report on Form 10-K for the year ended December 31, 2007, as filed with the Securities and Exchange Commission.
 
Item 6.                                Exhibits
 
Exhibit No.
  
Description
31.1
—
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
—
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
—
Certification of Principal Executive and Principal Financial Officers Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
Signatures
 

Pursuant to the requirements 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.
 

 
Lexicon Pharmaceuticals, Inc.
     
Date:  October 31, 2008
By:
/s/ Arthur T. Sands
   
Arthur T. Sands, M.D., Ph.D.
   
President and Chief Executive Officer

Date:  October 31, 2008
By:
/s/ James F. Tessmer
   
James F. Tessmer
   
Vice President, Finance and Accounting


Index to Exhibits
 

 
Exhibit No.
  
Description
31.1
—
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
—
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
—
Certification of Principal Executive and Principal Financial Officers Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002