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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)

Commission file number 0-19125

Isis Pharmaceuticals, Inc.

(Exact name of Registrant as specified in its charter)

1896 Rutherford Road, Carlsbad, CA 92008

(Address of principal executive offices, including zip code)

760-931-9200

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 Par Value

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12(b)-2 of the Securities Exchange Act of 1934). Yes o No x

The number of shares of voting common stock outstanding as of May 4, 2009 was 98,130,347.

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ISIS PHARMACEUTICALS, INC.
FORM 10-Q

INDEX

TRADEMARKS

Isis Pharmaceuticals® is a registered trademark of Isis Pharmaceuticals, Inc.

Regulus Therapeutics™ is a trademark of Regulus Therapeutics Inc.

Ibis T5000™ is a trademark of Ibis Biosciences, Inc.

Vitravene® is a registered trademark of Novartis AG.

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(1)       The Condensed Consolidated Balance Sheet at December 31, 2008 has been derived from the audited financial statements as adjusted for the required retroactive adoption of FSP 14-1 and SFAS 160.

See accompanying notes

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except for per share amounts)

(Unaudited)

(1)       Adjusted for the required retroactive adoption of FSP 14-1 and SFAS 160.

See accompanying notes.

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

See accompanying notes.

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ISIS PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2009

(Unaudited)

1.                                      Basis of Presentation

The unaudited interim condensed consolidated financial statements for the three month periods ended March 31, 2009 and 2008 have been prepared on the same basis as the audited financial statements for the year ended December 31, 2008. The financial statements include all normal recurring adjustments, which we consider necessary for a fair presentation of the financial position at such dates and the operating results and cash flows for those periods. The condensed consolidated financial statements have been adjusted for the required retroactive adoption of Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement), (“FSP 14-1”) and Statement of Financial Accounting Standards (“SFAS”) 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment to ARB No. 51.  See Note 5, Long-Term Obligations for additional information about FSP 14-1. Results for the interim periods are not necessarily indicative of the results for the entire year. For more complete financial information, these financial statements, and notes thereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2008 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).

The condensed consolidated financial statements include the accounts of Isis Pharmaceuticals, Inc. (“we”, “us” or “our”), our wholly owned subsidiaries, Isis USA Ltd. and Symphony GenIsis, Inc.  In addition to our wholly owned subsidiaries, our condensed consolidated financial statements include one variable interest entity, Regulus Therapeutics Inc., for which we are the primary beneficiary as defined by Financial Accounting Standards Board Interpretation (“FIN”) 46R (revised 2003), Consolidation of Variable Interest Entities, an Interpretation of ARB 51.  As a result of completing the sale of Ibis Biosciences, Inc. to Abbott Molecular Inc., or AMI, in January 2009, we have presented Ibis’ financial position and results of operations separately as discontinued operations in our condensed consolidated financial statements in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. We have reclassified amounts in the prior period financial statements to conform to the current period presentation.  Prior to the sale of Ibis, we identified Ibis as a variable interest entity that we consolidated.  All significant intercompany balances and transactions have been eliminated.

2.                                      Significant Accounting Policies

Revenue recognition

We follow the provisions as set forth by Staff Accounting Bulletin (“SAB”) 101, “Revenue Recognition in Financial Statements,” SAB 104, “Revenue Recognition,” and Financial Accounting Standards Board Emerging Issues Task Force (“EITF”) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.”

We generally recognize revenue when we have satisfied all contractual obligations and are reasonably assured of collecting the resulting receivable. We are often entitled to bill our customers and receive payment from our customers in advance of recognizing the revenue under current accounting rules. In those instances where we have received payment from our customers in advance of recognizing revenue, we include the amounts in deferred revenue on the consolidated balance sheet.

Research and development revenue under collaborative agreements

We often enter into collaborations where we receive non-refundable upfront payments for prior or future expenditures. We recognize revenue related to upfront payments ratably over our period of performance relating to the term of the contractual arrangements. Occasionally, we are required to estimate our period of performance when the agreements we enter into do not clearly define such information.  The revenue we recognize could be materially different if different estimates prevail. To date, we have not had to make material adjustments to our estimates. We have made estimates of our continuing obligations on several agreements. Our collaborative agreements typically include a research and/or development project plan that includes the activities the agreement requires each party to perform during the collaboration and the party responsible for performing them. We estimate the period of time over which we will complete the activities for which we are responsible and use that period of time as our period of performance for purposes of revenue recognition and amortize revenue over such period. When our collaborators have asked us to continue performing work in a collaboration beyond the initial period of performance, we have extended our amortization period to correspond to the new extended period of performance. In no case have adjustments to performance periods and related adjustments to revenue amortization periods had a material impact on our revenue.

Our collaborations often include contractual milestones. When we achieve these milestones, we are entitled to payment, according to the underlying agreements. We generally recognize revenue related to milestone payments upon completion of the milestone’s substantive performance requirement, as long as we are reasonably assured of collecting the resulting receivable and we have no future performance obligations related to the achievement of the milestone.

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We generally recognize revenue related to the sale of our drug inventory as we ship or deliver drugs to our partners. In several instances, we completed the manufacturing of drugs, but our partners asked us to deliver the drug on a later date. Under these circumstances, we ensured that we had met the provisions in SAB 104 before we recognized the related revenue.

We often enter into revenue arrangements that contain multiple deliverables. In these cases, we recognize revenue from each element of the arrangement as long as we are able to determine a separate fair value for each element, we have completed our obligation to deliver or perform on that element and we are reasonably assured of collecting the resulting receivable.

As part of our Genzyme strategic alliance, in February 2008 Genzyme Corporation made a $150 million equity investment in us by purchasing 5 million shares of our common stock at $30 per share. The price Genzyme paid for our common stock represented a significant premium over the fair value of our stock.  Using a Black-Scholes option valuation model, we determined that the value of the premium was $100 million, which represents value Genzyme gave to us to help fund the companies’ research collaboration, which began in January 2008.  We accounted for this premium as deferred revenue and are amortizing it along with the $175 million licensing fee that we received in June 2008 ratably into revenue until June 2012, which represents the end of our performance obligation based on the research and development plan included in the agreement.

Licensing and royalty revenue

We often enter into agreements to license our proprietary patent rights on an exclusive or non-exclusive basis in exchange for license fees and/or royalties. We generally recognize as revenue immediately those licensing fees and royalties for which we have no future significant performance obligations and are reasonably assured of collecting the resulting receivable.

Short-term investments

We have equity investments in privately- and publicly-held biotechnology companies.  We hold ownership interests of less than 20% in each of the respective entities except Regulus, our majority owned subsidiary, which we consolidate with our financial results. In determining if and when a decrease in market value below our cost in our equity positions is temporary or other-than-temporary, we examine historical trends in the stock price, the financial condition of the issuer, near term prospects of the issuer and our current need for cash.  We record unrealized gains and losses related to temporary declines in the publicly-held companies as a separate component of stockholders’ equity and account for securities in the privately-held companies under the cost method of accounting according to Accounting Principles Board (“APB”) 18, The Equity Method of Accounting for Investments in Common Stock. When we determine that a decline in value is other-than-temporary, we recognize an impairment loss in the period in which the other-than-temporary decline occurs.  We determined that there were no other-than-temporary declines in value of our investments during the three months ended March 31, 2009 and 2008.

Inventory valuation

In accordance with SFAS 2, Accounting for Research and Development Costs, we capitalize the costs of raw materials that we purchase for use in producing our drugs because until we use these raw materials they have alternative future uses. We include in inventory raw material costs and related manufacturing costs for drugs that we manufacture for our partners under contractual terms and that we use primarily in our clinical development activities and drug products. We can use each of our raw materials in multiple products and, as a result, each raw material has future economic value independent of the development status of any single drug. For example, if one of our drugs failed, we could use the raw materials allocated for that drug to manufacture our other drugs. We expense these costs when we deliver the drugs to our partners, or as we provide these drugs for our own clinical trials. We reflect our inventory on the balance sheet at the lower of cost or market value under the first-in, first-out method. We review inventory periodically and reduce the carrying value of items we consider to be slow moving or obsolete to their estimated net realizable value. We consider several factors in estimating the net realizable value, including shelf life of raw materials, alternative uses for our drugs and clinical trial materials and historical write-offs.  We did not record any inventory write-offs during the first three months of 2009 and 2008.  Total inventory, which consisted of raw materials, was $2.6 million and $2.7 million as of March 31, 2009 and December 31, 2008, respectively.

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Patents

We capitalize costs consisting principally of outside legal costs and filing fees related to obtaining patents. We review our capitalized patent costs regularly to ensure that they include costs for patent applications that have future value. We evaluate costs related to patents that we are not actively pursuing and write off any of these costs, if appropriate. We amortize patent costs over their estimated useful lives of ten years, beginning with the date the United States Patent and Trademark Office issues the patent. For the first quarter of 2009 and 2008, we recorded a non-cash charge of $186,000 and $96,000, respectively, which we included in research and development expenses, related to the assignment of patents to certain of our partners and the write-down of our patent costs to their estimated net realizable values.

Long-lived assets

We assess the value of our long-lived assets, which include property, plant and equipment, patent costs, and licenses acquired from third parties, under the provisions set forth by SFAS 144 and we evaluate our long-lived assets for impairment on at least a quarterly basis.

Use of estimates

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.  Historically, our estimates have been accurate as we have not experienced any material differences between our estimates and our actual results.

Basic and diluted net income (loss) per share

We follow the provisions of SFAS 128, Earnings per Share. We compute basic net income (loss) per share by dividing the net income (loss) by the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share reflects the potential dilution that could occur from the following items:

·                  25/8% convertible subordinated notes;

·                  GSK convertible promissory note;

·                  Dilutive stock options; and

·                  Warrants issued to Symphony GenIsis Holdings LLC

Computations for basic and diluted net income (loss) per share are as follows:  (in thousands, except per share amounts)

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As we incurred a loss for the three months ended March 31, 2008, we did not include diluted common equivalent shares in the computation of diluted net loss per share because the effect would be anti-dilutive.

Consolidation of variable interest entities

We have implemented the provisions of FIN 46R, which addresses consolidation by business enterprises of variable interest entities either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. As of March 31, 2009, we had collaborative arrangements with eight entities that we consider to be variable interest entities under FIN 46R. For the three months ended March 31, 2009, our condensed consolidated financial statements include one variable interest entity, Regulus, for which we were the primary beneficiary.  For the three months ended March 31, 2008, our condensed consolidated financial statements include two variable interest entities, Ibis and Regulus, for which we were the primary beneficiary.  Prior to completing the sale of Ibis to AMI in January 2009, we identified Ibis as a variable interest entity that we consolidated.

Noncontrolling Interests

On January 1, 2009, we adopted SFAS 160.  This statement recharacterizes the accounting and reporting for minority interests as noncontrolling interests and classifies them as a component of stockholders’ equity.  Although the adoption of SFAS 160 did not impact our results of operations and financial position, SFAS 160 required us to reclassify noncontrolling interests as stockholders’ equity, include the net loss attributable to noncontrolling interests as part of our consolidated net income (loss) and provide additional disclosures as part of our financial statements.  As required by SFAS 160, we implemented the presentation and disclosure requirements of this new standard retrospectively to all periods presented.

The following table presents the statement of changes in stockholders’ equity in conformity with the requirements of SFAS 160 for the quarter ended March 31, 2009 (in thousands):

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The following table presents the statement of changes in stockholders’ equity in conformity with the requirements of SFAS 160 for the quarter ended March 31, 2008 (in thousands):

Convertible debt

On January 1, 2009, we adopted FSP 14-1.  This standard requires us to account for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) by separating the liability and equity components of the instruments in a manner that reflects our nonconvertible debt borrowing rate when we recognize interest cost in subsequent periods.  Using the provisions of FSP 14-1, we assigned a value to the debt component of our 2 5/8% convertible notes equal to the estimated fair value of a similar debt instrument without the conversion feature, which resulted in us recording the debt at a discount.  We are amortizing the resulting debt discount over the life of the debt as additional non-cash interest expense.  As required by FSP 14-1, we implemented this standard retrospectively to all periods presented.  For additional information about FSP 14-1, see Note 5, Long-Term Obligations.

Stock-based compensation expense

We account for our stock-based compensation expense related to employee stock options and employee stock purchases under SFAS 123R, Share-Based Payment.  We estimate the fair value of each stock option grant and the employee stock purchase plan (“ESPP”) purchase rights on the date of grant using the Black-Scholes model.  The expected term of stock options granted represents the period of time that they are expected to be outstanding.  We estimated the expected term of options granted based on historical exercise patterns.

For the quarter ended March 31, 2009 and 2008, we used the following weighted-average assumptions in our Black-Scholes calculations:

Employee Stock Options:

ESPP:

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We record stock options granted to non-employees, which consist primarily of options granted to Regulus’ Scientific Advisory Board, at their fair value in accordance with the requirements of SFAS 123R, then periodically remeasure them in accordance with EITF 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and recognize the expense over the service period.

Stock-based compensation expense for the three months ended March 31, 2009 and 2008 (in thousands, except per share data) was allocated as follows:

As part of our Regulus joint venture, both we and Alnylam Pharmaceuticals, Inc. issued our own company’s stock options to members of Regulus’ Board of Directors and Scientific Advisory Board.  In addition, we and Alnylam issued our own company’s stock options to those employees of each company who were seconded to Regulus under the three companies’ limited liability agreement.  These employees became Regulus employees in January 2009 as part of Regulus’ conversion to a C-Corporation.  As part of the conversion, both we and Alnylam modified our own company’s stock options issued to Regulus’ employees, members of Regulus’ Board of Directors and Scientific Advisory Board to stop vesting in these stock awards before the awards were fully vested.  Additionally, in February 2009, Regulus issued options to purchase its own common stock to Regulus’ employees, members of Regulus’ Board of Directors and members of Regulus’ Scientific Advisory Board.  Consistent with our accounting policies discussed above, Regulus accounts for these options using SFAS 123R for employees and members of Regulus’ Board of Directors and EITF 96-18 for members of Regulus’ Scientific Advisory Board.  Regulus records the expenses associated with these options on its books.

As of March 31, 2009, total unrecognized compensation cost related to non-vested stock-based compensation plans was $18.5 million.  We will adjust total unrecognized compensation cost for future changes in estimated forfeitures.  We expect to recognize this cost over a weighted average period of 1.5 years.

Impact of recently issued accounting standards

On April 9, 2009, the Financial Accounting Standards Board (“FASB”) issued three FSPs intended to provide additional application guidance and enhanced disclosures regarding fair value measurements and other-than-temporary impairments of securities.

·     FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, provides guidelines for making fair value measurements more consistent with the principles presented in SFAS 157, Fair Value Measurements. FSP FAS 157-4 must be applied prospectively.

·     FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on debt securities. FSP FAS 115-2 and FAS 124-2 must be applied retrospectively.

·     FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, enhances consistency in financial reporting by increasing the frequency of fair value disclosures. FSP FAS 107-1 and APB 28-1 must be applied prospectively.

These FSPs are effective for interim and annual periods ending after June 15, 2009, which will be effective for our quarter ending June 30, 2009.  We are currently evaluating what the impact of adopting these FSPs will have on our condensed consolidated financial statements.

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3.                                      Discontinued Operations

In 2008, AMI purchased approximately 18.6% of the issued and outstanding common stock of Ibis for a total purchase price of $40 million.  In December 2008, we, Ibis and AMI executed a stock purchase agreement (the “Stock Purchase Agreement”).  Under the Stock Purchase Agreement, AMI purchased the remaining equity in Ibis from us for $175 million.  We, Ibis and AMI completed the acquisition on January 6, 2009.

We reflect Ibis as a discontinued operation because Ibis meets the criteria for a component of an entity under SFAS 144.  Accordingly, we have presented the operating results of Ibis in our Condensed Consolidated Statements of Operations as discontinued operations and we have reclassified all prior periods.  Net income from discontinued operations in the first quarter of 2009 primarily consists of the $202.5 million gain related to the sale of Ibis to AMI less $30.7 million of income tax expense.  The components of discontinued operations for the periods presented are as follows (in thousands):

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At December 31, 2008, we had the following assets and liabilities as assets and liabilities from discontinued operations in our accompanying Condensed Consolidated Balance Sheets (in thousands):

As permitted by SFAS 95, Statement of Cash Flows, we have not separately classified cash flows from discontinued operations in our Condensed Consolidated Statement of Cash Flows.

4.                                    Fair Value Measurements

In September 2006, the FASB issued SFAS 157, Fair Value Measurements.  SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements.  We adopted the provisions of SFAS 157 on January 1, 2008.  Although the adoption of SFAS 157 did not impact our financial condition, results of operations, or cash flow, SFAS 157 requires us to provide additional disclosures as part of our financial statements.

SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value.  These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets, which includes our money market funds and treasury securities classified as available-for-sale securities and equity securities in publicly-held biotechnology companies; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable, which includes our fixed income securities and commercial paper classified as available-for-sale securities; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

We measure our assets and liabilities that SFAS 157 requires us to measure at fair value on a recurring basis using the following inputs in accordance with SFAS 157 at March 31, 2009 (in thousands):

(1)          Included in cash and cash equivalents and short-term investments on our Condensed Consolidated Balance Sheet.

(2)          Included in other current assets on our Condensed Consolidated Balance Sheet.

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5.                                    Long-Term Obligations

Convertible Subordinated Notes

In January 2007, we completed a $162.5 million convertible debt offering, which raised proceeds of approximately $157.1 million, net of $5.4 million in issuance costs. We included the issuance costs in our balance sheet and are amortizing these costs to interest expense over the life of the debt. The $162.5 million convertible subordinated notes mature in 2027 and bear interest at 25¤8%, which is payable semi-annually. The 25¤8% notes are convertible, at the option of the note holders, into approximately 11.1 million shares of our common stock at a conversion price of $14.63 per share. At December 31, 2008, the principal and accrued interest outstanding on the notes was $162.5 million and $1.6 million, respectively.  In the first quarter of 2009, we included 11.1 million shares of our common stock in the computation of diluted net loss per share for the conversion of the 25¤8% Notes.  We did not include any shares in the first quarter of 2008 because the effect would have been anti-dilutive.

We will be able to redeem the 25¤8% notes at a redemption price equal to 100.75% of the principal amount between February 15, 2012 and February 14, 2013; 100.375% of the principal amount between February 15, 2013 and February 14, 2014; and 100% of the principal amount thereafter. Holders of the 25¤8% notes also are able to require us to repurchase these notes on February 15, 2014, February 15, 2017 and February 15, 2022, and upon the occurrence of certain defined conditions, at 100% of the principal amount of the 25¤8% notes being repurchased plus accrued and unpaid interest.

In 2009, we began accounting for the 25¤8% Notes using the guidance contained in FSP 14-1.   This standard requires us to assign a value to our convertible debt equal to the estimated fair value of a similar debt instrument without the conversion feature, which results in us recording our convertible debt at a discount.  FSP 14-1 then requires us to amortize the resulting debt discount over the expected life of the debt as additional non-cash interest expense. FSP 14-1 requires retrospective application to all periods presented.  Using a combination of the present value of the debt’s cash flows and a Black-Scholes valuation model, we determined that our nonconvertible debt borrowing rate for the notes was 9.3%.  As a result, we retrospectively adjusted the carrying value of the notes.  Below is a table summarizing the changes to our balance sheet as of December 31, 2008 as a result of adopting this new accounting standard (in thousands):

Additionally, we adjusted interest expense for the first quarter of 2008 to reflect our nonconvertible debt borrowing rate as follows (in thousands):

As a result of adopting FSP 14-1, interest expense for the first quarter 2009 includes $1.7 million, or $0.02 and $0.01 for basic and diluted per share, respectively, of non-cash interest expense related to the amortization of the debt discount.

Equipment Financing Arrangement

In October 2008, we entered into a loan agreement related to an equipment financing.  Under the loan agreement, we may borrow up to approximately $10 million in principal to finance the purchase of equipment.  The $10 million includes the $600,000 Ibis borrowed in October 2008 that was fully repaid in the first quarter of 2009.  Each loan under the loan agreement will have a term of approximately three years, with principal and interest payable monthly.  We calculate interest on amounts we borrow under the loan agreement based upon the three year interest rate swap at the time we make each draw down plus 4%.  We are using the equipment purchased under the loan agreement as collateral.  In October 2008, we drew down $6.6 million in principal under the loan agreement at an interest rate of 7.22%.  In March 2009, we drew down an additional $2.7 million in principal under this loan agreement at an interest rate of 6.28%.  We have now drawn down the full amount available under the loan.  The carrying balance under this loan agreement at March 31, 2009 and December 31, 2008 was $8.7 million and $6.5 million, respectively.

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6.                                    Income Taxes

Primarily as a result of the significant upfront funding that we received from our strategic alliance with Genzyme in 2008 and the gain we recognized on the sale of Ibis to AMI earlier this year, we will have a substantial amount of taxable income in 2009.  To reduce our tax liability, we will offset a portion of the taxable income with our projected 2009 loss from continuing operations.  We will also use some of our net operating loss carryforwards (NOL’s) to reduce our federal income taxes in 2009.  The tax law changes that were enacted with the 2008/2009 California Budget have suspended our ability to use NOL’s to offset our California tax expense for 2009.  However, we will offset our California income tax liability to the full extent allowed under the tax regulations with our research and development tax credit carryforwards, which California tax regulations limit to 50% of our California liability.  After using all of our allowable losses and tax credits to reduce our tax liability, we estimate that our annual tax expense will be approximately $20 to 25 million for the entire year of 2009.

SFAS 109, Income Taxes, requires us to allocate our 2009 tax expense between discontinued operations and continuing operations in our Consolidated Statement of Operations. Since the sale of Ibis to AMI was a discrete event that occurred in the first quarter of 2009, SFAS 109 requires us to record the total amount of our estimated income tax expense for discontinued operations in the first quarter of this year.  Further, the allocation rules of SFAS 109 require us to gross up this amount by the projected annual tax benefit we expect to record as part of our loss from continuing operations in 2009, which we describe below.  This means that in addition to the tax expense for the gain on the sale of Ibis, discontinued operations also includes the tax expense for other timing differences, which principally consists of the timing difference associated with the upfront funding we received from Genzyme.  Accordingly, we have recorded tax expense of $30.7 million in discontinued operations in the first quarter of 2009.

SFAS 109 requires us to include an income tax benefit in continuing operations because we will be using the tax benefits generated from our current year loss from continuing operations to offset a portion of our taxable income. We calculated this benefit by applying our estimated effective tax rate to our loss from continuing operations for the quarter. As a result, in the first quarter of 2009, we recorded an income tax benefit of $717,000.

At March 31, 2009, our balance sheet includes an income tax payable of $29.6 million.  For each quarter in which we incur a loss from continuing operations during the rest of this year, we will record an income tax benefit using the calculation above. The income tax benefit we record each quarter will reduce our overall tax expense and income tax payable until we reach our estimated annual amount of $20 to 25 million at the end of 2009.

Pursuant to Internal Revenue Code Sections 382 and 383, annual usage of our NOL’s and credit carryforwards to offset future taxable income may be limited due to changes in ownership of more than 50%.  We recently completed a Section 382 analysis and determined that we have not experienced a change in ownership that limits our ability to use our NOL’s and credit carryforwards that we had accumulated through December 31, 2008.  At December 31, 2008, we had federal, California and foreign tax net operating loss carryforwards of approximately $591.1 million, $180.6 million and $1.1 million, respectively. The Federal and California tax loss carryforwards will continue to expire in 2010 and 2013, respectively, unless previously utilized.  We also had federal and California research and development tax credit carryforwards of approximately $31.3 million and $22.2 million, respectively. The Federal research and development tax credit carryforwards began expiring in 2004 and will continue to expire unless utilized.  The California research and development tax credit carryforwards are available indefinitely.  The difference between the tax loss carryforwards for federal and California purposes is attributable to the capitalization of research and development expenses for California tax purposes and a required 50% to 60% limitation on the utilization of prior years’ California loss carryforwards. The foreign tax losses may be carried forward indefinitely and used to offset future taxable profits, provided there is no substantial change in ownership.

7.                                    Collaborative Arrangements and Licensing Agreements

The information discussed below represents material changes to partnerships entered into prior to 2009.  There are no other material changes from the information provided in Note 7—Collaborative Arrangements and Licensing Agreements of the Consolidated Financial Statements section, included in our Annual Report on Form 10-K for the year ended December 31, 2008.

Regulus Collaboration

In September 2007, we and Alnylam established Regulus as a company focused on the discovery, development, and commercialization of microRNA-based therapeutics.  We and Alnylam each granted Regulus exclusive rights to our respective intellectual property for microRNA therapeutic applications, including a portfolio of over 900 patents and patent applications (including over 600 issued patents) owned by us and Alnylam pertaining to chemical modifications as well as certain early fundamental patents in the microRNA field, including the “Tuschl III”, “Sarnow” and “Esau” patent series.  Alnylam made an initial investment of $10 million in Regulus to balance venture ownership. Thereafter, we and Alnylam share funding of Regulus. We own 51% of Regulus and Alnylam owns the remaining 49%. Regulus operates as an independent company with a separate board of directors, scientific advisory board and management team. We and Alnylam retain rights to develop and commercialize on pre-negotiated terms microRNA therapeutic products that Regulus decides not to develop either itself or with a partner.

We and Alnylam provide Regulus research and development and general and administrative services under the terms of a services agreement.

In January 2009, Regulus completed a legal reorganization from an LLC to a C-Corporation.  In March 2009, Regulus raised $20 million in a Series A preferred equity financing.  We and Alnylam were the sole and equal investors in the financing. Since we are consolidating the financial results of Regulus, our cash and cash equivalents balance only increased by the $10 million Alnylam contributed.

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8.                                      Segment Information and Concentration of Business Risk

Segment information

Prior to AMI’s acquisition of our Ibis business, we reported our financial results in three segments.  We currently report our financial results in two reportable segments, Drug Discovery and Development and Regulus.  Segment loss from operations includes revenue less research and development expenses and general and administrative expenses attributable to each segment.  See the Business Segments discussion within the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2 below for additional information on the segments.

Our Drug Discovery and Development segment generates revenue from collaborations with corporate partners and from licensing proprietary patent rights. Revenue from collaborations with corporate partners may consist of upfront payments, funding for research and development activities, milestone payments and royalties or profit sharing payments. This segment’s proprietary technology to discover and characterize novel antisense inhibitors has enabled our scientists to modify the properties of our antisense drugs for optimal use with particular targets and thus, to produce a broad proprietary portfolio of drugs applicable to many disease targets.

Our Regulus segment generates revenue from research grants and collaborations with corporate partners such as its strategic alliance with GSK.

The following is information for revenue, loss from operations and total assets by segment (in thousands):