UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File Number 0-22570

Lynx Therapeutics, Inc.

25861 Industrial Blvd.
Hayward, CA 94545
(Address of principal executive offices)

(510) 670-9300
(Registrant’s telephone number, including area code)

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

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

The number of shares of common stock outstanding as of November 5, 2004 was 7,527,538.

Lynx Therapeutics, Inc.

FORM 10-Q
For the Quarter Ended September 30, 2004
INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Lynx Therapeutics, Inc.

See accompanying notes.

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Lynx Therapeutics, Inc.

See accompanying notes.

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Lynx Therapeutics, Inc.

See accompanying notes.

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Lynx Therapeutics, Inc.

September 30, 2004

1. Nature of Business

     We believe that Lynx Therapeutics, Inc., or Lynx or the Company, is a leader in the development and application of novel genomics analysis solutions that provide comprehensive and quantitative digital gene expression information important to modern systems biology research in the pharmaceutical, biotechnology and agricultural industries. These solutions are based on Megaclone and Massively Parallel Signature Sequencing, or MPSS, Lynx’s unique and proprietary cloning and sequencing technologies. Gene expression refers to the number of genes and the extent a cell or tissue expresses those genes, and represents a way to move beyond DNA sequence data to understand the function of genes, the proteins they encode and the role they play in health and disease. Systems biology is an approach in which researchers seek to gain a complete molecular understanding of biological systems in health and disease.

     On September 28, 2004, Lynx announced that it had entered into a definitive agreement with Solexa Limited, a United Kingdom company, or Solexa. Solexa is a privately held company that develops systems for the comprehensive and economical analysis of individual genomes. The transaction is subject to customary conditions of closing, including approval by the Lynx stockholders and acceptance of the offer by the Solexa shareholders. (See Note 8)

2. Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Lynx without audit, pursuant to the rules and regulations promulgated by the Securities and Exchange Commission, or the SEC. Certain prior year amounts have been reclassified to conform to current year presentation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to SEC rules and regulations; nevertheless, Lynx believes that the disclosures are adequate to make the information presented not misleading. In the opinion of management, the financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows of the Company for the interim periods presented. The results of operations for the nine months ended September 30, 2004 are not necessarily indicative of the results for the full year.

     Our unaudited condensed consolidated financial statements have been presented on a basis that contemplates the realization of assets and satisfaction of liabilities in the normal course of business. We have experienced losses since our inception, including a net loss for the nine months ended September 30, 2004. We expect to continue to incur net losses as we proceed with the commercialization and additional development of our technologies. The size of these losses will depend on the rate of growth, if any, in our revenues and on the level of our expenses. Our cash and cash equivalents have decreased from the $5.6 million, including $0.7 million of restricted cash, as of December 31, 2003. As of September 30, 2004, our cash and cash equivalents consisted of $1.6 million in unrestricted cash and cash equivalents and restricted cash of $0.1 million. We will require additional funding to continue our business activities through at least December 31, 2005. We are considering various options, which include securing additional equity financing, obtaining new collaborators and customers and other strategic actions. If we raise additional capital by issuing equity or convertible debt securities, our existing stockholders may experience substantial dilution. There can be no assurance that additional financing will be available on satisfactory terms, or at all. If we are unable to secure additional financing on reasonable terms, or are unable to generate sufficient new sources of revenue through arrangements with customers, collaborators and licensees, we will be forced to take substantial restructuring actions, which may include significantly reducing our anticipated level of expenditures, the sale of some or all of our assets, or obtaining funds by entering into financing or collaborative agreements on unattractive terms, or we will not be able to fund operations. The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern. The financial statements do not include any

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adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the matters discussed above.

     The unaudited condensed consolidated financial statements include all accounts of Lynx and our wholly-owned subsidiary, Lynx Therapeutics GmbH, or Lynx GmbH, formed under the laws of the Federal Republic of Germany. All significant intercompany balances and transactions have been eliminated.

     These financial statements should be read in conjunction with Lynx’s audited consolidated financial statements and notes thereto for the year ended December 31, 2003, included in Lynx’s annual report on Form 10-K, as amended, filed with the SEC.

3. Summary of Significant Accounting Policies

Revenue Recognition

     Technology access fees have generally resulted from upfront payments from collaborators, customers and licensees who are provided access to our technologies for specified periods. We receive service fees from collaborators and customers for genomics discovery services performed by us on the biological samples they send to us. Collaborative research revenues are payments received under various agreements and include such items as milestone payments. Milestone payments are recognized as revenue pursuant to collaborative agreements upon the achievement of specified technology developments, representing the culmination of the earnings process. Other revenues include the proceeds from the sale of technology assets, the sale of proprietary instruments and reagents, and grant revenue.

     Technology access and license fees are deferred and recognized as revenue on a straight-line basis over the noncancelable term of the agreement to which they relate. Payments for services and/or materials provided by Lynx are recognized as revenues when earned over the period in which the services are performed and/or materials are delivered, provided that no other consequential obligations, refunds or credits to be applied to future work exist. Revenues from the sale of technology assets are recognized upon the transfer of the assets to the purchaser. Revenues from the sales of instruments and reagents are recognized upon shipment to the customer.

Inventory

     Inventory is stated at the lower of cost (which approximates first-in, first-out cost) or market. The balances at September 30, 2004 and December 31, 2003 were classified as raw materials and work in process. The raw material inventories consist primarily of reagents and other chemicals utilized while performing genomics discovery services and work in process consists of accumulated cost of experiments not completed. Inventory used in providing genomics discovery services and for reagent sales is charged to cost of service fees and other as consumed. Reagents and chemicals purchased for internal development purposes are charged to research and development expense upon receipt or as consumed.

     Inventory consisted of the following (in thousands):

Net Loss Per Share

     Basic net income (loss) per share has been computed using the weighted-average number of shares of common stock outstanding during the period. Basic and diluted net loss per share amounts are the same for each period in which we have incurred a net loss. At September 30, 2004, options to purchase approximately 550,000 shares of common stock at a weighted-average exercise price of $25.82 per share and warrants to purchase approximately

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1,544,000 shares of common stock at exercise prices ranging from $6.12 to $39.76 per share, were excluded from the calculation of diluted loss per share for the 2004 periods because the effect of inclusion would be antidilutive. The options and warrants will be included in the calculation at such time as the effect is no longer antidilutive, as calculated using the treasury stock method.

     At September 30, 2003, due to our net income for the three months ended September 30, 2003, options to purchase approximately 238,000 shares of common stock at a weighted-average exercise price of $2.12 were included in the calculation of diluted net income per share which resulted in approximately 112,000 shares of common stock, calculated using the treasury stock method, being added to the weighted-average number of shares of common stock outstanding during the period to determine the number of shares used to compute diluted net earnings per share. Options to purchase approximately 291,300 shares of common stock at a weighted average exercise price of $70.58 per share and warrants to purchase approximately 1,163,000 shares of common stock at exercise prices ranging from $9.91 to $39.76 per share were excluded from the calculation of diluted net income per share for the third quarter of 2003 because the effect of inclusion would be antidilutive. All outstanding options and warrants were excluded from the calculation of diluted net loss per share for the nine months ended September 30, 2003 because the effect of inclusion would be antidilutive. These remaining options and warrants will be included in the calculation at such time as the effect is no longer antidilutive, as calculated using the treasury stock method.

Stock-Based Compensation

     We grant stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares on the day prior to the date of grant. We account for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and related Interpretations. Under APB 25, when the exercise price of the Company’s employee stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized.

     All stock option awards to non-employees are accounted for at the fair value of the equity instrument issued, as calculated using the Black-Scholes model, in accordance with Statement of Financial Accounting Standards No.123, Accounting for Stock-based Compensation, or SFAS 123, and Emerging Issues Task Force Consensus No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The option arrangements are subject to periodic remeasurement over their vesting terms.

     Pro forma information regarding net loss and net loss per share required by SFAS 123, as amended by SFAS 148, is presented below and has been determined as if the Company had accounted for awards under its stock option and employee stock purchase plans using the fair value method:

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4. Comprehensive Loss

     The following are the components of comprehensive loss (in thousands):

     For the nine-month periods ended September 30, 2004 and 2003, the comprehensive loss equaled the net loss.

5. Related-Party Transactions

Axaron Bioscience AG

     We hold an equity investment in Axaron Bioscience AG, or Axaron, a company owned primarily by BASF AG and us. As of September 30, 2004, we held approximately a 42% ownership interest in Axaron and had the ability to exercise significant influence over Axaron’s operating and accounting policies. We initially accounted for our investment in Axaron using the equity method in accordance with APB 18. Under the equity method, we recorded our pro-rata share of the income or losses of Axaron. We discontinued applying the equity method as of December 31, 2003, as our investment in Axaron has been reduced to zero.

     In 2001, we extended our technology licensing agreement with Axaron. The license extends Axaron’s right to use our proprietary MPSS and Megasort technologies non-exclusively in Axaron’s neuroscience, toxicology and microbiology programs until December 31, 2007. We received from Axaron a $5.0 million technology license fee, which was recorded as deferred revenue and is being recognized on a straight-line basis over the noncancelable term of the agreement. The recorded revenue for the three-month and nine-month period ended September 30, 2004 was $190,000 and $570,000, respectively. The recorded revenue for the three-month and nine-month period ended September 30, 2003 was $190,000 and $570,000, respectively. In accordance with APB 18, we have discontinued applying the equity method as our investment in Axaron has been reduced to zero and no pro-rata share of Axaron losses has been reflected in the Condensed Consolidated Statement of Operations for the three months and nine months ended September 30, 2004. Our pro-rata share of Axaron’s losses for the three-month and nine-month periods ended September 30, 2003 was approximately $0.9 million and $1.7 million, respectively.

     We also subleased certain offices in Germany to Axaron. During 2003, the Company received an immaterial amount of sublease income from Axaron. The sublease terminated on December 31, 2003.

Other Transactions with Related Parties

     For legal services, Lynx paid approximately $106,000 during the quarter ended September 30, 2004 and approximately $290,000 during the nine months ended September 30, 2004 to Cooley Godward LLP, Lynx’s counsel. A partner of Cooley Godward LLP is a director of Lynx. At September 30, 2004, Lynx had an outstanding liability to Cooley Godward LLP of approximately $238,000. At December 31, 2003, Lynx had an outstanding liability to Cooley Godward LLP of approximately $55,000.

     During the three month period ended September 30, 2004, Lynx did not perform genomics discovery services for the Institute for Systems Biology. During the nine month period ended September 2004 Lynx received $60,000 for genomics discovery services performed. The President and Director of the Institute for Systems Biology is a director of Lynx.

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     In June 2001, Lynx entered into a consulting agreement with Dr. Sydney Brenner, a director of the Company. Pursuant to the agreement, Dr. Brenner may perform consulting services of at least eight to 16 hours per month in consideration of his standard consulting fee. During the three and nine months ended September 30, 2004 and September 30, 2003, Dr. Brenner received no consulting fees under this agreement.

6. Restructuring Charges

     In March 2004, we implemented a reduction of approximately 15% of our workforce, or 14 people. The reduction included positions in all functions of the Company’s business. The workforce reduction was intended to further focus our financial and human resources on expanding the commercial use of MPSS. We recorded a workforce reduction charge of $118,000 in the nine months ended September 30, 2004, which related primarily to severance compensation expense for our former employees, which amounts were paid in April and May 2004.

7. Common Stock

     On March 9, 2004, Lynx completed a $4.0 million private placement of common stock and warrants to purchase common stock resulting in proceeds of $3.8 million, net of commissions and expenses. The financing included the sale of 788,235 newly-issued shares of common stock at $5.10 per share and the issuance of warrants to purchase 181,295 shares of common stock at an exercise price of $6.25 per share.

8. Transactions with Solexa

     In April 2004, Lynx and Solexa jointly acquired from Manteia SA, a company established under the laws of Switzerland, or Manteia, the rights to proprietary technology assets for DNA colony generation. The acquired technology assets feature a process to enable parallel amplification of millions of DNA fragments, each from a single DNA molecule, to create DNA colonies or “clusters.” The clusters are dense collections of DNA molecules on a surface, which should enable fast and simplified preparation of the biological sample for analysis and allow reduced reagent consumption as a result of the highly parallel nature of the analysis. We intend to incorporate the cluster technology assets into our MPSS process, with the goal of streamlining our sequencing service operations and developing commercial sequencing instrumentation for widespread laboratory use. The cluster technology is expected to improve our current bead-based sequencing process by delivering higher density, thus greater information content. This improvement targets a significant reduction in the cost of DNA sequencing and is expected to create multiple market opportunities in basic and applied research. Lynx and Solexa have entered into a technology sharing agreement for the purpose of managing the ownership and development of the asset acquired from Manteia.

     Lynx issued and delivered to Manteia 540,058 shares of common stock of Lynx for a value representing fifty percent of the purchase price. The shares were valued at $2.55 million and the purchase price was allocated to intellectual property in the amount of $2.45 million and equipment and supplies valued at $100,000. The acquired intellectual property is being amortized over 8 years.

     In October 2004, pursuant to the terms of a loan agreement dated August 12, 2004, Lynx and Solexa entered into a deed to amend the technology sharing agreement. Under the terms of the deed, in the event that the first closing of the proposed combination with Solexa does not take place and the transaction is, therefore, not completed, Lynx has agreed to transfer its right, title and interest in the cluster technology to Solexa in consideration for the grant of a worldwide, perpetual and non-exclusive license of the cluster technology.

     On August 12, 2004, Lynx and Solexa entered into a loan agreement pursuant to which Lynx issued Solexa four promissory notes each bearing an interest rate of 10% in the aggregate principal amount of $2,500,000. Under the loan agreement and as a result of the issuance of the promissory notes, certain royalty rates contained in the technology sharing agreement were reduced and Lynx was obligated to make certain instruments available to Solexa.

     On September 28, 2004, Lynx announced that it had entered into a definitive agreement with Solexa, under which, for accounting purposes, Solexa will acquire Lynx. Solexa is a privately held company that develops

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systems for the comprehensive and economical analysis of individual genomes. Under the acquisition agreement, Lynx will issue up to 29.5 million shares or options to purchase shares of its common stock in exchange for all of the outstanding share capital and outstanding share options of Solexa. The transaction is subject to customary conditions of closing, including approval by the Lynx stockholders and acceptance of the offer by the Solexa shareholders.

     In connection with the acquisition agreement, the directors and the executive officers and major shareholders of Solexa who are registered holders of approximately 90% of the outstanding shares of Solexa’s share capital entered into support agreements with Lynx, pursuant to which they agreed to exchange their shares of Solexa capital stock for Lynx common stock in connection with the transaction. In addition, certain directors and executive officers of Lynx entered into support agreements with Solexa, pursuant to which they agreed to approve the transaction and the issuance of shares of Lynx common stock to the Solexa shareholders in connection with the combination.

     In October 2004, Lynx signed an original equipment manufacturer development agreement with Solexa whereby Solexa will provide additional funding to Lynx to accelerate development of the next generation DNA sequencing instruments.

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

     This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included in this report and our 2003 audited financial statements and notes thereto included in our 2003 Annual Report on Form 10-K, as amended. Operating results for the quarter and nine months ended September 30, 2004 are not necessarily indicative of results that may occur in future periods.

     Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. When used herein, the words “believe,” “anticipate,” “expect,” “estimate” and similar expressions are intended to identify such forward-looking statements. There can be no assurance that these statements will prove to be correct. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section, as well as in our 2003 Annual Report on Form 10-K, as amended, as filed with the SEC. We undertake no obligation to update any of the forward-looking statements contained herein to reflect any future events or developments.

Overview

     We believe that Lynx Therapeutics, Inc. is a leader in the development and application of novel genomics analysis solutions that provide comprehensive and quantitative digital gene expression information important to modern systems biology research in the pharmaceutical, biotechnology and agricultural industries. These solutions are based on Megaclone and Massively Parallel Signature Sequencing, or MPSS, our unique and proprietary cloning and sequencing technologies. Gene expression refers to the number of genes and the extent a cell or tissue expresses those genes, and represents a way to move beyond DNA sequence data to understand the function of genes, the proteins they encode and the role they play in health and disease. Systems biology is an approach in which researchers seek to gain a complete molecular understanding of biological systems in health and disease.

     We have incurred net losses each year since our inception in 1992. As of September 30, 2004, we had an accumulated deficit of approximately $119.8 million. We have experienced losses since our inception, including a net loss for the nine months ended September 30, 2004. We expect to continue to incur net losses as we proceed with the commercialization and additional development of our technologies. The size of these losses will depend on the rate of growth, if any, in our revenues and on the level of our expenses. Our cash and cash equivalents have decreased from the $5.6 million, including $0.7 million of restricted cash, as of December 31, 2003. As of September 30, 2004, our cash and cash equivalents consisted of $1.6 million in unrestricted cash and investments and restricted cash of $0.1 million. We will require additional funding to continue our business activities through at least December 31, 2005. We are considering various options, which include securing additional equity financing, obtaining new collaborators and customers and other strategic actions. If we raise additional capital by issuing equity or convertible debt securities, our existing stockholders may experience substantial dilution. There can be no assurance that additional financing will be available on satisfactory terms, or at all. If we are unable to secure additional financing on reasonable terms, or are unable to generate sufficient new sources of revenue through arrangements with customers, collaborators and licensees, we will be forced to take substantial restructuring actions, which may include significantly reducing our anticipated level of expenditures, the sale of some or all of our assets, or obtaining funds by entering into financing or collaborative agreements on unattractive terms, or we will not be able to fund operations. The accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the matters discussed above.

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     To date, we have received, and expect to continue to receive in the future, a significant portion of our revenues from a small number of collaborators, customers and licensees, as shown in the following table.

     Revenues in each quarterly and annual period have in the past, and could in the future, fluctuate due to: the timing and amount of any technology access fees and the period over which the revenue is recognized; the level of service fees, which is tied to the number and timing of biological samples received from our collaborators and customers, as well as our performance of the related genomics discovery services on the samples; the timing of achievement of milestones and the amount of related payments to us; the sale of instruments, if any, and the number, type and timing of new, and the termination of existing, agreements with collaborators, customers and licensees.

     Our operating costs and expenses include service fees and other, research and development expenses and general and administrative expenses. Service fees and other includes primarily the costs of direct labor, materials and supplies, outside expenses, equipment and overhead incurred by us in performing our genomics discovery services for, and the costs of reagents and instruments sold to, our collaborators, customers and licensees. Research and development expenses include the costs of personnel, materials and supplies, outside expenses, equipment and overhead incurred by us in our technology and application development and process improvement efforts. Research and development expenses may increase due to spending for ongoing technology development and implementation, as well as new applications, primarily for our technology. General and administrative expenses include the costs of personnel, materials and supplies, outside expenses, equipment and overhead incurred by us primarily in our administrative, business development, legal and investor relations activities. General and administrative expenses may increase in support of our research and development, commercial and business development efforts.

     We initially accounted for our investment in Axaron, using the equity method. In accordance with APB 18, we have discontinued applying the equity method as of December 31, 2003, as our investment in Axaron has been reduced to zero.

     As of September 30, 2004, we employed 78 full-time employees, of which 65 were engaged in production and research and development activities. In March 2004, we implemented a reduction of approximately 15% of our total workforce, or 14 people. The reduction included positions in all functions of our business. The workforce reduction is intended to further focus our financial and human resources on expanding the commercial use of our technology.

     On September 28, 2004, we announced that we had entered into a definitive agreement with Solexa, under which, for accounting purposes, Solexa will acquire Lynx. Solexa is a privately held company that develops systems for the comprehensive and economical analysis of individual genomes. Under the agreement, we will issue up to 29.5 million shares of common stock in exchange for all of the outstanding share capital and outstanding share options of Solexa. The transaction is subject to customary conditions of closing, including approval by our stockholders and acceptance of the offer by the Solexa shareholders.

     On August 12, 2004 we entered into a loan agreement with Solexa whereby Solexa agreed to loan us an aggregate principal amount of up to $2.5 million. At September 30, 2004, we had received $2.0 million under the loan agreement and in October 2004 received the remaining $0.5 million.

     On April 14, 2004, we closed a transaction with Solexa to jointly acquire from Manteia the rights to proprietary technology assets for DNA colony generation. We issued and delivered to Manteia 540,058 shares of our common stock for a value representing fifty percent of the purchase price. The acquired technology assets feature a process to enable parallel amplification of millions of DNA fragments, each from a single DNA molecule, to create DNA

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colonies or “clusters.” The clusters are dense collections of DNA molecules on a surface, which should enable fast and simplified preparation of the biological sample for analysis and allow reduced reagent consumption as a result of the highly parallel nature of the analysis.

     We have entered into a technology sharing agreement with Solexa, dated as of March 22, 2004, for the purpose of managing the ownership and development of the assets acquired from Manteia. On October 25, 2004, Lynx and Solexa entered into a deed to amend the technology sharing agreement. Under the terms of the deed and pursuant to the terms of a loan agreement dated August 12, 2004, in the event that the first closing of the proposed combination with Solexa does not take place and the transaction is, therefore, not completed, Lynx shall transfer its right, title and interest in the cluster technology to Solexa in consideration for the grant of a worldwide, perpetual and non-exclusive license of the cluster technology.

Results of Operations

Revenues

     Revenues for the three-month period ended September 30, 2004 were approximately $1.6 million, compared to revenues of $8.3 million for the corresponding three-month period of 2003. Revenues for the three-month period in 2004 included technology access and service fees of $1.3 million, license fees from Axaron, a related party, of $190,000 and other revenues of $39,000. Revenues for the three-month period in 2003 included technology access and service fees of $7.0 million, license fees from Axaron of $190,000 and other revenues of $1.0 million.

     Revenues for the nine months ended September 30, 2004 were approximately $4.6 million, compared to revenues of $16.1 million for the corresponding nine-month period of 2003. Revenues for the nine-month period in 2004 included technology access and service fees of $3.9 million, license fees from Axaron of $570,000 and other revenues of $117,000. Revenues for the nine-month period in 2003 included technology access and service fees of $14.2 million, license fees from Axaron of $570,000 and other revenues of $1.3 million.

     The decrease in technology access and service fees revenues in 2004 compared to 2003 was due to full recognition of previously deferred technology access fee revenue of $7.0 million in 2003, for which there was no corresponding amount in 2004, and a decrease in fees charged per MPSS experiment. The decrease in other revenues for 2004 compared to 2003 was due to the sale of MPSS instruments to Takara in 2003 for which there was no corresponding amount in 2004. The instrument sales were related to an amendment of the existing collaboration agreement between Lynx and Takara.

     Our revenues have historically fluctuated from quarter to quarter and year to year and may continue to fluctuate in future periods due primarily to our service fees, which are impacted principally by the timing and number of biological samples received from existing customers and collaborators, as well as our performance of related services on these samples. Additionally, the number, type and timing of new collaborations and agreements and the related demand for, and delivery of, our services or products and the sale of instruments, if any, will impact the level of future revenues.

Operating Costs and Expenses

     Total operating costs and expenses were approximately $5.8 million for the three-month period ended September 30, 2004, compared to approximately $5.8 million for the three-month period ended September 30, 2003. For the nine-month periods ended September 30, 2004 and 2003, operating costs and expenses were approximately $16.8 million and $18.7 million, respectively.

     Cost of service fees and other reflect primarily the costs of providing our genomics discovery services. For the three-month period in 2004, cost of service fees and other was $1.2 million, compared to $1.5 million for the corresponding period in 2003. The decrease in cost of service fees and other for the quarter ended September 30, 2004 was due to lower quarterly costs in two of the main production processes partially offset by organizational changes discussed below. Cost of service fees and other for the nine-months ended September 30, 2004 and 2003 were $3.9 million and $3.6 million, respectively. The increase in cost of service fees for the nine-month period in

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2004 reflects our organizational changes where proporti