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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

Commission file number 0-19125

Isis Pharmaceuticals, Inc.
(Exact name of registrant as specified in its charter)

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.

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12(b)-2 of the Securities Exchange Act of 1934). Yes ý    No o

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

ISIS PHARMACEUTICALS, INC.
FORM 10-Q

INDEX

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ISIS PHARMACEUTICALS, INC.

CONDENSED BALANCE SHEETS

(in thousands, except share data)

Note:  The balance sheet at December 31, 2002 has been derived from the audited financial statements at that date.

See accompanying notes

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ISIS PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF OPERATIONS

(in thousands, except for per share amounts)

(Unaudited)

See accompanying notes

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ISIS PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

See accompanying notes

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ISIS PHARMACEUTICALS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS

June 30, 2003

(Unaudited)

1.    Basis of Presentation

        The unaudited interim financial statements for the six month periods ended June 30, 2003 and 2002 have been prepared on the same basis as the Company's audited financial statements for the year ended December 31, 2002. The financial statements include all adjustments (consisting only of normal recurring adjustments), which the Company considers necessary for a fair presentation of the financial position at such dates and the operating results and cash flows for those periods. 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, 2002 included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission.

2.     Significant Accounting Policies

Revenue Recognition

        The Company recognizes revenue when all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured.

Research and development revenue under collaborative agreements

        The Company recognizes research and development revenue under collaborative agreements as it incurs the related expenses, up to contractual limits. The Company defers payments received under these agreements that are related to future performance and records revenue as it is earned over the specified future performance period. The Company recognizes revenue that relates to nonrefundable, upfront fees over the period of the contractual arrangements as it satisfies its performance obligations. The Company recognizes revenue that relates to milestones, under existing arrangements, upon completion of the milestone's performance requirement. The Company will recognize revenue related to milestones that are part of arrangements entered into subsequent to June 30, 2003 in accordance with Emerging Issues Task Force Issue No. 00-21 (EITF 00-21). EITF 00-21 requires the Company to recognize revenue related to the milestones over the period of obligation. The Company records revenue from federal research grants during the period in which it incurs the related expenditures. The Company recognizes revenue from product sales as it ships the products.

        As part of the Company's alliance with Eli Lilly and Company in August 2001, Lilly provided Isis a $100.0 million interest free loan to fund the research collaboration. As of June 30, 2003, the Company had drawn down $61.3 million on the $100.0 million loan. The Company discounted the $61.3 million to its net present value by imputing interest on the amount at 20%, which represented market conditions in place at the time the Company entered into the loan. The Company accretes the loan up to its face value over its term by recording interest expense. The difference between the cash received and the present value of the loan represents value Lilly gave to Isis to help fund the research collaboration. The Company accounts for this value as deferred revenue and recognizes it as revenue over the period of performance.

Research and development revenue from affiliates

        The Company recognized research and development revenue from affiliates as it incurred the related expenses, up to contractual limits. The Company recognized revenue related to milestones upon

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completion of the milestone's performance requirement. In late 2002, the Company terminated its HepaSense and Orasense collaborations with Elan Corporation plc and as a result, the Company no longer earns revenue from these collaborations.

Licensing and royalty revenue

        The Company recognizes licensing and royalty revenue immediately, if collectibility is reasonably assured, for arrangements in which the Company is not required to provide services in the future.

Concentration of credit risk

        Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, short-term investments and receivables. The Company places its cash equivalents and certain of its short-term investments with high credit-quality financial institutions. The Company invests its excess cash primarily in auction and money market instruments, and municipal and floating rate bonds. The Company and its audit committee established guidelines relative to credit ratings, diversification and maturities that seek to maintain safety and liquidity.

Cash, Cash Equivalents and Short-Term Investments

        The Company considers all liquid investments with maturities of ninety days or less when purchased to be cash equivalents. The Company's short-term investments have initial maturities of greater than ninety days from date of purchase. The Company classifies its securities as "available-for-sale" in accordance with SFAS 115, Accounting for Certain Investment in Debt and Equity Securities. The Company carries these investments at fair market value with any unrealized gains and losses recorded as a separate component of stockholders' equity. Fair value is based upon market prices quoted on the last day of the fiscal quarter. The cost of debt securities sold is based on the specific identification method. The Company includes gross realized gains and losses in investment income and these amounts have not been material. To date, the Company has not had any material losses related to its cash or cash equivalents. During the first quarter of 2003, the Company recorded a non-cash loss of $2.4 million related to the impairment of its equity investments in Antisense Therapeutics Limited (ATL) and Hybridon, Inc. This charge reflected the then-current market climate and was associated with the decline in market value of the equity investments from their initial valuations and was determined to be other-than-temporary. In the second quarter of 2003, the Company recorded unrealized gains related to its equity investments in ATL and Hybridon as a separate component of stockholders' equity, which reflected the increase in the market value of the investments since the first quarter of 2003.

Inventory Valuation

        The value at which the Company carries its inventory directly impacts the Company's results of operations. The Company's inventory includes drugs with alternative uses that are used primarily for its development activities and drugs it manufactures for its partners under contractual terms. The Company states its inventories at the lower of cost or market, with cost determined under the first-in, first-out method. The Company reviews inventories periodically and reduces the carrying value of items considered to be slow moving or obsolete to its estimated net realizable value. In the second quarter of 2003, the Company reduced the carrying value of its raw materials related to Affinitak to their

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estimated net realizable value. Inventory includes the following categories as of June 30, 2003 and December 31, 2002, net of reserves (in thousands):

Use of Estimates

        The preparation of 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 financial statements and accompanying notes. Actual results could differ from those estimates.

Stock-Based Employee Compensation

        In April 2003, the Company implemented an employee stock option exchange program to maintain one of the Company's key assets, its employee base, in a manner that was sensitive to shareholder interests. The exchange program allowed employees during the offering period, which began on April 8, 2003 and ended on May 8, 2003, to surrender options, granted prior to January 5, 2002, which typically were higher priced, in exchange for a lesser number of options, which typically were lower priced. Employees exchanged 2.2 million options with a weighted-average exercise price of $14.89 for 1.0 million options with an exercise price of $5.15. The new options vest over 3 years beginning on January 1, 2003 and expire on December 31, 2008. The Company accounted for the affected options using variable accounting consistent with the provisions of Accounting Principles Board Opinion No. 25 and Financial Accounting Standard Board Interpretation No. 44. As a result, the Company recorded compensation expense of approximately $115,000 in the second quarter of 2003 and will continue to account for the affected options using variable accounting until all affected options have been exercised or cancelled.

        The Company has adopted the disclosure-only provision of SFAS 123, Accounting for Stock-Based Compensation. Accordingly, no compensation expense, except for compensation expense primarily related to the affected options from the 2000 and 2003 exchange programs, has been recognized for the Company's stock option plans. Had compensation expense been determined consistent with SFAS 123,

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the Company's net loss and basic and diluted net loss per share would have been changed to the following proforma amounts (in thousands, except per share amounts):

        For the purpose of this proforma calculation, the Company estimates the fair value of each option grant on the date of grant using the Black-Scholes option pricing model with the following assumptions for June 30, 2003 and 2002: 1) a risk free rate of 3.53% and 4.82%, respectively; 2) a dividend yield of 0% each year; 3) a volatility factor of 85.6% and 73.9%, respectively; and 4) an option life of 5.1 and 5.8 years, respectively. The weighted average fair value of options granted was $5.11 and $5.79 for the three and six months ended June 30, 2003, respectively. The weighted average fair value of options granted was $12.04 and $17.83 for the three and six months ended June 30, 2002, respectively.

Reclassification

        Certain prior period amounts have been reclassified to conform to current presentation.

Impact of Recently Issued Accounting Standards

        In November 2002, the Emerging Issues Task Force issued Issue No. 00-21 (EITF 00-21), Accounting for Revenue Arrangements with Multiple Deliverables. This issue addresses the timing and method of revenue recognition for revenue arrangements that include the delivery of more than one product or service. EITF 00-21 is effective for revenue arrangements entered into in fiscal quarters beginning after June 15, 2003. The Company reviewed EITF 00-21 and determined that this issue will not have a material impact on its operating results and financial position.

        In December 2002, the Financial Accounting Standards Board issued SFAS 148, Accounting for Stock-Based Compensation—Transition and Disclosure, effective for fiscal years ending after December 15, 2002. The rule amends SFAS 123 to provide several alternatives for adopting the stock option expense provisions of SFAS 123, as well as additional required interim financial statement disclosures. SFAS 148 does not require companies to expense stock options in current earnings. The Company has not adopted the provisions of SFAS 123 for expensing stock based compensation; however, the Company has adopted the additional interim disclosure provisions of the statement (see Stock-Based Employee Compensation above). The impact of the new standard is not expected to have a material impact on the results of operations or the financial position of the Company.

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3.     Strategic Alliances

Affiliates

Orasense

        Due to the significant minority investor rights retained by Elan and its subsidiaries, the Company accounted for its investment in Orasense under the equity method of accounting. Through December 2002, Orasense incurred research and development expenses, performed by Elan and the Company on Orasense's behalf, in the course of its product development. In conjunction with its continuing restructuring efforts, Elan concluded its participation in the Orasense collaboration effective December 31, 2002, and the Company reacquired all rights to ISIS 104838, the compound that the collaboration had been developing. The following table presents summary results of operations for the three and six months ended June 30, 2002 for Orasense (in thousands):

HepaSense

        Due to the significant minority investor rights retained by Elan and its subsidiaries, the Company accounted for its investment in HepaSense under the equity method of accounting. Through December 2002, HepaSense incurred research and development expenses, performed by Elan and the Company on HepaSense's behalf, in the course of its product development. In conjunction with its continuing restructuring efforts, Elan concluded its participation in the HepaSense collaboration in 2002 and the Company reacquired all rights to ISIS 14803, the compound that the collaboration had been developing. As a result of the collaboration termination, there was no activity during the six months ended June 30, 2003. The following table presents summary results of operations for the three and six months ended June 30, 2002 for HepaSense (in thousands):

Amgen

        In February 2003, the Company earned a second research milestone in its drug discovery collaboration with Amgen, which was initiated in December 2001. Amgen and the Company are collaborating to discover and develop new antisense drugs utilizing the Company's proprietary second-

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generation chemistry. Amgen has the right to develop and commercialize antisense drugs resulting from the collaboration.

Lilly Oncology Collaboration

        In April 2003, the Company earned a $1.5 million milestone from Lilly in the development of ISIS 23722, the antisense inhibitor of survivin, as part of the research collaboration oncology expansion entered into in fiscal year 2002 with Lilly. ISIS 23722 is the first compound from the partnership to be selected for clinical development by Lilly.

Pantheco A/S

        In May 2003, the Company entered into an amended and restated license agreement with Pantheco A/S. The amended and restated license agreement replaces the nonexclusive license agreement the Company entered with Pantheco in September 2000 and the exclusive license agreement the Company entered with Pantheco in November 1998. Under the terms of the amended and restated license agreement, the Company licensed its novel antisense chemistry, Peptide Nucleic Acid, or PNA, to Pantheco on a limited exclusive basis to develop products. The license is restricted to a limited number of molecular targets that are subject to the Company's approval. In consideration for the license, Pantheco agreed to pay the Company royalties and milestones on any products developed under the license.

        In addition, in May 2003, Pantheco A/S and Cureon A/S merged to form Santaris Pharma A/S. Prior to the merger, the Company purchased additional shares of Pantheco for $55,000 as the result of antidilution provisions in Pantheco's stock. After the merger and as of June 30, 2003, the Company's ownership interest in Santaris is 7.4%.

Ercole

        In May 2003, the Company and Ercole Biotech, Inc. (Ercole) initiated a multi-year collaboration to discover antisense drugs that regulate alternative RNA splicing. As part of the collaboration, the parties cross-licensed their respective splicing-related intellectual property. Ercole also received a license to some of the Company's chemistry patents. The Company has taken an equity ownership in Ercole, with the initial funding in the form of convertible debt, which the companies anticipate will convert into securities Ercole issues in its next venture capital financing. The Company also has the option to make an additional equity investment in Ercole.

Lilly

        In June 2003, the Company and Lilly reached a mutually beneficial renegotiation of their manufacturing relationship. Lilly waived repayment of the $21.2 million manufacturing loan it provided the Company to build the Affinitak manufacturing facility. Lilly agreed to allow the Company to use the facility to manufacture other drugs. In exchange, the Company released Lilly from its obligations contained in the supply agreement for Affinitak, including the obligation to purchase additional product from the Company and the obligation to pay for the costs of maintaining an idle manufacturing suite.

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Industrial and Technology Research Institutes of Taiwan

        In June 2003, Isis initiated a collaboration with the Industrial and Technology Research Institutes (ITRI) of Taiwan to identify antisense candidates targeting the coronavirus associated with Severe Acute Respiratory Syndrome (SARS). The Company is conducting the antisense drug discovery research and ITRI will provide up to $2.0 million in funding to support the collaboration, with the potential for further funding.

4.     Comprehensive Loss

        SFAS No. 130, Reporting Comprehensive Income, requires the company to report, in addition to net loss, comprehensive loss and its components. A summary follows (in thousands):

5.     Restructuring

        In November 2002, the Company discontinued its GeneTrove database product offering and reorganized the GeneTrove division. As a result, the Company reduced its workforce by approximately 25 people. The restructuring plan also provided for the write-down of certain intellectual property. As a result of this plan, the Company recognized restructuring related charges of approximately $1.4 million as operating expenses in the fourth quarter of 2002. The Company did not recognize any additional GeneTrove restructuring related charges in the first six months of 2003 and expects to complete utilization of the reserve related to this restructuring by October 2003.

        In April 2003, the Company initiated a restructuring in response to disappointing results from the first Phase III trial of Affinitak. As a result, the Company had a small reduction in its workforce, which primarily represented positions that were in support of the commercialization and manufacture of Affinitak. Consequently, the Company incurred a one-time restructuring charge of approximately $1.8 million during the second quarter of 2003 and expects to complete the utilization of the reserve related to this restructuring in the fourth quarter of 2003.

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        The following table summarizes the balance of the accrued restructuring reserve related to GeneTrove and Affinitak, which has been included in accrued liabilities at June 30, 2003 (in thousands):

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ITEM 2.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        In addition to historical information contained in this Report, this Report contains forward-looking statements regarding our business and the therapeutic and commercial potential of our technologies and products in development. Any statement describing our goals, expectations, intentions or beliefs is a forward-looking statement and should be considered an at-risk statement. Such statements are subject to certain risks and uncertainties, particularly those risks and uncertainties inherent in the process of discovering, developing and commercializing drugs that can be proven to be safe and effective for use as human therapeutics, in the process of conducting gene functionalization and target validation services, and in the endeavor of building a business around such products and services. Actual results could differ materially from those discussed in this Form 10-Q. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2002, which is on file with the U.S. Securities and Exchange Commission and those identified in the section of Item 2 entitled "Risk Factors" beginning on page 24 of th