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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

     
For the Quarter Ended March 31, 2005   Commission File No. 000-21429

ArQule, Inc.

(Exact Name of Registrant as Specified in its Charter)
     
Delaware   04-3221586
(State of Incorporation)   (I.R.S. Employer Identification Number)

19 Presidential Way, Woburn, Massachusetts 01801
(Address of Principal Executive Offices)

(781) 994-0300
(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     þ   NO     o        

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

             
YES     þ   NO     o        

Number of shares outstanding of the registrant’s Common Stock as of April 29, 2005:

             
Common Stock, par value $.01   34,813,648   shares outstanding        
 
 

 


 

ArQule, Inc.

Quarter Ended March 31, 2005

Table of Contents

         
PART I - FINANCIAL INFORMATION   Page  
         
 
       
Item 1 – Unaudited Consolidated Financial Statements
       
 
       
Condensed Consolidated Balance Sheet (Unaudited) March 31, 2005 and December 31, 2004
    3  
 
       
Condensed Consolidated Statement of Operations (Unaudited) Three months ended March 31, 2005 and 2004
    4  
 
       
Condensed Consolidated Statement of Cash Flows (Unaudited) Three months ended March 31, 2005 and 2004
    5  
 
       
Notes to Unaudited Consolidated Financial Statements
    6  
 
       
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
    11  
 
       
Item 3 – Quantitative and Qualitative Disclosures about Market Risk
    21  
 
       
Item 4 –Controls and Procedures
    21  
 
       
PART II — OTHER INFORMATION
    22  
 
       
Signatures
    23  

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ArQule, Inc.

Condensed Consolidated Balance Sheet (Unaudited)
(In thousands, except share data)

                 
    March 31,     December 31,  
    2005     2004  
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 2,000     $ 7,131  
Marketable securities
    83,497       64,234  
Accounts receivable
    10,536       319  
Prepaid expenses and other current assets
    3,542       2,893  
 
           
 
               
Total current assets
    99,575       74,577  
 
               
Property and equipment, net
    44,209       44,895  
Other assets
    748       746  
 
           
 
  $ 144,532     $ 120,218  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable and accrued expenses
  $ 5,853     $ 7,683  
Current portion of long-term debt
    118       144  
Current portion of deferred revenue
    11,673       11,968  
 
           
Total current liabilities
    17,644       19,795  
 
               
Restructuring accrual, long-term portion
    2,545       2,728  
Long-term debt, net of current portion
          17  
Deferred revenue, net of current portion
    15,077       15,226  
 
           
 
               
Total liabilities
    35,266       37,766  
 
           
 
               
Stockholders’ equity:
               
Common stock, $0.01 par value; 50,000,000 shares authorized; 34,783,477 and 28,982,774 shares issued and outstanding at March 31, 2005 and December 31, 2004, respectively
    348       290  
Additional paid-in capital
    300,206       271,805  
Accumulated other comprehensive loss
    (588 )     (386 )
Accumulated deficit
    (190,700 )     (189,257 )
 
           
Total stockholders’ equity
    109,266       82,452  
 
           
 
  $ 144,532     $ 120,218  
 
           

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

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ArQule, Inc.

Condensed Consolidated Statement of Operations (Unaudited)
(In thousands, except per share data)

                 
    Three Months Ended  
    March 31,  
    2005     2004  
Revenue:
               
Compound development revenue
  $ 12,290     $ 11,493  
Compound development revenue — related party
          268  
Research and development revenue
    1,653        
 
           
Total revenue
    13,943       11,761  
 
           
 
               
Costs and expenses:
               
Cost of compound development revenue
    7,352       8,404  
Cost of compound development revenue – related party
          134  
Research and development
    5,853       4,968  
Marketing, general and administrative
    2,684       2,603  
Restructuring charge
          1,072  
 
           
Total costs and expenses
    15,889       17,181  
 
           
 
               
Loss from operations
    (1,946 )     (5,420 )
 
               
Net investment income
    504       169  
 
           
 
               
Net loss
  $ (1,442 )   $ (5,251 )
 
           
 
               
Basic and diluted net loss per share
  $ (0.04 )   $ (0.18 )
 
           
 
               
Weighted average common shares outstanding – basic and diluted
    33,040       28,729  
 
           

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

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ArQule, Inc.

Condensed Consolidated Statement of Cash Flows (Unaudited)
(In thousands)

                 
    Three Months Ended  
    March 31,  
    2005     2004  
Cash flows from operating activities:
               
Net loss
  $ (1,442 )   $ (5,251 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    1,823       1,839  
Non-cash stock compensation
    56        
Non-cash restructuring charge
          76  
Changes in operating assets and liabilities:
               
Accounts receivable
    (10,217 )     (9,625 )
Prepaid expenses and other current assets
    (649 )     (346 )
Other assets
    (2 )     135  
Accounts payable and accrued expenses
    (1,830 )     (3,712 )
Deferred revenue
    (444 )     73  
Restructuring accrual, long-term portion
    (183 )     (348 )
 
           
Net cash used in operating activities
    (12,888 )     (17,159 )
 
           
 
               
Cash flows from investing activities:
               
Purchases of marketable securities
    (36,248 )     (7,249 )
Proceeds from sale or maturity of marketable securities
    16,784       12,034  
Additions to property and equipment
    (1,138 )     (103 )
 
           
 
               
Net cash provided by (used in) investing activities
    (20,602 )     4,682  
 
           
 
               
Cash flows from financing activities:
               
Principal payments of long-term debt
    (43 )     (1,738 )
Proceeds from issuance of common stock, net
    28,402       29  
 
           
 
               
Net cash provided by (used in) financing activities
    28,359       (1,709 )
 
           
 
               
Effect of foreign exchange rates on cash and cash equivalents
          12  
 
           
 
               
Net decrease in cash and cash equivalents
    (5,131 )     (14,174 )
 
               
Cash and cash equivalents, beginning of period
    7,131       18,839  
 
           
 
               
Cash and cash equivalents, end of period
  $ 2,000     $ 4,665  
 
           

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

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ArQule, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Nature of Operations

     We are a biotechnology company engaged in the research and development of small molecule cancer therapeutics based on a novel biological approach to cancer, our Activated Checkpoint TherapySM (ACTSM) platform, and our expertise in small molecule chemistry and intelligent drug design. We also provide fee-based services to pharmaceutical companies and biotechnology companies, using our chemistry-based technology and expertise to attract collaborators. We have an experienced and highly qualified scientific and management team that can apply our chemistry technology platform to produce compounds that have medicinal attributes.

     We are subject to risks common to companies in the biotechnology, pharmaceutical, medical services, and diagnostics industries, including but not limited to, development by the Company or our competitors of new technological innovations, dependence on key personnel, protection of proprietary technology, and compliance with governmental regulation.

2. Basis of Presentation

     We have prepared the accompanying condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to these rules and regulations. These condensed consolidated financial statements should be read in conjunction with our audited financial statements and footnotes related thereto for the year ended December 31, 2004 included in our annual report on Form 10-K filed with the Securities and Exchange Commission on March 16, 2005. The unaudited condensed consolidated financial statements include, in our opinion, all adjustments (consisting only of normal recurring adjustments) necessary to present fairly our financial position as of March 31, 2005, and the results of our operations and cash flows for the three months ended March 31, 2005 and March 31, 2004. The results of operations for such interim periods are not necessarily indicative of the results to be achieved for the full year.

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3. Marketable Securities

     We classify our auction rate certificates as marketable securities. Our auction rate certificate investments are typically issued by state agencies and backed by student loans, with long-term stated contractual maturities and variable interest rates which reset every 28 days. In prior years, such investments had been classified as cash and cash equivalents. Accordingly, for comparative purposes, we have revised the classification to report these securities as marketable securities in all prior periods. We have also made corresponding adjustments to our Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2004 to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. The Company held auction rate certificates of $11.3 million at March 31, 2004 which were previously recorded as cash equivalents.

4. Comprehensive Loss

     Comprehensive loss is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) includes certain changes in stockholders’ equity that are excluded from net loss. Other comprehensive income (loss) includes unrealized gains and losses on our available-for-sale securities and interest rate swaps and foreign currency translation amounts. Total comprehensive loss for the three months ended March 31, 2005 and March 31, 2004 was as follows (in thousands):

                 
    2005     2004  
Net loss
  $ (1,442 )   $ (5,251 )
Unrealized gain (loss) on marketable securities and interest rate swaps
    (202 )     42  
Foreign currency translation adjustments
          15  
 
           
Comprehensive loss
  $ (1,644 )   $ (5,194 )
 
           

5. Restructuring Actions

     In the first quarter of 2004, we implemented a restructuring to shift resources from our chemical technologies business to our internal cancer therapy research and development. The restructuring included the termination of 53 staff and managerial employees, or approximately 18% of the workforce, in the following areas: 30 in chemistry production positions, 7 in chemistry-based research and development positions and 16 in administrative positions. In connection with these actions we recorded a restructuring charge of $1.1 million in the first quarter of 2004 for termination benefits. All termination benefits were paid in 2004.

     In 2002, the Company recorded a restructuring charge associated with abandoning its facility in Redwood City, California. The remaining facility-related restructuring accrual is

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primarily comprised of the difference between the Company’s lease obligation for this facility, which will be paid out through 2010, and the amount of sublease payments it will receive under its sublease agreement. Current year activity against the facility-related restructuring accrual was as follows (in thousands):

                         
    Balance as of             Balance as of  
    December 31, 2004     Payments     March 31, 2005  
Facility-related accrual
  $ 3,421     $ (294 )   $ 3,127  

     The portions of the restructuring accrual which are expected to be paid out within one year and longer than one year are included in the Condensed Consolidated Balance Sheet under “Accounts payable and accrued expenses” and “Restructuring accrual, long-term portion”, respectively.

6. Loss Per Share

     The computations of basic and diluted loss per common share are based upon the weighted average number of common shares outstanding and potentially dilutive securities. Potentially dilutive securities include stock options. Options to purchase 4,664,968 and 4,447,996 shares of common stock were not included in the March 31, 2005 and March 31, 2004 computations of diluted net loss per share, respectively, because inclusion of such shares would have an anti-dilutive effect on net loss per share.

7. Stock-Based Compensation

     We apply APB No. 25 and related interpretations in accounting for option grants under the Company’s stock option plans. Had compensation cost been determined based on the estimated fair value of options at the grant date consistent with the provisions of SFAS No. 123, as amended, our pro forma net loss and pro forma basic and diluted net loss per share would have been as follows for the three months ended March 31, 2005 and 2004 (in thousands, except per share amounts):

                 
    2005     2004  
Net loss
               
Net loss as reported
  $ (1,442 )   $ (5,251 )
Less: Total stock-based employee compensation under the fair value method of SFAS 123
    (1,829 )     (2,955 )
 
           
Pro forma net loss
  $ (3,271 )   $ (8,206 )
 
           
 
               
Basic and diluted net loss per share:
               
As reported
  $ (0.04 )   $ (0.18 )
Pro forma
  $ (0.10 )   $ (0.29 )

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     For the purposes of pro forma disclosure, the estimated value of each employee option grant was calculated on the date of grant using the Black-Scholes option-pricing model. The model was calculated using the following weighted-average assumptions: no dividend yield for all years; volatility of 90% for 2005 and 95% for 2004; risk-free interest rates of 4.21% in 2005 and 1.5% in 2004; expected lives of 6 to 18 months for options granted under the Company’s Employee Stock Purchase Plan; and expected lives of five years for 2005 and 2004 for all other options granted.

     In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123R, Accounting for Stock-Based Compensation (“SFAS No. 123R”). SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. If we had included the fair value of employee stock options in our financial statements for the three month periods ended March 31, 2005 and March 31, 2004, our net loss would have been as disclosed above. The provisions of this Statement, which were amended in April 2005, are effective for fiscal years beginning after June 15, 2005. Accordingly, we will adopt SFAS No. 123R commencing with the quarter ending March 31, 2006. The Company is currently studying various adoption alternatives, but expects the adoption of SFAS No. 123R will have a material effect on our financial statements.

8. Stock Offering

     On January 28, 2005, we sold 5.79 million shares of common stock at $5.25 per share for aggregate net proceeds of approximately $28.3 million after commission and offering expenses.

9. Pfizer Inc

     Since the inception of our relationship with Pfizer Inc in 1999, we have produced collections of chemical compounds exclusively for Pfizer using our automated high-speed compound production system. Pfizer also received a non-exclusive license to use this system in its internal production program. We expanded this contract in December 2001 to a seven-year agreement. We renegotiated this contract again in early February 2004. Under the amended terms of the contract, ArQule will continue to work with Pfizer’s scientists to match more closely its compound deliveries to those libraries which Pfizer believes have the greatest developmental opportunity. Under this new agreement, ArQule will maintain compound deliveries at approximately the same level to be supplied in 2004 instead of increasing compound deliveries as specified in the previous agreement. As of March 31, 2005, we have received $234 million from Pfizer since the inception of this relationship in 1999. If our relationship with Pfizer is successful, we could receive up to an additional $136 million over the remaining term of the contract.

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10. Hoffmann-La Roche

     On April 2, 2004, ArQule announced an alliance with Hoffmann-La Roche (“Roche”) to discover and develop drug candidates targeting the E2F biological pathway. The alliance includes a compound which is currently in phase 1 clinical development. Under the terms of the agreement, Roche obtained an option to license ArQule’s E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million, and financial support for ongoing research and development. ArQule is responsible for advancing drug candidates from early stage development into phase 2 trials. Roche may opt to license worldwide rights for the development and commercialization of products resulting from this collaboration by paying an option fee. Assuming the successful development and commercialization of a compound under the program, ArQule could receive up to $276 million in pre-determined payments, plus royalties based on net sales. Additionally, ArQule has the option to co-promote products in the U.S. The cost associated with satisfying the Roche contract is included in research and development expense in the Condensed Consolidated Statement of Operations.

11. Subsequent Event

     On April 28, 2005, we entered into a Purchase and Sale Agreement with an affiliate of Alexandria Real Estate Equities, Inc., to sell our Woburn facility and simultaneously lease the facility from the purchaser. Under the terms of the Purchase and Sale Agreement, the purchaser will obtain two parcels of land and our headquarters building. At closing, the purchaser will pay approximately $40.1 million for the properties. We will lease our existing facility and the land on which it is situated for a period of ten years at an initial annual rate of approximately $2.9 million, subject to annual escalations. We will also have options to extend the lease for up to an additional ten years.

     Upon signing of the Purchase and Sale Agreement, the purchaser was obligated to make a $500,000 deposit in escrow. In the event the purchaser defaults in its obligation to complete the transaction, the deposit will be paid to us as liquidated damages which will constitute our exclusive remedy for such breach. The transaction is expected to be completed early in May 2005.

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

OVERVIEW

     We are a biotechnology company engaged in the research and development of small molecule cancer therapeutics. We also provide fee-based chemistry services to pharmaceutical and biotechnology companies to produce novel chemical compounds with drug-like characteristics.

     We have incurred a cumulative net loss of $191 million from inception through March 31, 2005. Our expenses prior to September 2003 related to development activities associated with our chemistry services, the associated administrative costs required to support those efforts, and the cost of acquisitions. We expect research and development costs to increase in 2005 as we pursue development of our cancer programs. Although we have generated positive cash flow from operations for the last six years, we have recorded a net loss for each of those years. We expect to record a loss for 2005. We expect to continue to operate our chemistry services on a cash flow positive basis, and to invest in cancer related research and development.

     Our revenue is derived from chemistry services performed for customers, and research and development funding from our alliance with Hoffmann-La Roche (“Roche”). Revenue, expenses and gross margin fluctuate from quarter-to-quarter based upon a number of factors, notably: the timing of the recognition of revenue under our revenue recognition policy; the efforts expended on our chemistry services contractual deliverables; and the timing and extent of our cancer related research and development activities.

     This report, including the Management’s Discussion and Analysis of Financial Condition and Results of Operation (“MD&A”), contains statements reflecting management’s current expectations regarding our future performance. These statements are “forward looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements also may be included in other statements that we make. All statements that are not descriptions of historical fact are forward-looking statements, based on estimates, assumptions and projections that are subject to risks and uncertainties. These statements can generally be identified by use of forward looking terminology such as “believes”, “expects”, “intends”, “may”, “will”, “should”, “anticipates” or similar terminology. Although we believe that the expectations reflected in such forward looking statements are reasonable as of the date thereof, such expectations are based on certain assumptions regarding the progress of product development efforts under collaborative agreements, the execution of new collaborative agreements and other factors relating to our growth. Such expectations may not materialize if product development efforts, including any necessary trials of our potential drug candidates, are delayed or suspended, if positive early results are not repeated in later studies or in humans, if planned acquisitions or negotiations with potential collaborators are delayed or unsuccessful, if we are unsuccessful at integrating acquired assets or technologies or if other assumptions prove incorrect. As a result, actual results could differ materially from those currently anticipated. See

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also the risks and uncertainties discussed in our Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission on March 16, 2005.

LIQUIDITY AND CAPITAL RESOURCES

                                 
    March 31,     December 31,     Increase/(Decrease)  
    2005     2004     $     %  
    (in millions)  
Cash, cash equivalents and marketable securities
  $ 85.5     $ 71.4     $ 14.1       20 %
Working capital
    81.9       54.8       27.1       50 %
                                 
                    Increase/(Decrease)  
    Q1 2005     Q1 2004     $     %  
Cash flow from:
                               
Operating activities
  $ (12.9 )   $ (17.2 )   $ 4.3     nm
Investing activities
    (20.6 )     4.7       (25.3 )   nm
Financing activities
    28.4       (1.7 )     30.1     nm

     nm = not meaningful

     Cash flow from operating activities. The uses of our cash flow from operating activities have primarily consisted of salaries and wages for our employees, facility and facility-related costs for our offices and laboratories, fees paid in connection with preclinical and clinical studies, laboratory supplies and materials, and professional fees. The sources of our cash flow from operating activities have consisted of payments from our collaborators for services performed or upfront payments for future services. For the three months ended March 31, 2005, the total use of cash of $12.9 million was comprised of an operating profit (excluding non-cash charges) of $0.4 million, offset by an increase in accounts receivable of $10.2 million related to amounts due from Pfizer, an increase in prepaid expenses of $0.6 million related to payments for annual service agreements, a decrease in accounts payables and accruals of $1.7 million resulting from the pay-down in the first quarter of 2005 of annual bonuses and other accruals at December 31, 2004, facilities-related restructuring costs of $0.3 million, and a reduction in deferred revenues of $0.4 million. At December 31, 2004, Pfizer had prepaid for a portion of their contractual obligations due in the first quarter of 2005; similar contractual payment obligations from Pfizer due in the second quarter of 2005 were received in April 2005. Although cash flow from operations was impacted by the increase in unpaid accounts receivable in the first quarter of 2005, we do not anticipate outstanding accounts receivable will significantly increase in subsequent periods.

     Cash flow from investing activities. For the three months ended March 31, 2005, the total use of $20.6 million was comprised of net purchases of marketable securities of $19.5 million and acquisitions of fixed assets of $1.1 million. The composition and mix of cash, cash equities and marketable securities may change frequently as a result of the Company’s constant

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evaluation of conditions in financial markets, the timing of specific investments and the Company’s near term need for liquidity.

     Cash flow from financing activities. For the three months ended March 31, 2005, the total source of $28.4 million was comprised primarily of the proceeds from our January 28, 2005 stock offering, whereby we sold 5.79 million shares of common stock at $5.25 per share for aggregate net proceeds of $28.3 million after commissions and offering expenses.

     As more fully disclosed in Note 11 to our condensed consolidated financial statements and in Item 5 below, on April 28, 2005 we entered into agreements with an affiliate of Alexandria Real Estate Equities, Inc., to sell our Woburn facility and simultaneously lease the facility from the purchaser. Pursuant to the terms of the agreement, we will receive approximately $40.1 million and will lease our existing facility for a period of ten years at an initial annual rate of approximately $2.9 million, subject to annual escalations. We will also have options to extend the lease for up to an additional ten years.

     We have been cash flow positive from operations for six consecutive years, although we do not expect to be cash flow positive from operations in 2005 as we pursue development of our cancer programs. We expect that our available cash and marketable securities of $85.5 million at March 31, 2005, together with operating revenues, investment income, and the approximately $40.1 million we expect to receive from the sale of our Woburn facility, will be sufficient to finance our working capital and capital requirements for the next three to four years.

     Our cash requirements may vary materially from those now planned depending upon the results of our drug discovery and development strategies, our ability to enter into any additional corporate collaborations in the future and the terms of such collaborations, results of research and development, the need for currently unanticipated capital expenditures, competitive and technological advances, acquisitions and other factors. We cannot guarantee that we will be able to obtain additional customers for our chemistry services, or that such services will produce revenues adequate to fund our operating expenses. We cannot guarantee that we will be able to develop any of our drug candidates into a commercial product. If we experience increased losses, we may have to seek additional financing from public and private sale of our securities, including equity securities. There can be no assurance that additional funding will be available when needed or on acceptable terms.

     Our principal contractual obligations were comprised of the following as of March 31, 2005 (in thousands):

                                         
                    Within              
            Within     1-4     Within        
    Total     1 year     years     4-7 years     After 7 years  
Long-term debt obligations
  $ 18     $ 18     $     $     $  
Capital lease obligation
    100       100                    
Operating lease obligations
    7,834       2,826       3,910       1,098        
Purchase obligations
    2,251       2,051       200              
 
                             
Total
  $ 10,203     $ 4,995     $ 4,110     $ 1,098     $  
 
                             

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     Included in the total minimum payments for operating leases is approximately $5.5 million related to unoccupied real estate in California which was accrued as a liability, net of contractual sublease income, as a part of the Company’s restructuring actions (see Restructuring charges below). Purchase obligations are comprised primarily of outsourced preclinical and clinical trial expenses and payments to license certain intellectual property to support the Company’s research efforts.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     A “critical accounting policy” is one which is both important to the portrayal of the Company’s financial condition and results and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. See the discussion in our significant accounting policies in Note 2 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for additional information.

Revenue Recognition — Compound Development Revenue

     Historically, ArQule has entered into various chemistry-based collaborative agreements with pharmaceutical and biotechnology companies under which ArQule produces and delivers compound arrays and performs other research and development services. Revenue from collaborative agreements includes non-refundable technology transfer fees, funding of compound development work, payments based upon delivery of specialized compounds meeting the collaborators specified criteria, and certain milestones and royalties on product sales. Non-refundable technology transfer fees are recognized as revenue when we have the contractual right to receive such payment, provided a contractual arrangement exists, the contract price is fixed or determinable, the collection of the resulting receivable is reasonably assured and we have no further performance obligations under the license agreement. When we have performance obligations under the terms of a contract, non-refundable fees are recognized as revenue as we complete our obligations. Where our level of effort is relatively constant over the performance period, the revenue is recognized on a straight-line basis. Funding of compound development work is recognized over the term of the applicable contract using the proportional achievement of deliveries against a compound delivery schedule or the development labor expended against a total research and development labor plan as the measure of progress toward completion. Any significant changes in the assumptions underlying our estimates to complete a contract (e.g., changes in the number of person hours to develop compounds, or changes in throughput capacity of our machinery and equipment) could impact our revenue recognition. Payments based upon delivery of specialized compounds meeting the collaborator’s specified criteria are recognized as revenue when these compounds are delivered and payment by the collaborator is reasonably assured. Revenues from milestone payments related to chemistry-based collaboration arrangements under which we have no continuing performance obligations are recognized upon achievement of the related milestone. Revenues from milestone payments related to arrangements under which the Company has continuing performance obligations are recognized

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as revenue upon achievement of the milestone only if all of the following conditions are met: the milestone payments are non-refundable; achievement of the milestone was not reasonably assured at the inception of the arrangement; substantive effort is involved in achieving the milestone; and the amount of the milestone is reasonable in relation to the effort expended or the risk associated with achievement of the milestone. If any of these conditions are not met, the milestone payments are deferred and recognized as revenue over the term of the arrangement as we complete our performance obligations. Payments received under these arrangements prior to the completion of the related work are recorded as deferred revenue. The Company applies Emerging Issues Task Force No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”), to determine if a contract with multiple deliverables has more than one unit of accounting.

     Compound development revenue was derived from the following contractual elements for the three months ended March 31, 2005 and 2004 (in thousands):

                 
    2005     2004  
Non-refundable technology transfer payments
  $ 2     $ 2  
Funding of compound development
    172       581  
Payments based on delivery of specialized compounds
    12,116       10,428  
Milestone payments
          750  
 
           
Total compound development revenue
  $ 12,290     $ 11,761  
 
           

Revenue Recognition — Research and Development Revenue

     On April 2, 2004, ArQule announced an alliance with Roche to discover and develop drug candidates targeting the E2F biological pathway. The alliance includes a compound which is currently in phase 1 clinical development. Under the terms of the agreement, Roche obtained an option to license ArQule’s E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million and financial support for ongoing research and development. ArQule is responsible for advancing drug candidates from early stage development into phase 2 trials. Roche may opt to license worldwide rights for the development and commercialization of products resulting from this collaboration by paying an option fee. Assuming the successful development and commercialization of a compound under the program, ArQule could receive up to $276 million in pre-determined payments, plus royalties based on net sales. ArQule considers the development portion of the arrangement to be a single unit of accounting purposes of revenue recognition, and will recognize the initial and ongoing development payments as research and development revenue on a straight-line basis over the maximum estimated development period. We estimate the maximum development period could extend until December 2009, although this period may ultimately be shorter depending upon the outcome of the development work, which would result in accelerated recognition of the development revenue. Milestone and royalty payments will be recognized as revenue when earned. The cost associated with satisfying the Roche contract is included in research and development expense in the Condensed Consolidated Statement of Operations as incurred.

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RESULTS OF OPERATIONS

Three months (Q1) ended March 31, 2005 and 2004:

Revenue

                                 
    Q1     Q1     Increase/(decrease)  
    2005     2004     $     %  
    (in millions)  
Compound development revenue
  $ 12.3     $ 11.8     $ 0.5       4 %
Research and development revenue
    1.7             1.7        
 
                       
Total revenue
  $ 13.9     $ 11.8     $ 2.2       19 %
 
                       

     The increase in compound development revenue is primarily due to an increase in revenue from Pfizer, from $10.4 million in the first quarter of 2004 to $12.1 million in the first quarter of 2005, as a result of an increase in the number of compounds shipped under the collaboration. This increase was partially offset by reductions in revenue from Solvay of $0.3 million, whose contract ended in June 2004, and from Wyeth of $0.8 million, relating to a contractual milestone payment received in the first quarter of 2004. Research and development revenue is comprised of revenue from Roche in connection with the alliance agreement signed in April 2004.

Cost of revenue — compound development and gross margin percentage

                                 
    Q1     Q1     Increase/(decrease)  
    2005     2004     $     %  
    (in millions)  
Cost of compound development revenue
  $ 7.4     $ 8.5     $ (1.2 )     (14 %)
Gross margin % of revenue
    40.2 %     27.4 %     12.8 %        

     The decrease in cost of compound development revenue is primarily due to lower headcount, lower material and supply costs, improved manufacturing yields, and lower facility costs due to the consolidation of certain manufacturing facilities. Compound development gross margin percentage tends to vary from quarter to quarter. It is higher in the first quarter of 2005 than the first quarter of 2004 due to improved manufacturing yields and the timing of revenue recognition and materials purchased to satisfy the Pfizer contract.

Research and development

                                 
    Q1     Q1     Increase/(decrease)  
    2005     2004     $     %  
    (in millions)  
Research and development
  $ 5.9     $ 5.0     $ 0.9       18 %

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     ArQule’s research and development expense consists primarily of salaries and related expenses for personnel, costs of contract manufacturing services, costs of facilities and equipment, fees paid to professional service providers in conjunction with independently monitoring our clinical trials and acquiring and evaluating data in conjunction with our clinical trials, fees paid to research organizations in conjunction with preclinical animal studies, costs of materials used in research and development, consulting, license, and sponsored research fees paid to third parties and depreciation of capital resources used to develop our products. We expect our research and development expense to increase as we continue to develop our portfolio of oncology programs.

     We have not accumulated and tracked our internal historical research and development costs or our personnel and personnel-related costs on a program-by-program basis. In addition, we use our employee and infrastructure resources across several projects, and many of our costs are not attributable to an individually named project; rather they are directed to broadly applicable research endeavors. As a result, we cannot state the costs incurred for each of our oncology programs on a program-by-program basis, or to support our alliance agreement with Roche. While we cannot state the internal costs incurred for each of our oncology programs on a program-by-program basis, the expenses incurred by us to third parties for preclinical and clinical trials since inception of each program were as follows (in thousands):

                         
Oncology program   Current status     2005-to-date     Program-to-date  
E2F modulation — ARQ501
  Phase 1   $ 492     $ 2,476  
E2F modulation — 550 series
  Preclinical           83  
Cancer Survival Protein modulation - 650 series
  Preclinical     756       1,035  

     We expect that a large percentage of our research and development expenses in the future will be incurred in support of our current and future oncology programs. These expenditures are subject to numerous uncertainties in timing and cost to completion. We test potential products in numerous preclinical studies for safety, toxicology, and efficacy. We then may conduct multiple clinical trials for each product. As we obtain results from trials, we may elect to discontinue or delay clinical trials for certain products in order to focus our resources on more promising products. Completion of clinical trials may take several years or more, but the length of time generally varies substantially according to the type, complexity, novelty, and intended use of a product. It is not unusual for the preclinical and clinical development of these types of products to each take nine years or more, and for total development costs to exceed $500 million for each product.

     We estimate that clinical trials of the type generally needed to secure new drug approval are typically completed over the following timelines:

         
Clinical Phase   Estimated Completion Period  
Phase 1
  1-2 years
Phase 2
  2-3 years
Phase 3
  2-4 years

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The duration and the cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including, among others, the following:

  •   the number of clinical sites included in the trials;
 
  •   the length of time required to enroll suitable patient subjects;
 
  •   the number of patients that ultimately participate in the trials;
 
  •   the duration of patient follow-up to ensure the absence of long-term adverse events; and
 
  •   the efficacy and safety profile of the product.

     An element of our business strategy is to pursue the research and development of a broad pipeline of products. This is intended to allow us to diversify the risks associated with our research and development expenditures. As a result, we believe our future capital requirements and future financial success are not substantially dependent on any one product. To the extent we are unable to maintain a broad pipeline of products, our dependence on the success of one or a few products increases.

     Our strategy includes the option of entering into alliance arrangements with third parties to participate in the development and commercialization of our products, such as our collaboration agreement with Roche. In the event that third parties have control over the clinical trial process for a product, the estimated completion date would largely be under control of that third party rather than under our control. We cannot forecast with any degree of certainty whether our products will be subject to future collaborative arrangements or how such arrangements would affect our development plans or capital requirements.

     As a result of the uncertainties discussed above, we are unable to determine the duration and completion costs of our oncology programs or when and to what extent we will receive cash inflows from the commercialization and sale of a product. Our inability to complete our oncology programs in a timely manner or our failure to enter into collaborative agreements, when appropriate, could significantly increase our capital requirements and could adversely impact our liquidity. These uncertainties could force us to seek additional, external sources of financing from time-to-time in order to continue with our strategy. Our inability to raise additional capital, or to do so on terms reasonably acceptable to us, would jeopardize the future success of our business.

     The increase in total research and development expense in the three months ended March 31, 2005 versus the same period last year reflects the hiring of additional scientists, increased laboratory expenses and the cost of preclinical and clinical studies to advance the Company’s oncology programs. At March 31, 2005, we had approximately 70 employees dedicated to our

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research and development programs, up from 67 at December 31, 2004 and 48 at March 31, 2004.

Marketing general and administrative

                                 
    Q1     Q1     Increase/(decrease)  
    2005     2004     $     %  
    (in millions)  
Marketing, general and administrative
  $ 2.7     $ 2.6     $ 0.1       3 %

     Marketing, general and administrative expense was essentially flat period over period, as cost savings associated with headcount reductions and lower professional fees were more than offset by charges associated with severance paid to certain senior managers. Marketing, general and administrative headcount was 47 at March 31, 2005, compared to 51 at December 31, 2004 and 52 at March 31, 2004.

Restructuring charges

     In the first quarter of 2004, we implemented a restructuring to shift resources from our chemical technologies business to our internal cancer therapy research and development. The restructuring included the termination of 53 staff and managerial employees, or approximately 18% of the workforce, in the following areas: 30 in chemistry production positions, 7 in chemistry-based research and development positions and 16 in administrative positions. In connection with these actions we recorded a restructuring charge of $1.1 million in the first quarter of 2004 for termination benefits. All termination benefits were paid in 2004.

     In 2002, the Company recorded a restructuring charge associated with abandoning its facility in Redwood City, California. The remaining facility-related restructuring accrual is primarily comprised of the difference between the Company’s lease obligation for this facility, which will be paid out through 2010, and the amount of sublease payments it will receive under its sublease agreement. Current year activity against the facility-related restructuring accrual was as follows (in thousands):

                         
    Balance as of             Balance as of  
    December 31, 2004     Payments     March 31, 2005  
Facility-related accrual
  $ 3,421     $ (294 )   $ 3,127  

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Net investment income

                                 
    Q1     Q1     Increase/(decrease)  
    2005     2004     $     %  
    (in millions)  
Net investment income
  $ 0.5     $ 0.2     $ 0.3       198 %

     Net investment income increased due to a higher average balance of marketable securities as a result of the $28.3 million net proceeds from our stock offering in January 2005, and to lower interest expense as a result of paying down our outstanding loan balances.

Net loss

                                 
    Q1     Q1     Increase/(decrease)  
    2005     2004     $     %  
    (in millions)  
Net loss
  $ 1.4     $ 5.3     $ (3.8 )     (73 %)

     The reduction in net loss is the result of the increased revenues, improved gross margin and increased net investment income, which more than offset the increase in research and development expense. Further, we recorded a $1.1 million restructuring charge in the first quarter of 2004 with no comparable charge in 2005.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As part of our investment portfolio we own financial instruments that are sensitive to market risk. Our investment portfolio is used to preserve our capital until it is used to fund operations, including our research and development activities. None of these market-risk sensitive instruments are held for trading purposes. We invest our cash primarily in money market mutual funds and U.S. Government and other investment grade debt securities. These investments are evaluated quarterly to determine the fair value of the portfolio. Our investment portfolio includes only marketable securities with active secondary or resale markets to help ensure liquidity. We have implemented policies regarding the amount and credit ratings of investments. Due to the conservative nature of these policies, we do not believe we have material exposure from market risk.

     The carrying amounts reflected in the consolidated balance sheet of cash and cash equivalents, trade receivables, and trade payables approximate fair value at March 31, 2005 due to the short-term maturities of these instruments.

ITEM 4. CONTROLS AND PROCEDURES

     Under the supervision and with the participation of the Company’s President and Chief Executive Officer and Chief Financial Officer (its principal executive officer and principal accounting and financial officer), the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures. Based on that evaluation, the President and Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures as of March 31, 2005 are effective in controlling and reporting the financial results of the Company’s operations. There were no changes in the Company’s internal controls and procedures over financial reporting during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1 – Legal Proceedings. None.

Item 2 – Changes in Securities and Use of Proceeds. None.

Item 3 – Defaults Upon Senior Securities. None.

Item 4 – Submission of Matters to a Vote of Security Holders. None.

Item 5 – Other Information.

     On April 28, 2005, we entered into a Purchase and Sale Agreement with an affiliate of Alexandria Real Estate Equities, Inc., to sell our Woburn facility and simultaneously lease the facility from the purchaser. Under the terms of the Purchase and Sale Agreement, the purchaser will obtain two parcels of land and our headquarters building. At closing, the purchaser will pay approximately $40.1 million for the properties. We will lease our existing facility and the land on which it is situated for a period of ten years at an initial annual rate of approximately $2.9 million, subject to annual escalations. We will also have options to extend the lease for up to an additional ten years.

     Upon signing of the Purchase and Sale Agreement, the purchaser was obligated to make a $500,000 deposit in escrow. In the event the purchaser defaults on its obligation to complete the transaction, the deposit will be paid to us as liquidated damages which will constitute our exclusive remedy for such breach. Although the transaction is expected to be completed early in May 2005, the transaction is subject to certain closing conditions and there can be no assurance that the transaction will be consummated.

Item 6 – Exhibits.

  31.1   Rule 13a-14(a) Certificate of Chief Executive Officer
 
  31.2   Rule 13a-14(a) Certificate of Chief Financial Officer
 
  32   Rule 13a-14(b) Certificate of Chief Executive Officer and Chief Financial Officer

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ArQule, Inc.

SIGNATURES

Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

     
  ArQule, Inc.
 
   
Date: April 29, 2005
  /s/ Louise A. Mawhinney
Louise A. Mawhinney
Vice President, Chief Financial Officer, Treasurer and Secretary

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