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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 June 30, 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 August 3, 2005:
Common Stock, par value $.01 35,170,177 shares outstanding          
 
 


ARQULE, INC.
QUARTER ENDED JUNE 30, 2005
TABLE OF CONTENTS
             
        Page
         
PART I — FINANCIAL INFORMATION        
Item 1 —
  Unaudited Consolidated Financial Statements        
     Condensed Consolidated Balance Sheet (Unaudited) June 30, 2005 and December 31, 2004     2  
     Condensed Consolidated Statement of Operations (Unaudited) Three months and six months ended June 30, 2005 and 2004     3  
     Condensed Consolidated Statement of Cash Flows (Unaudited) Six months ended June 30, 2005 and 2004     4  
     Notes to Unaudited Consolidated Financial Statements     5  
   Management’s Discussion and Analysis of Financial Condition and Results of Operations     10  
   Quantitative and Qualitative Disclosures about Market Risk     17  
   Controls and Procedures     18  
 PART II — OTHER INFORMATION     18  
 Signatures     20  
 EX-21 Amended and Restated Lease
 EX-31.1 Section 302 CEO Certification
 EX-31.2 Section 302 CFO Certification
 EX-32 Section 906 CEO & CFO Certification

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ARQULE, INC.
CONDENSED CONSOLIDATED BALANCE SHEET (UNAUDITED)
                     
    June 30,   December 31,
    2005   2004
         
    (In thousands,
    except share data)
ASSETS
Current assets:
               
 
Cash and cash equivalents
  $ 5,580     $ 7,131  
 
Marketable securities
    124,604       64,234  
 
Accounts receivable
    3,994       319  
 
Prepaid expenses and other current assets
    3,402       2,893  
             
   
Total current assets
    137,580       74,577  
 
Property and equipment, net
    9,352       44,895  
 
Other assets
    1,492       746  
             
    $ 148,424     $ 120,218  
             
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
 
Accounts payable and accrued expenses
  $ 6,687     $ 7,683  
 
Current portion of long-term debt
    74       144  
 
Current portion of deferred revenue
    11,567       11,968  
 
Current portion of deferred gain on sale leaseback
    558        
             
   
Total current liabilities
    18,886       19,795  
Restructuring accrual, net of current portion
    2,378       2,728  
Long-term debt, net of current portion
          17  
Deferred revenue, net of current portion
    13,554       15,226  
Deferred gain on sale leaseback, net of current portion
    4,973        
             
   
Total liabilities
    39,791       37,766  
             
Stockholders’ equity:
               
 
Common stock, $0.01 par value; 50,000,000 shares authorized; 35,106,617 and 28,982,774 shares issued and outstanding at June 30, 2005 and December 31, 2004, respectively
    351       290  
 
Additional paid-in capital
    301,881       271,805  
 
Accumulated other comprehensive loss
    (471 )     (386 )
 
Accumulated deficit
    (193,128 )     (189,257 )
             
   
Total stockholders’ equity
    108,633       82,452  
             
    $ 148,424     $ 120,218  
             
The accompanying notes are an integral part of these interim unaudited financial statements.

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ARQULE, INC.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS (UNAUDITED)
                                     
    Three Months Ended   Six Months Ended
    June 30   June 30
         
    2005   2004   2005   2004
                 
    (In thousands, except per share data)
Revenue:
                               
 
Compound development revenue
  $ 11,802     $ 12,110     $ 24,093     $ 23,603  
 
Compound development revenue — related party
          250             518  
 
Research and development revenue
    1,652       1,652       3,304       1,652  
                         
   
Total revenue
    13,454       14,012       27,397       25,773  
                         
Costs and expenses:
                               
 
Cost of compound development revenue
    7,674       7,340       15,027       15,745  
 
Cost of compound development revenue — related party
          125             259  
 
Research and development
    6,217       4,712       12,070       9,679  
 
Marketing, general and administrative
    2,238       2,215       4,922       4,818  
 
Restructuring charge
                      1,072  
                         
   
Total costs and expenses
    16,129       14,392       32,019       31,573  
                         
   
Loss from operations
    (2,675 )     (380 )     (4,622 )     (5,800 )
Net investment income
    498       246       1,001       415  
Loss on investment
    (250 )           (250 )      
                         
   
Net loss
  $ (2,427 )   $ (134 )   $ (3,871 )   $ (5,385 )
                         
Basic and diluted net loss per share
  $ (0.07 )   $ (0.00 )   $ (0.11 )   $ (0.19 )
                         
Weighted average common shares outstanding —
basic and diluted
    34,953       28,808       34,003       28,769  
                         
The accompanying notes are an integral part of these interim unaudited financial statements.

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ARQULE, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
                         
    Six Months Ended
    June 30
     
    2005   2004
         
    (In thousands)
Cash flows from operating activities:
               
 
Net loss
  $ (3,871 )   $ (5,385 )
 
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
               
   
Depreciation and amortization
    3,396       3,723  
   
Amortization of premium/discount on marketable securities
    181       224  
   
Non-cash restructuring charge
          76  
   
Non-cash stock compensation
    345       49  
   
Loss on investment
    250        
   
Loss on disposal of fixed assets
    228        
   
Changes in operating assets and liabilities:
               
     
Accounts receivable
    (3,675 )     (3,391 )
     
Prepaid expenses and other current assets
    (510 )     613  
     
Other assets
    (996 )     135  
     
Accounts payable and accrued expenses
    (1,346 )     (3,792 )
     
Deferred revenue
    (2,073 )     11,609  
             
       
Net cash provided by (used in) operating activities
    (8,071 )     3,861  
             
Cash flows from investing activities:
               
 
Purchases of marketable securities
    (98,136 )     (27,348 )
 
Proceeds from sale or maturity of marketable securities
    37,503       16,888  
 
Additions to property and equipment
    (1,791 )     (635 )
 
Net proceeds from sale of facility
    39,385        
             
   
Net cash used in investing activities
    (23,039 )     (11,095 )
             
Cash flows from financing activities:
               
 
Principal repayments of long-term debt
    (232 )     (3,476 )
 
Proceeds from registered direct stock offering, net
    28,349        
 
Proceeds from exercise of common stock options
    1,442       416  
             
   
Net cash provided by (used in) financing activities
    29,559       (3,060 )
             
 
Effect of foreign exchange rates on cash and cash equivalents
          14  
             
 
Net decrease in cash and cash equivalents
    (1,551 )     (10,280 )
 
Cash and cash equivalents, beginning of period
    7,131       18,839  
             
 
Cash and cash equivalents, end of period
  $ 5,580     $ 8,559  
             
The accompanying notes are an integral part of these interim 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 and pharmaceutical 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 U.S. 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 June 30, 2005, the results of our operations for the three and six months ended June 30, 2005 and June 30, 2004, and cash flows for the six months ended June 30, 2005 and June 30, 2004. The results of operations and cash flows for such interim periods are not necessarily indicative of the results to be achieved for the full year.
3. Marketable Securities
      The following is a summary of the available-for-sale marketable securities we held at June 30, 2005 and December 31, 2004 (in thousands):
                                   
        Gross   Gross    
    Amortized   Unrealized   Unrealized   Fair
June 30, 2005   Cost   Gains   Losses   Value
                 
Corporate bonds
                               
 
Due within 1 year
  $ 5,538     $     $ (9 )   $ 5,529  
 
Due within 1 to 5 years
    11,361             (76 )     11,285  
                         
Total corporate bonds
    16,899             (85 )     16,814  
US federal and state agency backed securities
                               
 
Due within 1 to 5 years
    108,176             (386 )     107,790  
                         
Total marketable securities
  $ 125,075     $     $ (471 )   $ 124,604  
                         

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        Gross   Gross    
    Amortized   Unrealized   Unrealized   Fair
December 31, 2004   Cost   Gains   Losses   Value
                 
Corporate bonds
                               
 
Due within 1 to 5 years
  $ 11,567     $     $ (64 )   $ 11,503  
US federal and state agency backed securities
                               
 
Due within 1 to 5 years
    53,053             (322 )     52,731  
                         
Total marketable securities
  $ 64,620     $     $ (386 )   $ 64,234  
                         
      Marketable securities are carried at fair market value at June 30, 2005 and December 31, 2004, and are classified as current as the funds are highly liquid and are available to meet working capital needs and to fund current operations. The gross unrealized losses on marketable securities at June 30, 2005 and December 31, 2004 relate to unfavorable market rate fluctuations which have decreased the fair value of the investments below the amortized cost. The Company believes these fluctuations are temporary and therefore has not realized an impairment loss on these investments at June 30, 2005.
      We classify auction rate certificates as marketable securities in 2005. 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. Through September 30, 2004, such investments were classified as cash and cash equivalents. Accordingly, for comparative purposes, we have revised the classification to report these securities as marketable securities in prior periods. We have also made corresponding adjustments to our Condensed Consolidated Statement of Cash Flows for the six months ended June 30, 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 $18.3 million at June 30, 2004 which were previously recorded as cash equivalents. Auction rate security purchases of $7.0 million and sales of $2.0 million through June 30, 2004 were previously reflected as cash and cash equivalents in the Condensed Consolidated Statement of Cash Flows.
4. Investment in Non-Marketable Securities
      In July 2001, we purchased approximately 1.8 million preferred shares of a privately-owned proteomics company for $5 million, representing an approximate 8% ownership interest. Based on events affecting the financial condition of the company during the second quarter of 2005, we determined that the value of the investment had declined to the degree of other than temporary impairment, and as such, we recorded a non-cash loss on investment of $250,000 to write off the remaining carrying value of this investment.
5. 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 marketable securities and interest rate swaps and foreign currency translation amounts. Total comprehensive loss for the three and six months ended June 30, 2005 and June 30, 2004 was as follows (in thousands):
                                 
    Three Months Ended   Six Months Ended
    June 30   June 30
         
    2005   2004   2005   2004
                 
Net loss
  $ (2,427 )   $ (134 )   $ (3,871 )   $ (5,385 )
Unrealized gain (loss) on marketable securities and interest rate swaps
    117       (445 )     (85 )     (403 )
Foreign currency translation adjustments
          71             15  
                         
Comprehensive loss
  $ (2,310 )   $ (508 )   $ (3,956 )   $ (5,773 )
                         

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6. 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, consistent with our decision at that time to focus on oncology. 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,       June 30,
    2004   Payments   2005
             
Facility-related accrual
  $ 3,421     $ (462 )   $ 2,959  
      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, net of current portion”, respectively.
7. 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, including stock options. Options to purchase 4,305,120 and 4,502,515 shares of common stock were not included in the computations of diluted net loss per share for the three and six months end June 30, 2005 and June 30, 2004, respectively, because inclusion of such shares would have an anti-dilutive effect on net loss per share.
8. 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 and six months ended June 30, 2005 and 2004 (in thousands, except per share amounts):
                                   
    Three Months Ended   Six Months Ended
    June 30   June 30
         
    2005   2004   2005   2004
                 
Net loss
                               
Net loss as reported
  $ (2,427 )   $ (134 )   $ (3,871 )   $ (5,385 )
 
Add: Stock-based employee compensation expense included in reported net loss
    289             289        
 
Less: Total stock-based employee compensation under the fair value method of SFAS 123
    (1,078 )     (1,154 )     (2,907 )     (4,141 )
                         
Pro forma net loss
  $ (3,216 )   $ (1,288 )   $ (6,489 )   $ (9,526 )
                         
Basic and diluted net loss per share:
                               
As reported
  $ (0.07 )   $ (0.00 )   $ (0.11 )   $ (0.19 )
Pro forma
  $ (0.09 )   $ (0.04 )   $ (0.19 )   $ (0.33 )

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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 85% for 2005 and 95% for 2004; risk-free interest rates of 3.71% 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 requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. SFAS No. 123R requires that the fair value of such stock-based compensation be recognized as an expense beginning on the date that a company grants the awards to an employee and 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 and six month periods ended June 30, 2005 and June 30, 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.
9. 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.
10. Pfizer Inc
      Since the inception of our contractual agreement with Pfizer Inc (“Pfizer”) 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 supplied in 2004 instead of increasing compound deliveries as specified in the previous agreement. As of June 30, 2005, we have received $251 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 $119 million over the remaining term of the contract.
11. Hoffmann-La Roche
      On April 2, 2004, we announced an alliance with Hoffmann-La Roche (“Roche”) to discover and develop drug candidates targeting the E2F biological pathway. The alliance includes a compound, ARQ 501, currently in phase 1 clinical development. Under the terms of our contractual agreement, Roche obtained an option to license our E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million and is providing financial support for ongoing research and development. We are 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, we could receive up to $276 million in pre-determined payments, plus royalties based on net sales. Additionally, we have 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.

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12. Sale Leaseback Transaction
      On May 2, 2005, we completed a transaction to sell our Woburn facility and simultaneously lease the facility from the purchaser. The lease was subsequently amended on June 30, 2005. Under the terms of the transaction, the purchaser obtained two parcels of land and our headquarters building in exchange for a cash payment of approximately $40.1 million. We are leasing our existing facility and the associated land for a period of ten years at an average annual rental rate of $3.4 million. We also have options to extend the lease for up to an additional ten years. In accordance with Statement of Financial Accounting Standards No. 98, Accounting for Leases, we are applying sale leaseback accounting to the transaction and are treating the lease as an operating lease. As a result, we reduced our net fixed assets by $33.7 million, representing the net book value of the assets sold on the date of the lease amendment, and realized a gain on the sale of $5.5 million, which has been deferred and will be amortized over the initial ten-year lease term as a reduction in rent expense.

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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 based on our proprietary Activated Checkpoint Therapysm (ACTsm) platform. 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 $193 million from inception through June 30, 2005. We have recorded a net loss for the last six years, and we expect to record a net loss for 2005. Our expenses prior to September 2003 related to our chemistry services operations and the cost of acquisitions. In September 2003, we acquired Cyclis Pharmaceuticals, Inc. (“Cyclis”), an early stage oncology company. As a result of our strategic corporate decision to focus on oncology drug discovery and development following this acquisition, we expect research and development costs to increase in 2005 and in future years as we pursue the clinical and pre-clinical development of products generated from our multiple cancer programs. We may retain proprietary rights for certain of these programs, which could require an increased investment. We expect to continue to operate our chemistry services on a cash flow positive basis based on the continuation of our contractual agreement with Pfizer Inc (“Pfizer”) and to continue investing in both partnered and proprietary cancer-related research and development.
      Our revenue is derived from chemistry services performed for customers, particularly Pfizer, and from research and development funding provided under our agreement 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.
Liquidity and Capital Resources
                                   
            Increase/(Decrease)
    June 30,   December 31,    
    2005   2004   $   %
                 
    (In millions)
Cash, cash equivalents and marketable securities
  $ 130.2     $ 71.4     $ 58.8       82%  
Working capital
    118.7       54.8       63.9       117%  
 
      Q2 YTD
2005
      Q2 YTD
2004
                 
                         
 
Cash flow from:
                               
 
Operating activities
  $ (8.1 )   $ 3.9     $ (11.9 )     nm  
 
Investing activities
    (23.0 )     (11.1 )     (11.9 )     nm  
 
Financing activities
    29.6       (3.1 )     32.6       nm  
 
nm = not meaningful
      Cash flow from operating activities. Cash used in operating activities has primarily consisted of salaries and wages, facility and facility-related costs, preclinical and clinical study costs, 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 six months ended June 30, 2005, the net use of cash of $8.1 million was primarily comprised of an increase in accounts receivable of $3.7 million related to amounts due from Pfizer, an increase in prepaid and other assets of $1.5 million, a decrease in accounts payable and accruals of $1.3 million, and a reduction in deferred revenues of $2.1 million, partially offset by an operating profit (excluding non-cash items) of $0.5 million.

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      Cash flow from investing activities. For the six months ended June 30, 2005, the net use of $23.0 million was comprised of net purchases of marketable securities of $60.6 million and acquisitions of fixed assets of $1.8 million, offset by the proceeds from the sale of the Company’s Woburn headquarters facility, net of commissions and closing costs, of $39.4 million. The net purchases of marketable securities reflect the investment of the Company’s net proceeds from the issuance of common stock and the sale of its Woburn facility. The composition and mix of cash, cash equivalents and marketable securities may change frequently as a result of the Company’s constant 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 six months ended June 30, 2005, the total source of $29.7 million was comprised 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, and the proceeds from the issuance of common stock associated with the exercise of stock options of $1.4 million, partially offset by principal payments on long-term debt of $0.2 million.
      As more fully disclosed in Note 12 to our condensed consolidated financial statements, on May 2, 2005 we completed a transaction to sell and lease back our Woburn facility. The lease portion of the transaction was amended on June 30, 2005. Pursuant to the terms of the agreement, we received approximately $40.1 million, before commissions and closing costs, and will lease our existing facility for a period of ten years at an average annual rental rate of $3.4 million. We also have options to extend the lease for up to an additional ten years.
      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 $130 million at June 30, 2005, together with operating revenues and investment income, will be sufficient to finance our working capital and capital requirements for approximately the next three 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 June 30, 2005 (in thousands):
                                           
            Within   Within    
        Within   1-4   4-7   After 7
    Total   1 Year   Years   Years   Years
                     
Long-term debt obligations
  $ 9     $ 9     $     $     $  
Capital lease obligation
    65       65                    
Operating lease obligations
    40,754       6,822       13,417       11,145       9,370  
Purchase obligations
    3,968       3,368       390       210        
                               
 
Total
  $ 44,796     $ 10,264     $ 13,807     $ 11,355     $ 9,370  
                               
      Included in the total minimum payments for operating leases is approximately $5.2 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.

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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, we have entered into various chemistry-based collaborative agreements with pharmaceutical and biotechnology companies under which we produce and deliver compound arrays and perform 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 we have continuing performance obligations are recognized 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 six months ended June 30, 2005 and 2004 (in thousands):
                 
    2005   2004
         
Non-refundable technology transfer payments
  $ 5     $ 5  
Funding of compound development
    235       1,143  
Payments based on delivery of specialized compounds
    23,853       22,223  
Milestone payments
          750  
             
Total compound development revenue
  $ 24,093     $ 24,121  
             

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Revenue recognition — research and development revenue
      On April 2, 2004, we 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 our E2F program in the field of cancer therapy. Roche provided immediate research funding of $15 million and is providing financial support for ongoing research and development. We are responsible for advancing drug candidates from early stage development into phase 2 trials. Roche may exercise its option 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, we could receive up to $276 million in pre-determined payments, plus royalties based on net sales. We consider the development portion of the arrangement to be a single unit of accounting for the purposes of revenue recognition, and we 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.
Results of Operations
      Three months (Q2) and six months ended June 30, 2005 and 2004:
Revenue
                                     
            Increase/
            (Decrease)
             
    2005   2004   $   %
                 
    (In millions)
For the three months ended June 30:
                               
 
Compound development revenue
  $ 11.8     $ 12.4     $ (0.6 )     (5 )%
 
Research and development revenue
    1.7       1.7              
                         
   
Total revenue
  $ 13.5     $ 14.0     $ (0.6 )     (4 )%
                         
For the six months ended June 30:
                               
 
Compound development revenue
  $ 24.1     $ 24.1     $        
 
Research and development revenue
    3.3       1.7       1.7       100 %
                         
   
Total revenue
  $ 27.4     $ 25.8     $ 1.6       6 %
                         
      The decrease in compound development revenue in the second quarter of 2005 from the second quarter of 2004 reflects reductions in revenue from Sankyo of $0.3 million and Novartis of $0.3 million, whose contracts ended in June 2004 and February 2005, respectively. Pfizer revenue was approximately $11.7 million in Q2 2005 and Q2 2004. Total compound development revenue was flat in the first six months of 2005 compared to the same six month period of 2004, as an increase in Pfizer revenue to $23.9 million in 2005 from $22.2 million in 2004 was offset by a.) reductions in revenue from Sankyo of $0.6 million and from Novartis of $0.3 million, as these contracts ended in June 2004 and February 2005 respectively, and b.) a reduction in revenue 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 our alliance agreement. The Company recognized three months of revenue under the Roche agreement in 2004 and six months in 2005.

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Cost of revenue — compound development and gross margin percentage
                                   
            Increase/(Decrease)
             
    2005   2004   $   %
                 
    (In millions)
For the three months ended June 30:
                               
 
Cost of revenue-compound development
  $ 7.7     $ 7.5     $ 0.2       3 %
 
Compound development gross margin %
    35.0 %     39.6 %             (4.6 )%
For the six months ended June 30:
                               
 
Cost of revenue-compound development
  $ 15.0     $ 16.0     $ (1.0 )     (6 )%
 
Compound development gross margin %
    37.6 %     33.7 %             4.0 %
      Cost of compound development revenue in the second quarter of 2005 increased slightly over the same period of 2004. Gross margin percentage, which tends to vary from quarter to quarter, decreased in the second quarter of 2005 from the second quarter of 2004 due to the inclusion in Q2 2004 of $0.6 million of revenue from Sankyo and Novartis with no associated cost of revenue. Cost of compound development revenue for the six months ended June 30, 2005 decreased from the same period of 2004 due to cost savings associated with lower headcount, lower material and supply costs, improved manufacturing yields and lower facility costs. Gross margins for the first six months of 2005 increased due primarily to improved manufacturing yields and other cost savings in the first quarter of 2005.
Research and development
                                   
            Increase/(Decrease)
             
    2005   2004   $   %
                 
    (In millions)
For the three months ended June 30:
                               
 
Research and development
  $ 6.2     $ 4.7     $ 1.5       32 %
For the six months ended June 30:
                               
 
Research and development
  $ 12.1     $ 9.7     $ 2.4       25 %
      Our research and development expense consists primarily of: salaries and related expenses; costs of contract manufacturing services; costs of facilities and equipment; fees paid to professional service providers 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. 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. Our employee and infrastructure resources are allocated across several projects, and many of our costs 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 the costs to support our alliance agreement with Roche. The expenses incurred by us to third parties for preclinical and clinical trials since inception of each program were as follows (in thousands):
                         
    Current        
Oncology Program   Status   2005-to-Date   Program-to-Date
             
E2F modulation — ARQ501
    Phase 1     $ 1,121     $ 3,133  
E2F modulation — 550 series
    Preclinical       15       98  
Cancer Survival Protein modulation — 650 series
    Preclinical       1,658       1,937  
      Our future research and development expenses in support of our current and future oncology programs will be subject to numerous uncertainties in timing and cost to completion. We test potential products in numerous preclinical studies for safety, toxicology, and signs of potential efficacy. We then may conduct

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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, and 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:
         
    Estimated
    Completion
Clinical Phase   Period
     
Phase 1
    1-2 years  
Phase 2
    2-3 years  
Phase 3
    2-4 years  
      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 increases in total research and development expense for the three and six months ended June 30, 2005 versus the same periods of 2004 are primarily due to costs of pre-clinical and clinical studies for advancement of the Company’s oncology programs, which increased by $1.3 million and $1.7 million, respectively. The remainder of the increases relates to headcount and laboratory related expenses as the Company increases its internal research and development efforts.

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Marketing, general and administrative
                                   
            Increase/(Decrease)
             
    2005   2004   $   %
                 
    (In millions)
For the three months ended June 30:
                               
 
Marketing, general and administrative
  $ 2.2     $ 2.2             1 %
For the six months ended June 30:
                               
 
Marketing, general and administrative
  $ 4.9     $ 4.8     $ 0.1       2 %
      Marketing, general and administrative expense was essentially flat period-over-period.
Restructuring charges
      In the first quarter of 2004, we implemented a restructuring to shift resources from our chemical technologies business to our oncology 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 all termination benefits, which 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   June 30, 2005
             
Facility-related accrual
  $ 3,421     $ (462 )   $ 2,959  
Net investment income
                                   
            Increase/(Decrease)
             
    2005   2004   $   %
                 
    (In millions)
For the three months ended June 30:
                               
 
Net investment income
  $ 0.5     $ 0.2     $ 0.3       102 %
For the six months ended June 30:
                               
 
Net investment income
  $ 1.0     $ 0.4     $ 0.6       141 %
      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 $39.4 million net proceeds from the sale of our Woburn facility in May 2005.
Loss on investment
      In Q2 2005, the Company reassessed the carrying value of its investment in a privately-owned proteomics company. Based on events affecting the financial condition of the company during the second quarter of 2005 we concluded that the value of the investment had declined to the degree of other than temporary impairment, and as such, we recorded a non-cash loss on investment of $250,000 to fully write-off the carrying value.

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Net loss
                                   
            Increase/(Decrease)
             
    2005   2004   $   %
                 
    (In millions)
For the three months ended June 30:
                               
 
Net loss
  $ (2.4 )   $ (0.1 )   $ 2.3       1,711 %
For the six months ended June 30:
                               
 
Net loss
  $ (3.9 )   $ (5.4 )   $ (1.5 )     (28 )%
      The increase in net loss for the three months ended June 30, 2005 compared to the same period of 2004 reflects the decrease in compound development revenue, increased research and development spending and the loss on investment, partially offset by increased net investment income. The decrease in net loss for the six months ended June 30, 2005 is primarily due to the $1.1 million restructuring charge in the first quarter of 2004. Also contributing to the reduction in net loss in 2005 is the increase in research and development revenue, reduction in cost of compound development revenue and increased net investment income, partially offset by the increase in research and development expense.
Forward Looking Statements
      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 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.
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. federal and state agency backed obligations 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 June 30, 2005 due to the short-term maturities of these instruments.

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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 (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934). Based on that evaluation, the President and Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures as of June 30, 2005 are effective in recording, processing, summarizing 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 June 30, 2005 that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.
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.
      At the Annual Meeting of the Stockholders held on May 18, 2005, the Company’s stockholders voted as follows:
        1. To elect William G. Messenger and Patrick J. Zenner as directors to hold office for a term of three years and until their respective successors are elected and qualified;
         
    For   Withheld
         
William G. Messenger
  27,166,108   2,416,062
Patrick J. Zenner
  24,656,774   4,925,396
        2. To approve an amendment to the Company’s Amended and Restated 1994 Equity Incentive Plan to increase the aggregate number of shares of common stock that may be issued under the plan by 1,300,000 shares from 8,300,000 to 9,600,000 shares;
                     
For   Against   Abstain   Broker Non-Vote
             
9,091,903
  6,388,486     37,155       14,064,626  
        3. To approve an amendment to the Company’s Amended and Restated 1996 Director Stock Option Plan to increase the aggregate number of shares of common stock that may be issued under the plan by 150,000 shares from 350,500 to 500,500 shares;
                     
For   Against   Abstain   Broker Non-Vote
             
12,925,071
  2,555,378     37,095       14,064,626  

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        4. To approve an amendment to the Company’s Amended and Restated 1996 Employee Stock Purchase Plan to increase the aggregate number of shares of common stock that are available for purchase under the plan by 210,000 shares from 1,020,000 to 1,230,000 shares; and
                     
For   Against   Abstain   Broker Non-Vote
             
14,918,164
  569,386     29,995       14,064,625  
        5. To ratify and confirm the appointment by the Company’s Audit Committee of PricewaterhouseCoopers LLP, an independent registered public accounting firm, to serve as the Company’s independent auditors for the fiscal year ending December 31, 2005.
             
For   Against   Abstain
         
29,422,160
  136,013     23,997  
      At the close of business on April 1, 2005, the record date for the determination of shareholders entitled to vote at the Meeting, there were 34,783,481 shares of the Company’s Common Stock, each share being entitled to one vote, constituting all of the outstanding voting securities of the Company. At the Meeting, the holders of 29,582,170 shares of the Company’s Common Stock were represented in person or by proxy constituting a quorum.
Item 5 — Other Information.
      None.
Item 6 — Exhibits.
         
  10 .21   Amended and Restated Lease by and Between ARE-MA Region No. 20, LLC and ArQule, Inc dated June 30, 2005.
 
  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.
 
  /s/ Louise A. Mawhinney
 
 
  Louise A. Mawhinney
  Vice President, Chief Financial Officer, Treasurer and Secretary
Date: August 4, 2005

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