Overview

We are a biopharmaceutical company focused on the discovery and development of breakthrough treatments for human disease. We have used our proprietary gene knockout technology and an integrated platform of advanced medical technologies to identify and validate, in vivo, more than 100 targets with promising profiles for drug discovery. For targets that we believe have high pharmaceutical value, we engage in programs for the discovery and development of potential new drugs, focusing in the core therapeutic areas of immunology, metabolism, cardiology and ophthalmology. Human clinical trials are currently underway for four of our drug candidates, with one additional drug candidate in preclinical development and compounds from a number of additional programs in various stages of preclinical research.

We are working both independently and through strategic collaborations and alliances to capitalize on our technology, drug target discoveries and drug discovery and development programs. Consistent with this approach, we seek to retain exclusive rights to the benefits of certain of our small molecule drug programs by developing and commercializing drug candidates from such programs internally and to collaborate with third parties with respect to the discovery, development and commercialization of small molecule and biotherapeutics drug candidates for other targets, particularly when the collaboration provides us with access to expertise and resources that we do not possess internally or are complementary to our own. We have established drug discovery and development collaborations with a number of leading pharmaceutical and biotechnology companies which have enabled us to generate near-term cash while offering us the potential to retain economic participation in products our collaborators develop through the collaboration. In addition, we have established collaborations and license agreements with other leading pharmaceutical and biotechnology companies, research institutes and academic institutions under which we receive fees and, in some cases, are eligible to receive milestone and royalty payments, in return for granting access to some of our technologies and discoveries for use in the other organization's own drug discovery efforts.

We derive substantially all of our revenues from drug discovery and development collaborations and other collaborations and technology licenses. To date, we have generated a substantial portion of our revenues from a limited number of sources.

Our operating results and, in particular, our ability to generate additional revenues are dependent on many factors, including our success in establishing new collaborations and technology licenses, expirations of our existing collaborations and alliances, the success rate of our discovery and development efforts leading to opportunities for new collaborations and licenses, as well as milestone payments and royalties, the timing and willingness of collaborators to commercialize products which may result in royalties, and general and industry-specific economic conditions which may affect research and development expenditures. Our future revenues from collaborations and technology licenses are uncertain because our existing agreements have fixed terms or relate to specific projects of limited duration and we depend, in part, on securing new agreements. Our ability to secure future revenue-generating agreements will depend upon our ability to address the needs of our potential future collaborators and licensees, and to negotiate agreements that we believe are in our long-term best interests. We may determine that our interests are better served by retaining rights to our discoveries and advancing our therapeutic programs to a later stage, which could limit our near-term revenues. Because of these and other factors, our operating results have fluctuated in the past and are likely to do so in the future, and we do not believe that period-to-period comparisons of our operating results are a good indication of our future performance.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles requires us to make judgments, estimates and assumptions in the preparation of our consolidated financial statements and accompanying notes. Actual results could differ from those estimates. We believe there have been no significant changes in our critical accounting policies as discussed in our Annual Report on Form 10-K for the year ended December 31, 2008.

Recent Accounting Pronouncements

In September 2006, the FASB issued a new accounting pronouncement regarding fair value measurements (formerly SFAS No. 157, "Fair Value Measurements"). The pronouncement, found under FASB Accounting Standards Codification ("ASC") Topic 820, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This pronouncement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this pronouncement does not require any new fair value measurements. More specifically, this pronouncement emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy, which ranks the quality and reliability of the information used to determine fair value. This pronouncement was effective January 1, 2008 for financial assets and liabilities and January 1, 2009 for non-financial assets and liabilities. The adoption of this pronouncement did not have an effect on our financial position or results of operations.

In December 2007, the FASB issued a new accounting pronouncement regarding business combinations (formerly SFAS No. 141(Revised), "Business Combinations"), which requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. This pronouncement, found under FASB ASC Topic 805, also requires the acquirer in a business combination achieved in stages to recognize the identifiable assets and liabilities, as well as the noncontrolling interest in the acquiree, at the full amounts of their fair values. This pronouncement makes various other amendments to authoritative literature intended to provide additional guidance or to confirm the guidance in that literature to that provided in this pronouncement. This pronouncement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Our adoption of this pronouncement did not have an effect on our financial position or results of operations.

In December 2007, the FASB ratified a new accounting pronouncement regarding collaborative arrangements (formerly Emerging Issues Task Force ("EITF") Issue No. 07-01, "Accounting for Collaborative Arrangements"), which provides guidance on how the parties to a collaborative agreement should account for costs incurred and revenue generated on sales to third parties, how sharing payments pursuant to a collaboration agreement should be presented in the income statement and certain related disclosure requirements. The adoption of this pronouncement, found under FASB ASC Topic 808, did not have an effect on our financial position or results of operations, other than requiring additional disclosures. Most of the required disclosures were included in our annual report on Form 10-K for the year ended December 31, 2008. See note 11, "Collaboration and License Agreements," in the accompanying footnotes for additional required disclosures.

In May 2009, the FASB issued a new accounting pronouncement regarding subsequent events (formerly SFAS No. 165, "Subsequent Events"), which provides guidance to establish general standards of accounting for, and disclosures of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The pronouncement, found under FASB ASC Topic 855, also requires disclosure of the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued or the date the financial statements were available to be issued. The pronouncement is effective for interim or fiscal periods ending after June 15, 2009. We evaluated subsequent events through October 30, 2009, which is the date the financial statements were issued. Our adoption of this pronouncement did not have an effect on our financial position or results of operations.

In June 2009, the FASB issued SFAS No. 167, "Amendments to FASB Interpretation No. 46(R)," which changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities that most significantly impacts the entity's economic performance. This pronouncement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after November 15, 2009. We are currently evaluating the effect, if any, of this statement on our financial condition and results of operations.

Results of Operations

Revenues

Total revenues and dollar and percentage changes as compared to the
corresponding period in the prior year are as follows (dollar amounts are
presented in millions):

                       Three Months Ended September 30,      Nine Months Ended September 30,
                            2009               2008              2009               2008
Total revenues          $   2.1            $        7.5      $    9.3            $       26.0
Dollar decrease         $  (5.4 )                            $  (16.7 )
Percentage decrease         (72 )%                                (64 )%

· Collaborative research - Revenue from collaborative research for the three months ended September 30, 2009 decreased 77% to $1.7 million, and for the nine months ended September 30, 2009 decreased 65% to $8.0 million, as compared to the corresponding period in 2008, primarily due to reduced revenues in the three and nine months ended September 30, 2009 under our alliances with Bristol-Myers Squibb and N.V. Organon due to our progress towards completing the target discovery portion of the alliances, and the completion in 2008 of the target discovery portion of our alliance with Genentech, partially offset by increases in revenue from our collaboration with Taconic.

· Subscription and license fees - Revenue from subscription and license fees for the three months ended September 30, 2009 increased 55% to $0.5 million, as compared to the corresponding period in 2008, primarily due to an increase in technology license fees. Revenue from subscription and license fees for the nine months ended September 30, 2009 decreased 61% to $1.2 million, as compared to corresponding period in 2008, primarily due to a decrease in technology license fees.

Research and Development Expenses

Research and development expenses and dollar and percentage changes as compared
to the corresponding period in the prior year are as follows (dollar amounts are
presented in millions):

                               Three Months Ended         Nine Months Ended September 30,
                                  September 30,
                                2009            2008          2009               2008
   Total research and       $  19.3            $  27.3    $   62.4            $       84.9
   development expense
   Dollar decrease          $  (8.0 )                     $  (22.5 )
   Percentage decrease          (29 )%                         (26 )%

Research and development expenses consist primarily of salaries and other personnel-related expenses, facility and equipment costs, laboratory supplies, third-party and other services principally related to preclinical and clinical development activities, and stock-based compensation expenses.

· Personnel - Personnel costs for the three months ended September 30, 2009 decreased 19% to $7.1 million, and for the nine months ended September 30, 2009 decreased 22% to $25.7 million, as compared to the corresponding period in 2008, primarily due to reductions in our personnel in May 2008 and January 2009. Salaries, bonuses, employee benefits, payroll taxes, recruiting and relocation costs are included in personnel costs.

· Facilities and equipment - Facilities and equipment costs for the three months ended September 30, 2009 decreased 23% to $3.7 million, and for the nine months ended September 30, 2009 decreased 18% to $11.5 million, as compared to the corresponding period in 2008, primarily due to decreases in depreciation expense and utilities expense.

· Laboratory supplies - Laboratory supplies expense for the three months ended September 30, 2009 decreased 19% to $1.6 million, and for the nine months ended September 30, 2009 decreased 28% to $4.8 million, as compared to the corresponding period in 2008, primarily as a result of reductions in our genetics research.

· Third-party and other services - Third-party and other services for the three months ended September 30, 2009 decreased 47% to $5.2 million, and for the nine months ended September 30, 2009 decreased 38% to $15.2 million, as compared to the corresponding period in 2008, primarily due to a decrease in external preclinical research and development costs.

· Stock-based compensation - Stock-based compensation expense for the three months ended September 30, 2009 decreased 12% to $0.7 million, and for the nine months ended September 30, 2009 decreased 20% to $2.3 million, as compared to the corresponding period in 2008.

· Other - Other costs for the three months ended September 30, 2009 decreased 11% to $1.0 million, and for the nine months ended September 30, 2009 decreased 25% to $2.8 million, as compared to the corresponding period in 2008.

General and Administrative Expenses

General and administrative expenses and dollar and percentage changes as
compared to the corresponding period in the prior year are as follows (dollar
amounts are presented in millions):

                            Three Months Ended September 30,        Nine Months Ended
                                                                      September 30,
                                 2009               2008            2009            2008
   Total general and        $    4.6            $        5.0   $   15.0           $   16.7
   administrative expense
   Dollar decrease          $   (0.4 )                         $   (1.8 )
   Percentage decrease            (8 )%                             (10 )%

General and administrative expenses consist primarily of personnel costs, facility and equipment costs, professional fees such as legal fees, and stock-based compensation expenses.

· Personnel - Personnel costs for the three months ended September 30, 2009 decreased 5% to $2.2 million, and for the nine months ended September 30, 2009 decreased 16% to $7.1 million, as compared to the corresponding period in 2008, primarily due to reductions in our personnel in May 2008 and January 2009. Salaries, bonuses, employee benefits, payroll taxes, recruiting and relocation costs are included in personnel costs.

· Facilities and equipment - Facilities and equipment costs for the three months ended September 30, 2009 increased 8% to $0.7 million, and for the nine months ended September 30, 2009 increased 10% to $2.1 million, as compared to the corresponding period in 2008, primarily due to increased property taxes.

· Professional fees - Professional fees for the three months ended September 30, 2009 decreased 29% to $0.7 million, and for the nine months ended September 30, 2009 decreased 7% to $2.9 million, as compared to the corresponding period in 2008, primarily due to decreased consulting fees.

· Stock-based compensation - Stock-based compensation expense for the three months ended September 30, 2009 decreased 6% to $0.5 million, and for the nine months ended September 30, 2009 decreased 6% to $1.8 million as compared to the corresponding period in 2008.

· Other - Other costs for the three months ended September 30, 2009 decreased 4% to $0.4 million, and for the nine months ended September 30, 2009 decreased 19% to $1.2 million, as compared to the corresponding period in 2008.

Gain (Loss) on Investments, Net, Interest Income, Interest Expense and Other Expense, Net

Gain (Loss) on Investments, Net. Gain on investments, net was $0.2 million and $1.0 million for the three and nine months ended September 30, 2009, representing the net increase in the fair value of our student loan auction rate securities and the rights obtained from UBS AG, the investment bank that sold us our auction rate securities. Loss on investments, net was $3.3 million for the three and nine months ended September 30, 2008, representing the other-than-temporary decline in fair value of our student loan auction rate securities.

Interest Income. Interest income for the three months ended September 30, 2009 decreased 89% to $0.1 million, and for the nine months ended September 30, 2009 decreased 87% to $0.7 million, as compared to the corresponding period in 2008, due to lower yields on our investments as well as lower cash and investment balances.

Interest Expense. Interest expense for the three months ended September 30, 2009 increased 16% to $0.8 million, and for the nine months ended September 30, 2009 increased 8% to $2.2 million, as compared to the corresponding period in 2008, primarily due to our line of credit with UBS Bank USA.

Other Expense, Net. Other expense, net for the three months ended September 30, 2009 was $0.5 million, consistent with the corresponding period in 2008. Other expense, net for the nine months ended September 30, 2009 increased 26% to $2.0 million as compared to the corresponding period in 2008, primarily due to an impairment of surplus equipment as a result of our restructuring in January 2009.

Income Tax Benefit

The income tax benefit for the three and nine months ended September 30, 2009 was $102,000.

Noncontrolling Interest in Symphony Icon, Inc.

The loss attributable to the noncontrolling interest holders of Symphony Icon for the three months ended September 30, 2009 decreased 29% to $3.5 million, and for the nine months ended September 30, 2009 decreased 39% to $9.8 million, as compared to the corresponding period in 2008, due to the timing of expenditures related to clinical development of the drug candidates licensed to Symphony Icon.

Net Loss Attributable to Lexicon Pharmaceuticals, Inc. and Net Loss Attributable to Lexicon Pharmaceuticals, Inc. per Common Share

Net loss attributable to Lexicon Pharmaceuticals, Inc. decreased to $19.1 million in the three months ended September 30, 2009 from $23.5 million in the corresponding period in 2008. Net loss attributable to Lexicon Pharmaceuticals, Inc. per common share decreased to $0.14 in the three months ended September 30, 2009, from $0.17 in the corresponding period in 2008. Net loss attributable to Lexicon Pharmaceuticals, Inc. decreased to $60.8 million in the nine months ended September 30, 2009 from $61.4 million in the corresponding period in 2008. Net loss attributable to Lexicon Pharmaceuticals, Inc. per common share decreased to $0.44 in the nine months ended September 30, 2009 from $0.45 in the corresponding period in 2008.

Our quarterly operating results have fluctuated in the past and are likely to do so in the future, and we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.

We have financed our operations from inception primarily through sales of common and preferred stock, contract and milestone payments to us under our drug discovery and development collaborations, target validation, database subscription and technology license agreements, government grants and contracts, and financing obtained under debt and lease arrangements. We have also financed certain of our research and development activities under our agreements with Symphony Icon, Inc. From our inception through September 30, 2009, we had received net proceeds of $550.3 million from issuances of common and preferred stock, including $203.2 million of net proceeds from the initial public offering of our common stock in April 2000, $50.1 million from our July 2003 common stock offering, $37.5 million from our October 2006 common stock offering and $198.0 million from our August 2007 sale of common stock to Invus, L.P. We also received net proceeds of $55.2 million from our October 2009 common stock offering. In addition, from our inception through September 30, 2009, we received $446.9 million in cash payments from drug discovery and development collaborations, target validation, database subscription and technology license agreements, sales of compound libraries and reagents, and government grants and contracts, of which $433.3 million had been recognized as revenues through September 30, 2009.

As of September 30, 2009, we had $119.5 million in cash, cash equivalents and investments, including $56.2 million in auction rate securities and related rights as discussed below under "Disclosure about Market Risk," and $5.7 million in investments held by Symphony Icon. As of December 31, 2008, we had $142.2 million in cash, cash equivalents and investments, including $55.7 million of auction rate securities and related rights, and $16.6 million in investments held by Symphony Icon. We used cash of $71.8 million in operations in the nine months ended September 30, 2009. This consisted primarily of the consolidated net loss for the period of $70.5 million, a net decrease in other operating liabilities net of assets of $6.5 million, a $4.6 million decrease in deferred revenue, and a gain on investments and auction rate security rights of $1.0 million, partially offset by non-cash charges of $4.8 million related to depreciation expense, $4.1 million related to stock-based compensation expense and $1.6 million related to the amortization of the Symphony Icon purchase option. Investing activities provided cash of $11.3 million in the nine months ended September 30, 2009, primarily due to maturities of investments of $73.0 million, partially offset by purchases of investments of $61.5 million. Financing activities provided cash of $37.3 million due to proceeds from debt borrowings of $38.6 million, partially offset by repayment of debt borrowings of $1.5 million.

In January 2009, we entered into a credit line agreement with UBS Bank USA that provides, as of September 30, 2009, up to an aggregate amount of $37.8 million in the form of an uncommitted, demand, revolving line of credit. We entered into the credit line in connection with our acceptance of an offer from UBS AG, the investment bank that sold us our auction rate securities, providing us with rights to require UBS to purchase our $56.5 million (par value) of auction rate securities at par value during the period from June 30, 2010 through July 2, 2012. The credit line is secured only by these auction rate securities and advances under the credit line will be made on a "no net cost" basis, meaning that the interest paid by us on advances will not exceed the interest or dividends paid to us by the issuer of the auction rate securities. As of September 30, 2009, we had $37.8 million outstanding under this credit line.

In June 2007, we entered into a securities purchase agreement with Invus, L.P, pursuant to which Invus purchased 50,824,986 shares of our common stock for approximately $205.4 million in August 2007. This purchase resulted in Invus' . . .