In this Report on Form 10-Q, unless the context requires otherwise, "Isis," "Company," "we," "our," and "us," means Isis Pharmaceuticals, Inc. and its subsidiaries.

Forward-Looking Statements

In addition to historical information contained in this Report on Form 10-Q, this Report includes forward-looking statements regarding our business, the therapeutic and commercial potential of our technologies and products in development, and the financial position of Isis Pharmaceuticals, Inc. and Regulus Therapeutics, our majority-owned subsidiary. Any statement describing our goals, expectations, financial or other projections, intentions or beliefs is a forward-looking statement and should be considered an at-risk statement. Such statements are subject to certain risks and uncertainties, particularly those inherent in the process of discovering, developing and commercializing drugs that are safe and effective for use as human therapeutics, and in the endeavor of building a business around such products. Our forward-looking statements also involve assumptions that, if they never materialize or prove correct, could cause our results to differ materially from those expressed or implied by such forward looking statements. Although our forward-looking statements reflect the good faith judgment of our management, these statements are based only on facts and factors currently known by us. As a result, you are cautioned not to rely on these forward-looking statements. These and other risks concerning our programs are described in additional detail in our Annual Report on Form 10-K for the year ended December 31, 2008, which is on file with the U.S. Securities and Exchange Commission, and those identified within this Item entitled "Risk Factors" beginning on page 32 of this Report.

Overview

We are the leading company in antisense technology, exploiting a novel drug discovery platform we created to generate a broad pipeline of first-in-class drugs. Antisense technology is a direct route from genomics to drugs. Our highly efficient and prolific drug discovery platform enables us to expand our drug pipeline and our partners' pipelines with antisense drugs that address significant unmet medical needs. Our business strategy is to do what we do best-to discover unique antisense drugs and develop these drugs to key value inflection points. In this way, our organization remains small and focused. We discover new drugs, outlicense our drugs to partners and build a broad base of license fees, milestone payments and royalty income. We maximize the value of the drugs we discover by putting them in the hands of quality partners with late-stage development and commercialization expertise. For example, we partner our drugs with leading pharmaceutical companies with mature development, commercialization and marketing expertise, such as Bristol-Myers Squibb Company, or BMS, Genzyme, Eli Lilly and Company and Ortho-McNeil-Janssen Pharmaceuticals, Inc., or OMJP. Additionally, we created a consortium of smaller companies that can broadly exploit the technology with their expertise in specific disease areas. We call these smaller companies our satellite companies. In addition to our cutting edge antisense programs, we maintain technology leadership beyond our core areas of focus through collaborations with Alnylam and Regulus, our jointly owned company focused on microRNA therapeutics. We also exploit our inventions with other therapeutic opportunities through collaborations with Achaogen and Archemix Corp. Beyond human therapeutics, we benefit from the commercialization of products of our inventions by other companies that are better positioned to maximize the commercial potential of these inventions, such as our Ibis Biosciences subsidiary, which we sold to AMI in the first quarter of 2009. All of these aspects fit into our unique business model and create continued shareholder value.

We protect our proprietary RNA-based technologies and products through our substantial patent estate. We remain one of the most prolific patent holders in the United States, ranked as having one of the highest ratios of issued patents per employee with more than 1,600 issued patents. With our ongoing research and development, our patent portfolio continues to grow. The patents not only protect our key assets-our technology and our drugs-they also form the basis for attractive licensing and partnering arrangements. To date, we have generated more than $345 million from our intellectual property sale and licensing program that helps support our internal drug discovery and development programs.

The clinical success of mipomersen, the lead drug in our cardiovascular franchise, is a clear example of the power of our RNA-based technology because it demonstrates that antisense drugs can work in man. With mipomersen we have additional evidence, as we have shown with other antisense drugs, that we can predict the activity of our drugs in man from the preclinical successes we observe in animals. We believe mipomersen's success has validated our technology platform, increased the value of our drugs, and created renewed interest from potential partners in antisense technology.

The clinical successes of the drugs in our pipeline continue to result in new partnering opportunities. Since 2007, we have established a number of notable pharmaceutical partnerships, which include Genzyme, BMS and OMJP, to develop and commercialize certain of our key cardiovascular and diabetes drugs. Since 2007, we have also added more than $760

million in cash from our partnerships. If our current partnerships continue to be successful, we have the opportunity to earn additional milestone payments. We also will share in the future commercial success of our inventions and drugs resulting from these partnerships through earn out, profit sharing, and/or royalty arrangements. Our strong financial position is a result of the persistent execution of our business strategy and our inventive and focused research and development capabilities.

Business Segments

Prior to AMI's acquisition of our Ibis Biosciences business, we focused on three segments. We currently focus our business on two principal segments:

Drug Discovery and Development Within our primary business segment, we are exploiting a novel drug discovery platform we created to generate a broad pipeline of first-in-class drugs for us and our partners. Our proprietary drug discovery platform enables us to rapidly identify drugs, providing a wealth of potential targets to treat a broad range of diseases. We focus our efforts in therapeutic areas where our drugs will work best, efficiently screening many targets in parallel and carefully selecting the best drugs. This efficiency combined with our rational approach to selecting disease targets enables us to build a large and diverse portfolio of drugs designed to treat a variety of health conditions including cardiovascular, metabolic, inflammatory, ocular and neurodegenerative diseases, and cancer. We currently have 19 drugs in development. Our partners are licensed to develop, with our support, 15 of these 19 drugs, which substantially reduces our development costs.

Regulus Therapeutics Inc. In September 2007, we and Alnylam established Regulus as a company focused on the discovery, development and commercialization of microRNA therapeutics. Regulus is addressing therapeutic opportunities that arise from alterations in microRNA expression. Since microRNAs may act as master regulators, affecting the expression of multiple genes in a disease pathway, microRNA therapeutics define a new platform for drug discovery and development and microRNAs may also prove to be an attractive new diagnostic tool for disease characterization.

Ibis Biosciences, Inc. In January 2009, we sold our Ibis Biosciences subsidiary to AMI for a total purchase price of $215 million. In 2008, AMI invested $40 million in Ibis, which provided the capital for Ibis to make significant progress in expanding commercial product offerings and building the foundation for Ibis to enter regulated markets, such as clinical diagnostics. When AMI completed the acquisition of Ibis, we received an additional $175 million. We are also eligible to receive an earn out on future sales of Ibis products that will enable us and our shareholders to continue to benefit from Ibis' successes. The earn out payments from AMI are equal to a percentage of Ibis' revenue related to sales of Ibis systems, including instruments, assay kits and successor products, through the end of 2025. The earn out payments will be 5% of net sales over $140 million through net sales of $2.1 billion and 3% of net sales over $2.1 billion, with the percentages subject to reduction in certain circumstances.

As a result of selling Ibis to AMI, Ibis' financial results are considered discontinued operations. Accordingly, we have presented the operating results of Ibis for all prior periods in our financial statements separately as discontinued operations and therefore Ibis is no longer included in our segment reporting. Net income from discontinued operations in the first nine months of 2009 primarily consists of a $202.5 million gain related to the sale of Ibis to AMI less $30.7 million of income taxes.

Recent Events

We reported positive top-line Phase 2 data on ISIS 113715 in patients with type 2 diabetes on stable doses of sulfonylurea.

† Treatment with 200 mg per week of ISIS 113715 for 13 weeks showed consistent and statistically significant reductions in multiple short and intermediate measures of glucose control.

† ISIS 113715 also showed statistically significant and clinically meaningful reductions in LDL-C and a tendency toward weight loss.

† The safety profile of the drug remains positive with no exacerbation of sulfonylurea-induced hypoglycemia or other clinically significant adverse effects.

Our pipeline matures as antisense drugs continue to advance in development and show promise in clinical studies.

† Altair reported the successful completion of a Phase 1 study that showed AIR645 was safe and well tolerated. Altair intends on initiating Phase 2 studies on AIR645 soon.

† OncoGenex initiated a Phase 1 study evaluating OGX-427 in patients with bladder cancer.

† Achaogen reported the successful completion of a Phase 1 study on ACHN-490.

We support our dominant patent estate and maintain an extensive and broad intellectual property position.

† We received a notice of allowance that expands the scope of our Crooke patents and we, Alnylam and Regulus were granted a key microRNA patent in Japan.

Critical Accounting Policies

We prepare our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable, based upon the information available to us. These judgments involve making estimates about the effect of matters that are inherently uncertain and may significantly impact our quarterly or annual results of operations and financial condition. Each quarter, our senior management discusses the development, selection and disclosure of such estimates with our audit committee of our board of directors. There are specific risks associated with these critical accounting policies and we caution that future events rarely develop exactly as expected, and that best estimates routinely require adjustment.

Historically, our estimates have been accurate as we have not experienced any material differences between our estimates and our actual results. The significant accounting policies, which we believe are the most critical to aid in fully understanding and evaluating our reported financial results, require the following:

† Assessment of the propriety of revenue recognition and associated deferred revenue;

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† Determination of the proper valuation of investments in marketable securities and other equity investments;

†

† Estimations to assess the recoverability of long-lived assets, including property and equipment, intellectual property and licensed technology;

†

†          Determination of the proper valuation of inventory;

†

†          Determination of the appropriate cost estimates for unbilled
preclinical studies and clinical development activities;

†

†          Estimation of our net deferred income tax asset valuation allowance;

†

†          Determination of the appropriateness of judgments and estimates used
in allocating revenue and expenses to operating segments; and

†

†          Estimations to determine the fair value of stock-based compensation,

Except as set forth below, there have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", included in our Annual Report on Form 10-K for the year ended December 31, 2008.

Convertible debt

On January 1, 2009, we adopted an accounting standard that became effective in January 2009, which requires us to account for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) by separating the liability and equity components of the instruments in a manner that reflects our nonconvertible debt borrowing rate when we recognize interest expense in subsequent periods. As a result, we assigned a value to the debt component of our 25/8% convertible notes equal to the estimated fair value of a similar debt instrument without the conversion feature, which resulted in us recording the debt at a discount. We are amortizing the resulting debt discount over the life of the debt as additional non-cash interest expense. At adoption, we retrospectively implemented the presentation and disclosure requirements to all periods presented in our condensed consolidated financial statements. For additional information, see Note 6, Long-Term Obligations.

Determining the fair value of the debt component requires the use of accounting estimates and assumptions. These estimates and assumptions are judgmental in nature and could have a significant impact on the determination of the debt component and in effect, the associated non-cash interest expense. The carrying amount of the liability component is determined by measuring the fair value of a similar debt instrument that does not have the conversion feature. If no similar debt instrument exists, estimates of fair value are primarily determined using assumptions that market participants would use in pricing a debt instrument, including market interest rates, credit standing, yield curves and volatilities.

Results of Operations

Revenue

Total revenue for the three and nine months ended September 30, 2009 was $26.8 million and $89.3 million, respectively, compared to $29.5 million and $77.5 million for the same periods in 2008. Our revenue fluctuates based on the nature and timing of payments under agreements with our partners, including license fees, milestone-related payments and other payments. In August 2009, we finished amortizing the revenue associated with the $50 million upfront payment we received from OMJP in 2007 resulting in less revenue in the third quarter of 2009 compared to the same period in 2008. Our revenue for the first nine months of 2009 increased compared to the same period in 2008 due primarily to an increase in revenue from our collaboration with Genzyme. As part of our strategic relationship with Genzyme, in the first quarter of 2008 Genzyme purchased $150 million of our common stock at $30 per share and in the second quarter paid us a license fee of $175 million. We are amortizing the premium on the stock, $100 million calculated using a Black-Scholes option valuation model, and the license fee ratably into revenue through June 2012, which represents the end of our performance obligation based on the research and development plan included in the agreement.

Collaborations with Alnylam, BMS, Genzyme and Regulus' strategic alliance with GSK include ongoing research and development activities. Therefore, we will continue to recognize significant amounts of revenue from these collaborations in the future from the amortization of the upfront fees we received and from research and development funding.

The following table sets forth information on our revenue by segment (in thousands):

                                         Three Months Ended        Nine Months Ended
                                            September 30,            September 30,
                                           2009         2008        2009         2008
    Drug Discovery and Development:
    Research and development revenue   $     25,337   $ 27,807   $    84,027   $ 68,321
    Licensing and royalty revenue               809        975         2,923      7,790
                                       $     26,146   $ 28,782   $    86,950   $ 76,111

    Regulus Therapeutics:
    Research and development revenue   $        625   $    681   $     2,388   $  1,429
                                       $        625   $    681   $     2,388   $  1,429

    Total Revenue:
    Research and development revenue   $     25,962   $ 28,488   $    86,415   $ 69,750
    Licensing and royalty revenue               809        975         2,923      7,790
                                       $     26,771   $ 29,463   $    89,338   $ 77,540

Drug Discovery & Development

Research and Development Revenue Under Collaborative Agreements

Research and development revenue under collaborative agreements for the three and nine months ended September 30, 2009 was $25.3 million and $84.0 million, respectively, compared to $27.8 million and $68.3 million for the same periods in 2008. The decrease in our revenue for the three months ended September 30, 2009 compared to the same period in 2008 was primarily due to a decrease in revenue from our collaboration with OMJP that is described above. The increase in our revenue for the first nine months of 2009 compared to the same period in 2008 was primarily due to the increase in revenue from our collaboration with Genzyme.

Licensing and Royalty Revenue

Our revenue from licensing activities and royalties for the three and nine months ended September 30, 2009 was $809,000 and $2.9 million, respectively, compared to $975,000 and $7.8 million for the same periods in 2008. Revenue was higher in 2008 primarily due to the $4.6 million and $1.4 million of sublicensing revenue we earned from Alnylam and ATL, respectively, in the second quarter of 2008 offset, in part, by the $1 million sublicensing revenue received in the first quarter of 2009 from Alnylam when Alnylam entered into a transaction with Cubist that included technology we had licensed to Alnylam.

Regulus Therapeutics

Regulus' revenue for the three and nine months ended September 30, 2009 was $625,000 and $2.4 million, respectively, compared to $681,000 and $1.4 million for the same periods in 2008. The increase in the first nine months of 2009 compared to the same period in 2008 was primarily related to revenue from its collaboration with GSK including the $500,000 discovery milestone payment that Regulus received from GSK for demonstrating a pharmacological effect in immune cells by specific microRNA inhibition. As part of Regulus' strategic alliance with GSK, Regulus received a $15 million upfront fee, which Regulus began amortizing into revenue in the second quarter of 2008 and will continue to amortize over Regulus' six year period of performance under the agreement.

Operating Expenses

Operating expenses for the three and nine months ended September 30, 2009 were $37.2 million and $105.2 million, respectively, compared to $29.3 million and $82.5 million for the same periods of 2008. The higher expenses in 2009 compared to 2008 were primarily due to the expansion of our clinical development programs, including additional expenses associated with the broad Phase 3 clinical program for mipomersen, the lead drug in our cardiovascular franchise, expenses for Regulus as it builds its core team and expenses related to the expansion of our drug discovery activities into new therapeutic areas.

Our operating expenses by segment were as follows (in thousands):

                                         Three Months Ended       Nine Months Ended
                                           September 30,            September 30,
                                          2009         2008        2009        2008
      Drug Discovery and Development   $    34,230   $ 26,396   $   96,941   $ 75,904
      Regulus Therapeutics                   2,937      2,891        8,264      6,620
      Total operating expenses         $    37,167   $ 29,287   $  105,205   $ 82,524

In order to analyze and compare our results of operations to other similar companies, we believe that it is important to exclude non-cash compensation expense related to stock options. We believe non-cash compensation expense is not indicative of our operating results or cash flows from our operations. Further, we internally evaluate the performance of our operations excluding it.

Research and Development Expenses

Our research and development expenses consist of costs for antisense drug discovery, antisense drug development, manufacturing and operations and R&D support costs. In addition, our research and development expenses include costs associated with the research activities Regulus is conducting to advance its microRNA technology.

The following table sets forth information on research and development costs (in thousands):

                                       Three Months Ended            Nine Months Ended
                                          September 30,                September 30,
                                       2009           2008          2009           2008

Research and development
expenses                            $    30,939    $   23,228    $    86,489    $   64,718
Non-cash compensation expense
related to stock options                  2,893         2,796          8,031         8,378
Total research and development
expenses                            $    33,832    $   26,024    $    94,520    $   73,096

Our research and development expenses by segment were as follows (in thousands):

                                             Three Months Ended       Nine Months Ended
                                               September 30,            September 30,
                                              2009         2008        2009        2008

 Drug Discovery and Development            $    31,607   $ 23,650   $   88,238   $ 67,804
 Regulus Therapeutics                            2,225      2,374        6,282      5,292
 Total research and development expenses   $    33,832   $ 26,024   $   94,520   $ 73,096

For the three and nine months ended September 30, 2009, we incurred total research and development expenses of $30.9 million and $86.5 million, respectively, compared to $23.2 million and $64.7 million for the same periods in 2008, all amounts excluding non-cash compensation expense related to stock options. We attribute the increase in expenses to the expansion of our clinical development programs, including additional expenses associated with the broad Phase 3 clinical program for mipomersen, the lead drug in our cardiovascular franchise, expenses for Regulus as it builds its core team and expenses related to the expansion of our drug discovery activities into new therapeutic areas. We discuss expenses related to Regulus in a separate section below.

Drug Discovery & Development

Antisense Drug Discovery

We use our proprietary antisense technology to generate information about the function of genes and to determine the value of genes as drug discovery targets. We use this information to direct our own antisense drug discovery research, and that of our antisense drug discovery partners. Antisense drug discovery is also the function within Isis that is responsible for advancing antisense core technology.

As we continue to advance our antisense technology, we are investing in our antisense drug discovery programs to expand our and our partners' drug pipeline. We anticipate that our existing relationships and collaborations, as well as prospective new partners, will continue to help fund our research programs, as well as contribute to the advancement of the science by funding core antisense technology research.

Our antisense drug discovery expenses were as follows (in thousands):

                                        Three Months Ended            Nine Months Ended
                                          September 30,                 September 30,
                                       2009           2008           2009           2008
Antisense drug discovery            $     6,987    $     4,630    $    18,386    $   13,355
Non-cash compensation expense
related to stock options                    771            583          2,281         1,766
Total antisense drug discovery      $     7,758    $     5,213    $    20,667    $   15,121

Antisense drug discovery costs for the three and nine months ended September 30, 2009 were $7.0 million and $18.4 million, respectively, compared to $4.6 million and $13.4 million for the same periods in 2008, all amounts excluding non-cash compensation expense related to stock options. The higher expenses were primarily due to increased activity levels related to our planned investment to fill our pipeline and additional spending to enhance our platform technology and to support collaborative research efforts for which we earn revenue. These activities resulted in an increase in personnel and laboratory supplies in 2009.

Antisense Drug Development



The following table sets forth research and development expenses for our major
antisense drug development projects (in thousands):



                                         Three Months Ended        Nine Months Ended
                                           September 30,             September 30,
                                         2009          2008         2009        2008

Mipomersen                            $     7,605    $   2,611   $   17,894   $   9,193
Other antisense development
products                                    3,487        3,417       11,766      10,206
Development overhead costs                  1,174          910        3,621       2,657
. . .