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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the transition period from        to       

Commission File Number: 0-27488

INCYTE CORPORATION

(Exact name of registrant as specified in its charter)

Experimental Station, Route 141 & Henry Clay Road,

Building E336, Wilmington, DE  19880

(Address of principal executive offices)

(302) 498-6700

(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. x   Yes    o   No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). o   Yes    o   No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o   Yes    x   No

The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 118,540,444 as of October 30, 2009.

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INCYTE CORPORATION

INDEX

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PART I:    FINANCIAL INFORMATION

Item 1.    Financial Statements

INCYTE CORPORATION

Condensed Consolidated Balance Sheets

(in thousands)

*      The condensed consolidated balance sheet at December 31, 2008 has been derived from the audited financial statements at that date.

(1)   The restricted cash balance at September 30, 2009 represents funds escrowed for the first three years of interest payments for our 4.75% Convertible Senior Notes due 2015.

See accompanying notes.

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INCYTE CORPORATION

Condensed Consolidated Statements of Operations

(in thousands, except per share amounts)

(unaudited)

See accompanying notes.

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INCYTE CORPORATION

Condensed Consolidated Statements of Comprehensive Loss

(in thousands)

(unaudited)

See accompanying notes.

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INCYTE CORPORATION

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

See accompanying notes.

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INCYTE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2009

(Unaudited)

1.     Organization and business

Incyte Corporation (“Incyte,” “we,” “us,” or “our”) is a drug discovery and development company focused on developing proprietary small molecule drugs to treat serious unmet medical needs. We have a pipeline with programs focused primarily in the areas of oncology, inflammation, and diabetes.

2.     Summary of significant accounting policies

Basis of presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  The condensed consolidated balance sheet as of September 30, 2009 and the condensed consolidated statements of operations, comprehensive loss for the three and nine months ended September 30, 2009 and 2008, and cash flows for the nine months ended September 30, 2009 and 2008 are unaudited, but include all adjustments, consisting only of normal recurring adjustments, which we consider necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.  The condensed consolidated balance sheet at December 31, 2008 has been derived from audited financial statements.

Although we believe that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote information normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance on fair value measurements. This guidance establishes a common definition for fair value to be applied to U.S. GAAP requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. We adopted this new accounting guidance effective January 1, 2008. Issued in February 2008, an FASB staff position removed leasing transactions from the scope of the new fair value guidance. Also in February 2008, the FASB issued authoritative guidance deferring the effective date of the fair value guidance for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.  We adopted this new accounting guidance for all nonfinancial assets and nonfinancial liabilities effective January 1, 2009.

In April 2009, the FASB issued a staff position providing additional guidance on factors to consider in estimating fair value when there has been a significant decrease in market activity for a financial asset. The guidance was effective for interim and annual periods ending after June 15, 2009, and we adopted this guidance commencing with our June 30, 2009 consolidated financial statements. The implementation of this standard had no material impact on our consolidated financial statements.

In June 2008, the FASB issued new guidance related to assessing whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock for the purposes of determining whether such equity-linked financial instrument (or embedded feature) is subject to derivative accounting   We adopted this new guidance effective January 1, 2009.  Pursuant to this guidance, at September 30, 2009, in connection with the issuance of our 4.75% convertible senior notes due 2015 (the “4.75% Senior Notes”), we recorded a liability of $148.1 million, which is included in embedded derivative liability on 4.75% convertible senior notes in the accompanying consolidated balance sheet.

In April 2009, the FASB issued a staff position which changes the method for determining whether an other-than-temporary impairment exists for debt securities and the amount of the impairment to be recorded in earnings. The guidance is effective for interim and annual periods ending after June 15, 2009, and we adopted this guidance commencing with our June 30, 2009 consolidated financial statements.  During the three months ended June 30, 2009, we recorded an other than temporary impairment charge on our marketable securities of $1.3 million, which is included in interest and other income (expense), net in the accompanying consolidated statement of operations.

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In April 2009, the FASB issued a staff position requiring fair value disclosures in both interim as well as annual financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. The guidance is effective for interim and annual periods ending after June 15, 2009, and we adopted this guidance commencing with our June 30, 2009 consolidated financial statements. The implementation of this standard did not have a material impact on our consolidated balance sheet and results of operations.

In May 2009, the FASB issued new guidance on subsequent events. The standard provides guidance on management’s assessment of subsequent events and incorporates this guidance into accounting literature. The standard is effective prospectively for interim and annual periods ending after June 15, 2009, and we adopted this guidance commencing with our June 30, 2009 consolidated financial statements. The implementation of this standard did not have a material impact on our consolidated financial position and results of operations. We have evaluated subsequent events through November 5, 2009, the date of issuance of our consolidated balance sheet and results of operations.

On July 1, 2009, the FASB issued the FASB Accounting Standards Codification (the “Codification”). The Codification became the single source of authoritative nongovernmental U.S. GAAP, superseding existing literature of the FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force and other sources. The Codification was effective for interim and annual periods ending after September 15, 2009. We adopted the Codification for the quarter ended September 30, 2009. There was no impact on our consolidated balance sheet and results of operations as this change is disclosure-only in nature.

In October 2009, the FASB issued amendments to the accounting and disclosure for revenue recognition. These amendments, effective for fiscal years beginning on or after June 15, 2010 (early adoption is permitted), modify the criteria for recognizing revenue in multiple element arrangements and the scope of what constitutes a non-software deliverable. The impact of the adoption of these amendments will depend on the nature of the arrangements that we enter into subsequent to the date we adopt the amendments.

3.     Fair value of financial instruments

FASB accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (“the exit price”) in an orderly transaction between market participants at the measurement date.  The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures.  In determining fair value we use quoted prices and observable inputs. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of us. The fair value hierarchy is broken down into three levels based on the source of inputs as follows:

Level 1 — Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 — Valuations based on observable inputs and quoted prices in active markets for similar assets and liabilities.

Level 3 — Valuations based on inputs that are unobservable and models that are significant to the overall fair value measurement.

Our marketable securities consist of investments in corporate debt securities, mortgage and asset-backed securities, U.S. Treasury notes, and other U.S. government agency securities that are classified as available-for-sale. We classify marketable securities available to fund current operations as current assets on the condensed consolidated balance sheet. Marketable securities are classified as long-term assets on the consolidated balance sheets if (i) they have been in an unrealized loss position for longer than six months and (ii) we have the ability to hold them until the carrying value is recovered and such holding period may be longer than one year.

The following fair value hierarchy table presents information about each major category of our financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2009 (in thousands):

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The table below sets forth a summary of changes in fair value of our level 3 liabilities at September 30, 2009.

Due to the variable mix of common stock and series A preferred stock that would be issued to satisfy the conversion of the 4.75% Senior Notes, until we have reserved sufficient shares of our common stock, the embedded conversion feature is not considered indexed to our stock.  As a result, the embedded conversion feature is not eligible for equity classification and is required to be bifurcated from the underlying debt instrument. The fair value of the embedded conversion feature on September 30, 2009 of $148.1 million was recorded as a derivative liability and the carrying value of the 4.75% Senior Notes was reduced to reflect a debt discount equal to the fair value of the embedded conversion feature .  The derivative liability related to the conversion feature will be revalued on a quarterly basis with changes in fair market value recorded through earnings until we have reserved sufficient shares of our common stock.  Once we have reserved sufficient shares of our common stock to satisfy the conversion provisions of the 4.75% Senior Notes, we expect the conversion feature to be considered indexed to our stock at which point the fair value of the conversion feature will be reclassified from a liability into stockholders’ deficit.  We valued the embedded conversion feature using a single factor binomial lattice model, with the assistance of a valuation consultant.  This model incorporates inputs such as stock price, historical volatility, risk free interest rate, equivalent bond yield, as well as assumptions about fundamental change and note holder behavior.

4.     Revenues

For the three and nine months ended September 30, 2009, one customer contributed 44% and 45%, respectively, of revenues.  For the three and nine months ended September 30, 2008, one customer contributed 42% and 30%, respectively, of revenues.

Three customers comprised 89% of the accounts receivable balance at September 30, 2009. Three customers comprised 78% of the accounts receivable balance at December 31, 2008.

5.     Stock compensation

Under FASB accounting guidance for stock compensation, we recorded $2.2 million and $8.1 million of stock compensation expense on our unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2009, respectively.  We recorded $3.9 million and $11.1 million of stock compensation expense on our unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2008, respectively.  We utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted, with the following weighted-average assumptions:

The risk-free interest rate is derived from the U.S. Federal Reserve rate in effect at the time of grant. The expected life calculation is based on the observed and expected time to the exercise of options by our employees based on historical exercise patterns for similar type options. Expected volatility is based on the historical volatility of our common stock over the period commensurate with the

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expected life of the options. A dividend yield of zero is assumed based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends.

Based on our historical experience, we have assumed an annualized forfeiture rate of 5% for our options. We will record additional expense if the actual forfeiture rate is lower than we estimated, and will record a recovery of prior expense if the actual forfeiture is higher than we estimated.

Total compensation cost of options granted but not yet vested, as of September 30, 2009, was $5.0 million, which is expected to be recognized over the weighted average period of 2.98 years.

The following table summarizes activity under all stock option plans:

6.     Common stock offering

On September 30, 2009, we completed a public offering of 20,700,000 shares of our authorized but unissued common stock at a price to the public of $6.75 per share pursuant to an effective shelf registration statement, which resulted in net proceeds of approximately $132.7 million.  Entities affiliated with Julian C. Baker, one of our directors and principal stockholders (the “Baker Entities”), purchased an aggregate of 2,000,000 shares of our common stock in this offering.

7.     Debt

On September 30, 2009, we completed the sale, in a private placement, of $400.0 million aggregate principal amount of our 4.75% Senior Notes, which resulted in net proceeds of approximately $388.0 million.  The Baker Entities purchased $160.0 million aggregate principal amount of 4.75% Senior Notes in this private placement.

The 4.75% Senior Notes bear interest at the rate of 4.75% per year, payable semi-annually on April 1 and October 1, and are due October 1, 2015.  The 4.75% Senior Notes are pari passu in right of payment with our 3½% convertible senior notes due 2011 (the “3½% Senior Notes”) and senior in right of payment to our 3½% convertible subordinated notes due 2011 (the “3½% Subordinated Notes”) and convertible subordinated notes issued to Pfizer Inc. ( the “Pfizer Notes”).  The Indenture governing the 4.75% Senior Notes (the “Indenture”) contains a covenant that, among other things, limits our ability and the ability of any of our subsidiaries to incur additional indebtedness, create liens, or sell, lease, license, transfer or otherwise dispose of certain of our or their assets.   This covenant is subject to a number of exceptions, limitations and qualifications set forth in the Indenture.  We may not redeem the 4.75% Senior Notes prior to their scheduled maturity date.  If we undergo a fundamental change, as defined in the Indenture, subject to certain conditions, holders may require us to repurchase their 4.75% Senior Notes at a purchase price equal to 100% of the principal amount being purchased, plus accrued and unpaid interest, up to the date of purchase.

The 4.75% Senior Notes are convertible into shares of our common stock at an initial conversion rate of 113.9601 shares per $1,000 principal amount of the 4.75% Senior Notes, equivalent to an initial conversion price of approximately $8.78 per share.   We currently do not have a sufficient number of shares of our common stock reserved for issuance upon conversion for all of the 4.75% Senior Notes.  Until we have reserved sufficient shares of our common stock for issuance upon conversion of all the 4.75% Senior Notes, we will issue a combination of shares of our common stock and our series A preferred stock in lieu of shares of common stock based on an initial ratio of 1.1 shares of series A preferred stock for every 1,000 shares of common stock otherwise issuable, subject to certain adjustments.  Series A preferred stock is convertible into shares of common stock at a rate of 1,000 shares of common stock for each 1.1 shares of series A preferred stock, subject to certain adjustments, contingent upon the reservation of sufficient shares of common stock. We have agreed to use reasonable efforts to obtain stockholder approval to increase the number of shares of common stock we are authorized to issue to an amount sufficient for conversion of all 4.75% Senior Notes.  If we have not established a sufficient reserve of shares of our common stock by January 1, 2010, the 4.75% Senior Notes will accrue additional interest at the rate of 5.25% per annum (for a total interest rate of 10% per annum) from and after January 1, 2010.  If we have not established a sufficient reserve of shares of our common stock by June 30, 2010, the additional interest accruing on the 4.75% Senior Notes will increase from the rate of 5.25% per annum to the rate of 10.25% per annum (for a total interest rate of 15% per annum) from and after June 30, 2010,

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and such additional interest will increase by an additional 5% per annum on each June 30 thereafter. In each case, such additional interest will accrue until a reserve of shares of our common stock sufficient for conversion of all outstanding 4.75% Senior Notes has been established. Once the number of shares of common stock we are authorized to issue is increased to an amount sufficient for conversion of all 4.75% Senior Notes, we will no longer (and will cease to have the ability to) issue shares of our series A preferred stock in lieu of, or in combination with, shares of our common stock upon conversion of the 4.75% Senior Notes.

If, before there are sufficient shares of our common stock reserved for conversion of the 4.75% Senior Notes, a person or group acquires in a tender or exchange offer beneficial ownership of more than 50% of the voting power of our common equity (a “Qualifying Tender Offer”), then the 4.75% Senior Notes will accrue additional interest at a rate equal to the higher of the rate then in effect, as described in the preceding paragraph, or 10.25% per annum (for a total interest rate of 15% per annum), and such additional interest will increase by an additional 5% per annum on each anniversary of such Qualifying Tender Offer thereafter.  Such additional interest will accrue until a reserve of shares of our common stock sufficient for conversion of all outstanding 4.75% Senior Notes has been established.

In addition, if, and to the extent, a holder elects to convert any 4.75% Senior Notes in connection with a make-whole fundamental change transaction, as defined in the Indenture, we will, under certain circumstances, increase the applicable conversion rate by a number of additional shares of our common stock.

In connection with the private placement of the 4.75% Senior Notes, we entered into a Pledge and Escrow Agreement, pursuant to which an aggregate of approximately $56.3 million was placed into an escrow account. Funds in the escrow account will be invested in Permitted Securities (as defined in the Pledge and Escrow Agreement), and a portion of the Permitted Securities may be redeemed or sold for cash to make each of the first six scheduled semi-annual interest payments on the 4.75% Senior Notes. Pursuant to the Pledge and Escrow Agreement, we have pledged our interest in the escrow account to the Trustee under the Indenture as security for these interest payments.  The amounts held in escrow, totaling $56.2 million as of September 30, 2009, are included within restricted cash (short and long-term) in the consolidated balance sheet.

During the three months ended September 30, 2009, through various privately negotiated transactions, we repurchased $86.3 million in face value of our 3½% Senior Notes and $99.0 million in face value of our 3½% Subordinated Notes.  Among these transactions were the repurchases from the Baker Entities of $38.3 million in face value of our 3½% Senior Notes at a purchase price equal to 98.74% of face value and $59.1 million in face value of our 3½% Subordinated Notes at a purchase price equal to 97.88% of face value.  The prices paid by us in the repurchase transactions with the Baker Entities were equal to the weighted average prices paid by us to independent third parties in comparable transactions for the balance of the notes repurchased during this period.

Due to the variable mix of common stock and series A preferred stock that would be issued to satisfy the conversion of the 4.75% Senior Notes, until we have reserved sufficient shares of our common stock, the embedded conversion feature is not considered indexed to our stock.  As a result, the embedded conversion feature is not eligible for equity classification and is required to be bifurcated from the underlying debt instrument. Accordingly, the fair value of the embedded conversion feature on September 30, 2009 of $148.1 million was recorded as a derivative liability and the carrying value of the 4.75% Senior Notes was reduced to reflect a debt discount equal to the fair value of the embedded conversion feature.  The derivative liability is classified as the embedded derivative liability on 4.75% Senior Notes in the accompanying balance sheet.  The derivative liability related to the conversion feature will be revalued on a quarterly basis with changes in fair market value recorded through earnings until we have reserved sufficient shares of our common stock.  Once we have reserved sufficient shares of our common stock to satisfy the conversion provisions of the 4.75% Senior Notes, we expect the conversion feature to be considered indexed to our stock at which point the fair value of the conversion feature will be reclassified from a liability into stockholders’ deficit.  The debt discount related to the derivative liability will be amortized to interest expense over the six year term of the 4.75% Senior Notes using the effective interest method.  We valued the embedded conversion feature using a single factor binomial lattice model, with the assistance of a valuation consultant.  This model incorporates inputs such as stock price, historical volatility, risk free interest rate, equivalent bond yield, as well as assumptions about fundamental change and note holder behavior.

There are circumstances under which we may be required to pay a higher rate of interest, including those disclosed above that are triggered when we have not established a sufficient reserve of our common stock.  While these contingent interest rate provisions are considered derivatives, their fair value at September 30, 2009 was de minimis.  The fair value of the contingent interest rate provisions will be revalued on a quarterly basis with changes in fair market value recorded through earnings.

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The carrying amount and fair value of our Convertible Notes are as follows (in thousands):

8.     Preferred stock

We are authorized to issue 5,000,000 shares of preferred stock, none of which was outstanding as of September 30, 2009.  The Board of Directors may determine the rights, preferences and privileges of any preferred stock issued in the future. We have reserved 100,000 shares of preferred stock designated as series A preferred stock for issuance in connection with our 4.75% Senior Notes, as described in Note 7 above.

Except as required by law and as to matters that would adversely affect the rights of the series A preferred stock relative to common stock, the series A preferred stock does not have any voting rights.  Each share of series A preferred stock is generally entitled to receive a proportional amount of dividends declared on our common stock.  If a Qualifying Tender Offer occurs, then holders of the series A preferred stock will be entitled to receive, when, as and if declared by our board of directors, cumulative dividends, payable quarterly in cash, at the rate per annum equal to the then applicable interest rate per annum payable on the 4.75% Senior Notes, including additional interest that accrues upon a Qualifying Tender Offer.  The series A preferred stock is not convertible at the election of the holder of any series A preferred stock. Once the number of shares of common stock authorized and reserved is an amount sufficient for conversion of all 4.75% Senior Notes into shares of common stock, each 1.1 shares of series A preferred stock will convert into shares of our common stock at a rate of 1,000 shares of common stock, subject to adjustment (the “Common Conversion Number”).  The series A preferred stock is not redeemable.  In the event of a liquidation, dissolution or winding up, holders of the series A preferred stock will be entitled to receive, before any payment or distribution is made to holders of common stock, accumulated and unpaid dividends on the series A preferred stock.  In addition, holders of the series A preferred stock will be entitled to receive, upon a liquidation, dissolution or winding up, an amount per share equal to the Common Conversion Number multiplied by the amount to be distributed per share of common stock.  In the event of a merger or consolidation in which shares of common stock are exchanged for other securities, cash or property, each share of series A preferred stock will be exchanged for the Common Conversion Number multiplied by the consideration received per share of common stock.

9.     Net loss per share

For all periods presented, both basic and diluted net loss per common share are computed by dividing the net loss by the number of weighted average common shares outstanding during the period. Stock options and potential common shares issuable upon conversion of the 4.75% Senior Notes, the 3½% Senior Notes, the 3½% Subordinated Notes and the Pfizer Notes were excluded from the computation of diluted net loss per share, as their share effect was anti-dilutive for all periods presented. The potential common shares that were excluded from the diluted net loss per share computation are as follows:

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10.     Segment reporting

Our operations are treated as one operating segment, drug discovery and development.

11.     Other expenses

Below is a summary of the activity related to our restructuring programs for the nine months ended September 30, 2009. The estimates below have been made based upon management’s best estimate of the amounts and timing of certain events included in the restructuring plan that will occur in the future. It is possible that the actual outcome of certain events may differ from the estimates. Changes will be made to the restructuring accrual at the point that the differences become determinable. The accrual balances for the restructuring plans are included in accrued restructuring and other liabilities (long-term) in the consolidated balance sheets.

2004 Restructuring

2002 Restructuring

Maxia Acquisition Costs

12.     Subsequent event

From October 1, 2009 to November 5, 2009, we repurchased, and retired, $31.1 million principal amount of our 3½% Subordinated Notes.

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Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations as of and for the three and nine months ended September 30, 2009 should be read in conjunction with the financial statements and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q and our audited financial statements as of and for the year ended December 31, 2008 included in our Annual Report on Form 10-K previously filed with the SEC.

This report contains forward-looking statements that involve risks and uncertainties. These statements relate to future periods, future events or our future operating or financial plans or performance. These statements can often be identified by the use of forward-looking terminology such as “expects,” “believes,” “intends,” “anticipates,” “estimates,” “plans,” “may,” or “will,” or the negative of these terms, and other similar expressions. These forward-looking statements include statements as to:

·                  the discovery, development, formulation, manufacturing and commercialization of our compounds and our product candidates;

·                  focus on our drug discovery and development efforts;

·                  conducting clinical trials internally, with collaborators, or with clinical research organizations;

·                  our collaboration and strategic relationship strategy; anticipated benefits and disadvantages of entering into collaboration agreements;

·                  our licensing, investment and commercialization strategies;

·                  the regulatory approval process, including determinations to seek U.S. Food and Drug Administration (FDA) and other international health authorities approval for, and plans to commercialize, our products in the United States and abroad;

·                  the safety, effectiveness and potential benefits and indications of our product candidates and other compounds under development; potential uses for our product candidates and our other compounds;

·                  the timing and size of our clinical trials; the compounds expected to enter clinical trials; timing of clinical trial results;

·                  our ability to manage expansion of our drug discovery and development operations;

·                  future required expertise relating to clinical trials, manufacturing, sales and marketing;

·                  obtaining and terminating licenses to products, compounds or technology, or other intellectual property rights;

·                  the receipt from or payments pursuant to collaboration or license agreements resulting from milestones or royalties; the decrease in revenues from our information product-related activities;

·                  plans to develop and commercialize products on our own;

·                  plans to use third party manufacturers;

·                  expected expenses and expenditure levels; expected uses of cash; expected revenues and sources of revenues;

·                  expected losses; fluctuation of losses;

·                  our profitability; the adequacy of our capital resources to continue operations;

·                  the need to raise additional capital;

·                  the costs associated with resolving matters in litigation;

·                  our expectations regarding competition;

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·                  our investments, including anticipated expenditures, losses and expenses;

·                  our patent prosecution and maintenance efforts; and

·                  our indebtedness, and debt service obligations.

These forward-looking statements reflect our current views with respect to future events, are based on assumptions and are subject to risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from those projected and include, but are not limited to:

·                  our ability to discover, develop, formulate, manufacture and commercialize a drug candidate or product;

·                  the risk of unanticipated delays in research and development efforts;

·                  the risk that previous preclinical testing or clinical trial results are not necessarily indicative of future clinical trial results;

·                  risks relating to the conduct of our clinical trials;

·                  changing regulatory requirements;

·                  the risk of adverse safety findings;

·                  the risk that results of our clinical trials do not support submission of a marketing approval application for our product candidates;

·                  the risk of significant delays or costs in obtaining regulatory approvals;

·                  risks relating to our reliance on third party manufacturers, collaborators, and clinical research organizations;

·                  risks relating to the development of new products and their use by us and our current and potential collaborators;

·                  risks relating to our inability to control the development of out-licensed drug compounds or drug candidates;

·                  costs associated with prosecuting, maintaining, defending and enforcing patent claims and other intellectual property rights;

·                  our ability to maintain or obtain adequate product liability and other insurance coverage;

·                  the risk that our product candidates may not obtain or maintain regulatory approval;

·                  the impact of technological advances and competition;

·                  the ability to compete against third parties with greater resources than ours;

·                  risks relating to changes in pricing and reimbursements in the markets in which we may compete;

·                  competition to develop and commercialize similar drug products;

·                  our ability to obtain patent protection and freedom to operate for our discoveries and to continue to be effective in expanding our patent coverage;

·                  the impact of changing laws on our patent portfolio;

·                  developments in and expenses relating to litigation;

·                  the impact of past or future acquisitions on our business;

·                  the results of businesses in which we have made investments;

·                  our substantial leverage and limitations on our ability to incur additional indebtedness and incur liens on our assets

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imposed by our debt obligations;

·                  our ability to obtain additional capital when needed;

·                  fluctuations in net cash used by investing activities;

·                  our history of operating losses; and

·                  the risks set forth under “Risk Factors.”

Given these risks and uncertainties, you should not place undue reliance on these forward-looking statements. Except as required by federal securities laws, we undertake no obligation to update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

In this report all references to “Incyte,” “we,” “us,” “our” or the “Company” mean Incyte Corporation and our subsidiaries, except where it is made clear that the term means only the parent company.

Incyte is our registered trademark.  We also refer to trademarks of other corporations and organizations in this Quarterly Report on Form 10-Q.

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Overview

Incyte is a drug discovery and development company focused on developing proprietary small molecule drugs to treat serious unmet medical needs. We have a broad pipeline with programs focused primarily in the areas of oncology, inflammation, and diabetes.

Our wholly-owned pipeline includes the following compounds:

Since the beginning of 2009, we have focused our efforts on clinical programs that we believe have the greatest likelihood of creating near-term value and on compounds that we believe a company of our size can effectively develop and commercialize on its own, or that we can further develop and commercialize through strategic relationships. Currently, our highest priority program involves our JAK inhibitors. Our JAK inhibitor program includes an oral formulation of INCB18424 as a treatment for myeloproliferative disorders (myelofibrosis, polycythemia vera and essential thrombocythemia) and certain other oncology indications, a topical formulation of INCB18424 for psoriasis, and an oral formulation of INCB28050 for rheumatoid arthritis and other chronic inflammatory conditions.

We intend to retain rights in the United States for INCB18424 for myeloproliferative disorders and other oncology indications, as we believe this is a market where a company of our size can effectively compete. For markets outside of the United States, we are currently evaluating strategic relationships. We may progress topical INCB18424 for psoriasis on our own, or we may seek to partner INCB18424 for this indication. For INCB28050 for rheumatoid arthritis and other chronic inflammatory conditions, we are evaluating a number of broad global alliances which may allow us to participate in the commercialization of INCB28050 and retain rights in certain indications. We are evaluating strategic relationships with respect to several of our programs and may enter into an agreement with respect to one or more of these programs in the near future. However, these arrangements and negotiations are complex and time consuming and there can be no assurance that we will reach agreement with a strategic partner with respect to any of these programs in the near future or at all.

We have several other oncology programs, including our sheddase inhibitor, INCB7839, that is under development as a treatment for breast cancer. We have two earlier stage oncology programs involving an oral c-MET inhibitor, INCB28060, and an indoleamine dioxygenase, or IDO, inhibitor, INCB24360. We do not intend to initiate clinical trials for either of these programs until we have either secured additional capital or found a strategic partner for these programs.

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We have several other clinical programs that target either large primary care indications or require lengthy and expensive clinical development programs. These include: our 11ßHSD1 inhibitors, INCB13739 and INCB20817, for which we have shown positive results for the lead compound in a three-month Phase IIb trial in patients with type 2 diabetes; our HM74a agonist, INCB19602, also for type 2 diabetes; and our CCR5 receptor antagonists, INCB9471 and INCB15050, for HIV. Because these therapeutic areas require greater financial and commercial resources than we currently possess, we are seeking strategic relationships or collaborative partners for these programs.

We anticipate incurring additional losses for several years as we expand our drug discovery and development programs. We also expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial. Conducting clinical trials for our drug candidates in development is a lengthy, time-consuming and expensive process. We do not expect to generate product sales from our drug discovery and development efforts for several years, if at all. If we are unable to successfully develop and market pharmaceutical products over the next several years, our business, financial condition and results of operations would be adversely impacted.

Critical Accounting Policies and Significant Estimates

The preparation of financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements:

·      Investments;

·      Revenue recognition;

·      Research and development costs;

·      Valuation of long-lived assets;

·      Restructuring charges;

·      Stock compensation; and

·                  Convertible debt and derivative accounting

Investments.  We carry our investments at their respective fair values. We periodically evaluate the fair values of our investments to determine whether any declines in the fair value of investments represent an other-than-temporary impairment. This evaluation consists of a review of several factors, including the length of time and extent that a security has been in an unrealized loss position, the existence of an event that would impair the issuer’s future repayment potential, the near term prospects for recovery of the market value of a security and if we intend to sell or if it is not more likely than not that the we will be required to sell the security before recovery of its amortized cost basis.  If management determines that such an impairment exists, we would recognize an impairment charge. Because we may determine that market or business conditions may lead us to sell a short-term investment or marketable security prior to maturity, we classify our short-term investments and marketable securities as “available-for-sale.” Investments in securities that are classified as available-for-sale and have readily determinable fair values are measured at fair market value in the balance sheets, and unrealized holding gains and losses for these investments are reported as a separate component of stockholders’ equity until realized. We classify those marketable securities that may be used in operations within one year as short-term investments. Those marketable securities in which we have both the ability to hold until maturity and have a maturity date beyond one year from our most recent consolidated balance sheet date are classified as long-term marketable securities.

Revenue Recognition. Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed and determinable and collectibility is reasonably assured. We have entered into various types of agreements for access to our information databases and use of our intellectual property. Revenues are deferred for fees received before earned or until no further obligations exist. We exercise judgment in determining that collectibility is reasonably assured or that services have been delivered in accordance with the arrangement. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based primarily on the customer’s payment history and on the creditworthiness of the customer.

Revenues from ongoing database agreements are recognized evenly over the access period. Revenues from licenses to our intellectual property are recognized when earned under the terms of the related agreements. Royalty revenues are recognized upon the sale of

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products or services to third parties by the licensee or other agreed upon terms. We estimate royalty revenues based on previous period royalties received and information provided by the third party licensee. We exercise judgment in determining whether the information provided by licensees is sufficiently reliable for us to base our royalty revenue recognition thereon.

Under agreements involving multiple products, services and/or rights to use assets, the multiple elements are divided into separate units of accounting when certain criteria are met, including whether the delivered items have stand alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. When separate units of accounting exist, consideration is allocated among the separate elements based on their respective fair values. The determination of fair value of each element is based on objective evidence from historical sales of the individual elements by us to other customers. If such evidence of fair value for each undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value for each undelivered element does exist or until all elements of the arrangement are delivered. When elements are specifically tied to a separate earnings process, revenue is recognized when the specific performance obligation tied to the element is completed. When revenues for an element are not specifically tied to a separate earnings process, they are recognized ratably over the term of the agreement.

Research and Development Costs.   Our policy is to expense research and development costs as incurred. We often contract with clinical research organizations (“CROs”) to facilitate, coordinate and perform agreed upon research and development of a new drug. To ensure that research and development costs are expensed as incurred, we record monthly accruals for clinical trials and preclinical testing costs based on the work performed under the contract.

These CRO contracts typically call for the payment of fees for services at the initiation of the contract and/or upon the achievement of certain clinical trial milestones. In the event that we prepay CRO fees, we record the prepayment as a prepaid asset and amortize the asset into research and development expense over the period of time the contracted research and development services are performed. Most professional fees, including project and clinical management, data management, monitoring, and medical writing fees are incurred throughout the contract period. These professional fees are expensed based on their percentage of completion at a particular date.

Our CRO contracts generally include pass through fees. Pass through fees include, but are not limited to, regulatory expenses, investigator fees, travel costs, and other miscellaneous costs, including shipping and printing fees. We expense the costs of pass through fees under our CRO contracts as they are incurred, based on the best information available to us at the time. The estimates of the pass through fees incurred are based on the amount of work completed for the clinical trial and are monitored through correspondence with the CROs, internal reviews and a review of contractual terms. The factors utilized to derive the estimates include the number of patients enrolled, duration of the clinical trial, estimated patient attrition, screening rate and length of the dosing regimen. CRO fees incurred to set up the clinical trial are expensed during the setup period.

Valuation of Long-Lived Assets. We assess the impairment of long-lived assets, which includes property and equipment as well as intangible and other assets, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could indicate the need for an impairment review include the following:

·      Significant changes in the strategy of our overall business;

·      Significant underperformance relative to expected historical or projected future operating results;

·      Significant changes in the manner of use of the acquired assets;

·      Significant negative industry or economic trends;

·      Significant decline in our stock price for a sustained period; and

·      Our market capitalization relative to net book value.

When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we perform an undiscounted cash flow analysis to determine if impairment exists. If impairment exists, we measure the impairment based on the difference between the asset’s carrying amount and its fair value.

Restructuring Charges. Costs associated with restructuring activities initiated after December 31, 2002, including costs resulting from the acquisition of Maxia Pharmaceuticals, Inc. (“Maxia”), are comprised primarily of costs to exit facilities, reduce our workforce, write-off fixed assets, and pay for outside services incurred in the restructuring. The workforce reduction charge is determined based on the estimated severance and fringe benefit charge for identified employees. In calculating the cost to exit the facilities, we estimate for each location the amount to be paid in lease termination payments, the future lease and operating costs to be paid until the lease is terminated, the amount, if any, of sublease receipts and real estate broker fees. This requires us to estimate the timing and costs of each lease to be terminated, the amount of operating costs, and the timing and rate at which we might be able to sublease the site. To

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form our estimates for these costs, we perform an assessment of the affected facilities and consider the current market conditions for each site. We also estimate our credit adjusted risk free interest rate in order to discount our projected lease payments. Estimates are also used in our calculation of the estimated realizable value on equipment that is being held for sale. These estimates are formed based on recent history of sales of similar equipment and market conditions. Our assumptions on either the lease termination payments, operating costs until terminated, the offsetting sublease receipts and estimated realizable value of fixed assets held for sale may turn out to be incorrect and our actual cost may be materially different from our estimates. Our estimates of future liabilities may change, requiring us to record additional restructuring charges or reduce the amount of liabilities recorded.

At the end of each reporting period, we evaluate the remaining accrued balances to ensure their adequacy, that no excess accruals are retained and the utilization of the provisions are for their intended purposes in accordance with developed exit plans. We periodically evaluate current available information and adjust our restructuring reserve as necessary. We also make adjustments related to accrued professional fees to adjust estimated amounts to actual.

Stock Compensation.   Financial Accounting Standards Board (“FASB”) accounting guidance for stock compensation requires all share-based payment transactions with employees, including grants of employee stock options, to be recognized as compensation expense over the requisite service period based on their fair values.  The accounting guidance also requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility and expected option lives, as well as expected option forfeiture rates, to value equity-based compensation and requires the recognition of the fair value of stock compensation in the statement of operations.  We recorded $2.2 million and $8.1 million of stock compensation expense for the three and nine months ended September 30, 2009, respectively, and $3.9 million and $11.1 million for the three and nine months ended September 30, 2008, respectively.

Convertible Debt and Derivative Accounting.  We perform an assessment of all embedded features of a debt instrument to determine if (1) such features should be bifurcated and separately accounted for, and (2) if bifurcation requirements are met, whether such features should be classified and accounted for as equity or liability. If the embedded feature meets the requirements to be bifurcated and accounted for as a liability, the fair value of the embedded feature is measured initially, included as a liability on the consolidated balance sheet, and remeasured each reporting period. Any changes in fair value are recorded in the consolidated statement of operations. We monitor, on an ongoing basis, whether events or circumstances could give rise to a change in our classification of embedded features.

Due to the variable mix of common stock and series A preferred stock that would be issued to satisfy the conversion of our 4.75% convertible senior notes due 2015 (the “4.75% Senior Notes”), until we have reserved sufficient shares of our common stock for issuance upon conversion of all of the 4.75% Senior Notes, the embedded conversion feature is not considered indexed to our stock.  As a result, the embedded conversion feature is not eligible for equity classification and is required to be bifurcated from the underlying debt instrument. Accordingly, the fair value of the embedded conversion feature on September 30, 2009 of $148.1 million was recorded as a derivative liability and the carrying value of the 4.75% Senior Notes was reduced to reflect a debt discount equal to the fair value of the embedded conversion feature.  The derivative liability is classified as the embedded derivative liability on 4.75%  convertible senior notes in our balance sheet.  The derivative liability related to the conversion feature will be revalued on a quarterly basis with changes in fair market value recorded through earnings until we have reserved sufficient shares of our common stock.  Once we have reserved sufficient shares of our common stock to satisfy the conversion provisions of the 4.75% Senior Notes, we expect the conversion feature to be considered indexed to our stock at which point the fair value of the conversion feature will be reclassified from a liability into stockholders’ deficit.  The debt discount related to the derivative liability will be amortized to interest expense over the six year term of the 4.75% Senior Notes using the effective interest method.  We valued the embedded conversion feature using a single factor binomial lattice model, with the assistance of a valuation consultant.  This model incorporates inputs such as stock price, historical volatility, risk free interest rate, equivalent bond yield, as well as assumptions about fundamental change and note holder behavior.

Results of Operations

We recorded net losses of $43.4 million and $123.4 million and basic and diluted net losses per share of $0.44 and $1.26 per share for the three and nine months ended September 30, 2009, respectively, as compared to net losses of $44.8 million and $130.5 million and basic and diluted net losses per share of $0.48 and $1.50 per share in the corresponding periods in 2008.

Revenues.