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

The Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements about our expectations related to realizing new revenue streams and obtaining future collaboration agreements that include milestone and/or royalty payments, the success of our internal proprietary drug discovery activities, the expected level of our investment in proprietary research and our future headcount and capital expenditure requirements. These statements involve significant risks and uncertainties, including those discussed below and those described more fully in other reports filed by Array BioPharma with the Securities and Exchange Commission. Because these statements reflect our current expectations concerning future events, our actual results could differ materially from those anticipated in these forward-looking statements. The factors that could cause actual results to differ from our expectations include, but are not limited to, our ability to achieve and maintain profitability, the extent to which the pharmaceutical and biotechnology industries are willing to in-license drug candidates for their product pipelines and to collaborate with and fund third parties on their drug discovery activities, our ability to out-license our proprietary candidates on favorable terms, our ability to continue to fund and successfully progress internal research efforts and to create effective, commercially viable drugs, risks associated with our dependence on our collaborators for the clinical development and commercialization of our out-licensed drug candidates, the ability of our collaborators and of Array to meet objectives, including clinical trials, tied to milestones and royalties, our ability to attract and retain experienced scientists and management, and the risk factors contained in the Annual Report on Form 10-K filed by Array with the Securities and Exchange Commission (“SEC”) on September 13, 2005. We are providing this information as of the date of this report. We undertake no duty to update any forward-looking statements to reflect the occurrence of events or circumstances after the date of such statements or of anticipated or unanticipated events that alter any assumptions underlying such statements.

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and notes to those statements included elsewhere in this report.

Overview

Array BioPharma is a biopharmaceutical company focused on the discovery, development and commercialization of targeted small molecule drugs to treat life threatening and debilitating diseases. Our proprietary drug development pipeline is primarily focused on the treatment of cancer and inflammatory disease and includes clinical candidates that are designed to regulate therapeutically important targets. In addition, leading pharmaceutical and biotechnology companies collaborate with Array to discover and develop drug candidates across a broad range of therapeutic areas.

We have identified multiple drug candidates in our own proprietary programs and in collaborations with other drug companies. We intend to progress our proprietary drug programs internally through clinical testing and continue to evaluate select programs for out-licensing opportunities with pharmaceutical and biotechnology partners.

We have built our drug development pipeline, and our discovery and development capabilities, primarily through cash flow from collaborations and through sales of our equity securities. Through December 31, 2005, we have recognized $173.1 million in collaboration revenue, and we have received $18.2 million in up-front payments and $7.7 million in milestone payments from our collaborators and out-licensing partners. Under our existing collaboration agreements, we have the potential to earn over $190.0 million in additional milestone payments if we achieve all of the drug discovery objectives under these agreements, as well as royalties on any resulting product sales from 14 different programs.

We have incurred net losses since inception and expect to incur losses in the near future as we continue to invest in our proprietary drug discovery programs. As of December 31, 2005, we had an accumulated deficit of $112.4 million.

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Revenue . We generate revenue through the out-licensing of select proprietary drug discovery programs for license and up-front fees, research funding based on the number of full-time equivalents contractually assigned to the program, and research and development milestone payments. We also have the potential to generate revenue from royalties on future product sales. Four programs have been out-licensed to date to AstraZeneca, Genentech, Inc. and Amgen Inc., and we have received up-front license fees of $18.2 million in total for these programs.

We also generate revenue through collaborations aimed at inventing drug candidates for our collaborators. We receive research funding based on the number of full-time equivalent employees contractually assigned to a program, plus related research expenses. Under certain of these agreements, we are entitled to receive additional payments based on the achievement of research milestones, drug development milestones and/or royalty payments based on sales of products created as a result of these collaborations.

We sell our Optimer ^â building blocks, which are the starting materials used to create more complex chemical compounds in the drug discovery process, on a per-compound basis without any restrictions on use. In addition, we have licensed our Lead Generation Libraries, which are a collection of structurally related chemical compounds that may have the potential of becoming drug candidates, on a non-exclusive basis to our collaborators for their internal research purposes. We are no longer developing new Lead Generation Libraries other than for our proprietary research. Under our existing agreements, we retain all other rights to the compounds, which permits us to license the same compounds to other collaborators. Some of our existing Lead Generation Library agreements allow our collaborators to obtain exclusive rights to commercialize particular compounds upon the payment of additional fees. Lead Generation Library revenue represented less than 1% of total revenue for each of the three and six months ended December 31, 2005 and approximately 4% of revenue for the full 2005 fiscal year. Future revenue from any sales of compounds in our Lead Generation Library is not expected to be significant.

We report revenue for lead generation and lead optimization research, custom synthesis and process research, the development and sale of chemical compounds and the co-development of proprietary drug candidates we out-license, as collaboration revenue. License and milestone revenue is combined and reported separately from collaboration revenue.

Revenue recognition. We recognize revenue from fees under our collaboration agreements on a monthly basis as work is performed. Per-compound revenue is recognized as compounds are shipped. Revenue from license fees and up-front fees is recognized on a straight-line basis over the expected period of the related research program. Payments received in advance of performance are recorded as advance payments from collaborators until the revenue is earned. Milestone payments are non-refundable and are recognized as revenue over the expected period of the related research program. A portion of each milestone payment is recognized when the milestone is achieved based on the applicable percentage of the research term that has elapsed. Any balance is recognized ratably over the remaining research term. Revenue recognition related to license fees, up-front payments and milestone payments could be accelerated in the event of early termination of programs.

Customer concentration. Our top 20 collaborators contributed approximately 99% of our total revenue for the first six months of fiscal 2006, and our current top three collaborators, Genentech, AstraZeneca and InterMune, Inc, accounted for 33%, 25%, and 20%, respectively, of our total revenue. During the same period of fiscal year 2005, AstraZeneca, Genentech, and Eli Lilly and Company accounted for 29%, 28%, and 11%, respectively, of our total revenue. In general, our collaborators may terminate their collaboration agreements with us on 30 to 90 days’ prior notice.

Cost of revenue. Cost of revenue consists mainly of compensation, associated fringe benefits and other collaboration-related costs, including research and development conducted for our collaborators, supplies, small tools, facilities, depreciation, recruiting and relocation and other direct and indirect chemical handling and laboratory support costs. Fine chemicals consumed as well as any required inventory reserve adjustments are also recorded as cost of revenue. We review the levels and values of our chemical inventories periodically and, when required, write down the carrying cost of our inventories for non-marketability to estimated net realizable value through an appropriate reserve.

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Research and development expenses for proprietary drug discovery. Research and development expenses for proprietary drug discovery consists of all costs associated with our proprietary drug development pipeline, including compensation and fringe benefits, consulting and outsourced services, laboratory supplies, and allocated facility costs and depreciation. When an internal proprietary program is out-licensed, all subsequent costs of the out-licensed program are reported as cost of revenue.

Selling, general and administrative expenses. Selling, general and administrative expenses consist mainly of compensation and associated fringe benefits not included in cost of revenue or research and development expenses and include other management, business development, accounting, information technology and administration costs, including patent prosecution, recruiting and relocation, consulting and professional services, travel and meals, advertising, sales commissions, facilities, depreciation and other office expenses.

Business development. We currently license or sell our compounds and enter into collaborations directly with pharmaceutical and biotechnology companies through opportunities identified by our business development group, senior management, scientists and customer referrals. In addition, we license or sell our compounds and collaborations in Japan through an agent. International revenue represented 36% of our total revenue during the first six months of fiscal year 2006, down slightly from 37% for the same period in the prior year. Our international revenue is primarily attributable to both European and Japanese collaborations. All of our collaboration agreements and purchase orders are denominated in United States dollars.

Future outlook . We plan to increase our investment in proprietary research to broaden our product pipeline and to further enhance our clinical and regulatory capabilities to allow us to advance drugs further in clinical development. We will consider commercializing select programs ourselves with appropriate market characteristics while continuing to evaluate out-licensing opportunities to maximize the risk-adjusted return of our proprietary programs. We also intend to evaluate opportunities to grow our product pipeline by acquiring or in-licensing later-stage clinical programs. As part of these efforts, we expect near term selling, general and administrative costs to rise in connection with increased patent and other intellectual property related costs incurred to protect and enforce our intellectual property rights in our proprietary programs. As we devote more scientists to our proprietary research, we expect fewer scientists will be assigned to revenue generating collaborations. In addition, as of November 2005, we have fully recognized all revenue from previously received up-front and milestone payments from out-licensed proprietary programs. Because of our strategy to retain other proprietary programs later in clinical development before out-licensing them or commercializing them ourselves, it is unlikely that this revenue will be replaced during the remainder of fiscal 2006. Our statements about future events in this paragraph are subject to many risks and uncertainties, including many that are beyond our control. These risks are described in the risk factors included in our annual report on Form 10-K filed with the SEC on September 13, 2005, and in other reports we file with the SEC.

Three and Six Months Ended December 31, 2005 and 2004

Revenue. Total revenue for the three months ended December 31, 2005 was $11.9 million, down slightly from $12.0 million in the same period of the prior year. For the six months ended December 31, 2005, total revenue was $23.2 million, up 6% from $21.9 million in the same period of the prior year. Collaboration revenue from research collaborations increased by $4.1 million and $7.0 million for the three and six months ended December 31, 2005, respectively, over the same periods in the prior year, as a result of expanded programs with Genentech and InterMune and a new research collaboration with Ono Pharmaceutical Co., Ltd. These increases were partially offset

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by decreased collaboration revenue from research programs of $2.9 million and $4.4 million during the same time periods above, related to programs that expired in fiscal 2005 with QLT Inc., as well as the expiration of one of our two research programs with Eli Lilly. In addition, revenue from our programs with AstraZeneca declined over the first half of fiscal 2006 as the research-funding period expired in November 2005. Additionally, collaboration revenue from the sale of Lead Generation Libraries decreased during the three and six months ended December 31, 2005, by $1.5 million due to the sale of the remainder of our Lead Generation Library compounds to a single collaborator that occurred during December 2004.

License and milestone revenue increased by approximately $208,000 and $654,000 during the three and six months ended December 31, 2005, over the same periods of the prior year. This increase was due to the recognition of $1.5 million of milestone payments received from AstraZeneca during the first six months of fiscal 2006 for advancing our out-licensed compound, ARRY-142886, into Phase Ib clinical trials and the selection of a second clinical candidate. Partially offsetting this increase was one less month of recognized revenue from previously received up-front and milestone payments from out-licensed proprietary programs.

Cost of revenue. Cost of revenue increased by approximately 6% during each of the three and six months ended December 31, 2005 over the same periods of the prior year, primarily due to the recording of approximately $546,000 and $1.1 million, respectively, of share-based compensation expense in accordance with FASB Statement No. 123R, Share-Based Payment – an amendment of FASB Statement No. 123 and 95 (“SFAS 123R”). During the three and six months ended December 31, 2004, we expensed $0 and approximately $113,000, respectively, of share-based compensation expense, associated with the final amortization of deferred stock option compensation related to grants prior to our initial public offering of common stock in November 2000. In addition, during June 2005, we began amortizing the cost of leasehold improvements for our facility located in Boulder, Colorado over the remaining months of our initial lease term, which ends March 2008. Prior to that, all leasehold improvements were amortized over a period of 15 years, which included optional lease extension periods we were reasonably assured of exercising at that time. This change in useful life resulted in approximately $143,000 and $263,000, respectively, of additional leasehold improvement amortization to cost of revenue for the three and six months ended December 31, 2005 compared to the same periods of the prior year.

Research and development expenses for proprietary drug discovery. Research and development expenses for proprietary drug discovery increased by approximately 47% and 68% during the three and six months ended December 31, 2005, over the same periods of the prior year. This increase was primarily due to additional scientists and increased pharmacology studies supporting our expanded efforts to advance proprietary compounds into regulated safety testing and clinical trials. The most significant increase in costs came from outsourced pharmacology studies to support the advancement of our ErB2/EGFR, P38, Mek for inflammation, and other programs. We expect that proprietary research and development spending will continue to increase as we focus more resources on our proprietary drug discovery and development programs and advance our programs into and through clinical development. For the three and six months ended December 31, 2005, we expensed approximately $321,000 and $733,000, respectively, related to share-based compensation in accordance with SFAS 123R. In addition, as described in cost of revenue above, we recorded approximately $240,000 and $500,000, respectively, of additional leasehold improvement amortization to research and development expenses for proprietary drug discovery for the three and six months ended December 31, 2005 compared to the same periods of the prior year.

Selling, general and administrative expenses. Selling, general and administrative expenses increased 44% and 46%, respectively, during the three and six months ended December 31, 2005, over the same periods of the prior year. The increase was primarily the result of approximately $798,000 and $1.6 million, respectively, of share-based compensation in accordance with SFAS 123R. The remaining increase was primarily attributable to increases in compensation expense, as well as costs associated with the audit of our internal control over financial reporting in compliance with Section 404 of the Sarbanes Oxley Act for the end of fiscal year 2005 and the first half of fiscal 2006. For the three and six months ended December 31, 2005, compensation expense increased by approximately $98,000 and $212,000, respectively, over the same periods of the prior year, while consulting and audit fees related to Section 404 compliance increased by approximately $61,000 and $174,000 for the same comparable periods.

Interest expense. During the three and six months ended December 31, 2005, we incurred interest expense of approximately $153,000 and $282,000, respectively, associated with borrowings related to the Loan and Security Agreement that we entered into on June 28, 2005.

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Interest income. Interest income increased to approximately $696,000 and $1.4 million for the three and six months ended December 31, 2005, from approximately $192,000 and $330,000, respectively, in the same periods of the prior year. This increase was primarily due to higher investment interest rates earned on higher average cash and investment balances with the increased balances primarily being attributable to the Company’s public common stock offering in December 2004.

Share-Based Compensation . Effective July 1, 2005, we adopted the fair value method of accounting for share-based compensation arrangements in accordance with SFAS 123R, using the modified prospective method of transition. Share-based compensation arrangements covered by SFAS 123R currently include stock options granted under our Amended and Restated Stock Option and Incentive Plan (the “Option Plan”) and purchases of common stock by our employees at a discount to the market price during each offering period under our Employee Stock Purchase Plan (the “ESPP”). Prior to July 1, 2005, we accounted for share-based employee compensation plans using the intrinsic value method of accounting in accordance with APB 25. Under the provisions of APB 25, no compensation expense was recognized with respect to purchases of our common stock under the ESPP or when stock options were granted with exercise prices equal to or greater than market value on the date of grant and no compensation expense was recognized for purchases of shares of our common stock by employees under our ESPP. Under the modified prospective method of transition, we are not required to restate our prior period financial statements to reflect expensing of share-based compensation under SFAS 123R. Therefore, the results as of the three and six months ended December 31, 2005 are not directly comparable to the same periods in the prior year.

As required by the provisions of SFAS 123R, we recorded $1.7 million and $3.4 million, or $0.04 and $0.09 per share, respectively, of share-based compensation expense for the three and six months ended December 31, 2005. These amounts are allocated among cost of revenue, research and development expenses for proprietary drug discovery and selling, general and administrative expenses based on the function of the applicable employee. This charge had no impact on our reported cash flows. We used the Black-Scholes option pricing model to determine the estimated fair value of our share-based compensation arrangements.

As of December 31, 2005, there was $11.7 million of total unrecognized compensation expense related to unvested share-based compensation arrangements granted under the Option Plan. See Note 1, Accounting for Share-Based Compensation, to the Unaudited Notes to Condensed Financial Statements and Critical Accounting Policies – Share-Based Compensation below for more information about the adoption of SFAS 123R.

Liquidity and Capital Resources

We have historically funded our operations through revenue from our collaborations and the issuance of equity securities. As of December 31, 2005, cash, cash equivalents, restricted cash and marketable securities totaled $77.7 million compared with $92.7 million at June 30, 2005.

Net cash used in operating activities was $15.8 million and $5.3 million for the six months ended December 31, 2005, and 2004 respectively. During the first six months of fiscal year 2006, our net loss of $18.4 million was reduced by noncash charges of $8.0 million, primarily associated with depreciation, share-based compensation, and an increase in our net operating assets and liabilities, excluding cash and marketable securities, of approximately $5.4 million. Net operating assets and liabilities increased due to decreases in advance payment balances from collaborators and decreased accrued compensation and benefits. Advance payments from collaborators decreased by $4.5 million due to the recognition of revenue from previously received up-front license and milestone payments. Accrued compensation and benefits decreased by $1.3 million primarily due to the payment of the fiscal year 2005 employee bonuses during August 2005, partially offset by the bonus accrual amounts recorded through December 31, 2005 for fiscal 2006.

During the six months ended December 31, 2005, we invested $2.4 million in laboratory equipment, primarily for biology and drug metabolism operations, as well as in various computer hardware and software. Purchases of marketable securities used $34.9 million of cash while proceeds from the sale and maturity of marketable securities provided $47.7 million of cash. During the six months ended December 31, 2005, p reviously restricted cash in the amount of $2.0 million became available for use in operations. Financing activities provided $3.2 million of cash consisting of $2.6 million from the issuance of long term debt used to finance purchases of capital equipment and approximately $695,000 of cash resulting from the exercise of stock options under our stock option plan and purchases of stock under our employee stock purchase plan.

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As of December 31, 2005, we had a $10 million term loan and $2.6 million of equipment advances outstanding under our Loan and Security Agreement, which currently bear interest at the rate of 5.5% per annum. Interest on the loans is payable in monthly installments. A balloon payment of $12.6 million is due at maturity of the loan on June 28, 2010, based on current amounts outstanding as of December 31, 2005. We also have a revolving line of credit, with a maturity date of June 28, 2008, in the amount of $2 million to support outstanding standby letters of credit that have been issued in relation to our facilities leases.

Our future capital requirements will depend on a number of factors, including the rate at which we invest in proprietary research, the growth of our collaboration business and the amount of collaboration research funding we receive, the timing of milestone and royalty payments, if any, from our collaboration and out-licensed programs, our capital spending on new facilities and equipment, expenses associated with unforeseen litigation, regulatory changes, competition, technological developments, general economic conditions and the extent to which we acquire or invest in other businesses, products and technologies.

In addition, our future capital requirements may be impacted if we do not receive milestone or royalty payments under our existing or future collaboration agreements. Our ability to realize these payments is subject to a number of risks, many of which are beyond our control and include the following: the drug development process is risky and highly uncertain, and we or our collaborators may not be successful in commercializing drug candidates we create; our collaborators have substantial control and discretion over the timing and continued development and marketing of drug candidates we create; the sale and manufacture of drug candidates we develop may not obtain regulatory approval; and, if regulatory approval is received, drugs we develop will remain subject to regulation or may not gain market acceptance, which could delay or prevent us from generating milestone or royalty revenue from the commercialization of these drugs.

We believe that our existing cash, cash equivalents and marketable securities and anticipated cash flow from existing collaboration agreements will be sufficient to support our current operating plan for at least the next 12 months. This estimate of our future capital requirements is a forward-looking statement that is based on assumptions that may prove to be wrong and that involve substantial risks and uncertainties. Our actual future capital requirements could vary as a result of a number of factors, including:

•                   the decision to stay in our current facilities, or to consolidate operations in an existing or new location;

•                   the costs and timing of regulatory approvals; and

•                   the costs of establishing clinical development, business development and distribution or commercialization capabilities.

Until we can generate sufficient levels of cash from our operations, which we do not expect to achieve in the foreseeable future, we expect to continue to utilize our existing cash and marketable securities resources that were primarily generated from the proceeds of our equity offerings. In addition, we may finance future cash needs through the sale of equity securities, strategic collaboration agreements and debt financing. We cannot assure that we will be successful in obtaining new or in retaining existing out-license or collaboration agreements, in securing agreements for the co-development of our proprietary drug candidates, or in receiving milestone and/or royalty payments under those agreements, that our existing cash and marketable securities resources will be adequate or that additional financing will be available when needed or that, if available, this financing will be obtained on terms favorable to us or our stockholders. Insufficient funds may require us to delay, scale back or eliminate some or all of our research or development programs or to relinquish greater or all rights to product candidates at an earlier stage of development or on less favorable terms than we would otherwise choose, or may adversely affect our ability to

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operate as a going concern. If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders may result.

We are obligated under noncancelable operating leases for our facilities and certain equipment. The original lease terms for our facilities range from seven to eight years with renewal options and generally require us to pay a proportionate share of real estate taxes, insurance, common area and other operating costs. Equipment leases generally range from three to five years.

Due to the high cost to replace and the limited availability of laboratory facilities, we concluded that the exercise of a portion of our lease term options for at least 15 years was reasonably assured. During the last quarter of fiscal 2005, we reassessed our facility requirements and began to consider the possibility of consolidating operations in one of our existing locations, or a new location. During the second quarter of fiscal 2006, we entered into an agreement to extend and expand our existing facility in Longmont, Colorado. Therefore it is no longer reasonably assured that we will remain in our Boulder, Colorado location beyond the initial lease term, which ends in March 2008. We have not changed our determination that it is reasonably assured that we will exercise certain of our lease extensions and lease our other facility, located in Longmont, Colorado, for at least another 13 years. Therefore, we have included in our operating lease obligations reflected in the table above the cash to be paid for our facility leases for the remaining reasonably assured lease terms of 2-1/4 years for our Boulder facility and 13 years for our Longmont facility. The portion of operating lease obligations that is related to optional extension periods for our Longmont facility is $4.8 million and is included within the “after 5 years” column above. 

Critical Accounting Policies

We believe critical accounting policies are essential to the understanding of our results of operations and require our management to make significant judgments in preparing the financial statements included in this report. Management has made estimates and assumptions based on these policies. We do not believe that materially different amounts would be reported if different assumptions were used. However, the application of these policies involves judgments and assumptions as to future events and, as a result, actual results could differ. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results.

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Revenue Recognition

We believe our revenue recognition policy is significant because the amount and timing of revenue is a key component of our results of operations. We follow the guidance of Staff Accounting Bulletin No. 104, which requires that a series of criteria be met in order to recognize revenue related to the performance of services or the shipment of products. If these criteria are not met, the associated revenue is deferred until the criteria are met. We recognize revenue when (a) persuasive evidence of an arrangement exists, (b) products are delivered or services are rendered, (c) the sales price is fixed or determinable and (d) collectibility is assured.

Most of our revenue is derived from designing, creating, optimizing, evaluating and developing drug candidates for our collaborators. The majority of our collaboration revenue consists of fees received based on contracted annual rates for full time equivalent employees working on a project. Our collaboration agreements also include license and up-front fees, milestone payments upon achievement of specified research or development goals and royalties on sales of resulting products. A small portion of our revenue comes from fixed fee agreements and from sales of compounds on a per-compound basis.

Our collaboration agreements typically call for a specific level of resources as measured by the number of full time equivalent scientists working a defined number of hours per year at a stated price under the agreement. We recognize revenue under our collaboration agreements on a monthly basis for fees paid to us based on hours worked. We recognize revenue from sales of Lead Generation Library and Optimer building block compounds as the compounds are shipped, as these agreements are priced on a per-compound basis and title and risk of loss passes upon shipment to our customers.

Revenue from license fees and up-front fees is non-refundable and is recognized on a straight-line basis over the expected period of the related research program. Milestone payments are non-refundable and are recognized as revenue over the expected period of the related research program. A portion of any milestone payment is recognized at the date the milestone is achieved which is determined using the applicable percentage of the research term that has elapsed at the date the milestone is achieved. Any balance is recognized ratably over the remaining research term. Revenue recognition related to license fees, up-front payments and milestone payments could be accelerated in the event of early termination of programs.

In general, contract provisions include predetermined payment schedules or the submission of appropriate billing detail. Payments received in advance of performance are recorded as advance payments from collaborators until the revenue is earned.

We report revenue for lead generation and lead optimization research, custom synthesis and process research, the development and sale of chemical compounds and the co-development of proprietary drug candidates we out-license, as collaboration revenue. License and milestone revenue is combined and reported separately from collaboration revenue.

Share-Based Compensation

During the first quarter of fiscal 2006, we adopted the fair value method of accounting for share-based awards using the modified-prospective method of transition as outlined in Financial Accounting Standards Board Statement No. 123R, Share-Based Payment (“SFAS 123R”). Under SFAS 123R, the estimated fair value of share-based-compensation, including stock options granted under the Option Plan and purchases of common stock by employees at a discount to market price under the ESPP, is recognized as compensation expense. The estimated fair value of stock options is expensed on a straight-line basis over the expected term of the grant. Compensation expense for purchases under the ESPP is recognized based on the estimated fair value of the common stock during each offering period and the percentage of the purchase discount. Prior to July 1, 2005, we accounted for share-based employee compensation plans using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and its related interpretations. Under the provisions of APB 25, no compensation expense was recognized with respect to purchases of common stock under the ESPP or when stock options were granted with exercise prices equal to or greater than market value on the date of grant.

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Under the modified prospective method of transition that we adopted, compensation expense is recognized beginning with the effective date of adoption for all share-based payments (i) granted after the effective date of adoption and (ii) granted prior to the effective date of adoption and that remain unvested on the date of adoption. Under the modified prospective method of transition, we are not required to restate our prior period financial statements to reflect expensing of share-based compensation under SFAS 123R. Therefore, the results for the periods ended September 30, 2005 and December 31, 2005 are not comparable to the same periods in the prior year.

Under SFAS 123R, we use the Black-Scholes option pricing model to estimate the fair value of the share-based awards as of the grant date. The Black-Scholes model, by its design, is highly complex, and dependent upon key data inputs estimated by management. The primary data inputs with the greatest degree of judgment are the estimated lives of the share-based awards and the estimated volatility of our stock price. The Black-Scholes model is highly sensitive to changes in these two data inputs. Beginning in fiscal year 2006, we calculated the estimated life of stock options granted using a “simplified” method, which is based on the average of the vesting term and the term of the option, as a result of guidance from the SEC as contained in Staff Accounting Bulletin No. 107 permitting the initial use of this method. Previously, we calculated the estimated life based on the expectation that options would be exercised on average five years after the date of grant. We determined expected volatility for fiscal year 2006 using the historical method, which is based on the daily historical trading data of our common stock from November 2000, the date of our initial public offering, through the last day of the applicable period. For fiscal year 2005, we determined expected volatility using the same method as fiscal year 2006, using the period from November 2001 though the last day of the applicable period. Management selected the historical method primarily because we have not identified a more reliable or appropriate method to predict future volatility. See Note 1, Accounting for Share-Based Compensation, to our financial statements for more information about the adoption of SFAS 123R.

Recent Accounting Pronouncements

For a summary description of a recent accounting pronouncement, see Note 8 to the Unaudited Notes to Condensed Financial Statements.