Gyre Therapeutics (GYRE) 10-Q 2013 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2013

or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                    to                    

Commission File Number: 000-51173

Targacept, Inc.

(Exact Name of Registrant as Specified in its Charter)

Delaware	56-2020050
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
100 North Main Street, Suite 1510 Winston-Salem, North Carolina	27101
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (336) 480-2100

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    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).    Yes  x    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.

Large accelerated filer	¨	Accelerated filer	x
Non-accelerated filer	¨  (do not check if a smaller reporting company)	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No

As of April 30, 2013, the registrant had 33,618,675 shares of common stock, $0.001 par value per share, outstanding.

TARGACEPT, INC.

FORM 10-Q

TABLE OF CONTENTS

		Page
PART I — FINANCIAL INFORMATION
Cautionary Note Regarding Forward-Looking Statements			1
Item 1.	Financial Statements		3
	Balance Sheets as of March 31, 2013 and December 31, 2012 (Unaudited)		3
	Statements of Comprehensive Income (Loss) for the Three Months Ended March  31, 2013 and 2012 (Unaudited)		4
	Statements of Cash Flows for the Three Months Ended March 31, 2013 and 2012 (Unaudited)		5
	Notes to Unaudited Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		29
Item 4.	Controls and Procedures		30
PART II — OTHER INFORMATION
Item 6.	Exhibits		30
SIGNATURES			31
EXHIBIT INDEX			32

PART I. Financial Information

Cautionary Note Regarding Forward-Looking Statements

This quarterly report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, which we refer to as the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act. For this purpose, any statement contained in this quarterly report, other than statements of historical fact, regarding, among other things:

• the progress, scope or duration of the development of TC-5619, TC-5214, TC-1734, AZD1446 (TC-6683), TC-6987, TC-6499 or any of our other product candidates or programs, such as the target indication(s) for development, the size, design, population, location, conduct, objective, duration or endpoints of any clinical trial, or the timing for initiation or completion of or availability of results from any clinical trial, for submission or approval of any regulatory filing, for interactions with regulatory authorities, or, where applicable, for a decision by AstraZeneca as to whether to conduct particular development;

• the benefits that may be derived from any of our product candidates or the commercial opportunity in any target indication;

• the timing or amount of any payments that AstraZeneca may make to us;

• our operations, financial position, revenues, costs or expenses; or

• our strategies, prospects, plans, expectations or objectives

is a forward-looking statement made under the provisions of The Private Securities Litigation Reform Act of 1995. In some cases, words such as “may,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing,” “scheduled” or other comparable words identify forward-looking statements. Actual results, performance or experience may differ materially from those expressed or implied by any forward-looking statement as a result of various important factors, including our critical accounting policies and risks and uncertainties relating, among other things, to:

• whether favorable findings from our completed clinical trial of TC-5619 in patients with schizophrenia will be replicated in our ongoing clinical trial of TC-5619 or potential future clinical trials of TC-5619;

• whether the designs and endpoints of our ongoing clinical trial of TC-5619 and potential future clinical trials of TC-5619 will be deemed by applicable regulatory authorities to be sufficient to support approval of TC-5619 to treat negative symptoms of schizophrenia or cognitive dysfunction in schizophrenia;

• whether findings from nonclinical studies and assessments of TC-5214 and clinical trials of TC-5214 in a different indication will be predictive of a positive outcome in our planned Phase 2b clinical trial of TC-5214 in overactive bladder;

1

• the conduct and results of clinical trials and non-clinical studies and assessments of TC-5619, TC-5214, TC-1734, AZD1446, TC-6987, TC-6499 or any of our other product candidates, including the performance of third parties engaged to execute them, delays resulting from any changes to the applicable protocols or difficulties or delays in subject enrollment or data analysis;

• whether the executive turnover and two workforce reductions that we experienced in 2012 will have an adverse impact on the development of any of our product candidates or our business generally;

• whether TC-5214 will be eligible for treatment in the United States as a new chemical entity with a five-year statutory exclusivity period, either because we submit a new drug application for TC-5214 prior to October 1, 2017 or because the applicable statutory provision is re-authorized by the U.S. Congress;

• the control or significant influence that AstraZeneca has over any future development of AZD1446, including as to the timing, scope and design of any future clinical trials;

• our ability to establish additional strategic alliances, collaborations or licensing or other comparable arrangements on favorable terms;

• our ability to protect our intellectual property; and

• the timing and success of submission, acceptance and approval of regulatory filings.

Risks and uncertainties that we face are described in greater detail under the caption “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2012 and in other filings that we make with the Securities and Exchange Commission, or SEC. As a result of the risks and uncertainties to which our business is subject, the results or events indicated by any forward-looking statement may not occur. We caution you not to place undue reliance on any forward-looking statement.

In addition, any forward-looking statement in this quarterly report represents our views only as of the date of this quarterly report and should not be relied upon as representing our views as of any later date. We anticipate that subsequent events and developments may cause our views to change. Although we may elect to update these forward-looking statements publicly at some point in the future, we specifically disclaim any obligation to do so, except as required by applicable law. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make or any future strategic alliances, collaborations or licensing or other comparable arrangements that we may enter into.

2

Item 1. Financial Statements

TARGACEPT, INC.

BALANCE SHEETS

(in thousands, except share and par value amounts)

(unaudited)

	March 31, 2013			December 31, 2012
ASSETS
Current assets:
Cash and cash equivalents	$	69,861		$	82,240
Investments in marketable securities - short term		39,978			42,721
Receivables from collaborations		383			1,380
Prepaid expenses		1,405			1,402
Total current assets		111,627			127,743
Investments in marketable securities - long term		65,220			59,966
Property and equipment, net		1,501			1,639
Intangible assets		110			115
Other assets		287			116
Total assets	$	178,745		$	189,579
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,516		$	2,056
Accrued expenses		4,998			6,085
Current portion of long-term debt		858			851
Current portion of deferred revenue		—			2,357
Total current liabilities		8,372			11,349
Long-term debt, net of current portion		918			1,136
Deferred revenue, net of current portion		—			1,179
Total liabilities		9,290			13,664
Commitments and contingencies
Stockholders’ equity:
Common stock, $0.001 par value, 100,000,000 shares authorized and 33,616,675 and 33,615,081 shares issued and outstanding at March 31, 2013 and December 31, 2012, respectively		34			34
Preferred stock, $0.001 par value, 5,000,000 shares authorized and 0 shares issued and outstanding at March 31, 2013 and December 31, 2012		—			—
Capital in excess of par value		411,227			409,608
Accumulated other comprehensive income		188			201
Accumulated deficit		(241,994	)		(233,928	)
Total stockholders’ equity		169,455			175,915
Total liabilities and stockholders’ equity	$	178,745		$	189,579

See accompanying notes.

3

TARGACEPT, INC.

STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands, except share and per share amounts)

(unaudited)

	Three Months Ended March 31,
	2013						2012
Operating revenues:
License fees and milestones from collaborations				$	3,536				$	22,607
Grant revenue					—					250
Net operating revenues					3,536					22,857
Operating expenses:
Research and development (including stock-based compensation of $779 and $1,094 for the three months ended March 31, 2013 and 2012, respectively)					8,320					17,801
General and administrative (including stock-based compensation of $835 and $822 for the three months ended March 31, 2013 and 2012, respectively)					3,490					3,070
Total operating expenses					11,810					20,871
(Loss) income from operations					(8,274	)				1,986
Other income (expense):
Interest income					224					299
Interest expense					(16	)				(26	)
Total other income (expense)					208					273
Net (loss) income				$	(8,066	)			$	2,259
Basic net (loss) income per share	$	(0.24	)				$	0.07
Diluted net (loss) income per share	$	(0.24	)				$	0.07
Weighted average common shares outstanding - basic		33,616,342						33,390,286
Weighted average common shares outstanding - diluted		33,616,342						33,822,010
Unrealized (loss) gain on available-for-sale securities, net					(13	)				191
Comprehensive (loss) income				$	(8,079	)			$	2,450

See accompanying notes.

4

TARGACEPT, INC.

STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Three Months Ended March 31,
	2013			2012
Operating activities
Net (loss) income	$	(8,066	)	$	2,259
Adjustments to reconcile net (loss) income to net cash used in operating activities:
Recognition of deferred revenue		(3,536	)		(22,857	)
Amortization of premium on marketable securities, net		226			239
Depreciation and amortization		213			632
Stock-based compensation expense		1,614			1,916
Changes in operating assets and liabilities:
Receivables from collaborations		997			(101	)
Other assets		(141	)		1,036
Accounts payable and accrued expenses		(627	)		(8,274	)
Deferred revenue		—			250
Net cash used in operating activities		(9,320	)		(24,900	)
Investing activities
Purchase of investments in marketable securities		(19,242	)		(41,916	)
Proceeds from sale of investments in marketable securities		16,459			48,754
Purchase of property and equipment		(70	)		(46	)
Net cash (used in) provided by investing activities		(2,853	)		6,792
Financing activities
Principal payments on long-term debt		(211	)		(555	)
Proceeds from issuance of common stock, net		5			48
Net cash used in financing activities		(206	)		(507	)
Net decrease in cash and cash equivalents		(12,379	)		(18,615	)
Cash and cash equivalents at beginning of period		82,240			107,283
Cash and cash equivalents at end of period	$	69,861		$	88,668

See accompanying notes.

5

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS

March 31, 2013

1. The Company and Nature of Operations

Targacept, Inc., or the Company, is a Delaware corporation formed on March 7, 1997. The Company is a biopharmaceutical company engaged in the development of novel NNR Therapeutics™ for the treatment of diseases and disorders of the nervous system. The Company’s NNR Therapeutics selectively target neuronal nicotinic receptors, which it refers to as NNRs. Its facilities are located in Winston-Salem, North Carolina.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP, for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the Company’s audited financial statements and notes thereto included in its Annual Report on Form 10-K for the year ended December 31, 2012. In the opinion of the Company’s management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of its financial position, operating results and cash flows for the periods presented have been included. Operating results for the three months ended March 31, 2013 are not necessarily indicative of the results that may be expected for the full year, for any other interim period or for any future year.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in the financial statements and accompanying notes. Actual results could differ from these estimates.

Fair Value Measurement

The Company follows Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, Topic 820,Fair Value Measurements and Disclosures, or ASC 820, for application to financial assets. ASC 820 defines fair value, provides a consistent framework for measuring fair value under GAAP and requires fair value financial statement disclosures. ASC 820 applies only to the measurement and disclosure of financial assets that are required or permitted to be measured and reported at fair value under other ASC topics (except for standards that relate to share-based payments such as ASC Topic 718,Compensation – Stock Compensation).

6

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

The valuation techniques required by ASC 820 may be based on either observable or unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, and unobservable inputs reflect the Company’s market assumptions. These inputs are classified into the following hierarchy:

Level 1 Inputs– quoted prices (unadjusted) in active markets for identical assets that the reporting entity has the ability to access at the measurement date;

Level 2 Inputs– inputs other than quoted prices included within Level 1 that are observable for the asset, either directly or indirectly; and

Level 3 Inputs– unobservable inputs for the assets.

The following tables present the Company’s investments in marketable securities (including, if applicable, those classified on the Company’s balance sheet as cash equivalents) that are measured at fair value on a recurring basis as of March 31, 2013 and December 31, 2012, respectively:

March 31, 2013	Quoted Prices in  Active Markets (Level 1)		Other Observable Inputs (Level 2)		Unobservable Inputs (Level 3)
	(in thousands)
U.S. Treasury and U.S. or state government agency-backed securities	$	44,359	$	—	$	—
Corporate debt securities		—		47,730		—
Municipal bonds		—		2,700		—
Certificates of deposit		10,000		—		—
Accrued interest		409		—		—
Total cash equivalents and marketable securities	$	54,768	$	50,430	$	—

December 31, 2012	Quoted Prices in  Active Markets (Level 1)		Other Observable Inputs (Level 2)		Unobservable Inputs (Level 3)
	(in thousands)
U.S. Treasury and U.S. or state government agency-backed securities	$	46,371	$	—	$	—
Corporate debt securities		—		47,173		—
Municipal bonds		—		2,700		—
Certificates of deposit		10,000		—		—
Accrued interest		443		—		—
Total cash equivalents and marketable securities	$	56,814	$	49,873	$	—

7

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

Corporate debt securities and municipal bonds are valued based on various observable inputs such as benchmark yields, reported trades, broker/dealer quotes, benchmark securities and bids.

Investments in Marketable Securities

Consistent with its investment policy, the Company invests its cash allocated to fund its short-term liquidity requirements with prominent financial institutions in bank depository accounts and institutional money market funds and the Company invests the remainder of its cash in corporate debt securities and municipal bonds rated at least A quality or equivalent, U.S. Treasury notes and bonds, U.S. and state government agency-backed securities and certificates of deposit.

The Company determines the appropriate classification of marketable securities at the time of purchase and reevaluates its classification as of each balance sheet date. All marketable securities owned during the three months ended March 31, 2013 and 2012 were classified as available for sale. The cost of securities sold is based on the specific identification method. Investments in marketable securities are recorded as of each balance sheet date at fair value, with unrealized gains and, to the extent deemed temporary, unrealized losses included in stockholders’ equity. Interest and dividend income on investments in marketable securities, accretion of discounts and amortization of premiums and realized gains and losses are included in interest income in the statement of comprehensive income (loss).

An investment in marketable securities is considered to be impaired when a decline in fair value below its cost basis is determined to be other than temporary. The Company evaluates whether a decline in fair value of an investment in marketable securities below its cost basis is other than temporary using available evidence. In the event that the cost basis of the investment exceeds its fair value, the Company evaluates, among other factors, the amount and duration of the period that the fair value is less than the cost basis, the financial health of and business outlook for the issuer, including industry and sector performance, operational and financing cash flow factors, overall market conditions and trends, the Company’s intent to sell the investment and whether it is more likely than not the Company would be required to sell the investment before its anticipated recovery. If a decline in fair value is determined to be other than temporary, the Company records an impairment charge in the statement of comprehensive income (loss) and establishes a new cost basis in the investment.

8

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

Revenue Recognition

The Company uses the revenue recognition guidance established by ASC Topic 605,Revenue Recognition, or ASC 605. In determining the accounting for collaboration and alliance agreements, the Company follows the provisions of ASC 605, Subtopic 25,Multiple Element Arrangements,or ASC 605-25. ASC 605-25 provides guidance on whether an arrangement that involves multiple revenue-generating activities or deliverables should be divided into separate units of accounting for revenue recognition purposes and, if division is required, how the arrangement consideration should be allocated among the separate units of accounting. If the arrangement constitutes separate units of accounting according to the separation criteria of ASC 605-25, the consideration received is allocated among the separate units of accounting and the applicable revenue recognition criteria must be applied to each unit. If the arrangement constitutes a single unit of accounting, the revenue recognition policy must be determined for the entire arrangement and the consideration received is recognized over the period of inception through the date on which the last deliverable within the single unit of accounting is expected to be delivered. Revisions to the estimated period of recognition are reflected in revenue prospectively.

Collaboration research and development revenue is earned and recognized as research is performed and related expenses are incurred. Non-refundable upfront fees, which may include, for example, an initial payment upon effectiveness of the contractual relationship, payment representing a common stock purchase premium or payment to secure a right for a future license, are recorded as deferred revenue and recognized into revenue as license fees and milestones from collaborations on a straight-line basis over the estimated period of the Company’s substantive performance obligations. If the Company does not have substantive performance obligations, it recognizes non-refundable upfront fees into revenue through the date the deliverable is satisfied.

Revenue for non-refundable payments based on the achievement of milestone events under collaboration agreements is recognized in accordance with ASC 605, Subtopic 28,Milestone Method, or ASC 605-28. Milestone events under the Company’s collaboration agreements may include research, development, regulatory, commercialization or sales events. Under ASC 605-28, a milestone payment is recognized as revenue when the applicable event is achieved if the event meets the definition of a milestone and the milestone is determined to be substantive. ASC 605-28 defines a milestone event as an event having all of the following characteristics: (1) there is substantive uncertainty regarding achievement of the milestone event at the inception of the arrangement; (2) the event can only be achieved based, in whole or in part, on either the company’s performance or a specific outcome resulting from the company’s performance; and (3) if achieved, the event would result in additional payment due to the company. The Company also treats events that can only be achieved based, in whole or in part, on either a third party’s performance or a specific outcome resulting from a third party’s performance as milestone events if the criteria of ASC 605-28 are otherwise satisfied.

9

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

A milestone is considered substantive if it meets all of the following criteria: (A) the payment is commensurate with either the Company’s performance to achieve the milestone or with the enhancement of the value of the delivered item; (B) the payment relates solely to past performance; and (C) the payment is reasonable relative to all of the deliverables and payment terms within the arrangement. If any of these conditions is not met, the milestone payment is deferred and recognized on a straight-line basis over a period determined as discussed above.

Research and development costs that are reimbursable under collaboration agreements are recorded in accordance with ASC 605, Subtopic 45,Principal Agent Considerations. Amounts reimbursed under a cost sharing arrangement are reflected as a reduction of research and development expense.

Grant payments received prior to the Company’s performance of work required by the terms of the award are recorded as deferred revenue and recognized as grant revenue as the Company performs the work and incurs qualifying costs.

Income Taxes

The Company uses the liability method in accounting for income taxes as required by ASC Topic 740,Income Taxes, or ASC 740. Under ASC 740, deferred tax assets and liabilities are recorded for operating loss and tax credit carryforwards and for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the results of operations in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not that the assets will be realized. ASC 740 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 requires interim income tax expense or benefit to be calculated using an estimated annual effective tax rate. If a reliable estimate of the annual effective tax rate cannot be made, the Company considers the effective tax rate for the year to date to be the best estimate. Accordingly, the income tax provisions for the three months ended March 31, 2013 were determined based on the actual year to date effective tax rate because a reliable estimate of the annual effective tax rate cannot be made. ASC 740 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures and transition. The Company’s policy is to classify any interest recognized in accordance with ASC 740 as interest expense and to classify any penalties recognized in accordance with ASC 740 as an expense other than income tax expense.

10

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

Net Income or Loss Per Share

The Company computes net income or loss per share in accordance with ASC Topic 260, Earnings Per Share, or ASC 260. Under the provisions of ASC 260, basic net income or loss per share, or Basic EPS, is computed by dividing net income or loss by the weighted average number of common shares outstanding. Diluted net income or loss per share, or Diluted EPS, is computed by dividing net income or loss by the weighted average number of common shares outstanding plus, in the case of diluted net income per share, dilutive common share equivalents outstanding. The calculations of Basic EPS and Diluted EPS are set forth in the table below (in thousands, except share and per share amounts).

	Three Months Ended March 31,
	2013			2012
Basic:
Net (loss) income	$	(8,066	)	$	2,259
Weighted average common shares - basic		33,616,342			33,390,286
Basic EPS	$	(0.24	)	$	0.07
Diluted:
Net (loss) income	$	(8,066	)	$	2,259
Weighted average common shares - basic		33,616,342			33,390,286
Common share equivalents		—			431,724
Weighted average common shares - diluted		33,616,342			33,822,010
Diluted EPS	$	(0.24	)	$	0.07

Common share equivalents consist of the incremental common shares that would be outstanding upon the exercise of stock options, calculated using the treasury stock method. For the three-month period ended March 31, 2013, the Company excluded all common share equivalents from the calculation of Diluted EPS because the Company had a net loss. As a result, Diluted EPS is identical to Basic EPS for that period. If the Company had been in a net income position for the three months ended March 31, 2013, 4,778,219 shares subject to outstanding stock options may have been included in the calculation of common share equivalents using the treasury stock method.

Shares subject to outstanding stock options that were anti-dilutive for the three months ended March 31, 2012, a period for which the Company had net income, and consequently not included in the calculation of common share equivalents totaled 2,467,564, calculated on a weighted average basis.

11

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

Common Stock and Stock-Based Compensation

The Company issued 1,594 shares of common stock upon the exercise of stock options during the three months ended March 31, 2013. The Company issued 231,678 shares of common stock upon the exercise of stock options during the year ended December 31, 2012.

The Company granted to employees options to purchase an aggregate of 573,050 shares of common stock on January 17, 2013. These stock options have an estimated aggregate fair value, using the Black-Scholes-Merton formula, of $1,810,000. The Company is recording this amount, as adjusted for forfeitures, as stock-based compensation on a straight line basis over 16 quarters that began with the quarter ended March 31, 2013.

On March 31, 2013, the Company partially accelerated the vesting of, and extended the permitted period for exercise for, some outstanding stock options held by an executive officer who departed the Company. These modifications resulted in incremental compensation cost recorded by the Company for the three months ended March 31, 2013 of $467,000.

Accumulated Other Comprehensive Income or Loss

Accumulated other comprehensive income or loss, as presented in stockholders’ equity on the Company’s balance sheet, reflects the cumulative net unrealized gains or losses on available-for-sale securities for all periods. The table below reflects changes in accumulated other comprehensive income for the three months ended March 31, 2013, in thousands.

Accumulated other comprehensive income, January 1, 2013	$	201
Unrealized loss on available-for-sale securities, net		(1	)
Net realized gains on available-for-sale securities reclassified from other comprehensive income		(12	)
Accumulated other comprehensive income, March 31, 2013	$	188

Intellectual Property

The Company capitalizes the cost of intellectual property acquired or licensed from external sources as intangible assets if, at the time of acquisition, the intellectual property has reached technological feasibility. The cost of intellectual property acquired or licensed from external sources that has not reached technological feasibility at the time of acquisition or that has no expected future use is charged to research and development expense as incurred. The Company records all other charges related to the filing, prosecution and maintenance of patents to expense as incurred.

12

TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

2. Summary of Significant Accounting Policies (continued)

Commitments and Contingencies

Under an employment agreement with a former executive officer and a related separation agreement and release, the Company has agreed to pay severance equal to the departing executive’s regular base salary as of March 31, 2013 for nine months, to pay a pro rata percentage of the departing executive’s target bonus for 2013, and to continue the departing executive’s health and life insurance benefits coverage provided to him as of March 31, 2013 for nine months. These payments and benefits, which represent an aggregate estimated amount of $306,000, were recorded as general and administrative expense for the three months ended March 31, 2013.

3. Investments in Marketable Securities

The following is a reconciliation of amortized cost to fair value of available-for-sale marketable securities (including, if applicable, those classified on the Company’s balance sheet as cash equivalents) held at March 31, 2013 and December 31, 2012:

March 31, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
Security type
Cash Equivalents
Corporate debt securities	$	—	$	—	$	—		$	—
Marketable Securities - Short term
U.S. Treasury and U.S. or state government agency-backed securities		16,069		13		—			16,082
Corporate debt securities		13,765		22		—			13,787
Certificates of deposit		10,000		—		—			10,000
Accrued interest		109		—		—			109
Marketable Securities - Long term
U.S. Treasury and U.S. or state government agency-backed securities		28,206		73		(2	)		28,277
Corporate debt securities - long term		33,770		180		(7	)		33,943
Municipal bonds		2,690		10		—			2,700
Accrued interest		300		—		—			300
Total available-for-sale marketable securities	$	104,909	$	298	$	(9	)	$	105,198

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TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

3. Investments in Marketable Securities (continued)

December 31, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
Security type
Cash Equivalents
Corporate debt securities	$	4,000	$	—	$	—		$	4,000
Marketable Securities - Short term
U.S. Treasury and U.S. or state government agency-backed securities		25,412		27		—			25,439
Corporate debt securities		7,193		16		—			7,209
Certificates of deposit		10,000		—		—			10,000
Accrued interest		73		—		—			73
Marketable Securities - Long term
U.S. Treasury and U.S. or state government agency-backed securities		20,846		86		—			20,932
Corporate debt securities - long term		35,802		177		(15	)		35,964
Municipal bonds		2,689		11		—			2,700
Accrued interest		370		—		—			370
Total available-for-sale marketable securities	$	106,385	$	317	$	(15	)	$	106,687

As of March 31, 2013, the Company held investments in marketable securities with unrealized gains of $298,000 and unrealized losses of $9,000. For the investments in an unrealized loss position, the duration of the loss was less than 12 months and they are not considered to be other-than-temporarily impaired.

As of March 31, 2013, the Company’s investments in marketable securities reach maturity between April 2013 and March 2016 with a weighted average maturity date in July 2014.

4. Income Taxes

For the three months ended March 31, 2013 and 2012, the Company did not recognize any income tax expense or benefit. Exercises of stock options may result in tax deductions for stock-based compensation in excess of expense recorded for the stock options under GAAP. For interim periods within years for which taxable net income is forecasted, the Company recognizes the income tax benefit related to the excess tax deductions as an increase to capital in excess of par value, which based on ASC 740 results in an offsetting charge in the same amount to income tax expense. As of March 31, 2013, the Company had $7,540,000 of cumulative tax deductions for periods of net loss from exercises of stock options in excess of expense recorded for the stock options under GAAP. The benefit of these excess tax deductions had not begun to be realized as of March 31, 2013 because the Company incurred net operating losses in the years the respective stock options were exercised and has incurred cumulative net operating losses since inception. Accordingly, the tax benefit will not be recognized as an increase to capital in excess of par value until the excess deductions reduce income taxes payable.

The Company’s 2010 federal income tax return is currently under examination. Because the Company has incurred cumulative net operating losses since inception, all tax years remain open to examination by U.S. federal, North Carolina and Massachusetts tax authorities.

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TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

5. Strategic Alliance and Collaboration Agreements

AstraZeneca AB

In December 2005, the Company entered into a collaborative research and license agreement with AstraZeneca AB that was initially focused in cognitive disorders. In March 2013, the Company and AstraZeneca amended the agreement. As amended, the agreement permits AstraZeneca to pursue development and commercialization of compounds that it has licensed from the Company in any therapeutic area.

The Company is eligible to receive license fees and milestone payments under the agreement. The amount of license fees and milestone payments depends on the timing and achievement of specified milestone events.

AstraZeneca paid the Company an initial fee of $10,000,000 in February 2006. Based on the agreement terms, the Company allocated $5,000,000 of the initial fee to a preclinical research collaboration that the Company conducted with AstraZeneca under the agreement, which the Company recognized as revenue on a straight-line basis over the four-year term of the research collaboration. The Company deferred recognition of the remaining $5,000,000 of the initial fee, which was allocated to grants of licenses to develop and commercialize the Company’s product candidate TC-1734 (formerly known also as AZD3480), until December 2006, when AstraZeneca made a determination to proceed with further development of TC-1734. As a result, in the first quarter of 2007, the Company began recognizing the $5,000,000 of the initial fee that it had previously deferred as revenue on a straight-line basis over the estimated development period for TC-1734. In September 2010, the Company and AstraZeneca amended the agreement to enable the Company to conduct a clinical trial of TC-1734 in mild to moderate Alzheimer’s disease and to provide for respective roles and responsibilities and associated financial terms for such a study. Under the 2010 amendment, the Company received from AstraZeneca $500,000 in October 2010, $2,000,000 in September 2011 and $3,500,000 in December 2011.

In March 2013, AstraZeneca exercised its right to terminate TC-1734 from the collaboration. At that time, the Company was recognizing both the portion of the $5,000,000 of the initial fee attributable to TC-1734 license grants not yet recognized and the payments received under the 2010 amendment into revenue on a straight-line basis over the period of the Company’s substantive performance obligations under the agreement as amended. As a result of AstraZeneca’s exercise of its termination right for TC-1734, the Company recognized into revenue the portion of these amounts not yet recognized as of the date of AstraZeneca’s action, totaling $3,142,000. The Company recognized an aggregate of $3,536,000 and $810,000 of the initial fee and the payments received under the 2010 amendment as revenue for the three months ended March 31, 2013 and 2012, respectively. As of March 31, 2013, the initial fee and the payments received under the 2010 amendment had been fully recognized into revenue.

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TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

5. Strategic Alliance and Collaboration Agreements (continued)

The Company is eligible to receive additional payments from AstraZeneca if specified milestone events under the agreement are achieved for the Company’s product candidate AZD1446. The amounts of the contingent milestone payments vary depending on the applicable indication pursued and range from an additional $7,000,000 to $14,000,000 if development milestone events are achieved, an additional $8,000,000 to $10,000,000 if a regulatory milestone event is achieved, up to an additional $12,000,000 to $49,000,000 if first commercial sale milestone events are achieved and, in specified circumstances, up to an additional $30,000,000 if sales-related milestone events are achieved. If regulatory approval is achieved for AZD1446 for any indication, the Company is also eligible to receive stepped royalties on any sales of AZD1446 for that indication or any other indication. If AZD1446 is subsequently developed under the agreement for other indications, the Company would also be eligible to receive contingent milestone payments of up to $35,000,000 for each successive indication, if development, regulatory and first detail milestone events are achieved. Based solely on projected activities and timelines, the Company expects that the maximum amount of contingent milestone payments that could conceivably be earned during 2013 with respect to AZD1446 is $2,000,000, if a development milestone event is achieved. The likelihood that the Company will earn that milestone amount or achieve any particular milestone event with respect to AZD1446 in 2013 or in any future period is uncertain, and the Company may not earn any milestone amount or achieve any milestone event with respect to AZD1446 in 2013 or ever.

The Company considers that each of the potential milestone events under the agreement with respect to AZD1446 would be substantive because the applicable criteria of its revenue recognition policy (see Note 2) would be satisfied.

AstraZeneca has paid the Company an aggregate of $88,120,000 under the agreement since its inception, including the initial fee and payments upon the achievement of milestone events, to maintain option rights and for research services rendered in the completed preclinical research collaboration. As of March 31, 2013, this entire amount had been fully recognized into revenue.

Prior Collaboration Agreement

In December 2009, the Company entered into a collaboration and license agreement with AstraZeneca AB for the global development and commercialization of TC-5214 as a treatment for major depressive disorder. Under the agreement, AstraZeneca made an upfront payment to the Company of $200,000,000. The Company recorded the upfront payment made by AstraZeneca as deferred revenue and began recognizing the payment as revenue on a straight-line basis over the estimated period of the Company’s substantive performance obligations under the agreement, or approximately 33 months after the agreement date. The Company recognized $21,797,000 of the upfront payment as revenue for the three months ended March 31, 2012.

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TARGACEPT, INC.

NOTES TO UNAUDITED FINANCIAL STATEMENTS (continued)

March 31, 2013

5. Strategic Alliance and Collaboration Agreements (continued)

The Company and AstraZeneca jointly designed a program for the global development of TC-5214 as an adjunct therapy and as a “switch” monotherapy, in each case in patients with major depressive disorder who do not respond adequately to initial antidepressant treatment. AstraZeneca was responsible for 80% and the Company was responsible for 20% of the costs of this program, except that AstraZeneca was responsible for 100% of development costs that were required only for countries outside the United States and the European Union. In addition, for each of the Company and AstraZeneca, costs that were not contemplated at execution to be part of the program were in some cases excluded from the cost-sharing arrangement.

The Company’s portion of the costs of the TC-5214 development program was $3,411,000, for the three months ended March 31, 2012. AstraZeneca’s allocable portion of the program costs paid by the Company was $122,000 for the three months ended March 31, 2012. AstraZeneca’s allocable portion of the program costs paid by the Company is reflected in the Company’s financial statements as a reduction to research and development expense.

In the first quarter of 2012, the Company and AstraZeneca announced that, based on the totality of the results of the Phase 3 development program for TC-5214, a regulatory filing for TC-5214 as an adjunct therapy for major depressive disorder would not be pursued. Also in the first quarter of 2012, the Company reported that the Company and AstraZeneca determined to discontinue a Phase 2b clinical trial of TC-5214 as a “switch” monotherapy. The determinations to not pursue a regulatory filing for TC-5214 as an adjunct therapy for major depressive disorder and to discontinue the Phase 2b clinical trial of TC-5214 as a “switch” monotherapy resulted in a change in the estimated period of the Company’s substantive performance obligations under the agreement, and the Company revised the revenue recognition period for the upfront payment previously received accordingly. As a result, the entire upfront payment was recognized into revenue by June 30, 2012. In April 2012, the Company received notice of termination of the agreement from AstraZeneca. By the terms of the agreement, the termination became effective in May 2012.

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

You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes included in this quarterly report and our audited financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2012, which is on file with the SEC. In addition to historical information, the following discussion contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results, performance or experience could differ materially from what is indicated by any forward-looking statement due to various important factors, risks and uncertainties, including, but not limited to, those set forth under “Cautionary Note Regarding Forward-Looking Statements” in Part I of this quarterly report or under “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2012 or other filings that we make with the SEC.

Overview

Background

We are a biopharmaceutical company engaged in the development of novel NNR Therapeutics™ for the treatment of diseases and disorders of the nervous system. Our NNR Therapeutics selectively target a class of receptors known as neuronal nicotinic receptors, which we refer to as NNRs. NNRs are found on nerve cells throughout the nervous system and serve as key regulators of nervous system activity.

We have multiple clinical-stage product candidates in areas in which we believe there are significant medical need and commercial potential, as well as an ongoing collaboration agreement with AstraZeneca focused on compounds that act on thea4ß2 NNR, including AZD1446.

Our most advanced product candidates are described briefly below.

• TC-5619. TC-5619 is a novel small molecule that modulates the activity of thea7 NNR. We are currently conducting a Phase 2b clinical trial of TC-5619 as a treatment for negative symptoms and cognitive dysfunction in schizophrenia. We are also currently evaluating potential additional Phase 2 development of TC-5619 as a treatment for Alzheimer’s disease.

• TC-5214. TC-5214 modulates the activity of thea3ß4 NNR. We are developing TC-5214 as a treatment for overactive bladder and plan to initiate a Phase 2b clinical trial of this product candidate in the second quarter of 2013.

• TC-1734. TC-1734 (formerly known also as AZD3480) is a novel small molecule that modulates the activity of thea4ß2 NNR. We are currently conducting a Phase 2b clinical trial of TC-1734 as a treatment for mild to moderate Alzheimer’s disease.

• AZD1446 (TC-6683). AZD1446 is a novel small molecule that modulates the activity of thea4ß2 NNR and is subject to our ongoing collaboration agreement with AstraZeneca. Future development steps for AZD1446 are under consideration by AstraZeneca.

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• TC-6987. TC-6987 is a novel small molecule that modulates the activity of thea7 NNR. We have previously evaluated TC-6987 in two Phase 2 exploratory studies and are evaluating potential future development options for this product candidate.

• TC-6499.TC-6499 is a novel small molecule that modulates the activity of thea4ß2 anda3ß4 NNRs. We are evaluating potential future development options for this product candidate as a treatment for gastrointestinal disorders.

Under our ongoing collaboration agreement with AstraZeneca:

• AstraZeneca has an exclusive license to AZD1446 and earlier-stage compounds that arose from the preclinical research collaboration conducted under the agreement described below;

• AstraZeneca is responsible for substantially all current and future development costs for AZD1446 and each other compound arising from the preclinical research collaboration described below that it elects to advance; and

• from January 2006 to January 2010, we and AstraZeneca conducted a preclinical research collaboration under the agreement to discover and develop compounds that act on thea4ß2 NNR as treatments for conditions characterized by cognitive impairment; AstraZeneca paid us research fees, based on a reimbursement rate specified under the agreement, for research services rendered in the preclinical research collaboration.

Our ongoing collaboration agreement with AstraZeneca can be terminated by AstraZeneca for an uncured material breach by us or upon 90 days’ notice given at any time.

Under a second collaboration agreement with AstraZeneca, which we refer to in this quarterly report as our “MDD agreement with AstraZeneca,” we had been co-developing TC-5214 as an adjunct, or add-on, therapy for patients with major depressive disorder who do not respond adequately to initial antidepressant treatment. Under the agreement, we received a $200.0 million upfront payment. Thereafter, AstraZeneca was responsible for 80% and we were responsible for 20% of the cost of the completed clinical program for TC-5214 in MDD, except that AstraZeneca was responsible for 100% of development costs that were required only for countries outside the United States and the European Union. In addition, for each of us and AstraZeneca, costs that were not contemplated at execution to be part of the program were in some cases excluded from the cost-sharing arrangement. Following completion of a Phase 3 clinical program for TC-5214 conducted under the agreement, we and AstraZeneca announced that a regulatory filing for TC-5214 as an adjunct therapy for MDD would not be pursued and we reported the discontinuation of a “switch” monotherapy trial. AstraZeneca subsequently terminated the agreement effective in May 2012. As a result of the termination, all rights and licenses for TC-5214 that we granted under the agreement to AstraZeneca terminated and reverted to us.

Since our inception, we have had limited revenue from product sales and have funded our operations principally through public and private offerings of equity securities, payments under collaboration and alliance agreements, grants and equipment financing. We have historically devoted substantially all of our resources to the discovery and development of our product candidates and technologies, including the design, conduct and management of preclinical and clinical studies and related manufacturing, regulatory and clinical affairs, as well as intellectual property prosecution.

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In the second quarter of 2012, we completed a reduction in force as part of a plan to focus our resources on our more advanced programs. In October 2012, we announced a second reduction in force, as well as our plan to close our laboratory operations. We completed the second reduction in force and the laboratory closings in December 2012. Following completion of the second workforce reduction, we are no longer devoting resources to drug discovery or preclinical programs.

Except for a small number of periods in which we generated net income due primarily to the recognition into revenue of amounts received under collaboration agreements, we have not been profitable. As of March 31, 2013, we had an accumulated deficit of $242.0 million. We expect that we will incur losses in future periods as our product candidates advance into later-stage development and as we progress our programs and invest in additional product opportunities. Drug development, including clinical trials in particular, is time-consuming, expensive and may never yield a product that will generate revenue.

As a clinical-stage company, our revenues, expenses and results of operations are likely to fluctuate significantly from quarter to quarter and year to year. We believe that period-to-period comparisons of our results of operations should not be relied upon as indicative of our future performance.

Revenue

In January 2010, we received the $200.0 million upfront payment under our MDD agreement with AstraZeneca, which we recorded as deferred revenue and began recognizing into revenue on a straight-line basis over the estimated period of our substantive performance obligations under the agreement.

In the first quarter of 2012, we and AstraZeneca announced that, based on the totality of the results of the Phase 3 program, a regulatory filing for TC-5214 as an adjunct therapy for MDD would not be pursued and we reported the discontinuation of a “switch” monotherapy trial. These events resulted in a change in the estimated period of our substantive performance obligations under our MDD agreement with AstraZeneca. Accordingly, we revised the revenue recognition period for the upfront payment that we previously received and began recognizing the portion of the upfront payment not yet recognized into revenue on a straight-line basis over the remainder of the revised period. We recognized the full amount of the upfront payment into revenue by June 30, 2012.

Pursuant to a September 2010 amendment to our ongoing collaboration agreement with AstraZeneca related to a clinical trial of TC-1734 in mild to moderate Alzheimer’s disease, we received a $500,000 payment in the fourth quarter of 2010 and cumulative payments of $5.5 million in the second half of 2011. We recorded all of these payments as deferred revenue and began recognizing them into revenue on a straight-line basis over the estimated period of our obligations with respect to the study. As a result of AstraZeneca’s exercise of its right to terminate TC-1734 from the collaboration in March 2013, we recognized the remaining unrecognized deferred amount of $3.5 million into revenue for the three months ended March 31, 2013.

As of March 31, 2013, we had received $61.6 million in aggregate upfront fees and milestone payments under our ongoing collaboration agreement with AstraZeneca and recognized an additional

20

$26.5 million in collaboration research and development revenue for research services that we provided in the preclinical research collaboration conducted under that agreement. We immediately recognized an aggregate of $32.6 million of the amounts received under the agreement for achievement of milestone events, because each event met the conditions required for immediate recognition under our revenue recognition policy. We deferred recognition of an aggregate of $29.0 million received under the agreement and have fully recognized these deferred amounts into revenue over the respective periods discussed in Note 5 to our unaudited financial statements included in this quarterly report.

From time to time we seek and are awarded grants or perform work under grants awarded to third-party collaborators from which we derive revenue. During the third quarter of 2011, we were awarded a third grant from The Michael J. Fox Foundation for Parkinson’s Research, or MJFF. Based on the terms of the grant, we received $250,000 upon inception of the grant term and an additional $250,000 in March 2012. In addition, we are a subcontractor under a grant awarded to The California Institute of Technology by the National Institute on Drug Abuse, or NIDA, part of the National Institutes of Health, to fund research on innovative NNR-based approaches to the development of therapies for smoking cessation. Based on the terms of this arrangement, we received $191,000 in May 2012. Funding for awards under federal grant programs is subject to the availability of funds as determined annually in the federal appropriations process.

Research and Development Expenses

Since our inception, we have focused our activities on drug discovery and development programs. We record research and development expenses as they are incurred. Research and development expenses represented approximately 70% and 85% of our total operating expenses for the three months ended March 31, 2013 and 2012, respectively. The lower percentage that research and development expenses represented of our total operating expenses for the three months ended March 31, 2013 as compared to the corresponding 2012 period resulted primarily from two reductions in force that we completed in the second and fourth quarters of 2012, the closing of our laboratory operations in the fourth quarter of 2012 and the completion in 2012 of the Phase 3 clinical program conducted under our MDD agreement with AstraZeneca.

We utilize our research and development personnel and infrastructure resources across several programs, and many of our costs are not specifically attributable to a single program. Accordingly, we cannot state precisely our total costs incurred on a program-by-program basis.

We have not received FDA or foreign regulatory marketing approval for any of our product candidates. Our current and future expenditures on development programs are subject to numerous uncertainties in timing and cost to completion. In addition, our strategy includes entering into alliances and collaborations with third parties to participate in the development and commercialization of some of our product candidates. Where a third party has responsibility for or authority over any or all of the non-clinical or clinical development of a particular product candidate, the estimated completion date may be largely under the control of that third party and not under our control. We cannot forecast with any degree of certainty whether any of our product candidates will be subject to future alliances or collaborations or how any such arrangement would affect our development plans or capital requirements. Because of this uncertainty, and because of the numerous uncertainties related to clinical trials and drug development generally, we are unable to determine the duration and completion costs of our development programs or whether or when we will generate revenue from the commercialization and sale of any of our product candidates.

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General and Administrative Expenses

General and administrative expenses consist principally of salaries and other related costs for personnel in executive, finance, business development, legal and human resource functions. Other general and administrative expenses include expenses associated with stock options granted to personnel in those functions, depreciation and other facility costs not otherwise included in research and development expenses, patent-related costs, insurance costs and professional fees for consulting, legal, accounting and public and investor relations services.

Income Taxes

We have incurred cumulative net operating losses through March 31, 2013 and have not paid federal, state or foreign income taxes for any period. The application of U.S. generally accepted accounting principles, or GAAP, may for some periods result in non-cash income tax expense or benefit being reflected in our Statement of Comprehensive Income (Loss). Exercises of stock options in periods of net income may result in tax deductions for stock-based compensation in excess of expense recorded for the stock options under GAAP. For interim periods within years for which net income is forecasted, we recognize the income tax benefit related to the excess tax deductions as an increase to capital in excess of par value and, based on Accounting Standards Codification ASC Topic 740,Income Taxes, record an offsetting charge in the same amount to income tax expense. As of March 31, 2013, we had $7.5 million of cumulative tax deductions for periods of net loss from exercises of stock options in excess of expense recorded for the stock options under GAAP. The benefit of these excess tax deductions had not begun to be realized as of March 31, 2013 because we have incurred cumulative net operating losses since inception. This benefit will not be recognized as an increase to capital in excess of par value until the excess deductions reduce income taxes payable.

As of March 31, 2013, we had net operating loss carryforwards of $197.6 million for federal income tax purposes and $186.3 million for state income tax purposes and we had research and development income tax credit carryforwards of $12.6 million for federal income tax purposes and $587,000 for state income tax purposes. The federal net operating loss carryforwards begin to expire in 2024. The state net operating loss carryforwards begin to expire in 2019. The federal and state research and development tax credits begin to expire in 2021. As a result of various factors, including the subjectivity of measurements used in the calculation of particular tax positions taken or that may in the future be taken in our tax returns, it is uncertain whether or to what extent we will be eligible to use the tax credits.

Utilization of the net operating loss carryforwards and credits may be subject to a substantial annual limitation due to ownership change limitations provided by Section 382 of the Internal Revenue Code of 1986, as amended, and similar state provisions. When an ownership change, as defined by Section 382, occurs, an annual limitation is imposed on a company’s use of net operating loss and credit carryforwards attributable to periods before the change. A series of stock issuances by us gave rise to such an ownership change in December 2004. As a result, an annual limitation is imposed on our use of net operating loss and credit carryforwards that are attributable to periods before the change. In addition, a portion of the net operating loss carryforwards described above may potentially not be usable by us if we experience further ownership changes in the future.

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For financial reporting purposes, we have recorded a valuation allowance to fully offset the deferred tax assets related to the carryforwards and tax credits discussed above until it is more likely than not that we will realize any benefit from them.

Fair Value

The carrying amounts of our cash and cash equivalents, investments in marketable securities, accounts receivable, accounts payable and accrued expenses are considered to be representative of their respective fair values due to their short-term natures and, in the case of short-term investments, their market interest rates. Likewise, the carrying amounts of our long-term debts are considered to be representative of their fair value due to their market interest rates. Cash that we do not expect to use to fund our short-term liquidity requirements is invested in corporate debt securities and municipal bonds rated at least A quality or equivalent, U.S. Treasury notes and bonds, U.S. and state government agency-backed certificates and certificates of deposit. Our investments in marketable securities, which include marketable securities classified on our balance sheet as cash equivalents, are recorded at quoted market prices or observable market inputs and totaled $105.2 million at March 31, 2013.

Critical Accounting Policies and Estimates

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our unaudited financial statements, which have been prepared in accordance with GAAP for interim financial information. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate these estimates and judgments. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. These estimates and assumptions form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenues and expenses that are not readily apparent from other sources. Actual results and experiences may differ materially from these estimates. In addition, our reported financial condition and results of operations could vary if new accounting standards are enacted that are applicable to our business.

Our significant accounting policies are described in Note 2 to our audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2012 and in the notes to our unaudited financial statements included in this quarterly report. We believe that our accounting policies relating to revenue recognition, accrued expenses and stock-based compensation are the most critical to understanding and evaluating our reported financial results. We have identified these policies as critical because they both are important to the presentation of our financial condition and results of operations and require us to make judgments and estimates on matters that are inherently uncertain and may change in future periods. These policies are described under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2012.

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Results of Operations

Three Months ended March 31, 2013 and 2012

Net Operating Revenues

	Three Months Ended March 31,
	2013		2012		Change
	(in thousands)
Operating revenues:
License fees and milestones from collaborations	$	3,536	$	22,607	$	(19,071	)
Grant revenue		—		250		(250	)
Net operating revenues	$	3,536	$	22,857	$	(19,321	)

Net operating revenues for the three months ended March 31, 2013 decreased by $19.3 million as compared to the three months ended March 31, 2012. The lower net operating revenues for the 2013 period were primarily attributable to a decrease of $19.1 million in license fees and milestones from collaborations. The lower license fees and milestones from collaborations for the 2013 period primarily resulted from the recognition into revenue for the 2012 period of the remaining unrecognized portion of the upfront payment previously received under our MDD agreement with AstraZeneca, totaling $21.8 million, partially offset by $2.7 million in increased recognition of revenue for the 2013 period for payments related to TC-1734 previously received under our ongoing collaboration agreement with AstraZeneca. We recognized into revenue for the 2013 period the remaining unrecognized portion of the payments related to TC-1734 previously received under our ongoing collaboration agreement with AstraZeneca, totaling $3.5 million.

We expect our net operating revenues for the year ended December 31, 2013 to be substantially lower than for the year ended December 31, 2012, primarily due to the upfront payment received under our MDD agreement with AstraZeneca becoming fully recognized in the second quarter of 2012. As of April 1, 2013, we have no amounts remaining to be recognized into revenue for payments previously received under any current or former collaboration agreement.

Research and Development Expenses

	Three Months Ended March 31,
	2013		2012		Change
	(in thousands)
Research and development expenses	$	8,320	$	17,801	$	(9,481	)

Research and development expenses for the three months ended March 31, 2013 decreased by $9.5 million as compared to the three months ended March 31, 2012. The lower research and development expenses were principally attributable to decreases of:

• $5.3 million in research and development-related operating costs, including infrastructure costs and stock-based compensation and other compensation-related expenses for research and

24

development personnel, to $3.2 million for the 2013 period, from $8.5 million for the 2012 period; this decrease resulted primarily from the two reductions in force completed in the second and fourth quarters of 2012 that reduced our workforce by approximately 65% and from the closing of our laboratory operations in the fourth quarter of 2012;

• $3.4 million in costs incurred for the Phase 3 development program for TC-5214 as a treatment for major depressive disorder, which completed in 2012; and

• $928,000 in costs incurred for third-party research and development services in connection with preclinical programs, as we focused our resources in the 2013 period on our clinical programs.

These decreases were partially offset by an increase of $127,000 in costs incurred for third-party services associated with our clinical-stage product candidates (excluding costs for the completed program in major depressive disorder) to $5.1 million for the 2013 period, from $5.0 million for the 2012 period. This increase, as detailed in the table below, was principally due to increased costs related to the ongoing Phase 2b study of TC-5619 in negative symptoms and cognitive dysfunction in schizophrenia, which became fully enrolled in April 2013, and costs related to the planned Phase 2b study of TC-5214 in overactive bladder. These increased costs were partially offset by decreased costs related to TC-6987, as we completed two exploratory studies of this product candidate in the first quarter of 2012.

The costs that we incurred for the three months ended March 31, 2013 and 2012 for third-party services in connection with research and development of clinical-stage product candidates are shown in the table below.

	Three Months Ended March 31,
	2013		2012		Change
	(in thousands)
TC-5619	$	3,411	$	2,087	$	1,324
TC-5214 overactive bladder		879		—		879
TC-1734		839		769		70
TC-5214 major depressive disorder		—		3,411		(3,411	)
TC-6987		—		2,153		(2,153	)
AZD1446		—		—		—

We expect our research and development expenses for the year ending December 31, 2013 to decrease as compared to the year ended December 31, 2012, principally due to the 2012 completion of the Phase 3 development program for TC-5214 as an adjunct therapy for major depressive disorder and our two reductions in workforce implemented in 2012. We also expect, however, to continue to incur significant research and development expenses for the remainder of 2013, including in particular expenses for the planned Phase 2b study of TC-5214 in overactive bladder and the ongoing Phase 2b clinical trials of TC-5619 in negative symptoms and cognitive dysfunction in schizophrenia and TC-1734 in mild to moderate Alzheimer’s disease.

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General and Administrative Expenses

	Three Months Ended March 31,
	2013		2012		Change
	(in thousands)
General and administrative expenses	$	3,490	$	3,070	$	420

General and administrative expenses for the three months ended March 31, 2013 increased by $420,000 as compared to the three months ended March 31, 2012. The higher general and administrative expenses were principally attributable to an increase of $607,000 in stock-based compensation, salary and other compensation-related expenses for general and administrative personnel. The increased stock-based compensation, salary and other compensation-related expenses for general and administrative personnel for the 2013 period was primarily attributable to $467,000 in non-cash stock-based compensation charges resulting from the partial accelerated vesting of, and extended exercise periods for, some outstanding stock options held by a former executive officer who departed Targacept in March 2013 and $309,000 in severance and other charges resulting from the departure of the former executive officer. Exclusive of stock-based compensation, salary and other compensation-related expenses, general and administrative expenses decreased by $187,000 for the 2013 period as compared to the corresponding 2012 period.

Liquidity and Capital Resources

Sources of Liquidity

We have historically financed our operations and internal growth principally through public and private offerings of equity securities, payments received under collaboration and alliance agreements, grants and equipment financing.

Our cash, cash equivalents and investments in marketable securities were $175.1 million as of March 31, 2013 and $184.9 million as of December 31, 2012. As of March 31, 2013, we had $67.8 million of cash in bank depository accounts and institutional money market funds at Branch Banking and Trust Company, PNC Bank and Wells Fargo & Company. Substantially all of our remaining cash, cash equivalents and investments were invested as of March 31, 2013 in corporate debt securities and municipal bonds rated at least A quality or equivalent, U.S. Treasury notes and bonds, U.S. and state government agency-backed securities and certificates of deposit.

We are eligible to receive additional payments under our ongoing collaboration agreement with AstraZeneca, contingent on the achievement of specified milestone events relating to AZD1446. The likelihood that we will achieve any particular milestone event in any particular period is uncertain, and we may not ever achieve future milestone events with respect to AZD1446. Our MDD agreement with AstraZeneca was terminated effective in May 2012 and is no longer a potential source of future funds.

We have borrowed amounts under a loan agreement with a bank that we entered into in July 2010 to fund the purchase of equipment, furnishings, software and other fixed assets. As of March 31, 2013, the aggregate outstanding principal balance under the loan facility was $1.8 million and there is no additional borrowing capacity remaining available to us.

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Cash Flows

	Three Months Ended March 31,
	2013			2012			Change
	(in thousands)
Net cash used in operating activities	$	(9,320	)	$	(24,900	)	$	15,580
Net cash (used in) provided by investing activities		(2,853	)		6,792			(9,645	)
Net cash used in financing activities		(206	)		(507	)		301
Net decrease in cash and cash equivalents	$	(12,379	)	$	(18,615	)

Net cash used in operating activities for the three months ended March 31, 2013 decreased by $15.6 million as compared to the three months ended March 31, 2012. For the three months ended March 31, 2013, net cash used in operating activities was primarily attributable to $10.8 million in payments made for third-party research and development services in connection with clinical-stage product candidates and personnel and infrastructure costs. These cash payments were partially offset by $1.0 million in proceeds received in January 2013 from the sale of laboratory equipment in December 2012 and $483,000 of investment-related cash receipts. For the three months ended March 31, 2012, net cash used in operating activities was primarily attributable to $25.6 million in payments made for third-party research and development services in connection with clinical-stage product candidates and preclinical programs, as well as personnel and infrastructure costs, partially offset by $570,000 of investment-related cash receipts and $250,000 received from MJFF under a grant awarded in the third quarter of 2011. The decrease of $14.8 million in payments made for third-party research and development services and personnel and infrastructure costs for the 2013 period as compared to the 2012 period was principally the result of: the wind-down during 2012 of the Phase 3 development program for TC-5214 as a treatment for major depressive disorder, for which we paid $9.7 million during the 2012 period; the decision in the second quarter of 2012 to focus our resources on our more advanced programs; and the closing of our laboratories and completion of two workforce reductions during 2012.

Net cash used in investing activities for the three months ended March 31, 2013 was $2.9 million as compared to net cash provided by investing activities of $6.8 million for the three months ended March 31, 2012, a difference of $9.6 million. Cash provided by or used in investing activities reflects the portion of our cash that we allocate to, and the timing of purchases and maturities of, our investments in marketable securities and equipment purchases. Our net purchases of investments in marketable securities for the three months ended March 31, 2013 were $2.8 million and occurred primarily as a result of the timing of maturities and subsequent reinvestment in marketable securities. Our net sales of investments in marketable securities for the three months ended March 31, 2012 were $6.8 million and occurred primarily to fund our short-term liquidity requirements.

Net cash used in financing activities for the three months ended March 31, 2013 decreased by $301,000 as compared to the three months ended March 31, 2012. The lower cash used in financing activities for the 2013 period was primarily due to the scheduled repayment in full of outstanding term loans on their respective maturity dates during 2012.

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Funding Requirements

As of March 31, 2013, we had an accumulated deficit of $242.0 million. We may require additional capital in future periods as our product candidates advance into later-stage development and as we progress our programs and invest in additional product opportunities. However, we may generate positive cash flow for any particular reporting period as a result of the timing of milestone events that may be achieved under our ongoing collaboration agreement with AstraZeneca or any potential future collaboration agreement that we enter into and the timing and extent of costs incurred related to development of our product candidates. Our future capital requirements are difficult to forecast and will depend on many factors, including:

• the scope, progress, duration, results and cost of clinical trials, as well as non-clinical studies and assessments, of our product candidates and programs;

• whether we establish additional strategic alliances, collaborations and licensing or other comparable arrangements, or whether we pursue and complete any merger, acquisition or other significant corporate transaction, and, if we do, the associated terms in each case;

• the costs to satisfy our obligations under potential future alliances, collaborations or licensing or other comparable arrangements;

• whether and to what extent milestone events are achieved for AZD1446 under our ongoing collaboration agreement with AstraZeneca;

• the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending patents and other intellectual property rights;

• the extent to which we retain development or commercialization rights or responsibilities for our product candidates and incur associated development costs, manufacturing costs or costs to establish sales and marketing functions;

• the number and characteristics of product candidates that we pursue and programs that we conduct;

• the costs of manufacturing-related services for our product candidates in development;

• the costs, timing and outcomes of regulatory reviews or other regulatory actions;

• the timing, receipt and amount of sales or royalties, if any, from our potential products;

• the extent of our general and administrative expenses; and

• the rate of technological advancements for the indications that we target.

Our existing capital resources may not be sufficient to enable us to fund the completion of the development of any of our product candidates. We currently expect our existing capital resources to be sufficient to fund our operations through at least the end of 2015, without taking into account any amounts that we would be entitled to receive if milestone events are achieved under our ongoing collaboration agreement with AstraZeneca. However, our operating plan may change as a result of many factors, including those described above, and we may need additional funds sooner than planned to meet operational needs and capital requirements.

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To the extent our capital resources are insufficient to meet future capital requirements or to the extent the conditions for raising capital are favorable, we may seek to finance future cash needs through public or private equity or debt offerings or other financings (whether using our currently effective Registration Statement on Form S-3 or otherwise). Our access in the future to additional equity or debt financing, on acceptable terms or at all, is uncertain. We may also seek to finance future cash needs through alliances, collaborations or licensing or other comparable arrangements. Strategic alliances, collaborations or licensing or other comparable arrangements may not be available on acceptable terms or at all. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate our development programs or obtain funds through arrangements with collaborators or others that may require us to relinquish rights to certain product candidates that we might otherwise seek to develop or commercialize independently. Additionally, any future equity funding may significantly dilute the ownership of our stockholders.

We cannot determine precisely the completion dates and related costs of our development programs due to inherent uncertainties in outcomes of clinical trials and regulatory approvals of our product candidates. We cannot be certain that we will be able to successfully complete our development programs or establish strategic alliances, collaborations or licensing or other arrangements for our product candidates. Our failure, or the failure of any of our present or future licensees or collaborators, to complete research and development programs for our product candidates could have a material adverse effect on our financial position or results of operations.

To date, inflation has not had a material effect on our business.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The primary objectives of our investment activities are to preserve our capital and meet our liquidity needs to fund operations. We also seek to generate competitive rates of return from our investments without assuming significant risk. To achieve our objectives, we maintain a portfolio of cash equivalents and investments in a variety of securities that are of high credit quality based on ratings from commonly relied upon rating agencies. As of March 31, 2013, we had cash, cash equivalents and investments in marketable securities of $175.1 million. Our cash, cash equivalents and investments in marketable securities may be subject to interest rate risk and could fall in value if market interest rates increase. However, because our cash is invested in accounts with market interest rates and because our cash equivalents and investments in marketable securities are traded in active markets, we believe that our exposure to interest rate risk is not significant and estimate that an immediate and uniform 10% increase in market interest rates from levels as of March 31, 2013 would not have a material impact on the total fair value of our portfolio.

We sometimes contract for the conduct of clinical trials or other research and development and manufacturing activities with contract research organizations, clinical trial sites and contract manufacturers in Europe or elsewhere outside of the United States. We may be subject to exposure to fluctuations in foreign currency exchange rates in connection with these agreements. If the average exchange rate between the currency of our payment obligations under any of these agreements and the U.S. dollar were to strengthen or weaken by 10% against the corresponding exchange rate as of March 31, 2013, we estimate that the impact on our financial position, results of operations and cash flows would not be material. We do not hedge our foreign currency exposures.

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We have not used derivative financial instruments for speculation or trading purposes.

Item 4. Controls and Procedures

(a)Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our chief executive officer and our chief financial officer, evaluated the effectiveness of our disclosure controls and procedures in accordance with Rule 13a-15 under the Exchange Act as of the end of the period covered by this quarterly report. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of the end of the period covered by this quarterly report, our chief executive officer and our chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is (a) accumulated and communicated to our management, including our chief executive officer and our chief financial officer, as appropriate to allow timely decisions regarding required disclosure and (b) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b)Changes in Internal Controls. No change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) occurred during the quarter ended March 31, 2013 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits

The exhibits listed in the accompanying exhibit index are filed as part of this quarterly report.

Targacept^® and NNR Therapeutics™ are trademarks of Targacept, Inc. Any other service marks, trademarks and trade names appearing in this quarterly report are the properties of their respective owners.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	TARGACEPT, INC.
Date: May 8, 2013	/s/ Stephen A. Hill
	Stephen A. Hill
	President and Chief Executive Officer
	(Principal Executive Officer)
Date: May 8, 2013	/s/ Alan A. Musso
	Alan A. Musso
	Senior Vice President, Finance and Administration, Chief Financial Officer and Treasurer
	(Principal Financial and Accounting Officer)

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EXHIBIT INDEX

Exhibit Number	Description
10.1+	Targacept, Inc. 2006 Stock Incentive Plan, as amended and restated through March 9, 2011 and further amended on December 7, 2012, March 13, 2013 and April 10, 2013 (incorporated by reference to the Appendix to the Company’s Definitive Proxy Statement for its 2013 annual meeting of stockholders filed on Schedule 14A with the Securities and Exchange Commission on April 17, 2013).
10.2+	Separation Agreement and Release, dated March 29, 2013, by and between the Company and Jeffrey P. Brennan.
10.3^	Amendment No. 5, effective as of March 5, 2013, to Collaborative Research and License Agreement between the Company and AstraZeneca AB dated December 27, 2005.
31.1	Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of the Principal Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of the Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101*	The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, formatted in XBRL (eXtensible Business Reporting Language): (i) the Balance Sheets as of March 31, 2013 and December 31, 2012 (Unaudited); (ii) the Statements of Comprehensive Income (Loss) for the three months ended March 31, 2013 and 2012 (Unaudited); (iii) the Statements of Cash Flows for the three months ended March 31, 2013 and 2012 (Unaudited); and (iv) the Notes to Unaudited Financial Statements.

+ Denotes management contract, compensatory plan or arrangement.

^ Portions of this Exhibit have been omitted and filed separately with the Securities and Exchange Commission as part of an application for confidential treatment pursuant to the Exchange Act.

* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files in Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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